How Does a Bank Borrow Overnight? Sell the Bonds and Promise to Buy Them Back

One party sells a security, typically a government bond, to another and simultaneously agrees to buy it back at a fixed price on a fixed date, usually the following morning. Economically this is a secured loan, since the seller receives cash, returns it the next day with a small addition, and the difference in the two prices is the interest. Legally it is two sales, and that distinction is the whole reason the structure exists, because the buyer owns the security outright during the period rather than merely holding it as collateral, and can sell it immediately if the other party fails.

Ownership rather than a security interest changes what happens in a failure:

• •The lender can sell the asset at once without a court process
• •No waiting for an insolvency procedure that can take years
• •Exemption from rules that freeze a failed firm's assets
• •Lenders therefore accept much finer rates than on unsecured loans
• •Borrowers can raise very large sums against high-quality assets
• •The same bond can support borrowing repeatedly as it moves along

The cash advanced is always less than the market value of the security, and that difference is the lender's protection against the price falling before it can be sold. A government bond might attract a haircut of a couple of per cent and a riskier asset far more. The size is set by how volatile and how liquid the asset is, and it is revalued daily, with more collateral demanded if prices move. The difficulty is that these requirements move together across the whole market and rise exactly when conditions deteriorate, so every borrower must post more at the same moment, which forces asset sales that push prices down and raise the requirements further.

The participants are less obvious than a simple picture of banks borrowing suggests, and knowing who does what explains the flows. Money market funds, corporate treasurers and others holding large cash balances lend, because leaving tens of millions in a bank account is an unsecured exposure while this structure is collateralised. Banks and dealers borrow to fund holdings of securities. Investors wanting to bet against a bond borrow it rather than cash, using the transaction in reverse to obtain the security itself. Central banks operate on both sides to manage the quantity of reserves in the system, which is one of the main instruments of day-to-day monetary policy.

The market has been at the centre of several episodes, which is unsurprising given that it funds long-term assets with borrowing that must be renewed every morning. Lehman Brothers relied heavily on it and was unable to renew as confidence went, which is the immediate mechanism by which the firm failed in 2008, and the wider withdrawal of this funding is generally described as a run. American rates spiked violently in September 2019 for reasons that are still debated, requiring central bank intervention. Reforms since have pushed much of the activity through central counterparties and increased reporting. The structural tension remains, since borrowing overnight to hold assets for years is inherently fragile.

Selling a bond and agreeing to buy it back the next morning is economically a secured loan, and the legal form of two sales lets the lender sell the asset immediately if the borrower fails, which is why rates are so fine. The cash advanced falls short of the asset's value by a haircut that rises exactly when conditions worsen, forcing sales that worsen them. Lehman failed when it could not renew.