Repos, Securities Lending, and Risks

Some forms of borrowing are so common and so collateralized that they go by different names.

Suppose that instead of really borrowing, you decided to sell something to get the money you need, but then you agreed with the buyer that you would buy it back at a later time. So it would work very much like a collateralized loan. If you did this, what would you need to do with the asset at the end of the agreed time period?

No. That's what the short-term buyer would do. But the borrower, who sold the asset, would then later repossess it.

Exactly.

This process is a __repurchase agreement__, and it's so popular that it has a nickname: a repo. The borrower sells something (usually a bond) to repo it later and ends up essentially with a loan. The other party acts as the lender (or buyer) and does things in reverse, so they are said to enter a reverse repo.

The repo rate is the rate of interest for the "loan" in a repo. It's pretty straightforward: just figure out the interest paid, divide it by the loan, and adjust for the number of days. $$\displaystyle \mbox{Interest} = \mbox{Principal} \times \mbox{Repo rate} \times \frac{\mbox{Term}}{360} $$ Often, repos are set up for just a day or two, so the interest amount is very small compared to the principal. Does the repo rate look like an annual rate or a periodic rate?

No, it's annual.

Yes!

So something like a 2.5% repo rate would cause a one-day, USD 1,000,000 repo to lead to interest of $$\displaystyle 1{,}000{,}000 \times 0.025 \times \frac{1}{360} = 69.44$$. Not much.

On top of that, there's credit risk. Maybe the repo party doesn't even buy the asset back. Then the reverse repo party is left holding an asset (again, usually a bond) that they probably didn't really want to buy. So, is it worth it to earn such a small amount of interest? It could be if the deal could be better. How might you change the terms of the loan (purchase price) to account for this risk?

Exactly!

Then if there's a default, the reverse repo party ends up underpaying for the bond a little, usually 1% to 3%. This is called the "haircut" to protect the lender from credit risk. A lot of times it's just these two parties taking care of things. Then it's also called a bilateral repo, referring to the two sides. But some repo deals involve a third party to take care of settlement and collateral management. Then it's called a tri-party repo.

__Securities lending__ is similar to a repo, and it's just what it sounds like. One party lends a security to another. Think about that happening for a moment. Which party would be more likely to expect the security to drop in value?

Not so. Actually, one of them would be more likely to expect a price drop. Consider which one would _not_ make this agreement if a price drop was expected.

Probably not. If you owned a security that you expected would drop in value, you probably wouldn't loan it out. You'd probably sell it instead.

If the lender expected it to drop in value, the loan probably wouldn't happen. The lender would want to sell it instead. But a borrower _can_ sell it, and that's typically why securities lending is done: to make a short sale arrangement possible. The borrower sells the security, expecting it to drop in value, so that it can be purchased later at a cheaper price and given back. If correct, a profit is earned.

Here's the thing: it's risky to lend securities, so these need to be collateralized as well. A borrower may want to short sell a stock but then has to put up a high-quality bond as collateral, essentially handing it over to the stock lender. If the stock pays no dividends, who gets more income from the securities they hold?

You got it.

No. The stock borrower has the non-dividend-paying stock in this scenario.

The stock lender is holding that nice bond for the time being and can get income from it. It's common that the collateral offers more income than the borrowed security, and this difference is called the __rebate rate__. $$\displaystyle \mbox{Rebate rate} = \mbox{Collateral earnings rate} - \mbox{Security lending rate} $$ So this difference is paid back to the securities borrower from the lender. It's possible that this rate is negative and goes the other way, but that doesn't usually happen.

A big difference between securities lending and repo deals is the timing. A repo is clear: "you buy it now, and I'll buy it back on this later date." But securities lending can be ended at any time by either party. The lender may call and say, "Give me the security back right now," or the borrower can show up and say, "Here's your security. I'm done with it." So the timing is open-ended. And that really highlights a general risk of leverage. If you borrow, there's always a risk that you may have to liquidate when times are bad. Financing dries up, lenders call loans early, and you may be in a cash crunch just when prices are dropping quickly. It's happened before, and it will probably happen again. You don't want to be part of a fire sale.

To summarize: [[summary]]

No. A higher loan than the collateral itself would actually add more risk to the reverse repo party.

No. If it were closer, even exact, then that wouldn't offer any added protection to the reverse repo party.

Yes.

Give it back

Repossess it

Annual

Periodic

Make it closer to the bond's principal

Make it lower than the bond's principal

Make it higher than the bond's principal

Neither

The lender

The borrower

Stock lenders

Stock borrowers

Continue

Continue

Continue

Continue

Continue

Continue