Published: January 01, 2012
The repurchase agreement market is one of the largest and most actively traded sectors in the short-term credit markets and an important source of liquidity for money market funds and institutional investors. Repurchase agreements (also commonly referred to as repo agreements) are short-term secured loans frequently obtained by dealers (borrowers) to fund their securities portfolios, and by institutional investors (lenders) such as money market funds and securities lending firms, as sources of collateralised investment.
In this article, we look to explain the fundamentals of this important sector and provide insight into its usage and operation.
In its simplest form, a repurchase agreement is a collateralised loan, involving a contractual arrangement between two parties, whereby one agrees to sell a security at a specified price with a commitment to buy the security back at a later date for another specified price. In essence, this makes a repurchase agreement much like a short-term interest-bearing loan against specific collateral. Both parties, the borrower and lender, are able to meet their investment goals of secured funding and liquidity.
There are three types of repurchase agreements used in the markets: deliverable, tri-party and held in custody. The latter is relatively rare, while tri-party agreements are most commonly utilised by money market funds. Repurchase agreements are typically done on an overnight basis, while a small percentage of deals are set to mature longer and are referred to as ‘term repo’. Additionally, some deals are referred to as ‘open’, and have no end maturity date, but allow the lender or borrower to mature the repo at any time. In a deliverable repurchase agreement, a direct exchange of cash and securities takes place between the borrower and lender.
As mentioned, the most widely used form of repurchase agreements by money market funds is referred to as the tri-party repo market which recently stood at approximately $1.7tr1. These agreements use a third party — a custodian bank or clearing organisation known as the ‘collateral agent’ — to act as an intermediary between the counterparties to a deal. The role of the collateral agent is critical: it acts on behalf of both the borrower and lender minimising the operational burden and receiving and delivering out securities and cash for the counterparties. The collateral agent also serves to protect investors in the event of a dealer’s bankruptcy, by ensuring the securities held as collateral are held separate from the dealer’s assets.[[[PAGE]]]
Repurchase agreements are used by money market funds to invest surplus funds on a short-term basis and by dealers as a key source of secured funding. Securities dealers use these deals to manage their liquidity and finance their inventories. While repurchase agreements are commonly found within money market funds as short term, mostly overnight investments, the cash investor might look to invest cash for a more customised period of time to fulfil a specific investment need. As these transactions are short term and considered relatively safe due to the secured collateral, market liquidity and rates remain competitive for all investors.
While there are several factors that impact market rates, two of the most important are the type of collateral behind a contract and the terms of a deal. Traditional, or general collateral (often referred to as GC), is comprised of government securities including treasuries, agencies and agency mortgage securities. As of Q2 2011, traditional collateral comprises approximately 80%2 of the outstandings in the tri-party market. Non-traditional/corporate or alternative repurchase agreements may include a range of non-government securities including corporate investment grade and non-investment grade debt and even equity securities as collateral.
Use of traditional collateral, coupled with a shorter term, will typically result in a lower yield whereas use of non-traditional collateral, together with a longer term, will generally result in higher yields. The level of returns offered by dealers will also highly fluctuate depending on market conditions and factors such as outstanding supply, demand for certain types of collateral (i.e. treasuries), and the specific credit risk of the counterparty.
As the events of the past few years have shown, preparation for unforeseen market conditions is vital. As such, over-collateralisation, or ‘haircuts’ are commonplace in the repo markets. They provide a level of increased security in the event of a default by a counterparty. Typical over-collateralisation percentages based on collateral type are as follows:
Traditional: 102-103%,
Non-traditional: 105-107%.
Under Rule 2a-7 of the Investment Company Act of 1940, money market funds are subject to a 5% maximum exposure to any single issuer. Due to the importance of liquidity within money market funds, as well as the secured nature of repurchase agreements, those that utilise traditional collateral are permitted to ‘look through’ to the high quality collateral and utilise less-restrictive exposure criteria. However, transactions that utilise non-traditional collateral would still be subject to these exposure limits.[[[PAGE]]]
One of the most common forms of repurchase agreements used by money market funds is the tri-party repurchase agreement. The ‘tri-party’ label comes from the fact that a third party, known as the ‘collateral agent’, acts as an intermediary in the agreement, ensuring that both lenders and borrowers are protected. Figure 1 illustrates how this type of agreement is structured and how it serves to protect lenders and borrowers in a transaction.
The recent financial crisis highlighted the significant role repurchase agreements have come to play in the short-term liquidity markets. In 2008 at the high water-mark for the sector, an estimated $2.8tr3 of securities, were funded through repurchase agreements. Major investment banks such as Bear Stearns and Lehman Brothers relied heavily on these deals to fund their operations. As their financial difficulties became more apparent, other institutions reduced their credit lines, including repurchase agreements, or declined to lend to them altogether.
As a result, they ran into financial difficulties, and regulators and investors alike became acutely aware of the extent to which these transactions were employed by investment banks’ dealers to fund their operations. Regulators concluded that banks’ over-reliance on repurchase agreements for short-term funding was a major contributing factor toward instability in the financial markets. As a result, domestic and international regulation in both the banking and securities markets has been amended in recent years, to reduce the potential for repurchase agreements to ‘freeze’ the credit markets. While this market remains a highly significant sector for lenders and borrowers alike, the overall size has been reduced from its 2008 peak to its current position of around $1.7tr4. Recent industry reforms, such as changes to custodial bank intra-day credit, settlement processes and a widespread reduction in banks’ leverage have strengthened the sector and it remains important for money market funds and other institutional investors, in particular as a source of overnight liquidity.
BlackRock and its predecessor companies have been involved in the management of money market funds since 1973. Today BlackRock is one of the largest cash management providers in the world, managing a range of US and internationally-domiciled money market funds. We have earned our clients’ trust through multiple interest rate cycles and a wide range of market events. BlackRock considers cash management a unique investment discipline requiring a distinct skill set for effective management. While our investment strategy is conservative by nature, we strive to deliver competitive, consistent returns over time. We understand the importance of putting safety and liquidity first, not as a marketing message, but as the core of our investment philosophy.[[[PAGE]]]
BlackRock’s investment process emphasises a commitment to fundamental research and independent credit evaluation. Our research team follows a rigorous process when assessing the creditworthiness of a security. In order to develop a formal view, we conduct both quantitative analyses of corporate capital structures and qualitative assessments of management and industry positioning.
BlackRock has also developed proprietary tools that support the research process. For example, Galileo™, our global research database, allows analysts to share, store and access information and insights across asset classes and locations. GPLive™, our risk monitor, enables portfolio managers to view issuer exposure across portfolios on a real-time basis.
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