Repos (repurchase agreements) may be defined as the sale of a security coupled with an agreement to repurchase it at a higher price at a fixed future date. However, in practical terms, the sale is not a real sale, but a loan, collateralised by the security.
As such, a repo is translated into receiving financing against collateral which could be fixed income or equities alike. The liquidity and the credit risk of the underlying instrument determine the financing which can be sourced against it, also known as the “haircut”. The annualised financing rate is fixed irrespective of the underlying collateral type and it is usually set by the financial institution willing to undertake the repo transaction.
As an example, US treasuries carry a ‘ AAA’ S&P rating and trade with very narrow spreads; the bid and ask difference being indicative of the liquidity of the underlying. These bonds require a much lower haircut than Russian Federation bonds of par maturity which carry a ‘ BBB’ S&P rating and have much wider bid and ask spreads (the haircut stands at an indicative 10% vs. 30%). So, an investor that puts up US$ 1 mln worth of US Treasuries as collateral would obtain $900,000 as financing at a fixed annual interest rate versus $700,000 financing against a collateral of Russian Federation bonds of equal worth. The same variants for financing apply in the instance of equities where blue chip stocks are inherently more liquid and have lower haircuts than stocks with lower credit ratings.
A reverse repo is defined as exactly the same operation but the swap is performed from the perspective of the buyer rather than the seller. As the labeling of the direction of the repo is seen from the side of the dealer, typically, if the dealer borrows money it’s a repo while if the dealer lends money it’s a reverse repo.
Tightening regulatory changes have made the repo business less attractive for banks. During the subprime crisis of 2007-08, numerous banks cut credit lines with each other amid a sentiment of high risk aversion, which resulted to a credit crunch. Consequently, financial regulators had to adjust regulatory measures so that they could have more control of liquidity. Adjustments of two particular ratios, the net stable funding ratio (proportion of long-term assets funded by longterm funding) and the supplementary leverage ratio (measures ability to meet financing obligations) make it less attractive for banks to engage in repo activity as it became much less attractive and possible to own short-term debt. This may trigger further settlement issues as lower liquidity and fewer, available short-term debt make it difficult to get hold of sought after, more liquid paper which can lead to failed trades. Although this undermines the Fed’s goals of financial stability, regulators consider the financial system stronger overall once the constituent players are less reliant on short-term funding like repo. Due to the above dynamics, the Fed formed a foothold in the repo business equipped with a portfolio of more than $4.3 trln bonds purchased while enacting its QE monetary policy operations. It utilises reverse repo operations (RRP) to raise short term financing from money market funds, a trade which in a more flexible era was enacted much more so by banks. The growing presence of the Fed in repos portrays its pursuit to formulate new methods to regulate short-term interest rates once it starts tapering its QE. Once monetary policy is reversed and short-term rates are hiked, the Fed may utilise RRP to squeeze cash out of the financial markets. By controlling the short-term loans of Treasuries of its huge balance sheet it may manage the liquidity pumped back into the capital markets, especially as banks’ current role in the repo market is less significant.
Moreover, as banks shift to longer-term financing, non-bank entities such as hedge funds and in particular REITS (Real Estate Investment Trusts) are gaining market share in the $4.2 trln market. Such players turn to repos to boost returns given the current economic environment of low rates. By using more borrowed money, or leverage, REITS and hedge funds can take larger positions to optimise returns, a strategy which works in stable markets; of course, if the market reverses, leveraged positions translate into larger losses.
Lastly, repo financing is also playing a new role in the marketing of CLOs (Collateralised Loan Obligations) which are bonds backed by loans to companies. They consist of tranches, whereby highly rated senior slices offer lower yields versus the riskiest slices. As investors are in pursuit of higher yields they either invest in the riskier slices or invest in the most senior slices by leveraging the respective position. Banks are involved in the latter by offering repo financing to buyers of the more senior tranches. The current, stricter banking regulatory environment where banks can’t hold CLOs as assets “onbalance sheet”, encourages lending against them and making returns in this manner.
The main risk with conducting repo transactions relates to collateral management following sharp financial market swings. For instance, in a repo transaction where the dealer borrows money against collateral, a sharp market downswing in the underlying position would translate into market value losses below the secured haircut, i.e. the borrower’s position not being collateralised enough. The dealer would then face a margin call. The opposite would occur in the instance of a reverse repo situation.
The main benefit of such transactions is facilitating financing by utilising idle paper or securities and it is a form of liquidity that is easily accessible also to retail investors that wish to capitalise on buy and hold positions held in their respective portfolios. Instead of undergoing voluminous due diligence procedures on prospective business projects and collateralising fixed assets such as real estate to raise financing, employing repo transactions for liquidity is a swifter and more flexible alternative.