Bearing in mind the preference repo counterparties have for liquidity, and the ability to recover some amount close to the loan value in the event of default, shorter maturity Treasuries, that is T Bills, are considered to be “better” forms of collateral.

“Better” in this case because, by being of shorter tenor, they have lower duration.

Duration is a measure of how sensitive a bond’s price is to changes in interest rates (mathematically, the first derivative of the curve). Longer tenor bonds are more sensitive to changes in rates (have higher duration) because the bulk of a bond’s cash flows come at the end, where the principal amount is repaid.

As such, this large lump sum payment is what affects the present value of the bond the most when interest rates change.

Since the primary purpose of collateral is to ensure that, in the event of default, lenders can recover as much of their loan values as possible, assets which trade with relatively higher levels of volatility are not that good forms of collateral. 

Consequently, while UST 10 year notes and 30 year bonds offer similar liquidity and flexibility characteristics, their longer durations ultimately put them at a disadvantage to T Bills, which are considered to be the most pristine form of collateral in the financial system.

But how exactly do these collateralized repo transactions work?

Firstly, “repo” is short for repurchase agreement, which is a sale of securities (the collateral), with the simultaneous obligation to buy them back on a certain date.

Repos allow institutions which hold large stocks of financial securities to use them as a way to obtain quick funding without having to sell them.

Examples of such institutions include Wall Street trading desks, brokerage houses, hedge funds, asset managers, and even pension funds.

The repo rate is the interest rate paid by the borrower, and in general, the lower quality the collateral, based on the factors discussed in Part 1, the higher the repo rate, more colloquially (and affectionately) known as the “haircut”.

It is important to note that the party selling the securities (and buying them back later) is the one engaging in the repo.

The counterparty, that is, the one purchasing the securities (and selling them back later) is said to be engaging in a reverse repurchase agreement.

Reverse repos are used by parties that require the securities pledged as collateral for use in their own financial transactions. This could be a hedge fund lending cash to receive UST Bills, which they in turn use as collateral in another financial transaction.

This is possible because repo transactions can be rolled over.

That is, when the specified date is reached, instead of going through with the repurchase leg of the transaction (refer to the diagram above), both parties agree to extend the transaction to a future date, and re-negotiate terms as necessary.

This brings us to another important aspect of repo transactions, which is that collateral values are recalculated daily based on price fluctuations. This recalculation results in securities or money being delivered in one direction or the other, depending on how prices change.

As such, repos are considered to be “safe” transactions as levels of collateral are adjusted according to market moves on a daily basis.

The exception to this is of course systemic events, where everyone scrambles for collateral at the same time, resulting in mass liquidations across global markets.

To be continued…