A reverse repurchase agreement (RRP), or “reverse repo“, involves the purchase of securities with the promise to sell them at a higher price at a future date.
For the party selling the security (and agreeing to repurchase it in the future), it is a repurchase agreement (RP) or repo; for the party on the other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement (RRP) or reverse repo.
Repurchase agreements, or repos, are a form of short-term borrowing used in the money markets, involving the purchase of securities with the agreement to sell them back at a specific date, usually for a higher price.
For the buyer of the securities, it is a way to lend money and get paid with interest in the future.
The securities serve as collateral for the loan.
Conversely, for the seller of the securities, the reverse repo is a way to borrow money and pay back with interest later on.
Such an agreement is a financial instrument that is often used to raise short-term capital.
Government securities are often used as collateral for reverse repo agreements.
Central banks typically make use of reverse repo agreements to drain the reserves in the banking system before adding them back later on.
For instance, the Fed uses a reverse repo to sell securities in exchange for US dollars in order to mop up the excess liquidity in the markets.
In this case, reverse repos could serve as an alternative to tightening monetary policies such as raising interest rates or the reserve requirement.
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.