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What Are Repurchase Agreements?
A repurchase agreement, or repo, is a type of short-term loan between banks or other financial companies. These loans are backed by government securities like U.S. Treasury notes or bonds.
In a repurchase agreement, one company agrees to sell securities to another party and buy back those securities after a specific amount of time – usually the next day. Then the seller buys back the securities at a higher price, essentially paying “interest” to the borrower.
The difference between the initial selling price and the amount repaid is known as the repo rate.
When you look at the transaction from the opposite side, it’s called a reverse repo. In a reverse repo, one party agrees to buy securities for a fixed amount and agrees to sell them back after a certain amount of time for a higher price.
Why Do Companies Engage in Repo Transactions?
Banks and other financial companies typically do not like to hold on to a lot of cash because banks can earn more money by investing it. Repo transactions allow companies with too much cash to invest it safely, while companies without enough cash can raise money quickly and cheaply.
Who Uses Repurchase Agreements?
While banks are often on either end of a repo agreement, other companies use the repo market, as well.
Repo sellers are companies looking to raise cash when needed. They could include:
- Hedge funds
- Broker-dealers
- Insurance companies
Repo buyers are looking to invest cash safely, and could include:
- Big corporations
- Money market mutual funds
The Fed also participates in the repo market to stabilize the economy.
The Role of the Federal Reserve
The Fed regularly engages in the repo market to implement monetary policy and keep the federal funds rate in the target range. By buying repos, the Fed can inject more cash into the economy – lowering interest rates and encouraging banks to lend.
By selling repos, on the other hand, the Fed can slow the economy’s growth, raise interest rates and curtail inflation.
Target Interest Rate
The Federal Reserve’s federal funds target rate sets a baseline for much of the financial industry. Interest rates on loans and savings accounts are generally tied to the federal funds rate.
In essence, the federal funds target rate is the interest rate at which the Federal Reserve participates in the repo market. Because the Fed is such a major player in this market, changing its target rate has a major influence on the repo rate as a whole.
When the Fed raises the federal funds target rate, it makes it more expensive for banks to borrow money – pushing interest rates up. The reverse is also true: When the target rate decreases, it’s cheaper to borrow money, lowering rates across the board.
>> Related: What is the Federal Reserve?
Why the Repo Market Matters
Although the repo market seems like an abstract concept, it can affect your personal finances more than you think. Changes in the federal funds target rate can contribute to or reduce inflation and affect interest rates on everything from personal loans and mortgages to savings accounts.
Additionally, money market funds are some of the biggest players in the repo market. Money market funds are a popular option for many investors. Depending on the exact setup of your investment portfolio, your assets might gain or lose value depending on what the repo market does.
Current Trends and Issues
While the repo market is generally stable, there have been some times when it has been problematic. For example, in September 2019, the overnight repo rate spiked significantly (up to nearly 10%), and the amount of available cash in the market plummeted.
The Fed conducted overnight repos to help keep the federal funds rate within the target range. The Fed continued to use repo and reverse repo operations to help stabilize the financial market in October 2019.
Several external factors contributed to the rate spike and volatility in the repo market in 2019, including the following:
- Corporate tax due date: Corporate taxes were due on September 16, so many organizations took money out of the market to pay their bills.
- Higher rate of Treasury issuance: A long-term Treasury debt was settled at the same time, which further reduced the amount of cash and increased the amount of Treasury securities in the market.
Both factors were expected to impact the repo market, but the effects were far greater than anticipated. Although the Fed has analyzed the factors that caused this rate spike and has taken measures to prevent something similar from happening, there is still an inherent level of instability in the repo market. As such, there may be situations in the future when the repo market is unstable and requires the Fed to take steps to stabilize things.
>> Related: Learn more about the federal funds rate history
The Bottom Line: The Repo Market Explained
The repo market isn’t often discussed, and many people don’t know how it works or why it matters. But the repo market is an important part of the U.S. economy, impacting everything from foreign exchange rates to short- and long-term interest rates and even inflation.
Additionally, money market funds are significant participants in the repo market — something many people invest in. It can be important to have a basic understanding of the repo market and to remain informed of any changes that could have a broad impact on your personal finances and the economy at large.
FAQs About the Repo Market
Securities dealers are the main participants in the repo market, according to the International Capital Market Association. Other organizations that participate in the repo market include the following:
- Corporations
- Government agencies (e.g., the New York Fed)
- Financial institutions (e.g., banks, insurance companies, hedge funds, money market funds and primary dealers)
- The Federal Reserve
The Bank of England created the gilt repo market in 1996. It’s essentially the U.K.’s version of the U.S. repo market, facilitating the purchase and sale of “gilt-edged” securities. Also called gilts, gilt-edged securities are U.K. government liabilities that are issued by HM Treasury in sterling denominations. They’re listed on the London Stock Exchange and can be sold and repurchased via the gilt repo market. The Bank of England also conducts money-market operations in the gilt repo market.
The three types of repos are third-party repos, specialized delivery repos and held-in-custody repos.
- Third-party repos: These are also called tri-party repos. They involve a third party (i.e., a bank or clearing agent) along with the buyer and seller. The clearing agent conducts the buying and selling transactions to protect everyone’s interests.
- Specialized delivery repos: These are not very common. They add a bond guarantee to the transaction.
- Held-in-custody repos: These aren’t very common either and require the seller to hold the cash from the sale in a custodial account for the buyer.
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someoneyou trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
If you have feedback or questions about this article, please email the MarketWatch Guides team ateditors@marketwatchguides.com.
Ashley DonohoeContributor
Ashley Donohoe is a personal finance writer based in Cincinnati. She has written for several personal finance websites such as GoBanking Rates, The Balance and PocketSense.
David GregoryEditor
David Gregory is a sharp-eyed content editor with more than a decade of experience in the financial services industry. Before that, he worked as a child and family therapist until his love of adventure caused him to quit his job, give away everything he owned and head off to Asia. David spent years working and traveling through numerous countries before returning home with his wife and two kids in tow. His love of reading led him to seek out training at UC San Diego to become an editor, and he has been working as an editor ever since. When he’s not working, he’s either reading a book, riding his bicycle or playing a board game with his kids (and sometimes with his wife).
