The most common and popular format for secured lending with securities or money is the repo transaction. What is this, let's try to figure it out from the very beginning. Repurchase Agreement (REPO, REPO) is a securities borrowing agreement guaranteed by cash. The situation may be reversed when securities are the guarantor of borrowed funds . A repurchase agreement is often referred to as a securities repurchase agreement. The agreement defines the opposite obligations for each of the parties: it is a sale and a purchase.
Types of REPO
There are two formats for repos: forward and reverse. A direct agreement determines the sale of securities by one party to the other. At the same time, it is agreed that the first party will buy back its securities in a timely manner and at a pre-agreed cost. Buyback will be carried out at a cost an order higher than the primary. The difference between the selling price and the purchase price of a package of securities reflects the profitability of this transaction. It is expressed in annual percent and is called the repo rate. The main objective of the implementation of direct agreements is to attract financial resources.
Reverse repurchase involves the acquisition of a package of documents and the adoption of obligations for its reverse sale. The main purpose of the agreement is to temporarily allocate free financial resources.
The economic essence of operations
Against the background of other manipulations with securities, the most popular is the repo operation. What it is from an economic point of view is quite obvious. One side acquires such financial resources necessary for it in the partnership process , while the second completely eliminates the lack of securities. Plus, the second side receives interest for the temporary use of its tangible assets. Transactions for the most part are conducted with government securities and are confined to the category of short-term arrangements. The contract governs partnerships lasting from several days to several months. In world practice, daily contracts are most often concluded. Securities transactions are concluded between the seller and the buyer through an intermediary. In the majority of situations, a banking institution acts as a third party, the duties of which are detailed in the contract. The situation provides for the opening of securities and cash accounts with an intermediary bank. An arrangement in which three parties are involved is less risky.
REPO and lending
If you look at repos generally, it can be called a modification of lending secured by valuable property. The only difference is that the transfer of securities and the receipt of funds on hand are carried out at the same time. The instant transfer of ownership from one party to the contract to another is another feature that a repo transaction has. What is it, we’ll try to figure it out in more detail, considering the stages of partnership.
REPO includes two stages:
- Initial purchase or sale of securities.
- Buyback or sale of securities.
The specifics of the implementation of the stages of the agreement
The time difference between the implementation of the first and second parts of the agreement is called the repo term. The time interval between manipulations is usually measured in calendar days. The countdown begins the day after the parties fulfill their obligations and ends on the day the second part of the agreement is implemented. Each of the parties is in the role of the buyer, and in the role of the seller. Quite often, the original buyer of securities is referred to as the lender, and the original seller is called the borrower. Securities investment transactions for the first seller have the direct repo format, the buyer sees the manipulation in the form of a reverse repo. The securities that are the subject of the agreement are referred to as either the underlying asset or collateral. REPO transactions associated with the provision of a loan secured by securities are valued at the repo rate.
Contract risks
Risk is a mandatory component, without which no repos are possible. What is it and what risks are typical for an agreement? Let's figure it out in order. The main dangers are related to the fact that the second stage of the agreement may not be implemented. There is a high probability that by the time of the buyback the seller will not have the same papers in his hands, and the buyer will have no funds. Help in such situations can be both bankruptcy and seizure of accounts. As an option: as a result of changes in the market situation, one of the parties may simply refuse to fulfill its obligations, pursuing its own benefit.
Repo risk mitigation
To reduce the risks of default of one of the parties, the purchase and sale of securities must be accompanied by the following points:
- Discounting collateral.
- Commitment needs to be overestimated.
- It is important to exercise systematic control over the adequacy of collateral.
- Making margin (compensation) contributions.
The discount in relation to repurchase transactions is a value that characterizes the market price of collateral in accordance with the size of existing liabilities at a certain point in time and throughout the partnership period.
The first part of the repo is estimated taking into account the primary value of the discount, which is determined by agreement between the parties when concluding a transaction. It is worth paying attention to the following:
- A higher discount value provides a good benefit for the buyer who receives security at a lower cost.
- The lower the initial discount, the more advantages the seller receives who offers collateral at a higher cost.
It can be concluded that the primary discount reflects the relationship between the collateral price and the value of obligations acceptable to each of the repurchase parties under the first part of the agreement.
Change in value of collateral for repos
Until the implementation of the first part of the repo, the cost of the obligation in most situations remains unchanged. Only collateral is subject to change, and even then insignificantly, in connection with a temporary delay in the execution of the contract of 1-3 days. At the same time, during a direct repo transaction with a term of 3 months or more, the price of both liabilities and collateral may change significantly. The following factors will affect the development of events:
- The dynamics of market value.
- Repo transaction income growth.
- A change in the discount compared to its initial cost, which will cause one of the parties to incur significant losses.
Compensation Contribution Mechanism
The mechanism of compensatory contributions can eliminate a probable situation. It is activated by concluding an agreement on the marginal indicators of discount: maximum and minimum. Throughout the entire repo term, the MICEX trading system conducts a daily reassessment of the value of liabilities and the price of collateral, and controls its adequacy.
If the value of the collateral is underestimated, and its preliminary assessment is overestimated, one of the parties is forced to make a compensatory contribution in order to eliminate the losses of the second side. It can be expressed both in securities and in monetary format. In this situation , the repurchase agreement is slightly modified. The obligations of one of the parties in the second part of the transaction are reduced. If, if necessary, a compensatory contribution is ignored by a party, it becomes necessary to implement the second part of the contract ahead of schedule. The compensation contribution mechanism helps maintain a balance between collateral and liabilities. He can become the initiator of the early fulfillment of obligations under the contract.
History tour
Active bank operations under a repo scheme in the bond market began to be practiced for the first time back in 2003, after the adoption of the relevant legislative act. During the periods of the economic crisis, which bloomed in all its glory in 2008, the significance of two operations - direct and reverse repos - has changed. They began to have a higher weight as the dominant instrument for ensuring the liquidity of a crumbling banking system. It is worth noting that, at certain times, the main, and sometimes the only, liquidity provider, starting in 2008, is the Central Bank of the Russian Federation. This fact was also successfully confirmed by the fact that the results of direct repo auctions of 2008 and 2009 clearly indicated the Central Bank as a liquidity provider.
The role of the Central Bank of the Russian Federation in repurchase agreements
Financial institutions are actively using the active operations of REPO Bank to maintain that very liquidity. This is evidenced by the fact that most of the agreements are concluded no more than a day. Transactions lasting from 3 to 7 days at a rate of 9.22-12.4% per annum are extremely rare. In the person of the buyer of bonds in the first part of the agreement and the seller in the second is almost always the Central Bank of the Russian Federation. It is the bank that determines the circle of participants for transactions after a preliminary consideration of applications.
The role of collateral or basic issues of bonds may be the bonds themselves, belonging to the category of securities, any other securities that are included in the Bank of Russia Lombard List. An advantage of the agreements can be called the fact that they are characterized by an individual tax regime. This makes manipulation almost the most effective lending mechanism.