Understanding Repurchase Agreements

The repurchase agreement market is one of the largest and most actively traded sectors in the short term credit markets and an important source of liquidity for money market funds and institutional investors. Repurchase agreements (also commonly referred to as Repo agreements) are short-term secured loans frequently obtained by dealers (borrowers) to fund their securities portfolios, and by institutional investors (lenders) such as money market funds and securities lending rms, as sources of collateralized investment. In this guide, we look to explain the fundamentals of this important sector and provide insight into its usage and operation.

How Investors Use Repurchase Agreements

Repurchase agreements are used by money market funds to invest surplus funds on a short term basis and by dealers as a key source of secured funding. Securities dealers use these deals to manage their liquidity and nance their inventories. While repurchase agreements are commonly found within money market funds as short term, mostly overnight investments, the cash investor might look to invest cash for a more customized period of time to fulll a specic investment need. As these transactions are short term and considered relatively safe due to the secured collateral, market liquidity and rates remain competitive for all investors. While there are several factors that impact market rates, two of the most important are the type of collateral behind a contract and the terms of a deal. Traditional, or general collateral (often referred to as GC), is comprised of government securities including treasuries, agencies and agency mortgage securities. As of 2Q 2011, traditional collateral comprises approximately 80% of the outstandings in the tri-party market. (Source: Federal Reserve Bank of New York). Non-traditional/corporate or alternative repurchase agreements may include a range of non-government securities including corporate investment grade and non-investment grade debt and even equity securities as collateral. Use of traditional collateral, coupled with a shorter term, will typically result in a lower yield whereas use of non-traditional collateral, together with a longer term, will generally result in higher yields. The level of returns offered by dealers will also highly uctuate depending on market conditions and factors such as outstanding supply, demand for certain types of collateral (i.e. Treasuries), and the specic credit risk of the counterparty. As the events of the past few years have shown, preparation for unforeseen market conditions is vital. As such, over-collateralization, or haircuts are commonplace in the repo markets. They provide a level of increased security in the event of a default by a counterparty. Typical over-collateralization percentages based on collateral type are as follows:
} Traditional: 102-103% } Non-traditional: 105-107%

What Is a Repurchase Agreement?

In its simplest form, a repurchase agreement is a collateralized loan, involving a contractual arrangement between two parties, whereby one agrees to sell a security at a specied price with a commitment to buy the security back at a later date for another specied price. In essence, this makes a repurchase agreement much like a short-term interest-bearing loan against specic collateral. Both parties, the borrower and lender, are able to meet their investment goals of secured funding and liquidity. There are three types of repurchase agreements used in the markets: deliverable, tri-party and held in custody. The latter is relatively rare, while tri-party agreements are most commonly utilized by money market funds. Repurchase agreements are typically done on an overnight basis, while a small percentage of deals are set to mature longer and are referred to as Term Repo. Additionally, some deals are referred to as Open, and have no end maturity date, but allow the lender or borrower to mature the repo at any time. In a deliverable repurchase agreement, a direct exchange of cash and securities takes place between the borrower and lender. As mentioned, the most widely used form of repurchase agreements by money market funds is referred to as the tri-party repo market which recently stood at approximately $1.7 trillion (source: Federal Reserve Bank of NY October 2011). These agreements use a third party a custodian bank or clearing organization known as the collateral agent to act as an intermediary between the counterparties to a deal. The role of the collateral agent is critical: it acts on behalf of both the borrower and lender minimizing the operational burden and receiving and delivering out securities and cash for the counterparties. The collateral agent also serves to protect investors in the event of a dealers bankruptcy, by ensuring the securities held as collateral are held separate from the dealers assets.

Under Rule 2a-7 of the Investment Company Act of 1940, money market funds are subject to a 5% maximum exposure to any single issuer. Due to the importance of liquidity within money market funds, as well as the secured nature of repurchase agreements, those that utilize traditional collateral are permitted to look through to the high quality collateral and utilize less-restrictive exposure criteria. However, transactions that utilize non-traditional collateral would still be subject to these exposure limits.

FOR INSTITUTIONAL AND FINANCIAL PROFESSIONAL USE ONLY.

How a Tri-Party Repo Agreement Works

One of the most common forms of repurchase agreements used by money market funds is tri-party repurchase agreements. The tri-party label comes from the fact that a third party, known as the collateral agent, acts as an intermediary in the agreement, ensuring that both lenders and borrowers are protected. The diagram below illustrates how this type of agreement is structured and how it serves to protect lenders and borrowers in a transaction.

Tri-Party Repo Transaction

Repo Investment Date 1 Cash balance sent to custodian (equals market value of securities less haircut) 2 Dealer sends eligible collateral to custodian Tri-Party Collateral Agent (Agent) Repo Dealer (Counterparty)

Investor (Money Market Fund)

3 A gent releases cash to dealer

Repo Maturity Date 6 A gent returns cash & interest to money market fund Investor (Money Market Fund) Tri-Party Collateral Agent (Agent) 4 Dealer returns cash & interest at end of term Repo Dealer (Counterparty)

5 A gent sends eligible collateral to the dealer

For illustrative purposes only

Why Is the Tri-Party Repo Market Important?

The recent nancial crisis highlighted the signicant role repurchase agreements have come to play in the short term liquidity markets. In 2008 at the high water-mark for the sector, an estimated $2.8 trillion of securities (source: Federal Reserve Bank of NY May 2010), were funded through repurchase agreements. Major investment banks such as Bear Stearns and Lehman Brothers relied heavily on these deals to fund their operations. As their nancial difculties became more apparent, other institutions reduced their credit lines, including repurchase agreements, or declined to lend to them altogether. As a result, they ran into nancial difculties, and regulators and investors alike became acutely aware of the extent to which these transactions were employed by investment banks dealers to fund their operations. Regulators concluded that banks over-reliance on repurchase agreements for shortterm funding was a major contributing factor toward instability in the nancial markets. As a result, domestic and international regulation in both the banking and securities markets has been amended in recent years, to reduce the potential for repurchase agreements to freeze the credit markets. While this market remains a highly signicant sector for lenders and borrowers alike, the overall size has been reduced from its 2008 peak to its current position of around $1.7 trillion (source: Federal Reserve Bank of NY October 2011). Recent industry reforms, such as changes to custodial bank intra-day credit, settlement processes and a widespread reduction in banks leverage have strengthened the sector and it remains important for money market funds and other institutional investors, in particular as a source of overnight liquidity.

FOR INSTITUTIONAL AND FINANCIAL PROFESSIONAL USE ONLY.

BlackRocks Investment Philosophy

BlackRock and its predecessor companies have been involved in the management of money market funds since 1973. Today BlackRock is one of the largest cash management providers in the world, managing a range of U.S. and internationally-domiciled money market funds. BlackRock money market funds do not seek to offer the highest yield; we believe they have grown because we have earned our clients trust through multiple interest rate cycles and a wide range of market events by making safety of principal and liquidity our highest priorities. BlackRocks investment philosophy emphasizes a commitment to fundamental research and independent credit evaluation. Our research team follows a rigorous process when assessing the creditworthiness of a security. In order to develop a formal view, we conduct both quantitative analyses of corporate capital structures and qualitative assessments of management and industry positioning. BlackRock has also developed proprietary tools that support the research process. For example, Galileo, our global research database, allows analysts to share, store and access information and insights across asset classes and locations. GPLive, our risk monitor, enables portfolio managers to view issuer exposure across portfolios on a real-time basis.

This material is provided as an educational tool and should not be considered investment advice. BlackRock cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. BlackRock is not engaged in rendering any legal, tax or accounting advice. Please consult with a qualified professional for this type of advice. The principal on asset-backed securities may normally be prepaid at any time, which will reduce the yield and market value of these securities. Obligations of government agencies and authorities are supported by varying degrees of credit but generally are not backed by the full faith and credit of the government. Although money market funds seek to preserve the value of ones investment at $1.00 per share, it is possible to lose money by investing in a fund. When you invest in a fund you are not making a bank deposit. Your investment is not insured or guaranteed by the Federal Deposit Insurance Corporation or by any bank or governmental agency. There is no guarantee that stress testing will eliminate the risk of investing in a money market fund. Stress testing strategies do not ensure a profit or a guarantee to keep a money market fund from breaking the buck.

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Lit. No. CM-BR-1211 CM5250-1211