The Infamous word “Repo.” How could there be an entire market for this kind of thing. However, this is not short for “Repossession” as it is when the hard money lender or car lot takes back your vehicle when you are too late on payments. No, here it means “Repurchase.” The Repo market is a short-term lending market involving the trading of various types of securities to the magnitude of literally trillions of dollars every day. Even by just its shear magnitude, explaining the repo market is necessary for understanding the plumbing of the global financial system, but its fundamental importance to the liquidity of all financial markets makes even more so.
What is the Repo Market?
The primary use of the repo market is to provide short-term liquidity in fixed-income markets by allowing financial institutions to trade their securities (i.e., government treasuries) for cash. Even though repos are sometimes thought of as collateralized loans, with the security as the collateral, they are called repurchase agreements for a reason. The securities are sold with the promise that they will be repurchased at a higher price on a specific date. With multiple types of transactions possible, this market has been quoted to trade between $2 trillion to $4 trillion each day[1] with overnight triparty repos being over $1 trillion alone[2].
As you can imagine with the nature of this market, counterparty risk is the name of the game. If a commercial bank is going to lend hundreds of billions of dollars overnight, and it needs to be repaid by the next day, the default risk of your counterparty is a major consideration. It is for this reason that the repo market is a great indicator of liquidity problems because you can see how the major financial institutions are pricing counterparty risk in real time, due to the fact that most of the transactions are overnight and so dependent on counterparty risk.
Naturally, with market participants such as hedge funds, commercial banks, money market funds, etc., the Federal Reserve must be involved as well, and they are. The Fed actually participates in the repo market as a way to conduct monetary policy. Just another way for them to influence the supply of treasuries and agency securities as well as set a floor for fed funds with their ON RRP rate.
How does it work?
Before we go too far in depth on how the repo market works, we need to clarify the different types of repurchase agreements possible. There are two main segments of the market that depend on who is participating in the transaction. These two segments are self-explanatory, being referred to as bilateral repo and tri-party repo. Bilateral repo consists of a collateral provider (provides/sells the security) and a cash investor (buys the security/ provides cash). In bilateral repo, the two parties agree on the terms of the trade themselves and conduct the transaction through a securities dealer as shown above. However, in triparty repo, the contracts settle on the books of the clearing bank where the cash and securities are held in the participants account.
For the terms of the transaction itself, we have the principal amount, the “interest” to be paid, the type of securities to be used as collateral, the maturity of the repo, and the haircut applied for the pledged collateral. As can be seen, repos are similar in structure to collateralized loans (they are actually treated as such in terms of taxes and accounting). However, there are some differences in the meaning of each of these aspects.
Fortunately, the principal here holds the same meaning as it does for a normal collateralized loan. It is just the amount of cash borrowed from the lender. If the interest rate were 0%, your principal would be the amount you needed to pay.
The interest for a repo transaction, however, is different from that of a typical loan. Since repos are repurchase agreements, the interest is calculated through an auctioning process. When a repo transaction is opened, there is a transfer of cash from the cash investor to the collateral provider. For example, if a hedge fund is the cash investor and a commercial bank is the collateral provider, then to open the transaction cash would move from the hedge fund to the commercial bank and the security would move from the commercial bank to the hedge fund. This is all done at the agreed upon sale price of the security. However, to close the repo transaction, the commercial bank must repurchase the security from the hedge fund. This price paid to repurchase the security is what is determined through the auctioning process, and the difference between this repurchase price and the sale price defines the interest on the repo transaction.
Types of collateral
Above is a bar graph of the different types of securities that are used as collateral in triparty repo transactions. As can be seen, U.S. treasuries are the most prominent security used followed by Agency MBS. Agency securities are those issued by government entities or government sponsored enterprises. In the case of Agency MBSs, these are mortgage-backed securities (MBS) that are issued by Freddie Mac, Fannie Mae, or Ginnie Mae. Considering that triparty repos are about 80% of the overall repo market, Agency MBSs and U.S. treasuries comprise of the majority of the repo market, but it is important to note that other agency backed securities, corporate bonds, equities, and other securities are involved as well.
Maturity
The final characteristic that is similar to a collateralized loan is its maturity. For a usual term repo, the date of repurchase is agreed upon at the time of the initial transaction. Normally this specific date is the next day, but it does not have to be. As can be seen below, the majority of triparty repos are overnight. The gray line is the daily volume of all triparty repos (of any maturity), and the black line is the daily volume of overnight repos. With the spread between the two lines being small relative to their overall magnitude, it seems like overnight repos comprise of 85% to 90% of all daily repo transactions.
However, not all repo transactions have maturity dates. There are open repo agreements (aka on-demand repos) where there is no maturity date for the repurchase. In the case of an open repo, the trade can be ended by either party by giving notice before it is agreed upon daily deadline. If not terminated, the agreement rolls over each day where the interest is paid monthly and is periodically repriced.
Haircuts
The final characteristic and one that differentiates between repurchase agreements and collateralized loans is the haircut of the agreement. Since the securities used as collateral in repurchase agreements are also traded in open markets, their prices can fluctuate throughout the duration of the agreement. So, to protect themselves from a serious decline in the value of the underlying collateral, the cash lenders will require overcollateralization. By providing more collateral for the agreement, the securities are discounted from their actual market value, this discounting is what is referred to as the haircut.
How is the Fed Involved?
Recall how the difference between the repurchased price and the sale price is the interest paid for the repo. Is there an entity that we know has a direct interest in controlling the interest rates of fixed income securities? Yes, the Federal reserve. The Fed is the lender of last resort in the repo market where they essentially set the bottom for the amount of interest that would be paid in a repo agreement. This is where their ON RRP rate (Overnight Reverse Repurchase Agreement rate) comes into play. The Fed uses the repo market to set the floor of the fed funds ranges for entities that are not eligible to hold reserve balances at the Fed as well as control the money supply (bank reserves in the banking system).
Now, the rate for repo transactions with the fed is the REVERSE repo rate, so what exactly is a reverse repo? A repo and reverse repo are referring to the same transaction, just from different perspectives. For the party originally selling the security (the one who repurchases it later) this is just a repo, however for the other party that is originally buying the security, therefore selling it in the future, this is a reverse repo.
So, by using reverse repos, the Fed gives cash (or bank reserves) for the treasuries held by the institutions in the repo market. Cash goes to the institution, treasury goes to the fed. Upon repurchase, the treasury is sold back to the institution, who then pays the fed more for the security (the interest from the repo). Therefore, reverse repos with the fed as a counter party effectively decrease the money supply, especially if the institution is a commercial bank and their cash is bank reserves. The amount of bank reserves in the system decease. If the roles were switched, and the fed did a regular repo transaction, then the amount of bank reserve in the system would increase because they would be the one paying the interest to the institution.
A necessary clarification of how repos with the fed affect the amount of bank reserves in the system. In the opening of the repo agreement, where the fed purchases the security from the institution, bank reserves go into the system. Therefore, money supply has temporarily increased. However, when the repo agreement is closed (when the fed sells the security back to the institution with interest), more bank reserves left the system than were added in the first place, inducing a net loss of bank reserves in the system.
The Fed does all of this with their Overnight Reverse Repurchase facility which is used by the Federal Open Market Committee (FOMC). When an institution uses this standing repo facility, it deposits bank reserves at the fed overnight in return for a security. The next day, the institution sells the security back to the fed with interest where the maximum amount of interest is the ON RRP rate. Under normal circumstances, the auctioned rate for the security will be equal to the ON RRP offered rate because any counterparty to the facility should be unwilling to invest funds overnight at a rate below the ON RRP. This is because the Fed is considered to counterparty with the least default risk since they can “print” the currency their obligations are denominated in.
A final note on the Fed’s involvement in open markets. Whenever the fed purchases securities in the open market, that decreases the supply of those securities available to the public, therefore, the price of those securities increase. This therefore drives their yields down, suppressing the interest rates on said securities.
Final Words
As a massive short-term lending market, the repo market provides liquidity to the financial system which is required for dollars to be able to flow and the system to function. If there is a liquidity crisis, meaning that dollars stop moving within an institution or even the financial system as a whole, entities need those dollars but are unable to receive them, leading to many defaults and bankruptcies. If this market seizes up, it is analogous to the engine in a car seizing up. Considering the sheer magnitude of the repo market and the entities that call it their playground, if this engine seizes up, the many countries involved are going to have a very, very bad day, to say the least…
To your wealth and future,
James Forsythe
For more comments on the Repo market
https://jamesdforsythe.com/the-federal-reserves-monetary-policy-regime-limited-and-ample-reserves/
For more on the banking system
https://jamesdforsythe.com/category/finance/banking-system/
[1] https://www.investopedia.com/terms/r/repurchaseagreement.asp
[2] https://www.brookings.edu/blog/up-front/2020/01/28/what-is-the-repo-market-and-why-does-it-matter/
[3] SIFMA Research US Repo Fact Sheet, January 2021
[4] Reference Guide to U.S. Repo and Securities Lending Markets, V. Baklanova, A. Copeland, R. McCaughrin, Federal Reserve Bank of New York Staff Reports, no. 740, September 2017; revised December 2015
[5] https://www.federalreserve.gov/econres/notes/feds-notes/the-dynamics-of-the-us-overnight-triparty-repo-market-20210802.htm
