Mastering repo trading: strategies, benefits, and market dynamics
What repo is and the role it plays
The repurchase agreement or repo market is one of the largest and most actively traded sectors in the short-term markets and an efficient source of funding for dealers and other types of financial institutions. It is a contractual arrangement between two parties, where, typically to raise cash, one agrees to sell securities (collateral) to another at a specified price with a commitment to buy them back later for another, usually higher specified price. A reverse repo is simply the mirror of the same transaction. In other words, the initiator purchases securities and agrees to sell them back at a later date.
The repo market underpins the stability of the wider financial markets, and, to stick with the typical metaphors, is viewed as the oil that lubricates the system or the plumbing through which liquidity flows.
Repo is used in certain money market funds (MMFs) to invest surplus cash on a short-term basis and by financial institutions to both manage their liquidity and finance their inventories. While repo is commonly held within MMFs as a short-term, overnight investment, a cash investor might look to use term repo to invest cash for a more customized period to fulfil a specific investment need. This makes repo economically similar to a short-term interest-bearing loan against specific collateral.
As short-term funding instruments, repos attracted unwanted publicity during the global financial crisis when the market temporarily seized up. This was due to questions over the true value of the securities underlying repo trading during the market turmoil. This prompted many financial institutions to adopt a more cautious stance about holding these assets for fear that the borrower on the other side of their agreement might go bankrupt.
There have been other bouts of volatility in the following 16 years. The most recent was in September 2019, when increased government borrowing exacerbated a shortage of bank reserves. This was created when the US Federal Reserve Bank put the brakes on buying US Treasuries, and investors took up the slack. Overnight repo rates in funding markets are widely relied upon by banks to fund day-to-day operations, and the central bank’s actions caused rates to temporarily jump fivefold to a high of 10%.
Although the ructions were much smaller, there was a jump in the Treasury GCF Repo Index from 30 November to 4 December 2023, over concerns about whether cash levels were sufficiently healthy. The end of December 2023 also saw the DTCC GCF Treasury Repo Index, which tracks the average daily interest rate paid for the most-traded General Collateral Finance (GFC) Repo contracts for US Treasuries, jump to 5.5.%. The spike resulted from dealers closing their books for the year, which meant borrowers had to pay more to fund their collateral.
There have also been a couple of much less disruptive hiccups in 2024, which only underscore the importance of these short-term funding markets and the need for greater transparency and automation.
Key concepts in repo trading
As with any financial instrument, repo has its own vernacular. The instruments are structured in diverse ways, but they are flexible in that they can be shorter or longer as needed compared to other short-term financing arrangements, such as commercial paper or certificates of deposit. Common arrangements include:
- Overnight repos, which typically mature the next business day, or term repos, which have specified maturity dates that can range from overnight, 1, 2, or 3 months, or even up to 1 or 2 years or longer for highly structured loans. Repos with a specified maturity date can be rolled over (repeated for broadly the same terms) or extended by mutual agreement of the parties.
- Open repos do not have maturity dates but can be terminated on any business day in the future provided there is sufficient notice by either participant, normally dictated by standard convention or by legal agreement, or agreed for specific periods.
- Other more complex structured term types exist, including evergreen or extendable types, or those with more complex options built into the agreements.
- Interest rates are at the heart of repo trading and central banks can raise the repo rate as a deterrent to make it more expensive for commercial banks to borrow, reducing the money in the system. They can also equally lower the rate to encourage borrowing and stimulate demand.
- The other main function of repo transactions is as a secondary market where financial players lend securities that they hold as inventory to meet their short-term funding requirements, providing a vital source of cheaper finance than would be available uncollateralized, and hence is commonly considered the oil that keeps the capital markets functioning efficiently.
Types of repo transactions
- Centrally Cleared Repo: whereby a central clearing counterparty (CCP) or clearing house, such as the DTCC Fixed Income Clearing Corporation (FICC), facilitates trading between member firms, reducing costs, removing bilateral credit exposure, and taking on the settlement risk when two member firms trade between each other. This is the most traded type of product between primary dealers in most highly liquid securities and when traded on electronic platforms. This is an area subject to significant, upcoming regulatory-driven changes (see <ION blog> for discussion).
- Bilateral Repo: whereby investors and collateral providers directly exchange money and securities. They either allow for general collateral or impose restrictions on eligible securities for collateral. Bilateral repos are preferred when market participants want to interact just with each other or if specific collateral is requested.
- Tri-Party Repo: the most widely used form of repo across Money Market Funds (MMFs). It differs from other forms in that a third party—typically a custodian bank or clearing bank—acts as an agent or intermediary between the counterparties to the deal. Agents play a key role in minimizing the operational burden of receiving and delivering the collateral and cash. Tri-party repo is used to finance general collateral, with investors accepting any security within a broad class of securities.
- Sponsored Repo: a variation whereby an approved member of a CCP backs a non-dealer counterparty to transact on its cleared repo platform. The platform settles trades through the delivery versus payment (DvP) settlement process, a method which permits the transfer of securities only after payment. Although the idea of sponsored repo is not a new phenomenon–FICC’s sponsored repo platform began in 2005–it has gained traction due to the exponential growth of assets in the money market sector as well as the plethora of post-financial crisis regulation that has squeezed banks’ balance sheets.
Geographies and repo market participants
The US repo and reverse repo market was estimated to be roughly USD 5.9 trillion as of May 2024, which is higher than the USD 5.3 trillion in the same month the previous year. Europe is also growing—reaching an all-time high of EUR 10.89 trillion at the end of 2023 compared to EUR 10.37 trillion a year earlier, according to the latest International Capital Market Association’s (ICMA’s) European Repo and Collateral Council survey. The tool is also commonly used in other markets, including Japan, and the wider Asian markets, particularly Singapore, Hong Kong, and Australia, and is growing in other emerging markets.
Broker-dealers, insurance companies, corporates, mutual, pension and hedge funds are active participants. However, central banks are also key players and use repo as a conduit to transmit their monetary policy to the wider financial community and provide emergency assistance to the banking system.
According to ICMA, the collateralized nature of the repo market not only reduces central banks’ credit risk but also broadens the range of assets they can tap into beyond outright purchases. This lets them execute their monetary policies seamlessly during periods of calm, while simultaneously enabling them to respond more quickly to major crises.
Benefits of repo trading
- Repos are secure, low-cost financing tools.
- Repos facilitate deliveries of securities, useful in shorter settlement cycles.
- Repos help insulate markets during times of turbulence.
- Central banks use repo lines to provide liquidity during crises.
- Financial institutions use repos to hedge interest rate exposures.
- Reverse repos are typically used by investors sitting on surplus cash.
Repo is a financing tool that offers security, low funding costs, operational efficiency, and standardized documentation. At the big picture level, market participants can obtain the necessary securities or cash to be deployed in other transactions, such as posting margin or meeting their settlement obligations.
As the ICMA report points out, repos offer assurance by facilitating the timely deliveries of securities in case there is a problem in the chain. “Without the ability to borrow securities, delivery failures might propagate through the market. Its role will become even more important as more markets shorten their settlement cycles from T+2 to T+1,” it said.
Repos have been instrumental in helping to insulate markets from recent periods of turbulence, most notably the pandemic, geopolitical tensions, and a higher interest rate environment over the past four years. They were an avenue for central banks to provide much-needed funds to financial markets early in the COVID-19 pandemic and following the events in Ukraine more recently.
For example, during both crises, the European Central Bank (ECB) used repo lines to provide extensive euro liquidity to several non-euro area counterparts, helping to prevent further market turmoil and contagion seeping into the bloc.
Financial institutions, on the other hand, use repos to hedge interest rate exposures, cover short sales, and bolster leveraged positions. A hedge fund, for example, might turn to the repo market to finance a trade designed to benefit from a mispricing of risk – which, in turn, will facilitate better price efficiency in the underlying cash markets.
Reverse repos are also popular during certain market conditions. They are widely seen as a low-risk and highly liquid investment tool for financial and non-financial institutions such as money market funds, asset managers, financial market infrastructures, and corporates that are sitting on surplus cash piles. They came into their own when interest rates were low, giving lenders safe, net incremental income and borrowers access to cheaper funding.
How repo rates and the use of collateral are determined
As repo is generally short-term in nature and considered less risky due to being the economic equivalent of a collateralized transaction, rates are typically competitive with those for other lower-risk securities. There are multiple factors that have an impact, although the two most important are the terms of the agreement, and the type of securities being sold and repurchased.
Traditional securities offered in repo – and referred to as general collateral (GC) – are government bonds. ICMA’s semi-annual survey of the European repo market estimates they account for over 90% of EU-originated repo collateral. In the US, Treasuries comprise about two-thirds, with the rest being agency debt and agency mortgage-backed securities.
There are also other illiquid asset classes that are used as collateral, but they are a smaller component of the repo market. This includes corporate bonds, typically senior unsecured debt issued by investment-grade banks and large non-financial companies. Sovereign, supernational or agency assets (for example, those issued by the World Bank or other public sector institutions), are also commonly traded in the repo market; as are covered bonds, such as Ppfandbrief, which are secured by pools of public loans or mortgages held on the balance sheet of the issuer but ring-fenced in statute by special public laws. They are issued in countries with stronger banking sectors and have been increasing in popularity as collateral, partly, because regulators have signaled its acceptability to meet regulatory liquidity ratios.
Returns from repo can fluctuate depending on market conditions and other factors such as outstanding supply and demand for certain forms of collateral. As a result, a discounted price for the collateral, also known as a haircut, is negotiated between the two parties. This so-called “over-collateralization”, or the provision of collateral that is worth more than enough to cover potential losses, is commonplace and may vary between repo transactions depending on the credit quality of the underlying collateral type or the counterparty. This is significant because this practice provides an additional measure of protection for investors in the event of a default by a counterparty.
Regulatory considerations and compliance in repo trading
Each country has its own rules and regulations, many of which align with more stringent capital and liquidity requirements under Basel III and the Fundamental Review of the Trading Book following the global financial crisis. In the European Union alone, market participants must deal with the Financial Collateral Directive, Short Selling Regulation, and the Securities Financing Transaction Regulation (SFTR). There is also other legislation that has an indirect impact, such as the European Market Infrastructure Regulation (EMIR), the Markets in Financial Instruments Directive (MiFID) and Regulation (MiFIR), the Bank Resolution and Recovery Directive (BRRD) and the Central Securities Depository Regulation (CSDR).
In the US, repo falls under the aegis of Dodd Frank’s enhanced prudential safety and soundness regulation (EPR) of large banks and systemically important financial market utilities (FMUs) that are viewed as posing systemic risk. The instrument has also been part of the ongoing discussion on shadow banking with the Financial Stability Board looking to implement a so-called macro-prudential regulation of collateral management through devices such as mandatory minimum haircuts.
The US Securities and Exchange Commission (SEC) is also hoping to make the system more resilient with its new rules on central clearing for Treasury and repo markets. Implementation is staggered with the first phase scheduled to come into effect in December 2025 for cash transactions and June 2026 for repo transactions. The ruling is agnostic to geography and could affect transactions that involve FICC members in Europe.
According to the DTCC, only about 15% of the interdealer cash market is centrally cleared at FICC, while in repo, that figure is just about USD 1 trillion. This presents leverage risks, particularly in bilateral trades where no margin is collected.
The aim of the SEC rules is to significantly reduce counterparty risk and enable dealers to net their repo positions with one counterparty against reverse repo positions with another counterparty to calculate certain regulatory ratios. This, in turn, is expected to lower the balance sheet costs of participating in repo.
Technological challenges and advances in repo
The new SEC rules mean that all firms will have to strengthen standards on risk management, access to settlement services, and protection of customer assets. Repo has historically lagged other liquid asset classes, such as equities and FX, in adopting new technologies, but firms will now need to embrace advanced trading tools to streamline operations and navigate the complexities of central clearing seamlessly.
Firms face four main challenges, which were highlighted in Greyspark and ION’s Trends in Repo Trading report. They include the unstandardized nature of repo instruments, their complexity, the persistence of voice trading, and pockets of opacity. This has led to a manual, often disjointed process for all market participants, with little automation, which is not fit for purpose in the new clearing world.
Although the report notes that, unsurprisingly, larger firms are ahead of their smaller to medium-sized counterparts on the tech curve, all participants will need to increase their adoption of automated platforms and electronic trading systems to further streamline operations and lower transaction costs. In addition, they will need to ensure that new systems can be integrated with existing infrastructures and enhance data aggregation.
Market participants expect the push to central clearing will accelerate acceptance of the Common Domain Model (CDM), which has hitherto struggled to gain traction. Launched in 2023, the CDM is a machine-executable industry standard based on cross-industry collaboration between ICMA, the International Securities and Derivatives Association (ISDA) and the International Securities Lending Association (ISLA).
By connecting systems internally and externally based on a common model, firms can benefit from increased efficiency, reduced friction, and risk of fragmentation. CDM is also expected to help facilitate the trade processing of modern technologies, such as distributed ledger technology (DLT) and cloud, as well as new business models.
Conclusion
Although voice trading will continue to have its place in the repo market, the recent levels of volatility over the past four years have underscored the need for reform and greater automation. Repo is a vital channel for transmitting central banks’ monetary policies and providing secured funding for financial market participants. As seen in the past, any cracks in the system can have consequences across the wider financial universe. This is why market participants must raise the technological bar to further develop a well-functioning, efficient and resilient market that can keep pace with regulatory developments and volatile trading conditions.
Don't miss out
Subscribe to our blog to stay up to date on industry trends and technology innovations.