Repo Rate and Reverse Repo Rate
Repurchase Options or in short Repo, is a money market instrument, which enables collateralised short term borrowing and lending through sale/purchase operations in debt instruments. This is an instrument used by the Central Bank and banking institutions to manage their daily / short term liquidity.
A legal definition of 'repo' and 'reverse repo' was inserted as sub-sections (c) and (d) of section 45 U of Chapter III D of the Reserve Bank of India (RBI) Act, 1934, vide The Reserve Bank of India (Amendment) Act, 2006 (w.e.f. 9.1.2007). Thus,
- "repo" means an instrument for borrowing funds by selling securities with an agreement to repurchase the securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed;
- "reverse repo" means an instrument for lending funds by purchasing securities with an agreement to resell the securities on a mutually agreed future date at an agreed price which includes interest for the funds lent."
This is the general definition of Repo and Reverse Repo in India. The securities transacted here can be either government securities or corporate securities or any other securities which the Central bank permits for transaction. Non-sovereign securities are used in many global markets for repo operations. Unlike them, Indian repo market predominantly uses sovereign securities, though repo is allowed on corporate bonds and debentures.
Thus, based on the securities used, a narrow definition for repo and reverse repo is also provided in Sub Section 12AB of Section 17 of the RBI Act in respect of the Liquidity Adjustment Facility (LAF) conducted by the Reserve Bank of India wherein only sovereign securities (not corporate securities) are used for infusing /sucking liquidity from the market. This section was inserted vide the same Reserve Bank of India (Amendment) Act, 2006 (w.e.f. 9.1.2007).
Sub-section (12AB) of section 17 of the RBI Act, 1934, defines
"repo" as "an instrument for borrowing funds by selling securities of the Central Government or a State Government or of such securities of a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to repurchase the said securities on a mutually agreed future date at an agreed price which includes interest for the funds borrowed".
"reverse repo" means an instrument for lending funds by purchasing securities of the Central Government or a State Government or of such securities of a local authority as may be specified in this behalf by the Central Government or foreign securities, with an agreement to resell the said securities on a mutually agreed future date at an agreed price which includes interest for the funds lent."
Structure of Repo and Reverse Repo
The Repo transaction, as adopted in India, has two legs:- in the first leg seller sells securities and receives cash while the purchaser buys securities and parts with cash. In the second leg, securities are repurchased by the original holder. He pays to the counter party the amount originally received by him plus the return on the money for the number of days for which the money was used by him, which is mutually agreed. All these transactions are reported on the electronic platform called the Negotiated Dealing System (NDS). The Clearing Corporation of India Ltd. (CCIL), has put in an anonymous online repo dealing system in India, thereby moving the telephonic over the counter trading to an anonymous order matching electronic platform.
Source: Golakanath (2013)
The duration between the two legs is called the ‘repo period’. Predominantly, repos are undertaken on overnight basis, i.e., for one day period. The consideration amount in the first leg of the repo transactions is the amount borrowed by the seller of the security. On this, interest at the agreed ‘repo rate’ is calculated and paid along with the consideration amount of the second leg of the transaction (this amount need not be the same as that in the first leg) when the borrower buys back the security. Settlement of repo transactions happens along with the outright trades in government securities.
In the first leg of the transaction, sale price of securities is usually based on the prevailing market price for outright deals. As the ownership of securities passes on from seller to buyer for the repo period, legally the coupon interest accrued for the period has to be passed on to the buyer. Hence, in the second leg happening on the future date, the price will be structured based on the funds flow of interest and tax elements of funds exchanged.
When repo rate is higher than current yield, repurchase price will be adjusted upward signifying a capital loss. If the repo rate is lower than the current yield, then the repurchase price will be adjusted downward signifying a capital gain. If the repo rate and coupon are equal, then the repurchase price will be equal to the sale price of security.
Repo is thus, a money market instrument combining elements of two different types of transactions viz., lending-borrowing and sale-purchase. A repo is also called a ready forward transaction as it is a means of funding by selling a security held on a spot (ready) basis and repurchasing the same on a forward basis.
The reverse of the repo transaction is called ‘reverse repo’. In a reverse repo transaction, the securities should be purchased in the first leg at prevailing market prices and sold in the second leg at the derived/calculated prices. When the reverse repurchase transaction matures, the counterparty returns the security to the entity concerned and receives its cash along with a profit spread. One factor which encourages an organisation to enter into reverse repo is that it earns some extra income on its otherwise idle cash.
Whether a transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction. In other words, a transaction is called a repo when viewed from the perspective of the supplier of the securities (the party acquiring funds) and a reverse repo when described from the point of view of the supplier of funds.
Buy-Sell Repo used in India Vs Ordinary Collateralised lending
Repos are hybrid transactions since they combine features of both secured loans and outright purchase and sale transactions, but they do not fit cleanly into either of these classifications. The use of margin/haircut in valuing repo securities, the right of repo borrowers to substitute collateral in term agreements, and the use of mark-to-market provisions (process of accounting the value of a security based on its current market price rather than its book value) are examples of repo features that typically are characteristics of secured lending arrangements but are rarely found in outright purchase and sale transactions. The repo buyer's right to trade the securities during the term of the agreement, by contrast, represents a transfer of ownership that typically does not occur in collateralized lending arrangements.
Since repos are attached with a repurchase agreement it makes the repo instrument less risky as there is no doubt about the liquidity of the security given as collateral since the borrower himself is willing to buy back the security.
Repo transactions have mostly replaced the non-collateralised borrowing (call loans) in the market.
Types of Repos based on Maturity
There are basically four types of repos based on its maturity period.
- Overnight refers to repos with a single-day maturity (eg. Additional repos conducted in the Indian market on the reporting Fridays (i.e., the Fridays on which banks have to report to RBI on the fortnightly position on CRR and SLR).
Indian Repo market is predominantly an overnight repo market.
- Term Repos refers to repos that have a fixed maturity longer than one day. If the period is fixed and agreed in advance, it is a term repo, where either party may call for the repo to be terminated at any time, though it may require one or two days' notice.
Since October 2013, the Reserve Bank has introduced Term Repo under the Liquidity Adjustment Facility (LAF) for 14 days and 7 days tenors for banks (scheduled commercial banks other than RRBs) in addition to the existing daily LAF (repo and reverse repo) and Marginal Standing Facility (MSF). The aim of term repo is to help develop inter-bank money market, which in turn can set market based benchmarks for pricing of loans and deposits, and through that improve transmission of monetary policy. Term repo auctions are conducted on e-kuber platform through electronic bidding as is done in the case of auctions under Open Market Operations (OMO) . The total amount of liquidity injected through term repos is limited to 0.75% of Net Demand and Time Liabilities (NDTL) of the banking system. Banks would be required to place their bids with the term repo rate that they are willing to pay to RBI for the tenor of the repo expressed in percentage terms up to two decimal places. While the 14 day term repo of tenor would be conducted every reporting Friday, the 7 day term repo would be conducted on every non-reporting Friday. In case the notified amount for the 14-day term repo is not fully subscribed, a 7-day term repo would be conducted on the following Friday for the remaining un-subscribed amount. In case of full subscription in the 14-day term repo, there will be no 7 day term repo auction on the following Friday.
At present, the objective of meeting short term liquidity needs is being accomplished through the provision of liquidity by the Reserve Bank under its regular facilities - variable rate 14-day/7-day repo auctions equivalent to 0.75 per cent of banking system NDTL, supplemented by daily overnight fixed rate repos (at the repo rate) equivalent to 0.25 per cent of bank-wise NDTL. Frictional and seasonal mismatches that move the system away from normal liquidity provision are addressed through fine-tuning operations, including variable rate repo/reverse repo auctions of varying tenors.
The 2014 Urjit Patel Committee recommended that as the 14-day term repo rate stabilizes, central bank liquidity should be increasingly provided at the 14-day term repo rate and through the introduction of 28-day, 56-day and 84-day variable rate auctioned term repos by further calibrating the availability of liquidity at the overnight repo rate as necessary. The objective should be to develop a spectrum of term repos of varying maturities with the 14-day term repo as the anchor. The 14-day term repo rate is superior to the overnight policy rate since it allows market participants to hold central bank liquidity for a relatively longer period, thereby enabling them to on lend/repo term money in the inter-bank market and develop market segments and yields for term transactions. More importantly, term repos can wean away market participants from the passive dependence on the RBI for cash/treasury management. The committee felt that overnight repos under the LAF have effectively converted the discretionary liquidity facility into a standing facility that could be accessed as the first resort, and precludes the development of markets that price and hedge risk. Improved transmission of monetary policy thus becomes the prime objective for setting the 14-day term repo rate as the operating target instead of the weighted average call money rates.
In its April 2016 Monetary Policy statement, RBI allowed substitution of securities in market repo transactions in order to facilitate development of the term money market.
- Open maturity repos are those transactions where both parties have the option to terminate the repo each day. In an open repo there is no such fixed maturity period and the interest rate would change from day to day depending on the money market conditions. In such cases, the lender agrees to provide money for an indefinite period and the agreement can be terminated on any day. The open maturity structure permits entities in the repo transaction to continuously roll over overnight repos.
- Under flexible repos the lender places funds, but they are withdrawn by the borrower as per his requirements over an agreed period.
Types of Repos based on structuring
Based on the structuring of the Repo, they are classified broadly into four types:
- Buy-sell repo transaction: Under a buy-sell repo transaction the lender actually takes possession of the collateral. Here a security is sold outright and bought back simultaneously for settlement on a later date. In a buy-sell repo the ownership is passed on to the buyer and hence he retains any coupon interest due on the security. The forward price of the security is set in advance at a level which is different from the spot price by actually adjusting the difference between repo interest and coupon earned on the security. The spot buyer/borrower of securities in effect earns the yield on the underlying security plus or minus the difference between this and the repo interest rate.
Indian markets follow this type of repos.
- Classic repo (US Style): Classic repo is an initial sale of securities with a simultaneous agreement to repurchase them at a later date. In this type of repo the start and end prices of the securities are the same and a separate payment of "interest" is made. Classic repo makes it explicit that the securities are only collateral for the loan of the cash. Here the coupon income will be accrued to the seller of the security.
- Hold in custody repo: Under a hold in custody repo the counterparties enter into an agreement whereby the securities sold are held in custody by the seller for the buyer until maturity of the repo, thus eliminating the settlement requirements.
- Bond lending/borrowing transaction: In a bond lending/borrowing transaction, the customer lends bonds for an open ended or fixed period in return for a fee. The fee charged would depend on the type of underlying instrument, size and term of the loan and the credit rating of the counterparty. The transaction would be taken care of by an agreement on securities lending and cash or other securities of equal value could be provided as collateral in the transaction.
Though this resembles more to a collateralised lending, it is treated as a category of repo; India has a separate “Security Lending and Borrowing Mechanism” (SLBM) under the regulatory jurisdiction of SEBI. SLBM is a mechanism under which securities are temporarily transferred by one party (the lender) to another (the borrower) via an approved intermediary (Clearing Corporations). While securities lending generally happens in many countries on the Over the Counter (OTC) negotiated platform, in India, securities lending is mandated to be on the stock exchange platform where automatic order matching is one. A SLB trade involves transfer of securities for a fee (lending Fees), for a pre-determined period from the lender to the borrower; the borrower is obliged to return them either on demand or at the end of the agreed term. The SLBM has mainly been used for shorting securities in the cash market (i.e., selling the security without having the same in hand, anticipating that prices would fall in future and then can be brought back for making the settlement), settling open short positions, and for arbitrage between cash and derivatives segments.
- Tripartite repo: Under a Tripartite repo a common custodian /clearing agency arranges for custody, clearing and settlement of repos transactions. They provide for Delivery Vs. Payment (DVP) system, substitution of securities, automatic marking to market, reporting and daily administration etc. and takes care of the counter-party risk on itself and helps in automatic rollovers while not insisting on disclosing the identities of trading entities. This type of arrangement minimizes credit risk and can be utilized when dealing with clients with low credit rating.
The Working Group on Enhancing Liquidity in the Government Securities and Interest Rate Derivatives (Chairman: Shri R. Gandhi) had recommended introduction of tripartite repo in India to develop a term repo market. In this context, it has been decided to undertake a comprehensive review of collateralised money market segments, including introduction of tripartite repo, in consultation with market participants. The review is scheduled to be published by RBI by September 2016 for wider feedback.
Collateralized Borrowing and lending Obligations (CBLO) developed by Clearing Corporation of India Ltd (CCIL) is considered as a repo variant with the combined structure of held -in-custody and tripartite repo in which the contract can be traded, unlike other standard repo in which the security under repo can be traded but the contract cannot be unwound till the end of the contract. CBLO is a money market instrument operated by the CCIL for the benefit of the entities who have either no access to the unsecured inter-bank call money market or have restricted access in terms of ceiling on call borrowing and lending transactions.
By participating in the CBLO market, CCIL members can borrow or lend funds against the collateral of eligible securities. Eligible securities are Central Government securities including Treasury Bills, and such other securities as specified by CCIL from time to time. Borrowers in CBLO have to deposit the required amount of eligible securities with the CCIL based on which CCIL fixes the borrowing limits. CCIL matches the borrowing and lending orders submitted by the members and notifies them. While the securities held as collateral are in custody of the CCIL, the beneficial interest of the lender on the securities is recognized through proper documentation.
CBLO is available for the maturity period ranging from one day to ninety days (up to one year as per RBI guidelines).
Here, the clearing corporation - CCIL - provides an anonymous order matching system for trading funds against the collaterals, which are immobilized at the service provider. In order to enable the market participants to borrow and lend funds, CCIL provides the Dealing System through Indian Financial Network (INFINET), a closed user group to the Members of the Negotiated Dealing System (NDS) who maintain Current account with RBI and through Internet for other entities who do not maintain Current account with RBI.
Membership to the CBLO segment is extended to entities who are RBI- NDS members, viz., Nationalized Banks, Private Banks, Foreign Banks, Co-operative Banks, Financial Institutions, Insurance Companies, Mutual Funds, Primary Dealers, etc. Associate Membership to CBLO segment is extended to entities who are not members of RBI- NDS, viz., Co-operative Banks, Mutual Funds, Insurance companies, NBFCs, Corporates, Provident/ Pension Funds, etc.
Types of Repo Market operating in India
The repo markets operating in India can be broadly classified into two, based on the nature of securities used for repo transactions.
a) Repo on sovereign securities
What is typically known as ‘Repo market in India’ is the repo market based on sovereign securities. It has got actually three different functional segments-
- RBI Repo or Liquidity Adjustment Facility Repo (LAF) at a fixed rate and
- Market repo among banks and institutions at market determined rates.
- Term Repo under the Liquidity Adjustment Facility (LAF) for 14 days and 7 days tenors for banks (scheduled commercial banks other than RRBs) introduced since October 2013, in addition to the existing daily LAF (repo and reverse repo), but the rates are market determined.
The operations of LAF are conducted by way of repos and reverse repos with RBI being the counter-party to all the transactions. It is conducted at a fixed time on a daily basis and on special occasions if liquidity situation warrants so. Also, an additional LAF repo is conducted on reporting Fridays.
On the other hand, Market repo rate is determined by the credit worthiness of the borrower, liquidity of the collateral and comparable rates of other money market instruments. Being a collateralised loan, its rate is generally lower than the unsecured call money rates. Here the seller and buyer can be banks or any authorised financial institution and the collateral used is government securities. Market repo rates are quoted on a daily basis by CCIL on its platform.
It may be noted that, the combo instrument - market Term Repos of 14-day and 7 day tenor under LAF - are conducted through e-kuber core banking solution of RBI.
In the LAF window, Repo rate, or repurchase rate, is the rate at which RBI lends to banks for short periods. This is done by RBI buying government bonds from banks with an agreement to sell them back at a fixed rate. Reverse repo rate is the rate of interest at which the RBI borrows funds from other banks in the short term. Like the repo, this is done by RBI selling government bonds to banks with the commitment to buy them back at a future date.
In India, overnight repo rate in the LAF window, as fixed by the RBI during its monetary policy announcements, is considered as the policy rate (the key rate based on which all other short term interest rates move). Repo rate changes transmit through the money market to alter the other interest rates in the financial system, which in turn influence aggregate demand - a key determinant of inflation and growth.
If the RBI wants to make it more expensive for banks to borrow money, it increases the repo rate. Similarly, if it wants to make it cheaper for banks to borrow money, it reduces the repo rate.
In other words, an increase in the repo rate will lead to liquidity tightening and vice-versa, other things remaining constant.
The policy framework of the RBI aims at setting the repo rate based on a forward looking assessment of inflation, growth and other macroeconomic risks, and modulation of liquidity conditions to anchor money market rates at or around the repo rate. Vide Finance Act 2016, the task of fixing the policy rate is assigned to the Monetary Policy Committee.
The banks use the reverse repo facility to deposit their short-term excess funds with the RBI and earn interest on it. An increase in the reverse repo rate will decrease the money supply and vice-versa, other things remaining constant. An increase in reverse repo rate means that commercial banks will get more incentives to park their funds with the RBI, thereby decreasing the supply of money in the market.
The securities used in the RBI LAF repo by a Bank (while borrowing money from RBI) can be considered under SLR requirement while the reverse repo deals entered with the RBI by a Bank does not provide SLR benefit as RBI does not use a pure Buy/Sell Back mechanism but credits the securities to a pool account and not to the account of the individual Subsidiary General Ledger (SGL) account of the Banks.
b) Repo on corporate Debt Securities:
As part of the measures to develop the corporate debt market, RBI has permitted select entities (scheduled commercial banks excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs), Primary Dealers (PDs), all-India Financial Institutions, Non-Banking Financial Companies (NBFCs), mutual funds, housing finance companies, insurance companies) to undertake repo in corporate debt securities since January 2010. This is similar to repo in Government securities except that corporate debt securities are used as collateral for borrowing funds. Only listed corporate debt securities that are rated ‘AA’ or above by the rating agencies are eligible to be used for repo. Commercial paper , certificate of deposit, non-convertible debentures of original maturity less than one year are not eligible for the purpose. These transactions take place in the over the counter (OTC) market and are required to be reported on FIMMDA platform within 15 minutes of the trade for dissemination of information. They are also to be reported on the clearing house of any of the exchanges for the purpose of clearing and settlement. More details may be seen here.
c) Other Repos:
CBLO segment operated by CCIL and SLBM operated by stock exchanges under the jurisdiction of SEBI are also treated as variants of the repo market in India.
Purpose of Repo and Reverse Repos
The overall effect of the repo transaction would be borrowing of funds backed by the collateral of Government / corporate securities.
Repos are used by traders to obtain cash or to obtain securities. A bank needing cash but having required securities can enter into a repo transaction with another institution by selling the securities under repo to acquire cash. In this case, the lender of the cash uses the securities as collateral. Alternatively, a bank in India can enter into a reverse repo transaction to borrow securities from another bank by lending cash so as to maintain its regulatory requirement of Statutory Liquidity Ratio (SLR). As Indian market follows a buy/sell-back repo mechanism, it allows the holder /borrower of the security to use the same for achieving the SLR level specified by RBI.
Repo transactions are also used to fund "long" positions in securities. That is, they are used to build up leveraged long positions in securities markets. A trader uses cash raised through an initial repo transaction to buy securities which, in turn, are repoed out to raise more cash to buy more securities and so on. With each transaction the leverage ratio is increased. The maximum extent of leverage that can be built up through this process is determined by the margin or “haircut”. Haircut depends on the credit worthiness of the borrower of funds and the price volatility of the collateral. Haircuts for low-risk borrowers like banks using less-volatile collateral like sovereign bonds can be very low. In India, such speculative activities using repo market are not that dominant, at present.
Under LAF-Repo, the Reserve Bank of India injects funds to organisations (Scheduled commercial Banks (SCBs) and Primary Dealers (PDs ) which have both current account and Subsidiary General Ledger (SGL) account with the Reserve Bank of India. Thus, repo is essentially a liquidity management tool at the hand of RBI. In fact, the LAF Repo Rate fixed by the RBI in the overnight segment serves as the policy rate in India.
Relationship between LAF- Repo and Reverse Repo rates in India
LAF Repo and reverse repo rates were being fixed separately till the monetary policy statement of 3.5.2011. In this 2011 monetary policy statement, it was decided that the reverse repo rate would not be announced separately but will be linked to repo rate. The reverse repo rate was proposed to be kept at 100 basis points below repo rate (100 basis points = 1%). Thus, reverse repo ceased to exist as an independent rate. In the April 2016 monetary policy statement, it was decided to keep reverse repo rate at 50 basis points (0.5%) below the repo rate.
The spread between Repo and Reverse repo forms the lower end of the interest rate corridor or policy corridor (which is the spread between Marginal Standing Facility (MSF) and Reverse Repo Rate). In April 2016, RBI narrowed the policy rate corridor from +/-100 basis points (bps) to +/- 50 bps. Thus, MSF will be fixed 50 basis points above repo rate and Reverse repo would be fixed 50 basis points below Repo rate. This was done with a view to ensure finer alignment of the weighted average call rate or the overnight money market rates with the repo rate (which essentially means more effective transmission of monetary policy).
History of Repo Rates in India: Changes in nomenclature
The introduction of Liquidity adjustment facility in India was on the basis of the recommendations of Narsimham committee on banking sector reforms. In April 1999, an interim LAF was introduced to provide a ceiling and the fixed rate repos were continued to provide a floor for money market rates (It may be noted that floor is technically represented by the reverse repo rates as per the present terminology). As per the policy measures announced in 2000, the Liquidity Adjustment Facility was introduced with the first stage starting from June 2000 onwards. Subsequent revisions were made in 2001 and 2004. When the scheme was introduced, repo auctions were described for operations which absorbed liquidity from the system and reverse repo actions for operations which injected liquidity into the system. However in international nomenclature, repo and reverse repo implied the reverse. Hence, in October 2004 when revised scheme of LAF was announced, the decision to follow the international usage of terms was adopted.
Accounting treatment of Repos
The RBI guidelines on the accounting treatment of repos in India were issued in 2003 and modified further in 2010. In the books of banks, repos are entered segment wise by breaking it into security price and interest income, as security value /price is a part of the Balance sheet (Asset side when it enters the book) while accrued interest is absorbed in the Profit and Loss Account.
It is proposed to align the accounting norms to be followed by market participants for repo/reverse repo transactions under the liquidity adjustment facility (LAF) and the marginal standing facility (MSF) with the accounting guidelines prescribed for market repo transactions. Guidelines in this regard is proposed to be issued by end-May 2016.
Federal Reserve started using a type of repo in 1920s, while Bank of Canada used repos since 1953. Bank of England started using repos with government securities in 1997, while Japan and Switzerland started using repos in 1997 and 1998, respectively. Canada, Italy and Sweden use the buy/sell-backs, while Japan uses securities borrowing with cash collateral. The Netherlands uses a special loans system in which loans are collateralised via pledge on a pool of collateral (general). Most of the countries use the forms of repo keeping in mind the legal and institutional framework that prevails in each country.
- Marginal Standing Facility (MSF)
- Statutory liquidity ratio (SLR)
- Cash reserve ratio (CRR)
- Liquidity Adjustment Facility (LAF)
- Base Rate
- Market Stabilization Scheme (MSS)
- Bank Rate
- Policy Rate
- RBI Act, 1934
- Repos: Concept Mechanics and Uses, RBI, 6 August 1999
- Dr. Golaka C Nath (2013): Repo Market - A Tool to Manage Liquidity in Financial Institutions, CCIL Monthly Newsletter, Clearing Corporation of India Ltd (CCIL), December 2013