Reverse repo – What is it, definition and concept

The reverse repo is an operation between two parties that consists of temporarily financing a counterparty by buying a financial asset from another agent, with the commitment to resell it on a future date established in advance.

In other words, a reverse repo is still a very short-term loan. It consists of acquiring a financial asset, agreeing to resell it, within an agreed term, to the same agent from whom it was purchased.

This type of operation is similar to a rental, in which the financial asset purchased temporarily acts as collateral.

The reverse repo is the opposite side of the repo. The first is from the position of the financier and the second occurs from the part of the person seeking financing.

Explanation of the reverse repo

From the foregoing, it is understood that in a reverse repo there is a party that buys the asset but also another party that has to sell it. To better understand the concept of reverse repo, we are going to analyze the two sides of the coin of this temporary sale and purchase operation of financial assets.

A repo or reverse repo is a transaction for the sale of an asset -a public debt security- with a repurchase agreement for said asset at a price –interest rate– and on a future date agreed in advance by both parties (maturity). .

  • A reverse repo, in Spanish, is a temporary acquisition of assets (ATA).
  • A repo is a temporary transfer of assets (CTA).

This means that:

  • The reverse repo occurs from the point of view of the person who buys the asset: The buyer’s objective is to obtain profitability by lending money or obtaining the title. The reverse repo is bought.
  • the repo occurs from the position of the person selling the asset: The objective of the seller of the asset is to finance himself. The repo is sold.
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Repo or reverse repo operations are loans collateralized by the financial asset agreed upon by the parties. So that:

Characteristics

Generally, the asset exchanged is a public debt security issued by governments, such as bonds, debentures or treasury bills. Precisely because they are collateralized by an underlying, repos or reverse repos represent secured or guaranteed financing, occupying an advantageous position in the priority order of the debt.

Ownership of the exchanged title transfers from the seller to the buyer on a temporary basis until the expiration date, when the buyer must return it—sell it—to the seller.

They are operations very similar to securities loans secured against cash.

The conditions that are negotiated in these operations are the following:

  • Value date: Day on which the operation comes to life. Generally, it is negotiated in D and the value date is usually in D+2, that is to say, two days after having agreed the operation.
  • Expiration date: Day on which the operation ends. They are usually short terms that range from one day to two months, but this depends on the needs of the entity.
  • Nominal value of the operation: Value expressed in millions according to the number of bonds.
  • Price or repo type: It is the interest rate that the seller of the securities must pay to the buyer for having lent him money. It is usually close to the money market rate and is applied to the nominal value of the operation to calculate the cash that the financier will pay to the financier. A haircut or valuation cut may also be applied by the buyer. The better the credit quality of the transferred asset, the more advantageous the repo rate will be for the seller of the asset.
  • Initial Cash: It is the amount of money that the financier will pay to the financier on the value date of the repo, that is, at the beginning of the operation. It corresponds to the dirty price of the bond (nominal x listing price + current coupon) on the value date of the transaction.
  • ending cash: It is the amount that the financier must return to the financier on the expiration date of the operation, that is, when the loan is extinguished. It corresponds to the initial cash + accrued interest at the agreed repo rate.
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Banks’ objectives when trading repos

These are some of the objectives of the two parties when they negotiate repos in the market:

  • Obtain money through the financing of own titles: The seller of the repo seeks financing in the short term to cover more or less punctual liquidity needs. Own titles are public debt bonds that are on the entity’s balance sheet.
  • Get profitability: The buying party earns an interest rate for lending money to the other party. You can also reinvest that amount in the market and make a profit.
  • Compliance with ratios liquidity finance: There are ratios imposed by the regulator of each country, such as, for example, the LCR ratio (liquidity coverage ratio), at the end of the month. This applies to both parts of the operation.

Practical example

Let’s assume the current negative rate environment. Bank A and bank B have entered into a repo/reverse repo transaction. Bank A sells repo and bank B buys reverse repo (A seeks financing and B finances).

A and B agree to close a nominal amount of 10 million euros of the 10-year Spanish bond that pays a coupon of 1.40% annually – collateral asset – for a period of one month. The value date of the repo is Monday 01/10/22 and the expiration date will be 01/25/22. That is, the operation will be alive for 15 days. The repo rate is -0.50% and the price of the collateral bond is quoted at par (ie at 100% of its face value). For the calculation of the running coupon, we know that the last coupon cut occurred on 04/30/21.

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What would be the beginning cash and the ending cash?

Initial Cash: €10,000,000 + €97,808.22 running coupon = €10,097,808.22

Calculation of the running coupon = Number of days since the payment of the last coupon / Number of days between coupons * repo rate = 255 days / 365 days * 1.40% = €97,808.22

ending cash: initial cash + accrued interest = €10,097,808.22 + (-€2,083.33) = €10,095,724.89

Calculation of accrued interest = Nominal * Number of repo days * Interest rate = €10,000,000 * 15 * (-0.50%) = €2,083.33

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