Unit
- Definition: A repurchase agreement, or repo, is a short-term borrowing arrangement where one party sells securities to another with a promise to repurchase them at a later date at a slightly higher price, functioning as a collateralized loan.
- Mechanics: The transaction involves two legs: the initial sale of securities for cash and the subsequent repurchase at a predetermined price, which includes interest.
- Cash vs. Securities: The cash provider lends money and receives securities as collateral; the securities provider borrows cash and relinquishes securities temporarily, with ownership transferring.
- Economic equivalence: Economically, a repo is equivalent to a secured loan where the securities serve as collateral, with the interest rate embedded in the price differential between sale and repurchase.
- Haircuts: Lenders typically apply a haircut, or margin, to the collateral value to protect against market fluctuations, requiring collateral worth more than the cash loaned.
- Maturity: Repos are typically overnight but can extend to longer terms (term repos), providing flexible short-term funding and liquidity management.
- Reverse repo: From the perspective of the cash provider, the transaction is a reverse repo, as they are lending cash and receiving securities as collateral.
- Market significance: The repo market is a cornerstone of the global financial system, facilitating liquidity, enabling leverage, and serving as a key instrument for monetary policy implementation.
- Collateral types: Eligible collateral includes government bonds, agency securities, mortgage-backed securities, and sometimes corporate bonds or equities. Higher quality collateral like Treasuries commands lower haircuts and rates due to lower risk of default.
- Tri-party repo: In a tri-party repo, a third party such as a clearing bank handles collateral valuation, custody, and settlement. This arrangement streamlines operations, reduces counterparty risk, and allows more efficient allocation of collateral among multiple trades.
- Default and close-out: If the borrower fails to repurchase, the lender can sell the collateral to recover the loan amount. Any surplus after sale is returned to the defaulting borrower, while any shortfall remains the borrower's obligation, reinforcing the secured nature of the loan.
- GC vs. specials: General collateral repos trade at the prevailing market rate for broad types of collateral, while special repos involve specific, in-demand securities and trade at lower rates. The spread between them signals scarcity in the underlying security.
Regulatory Requirement
Regulation: SEC Rule 2a-7 under the Investment Company Act of 1940 governs money market funds' participation in repos.
Money market funds are major participants in the repo market. Rule 2a-7 imposes limits on the maturity and concentration of repo investments to ensure liquidity and stability. Additionally, the Federal Reserve's repo operations influence short-term interest rates and market liquidity via open market operations.
Quick Revision
- A repo is a collateralized short-term loan using securities as collateral.
- The transaction involves a sale and repurchase at a higher price.
- Cash lenders apply haircuts to mitigate price risk.
- Repo maturities range from overnight to term.
- Reverse repo is the opposite perspective from the cash provider.