A repurchase agreement (“repo”) is a short-term secured loan: one party sells securities to another and agrees to repurchase those securities later at a higher 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.
These short-term agreements provide temporary lending opportunities that help to fund ongoing operations.
The Federal Reserve also uses the repo and reverse repo agreements as a method to control the money supply.
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.
Dealers who buy repo contracts are generally raising cash for short-term purposes.
Managers of hedge funds and other leveraged accounts, insurance companies, and money market mutual funds are among those active in such transactions.
Importance of Repos
The repo market is important for at least two reasons:
- 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.
- 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
In the U.S., standard and reverse repurchase agreements are the most commonly used instruments of open market operations for the Federal Reserve.1
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.