‘Repo’ is the generic term for repurchase agreements (also known as ‘classic repos’) and buy/sell-backs. These are financial instruments typically used by securities dealers and other leveraged traders to fund the purchase and holding of securities and other assets. Repo is therefore part of the wider market in securities financing (along with securities lending and borrowing).

A typical repo trade starts with a dealer buying an asset (eg a bond) in an outright purchase from the so-called ‘cash’ market. The dealer then has to borrow money to pay for this purchase, which he does by going into the repo market and selling the very asset that he has just bought outright. The proceeds from the repo sale are used to pay for the asset. However, as part of the repo transaction, the dealer not only sells the asset but simultaneously commits to buy it back from the repo counterparty at an agreed price at a future date. This is what differentiates a repo from normal (cash) trading (ie buying and selling outright). The fixed repurchase price means that, although the asset has been sold, a fall (rise) in value during the term of repo will be a loss (profit) to the seller, as he will have to buy it back at the price fixed at the start of the repo.

The repo counterparty who has temporarily bought the asset holds them as collateral (if the seller defaults on the repurchase, the buyer can sell the asset to recover her cash). However, the repo counterparty can also re-use the assets during the term of the repo: she can sell them outright, repo them or pledge them to a third party. If the repo counterparty sells the asset outright to a third party, she is taking a ‘short position’: if the asset falls in value, she will (in theory) be able to buy it back at a lower price and take a profit (in practice, it can be difficult to buy back some assets).

The price at which an asset is initially sold in a repo is usually the same price at which it is being sold outright in the cash market. However, any doubts about the liquidity of an asset (will the repo buyer be able to sell it quickly if the repo seller defaults?) or the quality of the repo counterparty may cause the repo buyer to insist on paying less than market value by deducting a discount called an initial margin (or ‘haircut’).

The price at which an asset is repurchased in a repo is equal to the price at which it was sold plus an amount of interest for the use of the cash. The amount of interest is calculated from a market-determined interest rate called the repo rate. Repo rates are lower than deposit rates like LIBOR and EURIBOR because lending cash through a repo is, by virtue of the collateral, less risky than making an unsecured loan. If an asset is strongly in demand, dealers may be willing to offer cheap cash to get hold of it in the repo market (repo rates can fall to zero or even go negative). When this happens to an asset, it is said to be special. In contrast, the normal repo rate is called the GC or general collateral rate (because there is nothing ‘special’ about the asset).

Because repo is a safer way to lend cash, lenders are willing to lend more. Cheapness and the ability to borrow more are the key attractions of repo for borrowers.

The advantage of repo for lenders is of course lower credit risk. In addition, because repo is less risky, regulations such as the Basle Accords and CAD require institutions lending through repo to hold less regulatory risk capital than unsecured lending. Consequently, there has been a major shift in liquidity from deposit markets to repo over the last 10 years.

However, the safety of repo ultimately relies on the adequacy of collateral. This requires repo players to take liquid collateral or to accept illiquid collateral only subject to appropriate initial margins and limits. It also requires that collateral is continuously revalued and, if its value falls, that extra collateral is quickly taken from the repo seller (a process called margin maintenance).

Because of the burden of operational requirements like margin maintenance, some repo players outsource the management of their collateral to agents: this is called tri-party repo.

Finally, the repo buyer needs to be sure that, in the event of a default by her counterparty, she can sell off collateral without hindrance from the other creditors of the defaulter and that her exposure to the defaulter can be reduced by ‘netting’ debts owed by the defaulter against debts owed to the defaulter. This requires legally enforceable documentation. In the international market, this is provided by the ICMA Global Master Repurchase Agreement (GMRA).

Most central banks use repo as their principal tool in open market operations to control short-term interest rates. However, these periodic official operations are not part of the repo market and, while the central bank repo rate provides a benchmark, market repo rates are determined between private institutions.


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