A European Central Bank working paper finds that bilateral dealer-to-client repo haircuts reflect dealer balance sheet constraints, collateral convenience yields and clients’ outside options, rather than serving solely as protection against counterparty risk. These frictions help explain why haircuts are frequently zero or carry the opposite sign from conventional risk management expectations, with materially different effects depending on whether clients seek securities or funding. Using transaction-level supervisory data from 2019 to June 2024, the authors find that the binding 3% leverage ratio requirement introduced in June 2021 pushed collateral-driven haircuts higher because the cash received expands dealers’ balance sheets. The most constrained dealers applied haircuts about 31 basis points higher than the least constrained dealers, with the effect present throughout the quarter rather than only at reporting dates. The leverage ratio had no comparable effect on funding-driven trades. Higher collateral convenience yields lowered haircuts when dealers lent scarce securities but raised them when dealers received securities that could be rehypothecated. Clients with more dealer relationships obtained higher haircuts in collateral-driven trades and lower haircuts in funding-driven trades. The paper also links leverage constraints to higher repo rate volatility and weaker transmission of European Central Bank deposit facility rate changes in collateral-driven trades. A one-standard-deviation higher dealer leverage ratio was associated with a 7.4-basis-point stronger post-decision rate adjustment in collateral-driven trades relative to funding-driven trades, indicating more complete pass-through among less constrained dealers.

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