• Repo—repurchase agreements if you will—is both simple and complex. Simple because once documentation is in place it’s quite easy to place a trade using a secure message, a trading platform or even—heaven forbid— a phone call.  We used to joke that it was as simple as pushing the repo button.  But the complexity is around “trading” what is largely an illiquid overnight investment. 
  • While some use repo to park remaining cash at the end of the day, the art and skill, for those who use it actively in managing a portfolio, is to know when to up the repo balance and when to put assets elsewhere, and how to manage other portfolio assets in concert with repo opportunities to achieve overall portfolio balances.
  • Repo can add meaningfully to the income of a short-term portfolio—perhaps ten basis points at some times, both because repo rates are often, but not always, quite attractive, and also because investing some cash overnight can allow for more flexibility in how the balance of a portfolio is managed. The accompanying chart compares repo rates with money fund yields. Repo is often thought of as an alternative to investing in a money fund because it has similar overnight liquidity.
  • Private money managers, particularly those that manage the $7 trillion in money market funds, have made extended use of repo. Use by public agencies has lagged.  Documentation challenges, investment policies that may not reflect recent changes in the repo market, and questions about credit risk have limited use. But recent and upcoming market changes present an opportunity for public agencies, particularly those with large portfolios, to expand their use of repo.

Deep dive.

Repurchase agreements have as long, and not always pristine, history as money market instruments. In 1982 Lombard-Wall, a securities broker that leveraged its balance sheet heavily with repo, went bankrupt and with that a number of municipalities that had invested in repo lost money.  Changes to the Federal bankruptcy code, designed to protect repo parties, followed and the securities industry developed uniform contract forms which, if strictly implemented, do well to protect repo investors.

The markets also grew from an estimated $1 trillion of daily volume a decade ago to about $5 trillion today. The growth was fueled largely by the huge increase in the issuance of Treasury securities (deficits do have consequences!) A good portion of today’s  $31 trillion of outstanding Treasury public debt is held by intermediaries who finance it by lending or offering it as collateral in the repo market.

No surprise that the  huge rise in market size has led to more transparency and liquidity; it has also boosted repo rates vis a vis rates on other short term  money market securities.  Managers of money market mutual funds regularly carry 25%-30% of their assets in repo.

The market also became more efficient as the practice of entering into repurchase agreements with specific securities was replaced by what is called tri-party repo, where a bank intermediary maintains accounts for both the repo “buyer” ( say a municipality) and “seller” (a dealer). Upon receiving matching instructions from both parties the bank ( the “custodian”) exchanges cash for securities. At maturity the process is reversed and the custodian credits the buyer’s account with the original invested amount plus interest. 

The tri-party process was more efficient than its predecessor, as it allows parties to net transactions and also avoided having to specify securities subject to a specific transaction early in the day.  The market moved strongly toward tri-party repo, with the volume increasing from about $600 billion a decade ago to $3.8 trillion at its peak in 2023.

With market growth came regulatory concerns about the risk that a fault in the repo market could disrupt the larger financial markets. This concern, which also applied to the growing Treasury market, led to a mandate that transactions be moved to central clearing organizations.(Depository Trust Company is the familiar entity that provides central clearing for securities.) 

With central clearing a new opportunity developed for the repo market: sponsored repo. In this arrangement the dealer repo party who is a member of the clearing organization could nominate an investor to become a sponsored member of the organization. The obligations of the dealer under a repo (to transfer securities, pay interest, etc.) could then be transferred to the clearing organization, taking the dealer out of the trade, if you will.  And the customer (municipality) would end the day with the obligation of  the clearing organization having replaced the initial obligation of the dealer. 

The single existing clearing organization, Fixed Income Clearing Corporation, is a subsidiary of DTCC.  It is closely supervised by regulators, has very strong credit characteristics (rated on a par with the United States) and is truly too large and too essential to be allowed to fail. 

The repo market in now shifting from tri-party to sponsored repo—shades of the shift 20 years ago from delivery vs. pay to tri-party, and the shift offers public funds investors an opportunity to expand their use of repo.  Regulators require that most Treasuries and repo transactions migrate to central clearing over the next two years. State and  local government Treasury repo transactions are not required to migrate but public funds managers have the option of doing so, and thus benefitting from the changes.

Sponsored repo transactions can allow investors to do repo with a variety of dealers without credit exposure to that dealer. In a few words, the obligation is fulfilled by the clearing corporation. This means smaller dealers, who may not have the credit standing of large shops, can participate in the repo market. If they are members of FICC their obligations can be fulfilled by the clearing organization.

Bottom line.

As the market moves toward central clearing better rates, more capacity and supporting technology will also migrate in this direction. Legacy investment policy requirements (for example limiting repo counterparties to Primary Dealers) may have to be addressed.  Repo documents, already off putting because of their complexity, will become even more complex.

Sponsored repo is a far better way to deal with credit risk than Primary Dealer requirements –both Brear Stearns and Lehman had the designation immediately prior to their insolvency.  Document complexity is always an issue in the investment business, but a “solution” could be in the offing if a working group of public sector investors, perhaps supported by government associations, developed a standard or recommended set of documents.  In all events, once documents are agreed to trade execution is easy.

Repo availability should also expand. It has sometimes been  difficult for all but the very largest investors to wrestle a repo allocation from the mega-banks that have dominated the space.  But some banks have rolled out electronic platforms designed to facilitate trades by mid-sized investors and the ability of smaller dealers to join FICC enables them to compete as well.

Repo is still not for everyone. Some targeted daily amount—I will guess at $50 million—might be required to get dealers to offer the product. And beware of repo look-alikes or “repo lite” which may not offer the strong protections of by-the-book tri-party or sponsored repo. But properly structured repo offers public funds investors a good way to enhance portfolio earnings while providing liquidity and protecting assets.

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*This post is a follow-up to a panel on repurchase agreements that I participated in on June 3 at the annual Treasury Management Training Symposium of the National Association of State Treasurers.  I was joined by representatives of BNY and PFM Asset Management.