A repurchase agreement (RP), also known as a repo or sale and repurchase agreement, is a form of short-term borrowing, mainly in government securities.
Repos typically involve two parties: the borrower, who needs short-term liquidity, and the lender, who has excess cash to invest.
One party sells securities to another and agrees to repurchase those securities later at a higher price.
What is a Repo?
A repo, or repurchase agreement, is a short-term transaction where a financial institution sells government securities to another party, usually the Federal Reserve or another financial institution, with an agreement to repurchase them at a specific date and price.
The securities serve as collateral. The difference between the securities’ initial price and their repurchase price is the interest paid on the loan, known as the repo rate.
In essence, a repo is a collateralized loan, where the borrower (the financial institution) temporarily exchanges government securities for cash, agreeing to buy back the securities at a later date.
Repurchase agreements are typically short-term transactions, often literally overnight. However, some contracts are open and have no set maturity date, but the reverse transaction usually occurs within a year.
For the buyer, a repo is an opportunity to invest cash for a customized period of time. It is short-term and safer as a secured investment since the investor receives collateral.
What are repos used for?
Buyers of repo contracts are generally raising cash for short-term purposes.
Repos are typically used by banks to finance their day-to-day operations.
They are also used by other financial institutions, such as hedge funds and money market funds, to manage their cash flow.
For example, money market funds are large buyers of repos. For traders in trading firms, repos are used to finance long positions (in the securities they post as collateral), obtain access to cheaper funding costs for long positions in other speculative investments, and cover short positions in securities (via a “reverse repo and sale”).
The Federal Reserve also uses the repo and reverse repo agreements as a method to control the money supply.
Why are repos important?
Repos are an essential yet often overlooked financial instrument that helps maintain the smooth functioning of financial markets.
They are vital for ensuring that financial institutions have access to short-term liquidity and that the Federal Reserve can manage short-term interest rates effectively
The repo market is important for several reasons:
- Providing short-term liquidity: The repo market allows financial institutions that own lots of securities (banks, broker-dealers, hedge funds) to borrow cheaply and allows parties with lots of spare cash (money market mutual funds) to earn a small return on that cash without much risk, because securities, often U.S. Treasury securities, serve as collateral. Financial institutions do not want to hold cash because it is expensive, it doesn’t pay interest. For example, hedge funds hold a lot of assets but may need money to finance day-to-day trades, so they borrow from money market funds with lots of cash, which can earn a return without taking much risk.
- Creating a low-risk investment option: For lenders, repos offer a low-risk, short-term investment opportunity. Because the transactions are secured by government securities, the risk of default is minimal. This safety makes repos an attractive option for investors seeking short-term, low-risk investments.
- Supporting the Federal Reserve’s monetary policy: The Federal Reserve uses repos and reverse repos to conduct monetary policy. When the Fed buys securities from a seller who agrees to repurchase them, it is injecting reserves into the financial system. Conversely, when the Fed sells securities with an agreement to repurchase, it is draining reserves from the system. Since the crisis, reverse repos have taken on new importance as a monetary policy tool. Reserves are the amount of cash banks hold – either currency in their vaults or on deposit at the Fed. The Fed sets a minimum level of reserves; anything over the minimum is called “excess reserves.” Banks can and often do lend excess reserves in the repo market.
How a Repo Works
The repo is a form of collateralized lending. A basket of securities acts as the underlying collateral for the loan.
The legal title to the securities passes from the seller to the buyer and returns to the original owner at the completion of the contract.
The collateral most commonly used in this market consists of U.S. Treasury securities.
However, any government bonds, agency securities, mortgage-backed securities, corporate bonds, or even equities may be used in a repurchase agreement.
The value of the collateral is generally greater than the purchase price of the securities.
The buyer agrees not to sell the collateral unless the seller defaults on their part of the agreement.
At the contract specified date, the seller must repurchase the securities including the agreed-upon interest or repo rate.
While the purpose of the repo is to borrow money, it is not technically a loan:
Ownership of the securities involved actually passes back and forth between the parties involved. Nevertheless, these are very short-term transactions with a guarantee of repurchase.
How the Fed Uses Repos
The Federal Reserve uses repo transactions as a tool for implementing its monetary policy.
By engaging in repo operations, the Fed can inject liquidity into the financial system, which can help maintain its target short-term interest rate range.
The central bank can boost the overall money supply by buying Treasury bonds or other government debt instruments from commercial banks.
This action infuses the bank with cash and increases its reserves of cash in the short term. The Federal Reserve will then resell the securities back to the banks.
When the Fed wants to tighten the money supply—removing money from the cash flow—it sells the bonds to the commercial banks using a repurchase agreement, or repo for short.
Later, they will buy back the securities through a reverse repo, returning money to the system
Repo vs. Reverse Repo
Repros and reverse repros represent the same transaction, but are titled differently depending on which side of the transaction you’re on.
- For the party originally selling the security (and agreeing to repurchase it in the future) it is a repurchase agreement (RP) or repo.
- For the party originally buying the security (and agreeing to sell in the future) it is a reverse repurchase agreement (RRP) or reverse repo.