The repo market was indeed large and unregulated, and many repo agreements were backed by securitized mortgages as collateral. Repo agreements are transactions where a large-scale depositor or institutional investor puts money in a bank for a short term, usually overnight. The bank agrees to some “overnight interest” on the deposited amount. The deposit is secured by an asset of roughly the same value. Between 2000 and 2007, the repo market accounted for up to 30% of the U.S. GDP. Despite the large scale of such transactions, the market was largely unregulated, making liabilities among dealers and brokers grow sharply. A popular view is that the repo market collapsed when cash depositors became concerned about the quality of the collateral backing repos and consequently withdrew their funding. This vulnerability was a significant factor that contributed to the financial crisis.

Choice A is incorrect. The repo market is generally not directly affected by fluctuations in foreign exchange rates. Repos are short-term borrowing agreements, typically collateralized with government securities, not foreign currencies.

Choice C is incorrect. While it's true that large financial institutions play a significant role in the repo market, the primary vulnerability was not a lack of competition or skewed pricing. The key issue leading up to the financial crisis was the lack of regulation and the use of risky collateral, like securitized mortgages.

Choice D is incorrect. Repo agreements are typically collateralized by safer assets like government securities, not equities. Therefore, the stability of the repo market is not directly tied to the performance of specific equity indices.

Things to Remember

• The repo market is a form of short-term borrowing for dealers in government securities.
• Repo agreements are essentially collateralized loans, where the borrower sells a security to an investor with an agreement to repurchase it at a higher price at a later date.