TOC
1. Repurchase Agreement (repo)
1.1 Definition
Repurchase agreement (repo) is a contract under which the seller sells a security on the initiation date with a deal to repurchase it at a higher price on a specified later date. Repo is an important short-term financing tool in financial markets
The repo transaction is essentially a secured loan for Y because it can always sell the Treasury note if the borrower (X) defaults on the repo contract. Institution X retains the cashflow right of the security.
Note that the profitability of Institution X goes up when the Treasury note price goes up because it can repurchase Treasury note by lower contract price and sell it at higher market price.
1.2 Reverse Repo
Through the reverse repo transaction, X borrows the security from Y using cash as collateral. Purposes of repo and reverse repo are different:
- For repo: its purpose is to borrow money using security as collateral
- For reverse repo: its purpose is to borrow security using cash as collateral
Note that for reverse repo, Y will receive the accured interest (always the seller receive that)
1.3 Repo Specialness
Special (collateral) repo: the party delivering the security must deliver a specific asset.
General (collateral) repo: the party can choose among a basket of possible assets for delivery.
General repo rate is higher than special repo rate because from reverse reposโ (who is borrowing securities) perspective, the needs are more desperate which yield less interest. A trading strategy can thus be borrow securties from general repo markets and gain higher interest rate while lend that security in special repo market and pay lower interest rate. (Arbitrage)
2. Repo in China
2.1 Repo & Markets
Pledged repo is a type of short-term financing business where bonds are used by both trading parties as a pledge of rights.
- The positive repo party (borrower) pledges bonds to the reverse repo party (lender) for funds, agreeing to return the amount of funds calculated at the specified repo rate at a future date; the lender lifts the pledeged rights on the bonds.
- Similar to conventional repo, but the pledged bonds are frozen, and the lender cannot dispose them.
- The borrower has the cash flow rights of the pledged bonds.
Outright repo refers to a trading business where the positive repo party (seller) sells bonds to the reverse repo party, agreeing that the positive repo party buys from the reverse repo party an equal number of same-type bonds at a pre-defined price in the future. The reverse repo party (buyer) has the cash flow rights of the bonds.
Repo markets
Interbank market:
- Qualified banks and financial institutions, no individual investors
- Bilateral trading
- 11 maturities: 1-day, 7-day, 14-day, 21-day, 1-month, 2-month, 3-month, 4-month, 6-month, 9-month, and 1-year
Exchanges (SSE and SZSE)
- No commercial banks
- Bilateral repos: bond pledge-style agreement repo (customized); bond universal pledge-style repo (standardized, e.g. maturity)
- Trilateral repos: a third party, a clearing house, facilitates repo settlement, improving transaction efficiency and reducing counterparty risk
2.2 OMO and short-term policy rates
Open market operation, OMO, refers to the purchase and sale of securities in the open market by the cental bank.
- For liquidity injection
- As short-term policy rate
- Key maturities: 7, 14 and 28 days
Chinaโs policy interest rate system is shown as below
DR007 represents the seven-day repurchase (repo) rate for depositary institutions, consituting the short-term market benchmark rate. Determined by market transactions.
Medium-term Lending Facility, MLF, is a lending facility that the PBoC lends to financial institutions through scheduled (monthly) auctions:
- Participants: policy and commerical banks
- High quality collateral, such Treasury bonds and central bank bills required.
- Maturity: 3 months, 6 months, and 1 year
Prime rate is the interest rate at which banks lend to customers with good credit.
Loan prime rate, LPR, is quoted by 18 banks based on OMO operations rates (maily MLF) and calculated by the National Interbank Funding Center.
- Published at 09:15 am on the 20th day of each month
- Maturities: 1 year and 5 years.
Interest rate corridor or policy corridor refers to the range within which the operating target of the monetary policy, a short term interest rate, moves around the policy rate announced by the central bank.
Standing lending facility (SLF) refers to a lending facility that lends on a bilateral and on-demand basis rather than in the open market through scheduled auctions
- Policy and commercial banks
- Maturities: O/N, 7-day, 1-month
Interest rate on reserve balances (IORB) is the rate of interest that the central bank pays on reserve balances maintained by depository institutions. The interest rate is set by the central bank, and it is an important tool of monetary policy.
Interest rate on excess reserves (IOER) gives banks an incentive to increase their liquidity buffer. The central bank can also use the IOER rate as a tool of monetary policy. By raising the IOER rate, the central bank gives commercial banks more incentives to hold excess reserves, which reduces the money supply.
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