THE MECHANICS OF REPO
In this chapter we talk further on the use of repo, and the mechanics of its daily operation. Repo is in essence a funding tool; it enables a market participant to obtain cash in order to fund positions. Alternatively, it is a means by which banks and other financial institutions can obtain specific securities. In this chapter we discuss further the background to and motivation behind repo trades. We also consider risk management issues associated with dealing in repo.
USES AND ECONOMIC FUNCTIONS
The repo mechanism allows for compensation for use of a desired asset. If cash is the desired asset, the compensation for its use is simply the repo rate of interest paid on it. If bonds are the desired asset, the buyer of stock (lender of cash) compensates the seller (borrower) by accepting a below-market repo rate of interest on cash lent out. Otherwise, the repo is a standard money market transaction, with the repo rate a function of the credit quality of the cash borrower, quality of collateral used and the term of the loan.
In the normal course of business a bond trader or market maker will need to finance his positions. Figure 3.1
illustrates the basic principle for a bond trader who has purchased bonds. Figure 3.2
shows the interaction of the repo desk in a bond financing trade.
To finance the position the bond trader can borrow money unsecured in the interbank market, assuming that he has a credit line in this market. However, ...