Repo transaction in simple words, how it works, what are the benefits of the agreement

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What is a buyback agreement and how does a repurchase agreement work? In the financial world, many different transactions are carried out, buying and selling, exchange (barter). Among them are REPO transactions (repurchase agreement), which provide for a short-term loan, followed by the redemption of financial assets. Such a transaction is similar to a loan at a pawnshop, only there the borrower does not receive interest on the loan, but gives in hard-earned money to return his thing.
Repo transaction in simple words, how it works, what are the benefits of the agreementREPO is a necessary thing in the world of the financial exchange. Thanks to this type of transactions, millions of traders around the world find money to buy securities, which they see as profitable. Is it so easy to conclude a repo, what is needed for this and what factors need to be taken into account when drawing up an agreement – all the pitfalls will be disclosed in this article.

REPO operation

A repo transaction is an agreement for the purchase and sale of financial assets with an obligation to repurchase. As a rule, transactions are carried out at night, and refunds are made the next morning or day. In other words, this is a short-term loan with collateral in the form of financial assets: stocks, bonds. The advantages of a REPO are factors for both sides of the transaction:

  1. The seller , most often a trader, receives funds without bank red tape.
  2. The buyer , usually a broker , invests at a fixed rate and minimal risk.

Repo transaction in simple words, how it works, what are the benefits of the agreement

When are REPO transactions applied?

The investor enters into a transaction only with a legal entity. Most often acts as a buyer: broker, bank, manager, dealer, etc. With several types of trading, debt becomes a necessity. As a rule, these are:

  1. Margin withdrawal of funds is a withdrawal of money in which stocks and other securities play a huge role.
  2. Margin trading – position transfer.
  3. Treyderstvo on the market with the Central Agent.

How a repo agreement works when withdrawing money

Many legal entities lend money by taking bonds, stocks and other securities for themselves. The money from the loan is withdrawn to a personal account for personal use. The maximum amount of money issued to one person is equal to the value of one security with an initial risk rate – a discount. Repo transaction in simple words, how it works, what are the benefits of the agreementSecurities admitted
to the repo market [/ caption]

The order of the transaction

At the very beginning, an agreement is drawn up, consisting of two parts: Based on this document, the seller transfers the financial assets to the buyer, the seller undertakes to accept them on the announced date and pay the agreed amount.
Repo transaction in simple words, how it works, what are the benefits of the agreementOn the day stipulated by the agreement, the investor returns the shares to the seller and pays a fee. The remuneration may differ from the initial value of financial assets on the exchange. REPO conducts two transactions at once: in securities and a forward contract.

Repo Classifications – Forward and Reverse

Two types of transactions exist today: direct and reverse REPO.

  1. Direct REPO transactions imply: the person who borrowed the money repurchases his shares on the specified day.
  2. Reverse REPOs differ significantly from the previous transaction – the investor receives the subject of the agreement for a time and pays the full amount for it. At the end of the transaction, he returns the paper, receiving the agreed amount.

Repo transaction in simple words, how it works, what are the benefits of the agreement There are several types of deals according to the validity period:

  1. Intraday – the trade takes place during the day.
  2. Deal every other night – a trade starts one day and ends the next.
  3. Existing – the term of the transaction may stretch for a month. With this type of deal, the deal is valid until a certain date, it has a fixed date for the last part of the deal.
  4. Open – the deadline for the second part of the REPO has not been set.

Repo transaction in simple words, how it works, what are the benefits of the agreement
For example, a notional trader in need of money entered into a reverse repo. A legal entity acted as a lender. 
The trader had 3,000 shares sold for $ 3 million, although they were worth 3,500,000. Based on the repo contract, the term was set for a month.
After this time, the trader withdraws his shares and pays an additional amount on top of the principal. As a result, a month later he took the shares for 3 million 200 thousand. 200 thousand – the percentage that came up over the month of using the broker’s money.Many people compare a repo to a pawnshop. The borrower also sells an expensive item and after a month returns his item by paying interest. If a person does not come for securities, then the broker who has issued the repo can sell them, as things are sold in pawnshops. How Repo and Reverse Repo Transactions Work – Video Explanation of the Buyout Agreement: https://youtu.be/p8Lx2dIUUj4

How to receive dividends on pledged shares?

If the list of those who should receive dividends is determined during the repo period, then all the money received from the dividends goes completely to the seller, because he is the official owner of the securities, albeit a temporary one. But the law “On the Securities Market” protects the sellers of shares. In case of receiving dividends from the pledged shares, the buyer must transfer this money to the seller. If he decides to keep them for himself, then the amount of the redemption of securities will begin to decrease due to the assigned dividends.

At the same time, the seller of securities also has a number of prohibitions. During the period of the transaction, he cannot take part in the meeting of shareholders, and also cannot appeal against their decisions and transactions of the joint-stock company.

What is a repo agreement, what an investor and a trader need to know: https://youtu.be/u38hZgb5dIo

Risks under the repo agreement

The main danger during such transactions is the failure to comply with the second part of the contract. Sometimes the seller of shares does not have enough funds to buy back their shares. Then the buyer sells them and completely recovers the loss. The situation is more terrible for traders when the seller returned a month later with money and interest, and the one who bought the portfolio has already sold it. It often happens that both intermediaries in the transaction refuse to fulfill the second part of the contract. This often happens when a stock rallies or declines in value. Because of this, there is a risk of market volatility, due to which one of the parties will refuse to fulfill their obligations, because one amount is written in the contract, and the securities may exceed this price, or they will start to cost unprofitably cheap.
Repo transaction in simple words, how it works, what are the benefits of the agreement

How to reduce risks

There are two ways to mitigate risks: discount and premium. Discount is the difference between the price of the pledged shares on the market and the money specified in the repo agreement. In the case of the example investor, it can be seen that the shares are worth much more than the amount that he will return to the broker with interest. Therefore, he has a motive to buy back these shares, even with a premium. This type of discount is called “initial”. The size of the discount is calculated as a percentage and directly depends on the stability of the shares. If a trader has laid stable
blue chips, then the discount percentage will be less than that of a less stable company. The compensation fee is another way to protect yourself when making a repo transaction. This is money, or securities, which the trader transfers to the broker, or vice versa, if the price of the pledged securities has changed dramatically. This is the free execution of the second clause of the agreement to reduce the risks of default.
Repo transaction in simple words, how it works, what are the benefits of the agreementRisk management [/ caption] To avoid litigation and other problems, it is necessary to prescribe additional obligations in the REPO for both parties in case of a sharp change in the share price. In this case, those who entered into the transaction are obliged to revalue and, on its basis, change the original purchase price, or surcharge. When the price of a share rises, the seller is obliged to demand a revaluation and additional compensation for losses in cash or part of the shares in order to get more profit. The same applies to those who bought shares for their own money. In the event of a market crash, it will turn out that he bought cheap securities for fabulous money and, upon resale, will not be able to make up for his losses. The law protects buyers from such cases and therefore they have the right to demand a revaluation and return their money to make up for the damage.Margin-type deposits are another method of risk protection. In this case, one of the parties makes a premature payment so that the other party cannot refuse to commit to the second part of the transaction. In this case, the margin contribution is not a pre-delivery for the final part or an advance payment.
Repo transaction in simple words, how it works, what are the benefits of the agreement

Revaluation of repo

The upper and lower revaluation must be present in the repo agreement. The owner of the shares has the right to conduct an upper revaluation if the price of the securities has gone up above the permitted level.
Repo transaction in simple words, how it works, what are the benefits of the agreementThe lower revaluation can only be carried out by the person who bought the securities. This happens at the moment when the market crashes and the securities lose their value. The margin deficit must reach or exceed the allowable line. In this case, the person who bought the securities may demand that the seller reimburse the costs.

Before concluding a repo, the parties agree on the moment when the price will rise and fall, and calculate the deficit and excess of the margin.

When the time comes for reassessment, both parties agree on further actions. They may not carry out revaluation, but complete the second act of the repo transaction ahead of schedule: one sells shares, and the other buys them with interest. The interest will be completely different from what is indicated in the contract and will vary from the growth of the shares. After the completion of the REPO, the parties can draw up a new agreement, taking into account the new securities prices and early closing of the transaction. There is a completely different line of behavior with price changes and revaluation. The party that suffered the most losses may require the payment of margin contributions in the form of a portion of stock and cash. If the payment was made in a monetary unit, and not in securities, then interest is charged. You can also return the entire amount with interest. The same applies to securities.

Revaluation of a repo agreement on the example of the Central Bank

Let’s look at how the revaluation of securities is carried out in the Bank of Russia. During the term of the repo agreement, the bank revaluates the pledged securities every day. After the revaluation, the entity sets the upper and lower limits for the discounts. Thanks to these calculations, the price is determined between the securities and the total amount that the borrower will repay. As a result, both parties avoid the obligation to pay material damage. However, the Bank of Russia is obliged to compensate for the losses of the borrower if the REPO was concluded at the auction and the discount exceeded the upper limit. If the discount crosses the lower limit, the Bank returns compensation in the form of money. If the REPO was concluded by persons not in organized trading using a number of special systems, then the Bank is relieved of the obligation to pay contributions in cash.First of all, the owed bank covers the damage to the borrower with securities. Money is issued only if the bank does not have the required number of shares. Such REPOs, concluded not in trading using the Bloomberg system, have a number of advantages: the Bank of Russia does not revaluate it separately for each transaction, but for the entire series of transactions completed by the Bank of Russia during the day.

Mandatory terms of the repo agreement

When concluding an agreement, both parties need to negotiate a number of conditions before entering into a deal. Mandatory repo conditions are:

  1. Possibility to re-evaluate the value of securities . It is necessary to add this clause to the agreement in order to avoid incidents and further problems.
  2. The legal status of both parties entering into a transaction . When concluding an agreement, the parties agree among themselves whether a general agreement will be concluded, or an agreement by each party in its own name.

Repo transaction in simple words, how it works, what are the benefits of the agreement

REPO in Russia

The instruments for trading on the stock exchange are shares of an investment fund, certificates, securities, shares – everything that has some value on the stock exchange. A repo is concluded between a person and a legal entity, if it is: broker, dealer, depository, clearing company, credit institution. Two individuals cannot conclude a deal
Repo transaction in simple words, how it works, what are the benefits of the agreementMore details about REPO with the Bank of Russia on the Moscow Stock Exchange at https://www.moex.com/s968:
Repo transaction in simple words, how it works, what are the benefits of the agreementIn many financial transactions, there are REPO transactions. This is a short-term loan in which collateral is issued, usually stocks or bonds (securities).

An example of a repo transaction

The broker and the trader entered into a forward repo transaction on September 23, 2021. In the first part of the transaction, the trader sold a stake with 1,000 shares of a natural resources company to a broker and received 300,000 rubles for them. The price for each share in the first part of the REPO was RUB 300. The agreement states that the seller undertakes to repurchase his shares back on 10/25/2021 for RUB 303,160. The percentage for each share at the end of the month was 3, 16 rubles. As a result, the trader paid only 3160 rubles, or 12% per annum. This transaction is direct, since the shares were returned by their owner. Based on this example, it becomes clear that the client has sold 1000 shares of a particular company, priced at 20% discount to hedge against price spikes. The period in which the deal was made 24.09 – 25.10.During this period, there was a correction and the company’s shares began to cost 309 rubles per share already on September 28. Banks of Russia carry out these operations to support cash in commercial banks. For this, the Central Bank calls REPO a transaction for the sale and purchase of securities with a mandatory redemption or sale on a specified date. To carry out such a transaction on the official website of the Central Bank, there is a list of shares that are ready for instant purchase / sale through REPO. It also contains the dates and results of such transactions.ready to buy / sell instantly through REPO. It also contains the dates and results of such transactions.ready to buy / sell instantly through REPO. It also contains the dates and results of such transactions.
Repo transaction in simple words, how it works, what are the benefits of the agreementThe entire list can be found at https://www.cbr.ru/hd_base/infodirectreporub/ Nowadays, many people use short-term repo transactions. Operations are carried out in trading on the market. With their help, investors and traders go short and sell stocks that they do not own. The broker simply lends the investment portfolio through repo and sells all the securities. The money received is invested in other securities, and when the price for them rises, then the person makes his own profit, buys back the borrower’s securities sold back and returns the investment portfolio. The net profit from the shares that have risen remains with the trader who sold the shares.

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