A retail repurchase agreement, often referred to as a ‘retail repo agreement,’ is a financial product that provides an alternative to traditional savings accounts. In such an agreement, an investor purchases a share of a pool of securities from a bank, typically consisting of U.S. government or agency debt with a term of fewer than 90 days. At the end of this period, the bank repurchases the share at a premium.
Key Takeaways:
– A retail repurchase agreement is a savings vehicle similar to money market accounts.
– It involves a transaction between an investor and a bank, with the investor purchasing assets for a period shorter than 90 days.
– The bank repurchases the assets at the end of the term, offering a premium to the investor.
How Retail Repurchase Agreements Work:
From an investor’s perspective, the profit from this transaction is akin to the interest earned on a traditional savings account. Retail repurchase agreements are a scaled-down version of the wholesale repurchase agreements that occur between banks, with the latter typically having minimum denominations of $1 million and being extended for short periods, such as overnight.
Retail repurchase agreements are sold in smaller denominations of $1,000 or less. The assets in the pool are sold and then repurchased by the bank within 90 days. Unlike wholesale agreements, where assets act as collateral and do not change hands, retail agreements involve the actual transfer of assets. The most common assets used as collateral in wholesale repurchase agreements are U.S. Treasury securities, though other forms of collateral like agency debt, corporate securities, or mortgage-backed securities (MBSs) may also be used.
The history of retail and wholesale repurchase markets dates back to the 1970s and 1980s, when they emerged as a means for large securities firms and banks to raise short-term capital amidst rising interest rates. Since then, the repo market has become a vital part of the U.S. financial system, catering to the daily liquidity needs of the nation’s banks.
In 1979, U.S. banking regulators exempted retail repurchase agreements from interest rate caps, leading banks and savings and loan institutions to offer these agreements to customers at premium rates. These products were designed to compete with money market funds, which are often sold as mutual funds to depositors. It’s important to note that retail repurchase agreements are not insured by the Federal Deposit Insurance Corporation (FDIC).
Real-World Example of a Retail Repurchase Agreement:
Michael, a long-time customer at XYZ Financial, engages in a retail repurchase agreement.
During a visit to the bank, Michael is informed by the teller that he could potentially earn a higher interest rate by converting his savings account into a retail repurchase agreement. Under this agreement, he would purchase a share of a pool of assets, with the bank committing to repurchase them from him at a premium within 90 days.
The assets in question are high-quality U.S. government debts, which the teller assures Michael of. Before making a decision, Michael decides to research retail repurchase agreements to understand their potential risks better.
Michael discovers that, while the proposed transaction offers higher interest than a traditional savings account, it does not come with FDIC protection. He also learns that if the bank, XYZ Financial, were to become bankrupt during the 90-day term, he might face difficulties in establishing his claim to the agreement’s underlying assets.
If Michael decides not to proceed with the proposed transaction, he could consider an alternative option: investing his money in a money market mutual fund, which is a popular alternative to retail repurchase agreements.
