What are Repurchase Agreements?

Tim Musial, CFA

September 20, 2019

Repurchase agreements, or “repos”, are a form of short-term borrowing. What’s behind the recent headlines, and what is the risk?

We have received a number of questions regarding developments in the short-term funding markets.  Yields for overnight “repos” surged to the 10% area earlier in the week and drew comparisons to market disruptions leading up to the financial crisis in 2007.  We see the current episode as a mismatch between the supply and demand for funding that can and has been addressed by overnight lending operations by the Fed.  This is very different from the 2007 episode which was a lending market freeze led by a refusal to have certain financial institutions as a counter-party at any price.  Left unchecked, the current episode could develop into a fundamental risk to the markets and economy.  The Fed action should alleviate funding pressure.  What follows is some background information on the repo market, how the funding gap developed, and the path ahead.  

What is “repo”?

  • It’s short for “repurchase agreement” and is a form of short-term borrowing. 
  • A typical transaction would consist of a seller of a government security that is exchanged for cash from the buyer with an agreement to “repurchase” those securities in the future at a higher price, usually very short-term in nature.
  • The repo market sees trillions of dollars flow through it daily.  Banks, brokers, and hedge funds borrow this money to pay for their daily bond trading operations.  The investors in repo could be money market funds or other investment managers looking for short-term parking spots for their cash. 

What happened?

  • In essence there is a cash shortage in the overnight funding system.  The Fed has injected up to $75 billion daily into the repo market. 
  • The possibility of a shortage has existed for a little while due to the very large deficit we are running and the Federal Reserve balance sheet unwind.
  • Large treasury bill issuance (deficit funding) and the recent Fed balance sheet unwind have removed cash from the system.
  • There was a corporate tax payment deadline earlier this week and the most recent treasury issuance was settling, both contributing to a reduction of available cash.
  • This effective shortage created a supply/demand imbalance for cash, so in order to get the cash funding these players needed they had to increase the rate they were willing to pay, some up to 10% overnight.

What is the risk?

  • Powell said yesterday in his press conference that this stress will not have much impact on the broader economy.
  • The recent headlines may be reminding investors of the last time funding markets tightened in 2007.  That was a credit problem, this is a supply problem.
  • Other short term borrowing rates could move higher as well.
  • Market participants unable to source funding could be forced into selling some of their holdings.

Now what?

  • The Fed will continue repo market operations to ensure enough liquidity available.
  • The volatility around the overnight funding markets could stay elevated into year-end.
  • Powell stated that the Fed may have to resume growing their balance sheet, which would add cash to the system as they buy securities.
  • We do not see broader strains across financial markets currently, but this has our attention as we move forward.

Tim Musial is a fixed income portfolio manager for CIBC Private Wealth Management with more than 20 years of experience. His role includes contributing to the firm’s fixed income portfolio strategy, analysis and trading of both taxable and tax-exempt bond investments.