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2. How is repo used?
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Repo performs four basic functions which are fundamental to the efficient working of many other financial markets (see question 3).
  1. One party can invest cash and earn interest against the security of the asset provided as collateral --- safe investment.
  2. The counterparty can borrow cash in order to finance a long position in the same asset, in amounts and at prices that reflect the security provided to the lender --- cheap borrowing.*
  3. One party can earn a return by lending out an asset that is in demand in the market, in exchange for cheap cash, which can be used for funding or reinvested for profit (see question 12) --- yield enhancement for securities investors.
  4. The counterparty can borrow an asset in order to cover a short position (see question 28) --- short-covering.**
For lenders of cash (repo buyers), repo offers a safe investment because:
  • The buyer receives collateral to hedge his credit risk on the seller.
  • The buyer can diversify his credit risk by taking collateral issued by a third party whose credit risk is uncorrelated with the credit risk of the seller.
  • Collateralisation can not only reduce the credit risk arising from lending but can also mitigate the liquidity risk. Where a buyer is given liquid collateral, he can meet any unforeseen need for liquidity during the life of the repo by selling the collateral to a third party, either through another repo or an outright sale (he would, of course, subsequently have to buy the collateral back in order to be able to return it to repo counterparty at the end of the repo).
For borrowers of cash (repo sellers), repo offers a cheap and potentially more plentiful source of funding, because the collateral they provide to the lenders (repo buyers) reduces the risks to the latter.

For lenders of securities (repo sellers), repo offers a means of generating incremental income, as in the securities lending market (see question 12).

For borrowers of securities (repo buyers), repo offers an alternative or supplement to the securities lending market, particularly for fixed-income securities.

Central banks use repo to conduct routine monetary policy operations and to provide emergency liquidity to the market in times of crisis. Repo mitigates their credit risk and connects them to an active interbank repo market through which liquidity can be efficiently redistributed to other banks and non-banks.

Although repo can be used to finance standalone long positions in a security or to cover standalone short positions, it is often used to fund and cover positions that have been created to hedge, arbitrage or trade against opposite positions in another security or in a derivative such as an interest rate swap or bond future. Repo consequently plays a pivotal role in the accurate pricing and smooth functioning of almost all financial markets.

Repo is essential in the primary securities market. It allows dealers to fund their bids at bond auctions and underwriting positions in syndicated bond issues at reasonable cost, as well as to hedge their underwriting risk by taking short positions, thereby providing cheaper and less risky access to the capital markets for issuers. In the secondary securities market, market-makers need repo to fund their inventory and, where there is no inventory or it has been exhausted, to cover the temporary short positions created by sudden customer purchases. Repo also helps to overcome settlement failures caused when securities to be delivered to one customer or other counterparty are being sourced by a delivery from another but the inward delivery is late, perhaps because of operational errors or market infrastructure inefficiencies. The security can be borrowed in the repo market until it arrives from the second customer or counterparty.

* A long position in an asset is created by buying the asset outright. The holder benefits from price rises and the accrual or payment of income on the asset.

** A short position in an asset is created by borrowing the asset and selling it outright. The holder will have to buy back the asset in due course in order to return it to the asset lender. This means he will benefit from a fall in the price of the asset between selling it and backing it back, but will lose the income.

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