The Role of the Government Bond Lending Market in Collateral Transformation

The securities lending market for government bonds is an active short-term funding market which not only facilitates repo and cash markets, but also has a unique role in transforming collateral from low-quality assets into high-quality liquid assets. Using data on the price and volume of securities lending and repo transactions in the market for European government bonds for the period 2006-2014, we examine the role of the securities lending market in collateral upgrading. We find that during periods of market stress, the average fee increases in the government bond lending market. The increase is significantly higher for high-quality bonds, consistent with a flight-to-quality effect. In addition, we find that in times of market stress borrowers increase the use of low-quality noncash collateral to upgrade to high-quality securities. Furthermore, there is increased usage of such borrowed securities to obtain cash in the repo market. This evidence is consistent with collateral upgrading in the securities lending market to obtain cash in the repo market. Finally, we show that central bank purchases of peripheral country government bonds mitigated disruptions in short-term funding markets by reducing the lending fees of these lower quality bonds.