Repurchase Agreement (Repo): What It Is And Examples (2024)

What Is a Repurchase Agreement?

A Repurchase Agreement (or ‘Repo’ for short) is an agreement between two parties for the sale of government securities and the subsequent repurchase of those securities, usually the next day. The agreement stipulates a slightly higher repurchase price than the original sales price, with the difference (called the Repo rate) essentially providing overnight interest to the buyer.

Repos are thus considered collateralized overnight loans and are classified as such for tax and accounting purposes. The party selling the government securities is considered the borrower (of the proceeds) and the party purchasing the securities is considered the lender.

Repos are used by government securities dealers, banks, money market funds, corporations, institutional investors, and the Federal Reserve. Because they are fully collateralized and generally only one day in duration, they serve as money-market instruments and their rate becomes a proxy for a risk-free daily interest rate. They are commonly used by the Federal Reserve as part of open market operations to regulate the money supply.

Key Point: A Repo is a short-term agreement to sell securities accompanied by a commitment to buy them back at a slightly higher price, typically the next day.

How Repurchase Agreements Work

Repos are agreements between two parties whereby one party sells government securities to the other along with a contractually agreed-upon repurchase, usually the next day. The sale and subsequent repurchase essentially constitute an overnight loan of cash from the buyer.

The implied interest rate of a Repo is the difference between the sale and repurchase prices divided by the sales price, since the sale price represents the amount of money being borrowed. Both the sales and repurchase price must account for any accrued interest in the underlying bonds being sold.

Types of Repos

There are three types of repurchase agreements:

Third-party (or ‘tri-party’) Repos

Third party Repos are by far the most common type, accounting for 80-90% of all Repo transactions. The third party in the transaction is a clearing agent that acts as a custodian between the buyer and seller, settles the transaction, holds the securities, maintains any margin requirements, and ensures that the appropriate amount of cash is transferred. JPMorgan Chase and Bank of New York Mellon are the two largest clearing agents for Repos.

Specialized Delivery Repos

A specialized delivery Repo requires a bond guarantee as part of the transaction and are not very common.

Held-in-Custody Repos

In a held-in-custody Repo, the cash from the sale is held in a custodial account rather than transmitted to the seller. This might be necessary in the case where the seller presents a risk that they might not be able to fund the repurchase.

The Tenor of a Repo

‘Tenor’ is another word for the term or maturity of a Repo. Most Repos have a tenor of just one day, but some can be for multiple days and others can be open-ended.

The longer the tenor of a Repo, the more risk there is, as interest rates, creditworthiness, inflation, and other factors can potentially enter into the picture.

Open Vs. Term Repurchase Agreements

Repos generally have a specific and very short-term maturity (usually one day to a week). Such Repos are called “Term Repos”. However, some (called “Open Repos” or “On demand Repos”) are arranged without a specified maturity.

An open repurchase agreement (also known as on-demand repo) works the same way as a term repo, except that the dealer and the counterparty agree to the transaction without setting the maturity date. In this case, the Repo remains open until terminated by one of the parties. That means an Open Repo remains active by ‘rolling over’ each day. Interest in Open Repos is typically renegotiated by mutual agreement and paid monthly.

The interest rate on an open repo is generally close to the federal funds rate. An open repo is used to invest cash or finance assets when the parties do not know how long they will need to do so. But nearly all open agreements conclude within one or two years.

What Is A Reverse Repo?

The term reverse repo doesn't actually describe a transaction indifferent to a regular repo.

The terms repo and reverse repo are simply used to describe the distinct participation of the 2 different parties involved in the transaction.

The seller of the collateral securities is considered to be borrowing money through a repo agreement, while the buyer is considered to be entering a reverse repo by lending money.

Understanding Repo Rates

Due to the fact that Repos are predominantly overnight transactions with extremely low risk, and since the Federal Reserve is an active participant in the Repo market, the overnight Repo rate tends to mirror the Fed Funds Rate, which is the overnight rate at which banks can borrow money directly from the Fed. Repos, therefore, represent an extension of the Fed Funds Rate to other non-bank participants, such as hedge funds, money market funds, and corporations.

There can be singular occasions, however, when the Repo rate diverges from the Fed Funds Rate due to exceptional circ*mstances. One such occurrence of this was on September 17, 2019, when the Repo rate spiked way above the Fed’s target rate at the time of 2-2.25%. The Brookings Institute attributed the divergence to two events which coincided simultaneously caused an increase the demand for cash: 1) quarterly corporate taxes were due, and 2) it was the settlement date for previously-auctioned Treasury securities.

Repurchase Agreement Risks

With any loan transaction, the primary risk is that the borrower cannot repay the loan as stipulated. In a Repo, that would mean the seller in the transaction is unable to repurchase the securities at the agreed price. Since the underlying collateral in a Repo transaction consists of government securities, which are considered extremely low risk and are highly liquid, the lender is deemed to have almost no credit risk in a Repo transaction.

That said, there could be a price risk, should there be a dramatic overnight change in the value of the underlying securities. If they dropped dramatically, the seller might balk at buying them back at the agreed price. If they increased dramatically, the buyer might be tempted to sell them at a profit and not have them available for the repurchase.

Both of these risks are considered extremely small. There is, however, a mechanism by which the transaction can call for under or over-collateralization to mitigate them.

Importance of the Repo Market

The Repo market represents transactions of as much as $2-4 trillion each day. Thus it is a vital source of overnight cash for financial institutions, corporations, and hedge funds, while providing overnight interest for cash-laden organizations, such as money market funds.

The Federal Reserve can also use the Repo markets to conduct monetary policy through open market transactions that extend beyond banks into the corporate world and among other financial institutions. For example, the Fed can buy securities from sellers using Repos to inject cash into the financial system.

While individuals do not participate directly in the Repo market, they benefit by having access through money market funds for idle investment capital.

Bottom Line

The Repo market is a highly active financial venue in which institutions, funds, and corporations can access cash or park cash as needed in the same way that banks can through the Federal Reserve. Using collateralized overnight repurchase agreements, the Repo market not only adds efficiency to the capital markets but provides the Fed with an additional way to implement monetary policy.

As investors, we can thank the Repo markets for providing a valuable ingredient in the money market funds we pervasively use to provide a safe, interest-bearing place to park our uninvested cash.