In today’s article, I will give a bit more information for the buyback process REPO. I will also, comment on how it works and what could be the possible outcomes from this repurchase agreement.
Let’s start with:
- What is repo?
A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day.
For the party selling the security and agreeing to repurchase it in the future, it is repo; for the party on the other end of the transaction, buying the security and agreeing to sell in the future, it is a reverse repurchase agreement.
- How the two parties benefit from repo?
The difference between the price paid by the buyer at the start of the repo and the price he receives at the end is his return on the cash that he is effectively lending to the seller. In repurchase transactions, and now usually in the case of buy/sell-backs, this return is quoted as a percentage per annum rate and is called the repo rate. Although not legally correct, the return itself is usually referred to as repo interest.
Another thing you should know is that the assets in repo are usually fixed – income securities and the FED is using when they need to. One of these occasions was just last week and the effect according to many analysts should be another passive rate cut.
- So, why the FED uses it and what is repo effect on the financial markets?
Repo is a widely-used instrument for central bank open market operations. Its collateralized nature reduces the credit risk of the central bank. And it allows the use of a wider range of assets than outright purchases, which are limited to short-term securities with maturities similar to the horizon of most money market operations. The repo market is a ready-made collateral market which enables central banks to implement monetary policy more efficiently under normal market conditions and to act more swiftly as lenders of last resort during periods of market stress. Central bank repo can feed seamlessly into the interdealer repo market through which liquidity can be efficiently redistributed to banks and non-banks. Moreover, a liquid repo market is a source of near risk-free interest rates which can provide the central bank with a sensitive gauge of monetary and macro-economic conditions and, in the form of a repo rate index, a meaningful operational target for open market operations.
- How REPO is filling the gaps?
Repurchase agreements can take place between a variety of parties. The Federal Reserve enters into repurchase agreements to regulate the money supply and bank reserves. Individuals normally use these agreements to finance the purchase of debt securities or other investments.
- Why the REPO is related to financial crises and what can we expect now?
Following the 2008 financial crisis, investors focused on a particular type of repo known as repo 105. There was speculation that these “repos” had played a part in Lehman Brothers’ attempts at hiding its declining financial health leading up to the crisis. In the years immediately following the crisis, the repo market in the U.S. and abroad contracted significantly. However, in more recent years it has recovered and continued to grow.
The crisis revealed problems with the repo market in general. Since that time, the Fed has stepped in to analyze and mitigate systemic risk.
Since the markets are close to all-time highs and there were no financial crises in more than a decade people are concern about what will be next. Well, my personal opinion is that with the current market conditions we should hope for the best but prepare for the worse. The FED actions are focused on balancing the situation on the markets and after the changes which were made after 2008, it is very unlikely to face again the same problems as before. However, the market cycle tells us that the resection will come sooner or later. Since financial crises never come from the same place twice we will never be prepared for 100% but maybe this time the FED actions will soften the effect from it and the markets will recover quicker.