A repurchase agreement (repo), commonly used by financial institutions, is a short-term borrowing arrangement primarily employed by dealers in government securities. In a repo transaction, the dealer sells government securities to investors, typically overnight, and repurchases them the following day at a slightly higher price, thereby incorporating an implicit overnight interest rate. Repos serve as a means to raise short-term capital and are frequently utilized in central bank open market operations.
From the perspective of the party selling the security and agreeing to repurchase it in the future, it is referred to as a repo. On the other end of the transaction, the party buying the security and agreeing to sell it in the future engages in a reverse repurchase agreement.
Repos play a significant role in the money market, attracting participants such as money market mutual funds, pension funds, and hedge funds. These transactions involve repo securities and government bonds as the underlying assets. They help manage liquidity in the banking system and facilitate credit risk mitigation. Central banks, such as the Federal Reserve Bank, employ repo operations as part of their monetary policy toolkit to regulate interest rates, money supply, and overall financial system stability.
During a repo, the dealer can use the securities as collateral to borrow funds, making it a collateralized loan. The party lending funds are exposed to counterparty credit risk. Credit risk-mitigated instruments and specified collateralized loans are employed to mitigate this risk. The fixed-income clearing corporation ensures the smooth settlement of repo agreements in the capital markets.
Repo transactions contribute to secondary market liquidity and allow primary dealers to manage their excess cash balances. Moreover, the repo market provides the Federal Reserve with a mechanism to sell securities, thereby managing liquidity in the financial system and mitigating systemic risk. The Federal Open Market Committee, the monetary policy-making body, sets the target range for the federal funds rate, influencing interest rates across the economy.
In times of market stress or volatility in the repo market, the central bank may utilize tools such as the standing repo facility to provide liquidity to repo borrowers. These facilities operate within specified maturity dates, allowing participants to borrow against high-quality liquid assets.
Repurchase agreements, commonly known as repos, are highly regarded as secure investments due to the presence of collateral, typically U.S. Treasury bonds. Functioning as a money-market instrument, a repo essentially acts as a short-term, collateralized loan with an added interest component. In this arrangement, the buyer assumes the role of a short-term lender, while the seller takes on the role of a short-term borrower. The securities being sold serve as the underlying collateral, satisfying the objectives of both parties, namely secured funding, and liquidity.
Repos can be executed among various entities. The Federal Reserve, for instance, engages in repurchase agreements to manage the money supply and regulate bank reserves. Individuals often utilize these agreements to finance the acquisition of debt securities or other investments. It’s important to note that repos are strictly short-term investments, and their duration is referred to as the "rate," the "term," or the "tenor."
Although repos share similarities with collateralized loans, they are distinct in nature. While repos involve an actual purchase of securities, the buyer only holds temporary ownership of the assets. Consequently, these agreements are often treated as loans for tax and accounting purposes. In the event of bankruptcy, repo investors generally can sell the collateral, differentiating repos from collateralized loans where bankrupt investors may face an automatic stay.
The most prevalent type is a third-party repo, also referred to as a tri-party repo. In this arrangement, a clearing agent or bank facilitates the transactions between the buyer and seller, safeguarding the interests of both parties. The clearing agent assumes custody of the securities, ensuring that the seller receives cash upfront and that the buyer transfers funds for the seller’s benefit and delivers the securities upon maturity. JPMorgan Chase and Bank of New York Mellon are the primary clearing banks in the United States for tri-party repos. These clearing agents not only hold the securities but also assess their value and apply a specified margin. They settle the transactions on their books and assist dealers in optimizing their collateral. It’s important to note that clearing banks do not act as intermediaries to match dealers with cash investors or function as brokers. While clearing banks typically initiate repo settlements early in the day, the actual settlement occurs at the end of the day. This delay in settlement often leads to the extension of billions of dollars of intraday credit to dealers. Third-party repos account for a significant portion of the overall repurchase agreement market, ranging from 80% to 90%, which had a total value of approximately $4.2 trillion as of June 9, 2022.
Another type is a specialized delivery repo, which entails a bond guarantee at the agreement’s inception and upon maturity. However, this type of repo arrangement is relatively uncommon.
The third type is a held-in-custody repo, where the seller receives cash for selling the security but retains it in a custodial account on behalf of the buyer. However, this type of repo agreement is even less common due to the inherent risk that the seller may become insolvent, potentially restricting the borrower’s access to the collateral.
Term repurchase agreements are repos with a specified maturity date, typically the following day or week. In this arrangement, a dealer sells securities to a counterparty with the agreement to repurchase them at a higher price on a specific future date. During the term of the transaction, the counterparty gains access to the securities and earns interest, which is determined by the difference between the initial sale price and the buyback price. The interest rate remains fixed, and the dealer pays it at maturity. Term repos are utilized when there is a known duration for investing cash or financing assets.
On the other hand, an open repurchase agreement, also known as an on-demand repo, functions similarly to a term repo, except that the maturity date is not set. Instead, the dealer and counterparty agree to the transaction without a specific maturity date. Either party can terminate the trade by providing notice to the other party before a pre-agreed daily deadline. If an open repo is not terminated, it automatically rolls over each day. Interest is paid on a monthly basis, and the interest rate is adjusted periodically through mutual agreement.
The interest rate for an open repo typically aligns closely with the federal funds rate. Open repos are employed when parties are uncertain about the duration for which they need to invest cash or finance assets. However, it is worth noting that the majority of open agreements conclude within one or two years.
The repo market serves as a crucial intersection where cash and Treasury securities converge, each striving to reach the other side.
In this market, one firm sells Treasury securities to a second institution and commits to repurchasing those assets at a higher price within a specified timeframe, often overnight. This contractual arrangement is commonly known as a repo, which essentially functions as a short-term loan backed by collateral. Similar to most loans, there is an associated interest payment, represented by the difference between the original price and the subsequent higher price, referred to as the "repo rate."
Conversely, when the Federal Reserve sells a security to a counterparty and agrees to repurchase it later, it is termed a "reverse repo" transaction.
Why would parties engage in the seemingly archaic repo market? The answer lies in the benefits it offers them. Financial firms with substantial cash reserves prefer not to let their money idle since it doesn’t generate interest or profits. By participating in the repo market, they can lend their excess cash at favorable rates to meet short-term funding requirements. Additionally, these transactions typically involve low levels of risk.
Bilateral Repo. In the bilateral repo market, investors and collateral providers directly engage in the exchange of money and securities without the involvement of a clearing bank. Bilateral repo transactions can be structured to allow for general collateral or impose specific restrictions on eligible securities as collateral. Market participants often choose bilateral repo when they prefer direct interaction with each other or have particular requirements for the collateral involved.
Tri-Party Repo. The tri-party repo market derives its name from the role played by clearing banks in facilitating the settlement process. Clearing banks serve as intermediaries, managing the administrative aspects of repo transactions between the two parties involved. Tri-party repo is commonly used to finance general collateral, where investors accept a broad range of securities within a specified class. According to the Federal Reserve Bank of New York (New York Fed), market participants often perceive tri-party repo as a more cost-efficient option.
When government central banks engage in the repurchase of securities from private banks, they do so at a discounted rate referred to as the repo rate. Similar to prime rates, repo rates are determined and set by central banks. The repo rate framework enables governments to regulate the money supply within economies by adjusting the availability of funds.
A decrease in repo rates incentivizes banks to sell securities back to the government in exchange for cash. This action increases the overall money supply in the economy. Conversely, by raising repo rates, central banks can effectively reduce the money supply by discouraging banks from reselling these securities.
To assess the costs and benefits associated with a repurchase agreement, individuals or entities interested in participating in the transaction need to consider three key calculations:
The cash amount paid during the initial sale of the security.
The cash amount to be paid upon repurchasing the security.
The implied interest rate.
The cash amounts involved in the initial sale and repurchase depend on the value and type of security used in the repo. For example, in the case of a bond, both the clean price and the accrued interest value of the bond need to be taken into account.
An essential aspect of any repo agreement is the implied interest rate. If the interest rate is unfavorable, a repo agreement may not be the most efficient method for accessing short-term cash. The formula below can be used to calculate the real rate of interest:
Interest rate = [(future value/present value) - 1] x (year/number of days between consecutive legs)
Once the real interest rate is calculated, comparing it with rates associated with other funding options determines whether the repurchase agreement offers favorable terms. Generally, as a secured form of lending, repurchase agreements provide better conditions than money market cash lending agreements. From the perspective of a reverse repo participant, the agreement can generate additional income on excess cash reserves as well.
Let’s consider a hypothetical scenario involving a repurchase agreement between a hedge fund and a money market fund.
The hedge fund holds 10-year Treasury securities in its portfolio and requires short-term financing for purchasing additional Treasury securities.
Meanwhile, the money market fund possesses the necessary capital that the hedge fund seeks and is willing to accept the 10-year Treasury securities as collateral.
Upon reaching an agreement, the hedge fund transfers its 10-year Treasury securities to the money market fund with an agreed-upon interest rate in exchange for cash.
Following the standard practice in repos, the hedge fund repays the borrowing amount plus interest to the money market fund on a subsequent day. Simultaneously, the 10-year Treasury securities used as collateral are returned to the hedge fund, finalizing the agreement.
Cash investors utilize repo as a means to invest their excess cash. Instead of letting their cash sit idle, cash investors enter into repurchase agreements with borrowers, typically financial institutions or government entities. By lending their cash in exchange for collateral, such as Treasury securities, cash investors earn interest on their investments while ensuring the safety of their funds.
Repo rates are determined through market forces, primarily influenced by the supply and demand dynamics in the repo market. The repo rate represents the interest rate at which borrowers can obtain short-term financing by pledging collateral. Factors such as prevailing interest rates, liquidity conditions, creditworthiness of borrowers, and market expectations impact repo rates. Central banks, including the Federal Reserve, also play a role in influencing repo rates through their monetary policy decisions.
The Federal Reserve uses repo transactions as a tool to implement monetary policy and manage the money supply in the economy. Through repurchase agreements, the Federal Reserve engages in open market operations to either inject liquidity into the financial system or absorb excess liquidity. By conducting repo transactions with authorized dealers, the Federal Reserve can influence short-term interest rates and regulate the availability of funds in the banking system.
While financial regulations aim to promote stability and mitigate risks in the financial system, certain regulations have contributed to challenges in the repo market. For example, regulatory requirements, such as the liquidity coverage ratio (LCR) and the enhanced prudential standards, have increased the demand for high-quality collateral, particularly Treasury securities. This heightened demand, coupled with limited supply, has at times strained the availability of eligible collateral in the repo market. Additionally, regulations surrounding capital requirements and balance sheet constraints for financial institutions have affected their ability to engage in repo transactions, potentially impacting market liquidity.
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