Repurchase Agreements and the Paradox of Risk

This paper examines how repurchase agreements (repos, in short) can give rise to the paradox of risk. Repos are financial contracts in which one party sells a security with the concomitant agreement to repurchase it at a certain price in a future date. In practice, they work as collateralized loans, being a source of liquidity for one party, and a substitute for bank deposits for the other. Our central argument is that while repos appear to be safe investments for lenders at the micro level, they contribute to greater financial fragility at the macro level. Our theoretical approach is the Monetary Circuit Theory. After a discussion of repos' main elements, such as haircuts, margining and market segmentation, we build a stylized monetary circuit to discuss repo's role as a catalyst of financial interconnectedness, facilitating the propagation of risk through the financial system even for agents not directly exposed to risky assets.