This article is written by Shreya Pandey, from RamSwaroop University, Lucknow. The article talks about a repurchase agreement, it’s important clauses, its types, and how to draft while also shedding some light on the advantages and disadvantages of a repurchase agreement.

Introduction 

When a company is in an urgent requirement of capital without selling its long-term securities then the best option available in this case is to form a repurchase agreement. A repurchase agreement is formed when a party seeking immediate cash sells its securities to another party with a condition that the seller shall repurchase the same security at a higher price at a future date. 

This article talks about the types, features, and risks involved in this agreement. It also talks about the pros and cons of repurchase agreements.

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Understanding a Repurchase Agreement

A repurchase agreement is an agreement that involves the sale and subsequent repossession of that same security that was earlier sold and then re-buying it at a higher price at a future date. A repurchase agreement is an exchange of security in return for cash that is often used to provide short-term liquidity. In this agreement the security functions as collateral, therefore it is a safe investment. It is also known as a ‘repo’ or ‘sale-and-repurchase agreement’. The party who is selling the repo is borrowing while the other party buying the security is lending. The interest rate that is decided upon the agreement is known as the repo rate. These agreements are short-time agreements and their maturity period is known as ‘rate’, ‘term’ or ‘tenure’.

The difference between repurchase agreements and collateralized loans is that the repurchase agreements are actual purchases where the buyer has temporary ownership over the security. Therefore, this agreement is treated as a loan for tax and accounting purposes. The other difference between repo and the collateralized loan is that during bankruptcy the repo investors can sell their collateral whereas in collateralized loans the bankrupt investor is subject to an automatic stay.   

In a repurchase agreement, the buyer (lender) gives cash to the seller (borrower) in exchange for collateral security, and then at a future date, the borrower repurchases that security by paying cash along with an interest to the lender.

Example of a Repurchase Agreement

Mr. X wants to start a business for which he needs an investment of Rupees 50 Lakhs. He has 20 lakhs but gets short of 30 lakhs. So he asks his friend Mr. Y to lend him 3 lakhs. Mr. Y agrees to give him 30 lakhs but in exchange, he asks for Mr. X’s house property papers as collateral. Mr. X agrees to the same but with a condition that he will pay back the money along with an interest of 3 lakhs in six months and Mr. Y has to return his house property papers to him. Mr. Y agreed to it and they both signed an agreement.

How to draft a Repurchase Agreement

Take the above example for drafting the repurchase agreement. The repurchase agreement can be drafted in this way:

THIS AGREEMENT is made on the 8th day of July in the year 1998, between the Party Mr. X, owner of X Pvt. Ltd., and Party Mr. Y.

INITIATION, CONFIRMATION, TERMINATION

  1. The agreement can be entered orally or in writing at the initiation of the buyer.
  2. Mr. X shall deliver written confirmation to Mr. Y upon agreeing to enter into the agreement.

The confirmation shall include:

  1. Purchase date
  2. Purchase price
  3. Repurchase date, if already decided
  4. Repo rate
  5. Details of bank account
  6. Additional terms or conditions
  1. On the purchase date, the seller shall transfer the security amount to the buyer and in return, the buyer shall transfer the amount of the purchase price to the buyer.
  2. Termination of the agreement shall occur at the demand of either of the parties or at the maturity date.

MARGIN MAINTENANCE

If in case the market value of the security decreases and gets lesser than the repurchase price then the seller shall transfer to the bank an aggregate margin value of the purchased securities.

PAYMENT

The payment shall be made by the transfer through book entry.

REPRESENTATIONS

Each party shall:

  1. Be authorized to execute and deliver this agreement
  2. Engage in this agreement and transactions contemplated 
  3. Party or its legal representative shall execute the agreement

DEFAULT PROVISIONS

  1. In a case where Mr. X makes default in the agreement then Mr. Y can file a case for specific performance of the contract.
  2. In a case where Mr. Y makes default in the agreement then Mr. X can file a case against Mr. Y and ask for compensation.

NOTICES

If in case either party wants to terminate the agreement then he may give notice to the other party showing his intention to terminate the agreement.

IN WITNESS whereof the parties have hereunto agreed upon the agreement on the 8th July 1998.

For Mr. X

In the presence of :

Witness 1: ___________

Witness 2: ___________

For Mr. Y

In the presence of:

Witness 1: ____________

Witness 2: ____________

Essentials of a Repurchase Agreement

Following are the essentials of a repurchase agreement:

  1. Selling securities: Certificates of bond, deposits, and stocks are sold to a financial institution by promising that the security will be repurchased by the borrower at a higher price.
  2. Buying back the security: It is agreed upon by the parties that the securities sold to the lender shall not sell to anyone else and the borrower shall repurchase it from the lender.
  3. Repo rate: It is the interest rate that is applied upon the money given by the lender to the borrower upon the selling of a security. Eg: A repo rate of 15% higher than the selling amount is decided for the repurchase of the security. 
  4. Margin payment: In case the value of security declines then the borrower has to pay a margin amount to the financial institution or the lender.
  5. Default provisions: In a case where either of the parties makes a default then the default provisions come into action that provides for the remedy for the aggrieved party against any default.

Features of a Repurchase Agreement

Following are some of the features of a repurchase agreement:

  1. In a repurchase agreement, there is a high premium in this market.
  2. In an open repo, the agreements get renewed daily unless it is terminated by either of the parties.
  3. The interest rate in the repo is lower than in an unsecured loan.
  4. Since the interest rate is less in repo therefore the collateral of high quality is offered.
  5. In a repo, there is a slight risk of loss for the lender as there is a chance of default from the side of the borrower and the securities are of dynamic nature so if the value of the securities depreciates it can cause loss to the lender.
  6. If the borrower commits a default then the lender has to suffer a lot while selling the securities.
  7. The repo rate changes according to the security offered by the borrower.  

Risks involved in repo

  1. The risk of default is the most common risk in the repo. The default can be done from either of the parties. A borrower can make default by not repurchasing the security at the maturity date. A lender can make default by not selling the securities back to the borrower in case the market value of the security increases above the amount decided in the agreement.
  2. The other risk in this agreement is liquidation risk where the lender sells the security in order to recover the amount.
  3. Since the security’s value is not stable it is risky for the lender because if the value of security declines, it increases the chance of default from the side of the borrower.
  4. Another risk is under-collateralization where the amount received is the same or lesser than the amount lent.

Lifecycle of a Repurchase Agreement

This process involves a party selling securities to the other party by signing an agreement to rebuy the same security at a decided future date and at a higher price. The hike in repurchasing amount reflects the time value of the money. 

Parties to a Repurchase Agreement

In this agreement, two parties are involved:

  1. Seller: Seller is the person who sells its securities to the other party in order to receive cash in exchange. Later, this party repurchases back the securities he sold at a future date.
  2. Buyer: Buyer basically acts as a lender here that purchases the securities sold by the seller and has its ownership and possession for a short time unless the seller buys it back from the buyer at a future date by paying the cash along with the accrued interest.

Central Banks, money market funds, corporate treasurers, insurance companies, etc can be parties to this agreement. 

Types of Repurchase Agreements

Following are the few types of repurchase agreements:

  1. Third-party repo: It is also known as a tri-party repo. It is the most common agreement in the market where a third party acts as an intermediary between the seller and buyer. Usually, a clearing agent or bank acts as an intermediary that protects the interests of both parties. The security or the collateral is handed over to the intermediary. It ensures that the party selling its securities should receive the cash at the starting of the agreement that is paid by the buyer and should receive back its securities after the agreement gets matured or terminated. The intermediaries value the securities and ensure that a specific margin is applied during the repurchase.
  2. Equity repo: In an equity repo, equity functions as collateral where the company’s stock acts as a security in the transactions. The equity repo is considered to be risky as the stock market keeps fluctuating and there is a high risk of loss if the stock value decreases.
  3. Specialized delivery repo: It is an uncommon type of agreement that requires a bond guarantee. In this agreement, a third party guarantees interest and principal amount before the beginning of the agreement and at the maturity time.
  4. Held-in custody repo: In this agreement, the security remains with the seller itself and the buyer pays cash to the seller without taking possession of the securities. It is quite risky as the seller has money and security and the buyer has nothing in his hand. Therefore this kind of agreement is rarely used.
  5. Whole loan repo: In this kind of agreement, a loan or debt obligation acts as collateral, instead of security.
  6. Sell/Buy or Buy/Sell repo: In Sell/Buy repo securities are firstly sold and then repurchased. In buy/sell repo securities are bought initially and then sold. They are different from normal repo as it is transacted in the market.
  7. Reverse repo: A reverse repo is an agreement that is viewed from the perspective of the lender. In this agreement, the lender purchases the security from the borrower with an agreement that the borrower will repurchase the same security at a higher price at a fixed date of maturity. 
  8. Securities lending: In this agreement, the investor borrows the security and hands it back to the lender when the transaction is completed. It is done when the investor does not have sufficient security.
  9. Due bill: In this agreement the borrower gives possession of the security to the lender in another bank account that is in the name of the borrower itself. It is a risky agreement for the lender. 

Types of Repurchase Agreements on the basis of tenor

Tenor is a term used to indicate the time period of the repurchase agreement. The tenor of a repo can be from an overnight to even a year. On the basis of tenor, there are two types of repurchase agreement:

  1. Term Repo: The agreement that has a fixed start and the fixed end is known as a term repo. It can be for a night or a day or two or may extend to a year. In this agreement, the buyer purchases the security on the condition that the seller shall repurchase those securities at a higher price at a specific fixed date. In the term repo interest rate is fixed and the seller has to repurchase the securities by paying the principal along with the interest at the maturity date of the agreement. It is used to invest cash or finance assets for a specific and fixed period of time.
  2. Open Repo: This agreement has a longer maturity. They do not have a fixed start and fixed end date. It is also an on-demand repo. It functions similar to the term repo. The only difference between open repo and fixed repo is that the buyer and seller agree to the transaction without fixing any maturity date. The open repo gets terminated by a notice by one party to the other before the agreed-upon daily deadline. If the notice is not served then the agreement will roll upon the next day and continue until the notice of termination is served. In this, interest is paid monthly and the interest rate increases periodically by a mutual agreement. 

Advantages of a Repurchase Agreement

  1. Repurchase agreements are useful for collecting short-term capital for any individual seeking money.
  2. It is a safe investment as the security acts as collateral in this agreement.
  3. A repurchase agreement is a secured loan.
  4. This agreement is a win-win situation for both parties as the intention behind this agreement gets fulfilled after the security gets repurchased by the seller.
  5. This agreement provides safety to the buyer that if in case the seller makes default then the buyer can sell the securities.
  6. It provides easy liquidity to the seller and secure funding to the buyer.

Disadvantages of a Repurchase Agreement

  1. This agreement is subject to counterparty risk.
  2. Where a party makes default, the loss that might be incurred cannot be calculated unless the process of selling the securities starts.
  3. In a case where the seller turns bankrupt then the buyer suffers a loss of not only interest but also of the principal amount.

Conclusion

A repurchase agreement fulfills the immediate need of the company without selling its securities. Understanding risks in this agreement it can be said that this agreement can be an option where the party is in need of cash and is ready to repurchase the security at a higher price without making any default. This agreement can be a win-win situation for both parties as the party selling its security only transfers the possession without losing the ownership of the security and the other party receives the principal along with the interest in a specified period of time.

References

  1. https://learn.robinhood.com/articles/4ySjMlQlL6jCwZxn5IYP57/what-is-a-repurchase-agreement-repo/#What_are_the_near_and_far_legs_in_a_repurchase_agreement
  2. https://www.investopedia.com/terms/r/repurchaseagreement.asp#citation-5
  3. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/repurchase-agreement-repo/
  4. https://www.wallstreetmojo.com/repurchase-agreement/ 
  5. https://www.educba.com/repurchase-agreement/ 
  6. https://www.contractscounsel.com/t/us/repurchase-agreement
  7. https://www.ttsec.org.tt/wp-content/uploads/pub100505.pdf 

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