Repo: A Clear Definition
A repo or a repurchase agreement is a contract in which a seller of securities promises to buy them back at a later date for a mutually agreed price. Overnight repo, term repo, reverse repo, purchase agreement, buyback, and leaseback are some of the terms that are related to this process.
Financial instruments, such as treasury or government bills, treasury/government or corporate bonds and stocks/shares are offered as securities in a repurchase agreement. Typically, in this agreement, a prospective seller submits these financial instruments in exchange for cash with a promise to repurchase them from the buyer later on. The repaid sum is always higher than the sum that is agreed upon in the beginning. The difference between the repaid sum and the sum that was originally agreed upon is called the repo rate.
A repo is slightly different from a loan transaction. While taking out a loan, the debtor places financial instruments under a lien to the lender. Lenders possess the securities during the tenancy of the loan. When the loan is finally settled, the borrower gains back the ownership of the securities. If the debtor fails to clear the loan, the lender can dispose of the securities to recover the dues. If the sale value of the securities is lesser than the total loan amount, the creditor holds the legal right to recover the balance amount from the debtor.
In the case of a repo, the cash provider can liquidate the securities if the seller defaults on the repurchase of the financial instruments. However, the repo buyer cannot recover the full amount if the sale value of the securities is lesser than the cash lent originally. This can happen if the financial instruments have depreciated in value during the period of time the repo was agreed upon. On the other hand, if the securities had appreciated during that period the buyer may receive a fair profit. Thus, a repo transaction definitely has a certain amount of risk. Normally, repos are invariably over collateralized to reduce the amount of risk involved. Repo agreements are also subject to daily marginalizing.
Persons trading in repos can also be market investors. These traders employ strategies of dealing in both repo and reverse repo transactions at the same time. They utilize the bid/ask spread that would normally be used by repo rates and reverse repo rates to make profits. However, if different parties had transacted the same instruments in a chain operation, the failure of one party can put all the parties that were involved in the repo transaction at risk. It can even spell ruin for all the concerned parties, particularly if the repo transaction was at a very high value. Such a situation arose when Refco, a New York-based financial services company, collapsed in October 2005.
