Investing in repos is certainly an absolute solution for investors holding cash for safekeeping or liquidity reasons. An excellent illustration of this situation may be the money market mutual fund industry, whose main aim should be to make investments to get investors disposed to just accept minimal returns with regard to safety and liquidity.
In essence, compared to liquid non-interest-bearing and super-safe bank deposits, repurchase agreement (repo) investments incorporate short-term pay rates even without making huge liquidity sacrifices as well as having to incur notable default risks.
Additionally, municipalities form another necessary classification of repo investors. The schedule of public expenditures has less association while using timing for tax receipts; municipalities would prefer to manage cash excesses from tax receipts to make certain money is easily obtainable at hand to satisfy expenditures. Investments of tax revenue can not be made under risky securities; however, the bucks collected mustn’t be left lying idle. Short term loans based on collaterals, like repos, fulfill both safety and revenue considerations.
Features of Repos
Investors are likely to lend overnight loans because there’s a premium affixed to liquidity. It identifies maturity that may be longer than every day. Most investors able to give money through repo platform for the extended period prefer getting involved in the open repo; i.e., a repo that will need daily renewal until either on the parties cancels it. However, lenders that are ready to undertake on some counterparty risks and liquidity with rate risks lend via repos terms. The term repos are accessible for investors and possess various maturities as much as several months.
The main feature of repos could be the fact that they normally accept securities on the highest quality as collateral. It is because safety factors are a fundamental consideration for repos investors. Thus, debt from government-sponsored businesses and government securities, amongst others, will be the most approved choices.
As noted, it can be taking the top quality assets as securities that define the main feature in the repo. However, when a borrower defaults repaying the loan, the loan originator eventually incurs losses since selling the collateral may not recover the complete loan amount. In that sense, haircuts are often provided in repos agreements, the location where the borrower offers security containing more worth than the credit. Furthermore, in repo agreements, you’ll find margin calls in which the money borrowers provide extra collateral in the event the value with the collateral decreases.
How Counterparty Risk and Liquidity Risk Arises by having a Repo Transaction
Repos and Long Financing
Financial institutions are definitely the primary cash borrowers in repo markets. Repo financial markets are utilized by commercial organizations to finance their inventories for making markets. Besides, they could be used in financing the institution’s customer and proprietary positions.
An reason behind proprietary repo positions may be accomplished by considering a relevant trading desk as being a counterparty with internal aims to purchases and then sell on bonds. Repo for financing customer positions can be seen in the sense that it truly is a customer who may be the counterparty and intends to finance the paying for DBR 4s.
The repo while using client, the transaction of funding (lending), plus the acquisition from the Treasury security as collateral are performed through the financial institution’s counterparty trading desk. A different trading desk avails the bucks and acquires the initially supplied guarantee, and so gets connected while using other counterparty in the back-to-back repo. Essentially, in each leg with the transaction, there’s a haircut charged, which heavily depends on the relevant counterparties’ creditworthiness.