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Also known as a repo agreement, a repurchase agreement is a strategy for acquiring a loan from a lender that involves the sale and repurchase of an asset or security. Essentially, the lender agrees to make the loan, with the understanding that the debtor will sell the lender the security. At an agreed upon later date, the debtor will regain control of the security, once the loan is repaid in full.
In the actual process, repurchase agreements function a great deal like any cash loan transaction, but adds on the basic approach that is involved with executing a forward contract. Funds are transferred from the lender to the borrower. Simultaneously, the borrower transfers ownership of the security to the lender. The settlement date identified in the dual transaction also functions as the maturity date for the loan.
During the time that the lender has control of the security, he or she earns interest on the transaction. The actual amount of interest is calculated by determining the difference between the forward price and the spot price. Assuming that the debtor repays the loan in full by the maturity date, interest ceases to accrue at that point of payment.
A repurchase agreement can apply to a one-time transaction between the debtor and lender, or set up a series of transactions, all of the employing this strategy. Sometimes referred to as a master repurchase agreement, the lender and debtor agree to an ongoing schedule of loans and repayments, with agreed upon securities used as collateral. This effective creates an ongoing reverse repurchase agreement, in that the same security may change ownership multiple times during the life of the master agreement.
It is possible to structure a repurchase as an overnight transaction, effectively completing the entire cycle within a twenty-four hour period. Other agreements of this type can also be arranged with a specific due date, ranging anywhere from several days to a month or more. It is even possible to structure what is known as an open agreement, meaning the maturity date is not set in stone. Essentially, this means the seller holds the security and earns a return until the buyer has repaid the face amount of the loan.
The type of security used for a single or reverse agreement strategy may vary, depending on the financial regulations set in place by the country of jurisdiction. The contract may be created as a stock repurchase agreement, using shares of stock. With a bank repurchase agreement, it may also be possible to make use of government issued bonds, or coupons as the collateral. Brokers and financial counselors associated with banking and finance companies will know which type of securities currently may be used as collateral, and advise both buyer and seller.
There is a great deal of confusion about 'repos' and 'sell buybacks' with the terms often being used interchangeably. At least per the Global Master Repurchase Agreement and in the jurisdictions that have chosen to abide by the European Collateral Directive, in a 'true' or 'classic' repo title changes hands as in 'true sale.' However, there is explicit interest paid at the 'repo interest rate' not just implicitly in terms of a difference between the selling and buying price. In addition (and this is a very important point for understanding the role of repos in the treasury markets) the repo agreement only stipulates that an equivalent security be returned. The reason that this is important is that it allows
the buyer to sell or lend the original security. In addition, the security that is sold stays on the books of the seller in a true repo; the logic being that since an equivalent (i.e. of same issue and thus of same value) security is to be returned (and this is contractually agreed to) the seller retains economic exposure to changes in the value of the security.
In a 'sell buyback' on the other hand, the security leaves the books of the seller, the buyer gets any coupon, and no explicit interest is paid.
For obvious reasons there is interest in some quarters in standardizing such transactions and now, sell buybacks can be done under the GMRA, per a separate appendix. The ECB is asking member countries to change legislation so that the buyer in a repo is deemed to have actually bought the security, rather than have the security treated as collateral only.
The Master Repurchase Agreement is more properly thought of as providing the legal framework under which the repos will be done between signing counterparties. Whether this agreement is used for repeating repos or reverses is an entirely different matter.
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