Elastic in cash, inelastic in repo: Hedge funds in the treasury and repo markets

Sovereign bond markets are a cornerstone of the financial system, and their functioning is tightly linked to repo markets, where investors finance long positions and source bonds for short sales. We show, theoretically and empirically, that repo prices are set in the cash bond market: when demand for cash bonds exceeds available supply, arbitrageurs accommodate the excess by shorting bonds and borrowing them in the repo market, opening a wedge between the policy and repo rates, i.e., generating specialness. An elastic supply of collateral, in turn, limits how much of the excess demand is capitalized into bond prices. Using regulatory data covering the universe of repos backed by German sovereign bonds, we identify the final borrowers and lenders of securities and estimate the first demand and supply elasticities for a repo market. Supply, dominated by the public sector, accounts for 87% of the aggregate elasticity. Demand, driven by hedge funds, is strongly inelastic: a 10% increase in borrowing costs reduces their borrowing by only 1%. Despite being among the most price-elastic investors in cash bond markets, hedge funds are inelastic in repo, as their borrowing sustains relative-value positions whose size is pinned by the preferred-habitat demand they intermediate: their elasticity is inherited from their cash-market counterparties rather than being a primitive. Specialness thus emerges as the equilibrium price of cash-market demand pressure-of which collateral scarcity from central bank purchases is a special case-tying safe-asset pricing and the transmission of monetary policy to the same imbalances in the cash bond market.