Repo Contracts and Collateral Pooling

Abstract:

We study the optimality of repurchase agreement (repo) contracts in a competitive asset market with agents facing liquidity need and adverse selection in asset quality. We show that, in the unique equilibrium, a single repo contract pools all assets together as collateral and features default. The repo contract differs from asset-sale contracts by embedding a repurchase option, hence mitigating adverse selection and providing higher liquidity. The equilibrium is constrained efficient and achieves maximum liquidity. Two applications are shown where the liquidity need is due to investment and consumption smoothing respectively.