Repo and Open Market Operations

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What are Repo and Open Market Operations?

When commercial banks need to raise funds from financial institutions, they can borrow overnight, engage in rediscounting, or engage in recapitalization. Another tool commonly used by banks when liquidity is needed is the repo. So, what is a repo?

What is Repo?

Repo (short for repurchase agreement), also known as a repurchase agreement, is a transaction in which one organization sells securities to another organization (such as bonds, stocks) while agreeing to buy them back at a specific price at a future date.

Conversely, we also have the concept of reverse repo, which is a transaction in which one organization buys securities from another organization while agreeing to sell them back at a specific price at a future date.

Thus, a repo transaction can be seen as a lending transaction, where the seller is the borrower and the buyer is the lender. This lending activity is secured by valuable securities (usually government bonds).

How is Repo Different from Recapitalization and Rediscounting?

One key difference from recapitalization and rediscounting is that ownership rights of the collateral are transferred entirely during the effective period of the repo contract. When the lender receives these securities, they are free to trade them in the market (and only have to buy them back at the repo contract maturity to sell them back to the borrower), unlike in recapitalization or rediscounting, where the securities are immobilized and the lender cannot freely trade them.

Characteristics of Repo

When conducting a repo transaction, there are three pieces of information that contract participants need to pay attention to:

1. Maturity Date: The period during which the borrower has the obligation to repurchase the securities, calculated from the time they were sold.
2. Hair-Cut Ratio: The seller (borrower) will not receive cash equal to the value of the assets they sell; instead, the amount they receive will be discounted based on a ratio calculated from the asset’s value. For example, if the hair-cut is 5%, and you conduct a repo transaction by selling a bond with a market value of $100, you will only receive $95 in cash. If we take 1 minus the hair-cut, we’ll get the loan-to-value ratio.
3. Repo Interest Rate: The borrower will be required to repurchase the securities at a price committed in the repo contract maturity, and the repurchase price will differ from the initial sale price. This difference is equivalent to the interest rate that the borrower must pay.

For example: If you conduct a repo transaction with a maturity of 1 month, with a 5% hair-cut, and you sell a bond with a market value of $100, you will receive $95 in cash. The repo interest rate is set at 4%. Then, at maturity, you will have to repurchase the bond at:

Which Organizations Conduct Repo Transactions?

Repo transactions frequently occur among banking systems involving financial institutions. In such cases, financial institutions repurchase valuable securities through repo agreements to provide liquidity to banks. Reverse repo transactions by financial institutions also increase reserves in commercial banks, thereby increasing the money supply. Therefore, financial institution repo transactions are part of Open Market Operations (OMO). Hence, financial institution repo rates are sometimes referred to as OMO rates. Moreover, during each monetary policy period, financial institutions also regulate repo rates of different terms in addition to setting policy rates.

Furthermore, currently, some financial organizations may also conduct repo transactions with customers, such as commercial banks, securities companies.

Open Market Operations

Through open market operations, central banks can regulate the amount of money in circulation by buying or selling government securities (certificates of deposit, treasury bills, government bonds) from commercial banks. When a central bank seeks to increase the money supply, they repurchase these securities from commercial banks, helping commercial banks have more cash to lend. Conversely, when a central bank wants to reduce the money supply, they sell these securities to commercial banks. Central banks can implement this OMO tool by directly buying or selling valuable securities, or by using repo or reverse repo instruments.