Definition of Repurchase Agreement
A repurchase agreement (famously known as “repo”) is a type of borrowing agreement entered into between two or more parties generally for a short period of time ranging from overnight up to a year and under such agreement the dealer offers the securities with a pre-defined agreement to repurchase the same securities at a set maturity date.
- Repurchase agreement basically means an agreement entered into between two parties to “repurchase” the assets sold to the buyer. Such agreement ensures that the asset will return back to the seller at a specific date in future.
- Say, you have an asset & you sold it to Mr. A for $ 1000 with repurchase clause of 110% after 1 year & you received $ 1000 from Mr. A. This means you will have to pay $ 1100 after 1 year to “repurchase” the said asset.
- What technically has been done here is, a loan is provided under the transaction for sale of asset. One year hence, the seller of assets pays for principal plus interest on such borrowing. Such borrowing is secured in nature since the buyer of asset holds ownership for the period of loan.
- The repurchase agreement has different maturity periods as required under the agreement. Normal maturity period is within a year, which is called as “term repos”. However, repurchase agreement which has more than 1 year of maturity period are called as “open REPOs”.
Features of Repurchase Agreement
- There is a huge premium in such a market.
- Open REPO demand for daily renewal since the contract is carried until cancelled by either of the parties.
- The interest rate is offered at a lower level than what is offered for an unsecured loan.
- The lender accepts only high quality of securities as collateral since the interest rate is lower.
- However, the lender is still exposed to default risk from the borrower. Even if the high-quality asset is given as collateral security, the lender may not recover the full amount due to the depreciating nature of securities.
- In case default by the borrower, the lender has to suffer from huge haircuts in the selling price of collateral asset.
- The repo rate changes as per the type of security offered.
How Does It Work?
- A trader (i.e. seller of security) offers to sell a specify security (i.e. the asset) to Mr. A (i.e. buyer of security) for an agreed price.
- The seller provides a clause in the agreement to repurchase the said asset after a certain period at a pre-determined price today.
- Such repurchase clause is nothing but financing provided by Mr. A to the trader against the collateral security received.
- The calculations are simple. After a specific time, the trader will repurchase the asset from Mr. A for the agreed price. Here, Mr. A earns on the differential amount (called as interest).
- In case of default by the trader, Mr. A can sell the asset to recover the said dues. In such a case, the differential may be profit or loss depending on the market value of the asset.
Example of Repurchase Agreement
Say, Mr. A need $ 100,000 for business urgency needs. Mr B is his relative who is ready to provide the finance against a personal asset as collateral security, for 1 year with the rate of interest 10%. The value of the security is $ 145000 as on today. Lets’ have the following situations in place:
Situation I: Mr A honours the payment
In such a case, the asset is returned back to Mr A & Mr A will pay $ 110,000 to Mr B
Situation II: Mr A defaults
In such a case, Mr. A will sell the asset at market value say $ 135000 & recover the said principal & interest amount. Here, Mr. B has a surplus $ 25000 which he will pay to Mr. A back.
Types of Repurchase Agreement
- The first-type is “Tri-patriate agreement”. We have a tri-party agreement wherein a clearing agent is involved in addition to normal buyer & seller. The agent ensures that the interest of each is secured. At the time of first sale, the agent will retain the asset from the seller (i.e. the borrower) of asset & will also ensure that the amount is realised to him from the buyer (i.e. the lender). After confirmation of obligations by each party, the agent releases the asset & the lending amount. The agent also provides independent valuation service to the parties of the contract. The agent is appointed separately by the consensus of both the parties. The agent will not be biased for any of either the party & hence, the agent will never search lender for a borrower or a borrower for a lender.
- The second type is “held-in-custody repo agreement”. Here, the borrower receives the amount from the lender. Instead of providing possession to the lender, the borrower holds the asset in a custody account in the name of a lender. This makes the transfer of ownership without providing possession of the asset. This provides insecurity to lender & excess confidence to the borrower.
- Third & another famous type is “Specialised Delivery Repo Agreement”. Here, guarantee through a bond is required at the beginning of the contract. Such a guarantee is also required at the time of maturity of the said contract.
Risk for Repurchase Agreement
- The most common risk for a lending agreement is a risk of default. This risk is crystalised when the borrower (i.e. seller of the asset) fails to honour the repurchase terms on the maturity date. However, a default may be incurred by the lender (i.e. buyer of the asset) in case the market value of the asset is higher than what is agreed over the agreement. In such a case, the lender may not sell back the asset to the borrower.
- Another common risk is liquidation risk wherein the lender may sell the asset in order to recover the cost of lending & default amount.
- Further, the value of security offered may decline over the period of the loan term, which will expose the lender to more risk in case the borrower defaults.
- Another risk is that the value of asset obtained at the same or lower value than the amount lent by the lender. Such a situation is called as under-collateralisation.
Uses of Repurchase Agreement
- The basic objective of a repurchase agreement is to facilitate finance between two parties through collateral security. There is no publicly available information for such arrangements.
- Repurchase agreements increase liquidity in the short-term market for the said asset.
- The basic intent of the repurchase agreement was to ensure huge money flows in the market for providing sufficient growth to the sectors. Many repurchase agreements are backed by government-backed securities which confirms the intent of the parties involved.
Some of the advantages are given below:
- The lender can sell the asset in case of any default incurred by the borrower.
- Repurchase agreements are secured in nature due to the collateral security offered.
- Since ownership is transferred, the parties have seriousness for the successful execution of the contract.
- It provides liquidity for the borrower through easy finance.
- The collateral security has some market value which provides confidence to the lender.
Some of the disadvantages are given below:
- The market value of a security may decline in future.
- There is counter-party default risk from the lender as well as the buyer.
- In case the asset becomes useful as, at end of the period, the lender is exposed to a high risk of default.
- The quantum of loss is not ascertainable at the time the agreement is entered into.
Considering all pros & cons of the repurchase agreement, such agreements are famous in today’s world due to the collateral offered. Also, the majority of contracts are ensured through a tri-patriate agreement which removes major risk to the contract. However, for the sake of liquidity, each party needs to take the decision on the basis of the respective risk appetite.
This is a guide to Repurchase Agreement. Here we also discuss the definition and how does repurchase agreement work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –