A repurchase agreement (PR) is a short-term loan in which both parties agree to sell and buy back assets in the future within a certain period of time of the contract. The seller sells a treasury bill or other government bond with a promise to redeem it on a specific date and at a price that includes the payment of interest. There are a number of differences between the two structures. A reverse repurchase is technically a one-time transaction, while a sell/buyback is a pair of trades (a sell and a buy). A sale/redemption does not require any special legal documentation, while a reverse repurchase usually requires a framework agreement between the buyer and seller (usually the Global Master Repo Agreement (GMRA) ordered by SIFMA/ICMA). For this reason, there is an associated increase in risk compared to repo. In the event of default by the other party, the absence of an agreement may reduce the legal situation in the recovery of securities. Any coupon payment on the underlying security during the term of the sale/redemption is usually returned to the buyer of the security by adjusting the money paid at the end of the sale/redemption. In a repurchase agreement, the coupon is immediately transmitted to the seller of the security. According to Yale economist Gary Gorton, repo has evolved to provide large non-custodian financial institutions with a secured loan method analogous to government custodian insurance in traditional banks, with collateral serving as collateral for the investor. [3] When the Fed wants to tighten the money supply and take money out of cash flow, it sells the bonds to commercial banks through a buyback agreement, or short-term repurchase agreement.
Later, they will buy back the securities through reverse reverse repurchase agreement and return money to the system. Although the transaction is similar to a loan and its economic impact is similar to that of a loan, the terminology is different from that of loans: the seller legally buys back the buyer`s securities at the end of the loan term. However, a key aspect of pensions is that they are legally recognized as a single transaction (significant in the event of the counterparty`s insolvency) and not as a sale and redemption for tax purposes. By structuring the transaction as a sale, a repo provides lenders with significant protection against the normal operation of U.S. bankruptcy laws. B such as the automatic suspension and challenge provisions. In July 2011, bankers and the financial press feared that the 2011 US debt crisis, if it led to a default, would lead to a significant disruption of the repo market. Indeed, Treasuries are the most commonly used collateral in the U.S. repo market, and since a default would have lowered the value of Treasuries, it could have meant that pension borrowers would have had to deposit many more collateral. [10] Once the real interest rate is calculated, a comparison of the interest rate with those of other types of financing will show whether the repurchase agreement is a good deal or not. In general, repurchase agreements, as a safe form of lending, offer better terms than cash lending operations on the money market.
From the perspective of a reverse reverse repurchase agreement participant, the agreement may also generate additional income from excess cash reserves. The accounting for repurchase agreements depends on whether they are a sale or a secured loan. ASC 860, Transfers and Services, deals with transfers of financial assets and provides advice. In Part 2 of this blog next week, we`ll explore accounting management and review examples of journal entries. Repo is a form of secured loan. A basket of securities serves as the underlying collateral for the loan. Legal ownership of the securities is transferred from the seller to the buyer and reverts to the original owner upon conclusion of the contract. The most commonly used collateral in this market are U.S. Treasury bonds. However, all government bonds, agency securities, mortgage-backed securities, corporate bonds or even shares can be used in a buyback agreement. In some cases, the underlying collateral may lose its market value during the term of the pension agreement.
The Buyer may ask the Seller to fund a margin account where the price difference is settled. Among the tools used by the Federal Reserve system to achieve its monetary policy objectives is the temporary addition or subtraction of reserve assets through repurchase agreements and reverse repurchase agreements in the open market. These operations have a short-term and self-reversing effect on bank reserves. Pensions that have a specific due date (usually the next day or week) are long-term repurchase agreements. A trader sells securities to a counterparty with the agreement that he will buy them back at a higher price at a certain point in time. In this agreement, the counterparty receives the use of the securities for the duration of the transaction and receives interest expressed as the difference between the initial sale price and the redemption price. The interest rate is fixed and the interest is paid by the merchant at maturity. A pension term is used to invest money or fund assets when the parties know how long to do so. In a repo, the investor/lender provides money to a borrower, with the loan secured by the borrower`s guarantee, usually bonds. In case of default of the borrower, the investor / lender receives the guarantee. Investors are typically financial institutions such as money market funds, while borrowers are non-custodian financial institutions such as investment banks and hedge funds.
The investor/lender charges an interest rate called the “reverse repurchase agreement”, lends $X and gets a higher amount $Y. In addition, the investor/lender may require a guarantee of a value greater than the amount he lends. This difference is the “haircut”. These concepts are illustrated in the diagram and in the Equations section. If investors perceive higher risks, they may demand higher repo rates and demand larger discounts. A third party may be involved to facilitate the transaction; In this case, the transaction is called a “tripartite deposit”. [3] Like many other parts of the financial world, repurchase agreements contain terminology that is not common elsewhere. One of the most common terms in the repo space is “leg”. There are different types of legs: for example, the part of the buyback agreement in which the security is originally sold is sometimes referred to as the “starting leg”, while the redemption part that follows is the “narrow part”. These terms are sometimes exchanged for “near leg” or “distant leg”. In the vicinity of a repurchase transaction, the security is sold.
In the distant leg, he is redeemed. For the party who sells the security and agrees to buy it back in the future, this is a deposit; For the party at the other end of the transaction that buys the security and agrees to sell in the future, this is a reverse repurchase agreement. .