What Is Repo Funding?
Repo funding, or repurchase agreement funding, is a financial instrument used by banks, financial institutions, and investors to access short-term liquidity.
It involves the temporary exchange of securities (usually government bonds) for cash, with a commitment to repurchase the securities at a later date.
The process is similar to a collateralized loan, where the securities act as collateral to secure the funds.
Repo funding allows market participants to manage cash balances more effectively, meet short-term obligations, and leverage their securities holdings.
Key Takeaways – Repo Funding
- Repo funding is a financial instrument used by banks, financial institutions, and investors to access short-term liquidity by exchanging securities for cash with a commitment to repurchase the securities at a later date.
- Repo rates are primarily influenced by the creditworthiness of the borrower, the quality and liquidity of the collateral, the term of the transaction, and prevailing market interest rates.
- Hedge funds use repo funding to finance leveraged positions, meet margin calls, manage cash flow, and take advantage of arbitrage opportunities. The Federal Reserve also uses repo transactions as part of its open market operations to maintain its target interest rate.
How Does Repo Funding Work?
In a repo transaction, the borrower (also called the cash borrower) agrees to sell securities to the lender (or cash provider) and repurchase them at a specified date and price.
The difference between the sale and repurchase price represents the interest paid by the borrower, known as the repo rate.
The transaction effectively works as a collateralized loan, with the lender having the security of the underlying assets in case of borrower default.
Types of Securities Used in a Repurchase Agreement
Some of the most common types of securities used in a repo include:
US Treasury securities
These are debt securities issued by the US government that have a fixed interest rate and are considered to be one of the safest investments available.
These are debt securities issued by government-sponsored entities, such as Fannie Mae and Freddie Mac.
They are considered to be slightly riskier than US Treasury securities.
These are securities that are backed by pools of mortgages.
They’re also considered to be riskier than US Treasury securities and agency securities.
These are debt securities issued by corporations to raise capital. They’re considered to be riskier than US Treasury securities, agency securities, and mortgage-backed securities.
The type of security used in a repo will depend on the preferences and risk tolerance of the parties involved.
Generally, the securities used in a repo are high-quality and highly liquid, meaning they can be easily bought and sold in the market.
3 Forms of Repos (specified delivery, tri-party, and held in custody)
Specified delivery repos
In these transactions, the borrower and lender agree upon specific securities to be exchanged as collateral.
The specified securities are delivered to the lender at the start of the transaction and returned to the borrower upon repurchase.
These involve a third-party agent (usually a clearing bank) that manages the collateral throughout the repo transaction.
The tri-party agent is responsible for selecting and valuing the collateral, ensuring its safekeeping, and facilitating the exchange of cash and securities.
Held in custody repos
In this type of repo, the securities remain in the custody of the borrower’s custodian bank.
The lender receives a claim on the securities as collateral, but the securities are not physically transferred.
Repo Calculation Example
Suppose a borrower needs $1 million for 7 days and offers $1.02 million in government bonds as collateral. The lender agrees to a repo rate of 2%.
The repurchase price is calculated as follows: $1,000,000 x (1 + (0.02 x 7/365)) = $1,003,835.62. The borrower will repurchase the bonds for $1,003,835.62 after 7 days.
Repo vs. Reverse Repo
A repo transaction is viewed from the borrower’s perspective, while a reverse repo is the same transaction viewed from the lender’s perspective.
In a repo, the borrower sells securities for cash and agrees to repurchase them later.
In a reverse repo, the lender buys securities and agrees to sell them back at a future date.
What Is an Example of Repo Funding?
A common example of repo funding occurs when a hedge fund needs cash to meet margin calls or cover short-term liabilities.
The hedge fund may enter into a repo agreement with a bank, providing government bonds as collateral in exchange for cash.
The hedge fund then repurchases the bonds at a later date, paying interest for the use of the cash.
What Is the Repo Funding Rate Based On?
The repo funding rate is primarily influenced by the creditworthiness of the borrower, the quality and liquidity of the collateral, the term of the transaction, and prevailing market interest rates.
Higher credit risk and less liquid collateral typically result in higher repo rates.
Is Repo Short-Term Funding?
Yes, repo funding is primarily a short-term funding mechanism, with maturities typically ranging from overnight to a few months.
However, some repo agreements can have longer terms, depending on the needs of the parties involved.
The short-term nature of repo transactions makes them a flexible and efficient tool for managing liquidity and meeting temporary funding needs.
Repurchase Agreements (Repo) & Reverse Repurchase Agreements (Reverse Repo) Explained in One Minute
FAQs – Repo Funding
What does it mean to “repo out” bonds?
To “repo out” bonds means to enter into a repurchase agreement using bonds as collateral.
In this process, the bondholder temporarily sells the bonds to a lender in exchange for cash, with a commitment to repurchase the bonds at a later date and a predetermined price.
The term “repo out” bonds essentially refers to using bonds as collateral in a repo transaction to obtain short-term funding.
How do hedge funds use repo funding?
Hedge funds use repo funding as a means of obtaining short-term liquidity to meet various needs, such as:
- Financing leveraged positions: Hedge funds may use repo transactions to borrow cash against their securities holdings, enabling them to take larger positions in the market and enhance returns.
- Meeting margin calls: When the market moves against a hedge fund’s positions, it may face margin calls from its brokers. Repo funding can provide the necessary cash to meet these margin requirements.
- Managing cash flow: Hedge funds may have short-term cash needs arising from investor redemptions or other liabilities. Repo funding can help them bridge temporary cash shortfalls without having to sell assets.
- Arbitrage opportunities: Hedge funds can use repo transactions to finance the purchase of undervalued securities, profiting from the eventual convergence of prices.
What is the Federal Reserve repo (“Fed repo”)?
The Federal Reserve repo, or “Fed repo,” refers to repurchase agreements conducted by the Federal Reserve with primary dealers (large financial institutions that trade directly with the Fed).
These transactions are part of the Fed’s open market operations, which aim to regulate the supply of money and maintain the target federal funds rate.
When the Fed conducts a repo operation, it buys securities from primary dealers with an agreement to sell them back at a future date.
This injects reserves into the banking system, increasing liquidity and influencing short-term interest rates.
What is the difference between a general collateral (GC) repo and a special repo?
In a general collateral (GC) repo, the lender is mainly concerned with the collateral’s market value rather than the specific securities being used.
Any security meeting certain criteria (e.g., credit rating, issuer) may serve as collateral.
In contrast, a special repo involves specific securities that the lender desires to obtain, often due to high demand or scarcity in the market.
Special repos generally have lower repo rates compared to GC repos, as the lender is willing to accept a lower return for access to the desired securities.
Can individual investors participate in repo transactions?
Although repo transactions primarily involve institutional market participants such as banks, hedge funds, and broker-dealers, individual investors can indirectly access repo markets through money market funds or other investment products that invest in repos.
What is the difference between a bilateral and a tri-party repo?
A bilateral repo is a transaction directly between two counterparties, with each party responsible for managing the collateral throughout the transaction.
In a tri-party repo, a third-party agent (usually a clearing bank) manages the collateral, selecting and valuing it, ensuring its safekeeping, and facilitating the exchange of cash and securities.
What happens in case of a borrower default in a repo transaction?
If a borrower defaults on a repo transaction, the lender has the right to sell the collateral to recover the loan amount and any accrued interest.
The specific terms of the transaction may dictate the exact process, but the lender generally has the right to liquidate the collateral in case of default.
Repo funding serves as an important tool in the financial markets, allowing participants to access short-term liquidity, manage cash balances, and leverage their securities holdings.
With various types of repos, such as specified delivery, tri-party, and held in custody, market participants can tailor their transactions to meet their specific needs.
Hedge funds, banks, and other financial institutions rely on repo funding for various purposes, from financing leveraged positions to meeting margin calls.
The Federal Reserve also utilizes repo transactions as part of its open market operations, injecting or withdrawing reserves from the banking system to maintain its target interest rate.
While primarily an instrument for institutional market participants, individual investors can gain indirect exposure to repo markets through money market funds and other investment products.
As a flexible and efficient source of short-term funding, repo transactions play a vital role in the smooth functioning of the financial markets, contributing to overall market stability and liquidity.