Section 4: Understanding Repurchase Agreements

Understanding the Federal Reserve (FED) > Interactive Video Lectures > Section IV – Understanding Repurchase Agreements

• When the Fed auctions off treasuries they do it through the primary dealers.
• When we put new treasuries into the market, they do it through the primary dealers.
• So these primary dealers have been the major sellers of treasuries to the Fed.
• Where do the dealers get the capital they need to support their trading operation? The answer is repo (repurchase agreements).
• Let us look at a traditional repo operation.
• The collateral that the dealers are lending to their customers are bonds.
• When an institution is lending out bonds, they are engaged in a Repurchase Agreement, a REPO.
• When an institution is taking in bonds, they are engaged in a Reverse REPO.
• So the dealers take the bonds they own, they lend the bonds out to their customers as collateral for borrowing money.
• On day two the customer gives back the dealer the bonds they were holding as collateral and the dealer gives back the customer the money they had borrowed plus a rate of interest.
• If you actually look at the books and records of both the primary dealer and the customer, what it looks like is, the customer is buying the treasuries, then tomorrow reselling them back to the dealer.
• This is not a sale of those securities, these securities still belong to the dealer.
• On day two, the dealer is going take back the bonds they’ve lent out, but they’re going to turn right back around and lend them out again.
• Why do this for one day? I mean wouldn’t it make more sense for the dealers to lend those bonds out for a longer period of time rather than keep having to renew this trade every day? Well, it is possible to do a longer dated repo, and the terminology for that is called a term repo.
• The repo rate that we are enjoying today is a one day very safe very conservative interest rate that benchmarks itself against the FED Funds Rate.
• Now let’s look at the real life application here:

• Let’s say the dealer has a customer who’s a money market fund or a family money market funds.
• So what money managers are using is they’re using repo as almost a one-day sweep account.
• They’re actually just using repo as a way of sweeping their idle cash to give them some rate of interest.

• When the highest rate was to be found in short term investments, that’s when portfolio managers were actually investing in repo, because it gave you the shortest term interest rate which was the highest interest rate in the market.
• So back in those days you would have seen portfolios loaded with repo.
• This is also how the primary dealers are funding their trading operation.
• Now what I’m describing here is the primary dealers using this as their source of capital, and every bond dealer is doing this.
• Why do the primary dealers only need to do this for one day?

• We’ve explained what the customers are looking for one day investments, but from the dealers’ point of view, this is their bond inventory and in an ideal world, this inventory’s going through turnover.
• In other words, the primary dealers are not trying to buy bonds just to be a warehouse, they’re buying bombs to hopefully resell them to their customers.
• So because this inventory is going through such a turnover it would be very hard for these dealers to be lending those bonds out for any longer than one day.