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The word repo is short for repurchase agreement.
So when we talk about repo operations, it basically refers to repurchase agreements between two parties. Can also be referred to reverse repo operations.
So the process of what happens with a repo operation can simply be explained as someone that has an asset and wants to borrow cash using that asset as collateral. So let’s make a super relatable example with a car.
So let’s say you have a car but you desperately need some cash in the short-term, so you go to a friend that has a lot of cash and you tell them that you need $5,000 right now. As in today. So you want to borrow that $5,000 for today and you are willing to pay some interest on that $5,000.
Let’s say you’re willing to pay 10% interest, so you’re willing to pay them back $5,500 tomorrow. And to make sure that your friend can trust you to pay back the money, you basically leave your car with him as collateral.
Now, repo operations work basically the same way in the finance world. In the finance world, they are always institutions that are cash-rich and institutions that are asset-rich. So institutions that are cash-rich would usually be someone like a money market fund or maybe a bank sitting with excess reserves. And then those that are asset-rich would be, let’s say hedge funds or banks owning a lot of security such as bonds, et cetera.
Now, those that are cash-rich like the money market fund or that bank that has excess reserves, they want to put their money to good use, their excess cash. So they are willing to lend out that cash in the short-term in order to make a profit from it. And to do that, obviously by lending it out at some interest. Now at the other end of the spectrum are those that are asset-rich.
So that’ll be your hedge funds which owns lots of bonds and other treasury securities. Now, they don’t hold as much cash as they do assets because it doesn’t really give them the same type of return on investment but they obviously will need cash to fund their regular daily operations and might also need cash in order to execute new trades.
So as an example of a repo agreement, a plain example would be a hedge fund borrowing money from, let’s say a money market fund by giving the money market fund bonds as collateral. And then after the repo time has lapsed, the hedge fund will basically buy back the bonds that they gave as collateral to the money market fund.
They’ll buy it back at a higher price, which is basically the money they borrowed plus interest. So for the person borrowing the money, it was a repo agreement. And for the money market, it was a reverse repo as they essentially bought those bonds from the hedge fund with the intention of selling it back to the hedge fund later for a profit.
Now, from a day-to-day operation point of view, these transactions are usually, for the most part, daily operations but it can also be seven-day operations or 30-day operations as we’ve seen previously. The biggest application for this in our trading however, is when it deals with actual liquidity in the market. So the only time when repo operations are really tradable is when repo operations fails due to a lack of cash in the system.
So we saw the reactions in the US Dollar quite clearly in September 2019 when we had that big lack of cash or liquidity in the system that caused huge demands for the US Dollar as people who wanted cash couldn’t get any, and those that had cash didn’t want to lend it out.
Now that caused a dry-up of cash which is why the Fed responded in September last year to introduce that 60 billion purchase program of short-term securities as a way of providing excess liquidity into the system in the form of reserves.
So the vehicle they used to alleviate the lack of money was basically QE or balance sheet expansion but it wasn’t QE in the same purposes and the same sense as they use QE to basically reduce long-term interest rates after the global financial crisis, just as an example.
Now, that is obviously going off on a little bit of a tangent but the important thing to focus on is not the day-to-day operations of repos necessarily but keeping your ear to the ground for when they ease a big liquidity issue and a huge demand for cash as that can see quite a lot of upside in something like the US Dollar in those particular cases.