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Institutions involved in the repo market
The above are the main reasons that give rise to repurchase agreements, i.e. a party wishing to acquire funds for a period and a party with a matching investment requirement. And there are many strategies that underlie these agreements.
In Local Country (LC) the parties involved in this market are the money market broker-dealers, the banks, corporate entities, pension funds, insurance companies, money market funds, the central bank, foreign investors, speculators in the bond market, etc.
Of all these institutions, the central bank and the banks are usually the largest participants, because the repo is the method used by the central bank to provide accommodation to the banks (in most countries) (see below).
Types of repurchase agreements
As noted earlier, there are two main types of repurchase agreements, i.e. the open repurchase agreement and the fixed term repurchase agreement. The former agreement is where there is no agreed termination date. Both parties have the option to terminate the agreement without notice. The rate on these agreements is usually a floating rate, the basis of which is agreed in advance.
Fixed term repurchase agreements are repurchase agreements where the rate and the term are agreed at the outset of the agreement. The term of repos usually range from a day to a few months.
Securities that underlie repos
Only prime marketable securities are used in repos, and this includes money market and bond market securities. Repos are usually done at market value of the underlying securities or lower than market value, and the securities are rendered negotiable. Securities are rendered negotiable to protect the investor against the maker of the repo, i.e. in the event of the maker reneging on a deal, the investor has the right to sell the underlying securities (in terms of the ISDA Master Repurchase Agreement).
What is meant by rendered negotiable is that the underlying securities are prepared in negotiable form. For example, a bank acceptance made payable to a particular investor is endorsed in blank. In the case of bond certificates this means that a signed securities transfer form accompanies each certificate.11
Mathematics of the repurchase agreement market
Repurchase agreements are dealt on a yield basis, i.e. the interest rate is paid on an add-on basis. The amount of interest is calculated in terms of the following formula:
IA = interest amount
C = consideration (i.e. the market value or lower of the securities)
ir = agreed interest rate per annum expressed as a unit of 1
t = term of the agreement, expressed in days / 365
If, for example, LCC10 million (nominal value) NCDs with a maturity value of LCC10 985 000, and a market value of LCC10 300 000, were sold for seven days at a repo rate of 12.0% pa, the interest payable would be as follows:
IA = C x ir x t
= LCC10 300 000 x 0.12 x 7 / 365 = LCC23 704.11.
It should be clear that the buyer would pay LCC10 300 000 for the repo and receive LCC10 323 704.11 upon termination of the agreement.
The mathematics of repos in the case of bonds is similar to that of bond forwards (remember a repo is a combination of a spot sale and a forward purchase). The carry rate is applied to the all-in price at the first settlement date of the deal (called reference price) to determine the price at termination (second settlement date).
Repos and the banking sector
Because the banks are the largest initiators of repos, and a large slice of the market takes place between banks, it is necessary to afford this sector a separate section.
Because repos are one method through which banks are able to acquire funding, many central banks require banks to report on balance sheet all their repos, for purposes of their capital adequacy requirement, i.e. banks are required to allocate capital to this activity (because the asset has to be bought back). It will be evident that if a bank brings back on balance sheet securities sold, it has to create a liability, and this liability item is termed "loans under repurchase agreements".
There are many reasons for banks engaging in the repo market. Perhaps the most prominent is that the repo instrument is a convenient method to satisfy wholesale clients' needs (retail clients do not feature in this market).
All the major banks have Treasury Departments, and this department is the hub of these banks. All wholesale transactions and portfolio planning take place in the Treasury Department. If a large mining house client, for example, would like to purchase LCC100 million securities that have 63 days to run (because it need the funds for an acquisition in 63 days' time and is "full"12 in terms of its limit for the bank), the bank is able to satisfy the client's investment requirement by selling LCC100 million of its strategic holding of government bonds to the client for 63 days.
Another example is a small bank losing a LCC100 million deposit at the end of the trading day, and not being able to negotiate a deposit to fund the shortfall with the non-bank sector. Assuming a large bank has a LCC100 million surplus, and that this bank does not want to be exposed to the small banks, it may offer the LCC100 million to the small bank against a repo, i.e. the small bank will sell securities to the value of LCC100 million to the large bank for a day or two (at the rate for this period). Clearly, if the small bank fails in this period, the large bank has claim to the repo securities.
In most countries banks are accommodated by the central bank effecting repos with them, i.e. the banking sector sells eligible securities to the central bank under repo. The style of monetary policy adopted in most countries is ensuring that the banks are indebted to the central bank at all times (i.e. borrow cash reserves on a permanent basis), in order to "make the KIR effective".
Listed repurchase agreements
Generally speaking, the repo market is an OTC market. However, in many countries repos on bonds are widely-used instruments; thus listed repos do exist.
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