Demystifying Repurchase Agreements

Demystifying repurchase agreements

A repurchase agreement (repo) is a short-term agreement in which one party sells securities to the other in exchange for cash, with the intention of buying them back at a specified price and time.

Repos provide the foundation for liquidity and portfolio structure for many money market funds (MMFs). In the case of a MMF, repos are investments. A fund lends cash to a counterparty (usually a bank or government securities dealer) in exchange for collateral, such as Treasury or U.S. government agency securities, and earns interest for the term of the agreement. Most repos unwind the next day, or within a relatively short amount of time. The transaction is typically “over-collateralized” meaning the counterparty provides more value in collateral than the amount of cash lent. A simple example Fund offered by Bank asset management firm (Seller/Cash borrower) (Buyer/Cash lender) Tuesday Collateral

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Collateral

Above, the bank pledges U.S. government securities as collateral to a fund offered by an asset management fi rm in exchange for a set amount of cash. Included in this agreement is the intention to repurchase this collateral the following day at the same price plus interest called the “repo rate.” This exchange provides fi nancing to the bank and investment income to the fund. If for some reason the bank is unable to buy back the collateral, it may be sold to another buyer.

Third-party repo Identifying the key players

The example above represents a bilateral repo trade, where the bank delivers collateral to the fund (at the fund’s custodian). Another common type of repo is third-party or tri-party repo. This is when another party joins and acts as the clearing agent for the bank and as the collateral manager for the fund. This role helps to reduce the administrative burden of the transaction. The dominant tri-party repo agent in the U.S. is the Bank of New York Mellon (BNY Mellon).

Bank BNY Mellon Fund offered by (Seller/Cash borrower) (Third party) asset management fi rm (Buyer/Cash lender)

Not FDIC Insured • May Lose Value • No Bank Guarantee Demystifying repurchase agreements

Choosing a counterparty

The typical repo counterparties for money market funds are banks or government securities dealers. Some MMFs may also engage in repos with the Federal Reserve, through the New York Federal Reserve Reverse Repo Facility. When entering into a repo, it is important not only to note the quality and amount of the collateral being provided but also to make an assessment of the credit quality of the counterparty. This additional credit analysis helps to protect the cash lender against the risk of default by the counterparty.

U.S. money market fund total investments in repos

$1.804 trillion

$721 billion

$516 billion

3/31/11 6/30/15 7/31/21

Source: Offi ce of Financial Research (OFR) SEC Form N-MFP2

Growth in the U.S. repo market for MMFs

The size of the overall repo market is estimated to be as large as $4.6 trillion, spanning a variety of counterparties and types of transactions. There has been substantial growth, especially over the past few years, in U.S. money market fund investments in the repo market. This increase refl ects the overall growth in assets in the types of mmfs that use repos, as well as an increase in the amount of collateral needing to be fi nanced due to expanded issuances of Treasury securities. On March 31, 2011, total U.S. MMF investments in repos were $516 billion. On July 31, 2021, that total was $1.804 trillion. This trend highlights the significance of repos in the everyday transactions of investment managers and money market funds.