What is the repo market
The Repo Market
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.Source: wfhummel.cnchost.com