Buy with a commitment to resell, or sell with a commitment to buy back? What are the advantages of a compromissada, the Brazilian repurchase agreement (repo), and what are its main features?
In practice, a compromissada works much like a CDB (Certificado de Depósito Bancário), a bank certificate of deposit. The investor hands money to the bank and takes on the bank's credit risk. The two agree on a rate, and at maturity the investor gets the money back with the agreed return. So what is the difference?
How does a compromissada work?
In a compromissada, the investor literally buys a security on a temporary basis. At the moment of purchase, the investor and the bank also commit to the resale of that security, agreeing on a date and a price. That sets a maturity, and the difference between the resale price and the purchase price determines the return. It can be expressed as a percentage a year, like any other fixed income investment.
Which security backs a compromissada?
The security bought or sold in a compromissada is the collateral (called lastro in the Brazilian market), and it can be almost anything: a debênture (a Brazilian corporate bond), a government bond and so on. In most cases, it is a government bond.
Compromissada returns
The most interesting part is the purchase and resale prices. They have little to do with the return of the security used as collateral. The initial purchase price is usually close to the collateral's market value. The resale price, however, is agreed between the investor and the bank, and it reflects the investor's index and rate. That rate can be fixed or floating, tied to a market benchmark such as the CDI (Certificado de Depósito Interbancário), the Brazilian interbank deposit rate, or the IPCA, Brazil's official consumer price index.
In other words, a security that is originally fixed-rate (say, 10% a year) can back a compromissada that pays the investor a floating rate (100% of CDI).
Why use a compromissada?
A compromissada is usually used by people or institutions whose cash is invested in securities but who need short-term money to make a payment or cover a cash mismatch. Imagine you have BRL 10,000 invested in LFT (Tesouro Selic), a floating-rate government bond tied to the Selic rate, Brazil's base interest rate. You need to make an urgent payment, but your salary arrives in a few days. Instead of selling your bonds, making the payment and buying the bonds back once your salary comes in, you keep the bonds and do a compromissada. You make the payment, and when your salary arrives, you repay the compromissada and get your bonds back.
For short-term needs, it is the ideal solution. It avoids the income tax due on selling the bonds under Brazilian rules, and it is much faster. Remember that selling a government bond can take one to two business days to settle. Imagine waiting two to four business days just for the sale and repurchase of the bonds to settle before you get the money. That is a long time without earning anything, and we do not always have that much time to plan payments and receipts.
In addition, a CDB costs more than a compromissada. To issue a CDB, the bank pays to register the transaction with CETIP, a Brazilian registry for fixed income securities, and pays the fee to the FGC (Fundo Garantidor de Créditos), Brazil's deposit insurance fund.
Finally, there is credit risk, which is much lower in a compromissada, as I explain below.
Who uses compromissadas
Compromissadas are widely used in financial markets and are usually the go-to instrument for cash management at banks and financial institutions. Because it is simple, efficient and fast, it lets a bank, broker or other financial institution invest its cash the same day if it ends the day with a surplus, or borrow if more cash went out than came in that day, without reshuffling its long-term investments.
Because it is so convenient, a compromissada in the financial market usually lasts just one business day. Every day, the cash manager (the trader) lends or borrows through compromissadas to square the institution's cash position, keeping the balance as close to zero as possible: no idle cash and no negative balance.
Beyond financial institutions, companies have more recently started using compromissadas to invest surplus cash, because compromissadas are exempt from IOF, the Brazilian tax on financial transactions. Since companies tend to have steadier cash flows, their compromissadas tend to run a little longer, though still shorter than CDBs, for example.
Credit risk in a compromissada
The primary credit risk in a compromissada is always the risk of the person or institution that borrowed the money. The lender always runs the risk that the counterparty will not repay the loan. This is where one of the instrument's most important features comes in: the collateral. The security used as collateral works as a guarantee. If the borrower defaults, the collateral becomes the lender's, since the lender already holds it in custody.