Repo Markets and Their Role in Funding

Repo funds fixed income through a cash leg and a collateral leg, and a scarce bond can push its own repo rate negative.

A repurchase agreement, or repo, is a short-term loan collateralized by a security, structured as a sale of that security today combined with an agreement to repurchase it at a fixed price on a future date. The gap between the sale price and the repurchase price is the interest on the loan, and the security posted as collateral is what allows the cash lender to charge a rate far below what an unsecured loan of the same size and term would command.

Every repo has two sides that move in opposite directions: the cash leg, in which the cash borrower receives money today and repays it, with interest, at maturity, and the collateral leg, in which the cash lender receives a security today and returns it at maturity. The two legs are not independent trades, they are structured as a single agreement, which is what allows the transaction to be treated legally as a secured loan rather than two separate sales.

The repo rate is the interest rate implied by the difference between the sale price and repurchase price, expressed on an annualized basis. A haircut is applied to the collateral's market value, meaning the cash lent is somewhat less than the collateral's current price, and that gap protects the cash lender against a fall in the collateral's value before the repo matures. A haircut of 2 percent on a Treasury security is standard for a short-dated, high-quality bond, while riskier or less liquid collateral commands a meaningfully larger haircut.

Most repo trades reference general collateral, meaning any security within a broad eligible category, typically a basket of Treasury securities of similar maturity, satisfies the agreement. General collateral rates track closely with the broader overnight funding market and with the policy rate set by the central bank, since a cash lender in a general collateral trade is largely indifferent to which specific bond ends up posted.

A special is a specific security that trades in a repo transaction at a rate below the general collateral rate, sometimes well below it, because demand to borrow that particular security is unusually high. A bond becomes special when it is needed to cover a short position or to satisfy a delivery obligation, and cash lenders who happen to hold that specific bond will accept a lower interest rate on their cash loan in exchange for receiving the scarce security as collateral.