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The Repo Market
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The over-the-counter repo market
is now one of
the largest and most active sectors in the US money market. Repos
are widely used for investing surplus funds short term, or for
borrowing
short term against collateral. Dealers in securities use repos to
manage their liquidity, finance their inventories, and speculate in
various
ways. The Fed uses repos to manage the aggregate reserves of the
banking system.
What are Repos?
Repos, short
for repurchase agreements, are contracts for the sale and
future
repurchase of a financial asset, most often Treasury securities. On the
termination date, the seller repurchases the asset at the same price at
which he sold it, and pays interest for the use of the funds.
Although
legally a sequential pair of sales, in effect a repo is a
short-term
interest-bearing loan against collateral.
The annualized rate of interest
paid on the loan
is known as the repo rate.
Repos can be of any duration but are most commonly overnight
loans.
Repos for longer than overnight are known as term
repos. There are also open
repos that can be terminated by either
side on a day’s notice. In common parlance, the seller of
securities does
a repo and the lender of funds does
a reverse. Because money is the
more liquid asset, the lender normally receives a margin on the
collateral,
meaning it is priced below market value, usually by 2 to 5 percent
depending
on maturity.
The overnight repo rate normally
runs slightly
below the Fed funds rate for two reasons: First a repo
transaction
is a secured loan, whereas the sale of Fed funds is an unsecured
loan.
Second, many who can invest in repos cannot sell Fed funds. Even
though the return is modest, overnight lending in the repo market
offers
several advantages to investors. By rolling overnight repos, they
can keep surplus funds invested without losing liquidity or incurring
price
risk. They also incur very little credit risk because the
collateral
is always high grade paper.
Repos are not for Small
Investors
The largest users of repos and
reverses are the
dealers in government securities. As of June 2008 there were 20
primary dealers recognized by the Fed, which means they were authorized
to bid on newly-issued Treasury securities for resale in the
market.
Primary dealers must be well-capitalized, and often deal in hundred
million
dollar chunks. In addition there are several hundred dealers who
buy and sell Treasury securities in the secondary market and do repos
and
reverses in at least one million dollar chunks.
The balance sheet of a government
securities dealer
is highly leveraged, with assets typically 50 to 100 times its own
capital.
To finance the inventory, there is a need to obtain repo money in large
amounts on a continuing basis. Big suppliers of repo money are
money
funds, large corporations, state and local governments, and foreign
central
banks. Generally the alternative of investing in securities that
mature in a few months is not attractive by comparison. Even
3-month
Treasury bills normally yield less than overnight repos.
Clearing Banks and Dealer Loans
A securities dealer must have an
account at a clearing
bank to settle his trades. For
example,
suppose ABC company has $20 million to invest short term. After
negotiating
the terms with the dealer, ABC has its bank wire $20 million to the
clearing
bank. On receipt, the clearing bank recovers the funds it loaned
the dealer to acquire the securities being sold, plus interest due on
the
loan. It then transfers the sold securities to a special
custodial
account in the name of ABC. Since government securities exist as
book entries on a computer, this is a trivial operation.
The next morning the dealer
repurchases the securities
from ABC, pays the overnight interest on the repo, and regains
possession
of the securities. Assuming a 5% repo rate, the interest due on
the
$20 million overnight loan would be $2,777.78, which is based on a
360-day
year. If both parties agree, the repo could be rolled over instead of
paid
off, thus providing another day of funds for the dealer and another day
of interest for ABC.
If the dealer is short on funds
needed to repurchase
the securities, the clearing bank will advance them with little or no
interest
if repaid the same day. Otherwise the bank will charge the dealer
interest on the loan and hold the securities as collateral until
payment
is made. Since dealer loans typically run at least 25 basis
points
above the Fed funds rate, dealers try to finance as much as they can by
borrowing through repos. By rolling over repos day by day, the
dealer
can finance most of his inventory without resorting to dealer
loans.
It is sometimes advantageous to repo for a longer period, using a term
repo to minimize transaction costs.
Clearing banks charge a fee for
executing dealer
transactions. They prefer not to issue large dealer loans because
it ties up the bank’s own reserves at little profit. In truth,
there
is not enough capacity in all of the clearing banks in New York to
provide
dealer loans sufficient to cover the financing needs of the large
securities
dealers.
Matched Books in Repos
A dealer who holds a large
position in securities
takes a risk in the value of his portfolio from changes in interest
rates.
Position plays are where the largest profits can be made. However
many dealers now run a nearly matched book to minimize market
risk.
This involves creating offsetting positions in repos and reverses by
“reversing
in” securities and at the same time “hanging out” identical securities
with repos. The dealer earns a profit from the bid-ask
spread.
Profits can be improved by mismatching maturities between the asset and
liability side, but at increasing risk.
As dealers move from simply using
repos to finance
their positions to using them in running matched books, they become de
facto financial intermediaries. In borrowing funds at one rate
and
relending them at a higher rate, a dealer is operating like a finance
company,
doing for-profit intermediation.
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