REPO operation - what is it? REPO transactions and securities lending

The most common and sought-after format of secured lending by securities or money is the repo transaction. What is this we try to understand from the very beginning. Repurchase Agreement (REPO) is a contract of borrowing securities, the guarantor of which are cash. The situation can be reversed, when the guarantee of borrowed funds is securities. The REPO contract is often referred to as the repurchase agreement. The arrangement defines the opposite obligations for each of the parties: this is sale and purchase.

Types of REPO

There are two formats of the repo operation: direct and reverse. A direct arrangement determines the sale of securities by one party to the other party. At the same time, it is agreed that the first party will buy back its securities on time and at a predetermined price. Reverse purchase will be carried out at a cost an order of magnitude higher than the primary one. The difference between the sale price and the purchase price of a package of securities reflects the profitability of this transaction. It is expressed in annual percentages and is called the REPO rate. The main objective of implementing direct agreements is to attract financial resources.

Reverse repurchase implies the acquisition of a package of documents and the acceptance of obligations for its repurchase. The main purpose of the arrangement is the temporary allocation of free financial resources.

The economic essence of operations

Against the backdrop of other manipulations with securities, the most popular is the repo operation. What is it from an economic point of view is quite obvious. One side acquires such financial resources necessary for it in the process of partnership , the second party completely eliminates the lack of securities. Plus, the second party gets the interest for the temporary use of its tangible assets. Transactions for the most part are conducted with government securities and are timed to the category of short-term arrangements. The contract regulates a partnership lasting from several days to several months. In the world practice, daily contracts are often concluded. Between the seller and the buyer through the intermediary deals are concluded with securities. As a third person in most situations, a banking institution, whose responsibilities are detailed in the contract. The situation provides for the opening of accounts for securities and cash in the intermediary bank. The arrangement, in which three parties are involved, is less risky.

REPO and lending

If you look at the REPO in general, then it can be called a modification of lending against security of valuable property. The only difference is that the transfer of securities and the receipt of funds are held at the same time. Immediate transfer of ownership from one contractor to another is another feature of the REPO transaction. What is this, we will try to understand even more thoroughly by considering the stages of partnership.

REPO includes two stages:

• Primary purchase or sale of securities.
• Reverse purchase or sale of securities.

Specificity of the stages of the agreement

The difference in time between the implementation of the first and second parts of the arrangement is called the term of REPO. The time interval between manipulations is usually measured in calendar days. The count starts the day after the parties fulfill their obligations and ends on the day of the implementation of the second part of the arrangement. 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 called a creditor, and the original seller is a borrower. Investment operations with securities for the first seller have the format of direct REPO, the buyer sees the manipulation in the form of reverse REPO. Securities that are the subject of an arrangement are referred to as either a basic asset or collateral. The repo transactions associated with the provision of a loan secured by securities are valued at the repo rate.

Contract risks

Risk is an obligatory component, without which no repo operation is possible. What is it and what risks are typical for the arrangement? 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 fulfilled. There is a high probability that by the time of the return purchase the seller will not have those securities on hand, and the buyer will not have the funds. Help for such situations can be both bankruptcy and the arrest of accounts. As an option: as a result of changing the market situation, one of the parties can simply refuse to fulfill their obligations, pursuing their own profit.

Reduction of repo risk

To reduce the risks of non-fulfillment of obligations of one of the parties, the purchase and sale of securities should be accompanied by the following points:

• Discounting of collateral.
• Obligations must be reassessed.
• It is important to exercise systematic control over the adequacy of the provision.
• Making margin (compensation) contributions.

The discount in relation to repo transactions is a value that characterizes the market price of collateral in accordance with the size of the existing obligations at a certain point in time and throughout the partnership term.

The repo's repos is evaluated taking into account the primary discount value, which is determined by agreement between the parties when concluding the transaction. It is worth paying attention to the following:

• A higher discount value provides a good benefit to the buyer, who receives collateral at a lower cost.
• The lower the primary discount, the more benefits the seller receives, which offers collateral at a higher cost.

It can be concluded that the primary discount reflects the mutuality of the collateral price and the value of the obligations for each of the REPO parties according to the first part of the agreement.

Change in the value of collateral under repurchase agreements

Until the first part of the REPO is realized, the value of the obligation remains unchanged in most situations. Only security is subject to changes, and even then it is insignificant, due to a temporary delay in the performance of the contract in 1-3 days. At the same time, during a direct repo operation with a maturity of 3 months or more, the price of both liabilities and collateral may vary significantly. The following factors will influence the development of events:

• Dynamics of market value.
• Increase in REPO transaction income.
• The change in discount compared to its primary value, which will cause one of the parties to incur significant losses.

The mechanism of compensation contributions

The mechanism of compensatory contributions can eliminate the likely situation. It is activated by concluding an agreement on the maximum discount rates: the maximum and the minimum. Throughout the REPO period, the MICEX trading system performs a daily revaluation of the value of liabilities and collateral price, and controls the level of its adequacy.

If the cost of collateral is underestimated, and its preliminary assessment is overvalued, one of the parties, in order to liquidate the losses of the second party, is forced to make a compensation contribution. It can be expressed both in securities, and in a monetary format. In this situation, the repo agreement is slightly modified. Obligations of one of the parties on the second part of the transaction are reduced. If, if necessary, to make a compensation contribution, the party ignores its obligations, it becomes necessary to early implement the second part of the contract. The mechanism of compensation contributions allows you to maintain a balance between collateral and liabilities. He can also initiate the early fulfillment of obligations under the treaty.

Excursion to the history

The bank 's active operations under the REPO scheme in the bond market began to be practiced for the first time in 2003, after the adoption of the relevant legislative act. During the economic crisis, which flourished in all its glory in 2008, the significance of two operations - direct and reverse REPO - has changed. They began to have a higher weight as the dominant instrument for providing liquidity to the crumbling banking system. It is worth noting that at certain time intervals, the main, and sometimes the only liquidity provider, since 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 CB as a supplier of liquidity.

The role of the CBR in repo transactions

Financial institutions actively use the active operations of the repo bank to maintain the same liquidity. This is evidenced by the fact that most of the agreements are not more than a day. Operations lasting from 3 to 7 days at a rate of 9.22-12.4% per annum are extremely rare. In the face of the buyer of bonds on the first part of the agreement and the seller for the second almost always acts as the CBR. It is the bank that determines the circle of participants for transactions after preliminary consideration of applications.

In the role of collateral or basic bond issues, bonds belonging to the category of securities, any other securities that are included in the Lombard List of the Bank of Russia, can act. The advantage of the agreements can also be called the fact that they are characterized by an individual taxation regime. This makes manipulation almost the most effective mechanism for lending.