Repurchase agreement

Repurchase agreement or "Repo" transaction components. In step one, the investor provides $80 cash and receives $100 in collateral, typically bonds. In step two, the borrower buys back the collateral, paying the investor their initial cash plus an interest amount. The "repo rate" is the interest rate received by the investor, in this case (88–80)/80 = 10%, while the "Haircut" is a ratio of the cash loan to collateral (100–80)/100 = 20%.[3]

In a repo, the investor/lender provides cash to a borrower, with the loan secured by the collateral of the borrower, typically bonds. In the event the borrower defaults, the investor/lender gets the collateral. Investors are typically financial entities such as money market mutual funds, while borrowers are non-depository financial institutions such as investment banks and hedge funds. The investor/lender charges an interest rate called the "repo rate," lending $X and receiving back a greater amount $Y. Further, the investor/lender may demand collateral of greater value than the amount that they lend. This difference is the "haircut." These concepts are illustrated in the diagram and in the equations section. When investors perceive greater risks, they may charge higher repo rates and demand greater haircuts. A third party may be involved to facilitate the transaction; in this case, the transaction is referred to as a "tri-party repo."[3]

Specifically, in a repo the security-buying party B acts as a lender of cash, whereas the seller A is acting as a borrower of cash, using the security as collateral; in a reverse repo, security purchaser (A) is the lender of cash and (B) is the borrower of cash.[5] A repo is economically similar to a secured loan, with the buyer (effectively the lender or investor) receiving securities for collateral to protect himself against default by the seller. The party who initially sells the securities is effectively the borrower. Many types of institutional investors engage in repo transactions, including mutual funds and hedge funds.[6] Almost any security may be employed in a repo, though highly liquid securities are preferred as they are more easily disposed of in the event of a default and, more importantly, they can be easily obtained in the open market where the buyer has created a short position in the repo security by a reverse repo and market sale; by the same token, non liquid securities are discouraged.

Treasury or Government bills, corporate and Treasury/Government bonds, and stocks may all be used as "collateral" in a repo transaction. Unlike a secured loan, however, legal title to the securities passes from the seller to the buyer. Coupons (interest payable to the owner of the securities) falling due while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller. This might seem counter-intuitive, as the legal ownership of the collateral rests with the buyer during the repo agreement. The agreement might instead provide that the buyer receives the coupon, with the cash payable on repurchase being adjusted to compensate, though this is more typical of sell/buybacks.

Although the transaction is similar to a loan, and its economic effect is similar to a loan, the terminology differs from that applying to loans: the seller legally repurchases the securities from the buyer at the end of the loan term. However, a key aspect of repos is that they are legally recognised as a single transaction (important in the event of counterparty insolvency) and not as a disposal and a repurchase for tax purposes. By structuring the transaction as a sale, a repo provides significant protections to lenders from the normal operation of U.S. bankruptcy laws, such as the automatic stay and avoidance provisions.

A reverse repo is a repo with the roles of A and B exchanged.

The following table summarizes the terminology:

In the United States, repos have been used from as early as 1917 when wartime taxes made older forms of lending less attractive. At first, repos were used just by the Federal Reserve to lend to other banks, but the practice soon spread to other market participants. The use of repos expanded in the 1920s, fell away through the Great Depression and WWII, then expanded once again in the 1950s, enjoying rapid growth in the 1970s and 1980s in part due to computer technology.[7]

According to Yale economist Gary Gorton, repo evolved to provide large non-depository financial institutions with a method of secured lending analogous to the depository insurance provided by the government in traditional banking, with the collateral acting as the guarantee for the investor.[3]

In 1982, the failure of Drysdale Government Securities led to a loss of $285 million for Chase Manhattan Bank. This resulted in a change in how accrued interest is used in calculating the value of the repo securities. In the same year, the failure of Lombard-Wall, Inc. resulted in a change in the federal bankruptcy laws pertaining to repos.[8][9] The failure of ESM Government Securities in 1985 led to the closing of Home State Savings Bank in Ohio and a run on other banks insured by the private-insurance Ohio Deposit Guarantee Fund. The failure of these and other firms led to the enactment of the Government Securities Act of 1986.[10]

In 2007–2008, a run on the repo market, in which funding for investment banks was either unavailable or at very high interest rates, was a key aspect of the subprime mortgage crisis that led to the Great Recession.[3]

In July 2011, concerns arose among bankers and the financial press that if the 2011 U.S. debt ceiling crisis led to a default, it could cause considerable disruption to the repo market. This was because treasuries are the most commonly used collateral in the US repo market, and as a default would have downgraded the value of treasuries, it could have resulted in repo borrowers having to post far more collateral. [11]

During September 2019, the U.S. Federal Reserve intervened in the role of investor to provide funds in the repo markets, when overnight lending rates jumped due to a series of technical factors that had limited the supply of funds available.[1]

Market size

Composition of SOFR Rate

The New York Times reported in September 2019 that an estimated $1 trillion per day in collateral value is transacted in the U.S. repo markets.[1] The Federal Reserve Bank of New York reports daily repo collateral volume for different types of repo arrangements. As of 24 October 2019, volumes were: secured overnight financing rate (SOFR) $1,086 billion; broad general collateral rate (BGCR) $453 billion, and tri-party general collateral rate (TGCR) $425 billion.[2] These figures however, are not additive, as the latter 2 are merely components of the former, SOFR.[12]

The Federal Reserve and the European Repo and Collateral Council (a body of the International Capital Market Association) have tried to estimate the size of their respective repo markets. At the end of 2004, the US repo market reached US$5 trillion. Especially in the US and to a lesser degree in Europe, the repo market contracted in 2008 as a result of the financial crisis. But, by mid-2010, the market had largely recovered and, at least in Europe, had grown to exceed its pre-crisis peak.[13]

A repurchase agreement is a transaction concluded on a deal date t_D between two parties A and B:

(i) A will on the near date ${\textstyle t_{N}}$ sell a specified security S at an agreed price P_N to B

(ii) A will on the far date t_F (after t_N) re-purchase S from B at a price P_F which is already pre-agreed on the deal date.

If positive interest rates are assumed, the repurchase price P_F can be expected to be greater than the original sale price P_N.

The (time-adjusted) difference ${\textstyle {\frac {P_{F}-P_{N}}{P_{N}}}\cdot {\frac {365}{t_{F}-t_{N}}}}$ is called the repo rate, which is the annualized interest rate of the transaction. ${\textstyle {\frac {P_{F}-P_{N}}{P_{N}}}\cdot {\frac {t_{F}-t_{N}}{365}}}$ can be interpreted as the interest rate for the period between near date and far date.

The term repo has given rise to a lot of misunderstanding: there are two types of transactions with identical cash flows:

(i) a sell-and-buy-back as well as,

(ii) a collateralized borrowing.

The sole difference is that in (i) the asset is sold (and later re-purchased), whereas in (ii) the asset is instead pledged as a collateral for a loan: in the sell-and-buy-back transaction, the ownership and possession of S are transferred at t_N from a A to B and in t_F transferred back from B to A; conversely, in the collateralized borrowing, only the possession is temporarily transferred to B whereas the ownership remains with A.

There are two types of repo maturities: term, and open repo.

Term refers to a repo with a specified end date: although repos are typically short-term (a few days), it is not unusual to see repos with a maturity as long as two years.

Open has no end date which has been fixed at conclusion. Depending on the contract, the maturity is either set until the next business day and the repo matures unless one party renews it for a variable number of business days. Alternatively it has no maturity date – but one or both parties have the option to terminate the transaction within a pre-agreed time frame.

Repo transactions occur in three forms: specified delivery, tri-party, and held in custody (wherein the "selling" party holds the security during the term of the repo). The third form (hold-in-custody) is quite rare, particularly in developing markets, primarily due to the risk that the seller will become insolvent prior to maturation of the repo and the buyer will be unable to recover the securities that were posted as collateral to secure the transaction. The first form—specified delivery—requires the delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party is essentially a basket form of transaction and allows for a wider range of instruments in the basket or pool. In a tri-party repo transaction, a third party clearing agent or bank is interposed between the "seller" and the "buyer". The third party maintains control of the securities that are the subject of the agreement and processes the payments from the "seller" to the "buyer."

For the buyer, a repo is an opportunity to invest cash for a customized period of time (other investments typically limit 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. Money Funds are large buyers of Repurchase Agreements.

For traders in trading firms, repos are used to finance long positions (in the securities they post as collateral), obtain access to cheaper funding costs for long positions in other speculative investments, and cover short positions in securities (via a "reverse repo and sale").

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 who 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. Currently, matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral swaps, and liquidity management.

Secured Overnight Financing Rate or SOFR, a proxy for the overnight repo interest rate. During September 2019, the SOFR significantly increased, resulting in intervention by the U.S Federal Reserve.[1]

While classic repos are generally credit-risk mitigated instruments, there are residual credit risks. Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold, at the maturity date. In other words, the repo seller defaults on their obligation. Consequently, the buyer may keep the security, and liquidate the security 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 risk, repos often are over-collateralized as well as being subject to daily mark-to-market margining (i.e., if the collateral falls in value, a margin call can be triggered asking the borrower to post extra securities). Conversely, if the value of the security rises there is a credit risk for the borrower in that the creditor may not sell them back. If this is considered to be a risk, then the borrower may negotiate a repo which is under-collateralized.[7]

Credit risk associated with repo is subject to many factors: term of repo, liquidity of security, the strength of the counterparties involved, etc.

Certain forms of repo transactions came into focus within the financial press due to the technicalities of settlements following the collapse of Refco in 2005. 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.

In 2008, attention was drawn to a form known as repo 105 following the Lehman collapse, as it was alleged that repo 105s had been used as an accounting trick to hide Lehman's worsening financial health. Another controversial form of repurchase order is the "internal repo" which first came to prominence in 2005. In 2011, it was suggested that repos used to finance risky trades in sovereign European bonds may have been the mechanism by which MF Global put at risk some several hundred million dollars of client funds, before its bankruptcy in October 2011. Much of the collateral for the repos is understood to have been obtained by the rehypothecation of other collateral belonging to the clients.[23][24]

During September 2019, the U.S. Federal Reserve intervened in the role of investor to provide funds in the repo markets, when overnight lending rates jumped due to a series of technical factors that had limited the supply of funds available.[1][4]

• Collateral management
• Currency swap
• Discount window
• Dollar roll
• Federal funds
• Implied repo rate
• Margin (finance)
• Money market
• Official bank rate
• Total return swap

• McCormick, Liz Capo; Alexandra Harris (11 September 2019). "Decade After Repos Hastened Lehman's Fall, the Coast Isn't Clear". Bloomberg Businessweek. Retrieved 15 June 2021.

• Baklanova, Viktoria; Copeland, Adam; McCaughrin, Rebecca (September 2015), "Reference Guide to U.S. Repo and Securities Lending Markets" (PDF), Staff Reports, Federal Reserve Bank of New York, no. 740
• Repurchase and Reverse Repurchase Transactions – Fedpoints – Federal Reserve Bank of New York
• Explanation of the Federal Reserve repurchase agreements actions of August 10, 2007
• Statement Regarding Counterparties for Reverse Repurchase Agreements March 8, 2010