Thursday, December 29, 2011

Understanding "Repos", Part 1

Funny, Spiky and Eccentric?
A repurchase agreement - also known as an "RP"or "repo" - is the sale of securities combined with an agreement by the seller to buy them back at a later date.  The subsequent repurchase price being greater than the sale price, the difference represents interest or "repo rate".  The party that buys the securities is effectively a lender.  The seller is effectively a borrower, using their security as collateral for a cash loan at a rate of interest. A repo is therefore equivalent to a secured cash transaction combined with a forward contract, two legal instruments combined in one product for ease of use.  The cash transaction results in a transfer of money to the seller in exchange for legal transfer of the security to the buyer, while the forward contract ensures repayment of the loan to the buyer and return of the collateral of the seller.  The difference between the forward price and the spot (current) price is effectively the interest on the loan, while the settlement date of the forward contract is the maturity date of the loan. A repo is thus economically similar to a secured loan, with the buyer (the lender or investor) receiving securities as collateral to protect him against default by the seller (the borrower).  Highly liquid securities are preferred as they are more easily disposed of in the event of a default and, more importantly, they can be easily obtained in the open market.  Unlike a secured loan, however, legal title to the securities actually passes from the borrower (seller) to the lender (buyer).  Coupons (interest payable to the owner of the securities) falling due during the period the repo buyer owns the securities are, in fact, usually passed directly on to the repo seller.  This might seem counterintuitive, as the legal ownership of the collateral rests with the buyer during the repo agreement.  (The agreement might instead provide that the buyer receives the coupon, with the cash payable on repurchase being adjusted to compensate, though this is atypical.)  Although the transaction is similar to a loan, and its economic effect is similar to a loan, the terminology differs from that applying to loans because the seller legally repurchases the securities from the buyer at the end of the loan term.  However a key aspect of repos is that they are legally recognised as a single transaction (important in the event of counterparty insolvency) and not as a disposal and repurchase for tax purposes.  Repurchase agreements when transacted by the Federal Open Market Committee of the Federal Reserve (the "Fed") adds reserves to the banking system and then after a specified period of time withdraws them; reverse repos initially drain reserves and later add them back.  This tool can also be used to stabilize interest rates.  Under a repurchase agreement, the Fed buys securities from a primary dealer who agrees to buy them back, typically within one to seven days; a reverse repo is the opposite.  (Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint.)  If the Federal Reserve is one of the transacting parties, it is called a "system repo", but if they are trading on behalf of a customer (eg. a foreign central bank) it is called a "customer repo".  Until 2003 the Fed did not use the term "reverse repo" - which implied that it was borrowing money (counter to its charter) - but used the term "matched sale" instead. (Wikipedia)