What are Repurchase Agreements (Repos)?

Repurchase agreement (AKA Repo)

A repo is the equivalent of a short term collateralized loan. The owner of a marketable security would sell these securities for cash - and then agree to purchase back the security at a later date, usually at a higher price than he/she sold it for. The spread between the two prices is equivalent to interest.

These are used by institutions who look for quick easy ways to make additional cash  with their current cash at little to no risk. So if  a bank had a surplus cash of £1 million, it would buy a repo, put in x buyback date and pay y for this lending as it is the buyer. The owner of the securitised assets would be selling or borrowing the cash in exchange. y is considered the equivalent of interest. To avoid the risk of the seller being unable to buy back those assets repo agreements are usually collateralised with securities with a market value in excess of the amount paid for them. As a consequence of this agreement the goals of both parties - secured funding and liquidity are achieved providing a mutually beneficial agreement.

Repos are considered generally safe investments since the security functions as collateral which explains why most repos consist of mostly U.S. treasury bonds. Repos are classified as money market instruments.

The tenor of a repo is a key factor in determining how risky of a financial instrument this is seen to be. As time progresses this means that more variables can impact on the credit worthiness of the repurchased asset. This is similiar to the factors that affect bond interest rates. 

Three types of repos

Term repurchase agreements - A dealer sells the securities to a counterparty and agree to buy them back at a higher price on a specific date. The interest rate is fixed and interest is paid at maturity by the dealer. When parties are aware of specific deadlines then this type of repo would typically be used.

Reverse repurchase agreement - this is the purchase of securities with the agreement to buy them back later at a higher price at a specific future date. For the party selling the security it is a repo for the party buying the security it is a reverse repo. This usually takes place between two banks; one has an excess of cash (beyond its capital requirements) and the other needs some cash to meet regulatory requirements. Thus the bank that needs cash will sell some securities in exchange for cash with the agreement being the bank with the surplus of cash will sell these at a later date in exchange for a higher price to account for overnight interest known as "imputed interest". If the selling bank become insolvent or does not buy the securities back the buying bank can sell these securities to get its cash back.

Open term - This is AKA a on-demand repo. It works the same way as a term expo except the dealer and counerparty agree without a specific date in mind. Instead, the parties can inform each other they wish to terminate the trade by a specific deadline per day. If this is not terminated the repo simply rolls over onto the next date. Interest is paid on a monthly basis and the interest paid is repriced based on mutual agreement. The interest rate would typically be close to the federal funds rate. These type of agreements tend to end within one - two years.

An open term repo has three further types under this type of repo, this follows:

1. A third party repo - This is when a clearing agent or bank conducts the transactions between the buyer and seller and protects the interests of each.
2. A specialized delivery repo - this is when transaction requires a bond guarantee at the beginning of the agreement and upon maturity. These are not common agreements
3. A held in custody repo - this is when the seller receives cash for the sale of the security but holds it in a custodial account for the buyer. This is the rarest type as there is a risk the seller may become insolvent and therefore the borrower may not have access to the collateral. 

Repo rate

Repo rates are set by central banks, these allow the central banks to control the money supply within an economy by changing the amount of available funds. A decrease in the repo rates encourages banks to sell securities for cash and therefore this will increase the money supply of the general economy. This is known as expansionary monetary policy. conversely, where the repo rate to increase this may tighten the money supply within a economy as banks are more likely to hold these securities.

Risks of Repo

• The largest risk is that the seller will be unable to purchase the securities back when it is meant to be sold at the maturity date. In this case, the buyer may choose to liquidate the security in an attempt to recover the cash. Over the time the security is owned the value of it may have declined since the initial sale, therefore the buyer has no choice but to sell the security at a loss. This is a double bladed sword - if the asset rises above the value the seller had sold it for the buyer may not choose to sell it back. 
• There are mechanisms that can be built into the terms to prevent the above from taking place. For instance, if it is likely that the asset may rise in value over the period the collateral may be under-collateralised to prevent the creditor not selling it back to the borrower. If it is likely that the asset may fall in value the buyer can insist the seller increases the collateralisation to ensure the party will buy back the loan. 
• Credit risk is ever present in repos too - but this tends to be dependent upon many factors including the terms and conditions, the specifics of the counterparties involved and the liquidity of the security.