The term Repurchase Agreement (Repo) and Reverse Repurchase Agreement (Reverse Repo) refer to a type of transaction in which money market participant raises funds by selling securities and simultaneously agreeing to repurchase the same after a specified time generally at a specified
price, which typically includes interest at an agreed upon rate. Sometimes it is also called Ready Forward Contract as it involves funding by selling securities (held on Spot i.e. Ready Basis) and repurchasing them on a forward basis.
Difference between Repo and Reverse Repo
(i) Repo rate is the rate at which Reserve Bank of India (RBI) lends to Commercial Banks for a short period of time against Government Securities. On the other hand, Reverse Repo is the rate at which Commercial Banks lend to RBI.
(ii) A transaction is called a Repo when viewed from the perspective of the seller of securities (the party acquiring funds) and Reverse Repo when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed a Repo or a Reverse Repo depends largely on which party initiated the transaction.
(iii) The purpose of Repo is to fulfill the deficiency of funds. While, the purpose of Reverse repo is to make sure that there is liquidity in the economy.
(iv) The Repo rate is comparatively high in comparison to Reverse Repo rate.
(v) The Repo rate strives to contain inflation in the economy. The Reverse repo aims to control money supply in the economy.
(vi) Repo is based on Repurchase Agreement i.e. there will be an agreement between two parties on the condition that one party will sell securities to the other on the promise that it will be bought back by him after a certain period of time. On the other hand, Reverse repo is based on the Reverse Repurchase Agreement which is just the opposite of whatever has been explained above.
Characteristics of Repo
(a) Origin: Repo transactions are of recent origin which has gained tremendous importance due to their short tenure and flexibility to suit both lender and borrower. Under these transactions the borrower places with lender certain acceptable securities against funds received and agrees to reverse this transaction on a pre–determined future date at agreed interest cost.
(b) Hybrid Instrument: In many respects, Repos are hybrid transactions that combine features of both secured loans and outright purchase and sale transactions but do not fit clearly into their classification.
(c) Repo Rates: The lender or buyer in a Repo is entitled to receive compensation for use of the funds provided to the counterparty. This is accomplished by setting the negotiated repurchase price over the initial sale price, the difference between the two representing the amount of interest or Repo rate owed to the lender. The Repo rate is negotiated by the counterparties independently of the coupon rate or rates of the underlying securities and is influenced by overall money market conditions. In India, Repo rates are determined on the basis of expected call money rates during a reserve mark-up period.
(a) Period: Repos are usually arranged with short-term maturity – overnight or a few days. However, the minimum period of Repo in India is fixed at 3 days. Elsewhere in the world, longer-term Repos are arranged for standard maturities between one day and 1 year.
(b) Interest: The interest on such transactions is market determined and built in the structure of the Repo.
(c) Eligibility: The transactions can be undertaken by commercial banks, financial institutions, brokers, DFHI.
(d) Hair Cut: The use of margins or haircuts in valuing repo securities, and the use of mark-to- market provisions are examples of Repo features that typically are characteristics of secured lending arrangements but are rarely found in outright purchase and sale transactions.
(e) Prohibition: At present, Repo transactions have been prohibited in all securities except treasury bills. However, Nand Karni panel set up for examining transactions in PSU bonds and UTI units have recognised the importance of this instrument as a money market instrument and recommended its re–introduction.
Role of RBI
The RBI intervenes in the market as and when required by conducting repos (ready forward purchases) through its two subsidiaries, namely, Securities Trading Corporation of India (STCI) and Discount and Finance House of India (DFHI). The central bank banned these transactions between banks following their misuse to divert funds from the banks to the stock market and reintroduced the same in April, 1992. The RBI has permitted repos in dated securities, and reverse repo transactions by non–bank subsidiary general ledger (SGL) account holders in the lean season credit policy announced in April, 1997. Non-bank entities holding SGL accounts can lend their surplus money to banks by entering into a reverse repurchase agreement or reverse repo. These entities entering into a reverse repo with banks purchase (permitted) repo securities from banks with a commitment to sell the same at an agreed future date and price.
When there is a spurt in call rates, the RBI intervenes through STCI/DFHI by conducting these repos to inject the required liquidity. STCI and DFHI are market-makers in dated GOI secs and T- bills. They give a two-way quote for the securities which they make the market for. The bid, or the buying rate, is always lower than the ask, or selling rate, for a given security. The spread between bid and ask (or offer) rate accounts for the transaction cost and normal profit from operations. The RBI intervenes to prevent the diversion of investment funds to the call money market.
For example, Bank A, which is short of cash, can sell its repo securities to Bank B or STCI or DFHI at ` 96.25 with a commitment to repurchase them at ` 96.75 after 14 days. The difference between the sale price and the repurchase price or the spread represents the interest rate on the borrowed money.
The Repo buyer’s rights to trade the securities during the term of the agreement, as it represents a transfer of ownership that typically does not occur in collateralised lending arrangements.
The amount of interest earned on funds invested in a Repo determined as follows : Interest earned = Funds Invested × Repo Rate × Number of Days/365
For example, if ` 1 crore is for 3 days @ 5% would yield interest return of ` 0.04 lakhs. 1,00,00,000 × 0.05 × 3/365 = ` 4110
Illustration
Bank A enters into a Repo for 14 days with Bank B in 12% GOI Bonds 2017 at a rate of 5.25% for
`5 Crore. Assuming that the clean price be 99.42, initial margin be 2% and days of accrued interest be 292, you are required to determine:
(a) Dirty Price
(b) Start Proceeds (First Leg)
(c) Repayment at Maturity (Second Leg) Note: Number of days in a year is 360.
Answer
(a) Dirty Price
= Clean Price + Interest Accrued
= 99.42 + 100 × 12 × 292
= 109.15
100
360
(b) First Leg (Start Proceed)
= Nominal Value x
Dirty Price 100 -Initial Margin
100
= `5,00,00,000 x 109.15 ´ 100- 2
100 100
100
= `5,34,83,500
(c) Second Leg (Repayment at Maturity)
= Start Proceed x (1+ Repo rate × No. of days)
360
= `5,34,83,500 x (1+ 0.0525 × 14 )
360
= `5,35,92,695In India, the repo market in Government securities and PSU bonds became very active in 1980s, and the deals were generally interbank. While certain regulatory restrictions were put in place in 1987, in the aftermath of securities scam, RBI imposed a ban on inter-bank repos in 1992 in all instruments except TBs. Since then RBI has made several relaxations in regard to Repo Transactions.
The conditions imposed by RBI in regard to repo transactions are:
(i) The banks should enter into Repo transactions only in respect of TBs of all maturities, notified Government of India dated securities, and private corporate bonds/PSU bonds which are in demateralised form and the transactions are done in recognised Stock Exchanges;
(ii) Repo transactions should be entered only with commercial and co-operative banks and Primary Dealers. However, non-bank entities who are holders of SGL Account with RBI can enter into Reverse Repo transactions with banks/Primary Dealers in TBs, notified Government of India stocks, debentures/PSU bonds:
(iii) The purchase/sale price should be in alignment with the ongoing market rates;
(iv) No sale of securities should be affected unless such securities are actually held by them in their own investment portfolio;
(v) Immediately on sale, the corresponding amount should invariably be deducted from the investment account of the banks;
(vi) The minimum period of the Repo should be 3 days; and
(vii) The securities under Repo should be marked to market on the balance sheet date.
DFHI/STCI/PDS are very active in Repo market and the volume of such transactions has shown substantial increase when the call money rates move up beyond a particular level. Of late, RBI has been conducting Repo auctions for 3/4 days to mop-up the excess liquidity released to the system through reduction of CRR/Intervention in the forex market.
Repo transactions are structured to suit the requirements of both the borrowers and the lender of funds and have become extremely popular mode of raising/investing short-term funds. Further, a SLR surplus and CRR deficit bank can use the repo deals as a convenient way of adjusting SLR/CRR positions simultaneously. The Repo is a convenient instrument for Asset-Liability management.
"Non-banking institutions like corporates, mutual funds and financial institutions can go to repo (repurchase) market for meeting their short-term funds or securities requirement".
Of late the Reserve Bank has been making efforts to develop the repo market in the country. Recently, it has initiated a series of measures to popularize and widen the participation in the repo market.
The measures include: permission to non-bank participants to undertake repo and reverse repo transactions, reduction in the minimum maturity for repo transactions to one day and offering even State government securities for undertaking repos.
"What we need is quick settlements in the repo market. The setting up of a clearing corporation will develop repo market very strongly. We expect the clearing corporation to come up before year." The repo (repurchase) market is mainly a buyback arrangement.
Under such an arrangement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price.
Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a prefixed price.
This is done mainly to bridge the short-term gap of either cash flow or securities (to meet SLR — statutory liquidity ratio — requirements).
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