A repurchase agreement (Repo), often known as a repo loan, is a transaction that enables institutions and governments to raise short-term financing from investors. To put it simply, financial institutions use the repo as an overnight transaction in which they sell securities to someone else and promise to buy them back at a higher price at a later date.
The buyer receives interest in exchange for the seller’s promise to pay back the money. The repo rate is the interest payable on the loan, which is the difference between the shares’ initial price and the repurchase price.
How repo works
It is the seller who takes on the role of the borrower in a buyback agreement and the buyer who assumes the role of a lender. The securities sold as collateral are often issued by the government. Repo loans enable governments to get quick liquidity.
In contrast to a secured deposit, the assets are sold immediately. Repos are safe since they are guaranteed by government assets, but their value may fall, resulting in a loss of investment for buyers who take them.
Overnight repo loans have a one-day repayment period. Both parties have the option of extending the maturity time, or the agreement may have no maturity date at all.
For example, Company X wishes to raise some funds in order to meet its operating expenses. To acquire $10 million in US Treasury bonds, it joins with Company Y, which pays $9,000,000 to Company X then receives the $10 million in bonds from the deal. Upon repayment of the repo loan, Company Y will get $10 million in addition to interest, while Company X will be the owner of $10 million in securities.
Types of repo
Repos are offered in four basic varieties on the market:
- Classic repo: This is where securities are sold with an accompanying agreement to buy them back at a later time. There is no difference between the start and end values of the securities in this sort of repo, and interest is paid separately. The collateral enables the borrower to secure the loan. In this case, the security’s seller will benefit from the coupon revenue.
- Tri-partite repo: A tri-party agent, often a custodial bank or clearing agency, acts as a go-between in a three-party repo. By holding the collateral apart from the dealer’s assets, the collateral agent reduces the transaction’s operational burden, values the securities involved in the transaction, and provides additional security for the buyer in the case of the dealer’s inability to pay.
- Buy-sell rep: In this transaction, the lender takes physical ownership of the collateral. The security is sold wholly, but it is to be bought back again at a later date after the requisite payment is made.
The ownership of the bonds is transferred to the buyer, who keeps any coupon interest that may be due on the bonds throughout this process. Adjusting the gap between repo interest and bond coupon is what sets the future price of a bond at a level different from its spot clean price.
- Borrowing/bond lending repo: In this case, a borrower loans bonds to a lender at a fee. Depending on the kind of underlying instrument, the quantity and period of the loan, and the credit rating of your counterparty, you may be charged an additional fee for the transaction. Cash or other assets of similar value can be used as collateral in a securities lending arrangement to facilitate the transaction.
Determining the repo rate
The types of assets covered by a repurchase agreement and the parameters of the agreement, particularly the duration and price of the collateral, are the two most significant elements that influence repo rates.
For a repo arrangement, there are two types of securities that are used:
- Traditional: These are government securities issued by the US government comprising Treasury bills, agency debt and mortgage-backed securities issued by government agencies.
- Non-traditional: securities issued by companies other than governments, such as investment-grade and non-investment-grade debt and equity.
Market circumstances, the availability and demand for specific types of collateral, and the credit quality of the underlying assets all play a role in determining the repo rate for any given transaction.
In the event that a security is in great demand, lenders or repossession purchasers may provide low-cost financing, resulting in negative interest rates.
Importance of the repo market
A number of factors contribute to the significance of the repo market:
- With the use of securities as collateral, financial entities with a lot of assets such as banks and hedge funds may borrow cheaply, and parties with a lot of spare cash like mutual funds can receive a tiny return on that capital without much risk.
- Keeping cash is expensive for financial organizations because it doesn’t pay any interest. Even though hedge funds have large amounts of assets, they may require cash for day-to-day trading. Therefore they borrow from money market funds that have a lot of cash.
- As part of its monetary policy, the Federal Reserve employs repos and reverse repos from time to time, depending on the performance of the economy. The Fed purchases securities from a seller who commits to repurchase them, creating reserves for the financial system. Conversely, when the Federal Reserve sells securities with a promise to buy them, it reduces the reserves available to the economy.
- As a hedge for debt issuance: Repo also helps issuers, including governments and corporations, access the capital markets at reasonable costs and with less risk. It also provides an avenue through which dealers can fund their bond purchases at relatively cheaper rates.
If an issuer has a long position in an issue while it is being distributed to investors, primary dealers and other underwriters use the repo market to hedge that risk by taking short positions in other issues that have the same risk.
- Preventing settlement failures: An intermediary can borrow securities from the repo market to assure timely delivery to the first party if the inbound delivery fails to arrive on time from the second party. Delivery problems might spread through the market, disrupting trading and damaging investor confidence if there is no way to borrow securities.
In summary
Short-term repurchase agreements (repo) are one of the most active and largest short-term credit markets, providing liquidity for money market funds and other investors. Not only that, but they also help the Fed to regulate liquidity in the economy.
