Repo rate, short for repurchase rate is the rate at which a central bank lends money to its commercial banks. You can think of a repo rate as the interest rate charged by a central bank when a commercial bank borrows money.
Whereas, a repo agreement forms the binding terms for the contract where one party puts up collateral in order to receive funding.
The repo rate is one of the most important tools that a central bank has. A central bank uses the repo rate as a means to influence the circulation of money in an economy. Thus, by extension, central banks use the repo rate as an indirect means of controlling inflation.
The repo market is estimated to be around $2 trillion – $4 trillion and is widely used for short term funding.
In layman’s terms, the repo rate and the repo agreement is simply the interest rate you pay to borrow funds, while pledging a security with the lender.
Is repo rate same as bank rate?
Although a repo rate might seem similar to a central bank’s interest rate, it is actually very different if you look under the hood.
One of the important distinctions between a repo rate and bank rate is that, commercial banks use the repo rate lending mechanism only when there is a shortfall in funding.
Therefore, a bank rate is always higher than a repo rate.
Furthermore, funding for repo rates should be backed by collateral. Thus, in other words, if a commercial bank wants to borrow money from a central bank, it can engage in a repo or a repurchase agreement.
However, to obtain this loan, the commercial bank pledges collateral with the central bank.
In order to understand the functioning of a repo rate, we must first understand the dynamics of a repo agreement.
How does a repo agreement work?
A repo agreement or a repurchase agreement (also known as classic repo) is made up of two counterparties. In a repo agreement, Party A which wants to borrow money, sells or pledges their securities to Party B which is the lender.
In the terms of the repo agreement, Party A pledges to buy back the securities at a later period in time at an agreed price. In the repo agreement, the securities being pledged to Party B are known as collateral.
Repo agreements are only done with primary dealers in the market. Primary dealers are trading counterparties of a central bank.
In the United States, examples of primary dealers include counterparties such as BNP Paribas Securities Corp., Goldman Sachs & Co. LLC, RBC Capital Markets, to name a few.
The table below gives an example from the New York Fed’s repo operations.
What is the minimum bid rate in a repo?
The minimum bid rate is the rate set by the central bank’s open market operations desk. The minimum bid rate is equal to the interest on excess reserves (IOER). The IOER is the rate that a central bank pays on deposits that are more than the required reserves. The IOER is quite different from the central bank’s interest rates or even the repo rate. Read more about Interest on excess reserves here.
What is proposition limit in a repo?
The proposition limit is the limit on the amount of loan a lender wants to bid on. The minimum proposition limit is $1 million and further bids can be submitted in increments of $1 million. Looking back at the above table, the first row indicates a cap of $20 billion on the proposed amount that a borrower can borrow.
What is the aggregate operation limit in a repo?
The aggregate operation limit is the total limit on a repo agreement. If the total amount sought for borrowing is equal to or less than the aggregate operation limit, the participants are awarded at the bid rates that they submitted.
However, in case of increased participation, which can lead to a breach of the aggregate operation limit, then only the most competitive bids are chosen.
What kind of collateral is accepted under a repo agreement?
A repo agreement requires only specific type of securities that qualify as collateral. These include:
- Agency Debt
- Mortgage Backed Securities
What is the duration of the repo agreement?
There are two types of repo agreement which determines the duration of the loan.
- Open repo
- Term repo
What is an open repo?
An open repo is an agreement where the maturity date is open. In other words, the counterparties involved in the repo agreement agree to the transaction without any specific maturity date set.
An open repo agreement can of course by terminated at any point where one of the counterparties gives a notice with a one-day deadline. An open repo rolls over to the next day when it is not terminated. The interest on the open repo agreement is paid out monthly and is re-priced on a daily basis.
Counterparties can engage in an open repo agreement when the borrower does not know the duration of the loan that they are going to borrow.
What is a term repo?
A term repurchase agreement, as the name suggests has a specific maturity date that is set. The term is usually one day or a week. The primary dealer pledges collateral to the lender and promises to buy them back (at usually a higher rate) at the maturity of the term.
A term repo can vary from as little as overnight and in some cases can be as long as 84 days.
The chart below, gives an example from the NY Fed’s actual repo operations that were conducted.
Repo agreement – Terms & Definitions
The table below gives a quick summary of the various terms that come up in a repo agreement and also its meaning.
|Seller||The borrower. The counterparty that receives cash. The counterparty that pledges the security as collateral.|
|Buyer||The lender. The counterparty that gives cash. The counterparty that is legally entitled to the collateral|
|Purchase||The sale (and transfer) of the security or asset at the start of a repo agreement|
|Repurchase||The repurchase of the security or asset at the end of a repo agreement|
|Purchase date||The date when the asset or collateral exchanges hands|
|Repurchase date||The date when the asset or collateral exchanges hands|
|Purchase price||The price or cash value that is paid by the buyer to the seller|
|Repurchase price||The price or cash value that is paid by the seller to the buyer at the end of the repo agreement|
|Collateral||Assets or securities used to back the repo agreement|
|Equivalent Collateral||Assets that are repurchased in the repo agreement by the seller on the Repurchase date|
|Repo rate||The rate of interest, expressed in a per annum rate which is paid by the seller over the term of the agreement|
|Tri-party Repo||A repo agreement that includes using a third-party custodian who undertakes settlement and management of the transaction including collateral management|
Aren’t repo agreements similar to securities lending?
In a way, yes! Repurchase agreements can be seen as a substitute for securities lending. And these two terms can often be used interchangeably. However, despite the similarity in the way a repo agreement and securities lending work, there is one major difference.
A repo agreement is driven by the need to borrow cash, whereas securities lending is driven by a need to borrow securities. The primary collateral in a repo agreement are fixed income instruments such as bonds whereas in securities lending, equities are the collateral.
Who are the major participants in a repo market?
The major participants in a repo market are:
- Securities dealers
- Primary dealers
- Leveraged investors
- Prime brokers
- Conduits such as SPV (Special purpose vehicles)
- Central banks