Repurchase AgreementExplained & Defined

Written By:
Adiste Mae

Reviewed By:
FundsNet Staff

What is a Repurchase Agreement?

A Repurchase Agreement (Repo) is a short-term borrowing of cash, with government security serving as collateral to buy back the same security at a price higher than the original selling price.

The timing agreement is usually on an overnight basis, and the commencement of payment of the borrowed amount or redemption of securities is on the day following the borrowing agreement.

One of the purposes a party enters into a repo agreement is to gain additional income through an implicit interest rate.

It is a repo agreement when a party is a seller of the securities with a sub-agreement to buy the same when the contract term ends.

On the other side, it is a reverse repurchase agreement if the party is the buyer, and will sell the same security back to the original seller when the contract ends.

Understanding Repurchase Agreements

A repurchase agreement is one of the less risky investment agreements because it is a collateral based-like borrowing agreement.

It is a collateral-based loan classified as a money market instrument and an interest-bearing loan agreement.

And the collateral is not just any depreciable item but government bonds that are considered highly liquid and safe investment items.

Qualified parties can enter into this type of agreement, but one of the frequent parties involved is the Federal Reserve.

It is a financial strategy to control money circulation and maintain bank reserves.

Like any other individual party, they enter into this agreement to acquire additional funds for other investment opportunities.

And this agreement is only for the short term. The other classification of maturity period is term, rate, or tenor.

The categorization of this agreement is somehow a secured type of borrowing due to the term collaterals.

But a repo constitutes an actual buying and selling of securities and grants the buyer temporary ownership.

This short-term agreement is more accurate to account as a liability account (short-term loan) applicable for taxation purposes.

There is a difference in the treatment of the collateral items in a repo and a collateral based-loan.

The seller may enter into another contract of sale to another party using the same securities as the object of the contract of sale.

While in a collateral-based loan, when a borrower is in default and can no longer fulfill to settle the loan obligation, the collateral items will remain in the lender’s custody.

Term vs. Open Repurchase Agreements

The distinction between the term and open repurchase agreement is the time difference or the period of the first sale transaction until the final sale transaction or the buyback transaction.

For example, in a repo agreement, the maturity dates or term agreements are on the day following the occurrence of the sale.

The seller or the dealer enters into a contract of sale of securities for a short term, with the sub-agreement to buy back the same at an agreed price usually higher than the first sale price.

The advantage of this agreement to the buyer is the granting of temporary ownership that could earn an interest income from the securities.

The interest is also the difference between the initial selling price and the buyback price.

A party enters into a term agreement if they are certain of the period that they need the additional cash fund.

The interest rate in this agreement is always at an agreed fixed rate.

An open repurchase agreement has the same function as a term repo,  only that there is no indication of maturity date on this agreement.

Whenever a party wants to terminate the contract, a notification is needed to the other party before the agreed daily deadline.

The interest payment is due monthly, and the interest rate undergoes a regular re-assessment.

The open repo’s interest rate is often closely similar to the federal funds rate.

The seller/dealer party enters into an open repo agreement when they are uncertain of how long they need the additional cash fund. Most of the maturity date of this agreement is a year or two.

The Significance of the Tenor

The downside of long tenors are:

• The buyer is at a higher risk of the repurchaser’s inability to pay the obligation on time.
• Fluctuation of interest rates affects the impairment of the market value of securities.

The same situation applies to a long-term contract loan, wherein the bond’s yield rate is higher when it is a long-term contract.

This situation has the same impact on the long-term repos because time has a significant impact on the market valuation of the security.

The longer the tenor is, the higher the possibility of the impairment of the investment securities. This results in the repurchaser’s capacity to fulfill the obligation to buy back the securities.

The creditor always bears the risk of loss whenever the debtor fails to pay its obligation on time in a loan contract.

On the other hand, a repo agreement has a minimal buyer risk due to the involvement of collateral-like securities.

It benefits both contracting parties because the agreed repo price is typically higher than the collateral’s value.

Types of Repurchase Agreements

The three main types of repurchase agreements are the following:

• Third-party repo (tri-party repo) – A bank act as a middle-man between a buyer and a seller, and the bank assures that both parties have fulfilled their obligations. It ensures that the buyer has paid the agreed amount and transfers back the securities when the contract ends, and the seller receives the cash when the agreement has been signed off. The bank will hold the securities until the maturity of the contract. In the United States, the clearing banks are JPMorgan Chase and Bank of New York Mellon. As the custodian of the securities, the bank should fairly apply the agreed margin. The recording of the parties’ transactions is in the bank’s book and it is obliged to help the dealer to set a relatively valuable sale price. Banks are not obliged to act as brokers, which means they do not look for dealers and interested investors. The time of clearing schedule of banks is in the early days. Whenever there is a delay in settlement, an extension of intraday credit of billions of dollars is offered to deals daily.
• Specialized delivery repo – a bond guarantee is the main requirement of this agreement. A few interest parties only enter into this type of transaction.
• Held-in-custody repo – this type of agreement is even less common than that of a specialized delivery repo. This requires the seller to keep the cash in a custodial account when it is received from the buyer. The associated risk here is the possibility of insolvency by the seller and that the buyer will no longer have an access to the collateral.

Near & Far Legs

Repo agreements contain common terms that may not be known to many. Among these, is the “leg”, which can either be the “start leg” or the “close leg”.

A start leg refers to the repo agreement’s portion that is sold initially. The subsequent repurchase refers to the close leg.

A start leg can also be referred to as the near leg, which is when the repo is sold. The close leg is also referred to as the far leg, referring to the repurchase.

Significance of the Repo Rate

The Central Bank has a primary role in setting the repo rate, which is also known as the discount rate.

Whenever the Central Banks enter into a repurchase agreement of securities from commercial banks, they use the discounted rate.

They do this practice to control the money supply in the market either to decrease the repo rate to increase money circulation or by increasing the rate to relatively decrease the money circulation in the market.

The major considerations needed to determine the full potential benefit of a repurchase agreement are:

1. Cash Payment (Initial sale transaction)
2. Agreed repayment price
3. Implied interest rate

The amount of cash payment in the initial sale transaction and the agreed repayment price depends on the marketable value of the investment securities.

In the case of bond securities, parties must consider the clean price and the bond’s accrued interest amount.

Implied interest plays a major role in the calculation of the repo agreement.

If the implied interest is unfavorable for the dealer, it may not be a good idea to enter into this agreement just to acquire additional funds.

The formula to calculate the real rate of interest is:

Interest rate = [(future value/present value) – 1] x year/number of days between consecutive legs

The interest rate can be used as a comparison tool to accurately distinguish if it is more beneficial for a party to enter into a repurchase agreement than the other funding methods.

The advantage of a repurchase agreement is that it provides a secured type of borrowing as it involves securities as collateral, as compared to any other lending agreement.

From the perspective of the party entering into a reverse repo agreement,  it can benefit from receiving additional income using its excess cash in this agreement.

Risks of Repo

One mitigating factor of a repurchase agreement is for the buyer to sell the collateralized securities to other interested investors whenever the original seller is in default and unable to repurchase the security on its maturity.

The sale proceeds from the securities will then be the settlement payment for the defaulted party.

A repo agreement burdens the buyer with an inherent risk of the fluctuating market value of securities.

From the initial sale of the securities, its value may decrease and cause a long-hold even if it’s not the agreed term to countermeasure a possible loss.

Or sometimes, buyers even sell the securities at a loss.

The risk for the borrower is that it may not be able to repurchase the security, and the creditor will not allow it when the security’s market value increases above the agreed terms.

The other mitigating factor in terms of possible risk involved in the repurchase agreement are:

• When there is a fluctuation in a security’s market value due to over-capitalization, the creditor may ask for a margin call for the amendment of the securities involved.
• To mitigate the risk, the parties under-collateralize securities when it is evident that the creditor may not be able to sell the securities back to the borrower due to the high rise of their market value.

Factors affecting the credit risk for repurchase agreement are:

• Term of transaction
• Securities liquidity rate
• Other related factors of both parties, etc.

The Financial Crisis and the Repo Market

There was a financial crisis in 2008 where a specific type of repo, which was the focus of interest of many investors.

Repo 105 was used by Lehman Brothers in the concealment of its true financial standing.

A significant downfall in the U.S repo market continued in the succeeding years, but it gradually recovered and continued its positive performance in the market.

The crisis revealed a huge issue in the repo market in general.

As such, the Fed found three major concerns and mitigated the risk.

1. The reliance on the intraday credit provided by the clearing bank in a tri-party repo agreement.
2. Lack of countermeasures whenever the dealer is in default.
3. Lack of risk management planning.

The Fed imposed new rules to decrease the possibility of risk such as incentivizing banks for holding on to and keeping safe their safest assets, which are Treasuries.

Since then, the world has seen an increase in the use of reports and has even closed in at $4 Trillion in late 2008.

To mitigate the fluctuations in the market, the Fed has entered into various repurchase agreements to prevent the upswing of bank reserves, no matter how temporary it might be.

While the risks have been mitigated, there are still inherent systemic risks present in the market.

There is also the risk of default of a major dealer which could negatively impact the repo space and result in a fire sale.

Regulations are imposed and updated regularly to prevent the risk of dealers’ default and to achieve a possible central clearing house system.

Currently, the repurchase agreement remains to have a significant role in providing an effective short-term borrowing transaction.