In this article we will discuss about:- 1. Meaning of Repo and Reverse Repo 2. Calculating Settlement Amounts in Repo Transactions 3. Uses of Repo 4. Repo Markets in India.
Meaning of Repo and Reverse Repo:
A repo is a transaction in which two parties agree to sell and repurchase the same security. Under such an agreement the seller sells specified securities with an agreement to repurchase the same at a mutually decided future date and a price. Similarly, the buyer purchases the securities with an agreement to resell the same to the seller on an agreed date in future at a predetermined price.
Such a transaction is called a ‘Repo’ when viewed from the perspective of the seller of securities (the party acquiring funds) and ‘Reverse Repo’ when described from the point of view of the supplier of funds. Thus, whether a given agreement is termed as Repo or Reverse Repo depends on which party initiated the first leg of the transaction.
At times a repo is also called a ready forward transaction since it is a means of financing under which security is sold on a spot (ready) basis and is repurchased on a forward basis. The lender or buyer in a repo is entitled to receive compensation for use of funds provided to the counterparty.
Effectively the seller of the security borrows money for a period of time (repo period) at a particular rate of interest from the buyer of the security who has lent the funds to the seller. The rate of interest agreed upon is called the ‘Repo rate’. The repo rate is negotiated by the counterparties independently at the coupon rate or rates of the underlying securities and is influenced by overall money market conditions.
Calculating Settlement Amounts in Repo Transactions:
There are two legs in a repo transaction namely:
a. The initial sale of securities and borrowing of funds, and
b. The repurchase of same securities and the returning of the funds borrowed.
The initial sale of securities is usually based on the prevailing market rate for outright sales. Further, since the accrued interest on the security passes to the buyer on transfer of the security, the element of accrued interest is to be added to the sales consideration.
Uses of Repo:
An active repo market improves the liquidity and depth of the money market due to the increase in turnover.
1. The use of repurchase operations to obtain funds is perhaps the most straight-forward as it can be compared to a collateralized loan. From this point of view, the principal merit of a repo transaction is cheaper financing relative to the uncollateralized market. For the lender of cash, the advantage is the provision of collateral.
2. Another use of repo transactions is to fund ‘long’ positions in securities. Specifically, repos can be used to build up leveraged long positions in securities markets since securities lenders maintain their exposures to the securities they might have repaid out.
3. Under a ready forward deal the seller of the security is the borrower and the buyer is the lender of funds. Such a transaction offers benefits both to the seller and the buyer.
4. It helps banks to invest surplus cash.
5. It helps investor achieve money market returns with sovereign risk.
6. It helps the borrower to raise funds at better rates.
7. An SLR surplus and CRR deficit bank can use the repo deals as a convenient way of adjusting SLR/CRR positions simultaneously.
8. Apart from inter-bank repos RBI has been using this instrument effectively for its liquidity management, both for absorbing liquidity and also for injecting funds into the system. Thus, repos and reverse repo are resorted to by the RBI as a tool of liquidity control in the system.
Repo Markets in India:
The repo market is governed by the Reserve Bank of India and only eligible parties can transact in eligible securities. Eligible parties include banks, primary dealers, mutual funds, insurance companies, non-banking finance companies (NBFCs) and housing finance companies. Repo transactions are currently carried out only in Mumbai.
Eligible Securities:
Repos can be undertaken only in dated Government securities and dated Treasury bills.
RBI has prescribed that following factors have to be considered while performing repo:
a. Purchase and sale price should be in alignment with the ongoing market rates.
b. No sale of securities should be effected unless the securities are actually held by the seller in his own investment portfolio.
c. Immediately on sale, the corresponding amount should be reduced from the investment account of the seller.
d. The securities under repo should be marked to market on the balance sheet date.