Checklist Description
This checklist outlines how the repos market works.
Definition
A repo, or repurchase agreement, is an agreement between two parties whereby one party sells the other a security at a specified price with a commitment to buy the security back at a later date. A repo is economically similar to a secured loan, with the buyer receiving securities as collateral to protect against default. Virtually any security can be used as a repo: treasury and government bills, corporate and government bonds, and stocks or shares can all be used as securities to back a repo. Although the transaction is similar to a loan, it differs in that the seller repurchases the legal ownership of the securities from the buyer at the end of the agreement. Also, while the legal title to the securities passes from the seller to the buyer, coupons that are paid while the repo buyer owns the securities are normally passed directly to the repo seller.
Repos are contracts for the sale and future repurchase of a financial asset, normally treasury securities. The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration, but are most commonly overnight loans, or overnight repos. Repos longer than this are known as term repos. There are also open repos, which can be terminated by either side on a day’s notice. The lender normally receives a margin on the security, meaning that it is priced below market value, typically by 2% to 5%, depending on maturity. Repos are normally not for the smaller investor: in the primary market dealers frequently transact hundreds of millions of dollars, and in the secondary market repos of one million dollars are not uncommon.
The Federal Reserve Bank also uses repos in its open-market operations as a method of fine-tuning the money supply. To expand the supply of money temporarily, the Federal Reserve arranges to buy securities from non-bank dealers, which deposit the proceeds in their commercial bank accounts, thereby adding to reserves. The repos usually last 1 to 15 days, or whatever length of time the Federal Reserve needs to make the adjustment. When it wishes to reduce the money supply, it reverses the process using a “matched sale purchase transaction”: it sells securities to dealers, who either draw on bank balances directly or take out a bank loan to make the payment, thereby withdrawing reserves.
Advantages
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Repos allow investors to keep surplus funds invested without losing liquidity or incurring price risk or credit risk because the collateral is more often than not in high-class securities.
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Repos can be used for investing surplus funds in the short term, or for short-term borrowing against collateral. Corporations can use repos to help manage their liquidity and short-term financing of their inventories.
Disadvantages
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Overnight changes in interest rates or currency fluctuations can affect the value of a dealer’s securities holding, and a dealer who holds a large position takes a risk.
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Repos are normally not for the smaller investor: in the primary market dealers frequently transact hundreds of millions of dollars, and in the secondary market repos of one million dollars are not uncommon.
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The seller could default on his or her obligation and fail to repurchase the securities.
Action Checklist
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What type of repo are you buying, and in which international market? Will risk and return be affected by currency fluctuations, credit risk, the type and liquidity of the security, or third-party involvement?
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Does the securities dealer have a special repo account at a clearing bank to settle his or her trades?
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Primary dealers must be authorized by the Federal Reserve Bank to bid on newly issued treasury securities for resale on the markets.
Dos and Don’ts
Do
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Check on any repos in equity securities. Complications can arise sometimes because of greater complexity in the tax rules on dividends.
Don’t
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Don’t fail to check on the credit risk associated with the repo, i.e. type and liquidity of security, other parties involved, etc.
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