Repurchase agreement
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Repurchase agreements (RPs or Repos) are financial instruments used in the money markets. A more accurate and descriptive term is Sale and Repurchase Agreement, since what transpires is sale of securities now for cash by party A (the cash borrower) to party B (the cash lender), with the promise made by A to B of repurchasing those securities later (with A paying the requisite implicit interest to B at the time of repurchase - the implicit interest rate is 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 the repo as seen from the point of view of the cash lender, since the cash lender does not repurchase, but rather has securities repurchased from (i.e. the cash lender is the passive party in the act of securities repurchasing).
Normally, both parties view the transaction from the trader's perspective. A trader looking to borrow money is transacting a repo, while a trader looking to obtain securities is executing a reverse repo. When a customer provides money to a trader in return for securities, the transaction is often termed a repo by both parties.
A repo is similar to a secured loan, with the lender of money receiving securities as collateral to protect against default. The legal title to securities passes from the seller to the investor. The one providing the cash is referred to as an "investor"; the provider of the collateral is the "seller". Coupons that are paid out on the securities during the life of the loan are generally passed directly onto the seller of the Repo. It is possible to instead pass on the coupon by altering the cash paid at the end of the agreement, though is this is more typcial of Sell/Buy Backs.
Typically, repos are short-term, either overnight, or with a maturity of few days. However, repo agreements up to 3 months are not uncommon; these can be used to cover futures contracts, and are commonly called term repos.
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Motivations for repos
For the customer, a repo is an opportunity to invest cash for a custom period of time (other investments typically involve whole numbers of months). It is a short-term and secure investment; in return for investing, the customer receives collateral. Market liquidity for repos is good and yields are competitive for investors.
For the trader, repos are used to finance long positions and reduce funding costs of other speculative investments.
There is a small credit risk with using repos. It is essentially a collateralized borrowing; but it is possible that the borrower of cash may fail to repurchase the securities sold at the promised date (in other words, default). In this case the lender may keep the security, but it may have lost value since the original transaction date. To prevent this minor amount of credit risk, some repos are over-collateralized. The credit risk is directly associated with the maturity of the repo: the longer the maturity, the greater the credit risk coming with the repo.
In addition to using repo as a vehicle to obtain cheap funding cost using secured financing, the best traders are also able to gain by making markets in repo using matched traders. The concept of a matched trade follows closely to that of a broker that takes both sides of an active trade, essentially having no risk. In the case of a matched repo trade, the trader engages in both a repo and a reverse repo within a short period of time. Profits can be obtained by traders who can take both sides of the market, but still leave themselves with a positive spread between the two repo rates.
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, Triparty, and held in custody. The third form is quite rare. The first form requires the delivery of a prespecified bond at the onset and maturity of the contractual period. Triparty allows for a wide range of instruments to satisfy a general pool in the repo contract.
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.
Types of Repo and Related Products
Tri-Party Repo The distinguishing feature of a Tri-Party Report 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 in transaction enter into these transactions to avoid the administrative burden of bi-lateral Repos.
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 GRMA/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 While general motivation of Repo is the borrowing or lending of cash, is securities lending the motivation is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structure. Securities are generally lent out for a fee. Securities lending trades are governed by different types of legal agreements to 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.