Repo - how it works

How it works

A repo involves two parties. One party, (the seller), gives collateral, normally bonds, to the other party, (the buyer). In return the buyer pays a cash amount to the seller. The cash amount involved is based on the market price of the collateral plus its accrued interest.

The seller does a repo, the buyer a reverse repo:

The two parties also agree a maturity date and an interest rate. The interest rate is called the repo rate. On the maturity date the collateral is returned by the buyer to the seller. The seller repays the cash plus the repo interest. The repo interest amount is calculated on a money market basis (actual/360 or actual/365).

Collateral

During the repo the market risk and the credit risk of the collateral remain with the seller. But during the life of the repo, the buyer can use the collateral for further repo trades unless this is prohibited in the repo master agreement.

What is used as collateral is entirely up to the agreement of the two parties involved. It is particularly important to the buyer who will often require high quality liquid collateral. In times of market stress this means government bonds or very high quality alternatives. This is because in the event that the seller does not return the buyer’s cash, the buyer can realise the collateral in order to get repayment.

Repo trades have normally been short term (between one day and one week in maturity) but the increased use of repo by central banks to facilitate lending to commercial banks has meant longer maturity transactions.

Repo terminology

Repo transactions have their own terminology. The key terms used by this market are as follows:

The repo rate

This is interest rate that accrues on the cash involved in the transaction. The repo rate is normally fixed for the full term of the repo. It is normally lower than the rate on unsecured lending because of the reduced credit exposure for the buyer. It is not unusual to find dealers quoting slightly different repo rates for similar transactions.

General collateral

All collateral within a specific category for example US treasury bonds is known as general collateral (GC) with the exception of special collateral (see below). Repos of similar maturities collateralised with GC have similar repo rates.

Special collateral:

Repo is not only a form of collateralised lending it is also used as a way to borrow securities. Dealers need to borrow securities they have sold short. If you want to borrow a particular security you enter a reverse repo for that specific security. If the demand to borrow a particular security in the repo market is very high the cost of borrowing that security will increase.

In the repo market this translates into an exceptionally low repo rate for that security, (because cash is being lent at a very low interest rate the cost of borrowing the security is high for the buyer). When this occurs the security with is said to be "on special" or "special" collateral:

In extreme situations where the demand to borrow the security outstrips supply the repo rate can become negative. For the dealer running a short position this is very expensive. In order to borrow the security he must lend cash for a negative interest rate. In other words he pays to lend money!

Haircuts

Haircuts are agreed at the start of a trade. For example if the cash amount is $9,500,000 and the collateral value is $10,000,000 the haircut is 5%. In this case the buyer has over collateralization. If the seller defaults and the buyer seeks to liquidate the collateral in order to get repayment there is a cushion of $500,000 protecting the buyer against any loss in the market value of the collateral.

Margin Call

If the market value of the collateral alters the parties have the right to ask for a margin call. The effect of the margin call is to rebalance the value of the collateral and cash.

In practice margin calls are normally required once the security value of the collateral falls below a pre-determined threshold amount. This prevents unnecessary cash flows for small sums.

Margin calls can be settled in three different ways:

Cash settlement: The accrued interest to date is added to the original cash amount of the repo. The collateral is revalued including the accrued interest. The difference between the two values is settled in cash.
Collateral settlement: The margin shortfall is determined as above with the shortfall being covered by collateral acceptable to the buyer.
Close out settlement: The repo transaction is terminated and repo interest is paid to date. A new repo is then started using the current collateral value and the original repo rate.

Close Out

Close out means early termination of the repo. It can arise as a result of mutual agreement or by default. Close out involves calculating the accrued interest to date and any additional losses that occur as a result of any changes in the repo rate.

Substitution

Collateral substitution occurs when the seller requests return of the original collateral and offers different collateral in its place. Substitution may be permitted provided that the collateral is acceptable to the buyer the repo master legal agreement permits it.

Coupon Payments

If a coupon is paid on the collateral whilst it is on repo who is entitled to the money? The coupon will be paid to the original owner of the securities. Since the securities will be in the account of the buyer, the buyer will receive the coupon. However if a repo master agreement has been signed between the two parties it is usual that the agreement stipulates the coupon is paid by the buyer to the seller:

The coupon is sometimes referred to as a “manufactured dividend”. This is what you would anticipate because the seller has the full credit and market risk on the collateral despite the fact that it is on repo. Coupon payments lead to a fall in the value of collateral and may trigger an additional margin call.

Documentation

What is clear from the above is that repo trades require proper documentation in order to protect the rights and obligations of both parties. Repo deals between two parties are normally covered by one negotiated master agreement that is then referred to in the confirmation process. Expert legal advice should always be used in negotiating this documentation.

First Published by Barbican Consulting Limited 2010