The Significance of the Tenor
Repos with longer tenors are usually considered higher risk. During a longer tenor, more factors can affect repurchaser creditworthiness, and interest rate fluctuations are more likely to have an impact on the value of the repurchased asset.?
It’s similar to the factors that affect bond interest rates. Long-term bond purchases are bets that interest rates will not rise substantially during the life of the bond. Over a longer duration, it is more likely that a tail event will occur, driving interest rates above payday loans Canton OH forecasted ranges. If there is a period of high inflation, the interest paid on bonds preceding that period will be worth less in real terms.
This same principle applies to repos. The longer the term of the repo, the more likely that the value of the collateral securities will fluctuate prior to the repurchase, and business activities will affect the repurchaser’s ability to fulfill the contract. In fact, counterparty credit risk is the primary risk involved in repos. As with any loan, the creditor bears the risk that the debtor will be unable to repay the principal. Repos function as collateralized debt, which reduces the total risk. And because the repo price exceeds the value of collateral, these agreements remain mutually beneficial to buyers and sellers.?
Types of Repurchase Agreements
- The most common type is a third-party repo (also known as a tri-party repo). In this arrangement, a clearing agent or bank conducts the transactions between the buyer and seller and protects the interests of each. It holds the securities and ensures that the seller receives cash at the onset of the agreement and that the buyer transfers funds for the benefit of the seller and delivers the securities at maturation. The primary clearing banks for tri-party repo in the United States are JPMorgan Chase and Bank of New York Mellon. In addition to taking custody of the securities involved in the transaction, these clearing agents also value the securities and ensure that a specified margin is applied.? They settle the transaction on their books and assist dealers in optimizing collateral. What clearing banks do not do, however, is act as matchmakers; these agents do not find dealers for cash investors or vice versa, and they do not act as a broker. Typically, clearing banks settle repos early in the day, although a delay in settlement usually means that billions of dollars of intraday credit are extended to dealers each day. These agreements constitute between 80%–90% of the repurchase agreement .??
- In a specialized delivery repo, the transaction requires a bond guarantee at the beginning of the agreement and upon maturity. This type of agreement is not very common.
- In a held-in-custody repo, the seller receives cash for the sale of the security, but holds it in a custodial account for the buyer. This type of agreement is even less common because there is a risk the seller may become insolvent and the borrower may not have access to the collateral.
Near and Far Legs
Like many other corners of the financial world, repurchase agreements involve terminology that is not commonly found elsewhere. One of the most common terms in the repo space is the “leg.” There are different types of legs: for instance, the portion of the repurchase agreement transaction in which the security is initially sold is sometimes referred to as the “start leg,” while the repurchase which follows is the “close leg.”? These terms are also sometimes exchanged for “near leg” and “far leg,” respectively. In the near leg of a repo transaction, the security is sold. In the far leg, it is repurchased.?