Very helpful post. However, I have one point of confusion:
On your diagram of a repo transaction/collateral chain “Credit Creation in the Financial Economy”, the MMF ends up selling their T-Bill. Is this T-Bill sold just to fund their reverse repo (is it that simple)? Or is there another reason for that? My confusion is because as part of the reverse repo asset, they are in fact receiving collateral (could be another T-Bill).
I guess theoretically the collateral chain has to end somewhere and is it fair to say the shorter the collateral chain, the quicker the deleveraging mechanism through asset prices (if more T-Bills have to be sold to fund repos, then the value of collateral - and this leverage- decreases)?
Whether or not the MMF sells a T-bill to fund a repo is more or less immaterial to the ultimate point that I'm trying to make. I could have just as well assumed that the MMF experienced an inflow of assets which increased their equity and they used this newfound inflow to invest in a RRP, or that they were simply holding "cash" in bank deposits while waiting for an investment.
Instead, what I'm implicity assuming in this case, is that the MMF was previously holding a T-bill, but sold that T-bill (perhaps because it was lower yielding) to instead invest in a RRP. Typically balance sheet accounting would not show the additional T-bill received (it stays on the balance sheet of the original holder), and the MMF would register an increase in RRP on their assets, but nothing more.
The accounting for the actual flows of collateral are all off-balance sheet, and it is difficult to map and keep track of because you would wind up with "duplicate" T-bills on different sets of balance sheets, because the T-bill has several "legal owners" at that point.
So for my assumption credit creation = money creation (because they're basically the same thing - purchasing power). Economists define money differently, they have specific definitions including the monetary base, M1, M2, formerly M3/M4/L, etc.
What separates credit creation from other types of transactions, at least from a balance sheet perspective, is that when credit is created BOTH sides of the balance sheet increase. When a bank extends a loan it issues a new deposit, as explained above, so both sides increase.
While the exact accounting for repo is a bit tricky because technically it is a distinct sale and repurchase which is usually rolled over every day/week/month, we can describe it in a stylized format as I have above.
The reason repo is credit creation is because the owner of the security who repo's the security out still maintains ownership and rights to profits/capital gains/interest payments, even if the security is technically "sold" to another party during the day and repurchased later. For the cash lender, the security is just collateral for a loan, they have rights to reuse it (rehypothecation/rights to reuse/pledge with ability to reuse), but they don't have claim over the capital gains or interest payments. So the cash borrower maintains possession of the security, receives funding, and incurs a repo liability which they have to repay at some point.
That's why it is credit creation. Because the security stays on the investor's balance sheet, but they receive funding and incur an additional liability - which increases BOTH sides of their balance sheet. Likewise for the dealer who will tend to fund this transaction by repledging the collateral received in another repo transaction (either TPR or to another dealer).
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Very helpful post. However, I have one point of confusion:
On your diagram of a repo transaction/collateral chain “Credit Creation in the Financial Economy”, the MMF ends up selling their T-Bill. Is this T-Bill sold just to fund their reverse repo (is it that simple)? Or is there another reason for that? My confusion is because as part of the reverse repo asset, they are in fact receiving collateral (could be another T-Bill).
I guess theoretically the collateral chain has to end somewhere and is it fair to say the shorter the collateral chain, the quicker the deleveraging mechanism through asset prices (if more T-Bills have to be sold to fund repos, then the value of collateral - and this leverage- decreases)?
Sorry I realize that part may be a bit unclear.
Whether or not the MMF sells a T-bill to fund a repo is more or less immaterial to the ultimate point that I'm trying to make. I could have just as well assumed that the MMF experienced an inflow of assets which increased their equity and they used this newfound inflow to invest in a RRP, or that they were simply holding "cash" in bank deposits while waiting for an investment.
Instead, what I'm implicity assuming in this case, is that the MMF was previously holding a T-bill, but sold that T-bill (perhaps because it was lower yielding) to instead invest in a RRP. Typically balance sheet accounting would not show the additional T-bill received (it stays on the balance sheet of the original holder), and the MMF would register an increase in RRP on their assets, but nothing more.
The accounting for the actual flows of collateral are all off-balance sheet, and it is difficult to map and keep track of because you would wind up with "duplicate" T-bills on different sets of balance sheets, because the T-bill has several "legal owners" at that point.
Thanks so much - appreciate the quick reply and additional color.
Could you explain how repo creates credit?
So for my assumption credit creation = money creation (because they're basically the same thing - purchasing power). Economists define money differently, they have specific definitions including the monetary base, M1, M2, formerly M3/M4/L, etc.
What separates credit creation from other types of transactions, at least from a balance sheet perspective, is that when credit is created BOTH sides of the balance sheet increase. When a bank extends a loan it issues a new deposit, as explained above, so both sides increase.
While the exact accounting for repo is a bit tricky because technically it is a distinct sale and repurchase which is usually rolled over every day/week/month, we can describe it in a stylized format as I have above.
The reason repo is credit creation is because the owner of the security who repo's the security out still maintains ownership and rights to profits/capital gains/interest payments, even if the security is technically "sold" to another party during the day and repurchased later. For the cash lender, the security is just collateral for a loan, they have rights to reuse it (rehypothecation/rights to reuse/pledge with ability to reuse), but they don't have claim over the capital gains or interest payments. So the cash borrower maintains possession of the security, receives funding, and incurs a repo liability which they have to repay at some point.
That's why it is credit creation. Because the security stays on the investor's balance sheet, but they receive funding and incur an additional liability - which increases BOTH sides of their balance sheet. Likewise for the dealer who will tend to fund this transaction by repledging the collateral received in another repo transaction (either TPR or to another dealer).
Maroon, If it is posible could you draw this scenario in balance sheet ?