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Repurchase Agreement (Repo)

A repurchase agreement is a short-term loan that is structured as the sale of securities, with the seller agreeing to buy them back at a later date. In a repurchase agreement, the borrower (i.e. the seller) sells securities to the buyer (the lender) for a predetermined price higher than what the securities were sold for. That difference is the interest on the loan and is treated as such for tax purposes.

The securities involved are usually U.S. Treasuries, which provide the collateral for the loan. If the seller can't buy them back for some reason, the buyer can readily sell them on the open market. As a result, repurchase agreements backed by Treasuries are considered very safe and are therefore a cheap way for institutions to borrow short-term money.

A reverse repurchase is simply the buyer, or lender, side of the agreement. In this case, the reverse repo holder is looking to earn extra interest income on their money with minimal risk and for a very short term. Buyers also earn the interest on the underlying securities for the duration they are held.

Repurchase agreements are often known as repos for short. However, they should not be confused with another type of repo, which is short for repossession, such as that of a physical asset backing a loan, such as an automobile.

Generally, repurchase agreements are very short-term loans, often overnight, although they can be for longer than that, although almost always less than one year.

The Tenor

The term or maturity of a repo is generally known as its "tenor," although "rate" and "term" are also commonly used. The tenor of the repo is very important, because the longer the term of the loan, the greater the credit risk that the seller won't be able to buy the securities back. There is also greater market risk that the price of the securities may drop in the meantime. As a result, repos are usually backed by securities with a market value higher than the amount paid for them.

While the vast majority of repos have set term limits, usually one day, some are open-ended, which means the buyer isn't sure how long they need to borrow the money. In this case, the loan rolls over each day. However, these transactions usually expire before one year.

In a typical repo, a clearing agent or a bank acts as the middleman, protecting the interest of both the buyer and the seller. It holds the securities and makes sure the seller gets the cash from the buyer at the beginning of the transaction and the buyer delivers the securities back to the seller when the term of the deal ends.

The repo market is huge. According to the Securities Industry and Financial Markets Association, the U.S. repo market had a daily turnover of $2.2 trillion in 2016. [1] That's more than four times the daily trading volume of U.S. Treasury securities.[2]

Central Bank Monetary Policy

Repos and reverse repos are generally used by large financial institutions, such as commercial banks, government securities dealers, hedge funds, money market funds, insurance companies, and the like. They are part of the money market. However, they have become a common instrument used by central banks to conduct monetary policy, such as to control interest rates and the money supply.

The U.S. Federal Reserve, for example, enters into repos and reverse repo agreements to regulate the money supply and bank reserves, and inject or remove funds from the financial markets. The Fed sets the rate at which it will buy securities, which is called the repo rate, and it's similar to the federal funds rate.

For example, if the Fed wants to inject liquidity into the market and boost the money supply, effectively lowering short-term interest rates, it would offer to buy Treasury bills or other government securities from banks. This raises their reserves and provides them with more money to lend, with the promise to sell the securities back at a later date. Conversely, if it wants to tighten the money supply and therefore raise interest rates, it would sell securities and buy them back later.

By using the repo market, the Fed can conduct monetary policy more discreetly without raising or lowering the federal funds rate, which would be a more dramatic move and might unsettle the markets.

Summary

A repurchase agreement is a short-term loan that is structured as the sale of securities, with the seller agreeing to buy them back at a later date for a higher price, with the difference being the effective interest on the loan. The securities involved are usually U.S. Treasuries, which provide the collateral for the loan.

A reverse repurchase is the other side of the transaction, with one party agreeing to buy securities and sell them back later. The repo market is huge, with daily volume about four times larger than the Treasury securities trading market itself.