Repurchase Agreements or Repo are short-term borrowing agreements usually between the dealer of government securities and investors. In this, the dealer/trader usually sells government securities to an investor on an overnight basis. And, the next day (or any other duration) dealer buys back the same security at a marginally higher price.
The difference amount is basically the absolute overnight interest rate or the repo rate. Primarily two factors affect the repo rate. First is the term or duration of the agreement, such as tenor and collateral, and second is the type of securities involved in the repurchase agreement.
For the seller of the security, the act of selling the security and then repurchasing it refers to the repo. On the other hand, for the investor or the buyer, the act of investing in the security and selling it in the future refers to the reverse repurchase agreement.
Understanding Repurchase Agreements
A repurchase agreement is a type of collateralized loan where the lender offers funds in exchange for security, which works as collateral. And in the future, the borrower buys back the security at a higher price. The securities in question in a repurchase agreement are high-quality debt securities—for example, government bonds, convertible bonds, emerging market bonds, and more.
Usually, repo transactions involve government or government-approved dealers. But, any two parties can also enter into a repurchase agreement. Another name for Repurchase Agreements is the sale-and-repurchase agreement. Repo’s are an effective tool to obtain short-term capital. Moreover, they also help central banks with their open market operations.
Normally, these agreements are safe investments as the security in question is the government security, such as U.S. Treasury bonds. Thus, such agreements are popular money-market instruments, where the buyer is a short-term lender, and the seller is the short-term borrower. And the securities are collateral. So, in a way, these agreements help to meet the short-term secured funding and liquidity requirements of the borrower and rotation of capital.
This repurchase agreement can work in many ways.
- One way is where the central bank enters into a repurchase agreement with the banks to control the money supply in an economy.
- Another way is where individual investors buy these securities from government-approved dealers.
Number of Parties in a Repurchase Agreement
A repurchase agreement involves two parties.
- First is the party that is willing to sell and repurchase that security.
- And the second is the party that is willing to buy and resell that security at a higher price to the original seller.
Usually, the participants in such an agreement are central banks, hedge funds, sovereign wealth funds, pension funds, banks, and insurance companies.
There can also be a Tri-party repo. In this, there is a “tri-party” agent or a third party. This third party is not either buyer or seller of the security and has no direct connection. However, this third party is the facilitator/intermediary/broker/agent who gets the deal between the buyer and seller. The agent is usually a clearing organization or a custodian bank, such as JPMorgan Chase and Bank of New York Mellon.
Usually, the agent helps to minimize the operational burden in the transaction. Also, the agent could hold the collateral, which helps protect the investor in case the dealer goes bankrupt. The agent also assists in valuing the security.
Uses of Repurchase Agreements
Following are the uses of repurchase agreements:
- Central bank uses these agreements to control and monitor inflation, liquidity, and money supply in an economy.
- If the central bank wants to check the rising inflation, it will increase the repo rate.
- This would raise the cost of borrowing, and in turn, the money supply in the economy will reduce.
- When the central bank wants to address a liquidity crunch situation, it would drop the repo rate. This, in turn, raises the cash flow in the economy.
- These agreements allow parties to meet their short-term capital needs.
- These agreements allow investors with surplus funds to invest their funds for the short term without taking too much risk to make a reasonable return.
Tenor of a Repurchase Agreement
Duration or the period of the repurchase agreement is termed as Tenor. Based on tenor, there can be two types of repurchase agreements:
Fixed Repo Tenor
As the name suggests, such agreements have a fixed start and end date. The tenor can be for a day, months, or up to 2 years. The agreements that mature the next day are ‘overnight repo.’
Open Repo Tenor
These agreements do not have any fixed start and end dates. This means either party can end the agreement on any future date by giving sufficient notice to the other party.
Three more types of repurchase agreements exist :
Specialized delivery repo – This agreement needs a bond guarantee at the start and maturity of the agreement. Such a type of agreement is very rare.
Held-in-custody repo – In this, the dealer stores the cash from selling the security in a custodial account on behalf of the buyer. Buyers do not prefer such agreements as they may lose access to the security of the seller if it gets insolvent.
Tri-party repo – Such an agreement involves three parties. The third party serves as a middleman/trustee/security holder between the buyer and the seller.
Risks in Repurchase Agreements
Normally, repurchase agreements are less risky instruments, but they still carry a credit risk. Credit risk in repurchase agreements depends on several factors. These factors are liquidity of the security, the credibility of the parties, terms of the agreement, and more.
The main risk with these agreements is that the seller may not keep their end of the commitment. And, thus they may not repurchase the security at maturity. In such a case, the buyer has the only option left is to liquidate the security to recover the funds advanced.
This, however, could prove risky as well because the price of the security may drop since entering the agreement. In such a scenario, the buyer would have two options. The first is to incur a loss by selling the security at less price. And second is to keep the security in the hope that its price would rise again in the future and he may be able to recover the original investment.
In a repurchase agreement, there is a risk for the seller of the security as well. The risk is if the value of the security increases by the maturity date, then the buyer may deny selling it back.
To mitigate such risks, a repurchase agreement may have some built-in features. For instance, some agreements may call for over-collateralization. So, if the value of the collateral drops, it automatically triggers a margin call. The borrower now will have to make adjustments or give another security as collateral to meet that shortfall or drop in value.
Similarly, suppose there is doubt that the buyer may not sell the security back, or there are chances that the security prices will increase after the deal in such a scenario. In that case, the parties may agree to under-collateralization of the Repurchase Agreement. That means the value of the security will be less than the agreement value.
The repurchase agreements are amongst the biggest and most active instruments in the short-term credit market. Moreover, they are a vital source of liquidity and help the government and central backs with their economic policies.