Updated July 15, 2023
Definition of Repurchase Agreement
A repurchase agreement (famously known as “repo”) is a type of borrowing agreement entered into between two or more parties generally for a short period of time ranging from overnight up to a year, and under such agreement, the dealer offers the securities with a pre-defined agreement to repurchase the same securities at a set maturity date.
Explanation
- A repurchase agreement is between two parties to “repurchase” the assets sold to the buyer. Such an agreement ensures that the asset will return to the seller at a specific date.
- Say, you have an asset & you sold it to Mr. A for $ 1000 with a repurchase clause of 110%. After 1 year & you receive $ 1000 from Mr. A. You will have to pay $ 1100 after 1 year to “repurchase” the said asset.
- What technically has been done here is a loan is provided under the transaction for the sale of the asset. One year hence, the seller of assets pays for the principal plus interest on such borrowing. Such borrowing secures since the asset buyer holds ownership for the loan period.
- The repurchase agreement has different maturity periods as required under the agreement. The normal maturity period is within a year, called “term repos”. However, repurchase agreement with more than 1 year of maturity is called “open REPOs”.
Features of Repurchase Agreement
- There is a huge premium in such a market.
- Open REPO demand for daily renewal since the contract is carried out until canceled by either of the parties.
- The interest rate offers at a lower level than what offers for an unsecured loan.
- The lender accepts only high quality securities as collateral since the interest rate is lower.
- However, the lender still exposes to default risk from the borrower. Even if the high-quality asset is given as collateral security, the lender may not recover the full amount due to the depreciating nature of securities.
- In case of the borrower defaults, the lender has to suffer from huge haircuts in the selling price of collateral assets.
- The repo rate changes as per the type of security offered.
How Does It Work?
- A trader (i.e., the seller of security) offers to sell a specific security (i.e., the asset) to Mr. A (i.e., the buyer of security) for an agreed price.
- The seller provides a clause in the agreement to repurchase the asset after a certain period at a pre-determined price today.
- Such a repurchase clause is nothing but financing provided by Mr. A to the trader against the collateral security received.
- The calculations are simple. After a specific time, the trader will repurchase the asset from Mr. A for the agreed price. Here, Mr. A earns on the differential amount (called interest).
- In case of default by the trader, Mr. A can sell the asset to recover the said dues. In such a case, the differential may be profit or loss depending on the asset’s market value.
Example of Repurchase Agreement
Say, Mr. A needs $ 100,000 for business urgency needs. Mr. B is his relative and is ready to provide the finance against a personal asset as collateral security for 1 year with a rate of interest of 10%. The value of the security is $ 145000 as of today. Let’s have the following situations in place:
The situation I: Mr. A honours the payment
In such a case, the asset returns to Mr. A & Mr. A will pay $ 110,000 to Mr B
Situation II: Mr. A defaults
In such a case, Mr. A will sell the asset at market value, say $ 135000 & recover the said principal & interest amount. Here, Mr. B has a surplus of $ 25000 which he will pay to Mr. A back.
Types of Repurchase Agreements
- The first type is a “Tri-patriate agreement”. We have a tri-party agreement wherein a clearing agent is involved in addition to the normal buyer & seller. The agent ensures that the interest of each is secured. At the time of the first sale, the agent will retain the asset from the seller (i.e., the borrower) of asset & will also ensure that the amount is realized to him from the buyer (i.e., the lender). After confirmation of obligations by each party, the agent releases the asset & the lending amount. The agent also provides independent valuation services to the parties of the contract. Both parties reach a consensus and appoint the agent separately. The agent will not be biased against either party & hence, the agent will never search for a lender for a borrower or a borrower for a lender.
- The second type is a “held-in-custody repo agreement”. Here, the borrower receives the amount from the lender. Instead of providing possession to the lender, the borrower holds the asset in a custody account in the lender’s name. This makes the transfer of ownership without giving possession of the asset. This provides insecurity to the lender & excess confidence to the borrower.
- The third & another famous type is the “Specialised Delivery Repo Agreement”. Here, a guarantee through a bond requires at the beginning of the contract. Such a guarantee also requires at the time of maturity of the said contract.
Risk for Repurchase Agreement
- The most common risk for a lending agreement is the risk of default. This risk crystallizes when the borrower (i.e., the asset seller) fails to honor the repurchase terms on the maturity date. However, a default may be incurred by the lender (i.e., the buyer of the asset) in case the market value of the asset is higher than what is agreed over the agreement. In such a case, the lender may not return the asset to the borrower.
- Another common risk is liquidation risk, wherein the lender may sell the asset to recover the cost of lending & default amount.
- Further, the value of the security offers may decline over the loan term period, exposing the lender to more risk in case the borrower defaults.
- Another risk is that the asset’s value is obtained at the same or lower value than the amount lent by the lender. Such a situation is called under-collateralization.
Uses of Repurchase Agreement
- The basic objective of a repurchase agreement is to facilitate finance between two parties through collateral security. There is no publicly available information for such arrangements.
- Repurchase agreements increase liquidity in the short-term market for the said asset.
- The basic intent of the repurchase agreement was to ensure huge money flows in the market to provide sufficient growth to the sectors. Many repurchase agreements are backed by government-backed securities confirming the parties intent.
Advantages
Below are some of the advantages:
- The lender can sell the asset in case of any default incurred by the borrower.
- Repurchase agreements are secured in nature due to the collateral security offered.
- Since ownership transfers, the parties have seriousness for the successful execution of the contract.
- It provides liquidity for the borrower through easy finance.
- The collateral security has some market value which provides confidence to the lender.
Disadvantages
Below are some of the disadvantages:
- The market value of a security may decline in the future.
- There is counter-party default risk from the lender as well as the buyer.
- In case the asset becomes useful, at the end of the period, the lender exposes to a high risk of default.
- The loss quantum is not ascertainable when the agreement is entered into.
Conclusion
Considering all pros & cons of the repurchase agreement, such agreements are famous today due to the collateral offered. Also, most contracts are ensured through a tri-patriate agreement, removing major risks. However, for the sake of liquidity, each party needs to decide based on the respective risk appetite.
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