repurchase agreement

Repurchase Agreement (Repo)

What Is a Repurchase Agreement?

A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate. Repos are typically used to raise short-term capital. They are also a common tool of central bank open market operations.

For the party selling the security and agreeing to repurchase it in the future, it is a repo; for the party on the other end of the transaction, buying the security and agreeing to sell in the future, it is a reverse repurchase agreement.

Repurchase agreements can take place between a variety of parties. The Federal Reserve enters into repurchase agreements to regulate the money supply and bank reserves. Individuals normally use these agreements to finance the purchase of debt securities or other investments. Repurchase agreements are strictly short-term investments, and their maturity period is called the "rate," the "term" or the "tenor."1

Despite the similarities to collateralized loans, repos are actual purchases. However, since the buyer only has temporary ownership of the security, these agreements are often treated as loans for tax and accounting purposes. In the case of bankruptcy, in most cases repo investors can sell their collateral. This is another distinction between repo and collateralized loans; in the case of most collateralized loans, bankrupt investors would be subject to an automatic stay.

Term vs. Open Repurchase Agreements

The major difference between a term and an open repo lies in the amount of time between the sale and the repurchase of the securities.

Repos that have a specified maturity date (usually the following day or week) are term repurchase agreements. A dealer sells securities to a counterparty with the agreement that he will buy them back at a higher price on a specific date. In this agreement, the counterparty gets the use of the securities for the term of the transaction, and will earn interest stated as the difference between the initial sale price and the buyback price. The interest rate is fixed, and interest will be paid at maturity by the dealer. A term repo is used to invest cash or finance assets when the parties know how long they will need to do so.2

An open repurchase agreement (also known as on-demand repo) works the same way as a term repo except that the dealer and the counterparty agree to the transaction without setting the maturity date. Rather, the trade can be terminated by either party by giving notice to the other party prior to an agreed-upon daily deadline. If an open repo is not terminated, it automatically rolls over each day. Interest is paid monthly, and the interest rate is periodically repriced by mutual agreement. The interest rate on an open repo is generally close to the federal funds rate. An open repo is used to invest cash or finance assets when the parties do not know how long they will need to do so. But nearly all open agreements conclude within one 

Risks of Repo

Repurchase agreements are generally seen as credit-risk mitigated instruments. The largest risk in a repo is that the seller may fail to hold up its end of the agreement by not repurchasing the securities which it sold at the maturity date. In these situations, the buyer of the security may then liquidate the security in order to attempt to recover the cash that it paid out initially. Why this constitutes an inherent risk, though, is that the value of the security may have declined since the initial sale, and it thus may leave the buyer with no option but to either hold the security which it never intended to maintain over the long term or to sell it for a loss. On the other hand, there is a risk for the borrower in this transaction as well; if the value of the security rises above the agreed-upon terms, the creditor may not sell the security back.

There are mechanisms built into the repurchase agreement space to help mitigate this risk. For instance, many repos are over-collateralized. In many cases, if the collateral falls in value, a margin call can take effect to ask the borrower to amend the securities offered. In situations in which it appears likely that the value of the security may rise and the creditor may not sell it back to the borrower, under-collateralization can be utilized to mitigate risk.10

Generally, credit risk for repurchase agreements is dependent upon many factors, including the terms of the transaction, the liquidity of the security, the specifics of the counterparties involved, and much more.

The Financial Crisis and the Repo Market

Following the 2008 financial crisis, investors focused on a particular type of repo known as repo 105. There was speculation that these repos had played a part in Lehman Brothers’ attempts at hiding its declining financial health leading up to the crisis.11 In the years immediately following the crisis, the repo market in the U.S. and abroad contracted significantly. However, in more recent years it has recovered and continued to grow.

The crisis revealed problems with the repo market in general. Since that time, the Fed has stepped in to analyze and mitigate systemic risk. The Fed identified at least three areas of concern:12

           1) The tri-party repo market’s reliance on the intraday credit which the clearing banks provide

           2) A lack of effective plans to help liquidate the collateral when a dealer defaults

           3) A shortage of viable risk management practices

KEY TAKEAWAYS

• A repurchase agreement, or 'repo', is a short-term agreement to sell securities in order to buy them back at a slightly higher price.
• The one selling the repo is effectively borrowing and the other party is lending, since the lender is credited the implicit interest in the difference in prices from initiation to repurchase.
• Repos and reverse repos are thus used for short-term borrowing and lending, often with a tenor of overnight to 48 hours.
• The implicit interest rate on these agreements is known as the repo rate, a proxy for the overnight risk-free rate.
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