Reverse Repo

The basics

There are two parties to a repurchase transaction (repo). The party that provides (sells) the collateral is doing a repo. The party that takes (buys) the collateral is doing a reverse repo.

Let's see this in a diagram:

The party buying the collateral is doing a reverse repo because the collateral is being "reversed" into its balance sheet.

The parties to the trade agree the start date, the maturity date, the collateral to be used, the amount of cash involved and interest rate that applies (repo rate).

At maturity the collateral and cash are respectively returned and repaid. The repayment of the cash involves interest. The interest amount is calculated using the repo rate and a money market calculation (Actual/360 or Actual/365):

Why do this trade?

The repo counterparty can use the trade to borrow cash, what's in it for the party doing reverse repo?

The party doing reverse repo obtains the collateral. In the event that the repo counterparty defaults on the transaction the collateral can be sold in order to obtain repayment. In this respect the reverse repo dealer has security in the form of the collateral.

One of the largest users of reverse repo transactions are central banks. They are not prepared to lend money to commercial banks on an unsecured basis because of the credit risk involved.

Reverse repo provides central banks with collateral against loans to commercial banks:

For the central bank (or any other party using reverse repo) there are still risks involved.

The main risk is default by the repo counterparty. In this case the reverse repo dealer is reliant on the value of the collateral being sufficient to repay the full cash sum and accrued repo interest.

Central banks reduce their risk by imposing restrictions on the types of securities eligible for reverse repo. These restrictions can vary depending on the central bank's objectives but normally securities used for collateral purposes need to be of the highest quality. This means they must have the highest ratings and they must be considered liquid.

The risk to the reverse repo party primarily arises from a deterioration in the value of the collateral as a result of adverse changes in credit or market risk or as a result of large differences between market buying and selling prices (illiquidity).

Haircuts

To protect itself from these risks the reverse repo party can (and frequently does) require the market value of the collateral to exceed the value of the cash involved. This is achieved by the imposition of a haircut. For example the amount of cash involved in the deal may be $9,500,000 and the market value of the collateral may be $10,000,000. In this case the reverse repo party has imposed a 5% haircut on the trade. In effect the reverse repo party is over collateralised by 5%. This 5% is designed to cushion against the possible diminution in value of the collateral should it need to be relied on.

Margin calls

Margin calls are used to maintain the haircut. If the collateral value declines the reverse repo counterparty requests (calls) for additional collateral or margin in order to maintain the haircut at the pre agreed level. Similarly if the value of the collateral increases the repo party is entitled to recall some of the collateral in order to maintain the pre-agreed haircut. This means that for both parties paying close attention to the collateral, the haircut and margin calls is essential.

First published by Barbican Consulting Limited 2010