A repurchase agreement (Repo) involves the sale of securities with a simultaneous agreement to repurchase those securities at a specified price on a predetermined future date.
In a repo transaction, the lender takes an asset (usually a Federal Government security) in exchange for cash, with an agreement to return the asset for the cash plus interest the next day, unless the loan is rolled over.
Example: If company A has N10 million worth of money market securities and is willing to sell to company B who has N10m in the bank, company A will sell the assets for N10m as long as it can buy the securities back in say 24hrs or a month for N10m plus interest.
Company B agrees to the terms of the deal and company A invests the money received from the sale until it’s time to buy back her securities.
Importance of Repos to the Financial System
Repos are popular tools in the financial system as Central Banks can use them to manage money supply. For example, Central Bank can buy T-bills or bonds temporarily to increase the amount of money in its reserves, or sell govt securities to reduce the amount of money in circulation.
Repo markets redistribute liquidity between financial institutions— not only banks, but also insurance companies, asset managers, money market funds, and other institutional investors. In so doing, they help financial markets to function smoothly.
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Risks of Repos to the Financial System
Though Repo trades are supposedly secured with high-quality collateral (usually Federal Government securities), they are not risk-free because of the practice of re-hypothecation: the short term owner of the collateral can use it as collateral for another loan, creating leverage — loans upon loans.
Since repos are short term loans, there is always a likelihood of default if a counterparty doesn’t have the money to repurchase the security and or the collateral loses value.
Most of the time, to reduce repo risk and ensure that the buyer isn’t on the losing end of the contract, the value of the security is set higher than the loan amount.
In May 2019, China repo rates soared to 1000% overnight due to the unexpected failure of a bank which caused a freeze in the interbank market amongst smaller, less credible banks, and sent the rates on negotiable certificates of deposit, and various bonds sharply higher.
In Nigeria, the repo market is quite big and it’s mostly an interbank affair.