I was discussing repos with someone the other day. The issue was whether the use of repos was a good thing or not.
In a repo, one party (the borrower) sells securities to another (the lender) and simultaneously agrees to buy them back at a later date at a fixed price. This is similar to borrowing money and providing the securities as collateral, as the borrower gets the use of cash for a period of time at a known cost, whilst retaining full exposure to the risks and rewards of the securities.
There are a few differences. With a repo, the lender has full use of the securities and can sell them or use them as collateral himself. Also, the amount of securities is adjusted (usually daily) for changes in the market value, so that the value of the collateral tracks the amount of cash provided apart from intra-day movements. (The value of the collateral to be maintained is typically slightly higher than the amount of cash).
Concerns have been raised about pro-cyclicality of repo finance and its potential to exacerbate market price movements. If the price of securities falls, the borrower is required to provide more securities as collateral. This reduces the overall amount that can be borrowed against the total portfolio, forcing the borrower to reduce his overall holdings. This forced sale of securities pushes down the price yet further. In this sense, repos seem to create a hard-wired feedback loop.
Whilst this is certainly an important issue to be aware of, the point I want to make here is that this is a function of leverage, not repos specifically. Compared with the same level of borrowing, but on an unsecured basis, repos are better. Credit risk is a deadweight loss to the economy. The uncertainty associated with the exposure has negative utility for the lender, but no positive utility for the borrower. Use of collateral to reduce this risk therefore has an overall benefit. Repos provide a very efficient way of using collateral.
So, a repo will in general always be better than an unsecured borrowing. The problem with repos is that, because of these same advantages, they allow greater leverage. It is the extra leverage that creates the additional risks to financial stability, not the structure of the repos themselves.
If there is concern about financial stability, the ideal solution would be to limit the amount that is borrowed, but to allow that as much of that borrowing as possible to be structured as repo or other secured borrowing.