Repo Market Visualized, How does it work?
In the world of finance, the U.S. repurchase agreement (repo) market plays a crucial role in providing short-term funding for banks and financial institutions. But how does it actually work?
In the U.S. financial market, the repurchase agreement (repo) market plays a crucial role in maintaining liquidity and supporting short-term borrowing needs. But how does this market actually work? In this article, we'll delve into the mechanics of the repo market, exploring the key players involved and the unique process of buying and selling repurchase agreements. Whether you're a seasoned investor or simply curious about the inner workings of the financial world, understanding the repo market is essential. Join us as we demystify this important aspect of the U.S. financial system and shed light on its significance in ensuring smooth operations for banks, hedge funds, and other institutions. What is the repo market, and why does it matter?
What is the repurchase agreement (repo) ?
A repurchase agreement (repo) is a financial transaction in which one party sells an asset to another party with a promise to repurchase the asset at a pre-specified later date.
The recipe for the basic repo:
2 parties
One party (Investor) gives the cash to borrower.
One party (Borrower) gives the collateral to investor.
The borrower buys back the collateral, paying the investor their initial cash plus an interest amount.
The "repo rate" is the interest rate received by the investor.
The repo market allows participants to give and receive loans that are backed by collateral. The repurchase agreement (repo) market plays a pivotal role in the normal functioning of the U.S. financial system by acting as an important source of secured short-term funding and supporting the liquidity of key fixed income markets, including U.S. Treasury and agency securities (Paddrik:2021).
The repo market has a long history and has gone through a number of institutional changes. Repo financing has been used by Federal Reserve banks to provide credit to member banks since 1917 (Beckhart, Smith and Brown 1932).
The Repo Market is different from The Federal Funds Market
Participants in the federal funds market trade uncollateralized loans, typically of overnight maturity, on a bilateral basis. Only institutions eligible to have a Federal Reserve account can trade fed funds. The main participants in this market are U.S. depository institutions (DIs), or “banks” for simplicity; U.S. branches and agencies of foreign banks; and Federal Home Loan Banks (FHLBs) (Gara:2021) *While the fed funds and repo markets are separate markets with distinct features, there are several links between the two (Gara:2021, page:7).
Who are the repo participants?
Although participants have varying business models, the incentives of cash lenders and cash borrowers differ. Within the overnight segment, most cash lenders seek interest income at very short maturities and/or a secured alternative to bank deposits for balances that exceed the deposit insurance cap. Most cash borrowers use this segment to obtain large amounts of short-term financing for their securities inventories and their own secured lending to clients at a low cost.(Paddrik:2021).
Financial institutions – Primary dealers, banks, insurance companies, mutual funds, pension funds, hedge funds
Public institutions – Fed, Central Banks, Municipalities
Corporations
Repo Participants’ Motivations
Paddrik (2021) indicated that nearly all participants act only as either a cash lender or a cash borrower, with the Federal Reserve being the only major participant that trades on both sides of the market. He also highlighted that primary dealers, non-primary dealers, and commercial banks account for the majority of cash borrowers, while collective investment vehicles (mostly money market funds), securities lenders, and commercial banks represent the majority of cash lenders.
Federal Reserve
Federal Reserve has conducted temporary open market operations by entering into repo and reverse repo transactions with primary dealers.
Primary Dealers
Securities dealers operate as intermediaries between those who lend cash collateralized by securities, and those who seek funding.
Money Market Funds
Money Market Funds use repo as a way to securely invest cash.
Hedge Funds
Hedge Funds enter into repo contracts to finance their securities positions or obtain leverage.
U.S. Repo Market
Antoine (2012) categorizes U.S. repo market into two groups*: tri-party repo and bilateral repo .
There are four main distinctions between bilateral and triparty repos:
• timing of settlement,
• settlement risk protections,
• cost of clearing and settlement, and
• the ability to specify that any security within a general asset class can serve as collateral (Viktoria:2015)
Currently, the Fed provides reliable information on tri party repo transactions. In this sense, we will focus on tri party repo in the rest of our article. There is the article on calculating the bilateral repo amount.
What is the volume of the repo market?
The repo market volume is about $3.8 trillion according to the Fed source (09 November 2023).
Other detailed source on repo is OFR U.S. Repo Markets Data Release. Transaction volume of all repurchase agreements starting on a given day that were settled in tri-party repo. The repo market volume is about $4.2 trillion according to the OFR source (13 December 2023).
Other source is Primary Dealer Statistics of NY Fed. This data tool is designed to offer you transparency and control of the available Primary Dealer time series data. You can find the repo statistics of Primary Dealers as follows.
BNY Mellon is the unique clearing bank in the tri party repo transactions. Fed realizes all the repo transactions in this market. The triparty repo service provides protection to both parties. Cash investors protect themselves from a dealer default by negotiating a haircut, which requires the dealer to overcollateralize the repos. Collateral providers are protected from settlement fails, because the securities they post as collateral remain in the custody of the clearing bank and cannot be reused outside the clearing banks’ triparty repo settlement platform (Viktoria:2015).
Engin YILMAZ (@veridelisi)
Online Data Sources:
OFR short-term funding monitor,
New York Fed’s tri-party repo statistics website,
New York Fed repo-reference rates
Sources:
Adam Copeland and Antoine Martin. (2021). Repo over the Financial Crisis .Federal Reserve Bank of New York Staff Reports, no. 996 December. Link
Adam Copeland, Darrell Duffie, Antoine Martin, and Susan McLaughlin. (2012). Key Mechanics of the U.S. Tri-Party Repo Market. Link
Adam Copeland, R. Jay Kahn, Antoine Martin, Matthew McCormick, William Riordan, Kevin Clark, and Tim Wessel (2021). How Competitive Are U.S. Treasury Repo Markets? Liberty Street Economics. Link
Antoine Martin. (2012 ). Mapping and Sizing the U.S. Repo Market, FEDS Notes. Washington: Board of Governors of the Federal Reserve System. Link
Beckhart, Benjamin, James Smith, and William Brown (1932). The New York Money Market, Vol. IV, External and Internal Relations. New York: Columbia University Press.
Gara Afonso, Marco Cipriani, Adam Copeland, Anna Kovner, Gabriele La Spada, and Antoine Martin. (2021). The Market Events of Mid-September 2019 Federal Reserve Bank of New York Economic Policy Review 27. Link
Paddrik, Mark E., Carlos A. Ramírez, and Matthew J. McCormick (2021). "The Dynamics of the U.S. Overnight Triparty Repo Market," FEDS Notes. Washington: Board of Governors of the Federal Reserve. Link
Tri-Party Repo. (2023). https://www.newyorkfed.org/data-and-statistics/data-visualization/tri-party-repo#interactive/gcfrepos
OFR U.S. Repo Markets Data Release . (2023). https://www.financialresearch.gov/short-term-funding-monitor/datasets/repo/ and https://www.financialresearch.gov/short-term-funding-monitor/market-digests/volume/chart-26/
Viktoria Baklanova, Adam Copeland, and Rebecca McCaughrin. (2015). Reference Guide to U.S. Repo and Securities Lending Markets, Federal Reserve Bank of New York Staff Reports, no. 740 Link
*The repo market is divided into three parts: (1) the triparty repo market, where transactions are centrally settled by two large clearing banks; (2) the general collateral financing, or GCF, market, where interdealer repo transactions are centrally cleared; and (3) the bilateral market, where repo transactions are conducted privately between two firms.
*The interdealer market has two components: 1) the GCF Repo market, which, like the tri-party repo market, settles on the book of BNYM, and 2) a bilateral market called the FICC DvP market, where DvP stands for “delivery versus payment.” Small dealers that borrow from large dealers in the interdealer market often lend to ultimate cash borrowers in the bilateral repo market.
