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the identity of the counterparty.6 The broker earns a
commission, which is paid by the person who accepted the bid or
offer.
III. Financing Positions in Treasury Securities
Treasury securities are excellent collateral for loans
because they are highly liquid. Loans secured by Treasury
securities usually take the form of a simultaneous "sale" of the
security by the borrower to the lender and a binding obligation
of the borrower to "repurchase" the security from the lender in
the future at a somewhat higher price than the original sale
price.7 The difference between the purchase and sale prices is
the functional equivalent of interest. A borrower calls these
transactions "repurchase agreements" or "repos", and a lender
calls these transactions "reverse repurchase agreements" or
"reverse repos". A reverse repo allows a person with idle cash
to earn interest on the idle funds, and it allows a seller of
unencumbered Treasury securities to finance a counterparty's
purchase of securities. A reverse repo also lets a short seller
of Treasury securities borrow the securities to cover a short
sale; cash is transferred to the security lender as collateral to
guarantee return of the borrowed security, and the short seller
6 For this reason, interdealer brokers are known as "blind
brokers".
7 Although the "loans" are actually independent purchase and
sale transactions, the terms "borrower" and "lender" are used
figuratively to simplify the explanation of these financing
arrangements.
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Last modified: May 25, 2011