N°24-37: The Collateral Spread Puzzle: Why Do Repo Rates Often Exceed Unsecured Rates?

Repo rates frequently exceed unsecured interbank rates. This apparent anomaly occurs under different institutional structures, currencies, and tenors, often over prolonged periods. I develop a theory of liquidity sourcing and provisioning under constraints that results in a trilateral linkage between unsecured and repo rates and the rate of return of the underlying collateral in the cash market. The model incorporates what differentiates repos from plain collateralized loans, namely, that cash providers get the collateral for the duration of the contract. The collateral spread (unsecured minus repo) emerges as a measure of stress. Negative spreads are symptoms of highly stressed markets.