Backround
When I was running a treasury, repo agreements, or repurchase agreements, were very instrumental in the type of work we were doing. For example, from time to time, we were running short positions, which involved selling bonds that we didn’t own.
To facilitate the short position, it meant borrowing a bond to make delivery to the person who had actually bought the bond. However, that’s not the only place where we came across and used repo agreements. We also used them to take advantage of very good rates for borrowing money.
How did that work? Well, it worked by taking a bond that we had and lending it out in order to borrow cash. The bond acted as a form of collateral. In return, we sometimes obtained a very low interest rate on the borrowing, predominantly because the bond was in demand in the repo market.
When interest rates in the repo market are on special, they are very low and, in some cases, can even be negative. What this means is that you can take your bond, if it’s on special, use it in a repo, give the bond to a second party, and they provide you with cash in return. As a result, you get the cash at a very low, advantageous interest rate.
From two points of view, the repo transaction is very important. It allows you to cover short positions and also to borrow money. More recently, we’ve seen repos extensively used by central banks. When banks want to borrow money from the central bank, the central bank requires some form of collateral.
The central bank lends money to the commercial bank, and in return, the commercial bank provides collateral, which indeed is a type of repo transaction. The commercial bank gives bonds or assets to the central bank, which then provides cash or a more liquid asset like a treasury bill to the commercial bank. The transaction has a start date, an end date, and a repo rate. In the UK, this repo rate is generally known as the bank base rate, and in Europe, simply as the repo rate.
Again, this is very important for lending money to the financial markets and, from time to time, to drain money from the financial markets, where the bank enters into reverse repos. In a reverse repo, the central bank actually takes cash out of the system by providing bonds to commercial banks. In return, the commercial banks provide cash to the central bank.
Now, as you’ve probably realised, it's a very simple transaction. It’s really a form of collateralised loan. But it also means that there are a number of risks involved. If you're involved in treasury and financial markets, you'll appreciate that risk is a much bigger subject today than it was a few years ago.
So, I decided to write this article, entitled "Exploring the Ins and Outs of Repurchase Agreement Risks", really to give you a little bit of insight into the risks associated with repo transactions. Here's the article:
Understanding the Risks of Repurchase Agreements
The repurchase agreement, commonly known as a repo, plays a vital role in the money market by facilitating short-term borrowing and lending. Yet, despite its ubiquity and importance, many remain unaware of the underlying risks it poses to both parties involved. This article aims to delve deeper into the intricacies of repo trades, shedding light on the potential hazards for both buyers and sellers.
Structure of a Repo Trade
At the heart of a repo trade are two parties: the seller and the buyer. The 'seller' is the entity that hands over collateral, usually in the form of securities, and receives cash at the beginning of the trade. Conversely, the 'buyer' receives this collateral and provides the cash. The fundamental understanding is that the seller will eventually repurchase the securities at a predetermined price.
Risks Encountered by the Seller
Market Risk:
The seller commits to repurchasing the securities at a predetermined price. Thus, any market-driven fluctuations in the value of those securities become the seller's responsibility. If the market value drops, the seller incurs a loss.
There's also the risk associated with the repo interest rate. Suppose market repo rates decline after sealing the deal. In that case, the seller might end up paying an interest rate higher than the prevailing market rate.
Margin Call Risk:
In a scenario where the value of the collateral drops significantly, the buyer may issue a margin call to the seller. This means the seller is required to provide additional cash or collateral to the buyer to maintain the agreed-upon levels of collateralisation. Not only does this introduce a sudden liquidity demand for the seller, but it also intensifies the seller's exposure to market fluctuations.
Credit Risk:
The onus to repurchase the securities also means the seller retains credit risk associated with those securities throughout the repo term.
The seller can face credit risk from the buyer, especially if the deal has been over-collateralised due to a 'haircut' or if the collateral's market value has risen.
Risks Borne by the Buyer
Market Risk:
A default by the seller means the buyer must liquidate the collateral to recover the funds. If the collateral's value has decreased, the buyer might face a shortfall. This is why buyers often apply 'haircuts' and require margins to protect themselves.
Secondary market risk emerges if the repo rate increases after the deal. The buyer would then receive a rate that's below the current market rate.
Credit Risk:
The buyer's primary risk is the potential default of the seller, especially concerning the principal and interest of the repo. In such cases, the collateral is the buyer's primary route to repayment, emphasising the importance of assessing the collateral's quality and its credit risk correlation with the seller.
Liquidity Risk:
Some collateral may be challenging to sell due to its illiquid nature. Such assets are less appealing to buyers, often prompting them to seek larger haircuts to buffer against this risk.
Foreign Exchange Risk:
When the collateral and the cash in a repo deal are denominated in different currencies, there's a risk tied to currency fluctuations. Should the need arise to rely on the collateral, its value might be inadequate if the exchange rate has moved unfavourably.
Conclusion
Repos, while essential in maintaining the liquidity and flow in money markets, are not devoid of risks. Both buyers and sellers must be astute in their assessments, ensuring they are well-protected against potential pitfalls. Understanding these risks is the first step towards navigating the intricate world of repurchase agreements safely and effectively.