A repurchase agreement (repo) is a type of short-term borrowing instrument that an entity, usually the government, can use to raise funds.
What a Repo is?
Repos serve the same purpose as payday loans. Financial institutions frequently do so on behalf of other businesses (such as the federal government). They are a type of money market instrument that typically matures overnight. The seller promises to repurchase the securities with interest the next day after the investor purchases it. Due to their quick maturity, repurchase agreements frequently have interest rates that are higher than those of other investment possibilities. When a company needs to raise quick cash, they may employ these agreements. On a short-term loan, the security they sell the investor serves as the security.
How do repurchase agreements operate?
A secured short-term loan with a repurchase agreement is sold by one party to another (typically a financial institution). The transaction involves the selling of securities that serve as the loan’s collateral.
The seller promises to repurchase the securities after a brief period of time when they sell the repurchase agreement to the buyer. Repurchase agreements frequently mature in a single day, but they may continue longer. Due to the short duration, repurchase agreements have higher interest rates than other securities transactions. The cost of a short-term loan is this interest, which the seller pays to the buyer.
Both parties benefit from these contracts. They first enable the seller to raise the urgently required short-term financing. The buyer will benefit from them as well because they will allow them to quickly turn a profit.
The securities that are exchanged as part of repurchase agreements, which are a component of the money market, are frequently securities with a government guarantee, like U.S. Treasury bills or bonds.
Repurchase agreements are frequently used by institutions to obtain short-term capital, but they can also be used by the Federal Reserve (commonly known as the Fed) to control the amount of money available. They might carry out this action to raise the available currency for borrowing.
Repo market operation principle
The repurchase agreement market is the financial system in which repurchase agreements are bought and sold. Every day, the repo market sells more than $3 trillion in debt securities.
Repurchase agreement lenders are frequently hedge funds and broker-dealers who manage large sums of money. The buyers of these agreements are frequently money market funds — so you could be involved in the repo market without even knowing it.
The current rate of return available to investors for overnight repurchase agreements is known as the repo rate. The New York Fed and the U.S. Office of Financial Research jointly publish the rate. In an effort to increase the repo market’s openness, they publicize these rates.
Three distinct rates are released by the New York Fed:
1. Overnight secured financing rate: This rate serves as a benchmark for the price of overnight securities.
2. Broad general collateral rate: This rate gauges the cost of overnight Treasury repo transactions involving broad collateral.
3. Tri-party general collateral rate: This rate serves as a benchmark for repurchase agreement rates between three parties. It is based on information gathered by the Bank of New York Mellon.
Types of repurchase agreements
Repurchase agreements often fall into one of three categories: third-party repo, held-in-custody repo, or specialized delivery repo.
- Third-party repo
A third party assists the transaction in a third-party repo (also known as a tri-party repo), which serves to safeguard the interests of both the buyer and the seller. The majority of buyback agreements are of this kind. In this kind of arrangement, the third party is frequently a bank; JPMorgan Chase and Bank of New York Mellon are two of the main financial institutions that support these repo transactions. They frequently keep the securities and make sure that both parties receive the money that was promised to them.
- Held-in-custody repo
In a held-in-custody repo, the securities are not delivered to the buyer of the securities. The seller keeps the securities in a custodial account at a financial institution while the buyer transfers the necessary funds for the transaction. Repurchase agreements of this kind are uncommon.
Since the seller retains ownership of both the securities and the funds for the transaction, there is a significant amount of risk for the buyer. With minimal guarantees on their end, the buyer must have faith that the vendor will fulfill their obligations.
- Specified delivery repo
Specified delivery repos are the last kind of repurchase arrangement. This form of repo is not very frequent, much like the held-in-custody repo. A bond guarantee is used in this kind of transaction when a third party agrees to guarantee the bond’s interest and principal payments. This guarantee applies to both the initial sale and the agreement’s maturity.
Repurchase agreement VS reverse repurchase agreement
A reverse repurchase agreement is the exact opposite of a repurchase agreement, in which one party sells a security with the intent to buy it back later. When one party purchases a security with the intent to resell it at a later date for a greater price, this is known as a reverse repurchase agreement (reverse repo).
It all boils down to whose party you’re referring to when you compare the terms. From the perspective of the first seller, the contract is a buyback agreement. The deal, as seen by the original buyer, is a reverse repurchase agreement.
A reverse repurchase agreement commits the party to lending money to another for a brief period of time (often a financial institution).
Repurchase agreement’s near and far legs
Repurchase agreements are frequently referred to as “legs”. When one party sells the other party the security, that is the beginning of the near leg of the trade. The maturity date, when the seller repurchases the security, is the far leg of the transaction. The near and far legs are other names for the start and close legs.