The European Central Bank (ECB) has published a working paper finding that excess demand for physical sovereign bonds drives hedge fund securities borrowing and widens the gap between policy rates and repo rates, known as repo specialness. The research contrasts hedge funds’ limited response to securities borrowing costs with the more responsive supply from public institutions and other lenders. This interaction affects repo pricing and the transmission of monetary policy. Using regulatory transaction data for repos backed by German government bonds from March 2021 to June 2024, the study estimates that a 10% increase in securities borrowing costs reduces offshore hedge funds’ borrowing by only about 1%. These funds short bonds to accommodate demand from investors seeking physical securities and hedge their positions with futures, leaving their borrowing needs primarily determined by cash market imbalances. Securities suppliers account for 87% of aggregate repo market price elasticity. Public institutions provide about 60% of net securities lending. A sectoral decomposition attributes an estimated reduction of 15 basis points in specialness to public securities lending at the peak of the 2022 episode. As cash market arbitrage opportunities narrowed in late 2022 and 2023, hedge fund borrowing and specialness declined without a material change in funds’ price sensitivity. The findings identify specialness as an observable signal of cash bond demand pressures and highlight how the design and pricing of securities lending facilities influence repo rates.

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