Tri-party repurchase agreements (repos) are a type of financial arrangement that involve three parties: a borrower, a lender, and a third-party custodian. This type of financial instrument is often used by financial institutions to access short-term funding.
In a tri-party repo, the borrower (usually a bank or other financial institution) sells securities to the lender (usually a money market fund), with an agreement to buy back the securities at a later date. The third-party custodian holds the securities as collateral for the transaction.
One advantage of using a tri-party repo is that it reduces risk for both the borrower and the lender. If the borrower defaults, the lender can sell the securities to recoup their investment. If the lender were to default, the third-party custodian would hold the securities and return them to the borrower.
Tri-party repos are also used for securities lending. In this case, the borrower uses the securities to speculate on the market or to cover short positions.
Tri-party repos are a common tool used in the financial industry, but they can also be risky. In times of market stress, they can become a source of systemic risk. For example, during the financial crisis of 2008, tri-party repos were a contributing factor to the collapse of Lehman Brothers.
To mitigate risk, the Federal Reserve implemented new rules for tri-party repos in 2010. These rules require financial institutions to have adequate collateral, limit the amount of time a repo can remain open, and require more frequent collateral valuations.
In conclusion, tri-party repos are an important financial instrument used by banks and other financial institutions to access short-term funding and to manage risk. However, they can also be risky, and it`s important for financial institutions to manage these risks appropriately.