INTRODUCTION

A repurchase agreement is a financing transaction executed when a holder of securities sells them to an investor and simultaneously agrees to repurchase them at the same dollar price on a specified future date. The difference between the sale price and the subsequent repurchase price represents interest over the period. In effect the seller of the securities is borrowing funds from the buyer and repaying the loan when the securities are repurchased. The term repo is used to describe the transaction from the perspective of the borrower or seller of the securities. The lender of the funds or purchaser of the securities initially is engaging in a reverse repurchase agreement (reverse repo). Repo transactions can alternatively be viewed as the economic equivalent of secured loans, where the seller of the securities is in effect borrowing funds from the buyer and pledging the securities as collateral. However, despite some economic similarities, repurchase agreements differ from secured loans as repos feature title transfer of collateral from the seller to the buyer. In contrast, a secured loan typically operates under a pledge structure in which the borrower retains ownership of the securities upon which the lender retains a lien. Another key difference between repos and secured loans is that repos are generally exempt from stay under the bankruptcy code. That means in an event of default, such as the failure of the seller to repurchase the collateral on the repurchase date, the buyer may endeavor to sell the collateral to recoup the monies owed without having to wait for permission of the bankruptcy court.

The rights and other obligations of buyers and sellers are usually detailed in a governing legal document called a master repurchase agreement (MRA).¹ A single properly executed MRA may be used to govern any number of transactions between a buyer and a seller and allows bespoke terms and conditions, including the security descriptions, purchase and repurchase prices, and transaction dates, all of which are required to be evidenced in written confirmations between the parties. Together, the MRA and confirmations constitute conclusive evidence of the agreed terms between the buyer and seller unless specific objection is communicated promptly after receipt of the confirmation.

In a repo agreement the two participants engaging in the transaction are known as counterparties. The securities and other assets underlying the transaction are called the collateral. On the settlement date, the selling counterparty will deliver securities to the buying counterparty, who in turn will deliver cash proceeds to the seller. The cash proceeds delivered at settlement are called the repo principal. The repo rate is the interest rate charged and used to determine the cash proceeds due back to the buyer on the repurchase date, also known as the maturity date. On this date, an unwind process occurs in which the seller returns the cash proceeds with accrued interest and the buyer returns the collateral.

Repo trade tenors represent the length of time between the start and maturity of repo transactions and tend to be short term, but the bespoke nature of repo transactions allows deals to be structured for almost any tenor. Trades structured to mature in one business day are referred to as overnight repos. Trades structured with fixed tenors of more than one day are known as term repos. Term trades of one week to one year are the most common, but longer terms are quite possible. Alternatively, counterparties might not establish a predetermined maturity date for a repo transaction. This type of transaction is terminable on demand, and is often referred to as being placed on open. When a trade is on open, on a daily basis the counterparties may agree to extend the maturity an additional day or allow the trade to mature. Trades placed on open allow counterparties to transact in a series of overnight repos without incurring the costs and risks associated with delivering securities back and forth.

An additional nuance with term repo trades involves the periodic income distributions on the underlying collateral, including coupon payments, bond amortization payments, and dividends. Typically the MRA dictates that these payments will be remitted to the seller as though the repo transaction had not occurred. These payments normally decrease the value of a security, as in the case of amortizing bonds, and will require additional collateral be posted to maintain the loan‐to‐collateral value ratio.

MECHANICS OF A REPO TRADE

To illustrate the mechanics of a repo transaction, suppose a hedge fund owns $10 million par of U.S. Treasury securities (T)2.50 2/15/2046, and would like to use this security as collateral to obtain repo financing from March 10 to March 29. A repo dealer quotes a repo rate of 53 basis points, which the hedge fund accepts.

On the settlement date of March 10, the two counterparties will agree on the current market price of the bond and use it to calculate the repo's principal value. Assume on March 10, the security has a price without accrued interest of 95.625. To calculate the purchase price or repo principal,

or

As the seller, the hedge fund will deliver $10 million par value of T 2.50 2/15/2046 to the repo dealer, who, as buyer, will deliver cash proceeds of $9,562,500 to the hedge fund.

On the maturity date of March 29, the trade will unwind. The repo dealer will return the collateral and the hedge fund will deliver the original proceeds plus accrued interest to the dealer. To calculate the repo interest, or price differential:

or

The repurchase price the hedge fund owes to the dealer is therefore

An important aspect of calculating interest is the day‐count convention. U.S. dollar–denominated repo transactions, like other dollar‐denominated money market instruments, follow an actual number of days/360 day‐count convention rather than a 30/360 day count. Day‐count calculations normally follow the standards and practices based on the currency underlying the transaction. For example, while USD repos follow an actual/360 approach, British pound sterling and Canadian dollar transactions use an actual/365 convention.

MARGINING TRADES

A key risk to the buyer in a repo trade is the potential for the value of the collateral to decline substantially in a short period of time. For example, a buyer could make a $100 million loan collateralized by $100 million worth of bonds. If the value of the bonds decreased by 10% before the maturity of the trade and the seller defaulted, the buyer would not be able to sell the collateral in the market at a price high enough to recover the purchase price.

To protect themselves, buyers often require repo transactions to be margined. Margin, commonly known as the haircut, involves the seller providing collateral valued greater than the cash proceeds. Collateral underlying a trade is marked to market on a daily basis. Shortfalls can result in a margin call, which are met with the delivery of cash or additional collateral. This helps ensure that in the event of a seller default, the buyer holds ample collateral that can be sold at prevailing market prices to recoup the original repo principal.

Margin is typically quoted as a percentage applied to the collateral. The margin percentage is set based on several factors: credit quality, volatility, and liquidity of the underlying collateral. Lower‐quality, highly volatile, illiquid securities will be subject to the largest haircuts while haircuts on high‐quality, less volatile, highly liquid securities will be far less. For example, agency pass‐through mortgage‐backed securities, such as Fannie Mae or Freddie Mac issues, might require a 5% haircut while riskier mortgages such as private‐label whole loan collateralized mortgage obligations (CMOs) might require more than a 10% haircut. Trade tenor can also factor into the margin rate, with longer maturities requiring higher haircuts. Additionally, the credit rating of the selling counterparty might affect margin rates. All things being equal, a buyer might require more margin from a highly leveraged hedge fund than from a highly rated, well‐capitalized bank.

Additive Approach

The additive approach is the industry convention and preferred method among repo market practitioners. This approach adds the quoted margin percentage to a 100% value of the collateral to determine the total market value of securities required for given repo principal. For example, if a buyer requires a 5% haircut on a trade, a seller will need to provide collateral worth 105% of the repo principal. Alternatively, a buyer who demands a 7% haircut would need the seller to deliver securities worth 107% of the value of the repo principal.

where

or for mortgages,

When a trade does not require margin (i.e., has a margin rate of 0%, the repo), principal is equal to 100% of the market value of the collateral.

To demonstrate, suppose an investor wanted to obtain $50 million of financing using the agency debenture FNMA 1.125 10/29/18 with a market price of 99½ as collateral. The buyer requires a 2% haircut. Using equation (1) to determine how much of this bond is needed yields:

To generate repo principal of $50 million against this issue, a buyer would require the seller to deliver $51,257,000 par to properly collateralize the repo transaction.

The previous example showed how much of a given security would need to be delivered to meet a specific repo principal. Now suppose an investor owns a bond and would like to know how much repo principal would be generated by financing the entire position. This equation can be rearranged algebraically to determine the repo principal using a given amount of a security as collateral by

For example, suppose the investor owned $25 million par of the FNMA 1.125 10/29/18 from the previous example, again with a market price of 99½. The buyer now requires a 5% haircut. Using this equation the investor can determine the repo principal attainable using this agency debenture as collateral. Specifically,

Subtractive Approach

Occasionally, market participants subtract the margin percentage from the collateral value to obtain the repo principal. For example, if the haircut is 5%, the loan will be for 95% of the collateral's market value.

where

or for mortgages,

For example, if an investor wanted to use $50 million face of a bond priced at 100, and the haircut was 2%, these bonds would support a repo principal of

The appeal of this method is its simplicity. However, as stated earlier the market convention is to use the additive approach. An additional consideration is that each approach results in a different repo principal. All things being equal, sellers will get greater leverage using the additive approach. Using the previous collateral example of the FNMA 1.125 10/29/18 with a market price of 99½, we saw that the repo principal of $50 million required $51,257,000 in par with a 2% margin rate. If the subtractive approach is applied, the same par amount of securities would yield repo principal of $49,980,700:

This is almost $20,000 less than the result obtained from the previous method. In fact, to obtain repo principal of $50 million desired in the first example would require $51,277,000 in par. Table 9.1: displays the different outcomes of the two approaches using a 5% margin rate and bond prices at premiums, par, and discounts. In each case the repo principal is greater using the additive approach.

Subtractive Approach
Par	100,000,000	100,000,000	100,000,000
Price	99.00	100.00	101.00
5% Margin	0.95	0.95	0.95
Loan	94,050,000	95,000,000	95,950,000
Additive Approach
Par	100,000,000	100,000,000	100,000,000
Price	99.00	100.00	101.00
5% Margin	1.05	1.05	1.05
Loan	94,285,714.29	95,238,095.24	96,190,476.19
Difference	235,714.29	238,095.24	240,476.19

MARKET PARTICIPANTS

While repo market participants may have unique needs, they can generally be grouped into several categories: natural buyers (cash providers), natural sellers (cash users), those who both buy and sell, those focusing on specials trading (providing and sourcing specific securities), and finally, the Federal Reserve, which will be discussed in a later section.

Natural buyers include a wide range of cash‐rich investors with short‐term investment horizons and low risk tolerances. Such investors are willing to accept relatively low yields compared to other money market instruments to obtain the additional safety provided by repo collateral. Natural buyers include money market funds, asset managers, pension funds, insurance companies, government‐sponsored entities (GSEs), corporations, and municipalities. For example, the maximum weighted average portfolio life for a money market fund is currently 60 days.² Short‐term instruments such as repos are often a natural fit.

While natural buyers use repos as a safe place to invest cash on a short‐term basis, natural sellers use repos to achieve low‐cost funding. By providing collateral and executing repos with short tenors, sellers often achieve favorable financing costs compared to longer‐term and unsecured financing alternatives. Natural sellers include hedge funds, asset managers, and real estate investment trusts (REITs). Such investors often employ financial leverage to increase portfolio returns and repo markets often provide such leverage. Conversely, natural buyers such as money market mutual funds and corporate treasurers utilize the repo market to maximize their return on short‐term cash.

Financial intermediaries, particularly securities broker‐dealers, often engage as both sellers and buyers in the repo markets. For example, a broker‐dealer may use repos to obtain low‐cost financing for its securities inventory and to fund its operations. At the same time, broker‐dealers may perform reverse repos as a way of providing clients financing for securities purchases. To obtain the financing needed to make these loans, the broker‐dealer will simultaneously use the collateral obtained in reverse repo transaction as collateral on a new repo trade. This is known as running a matched book. Similar to broker‐dealers, large banks will engage in both lending and borrowing in the repo markets (and often through the banks' own securities dealer). Eager for revenues, a bank will provide financing as a client service. At the same time, that bank may be borrowing in the repo markets as a tool to manage its own internal liquidity.

While it is intuitive to understand the borrowing and lending of securities to manage cash requirements, market participants also access the repo markets to borrow securities to meet specific needs. The most basic of these needs is borrowing specific securities to cover shorts. Traders often sell securities they do not own for a multitude of reasons. For example a trader may expect the price of a bond to go down and therefore sells it with the intention of buying it back when the price decrease materializes. A market maker may be short because of customer orders. A corporate bond trader may short a benchmark Treasury to hedge the interest rate risk associated with a long corporate bond position. Similarly, a swap dealer may short a Treasury bond to hedge a swap position. Regardless of the reason for the short, the ultimate purchaser on the other side of the trade expects delivery. The repo market provides a deep, highly liquid venue for traders to cover short positions. A detailed discussion follows in a later section, “General Collateral and Specials.”

RISKS ASSOCIATED WITH REPO TRANSACTIONS

There is a common misperception that because repo transactions are collateralized, they are considered risk free. Although collateral provided by the seller mitigates risk to the buyer, it does not entirely eliminate it. A broad understanding of risks inherent in repo trades as well as tools available to reduce the risks is therefore essential.

DELIVERY CONVENTIONS

An additional facet of a repo transaction involves the delivery method of the cash and collateral. The distinction between delivery methods divides the repo market into two broad segments: the bilateral repo market and the tri‐party repo market.

Tri‐Party Repo

A second segment of the repo market, and one used heavily by the broker‐dealer community to finance inventories, is tri‐party repo. As its name suggests, three parties are involved (Figure 9.2). The first two are the buying and selling counterparties, while the third party, which is typically a large clearing bank,⁹ acts as a custodian on their behalf. In a bilateral repo, actual delivery of cash and securities is made between the buyer and seller. In a tri‐party trade, the counterparties maintain custodial cash and securities accounts at the clearing bank. Rather than make the physical delivery of cash and securities to each other, the cash and securities remain under the custody of the clearing bank, which upon matching instructions from the buyer and seller makes internal transfers between the respective accounts of the two counterparties.

Tri‐party repo offers several advantages to participants. To begin, the custodian offers a layer of protection to both counterparties while providing a range of services. Clearing banks involved as custodians typically have the infrastructure in place to gain operational efficiencies. Services provided include collateral pricing, calculating daily markings to market, margining trades, and ensuring collateral posted meets the guidelines stated the master repurchase agreement's collateral schedule.¹⁰ A key advantage stemming from the clearing bank's infrastructure is the ability for sellers to use smaller denominations as collateral on a trade. For example, if a dealer held $100 million in bonds, but in issue sizes of $1 million, bilateral repo would be operationally challenging, especially for overnight repos. Each bond would need to be priced to calculate repo principal before 100 individual bonds could be delivered. But using a tri‐party trade, this issue is trivial since the clearing bank is able to quickly price the securities, calculate principal, and allocate collateral within the trade parameters. Another advantage of tri‐party repo is that instead of actual delivery, an internal journal entry on the books of the clearing bank is made. Since physical deliveries of securities are not made in a tri‐party trade, transactions costs are lower than in a bilateral repo. Furthermore, the risk of failing to deliver is eliminated since collateral remains with the custodian.

In addition to standard tri‐party, a second tri‐party product is available to participants in the inter‐dealer broker market called general collateral finance (GCF) repo. The GCF service is operated by the Fixed Income Clearing Corporation (FICC),¹¹ which guarantees settlement of trades upon notification. Unlike a standard tri‐party where the buyer and seller are known to one another, GCF trades anonymously, or blind. Further, collateral types are restricted to securities that settle on the Fedwire Securities Service, and each asset class trades using a unique CUSIP. A key advantage of GCF is the ability to net trades. For example, a dealer could sell $1 billion in Treasury GCF in the morning and repurchase $750 million Treasury GCF in the afternoon. The positions would net, leaving the dealer with an exposure of $250 million in Treasury GCF. This allows dealers flexibility in managing their positions.

GENERAL COLLATERAL AND SPECIALS

The repo markets play a unique and crucial role in the U.S. Treasury market, providing not only a way to finance positions, but a way for investors and traders to obtain specific Treasury issues. Often, counterparties engage in a transaction to be collateralized by Treasuries where both the buyer and seller are more interested in the asset class as opposed to specific issues. In this case, the counterparties are said to be trading general collateral (GC). Market participants frequently use the term GC rate when referring to financing rate for Treasury securities. GC refers to any Treasury bond, note, or bill, but excludes TIPS and STRIPS. Further, participants can deal in “under‐ten” GC, meaning any Treasury with a maturity of less than ten years remaining.¹² The reason for the distinction is that bilateral trades are done in par values as opposed to market values. Since long‐term bonds can trade at large premiums, it is possible for a seller to deliver a bond worth well beyond what the buyer was expecting. Imagine a trade for $1 billion and the seller delivers a bond with a price of 145‐00. The loan would be for $1.45 billion when the expectation was for $1 billion in loan proceeds. Additionally, some tri‐party schedules place higher margin rates on longer‐duration bonds. Buying a bond to put in a tri‐party could require the buyer to post more collateral than received in the bilateral trade if there is a margin mismatch.

An active market also exists for the borrowing and lending of specific Treasury issues. Traders will often sell bonds they do not own, which is known as shorting a bond. Delivery of the bond to the end buyer is still expected, and the U.S. Treasury imposes a steep penalty fee on sellers who fail to deliver bonds to buyers as a way of ensuring a sound and functioning Treasury market.¹³ Traders that need a specific issue are often willing to lend cash at below‐market rates in order to obtain the desired bond. That bond develops a scarcity value. When this happens, the bond is said to trade special, called on special or simply special. Rates in the specials market are highly dependent on the supply‐and‐demand dynamics for a particular issue, and can range from a couple of basis points below the GC rate to several percentage points below the GC rate. Demand for a particular bond might cause that bond to trade at negative rates in the specials market, meaning buyers will pay the seller simply to obtain that specific issue. It is important to understand that the more special a bond, the lower the repo rate for that bond since from an economic viewpoint the buying counterparty is willing to provide financing at lower rates to obtain the special bond.

The most heavily traded issues in the specials market tend to be the current on‐the‐run benchmarks and the most recent off‐the‐run issues.¹⁴ Traders and investors often prefer these benchmarks for their liquidity and duration characteristics. These issues are shorted for a number of reasons. For example, a corporate bond trader might short benchmark Treasuries to hedge interest rate risk of the trading book. A corporate Treasury might short a bond ahead of a debt issuance to lock in a rate. An asset manager might short a particular benchmark Treasury to change the duration of a fixed‐income portfolio. In each of these cases, the short position will need to be borrowed.

The supply and demand of a special will affect the rate. Benchmark issues often follow the Treasuries auction cycle, with specialness increasing over time. This is because with the passage of time, the benchmark issues slowly become part of longer‐term portfolios that may not necessarily be willing to lend the bond. This decreases the supply and increases the specialness. Alternatively, current market sentiment expecting interest rates to rise and bond prices to fall might result in larger short positions. This will increase the demand to borrow those shorted bonds, increasing the specialness of a bond.

DETERMINANTS OF REPO RATES

Several dynamics affect repo rates. Some are systemic, affected by the overall rate environment, and others are specific to an individual transaction. It is imperative that market participants understand the drivers of repo rates.

AVAILABILITY OF COLLATERAL

Collateral plays an essential role in the repo markets. Often, counterparties favor, or are possibly required to have, certain types of collateral. For example, a municipality with idle cash in its operating account may only be able to accept Treasuries as collateral versus a loan, or a bank may prefer to hold Treasuries on its balance sheet to meet regulatory requirements such as HQLA minimums. Because of these preferences, repo rates can be impacted by supply‐and‐demand functions of the underlying collateral. Decreases in the supply of collateral and increases in demand for collateral tend to decrease the repo rate on that collateral asset class. This is because investors buying collateral are in effect lending money. To meet specific collateral needs, these participants are willing to lend money at lower rates in exchange for the desired collateral, driving down the rate in the process. An example of this dynamic is Treasuries that trade special because of a large number of short positions. Sometimes a large volume of Treasury GC is traded in tri‐party transactions. Since collateral in a tri‐party trade is not rehypothecated as it is in bilateral trades, this removes GC supply and occasionally creates shortages. When the repo rate drops sharply due to a shortage of available collateral, repo market participants call this a collateral squeeze.

THE FEDERAL RESERVE AND REPO

The Federal Reserve often implements monetary policy by conducting open‐market operations utilizing repo and reverse repo facilities. Its purpose is to influence the level of reserves, or liquidity in the financial system, consistent with the targeted fed funds rate mandated by the Federal Open Markets Committee (FOMC). As discussed previously, higher levels of money supply lead to lower interest rates while lower levels lead to higher interest rates. To achieve the FOMC fed funds target, the Open Markets Trading Desk at the Federal Reserve Bank of New York will execute repos or reverse repos to increase or decrease liquidity to the banking system. The Federal Reserve adds money to the system using its repo facility, and removes money using the reverse repo facility. Some clarity needs to be given to the language chosen by the Federal Reserve. For example, when the Fed announces that it will conduct a repo operation, it is actually the Fed's counterparty that is doing the repo. Thus in a Fed repo, the Fed buys collateral and sells cash. In the same way, when the Fed announces a reverse repo, the counterparty is actually buying (reversing in) securities sold by the Fed. This use of terminology can be confusing, and market participants must understand what action is actually being done by the Federal Reserve.

REPO AND BOND CARRY

The interest rate carry, which is the difference between the accrued coupon and the financing expense, is an important factor in determining the price of a bond. The daily carry can be expressed as

where

and

For the trader, the profit or loss on a particular trade will be the difference between the purchase price and the sale price, plus the total carry earned over the holding period.

In an upward‐sloping yield curve environment, the coupon on the bond is typically higher than the overnight repo rate used to finance the bond. This leads to positive carry. If the financing cost is higher than the accrued coupon, it is referred to as negative carry. Negative carry can also occur when a trader takes a short position by selling a bond he or she does not own. In this case, during the period when the trader is short the bond accrues daily coupon interest that will need to be paid when the short is covered. This cost is offset since the trader will be able to take the proceeds and lend them at the overnight repo rate.

To demonstrate, suppose on January 13, 2016, a U.S. Treasury trader buys $100 million face of the T 2.25 11/15/2025 for a dollar price of 101‐12.¹⁶ The purchase is financed by selling the collateral in the repo market at an overnight repo rate of 35 basis points. The following day, the trader sells the bonds outright at a price of 101‐13. Given these details,¹⁷ the profit can be calculated and attributed to price change and carry on the trade. First, since the bond is held and financed overnight, the daily carry can be calculated as

so that daily carry equals

Adding the daily carry to the profit from selling the bond for a 1/32 of a point increase in price gives a total profit on the trade of

As can be seen, carry comprises almost 15% of the total P/L on the trade.

Now suppose a trader takes a short position and sells a bond not held in inventory. If the trader fails to deliver the bond to the buyer, the trader is exposed to a penalty fee.¹⁸ To avoid this, borrowing the bond using a reverse repo covers the short position. Assume on January 15, 2016, a trading desk sells short $100 million original face of the T 1.125 1/15/2019 at a price of 100‐04. The bond trades special and can be borrowed at a repo rate of 15 basis points. The next business day, January 19, 2016,¹⁹ the desk covers the short outright by purchasing the bonds at a price of 100‐02.

On the settlement date, the purchaser will pay for the bonds and the desk will receive proceeds of

Simultaneously, the desk will borrow the bond using a reverse repo and loaning the cash proceeds at an overnight rate of 15 basis points. The following day, the purchase to cover the short settles. Simultaneously, the reverse repo will unwind and the desk will receive the loan proceeds plus accrued interest. These proceeds will be used to pay for the bond purchased outright, which in turn will be delivered to the counterparty that lent the bond. The flows can be seen as follows.

For the interest earned on the reverse repo,

For the purchase of the bond, principal and accrued interest equal

Note that the accrued coupon interest on the sale is lower than the accrued coupon interest on the purchase by $3,090.66. In the first example when the trader was long the bond for one day, the trader earned the coupon interest. However, in the case of the short sale, the buyer on the other side of the short sale earns the coupon interest, which effectively is paid by the short seller. The short does benefit somewhat. Instead of paying interest to finance a bond, the short is able to use the proceeds to lend and earn interest. But since the yield curve is upward sloping, and the bond shorted traded special, the interest income from the reverse repo was less than the accruing coupon interest, resulting in negative carry of

The negative carry, added to profit from the change in price, gives the short sale a final profit of

CONCLUSION

Repurchase agreements are an effective tool for participants in the short‐term markets. Counterparties in need of financing are able to source liquidity by selling assets in the repo markets to cash‐rich investors in need of short‐term investments. Additionally, those in need of specific securities to deliver against short positions are often able to borrow those issues in the repo specials markets. Furthermore, the Federal Reserve often implements monetary policy by conducting open‐market operations utilizing repo and reverse repo facilities.

The future of repo markets will be closely tied to changes in the regulatory environment following the financial crisis of 2008. Rules such as the net stable funding requirement will require many participants to shift their financing from short‐term instruments such as repo into longer‐term debt. Regulations designed to shrink bank balance sheets such as the supplemental leverage ratio could result in less appetite to allocate balance sheet to low‐yielding short‐term assets. While these changes may reduce the size of the repo markets, repurchase agreements will still play an important role in finance.

For more, see Securities Industry and Financial Markets Association, Master Repurchase Agreement, http://www.sifma.org/services/standard‐forms‐and‐documentation/mra,‐gmra,‐msla‐and‐msftas/.