Types of repo transactions: characteristics and key points
There are various types of transactions in the financial sector, including repo. Its goal is to save as much money as possible.
The term itself appeared in 1917, when the U.S. took part in World War I. These events led to an increase in taxes, which led to a decrease in demand for existing at that time forms of credit. Therefore, the Federal Reserve introduced a type of REPO transactions, which were used as an option for lending to U.S. banks. Over time, they began to be used not only for financial institutions.
REPO is a process in which one party sells some tangible assets to the other, which in most cases are securities. However, the sale is conditional upon the redemption of the assets after a certain period of time at a previously designated value. It is important for the seller to receive the desired amount now, and the buyer is interested in the funds spent being returned to him with interest in the future. In such a transaction, one party loans to the other, and the risk of not recovering the money is minimal, since the property remains with the buyer until payment is made. If no refund is made after the agreed period, the property shall become the property of the buyer.
There are several repo transactions:
- direct repo, when the sale immediately goes with an obligation to repurchase;
- reverse repo assumes after a specified period of time a reverse sale.
It should be noted that any trade is both forward and reverse, depending on the angle from which it should be analyzed.
Repos can take place within one day or overnight. The last variant of the transaction assumes that one part is carried out on one day, and the other – on the next. If no deadlines are fixed, then a repo is called an open operation. Transactions, which are carried out in accordance with the exchange rules, are exchange repos. In this case, the trading floor shall guarantee compliance with all conditions. There are also tripartite transactions, where the execution of all points is monitored by a third party.
In most cases, repo is used for the sale of various securities. And at the conclusion of such a transaction the other party risks losing funds, because the shares may fall in price during the execution of the contract. To minimize the risks, two options are used. One of them is a discount, the size of which is determined by the level of reliability and liquidity of the securities. For blue chips, the discount will be lower than for less prestigious shares.
The second option to reduce the risks is compensation premiums. The amount of compensation is determined by the difference between the new share price and the value at which the transaction was concluded.