What it means
The term is mostly used in repurchase agreement markets, often called repo. In a repo, one party sells securities with a promise to buy them back later at a slightly higher price, which works like a short-term secured loan.
A dealer running a matched book borrows cash from one client by selling securities in a repo, and at the same time lends that cash to another client in a reverse repo, taking securities as collateral. Both deals have the same size and maturity, so the dealer's position is balanced.
The dealer's profit is the difference between the rate charged and the rate paid. For example, borrowing at 4.00% and lending at 4.25% for 30 days earns the dealer a quarter of a percentage point annualised on the amount involved.
On a large balance and a short term that is a small dollar figure, which is why volumes are high. The matched book is a low-risk business but not a risk-free one.
A counterparty can fail to deliver, collateral values can change, and if the two legs are not exactly matched in maturity, the dealer may have to fund the gap at an uncertain rate. Banks also use the phrase more broadly, to describe lending funded by liabilities of the same maturity and currency.
In both senses, the aim is to take away the risk of being caught with mismatched funding, which can be a serious problem during stress in financial markets.
In practice
Real-world examples.
Example
A securities dealer borrows $50,000,000 from a money market fund by selling government bonds under a repo. It lends the cash on to a hedge fund that needs funding, taking other bonds as collateral and earning a small spread. Both deals mature on the same day, so no gap needs to be refinanced.
Example
A bank funds a five-year loan to a business by issuing a five-year bond of the same size. Because the maturities match, the bank is not exposed to rising short-term rates during the loan. Its profit is the difference between the loan rate and the bond rate, which is fixed from the start.
Example
A broker lends shares to a client who wants to sell short and borrows the same shares from a pension fund, earning a fee on the difference. The loan and borrowing terms are matched so that the broker holds no net position. If the client returns the shares early, the broker returns the borrowed shares to the pension fund on the same day.
Formula
Calculation
Matched book profit = Amount x (Rate received - Rate paid) x (Days / 360)
A dealer borrows $100,000,000 for 30 days at 4.00% and lends the same amount for 30 days at 4.25%. The spread is 4.25% - 4.00% = 0.25%, or 0.0025.
Matched book profit = $100,000,000 x 0.0025 x (30 / 360) = $250,000 x 0.083333 = $20,833.33. Money market conventions often use a 360-day year, which is why the calculation divides by 360.Case study
Seen in the real world.
Stonebridge Securities is an illustrative, fictional dealer that ran a repo desk with a rule that every borrowing had to be matched by a lending of the same size and maturity. For years the desk earned a steady but small return of a few basis points on large volumes, where a basis point is one hundredth of a percentage point.
During a period of market stress, a counterparty failed to return cash on a reverse repo, but the desk held the bonds as collateral and could sell them. Because its own borrowing was term-matched, it did not need to find replacement funding at once.
The desk absorbed a small loss from collateral price movement, far less than a competitor that had funded long-dated holdings with overnight money. In this illustrative story the head of the desk used the episode to justify the cost of strict matching limits. The risk committee agreed to review the desk's maturity ladder every week, and not only at month-end.
Watch out
Common mistakes.
- Assuming a matched book has no risk, when counterparty failure and collateral value changes can still cause losses.
- Ignoring small maturity mismatches, which can grow into funding gaps during stressed markets when lenders become unwilling to roll over short-term funding.
- Forgetting that thin spreads need large volumes, so costs, capital charges and balance sheet limits can easily absorb the profit.
Questions
People also ask.
What is a matched book in repo?
It is a set of repos and reverse repos with equal size and maturity, so the dealer earns the spread without taking a view on rates.
Why is a 360-day year used?
Many money market instruments follow a convention of 360 days, so interest is calculated with that denominator, although some currencies and markets use 365 instead.
How does a matched book differ from a gap position?
A gap position deliberately or accidentally leaves assets and liabilities with different maturities, exposing the firm to funding and interest rate risk.
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