Repo and securities financing · RiskAtoms Academy

By the end you will be able to

1Explain a repo as a sale and repurchase that works like a secured loan, and name both sides.
2Work out the cash lent after a haircut, the repo interest and the repurchase price.
3Explain how haircuts and margin calls protect the lender and limit leverage.
4Explain why repo matters for funding banks, dealers and central bank operations.

Why it matters

A bond dealer may hold billions in government bonds but only a small slice of that in its own money. The rest is borrowed overnight, every night, against the bonds themselves. That borrowing is called repo, and when it stutters, the whole financial system feels it.

Core explanation

A loan dressed as a sale

Think of a pawnbroker. You hand over a watch, get cash, and come back later to pay a bit more and take the watch home. If you never come back, the pawnbroker keeps the watch. A repo (short for sale and repurchase agreement) works the same way, but with bonds and much larger sums.

In a repo, the borrower sells bonds to the lender for cash and agrees, at the same moment, to buy them back on a set date at a set, slightly higher price. The difference is the interest. Legally the bonds change hands; economically it is a loan secured on collateral. The lender's side of the same trade is called a reverse repo.

The two legs of a repo

Dealer (cash borrower)

Bonds, worth EUR 9,850,000

Cash, EUR 9,653,000

Money fund (cash lender)

Day 1. The dealer delivers bonds worth EUR 9,850,000 and receives EUR 9,653,000 of cash. The 2% gap is the haircut.

The haircut. The lender does not hand over the full value of the bonds. It applies a haircut: with bonds worth 100 and a 2% haircut, it lends 98. The 2 is a cushion in case bond prices fall, or the borrower fails and the lender must sell the bonds in a hurry. Safe, liquid government bonds get small haircuts; riskier or harder-to-sell bonds get larger ones.

Margin calls. Collateral is revalued every day. If prices fall so that the bonds no longer cover the cash after the haircut, the lender makes a margin call: the borrower must hand over more bonds or pay back some cash.

Who does it, and why. Dealers and banks use repo to finance the bonds they hold for clients. Hedge funds use it to buy more bonds than their own money allows. Money market funds, companies and central banks lend cash in repo because it is short, and secured. A dealer with a client who wants a particular bond can borrow it through a reverse repo. And central banks lend to banks through repo, so it is one of the main channels for monetary policy.

Kinds of repo. Most repos are overnight or run for a few days, though terms of weeks or months exist. In a general collateral (GC) repo, the lender accepts any bond from an agreed list. When one bond is in high demand, for example by short sellers (L1.5.07), its repo is said to be special and its repo rate falls below GC. In a tri-party repo, a custodian bank sits in the middle, holds and values the collateral, and handles margin.

Repo and leverage

The haircut is the slice of each bond the borrower must fund with its own money. With a 2% haircut, $1 of own money can carry $50 of bonds. Higher haircuts mean less leverage, which is why regulators watch haircuts closely, and why lenders raise them in a crisis.

Securities lending (L1.5.07) and repo are close cousins: both swap securities for cash or other collateral for a time. Together they are called securities financing transactions.

The formal version

Let $MV$ be the collateral's market value at its dirty price (including accrued interest, L1.4.05), $h$ the haircut, $r$ the repo rate and $t$ the days. Start from the amount repaid and expand one part per line:

\text{Repurchase price} = \text{Cash} + \text{Repo interest}

\text{Cash} = MV \times (1 - h)

\text{Repo interest} = \text{Cash} \times r \times \frac{t}{\text{basis}}, \qquad \text{basis} = 360 \text{ (USD, EUR)},\ 365 \text{ (GBP)}

After a price move, the margin call restores the haircut on the new value:

\text{Margin call} = \max\big(0,\ \text{Cash} - MV_{\text{new}} \times (1-h)\big)

Some markets state the haircut the other way round, as a ratio of collateral to cash (for example 102%). A 102% margin ratio and a haircut of about 1.96% describe the same trade.

Try it

Start with a 2% haircut on EUR 9,850,000 of bonds. Drag the price move down until a margin call appears. Then raise the haircut and see how the maximum leverage falls and the call disappears.

Try itRepo calculator

Currency and day count

Market value of the bonds (EUR)

Haircut2.0%

Repo rate3.00%

Term7 days

Cash lent today

9,653,000

Haircut cushion197,000

Repo interest5,630.92

Repurchase price9,658,630.92

Max leverage50.0×

Bond price moves during the repo0.0%

No margin call. The bonds still cover the cash after the haircut.

Bonds today9,850,000

Bonds after the move9,850,000

Cash they support after haircut9,653,000

Cash lent9,653,000

Collateral ÷ cash102.0%

Interest = cash × repo rate × days ÷ 360. The haircut is a percentage of the bonds' market value (dirty price). Figures are illustrative.

Worked example

Financing German government bonds for a week

A dealer in Frankfurt holds EUR 10,000,000 face value of a German government bond, at a dirty price of 98.50. It repos the bond to a money market fund for 7 days at 3.00%, ACT/360, with a 2% haircut.

Repo on EUR 10 million of bonds

Step 1 of 5

1
Market value
$10{,}000{,}000 \times 98.50 / 100 = 9{,}850{,}000$

The same maths works in sterling with a 365-day year: GBP 5,000,000 lent in a gilt repo for 30 days at 4.00% earns GBP 16,438.36 of interest.

Regulatory lens

Repo sits at the centre of several post-2008 rules. The Basel III leverage ratio counts banks' repo exposures, so repo uses up balance sheet even though it is secured. The liquidity rules treat short-term repo funding as money that may not roll over in stress, unless it is backed by the safest bonds. In the EU, the Securities Financing Transactions Regulation (SFTR) requires repo and securities lending trades to be reported, so supervisors can see who is borrowing against what.

Looking ahead: the Liquidity Coverage Ratio (L4.5) is built partly on how secured funding behaves in a crisis.

Sparks

SparkThe day overnight money cost 5.25%

On 17 September 2019, the US Secured Overnight Financing Rate (SOFR), which measures the cost of overnight repo backed by Treasuries, jumped to 5.25%, more than twice its level a few days earlier. A corporate tax deadline and a large Treasury bond settlement had drained cash from the system on the same day. The Federal Reserve Bank of New York began lending in repo to calm the market, the first time it had done so since the 2008 crisis.

SparkRepo 105

The report into Lehman Brothers' collapse, published in 2010, found that the bank had used repos it booked as sales, called “Repo 105”, to move as much as $50 billion of assets off its balance sheet at quarter-ends in late 2007 and 2008. The cash came back days later. Its reported leverage looked lower than it really was.

Key takeaways

A repo is a sale with an agreement to buy back at a higher price: in effect, a loan secured on bonds.
Cash lent = market value × (1 − haircut). Interest = cash × repo rate × days ÷ 360 (USD, EUR) or 365 (GBP).
Haircuts and daily margin calls protect the lender. The haircut also caps leverage at 1 ÷ haircut.
Dealers, banks and hedge funds fund bond holdings in repo; money funds and central banks lend in it.
Because so much funding rolls over in repo every day, stress in repo spreads quickly through markets.

Reaction

Check what stuck

Question 1 · objective 2

A hedge fund repos bonds with a market value of $20,000,000. The haircut is 5%. How much cash does it receive?

USD

Question 2 · objective 1

A bank borrows $50,000,000 overnight (one day) in repo at 5.25%, ACT/360. How much interest does it pay, in dollars?

USD

Question 3 · objective 3

If every bond can be financed in repo at a 4% haircut, what is the most bonds a fund can hold for each $1 of its own money?

USD of bonds

Question 4 · objective 2

A repo has $9,800,000 of cash outstanding with a 2% haircut. The collateral's value falls to $9,500,000. How much cash must the borrower return to restore the haircut?

USD

Question 5 · objective 4

Why did the September 2019 spike in US repo rates worry central bankers?

ABecause repo is only used by retail investorsBBecause banks and dealers fund large bond holdings overnight in repo, so a sudden jump in its cost can spread through marketsCBecause repo rates are set by the governmentDBecause a repo spike always means a bank has failed

Glossary

Repo: A sale of securities with an agreement to buy them back later at a fixed, higher price. In effect, a loan secured on the securities.
Reverse repo: The same trade seen from the cash lender's side: buy securities now, sell them back later.
Collateral: Assets handed over to secure a loan, which the lender can keep and sell if the borrower fails to repay.
Haircut: The percentage by which the collateral's market value is reduced when working out how much cash it can secure.
Repo rate: The interest rate on a repo, paid by the cash borrower, as simple interest on the cash.
Margin call: A demand for more cash or collateral when the collateral's value falls below what the agreement requires.
General collateral: General collateral: any bond from an agreed basket, such as government bonds, when the lender only cares about getting safe collateral.
Special: A repo in one particular bond that is in high demand, so lenders of that bond accept a lower repo rate.
Tri-party repo: A repo where a third-party agent holds the collateral, values it daily and moves it between the two sides.
Securities financing transaction: Securities financing transaction: repo, securities lending and similar trades that swap securities for cash or other securities for a time.

Deep Dives & Origins

Deep Dives

International Capital Market Association, Frequently Asked Questions on Repo (ICMA European Repo and Collateral Council, updated regularly). Beginner.
Choudhry, The Repo Handbook, 2nd edition (Butterworth-Heinemann, 2010). Intermediate.

Origins

International Capital Market Association, Global Master Repurchase Agreement (2011 version).
Avalos, Ehlers and Eren, “September stress in dollar repo markets: passing or structural?”, BIS Quarterly Review, December 2019.
Valukas, Report of Anton R. Valukas, Examiner, In re Lehman Brothers Holdings Inc., US Bankruptcy Court, Southern District of New York (March 2010).
Regulation (EU) 2015/2365 on transparency of securities financing transactions and of reuse (SFTR).
Basel Committee on Banking Supervision, Basel III leverage ratio framework and disclosure requirements (January 2014).

Watch this lesson

Video version

Prefer to watch? The same lesson as a 12-minute video will sit here, made from this page's script.