What is Direct Repo:
- Direct Repo also known as repurchase agreements take place to help facilitate short term borrowings in exchange of collaterals with relatively high creditworthiness like government bonds, high quality corporate bonds etc.
- Collateral providers/dealers sell such securities to set of investors for minimum 1 day up to maximum 1 year. Dealers buy back those securities at generally higher prices which are inclusive of interest payment for raising short term financing.
- Generally, such borrowings take place for fulfilling overnight financing needs. As shown in above diagram, collateral provider provides highly collateralised securities (which can provide cushion to lenders in case of high interest rate fluctuations) in exchange of immediate cash in their account.
- The interest rate that the borrower pays is known as repo rate. Direct Repo also helps central banks conduct Open Market Operations (OMO) for tweaking money supply & maintaining adequate liquidity in financial system.
What is Tri-Party Repo:
- Tri-party repurchase agreements are facilitated with an intermediary between lenders & borrowers. Tri-party agent helps in managing collateral selection, settlement & ensuring smooth flow of transactions. Tri-party agency collects cash & ensures delivery of securities.
- In other words, Tri-party agent takes painstaking care of outsourced all work related to post-trade tasks. It helps both parties to avoid the costs related to establishing of clearing & settlement house because of own economies of scale in managing them efficiently.
- Agents protect interest of both parties; manage baskets of securities which shall help them assist larger deals with cost efficiency and core expertise.
- Tri party repurchase agreements help in providing better liquidity through using underlying collateral in efficient fashion and deepen bond markets in India to offer short and long term financing through usage of structured finance vehicles as well.
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Examples of Direct Repo & Tri-Party Repo:
Direct Repo:
Direct repurchase agreements have two parties-dealers & money market investors. Dealers sell government securities & high corporate bonds to money market funds for maturity of 1 day to 1 year depending upon the purpose of raising financing. Usually, transactions take place for shorter term & dealers buy their securities back after paying repo rate. Direct Repo markets provide liquidity in money markets & help structured vehicles raise stable financing in exchange of creditworthy collateral.
Tri-Party Repo:
- There are two parties-dealers & cash investors. We shall assume this repurchase agreement with overnight tenure for simplification. A third party-agent takes care of clearing, settlement, management of entire activity & transactions.
- Dealers (banks, brokers-dealers for example) shall sell their collateral securities to cash investors (Money market funds for example) for financing their needs.
- Cash investors with probable short term requirements can fund those securities in order to earn some interest until they need to rope in cash for other purposes.
- Dealers may hold such set of securities because of market making business or business where they receive such securities as collaterals.
- In early morning, dealers sell securities & borrow cash.Third party agent (BNY Mellon in Unites States) shall transfer securities to investors’ accounts & transfer cash to dealers’ accounts in late afternoon.
- Next day, position unwinding takes place by third party intermediary who credits the interest and cash back to investors & credits dealers with their securities.
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Risks involved in Tri-Party Repo:
- In case of potential default of counterparty, risk management practices have not been adequate enough to provide market participants to allow such sale to take place in orderly fashion. When any financial institution of prime importance of country’s systemic risk faces potential headwinds for default, it can create panic in financial markets which will cause other investors to sell off their assets in distressed manner(known as fire sale as shown in movie- Margin Call). The default of dealers needs to be supported through orderly fashion in order to avoid spill over effects to other sections of financial markets.
- Through such defaults, clearing corporations stand exposed to unrealized losses through spill over impacts of counterparty defaults. Such losses can intensify panic among varied market participants.
- Tri Party repo markets have traditionally functioned on the credit line given for intraday facility. When such unwinding takes place, breach of margins below haircut precipitates financial crisis.
- JP Morgan versus Lehman Brothers Tri-Party Repo Agreement During Crisis:
- JP Morgan acted as a clearing bank for providing Tri-party Repo services to Lehman Brothers Incorporation (subsidiary of Lehman Brothers). Lehman Brothers Inc. pledged collateral securities & borrowed cash in overnight markets & bought them back in next day morning as part of unwinding. JP Morgan would act as an intermediary between Lehman Brothers Inc & repo investors.
- During crisis, Lehman Brothers’ losses amplified with growing derivative exposures & the company pledged collateral securities which were fairly illiquid with probably frothy valuations. JP Morgan continued to extend credit lines of billions of dollars in exchange of additional margins in the form of securities & cash margins as well instead of withholding repo-funding because it could have ripple effects in capital markets.
- Eventually, repo investors withdrew funding substantially which aggravated the situation for Lehman Brothers Inc to honour contracts & the company had to file for bankruptcy.
About the Author:
Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program. His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.
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