Repurchase Agreements (Repos): A Primer

Repurchase Agreements (Repos): A Primer

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December 9, 2019
Repurchase Agreements (Repos): A Primer
Repurchase agreements (repos) are a major source of short-
Participants
term funding for financial institutions. Repos are a policy
Repos are large-scale transactions that do not directly
concern because they have long been identified as a
involve retail investors. Financial institutions enter into
potential source of systemic risk, meaning that problems in
repos either because (1) one institution has short-term
that market could lead to broader financial instability.
borrowing needs and another institution has unused cash
that it would like to earn interest on (as shown in Figure 1);
Characteristics
or (2) one institution needs to borrow a certain security
Repos are legally arranged as a contract between two
(e.g., to complete a short sale) and another institution is
parties to sell a security, such as a Treasury bond, and then
willing to lend it for cash.
repurchase it at a later date at a higher prearranged price
(Figure 1). Economically, a repo is equivalent to a short-
Many types of financial institutions participate in repo
term collateralized loan, with the security serving as
markets, including hedge funds, money market funds,
collateral and the percentage change in price between sale
pension funds, insurance companies, government-sponsored
and repurchase acting as the interest rate on the loan (called
enterprises, and banks. Typically, repos involve securities
the repo rate). From the borrower’s perspective, the
dealers on at least one side of the transaction. Securities
transaction is called a repo (or an RP); from the lender’s
dealers are market makers in securities markets, requiring
perspective, it is called a reverse repo (or an RRP).
them to borrow and lend securities and cash to execute
client orders. Many of the largest securities dealers are
Figure 1. Bilateral Repurchase Agreement
owned by large bank holding companies or foreign bank
organizations.
Market Size
According to the Federal Reserve (Fed), there were $3.9
trillion of repos outstanding in the second quarter of 2019,
up 21.6% from the previous year. However, outstanding
repos are probably lower now than they were before the
financial crisis. Due to data gaps, the current relative size of
bilateral versus triparty repos and different institutions’
shares of the repo market are uncertain.
Repos in the Financial Crisis
In the 2007-2009 financial crisis, problems in the repo
Source: CRS
market contributed to the widespread liquidity problems
Repos’ characteristics vary widely, including the length to
faced by financial firms, including Bear Stearns and
maturity, whether they last for a specified term or are open-
Lehman Brothers. Many types of financial firms face a
ended, types of collateral accepted, and the size of the
liquidity mismatch, meaning that their assets are less liquid
haircut (i.e., the difference in value between the securities
(i.e., easily convertible into cash) than their liabilities. To
sold and cash delivered). As a result, repo rates vary based
meet ongoing cash-flow needs, some of these firms convert
on these varying characteristics. Generally, repos are short-
securities into cash by borrowing short term in the repo
term and repo rates are relatively low.
market. But the amount of borrowing available on the repo
market depends on the willingness of other firms with
Repos can be bilateral or triparty. In bilateral repos, cash
surplus cash to lend it. In normal conditions, firms are
and securities are exchanged directly between the two
relatively indifferent about whom they lend to in repo
parties. In triparty repos, the cash and securities are
markets because they are protected by collateral. During the
exchanged through a third-party clearing bank. In the
financial crisis, some argue that firms became less willing
United States, the Bank of New York Mellon (BoNYM) is
to lend and required higher-quality collateral or a larger
currently the only clearing bank for triparty repos. Triparty
haircut (particularly for non-Treasury collateral), thereby
repos eliminate the risk that the counterparty to the repo
reducing the amount of liquidity available to firms—
will not fulfill its terms at the unwind date. Instead,
including solvent firms. Although all short-term credit
counterparty risk is borne by the clearing bank if it provides
markets can be subject to this sort of run in a panic, the repo
credit. Bilateral repos can also eliminate counterparty risk if
market is a particular concern because of its size and use by
they are cleared. The primary U.S. clearinghouse for repos
a broad range of financial firms. The plethora of different
is the Fixed Income Clearing Corporation (FICC). FICC’s
types of firms using repos also meant there was inconsistent
counterparty exposure is mitigated through margin
requirements, which require cash to be posted upfront.
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Repurchase Agreements (Repos): A Primer
and, for some types of firms, little regulation of how firms
regulation changed how repos were netted when a failing
used repos.
G-SIB is resolved to maintain its value.
Postcrisis Reforms
Federal Reserve’s Role in Repo Markets
A number of reforms to mitigate systemic risk in the repo
The Fed also intervenes in repo markets to conduct
market were implemented after the financial crisis:
monetary policy. Called open market operations, the Fed
uses repos and reverse repos to affect overall liquidity and
Triparty Risks. The Tri-Party Repo Infrastructure Task
target the federal funds rate, its primary monetary policy
Force, a private-sector task force sponsored by the New
target. Traditionally, the Fed’s repo counterparties have
York Fed, was created in 2009 to recommend reforms to
been the primary dealers. In 2013, the Fed created a
reduce systemic risk in triparty repo. Clearing banks
standing facility called the Overnight Reverse Repurchase
reformed the triparty settlement process to reduce the need
Operations Facility to expand its operations to more
for them to offer intraday credit to finance repo settlement,
counterparties. (At this facility, the Fed is the cash
and required precommitment to access it. The share of
borrower.) The Fed also provides reverse repos to foreign
triparty repos relying on intraday credit fell from 92% in
official institutions as part of its services to them.
2012 to less than 5% in 2014. In 2016, the Fixed Income
During the financial crisis, the Fed intervened heavily in
Clearing Corporation (FICC) eliminated its interbank GCF
repo markets to restore overall liquidity. Because of the
Repo service, which made potentially unlimited intraday
severity of the crisis, this intervention alone could not
credit available from FICC to banks. In 2017, the Securities
restore liquidity for all firms, and the Fed was forced to
and Exchange Commission approved an expansion of
FICC’s central clearing of repos
lend directly to securities dealers and others. Changes
.
following the crisis in how monetary policy is conducted
had ended the Fed’s use of repos (but not reverse repos).
Fails. Settlement fails occur when a bilateral repo lender
However, the Fed has regularly used repos again since a
fails to return the pledged security at the unwind date.
spike in repo rates in September 2019.
Although routine, a surge in fails could be destabilizing in a
stressed environment. In 2009 and 2012, penalties were
Ongoing Issues
introduced to discourage certain fails. Nevertheless, fails
Repos remain an inherently unreliable source of funding in
have continued at a lower level, with occasional spikes.
a crisis, even if large banks are less reliant on them
following postcrisis reforms. The Fed can intervene in repo
Opacity. Lack of data on aspects of the repo market,
markets to restore overall market liquidity, but it cannot
including rates and volume, added to uncertainty during the
ensure all nonbank borrowers individually have access to
crisis. Subsequently, the Fed and the Office of Financial
liquidity because it does not provide repos directly to
Research (OFR) have attempted to gather more
borrowers on demand. Nevertheless, borrowers may rely
comprehensive data. The Fed has long published data on
more heavily on repos because they believe the Fed will
repos involving primary dealers (large Treasury security
step in during a crisis, which economists call moral hazard.
dealers), and in 2010 began publishing data on triparty
repos. In 2019, OFR issued a rule to collect data on repos
A more specific source of systemic risk is a scenario where
cleared by FICC. Since 2018, the Fed has published data on
a major securities dealer involved in the repo market faces a
key repo rates, such as the Secured Overnight Financing
liquidity crisis. This could cause a fire sale of the dealer’s
Rate. Regulators still do not collect comprehensive data on
assets if the dealer tried to raise cash or if the dealer failed
all types of repos, however.
and its repo counterparties sold its collateral to recoup cash.
Fire sales could impose losses on unrelated investors
Enhanced regulation. The 2010 Dodd-Frank Act (P.L.
holding similar assets, spreading financial instability.
111-203) required enhanced prudential (safety and
The greater reliance on triparty and cleared bilateral repos
soundness) regulation (EPR) of large banks and
since the crisis reduces overall risk but increases the
systemically important financial market utilities (FMUs)
systemic importance of the firms at the heart of those
who are viewed as posing systemic risk. The two firms that
transactions—BoNYM and FICC, respectively. Were either
clear triparty and bilateral repos, respectively, are subject to
firm to fail, it could destabilize financial markets because
EPR—BoNYM was designated as a global-systemically
their role in repo markets could not easily and quickly be
important bank (G-SIB), subjecting it to the Fed’s most
replaced. Policymakers debate whether enhanced prudential
stringent regulatory requirements, and FICC was designated
regulation has successfully contained the systemic risk
as a FMU, under SEC supervision. Repo participants that
posed by the banks and FMUs subject to it.
are not part of large banks are not subject to EPR.
Repos are not uniformly regulated—the market itself is not
Under EPR, large banks are subject to new liquidity rules.
regulated and the different types of participants face
Some, but not all, of the securities dealers active in repo
varying requirements governing their borrowing and
markets are owned by large banks. Certain rules already
lending. This complicates systemic risk regulation and
implemented make large banks less reliant on short-term
transparency. Most recent reforms to repo practices were
borrowing. However, the Net Stable Funding Ratio rule—
voluntary (e.g., penalties for fails) and thus potentially
which would directly limit their use of repos—has not been
calibrated from a user—instead of a policy—perspective.
finalized. Higher capital requirements introduced after the
crisis also make it more costly for banks (and dealers who
Marc Labonte, Specialist in Macroeconomic Policy
are part of banks) to engage in repos. Finally, a 2017
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Repurchase Agreements (Repos): A Primer

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