Repurchase Agreement (REPO) - Explained
What is a REPO Agreement?
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Table of ContentsWhat is a Repurchase Agreement?How Does a REPO Agreement Work? Term vs. Open Repurchase AgreementsTerm Repurchase Agreements Open Repurchase Agreements The Significance of the TenorTypes of Repurchase AgreementsNear and Far LegsThe Significance of the Repo RateRisks of RepoThe Financial Crisis and the Repo MarketAcademic Research on Repurchase Agreements
What is a Repurchase Agreement?
A repurchase agreement (repo) is a short-term agreement for borrowing between institutional dealers or dealers in government securities. Large financial institutions and banks, or those who deal in government securities often use repurchase agreement. Repurchase agreement are often initiates to generate short-term capital for the government, institution or business. In a repurchase agreement, a party sells a security to another party with the aim of buying them back the following day. The party that agrees to buy the security only to sell it back to the initial seller in the nearest future, it is a reverse repurchase agreement.
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How Does a REPO Agreement Work?
Repo as a form of short-term borrowing entails a seller selling a government security to a buyer but repurchases it at a later date (usually the following day) at a higher price. Repo commonly occurs during the sale of government securities such as Treasury bonds and other financial instruments used in the monetary market. Agreements of this nature offer a level of guarantee to the buyer of the security simply because they attract interest and backed by collateral despite the fact that they are short-termed. The collateral in repurchase agreements that the securities purchased by buyers, these securities ensure that the financial needs of both parties are met. Repurchase agreements have traits that are similar to collateralized loans, for tax purposes, repose are regarded as loans. However, the distinguishing factor is investors can sell their collateral which is the security purchased in a repo.
Term vs. Open Repurchase Agreements
There are two types of repo, these are the open repurchase agreements and term repurchase agreements. Both repos have some factors that distinguish them from one another.
Term Repurchase Agreements
These are forms of repo with a specific maturity date at which they can be repurchased. This is often the following day or week. When repos of this nature are being sold, the buyers buy with a consent that they would sell it back at a slightly higher price on the following day. Term repos are avenues through which both the sellers and buyers raise short-term capital.
Open Repurchase Agreements
Open repurchase agreements have no maturity date set at the time of the sale, this means the agreement is open and can be called off by any of the parties. Open repos are also called on-demand repos. A seller can repurchase the security on any date, all it requires is that he gives a prior notice to the buyer. Investors with no knowledge of the duration needed to invest in financial assets use open repos.
The Significance of the Tenor
The maturity date of repurchase agreements are also called tenor term or rate. Tenor plays a significant role in repos and determined the risk of the repos. Usually, when a repo has a long tenor, it indicates a higher risk such as fluctuations in interest rates or a decline in the creditworthiness of the repurchaser. Generally, investors avoid repos with longer tenor. Although, longer tenors mean that investors would have more interests on the security, it also implies more risks. There are many events that could unfold during a long duration of maturity which include high inflation, fluctuation of interest rates and other occurrences that are likely to affect the ability of the other party to fulfil his obligations.
Types of Repurchase Agreements
There are three types of repo, they are;
- Specialized delivery repo: a specialized delivery repo is not commonly used in repurchase agreements. It involves the use of a bond guarantee when the agreement is being initiated and at maturity of the agreement.
- Third party repo: this is also called a tri-party repo. It involves the presence of a middleman in a repurchase transaction. The third party, usually a clearing agent or bank executes that transaction between the buyer and seller of security in exchange for a fee. The third party protects the interests of both the buyer and the seller, he ensures that the seller receives cash for the security as well as the party when the repurchase is to take place. The third party is oten in custody of the securities in the transaction and ensure that each party is paid for the value of the security.
- Held-in-custody repo: in this type of repo, the security is held in custody (custodial account) after the seller has received cash for the security. Repo of this nature is not commonly used owing to the risk of insolvency of the seller, hence inability of the borrower to get a collateral.
Near and Far Legs
Leg is a term commonly used in repurchase agreements, it describes the steps taken in the agreement. We can have start leg, close leg, far leg, and near leg. For instance, the initiation of the agreement where the security is initially sold is called a start leg while the maturity date, upon which the security is repurchased is a close leg. Start leg is otherwise called a near leg while close leg is called a far leg.
The Significance of the Repo Rate
Every repurchase agreement has a repo rate which is the rate at which a security is repurchased in the agreement. Commonly, investors who enter repurchase agreements consent to the repurchase of the security at a price slightly higher than when it was sold. However, in the sale of government securities or repurchase agreements involving government central banks, repo rates are set by central banks. This is to enable a proper control of the government over the flow of cash in the economy. When a private bank sells back a security to the government in a repurchase, it is often at a discounted rate. There are two major effects that repo rates have on the economy, in times of decline in the rates, private banks are encouraged to sell their securities back to the government in exchange for money. However, increase in repo rate can likewise mean that the banks would not resell their securities. There are three ways of calculating the real cost of a repurchase agreement. Both buyers and sellers do the calculation to identify the benefits and costs of the agreements. The methods are;
- Implied interest rate
- Cash paid in the initial security sale
- Cash to be paid in the repurchase of the security
The real rate of interest in a repo can also be calculated using the formula below; Interest rate = [(future value/present value) 1] x year/number of days between consecutive legs
Risks of Repo
There are certain risks commonly associated with repurchase agreements, they are highlighted below;
- Risk of default: this occurs when a seller fails to fulfil his obligation in the agreement. This means the seller might fail to repurchase the security at a specified maturity date. A buyer can also default in a repo, especially if the value of the security has increased beyond what was agreed upon in the agreement. In this situation, a buyer might fail to sell back the security to the repurchaser.
- Liquidation of security: this is another risk which entails that the buyer, following the default of the seller to make a repurchase might liquidate the security to recover some cash.
- Decline in the value of the security: this owns to the difference in the purchase period and maturity date.
Given the underlying risks of repurchase agreements, there are some techniques that have been put in place to help reduce the risks. The major mechanism that helps limit risks is collateralization. Generally, repos are over-collateralized, which entails that the sale margin would be amended to match the value of the security. Under-collateralization is another strategy that help in reducing the risks of buyers; unwillingness to sell back a security to the original seller despite the existing agreement.
The Financial Crisis and the Repo Market
The 2018 financial crisis also had an impact on repurchase agreements. After the 2008 global financial crisis, the repo market in the United States and some other parts of the world notably reduced. It was after the crisis that repo 105 emerged and drew the attention of many investors. The numerous problems of the repo market were exposed significantly which warranted the intervention of the Fed to reduce the risk. The three problem areas analyzed by Fed were;
- Unavailability or scarcity of risk management metrics.
- Absence of an effective plan to liquidate collateral when dealers default.
- Heavy reliance on intraday credit by clearing agents in the tri-party repo market.
In recent times, the repo market after recovering from the 2008 financial crisis effects has continued to experience growth. After the 2008 financial crisis, there have been new rules and regulations put in place to address the problems of repo markets analyzed above. The rules were developed by the Fed alongside other regulators. Some parts of the new regulations require that banks maintain their treasuries and other safe assets, these assets are not to be sold in repo markets. The new rules also address the major concerns in the repo markets. However, despite the regulation of repo markets, some risks still persisted in the market. Hence, continued regulations are needed to help keep the sanity of the repo space and guarantee its future.
Academic Research on Repurchase Agreements