What is a Repo?

What is a Repo?

“Repos” is the shorthand term for “sale and repurchase agreements”, or simply “repurchase agreements”. The two species of repos are the “classic repo” and the “buy/sell back”.

The majority of repos are very simple structures. One party sells an asset to another for immediate delivery, and simultaneously with selling the asset, the selling party commits to buy back the same type of asset for a different price at a later date or, in the case of a so-called “open repo”, when one of the parties exercises its right to terminate the transaction. Party A sells a security to party B for 100 in cash and commits to buy back the same type of security in one week for 101. During the week, party A --- the repo seller --- has the use of the cash and party B --- the repo buyer --- has use of the security. If party A fails to pay cash at the end of the repo, party B can sell the security off to try to recover his cash. If party B fails to deliver the required security, party A can use the cash to try to buy the security back from a third party.

What is the legal structure of a repo?

A repo can be defined as “a sale of a quantity of an asset & a simultaneous agreement to repurchase the same quantity of an equivalent asset at a later date or on demand for the original value plus a return on the use of cash”.

What is meant by “equivalent”? Other legal agreements use comparable phrases such as “same or similar” or “substantially the same”. What they all mean is that the securities repurchased at the end of a repo must be part of the same issue as those sold at the start but they do not have to be precisely the same individual securities. The word “equivalent” is included in the definition of a repo in order to ensure that we can demonstrate that there has been an effective transfer of legal title to the collateral.

The purpose of selling collateral in a repo is to avoid the problems associated with pledges. By selling collateral and transferring legal title to the cash lender from the very start of a transaction, it should be possible to avoid being sucked into the insolvency process should the cash borrower default. As owner of the collateral, the buyer in a repo should be able to liquidate without interference.

What are the economics of a repo?

If the market value of the collateral falls during the repo, the seller takes the loss. On the other hand, if the market value of the asset rises during the repo, the seller will take the profit. The buyer is hedged against the risk on the collateral by the seller’s repurchase commitment. It does not matter what is driving the change in market value, whether it’s supply and demand, or a default by the issuer of the collateral.

The fact that the seller keeps the risk and return on collateral in a repo is critical. It means he can buy an asset in order to take the risk and earn the return on it and can use repo to fund his purchase without losing his exposure. This characteristic is what makes repo a financing tool. The seller can use repo just to borrow cash and the buyer can use repo just to lend cash. The buyer is not investing in the collateral, which is just there to hedge his risk. The fact that the seller in a repo keeps the risk and return on collateral means that anything affecting the value of collateral should impact the seller only.

How is the repo accounted for?

The collateral given in a repo does not leave the balance sheet of the seller. For example, the seller in a repo has 100 of bonds on the asset side of its balance sheet and the buyer has 100 of cash. They then do a repo for 10 of cash against 10 of collateral. The cash is deducted from the buyer’s balance sheet and replaced by a receivable representing the repayment due from the seller. The cash reappears on the asset side of the seller’s balance sheet and is balanced by an increase in its debt. However, no bonds disappear from the seller’s balance sheet and reappear on the buyer’s balance sheet.

What steps have the US repo market taken?

In 1984, a US court ruled, in the case of a defaulting firm called Lombard Wall, that the repos they had transacted were secured loans and not title transfers. In response, the US market tried to stem this “recharacterisation risk” by publishing the first standard repo legal agreement, the Master Repurchase Agreement or MRA.

This states that repo is a title-transfer instrument but includes a fall-back provision to the effect that, if a court disagrees about title transfer, the repo will become a pledged instrument. In order to overcome the two key problems of pledging, the US market secured a statutory exemption of repo collateral from the US Bankruptcy Code and, in the MRA, the seller gives the buyer the right to use the collateral during the repo.