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Repos that have a specified maturity date (usually the following day or week) are. A dealer sells securities to a with the agreement that he will buy them back at a higher price on a specific date. In this agreement, the counterparty gets the use of the securities for the term of the transaction, and will earn interest stated as the difference between the initial sale price and the buyback price. The interest rate is fixed, and interest will be paid at maturity by the dealer. A term repo is used to invest cash or finance assets when the parties know how long they will need to do so.
An open repurchase agreement (also known as on-demand repo) works the same way as a term repo except that the dealer and the counterparty agree to the transaction without setting the maturity date. Rather, the trade can be terminated by either party by giving notice to the other party prior to an agreed-upon daily deadline. If an open repo is not terminated, it automatically rolls over each day. Interest is paid monthly, and the interest rate is periodically repriced by mutual agreement. The interest rate on an open repo is generally close to the.
An open repo is used to invest cash or finance assets when the parties do not know how long they will need to do so. But nearly all open agreements conclude within one or two years. This same principle applies to repos. The longer the term of the repo, the more likely that the value of the collateral securities will fluctuate prior to the repurchase, and business activities will affect the repurchaser's ability to fulfill the contract.
In fact, counterparty credit risk is the primary risk involved in repos. As with any loan, the bears the risk that the will be unable to repay the Repos function as collateralized debt, which reduces the total risk.
And because the repo price exceeds the value of collateral, these agreements remain mutually beneficial to buyers and sellers. The most common type is a third-party repo (also known as a tri-party repo). In this arrangement, a clearing agent or bank conducts the transactions between the buyer and seller and protects the interests of each. It holds the securities and ensures that the seller receives cash at the onset of the agreement and that the buyer transfers funds for the benefit of the seller and delivers the securities at maturation. The primary clearing banks for tri-party repo in the United States are JPMorgan Chase and Bank of New York Mellon. In addition to taking custody of the securities involved in the transaction, these clearing agents also value the securities and ensure that a specified margin is applied.
They settle the transaction on their books and assist dealers in optimizing collateral. What clearing banks do not do, however, is act as matchmakers; these agents do not find dealers for cash investors or vice versa, and they do not act as a broker.
Typically, clearing banks settle repos early in the day, although a delay in settlement usually means that billions of dollars of intraday credit are extended to dealers each day. These agreements constitute more than 90% of the repurchase agreement market, which held approximately $1.8 trillion as of 2016. Like many other corners of the financial world, repurchase agreements involve terminology that is not commonly found elsewhere. One of the most common terms in the repo space is the “leg.” There are different types of legs: for instance, the portion of the repurchase agreement transaction in which the security is initially sold is sometimes referred to as the “start leg,” while the repurchase which follows is the “close leg.” These terms are also sometimes exchanged for “near leg” and “far leg,” respectively. In the near leg of a repo transaction, the security is sold. In the far leg, it is repurchased. When government repurchase securities from private banks, they do so at a discounted rate, known as the repo rate.
Like, repo rates are set by central banks. The repo rate system allows governments to control the money supply within economies by increasing or decreasing available funds. A decrease in repo rates encourages banks to sell securities back to the government in return for cash. This increases the money supply available to the general economy. Conversely, by increasing repo rates, central banks can effectively decrease the money supply by discouraging banks from reselling these securities.
Repurchase agreements are generally seen as credit-risk mitigated instruments. The largest risk in a repo is that the seller may fail to hold up its end of the agreement by not repurchasing the securities which it sold at the maturity date. In these situations, the buyer of the security may then liquidate the security in order to attempt to recover the cash that it paid out initially. Why this constitutes an inherent risk, though, is that the value of the security may have declined since the initial sale, and it thus may leave the buyer with no option but to either hold the security which it never intended to maintain over the long term or to sell it for a loss. On the other hand, there is a risk for the borrower in this transaction as well; if the value of the security rises above the agreed-upon terms, the creditor may not sell the security back. Starting in late 2008, the Fed and other regulators established new rules to address these and other concerns.
Among the effects of these regulations was an increased pressure on banks to maintain their safest assets, such as Treasuries. They are incentivized to not lend them out through repo agreements. Per Bloomberg, the impact of the regulations has been significant: up through late 2008, the estimated value of global securities loaned in this fashion stood close to $4 trillion. Since that time, though, the figure has hovered closer to $2 trillion. Further, the Fed has increasingly entered into repurchase (or reverse repurchase) agreements as a means of offsetting temporary swings in bank reserves. Nonetheless, in spite of regulatory changes over the last decade, there remain systemic risks to the repo space.
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The Fed continues to worry about a default by a major repo dealer that might inspire a fire sale among money funds which could then negatively impact the broader market. The future of the repo space may involve continued regulations to limit the actions of these transactors, or it may even eventually involve a shift toward a central clearinghouse system.
For the time being, though, repurchase agreements remain an important means of facilitating short-term borrowing.