Repo (Repurchase agreement)

Repo is an agreement in which one party sells a security to another party and agrees to repurchase it on a specified date for a specified price. In other words it is an agreement with a commitment by the seller (borrower) to buy a security back from the purchaser (lender) at a specified price at a designated future date. Repo represents a collateralized short-term loan for which, where the collateral may be a Treasury security, money market instrument, or mortgage-backed security. From the purchaser’s (lender) perspective, the deal is reported as a Reverse Repo.

So a Reverse Repo is simply the same repurchase agreement from the buyer’s viewpoint, not the seller’s. Hence, the seller executing the transaction would describe it as a “Repo”, while the buyer in the same transaction would describe it a “Reverse Repo”. So “Repo” and “Reverse Repo” are exactly the same kind of transaction, just described from opposite viewpoints.

A Repo is equivalent to a cash transaction combined with a forward contract. The cash transaction results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between the forward price and the spot price is the interest on the loan while the settlement date of the forward contract is the maturity date of the loan.

Structure and terminology

A Repo is economically similar to a secured loan, with the buyer (effectively the lender or investor) receiving securities as collateral to protect against default of the seller (effectively the borrower). Almost any security may be employed in a Repo, though practically speaking highly liquid securities are preferred because they are more easily disposed of in the event of a default and, more importantly, they can be easily secured in the open market where the buyer has created a short position in the Repo security through a Reverse Repo and market sale. By the same token, illiquid securities are discouraged. Unlike a secured loan, however, legal title to the securities clearly passes from the seller to the buyer.

The following table summarizes the terminology:

Risks

While classic Repos are generally credit-risk mitigated instruments, there are residual credit risks. Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold at the maturity date. In other words, the Repo seller defaults on his obligation. Consequently, the buyer may keep the security, and liquidate the security in order to recover the cash lent. The security, however, may have lost value since the outset of the transaction as the security is subject to market movements. To mitigate this risk, Repos often are over collateralized as well as being subject to daily mark-to-market margining. Credit risk associated with Repo is subject to many factors: term of Repo, liquidity of security, the strength of the counterparties involved, etc. Like other financial markets, Repo markets are subject to some credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on Repos from that associated with uncollateralised instruments is that Repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralisation of the Repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default. Leverage that is built up using Repos can increase these risks. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.