Repo, reverse repo, and the funding markets

Behind every bond trader's screen is a less visible but more important market: the repo market, where overnight and short-term funding for bond inventories changes hands. A bond dealer holding a USD 5 billion book does not pay for it with equity. The dealer borrows the cash in the repo market each night, pledging the bonds as collateral, and refinances at the next morning's rate. The repo market sets the marginal cost of leverage for the entire fixed-income complex, which is why dislocations there ripple instantly into bond yields, equity volatility, and the dollar funding cost of foreign banks. When the repo market malfunctions, every other market malfunctions with it.

What a repo is, mechanically

A repurchase agreement is the sale of a security combined with a simultaneous, binding agreement to repurchase the same security at a slightly higher price on a defined future date. Economically it is a collateralised loan: the seller-side party borrows cash, the buyer-side party lends cash and takes the security as collateral, and the gap between sale price and repurchase price is the interest. Standard tenor is overnight; term repo runs 1 week to 3 months; open repo rolls daily until either side terminates.

The repo interest equation in full

Repurchase price  =  Sale price  ×  ( 1  +  repo rate  ×  days / 360 )

or equivalently:

Interest paid in cash  =  Sale price  ×  repo rate  ×  days / 360

where:
  Sale price   =  the cash amount the borrower receives at trade inception
                  (also called the 'purchase price' in the document)
  Repo rate    =  the annualised interest rate on the cash leg of the trade,
                  expressed in decimal form (e.g. 0.0530 for SOFR + 10 bp)
  days         =  the number of days the cash is outstanding — usually 1
                  for overnight, 7 for one-week, 30 for one-month, etc.
  360          =  the money-market day-count convention used in US dollar repo
                  (some jurisdictions use 365; check the trade ticket)
  Repurchase   =  the cash amount the borrower returns at unwind. Always
   price          larger than the sale price by exactly the dollar interest.

Haircuts and the leverage they imply

A haircut is the gap between the market value of the pledged collateral and the cash actually lent against it. Lending USD 98 against USD 100 of bonds is a 2 percent haircut. The haircut protects the cash lender against a fall in collateral value during the time it would take to liquidate in a default scenario — and it has a second consequence that is the entire foundation of secured leverage: a small haircut implies a large leverage ratio for the borrower.

Haircut    =  ( Collateral market value  −  Cash lent )  /  Collateral market value

Implied leverage on borrower's equity  =  1  /  Haircut

where:
  Collateral market value  =  what the pledged bonds are worth in the market today
  Cash lent                =  the principal amount of the repo, what the borrower receives
  Haircut                  =  expressed as a decimal (0.02 for 2%)
  Implied leverage         =  the multiple of equity that the borrower can hold in
                              total position; a 2% haircut means equity supports 50x
                              the position size in collateral terms.

Worked example:
  $100m of Treasuries pledged → $98m cash received → borrower's equity is $2m
  Total position controlled: $100m
  Borrower's equity:         $2m
  Implied leverage:          $100m / $2m  =  50x

Typical haircut levels — the working ranges

• US Treasuries (GC repo): 1-2%. A 2% haircut on Treasuries is the canonical 50x-leverage benchmark and is why prime-broker financing for hedge funds running Treasury arbitrage is dirt cheap by hedge-fund standards.
• Investment-grade corporate bonds: 5-10%. Implies 10-20x leverage. Reflects the additional credit risk and the wider close-out window dealers price in.
• High-yield corporate bonds: 15-25%. Implies 4-7x leverage. The collateral can lose more than 5% in a single bad day, so the haircut must absorb that close-out risk.
• Equity collateral (margin lending): 25-50%. Reflects equity's higher volatility and the absence of a fixed maturity 'pulling collateral back to par' over time.

Mark-to-market and variation margin

Repo trades are not 'set and forget'. The collateral is marked to market every day (often intraday in stress), and either side must post additional collateral or cash when the value moves against them. If the collateral's market value falls, the borrower posts variation margin to bring the cash-to-collateral ratio back into compliance. If the value rises, the lender returns the excess collateral.

Variation margin call  =  Cash lent  /  ( 1 − haircut )  −  current collateral market value

where:
  Cash lent                       =  the original principal amount of the repo
  Haircut                         =  agreed at trade inception (e.g. 0.02)
  Current collateral market value =  today's mark on the pledged bonds
  Variation margin call           =  additional collateral (in market value)
                                     the borrower must post if the result
                                     is positive; if negative the lender
                                     returns the absolute value to the
                                     borrower as excess collateral.

Example: $100m collateral pledged against $98m cash, 2% haircut.
Next day Treasuries fall 0.5%, collateral now worth $99.5m.
  Required collateral = $98m / (1 − 0.02) = $100m
  Variation call = $100m − $99.5m = $0.5m of additional collateral to be posted.

GC versus specials

• General collateral (GC) repo: the borrower can deliver any bond meeting a broad eligibility list (e.g., 'any US Treasury'). GC rates track the central-bank policy rate plus a small premium. This is the bulk of the market and the rate that anchors SOFR.
• Specials: a specific bond is in such high demand — usually from short-sellers who borrowed it via reverse repo to deliver against short sales — that lenders of that specific bond charge a lower repo rate (sometimes near zero, occasionally negative). The on-the-run Treasury benchmark often trades special by 5-30 bp below GC; the difference is the 'specialness premium'.

The Fed's RRP facility and SOFR

After the 2008 reform of US dollar funding, the Federal Reserve has run a Reverse Repo (RRP) facility that absorbs trillions of dollars of cash overnight, paying a floor rate (the ON RRP rate) to eligible counterparties. SOFR (Secured Overnight Financing Rate) is the volume-weighted median rate on overnight Treasury repo and is now the dominant USD floating-rate benchmark, replacing LIBOR for new issuance from 2022. When SOFR diverges materially from the Fed's target range, that is the funding market telling you something — usually that quarter-end balance-sheet constraints are biting at large dealers.

Why this matters for the bond analyst

Funding-market stress is the canary in the coal mine. Widening repo haircuts, specials going expensive, GC trading above the Fed funds rate, term repo dislocations — these signals appear days or weeks before equity volatility spikes and credit spreads widen. Every fixed-income desk has a screen tracking them. Every macro analyst should at least know the basics: the cost of overnight financing, the level and direction of SOFR, the RRP take-up balance, and the persistent specialness on benchmark issues.