Repurchase Agreements / Repo Market

REPO means Sale and Repurchase Agreement.

  • In a typical Repurchase Agreement / REPO transaction, the holder of a security sells it to a counterparty and simultaneously agrees to buy it back again on a pre-determined date.
  • Conversely, on the other side of the typical Repurchase Agreement / REPO transaction, one party lends cash and receives delivery of the security as collateral and simultaneously agrees to sell it back again on the same pre-determined date.
  • The party borrowing the cash and pledging the security as collateral is entering into a Repurchase Agreement as they have contractually committed to "repurchase" the security on the expiration date of the Agreement.
  • The party lending the cash and taking the security as collateral is entering into a Reverse Repurchase Agreement as they have contractually committed to "sell" the security on the expiration date of the the Agreement.
  • The Reverse Repurchase Agreement party (the one taking delivery of the security and lending cash) deposits cash in an amount less than the full price of the security with the original owner (money is usually lent at a discount to the mark-to-market value of the security).
  • The price of a repo transaction is always expressed as an interest rate.
  • The "repo rate" reflects the rate on the cash extended but also takes into account the coupon and yield of the fixed income security offered as collateral in the repo transaction. The repo rate is usually lower than the rate of interest the bond pays. The lender of the cash earns the "repo rate." The lender of the bond earns the coupon the bond pays less the repo rate.
    In November 2008, the repo rate in the $4.5 trillion U.S. Treasury repo market declined to near zero, which was indicative that traders and investors would have rather held the security instead of the cash. The repo rate also tends to track the U.S. Federal Funds rate, which on October 29, 2008, was decreased to 1.0%. Due to the low repo rate, holders of Treasuries were reluctant to lend them, which further reduced the available supply. This led to a period in November where the number of settlement fails increased (a fail occurs when one party does not receive the security or one other party does not deliver the security).
  • During the transaction, any coupon payments that come due belong to the legal owner, the "borrower." However, when this happens, a cash amount equal to the coupon is paid to the original owner, this is called "manufactured payment." In order to avoid the tax payment on the coupon, some institutions will repo the security to a tax exempt entity and receive the manufactured payment and avoid the tax ("coupon washing")
  • A cash payment in an amount equal to the full mark-to-market value of the security on the initial date of the Repurchase Agreement is transferred on the expiration date of the Agreement to the Reverse Repurchase Agreement party and the security is returned to the original owner (Repurchase Agreement party).
  • In this manner the Reverse Repurchase Agreement party has essentially made a short-term, secured loan with minimal risk to the seller of the security and has earned a discount to yield return by lending less than the value of the security but receiving an amount equal to the value of the security at the end of the Agreement.
  • Conversely, the Repurchase Agreement party (the one that borrowed the cash and pledged the security as collateral) received a low cost, short-term loan and does not have to lose control over a desirable security in their portfolio.
  • Thus, REPOS cover a wide range of fixed income securities and is a sale and forward repurchase of a security at a specified price for a specified time period. There are no restrictions during the term of the transaction on the use of either the cash or the collateral, other than the agreement that the transaction will be unwound. The yields established in repo transactions are in part a function of the quality of the underlying collateral.

    Collateral is generally delivered to the lender through:

  • Actual delivery, either physically or by wire with simultaneous payment; also referred to as delivery vs. payment.
  • Third party custody, also known as a Tri-party Repo, which refers to having a third party involved in the transaction who acts as the custodian and transfer agent for both parties, In a tri-party repo, both parties to the repo must have cash and collateral accounts at the same triparty agent. The tri-party agent will ensure that collateral pledged is sufficient and meets eligibility requirements, and all parties agree to use collateral prices supplied by the tri-party agent.
  • HIC / Hold In Custody, sometimes also referred to as Due bill, is when the seller of the security does not deliver the securities for settlement but holds them as the custodian in the repo transaction, while it is more lucrative to both parties as they do not incur the delivery expense this situation can lead to fraud, sometimes it is the only route as the securities may only settle locally.
  • On maturity date, the cash plus accrued interest is exchanged for the securities (usually "substantially identical" securities).

    A back-to-back Repurchase Agreement is one in which the counterparties receive and redeliver the security in the same day.

    The United States is the largest repo market followed by France. The U.K. has the largest cross border, multi-currency repo market. In Germany, repo transactions are subject to the same minimum reserve requirements as sight demand deposits (2%).

    Why does it make sense for a large institution to be involved in the repo market / securities lending business? Some financial institutions, for instance an insurance company, accumulate various fixed-income securities (that are purchased with cusotmer premium income and held as investments to cover projected claims payments in the future). The yeild can be increased by lending out these long-term securities in a repurchase agreement. Additionally, the cash that is held as collateral can further be invested in short-term instruments to, again, even further increase the yield. The key is that this final round of investment of counterparty cash must be in high-quality, liquid investments or the institution may end up in a liquidity crunch if it cannot get the cash back in time to return as part of the underlying repurchase agreement.

    Commercial institutions enter into repo transactions in order to cover short positions (an institution sells a bond short and borrows the security in a repo transaction and if the bond price moves in their favor, lower, they buy the bonds back in the open market and then return them to the lender in the repo transaction), refinance long positions (a financial istitutions will borrow cash from a repo dealer, acquire the bond and then deposit it with the repo dealer), invest short-term cash (In the U.S., repos are seen as an alternative to traditional money market instruments, for instance by entering into a 6-month repo transaction with a AA-rated broker instead of investing in a lower yielding 6-month AA-rated time deposit), obtain short-term cash (investment banks cannot borrow in an inter-bank market like banks thus they pledge collateral in a repo and obtain lower borrowing costs then they would in an unsecured loan) or to increase the return of an existing portfolio (earn some additional percentage points on the portfolio, especially if the security is in demand and a premium is paid).

    Central Bank Repo Operations

    Central banks use repo transactions for open market operations (issue securities to primary dealers and take cash out of the market) as part of conducting monetary policy. In the U.S., there is a group of Primary Government Dealers (banks and dealers authorized to participate in auctions of U.S. Treasury securities through the New York Federal Reserve Bank and the Federal Open Market Committee). There is a secondary group of broker / dealers who act as intermediaries for U.S. regional banks, foreign banks and other dealers, in the negotiation and execution of U.S. Treasury and mortgaged-backed repurchase agreements, and then are also a member of a clearing house for the settlement of the repo agreements (in the U.S., most repos are cleared through the Government Securities Clearing Corporation / GSCC).

    The U.S. Federal Reserve Bank (FRB) uses repurchase agreements, also called "RPs" or "repos", to make collateralized loans to primary dealers. In a reverse repo or ?RRP?, the FRB borrows money from primary dealers (and exchanges Treasuries). The typical term of these operations is overnight, but the FRB can conduct these operations with terms out to 65 business days (in practice they rarely extend beyond 14 days). The FRB utilizes these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drains balances from the system.

    The Repo and reverse repo transactions are conducted by the FRB with the primary dealers via auction. In a repo, dealers bid on borrowing money versus various types of general collateral. In a reverse repo, dealers offer interest rates at which they would lend money to the Fed versus the Fed?s Treasury general collateral, typically Treasury bills.

    Repurchase agreements are made at the initiative of the trading desk at the New York Federal Reserve Bank (NYFRB), which implements monetary policy for the Federal Reserve System at the behest of the Federal Open Market Committee (FOMC).

    The NYFRB selects winning propositions on a competitive basis. Each dealer is requested to present the rates they are willing to pay for the agreements versus various types of collateral. The three types of general collateral, or GC, the FRB accepts are marketable U.S. Treasury securities (including STRIPS and TIPS), certain direct U.S. agency obligations, and certain agency ?pass-throughs? (or Mortgage Backed Securities, often called MBS).

    The collateral pledged by dealers towards the repo is discounted by the NYFRB, which means they are valued at slightly less than market value. This discounted value reflects the underlying risk of the collateral and protects the FRB against a change in its value. Discout amounts are specific to classes of collateral.

    Amount of interest earned = Dollar amount invested X Repo rate X Number of days to maturity/360

    In France the Spécialistes en Pension sur Valeurs du Trésor (SPVT) are the primary dealers.

    Credit Issues

    Market risk: rate increase results in a decline of the collateral value and the lender is committed to buying them back at above market prices. Conversely, the value of the collateral could increase and the borrower is holding cash that does not equate the value of the collateral (this rarely happens as the collateral is marked-to-market on a pre-determined basis; if the value rises, the counterparty must increase the cash collateral).

    Counterparty Risk: in such that the counterparty may not be able to return the securities at the end of the transaction (fail). The lender then keeps the cash collateral.

    Additional repo related documentation includes the PSA / ISMA Global Repurchase Agreement, which covers each parites obligations regarding repricing, margin and default. The local repo market in France has its guidelines defined in the Contrat Cadre de Pension Livre (and was the first agreement to allow netting of transactions in the event of a default of a counterparty).