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Repurchase agreement

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Repurchase agreements (RPs or Repos) are financial instruments used in the money markets and capital markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what occurs is that the cash receiver (aka repo seller) sells securities now, in return for cash, to the cash provider (aka repo buyer), and agrees to repurchase those securities from the cash provider for a greater sum of cash at some later date, that greater sum being all of the cash lent and some extra cash (constituting the implicit interest rate, known as the repo rate). There is little that prevents any security from being employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government bonds, and stocks / shares, may all be used as securities involved in a repo. A reverse repo is simply a repurchase agreement as described from the cash provider's not the repurchasing party, but the reverse i.e. the party from whom the security is repurchased. Hence, the cash receiver executing the transaction would describe it as a 'repo', while the cash provider in the same transaction would describe themselves as executing a 'reverse repo'. So 'repo' and 'reverse repo' are exactly the same kind of transaction, just described from opposite viewpoints.

A repo is economically similar to a secured loan, with the lender of money receiving securities as collateral to protect against default. However, the legal title to the securities clearly passes from the seller to the investor. The cash provider is referred to as an "investor" or "buyer"; the provider of the collateral (i.e. the security) is the "seller". Coupons (installment payments that are payable to the owner of the securities) which are paid while the repo buyer (aka cash lender i.e. cash provider) owns the securities are, in fact, usually passed directly onto the repo seller (i.e. cash receiver) which might seem counterintuitive, as the ownership of the collateral technically rests with the cash provider during the repo agreement. It is possible to instead pass on the coupon by altering the cash paid at the end of the agreement, though this is more typical of Sell/Buy Backs.

Although the underlying nature of the transaction is that of a loan, the terminology differs from that used when talking of loans due to the fact that the cash receiver does actually repurchase the legal ownership of the securities from the cash provider at the end of the agreement. So, although the actual effect of the whole transaction is identical to a cash loan, in using the 'repurchase' terminology, the emphasis is placed upon the current legal ownership of the collateral securities by the respective parties.

Although repos are typically short-term, it is not unusual to see repos with a maturity as long as two years.

Motivations for repos

For the cash investor, a repo is an opportunity to invest cash for a customized period of time (other investments typically with limited tenures). It is short-term and safer as a secured investment since the investor receives collateral. Market liquidity for repos is good and rates are competitive for investors.

For traders in trading firms, repos are used to finance long positions, obtain access to cheaper funding costs of other speculative investments, and cover short positions in securities.

While classic repos are generally credit-risk mitigated instruments, there are residual credit risks. Though it is essentially a collateralized transaction, the cash borrower (aka Repo Seller) may fail to repurchase the securities sold at the maturity date. In other words, the Repo Seller defaults on his obligation. Consequently, the cash lender (aka Repo Buyer) may keep the security, and liquidate the security in order to recover the cash lent. The security, however, may have lost value since the outset of the transaction as the security is subject to market movements. To mitigate this credit risk, repos often are overcollateralized as well as being subject to daily mark-to-market margining. Credit risk associated with repo is subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved, etc.

In addition to using repo as a funding vehicle, repo traders make markets. These traders have been traditionally known as "matched-book repo traders". The concept of a matched-book trade follows closely to that of a broker that takes both sides of an active trade, essentially having no market risk, only credit risk. Elementary matched-book traders engage in both the repo and a reverse repo within a short period of time, capturing the profits from the bid/ask spread between the reverse repo and repo rates. Presently, matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral swaps, liquidity management.

There are three types of repo maturities: overnight, term, and open repo. Overnight refers to a one-day maturity transaction. Term refers to a repo with a specified end date. Open simply has no end date.

Repo transactions occur in three forms: specified delivery, tri-party, and held in custody. The third form is quite rare in development markets primarily due to risks. The first form requires the delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party essentially is a basket form of transaction, and allows for a wider range of instruments in the basket or pool. Tri-party utilizes a tri-party agent and is a very efficient form of transaction.

Repo transactions came into focus within the financial press due to the technicalities of settlements following the collapse of Refco. Occasionally, a party involved in a repo transaction may not have a specific bond at the end of the repo contract. This may cause a string of failures from one party to the next, for as long as different parties have transacted for the same underlying instrument. The focus of the media attention centers on attempts to mitigate these failures.

Federal Reserve use of repos

Repurchase agreements when transacted by the Federal Open Market Committee of the Federal Reserve in open market operations initially add reserves to the banking system and then withdraw them; reverse repos initially drain reserves and later add them back.

Under a repurchase agreement ("RP" or "repo"), the Federal Reserve (Fed) buys US Treasury securities, U.S. agency securities, or mortgage backed securities from a primary dealer who agrees to buy them back, typically within one to seven days; a reverse repo is the opposite. Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint.

If the Fed is one of the transacting parties, the RP is called a "system repo," but if they are trading on behalf of a customer (e.g. a foreign central bank) it is called a "customer repo." Until 2003 the Fed did not use the term "reverse repo" - which it believed implied that it was borrowing money (counter to its charter) - but used the term "matched sale" instead.

Due bill/hold in-custody repo

In a Due Bill repo, the collateral pledged by the (cash) borrower is not actually delivered to the cash lender. Rather, it is placed in an internal account ("held in custody") by the borrower, for the lender, throughout the duration of the trade. This has become less common as the Repo market has grown, particularly owing to the creation of centralized counterparties. Due to the high risk to the security lender, these are generally only transacted with large, financially stable institutions.

Tri-party repo

The distinguishing feature of a Tri-Party Repo is that a custodian bank or international clearing organization acts as an intermediary between the two parties to the Repo. The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market and substitution of collateral. Both the lender and borrower of cash enter into these transactions to avoid the administrative burden of bi-lateral Repos. In addition, because the collateral is being held by an agent counterparty risk is reduced. A Tri-Party repo may be seen as the outgrowth of the Due Bill repo, in which the collateral is held by a neutral third party.

Whole loan repo

A Whole Loan Repo is a form of Repo where the transaction is collateralized by a loan or other form of obligation (e.g. mortgage receivables) rather than a security.

Equity repo

The underlying security for most Repo transactions are government or corporate bonds. Equity Repos are simply repos on Equity securities such as common (or ordinary) shares. Some complications can arise because of greater complexity in the tax rules for dividends as opposed to coupons.

Sell/buy backs and buy/sell backs

A Sell/Buy Back is the spot sale and a forward repurchase of a Security. The basic motivation of Sell/Buy Backs is generally same as for a Classic Repo i.e. attempting to benefit from the lower financing rates generally available for collateralized as opposed to non-secured borrowing. The economics of the transaction are also similar with the interest on the cash borrowed through the sell/buy back being implicit in the difference between the sale price and the purchase price.

There are a number of differences between the two structures. A Repo is technically a single transaction while a Sell/Buy Back is a pair of transactions (a sell and a buy). A Sell/Buy back does not require any special legal documentation while a Repo generally requires a master agreement to be in place between the buyer and seller (typically a GMRA/ISMA or PSA/ISMA).

Any coupon payment on the underlying security during the life of the Sell/Buy Back will generally be passed back to the seller of the security by adjusting the cash paid at the termination of the Sell/Buy Back. In a Repo the coupon will be passed on immediately to the seller of the security.

A Buy/Sell Back is the equivalent of a Reverse Repo.

Securities lending

The general motivation of Repo is the borrowing or lending of cash. In securities lending, the purpose is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structures. Securities are generally lent out for a fee. Securities lending trades are governed by different types of legal agreements than Repos.

The size of the repo market

The US Federal Reserve and the European Repo Council (a body of the International Securities Market Association) both try to estimate the size of their respective repo markets. At the end of 2004, the US repo market reached USD 5 trillion and the European one passed EUR 5 trillion in outstandings. Both are growing at two-digit pace. According to Celent, the European repo market has experienced a constant growth over the past five years, from €1.9 billion in 2001 to €6.4 trillion by the end of 2006. Celent estimates that, while the average value of transactions through the European OTC market and voice brokerage is around €165 million for an average total daily value of €1.4 trillion, it is only estimated at around €30 million on electronic platforms for an overall daily value of €370 billion. [1]

Other countries including India, Japan, Mexico, Hungary, Russia, China, and Taiwan, have their own repo markets, though activity varies by country, and no global survey or report has been compiled.

The impact of Basel on the repo market

The impact of Basel II and the Capital Adequacy Directive should be significant in the European repo market. There will likely be an increase of volume in the repo market in parallel with a higher level of standardization to achieve greater liquidity and acceptance among a wider spectrum of market participants. Also, the implementation of automated day-time bridge and an intraday borrowing fee waivers by Clearstream and Euroclear, solving some of the major cross-border settlement issues, will have a positive impact on the market. [1]

Who Buys Repo

Money Funds are large buyers of Repurchase Agreements.

See also

Footnotes

  1. ^ a b Celent Report: According to figures published by Celent 6 June 2007. See also The European Repo Market.
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