a repurchase agreement repo is a form of short term borrowing for dealers in government securities for a repo a dealer sells government securities to an investor usually overnight and buys them back the following day at a slightly higher price the small price difference is an implicit overnight interest rate repos are typically used to raise short term capital they are also commonly used in central bank open market operations during the early 2020s the federal reserve instituted changes that massively increased the volume of repos traded a trend it began to unwind in 2023 
the party selling the security and agreeing to repurchase it later is involved in a repo meanwhile the party buying the security and agreeing to sell it back is engaged in a reverse repurchase agreement or reverse repo 1the language around repos gets abstract even dry very fast but the daily work of finance is done through and with these mostly overnight flows it s a crucial issue for anyone interested in the market to watch since it s about nothing less than the liquidity of the capital markets that run our economy investopedia katie kerpelunderstanding repurchase agreementsin recent years the federal reserve has significantly increased its involvement in the repo market establishing the standing repo facility srf and the overnight reverse repo facility on rrp has given it powerful tools for managing liquidity in american short term funding markets repurchase agreements are safe investments because the securities involved typically treasury bonds federal agency mortgage backed securities mbs and others are the collateral classified as a money market instrument a repo is thus a short term collateral backed interest bearing loan the buyer acts as a short term lender while the seller is a short term borrower 23repurchase agreements are made between a variety of parties the u s federal reserve uses repos to regulate the money supply and bank reserves individuals typically use them to finance the purchase of debt securities or other investments repurchase agreements are strictly short term investments and their maturity period is called the rate the term or the tenor 3despite some similarities with collateralized loans repos count as purchases however because the buyer only temporarily owns the security these agreements are usually treated as loans for tax and accounting purposes 4 when there s a bankruptcy repo investors can generally sell their collateral this distinguishes repos from collateralized loans bankrupt investors would be subject to an automatic stay for most collateralized loans 5repurchase agreement examplesuppose a bank needs a quick cash injection it agrees with an investor who offers to give it the money it needs so long as it pays it back quickly with interest in the meantime the bank also puts up collateral in return at issue in the agreement are treasury bonds the bank sells them to the investor with a deal that it will repurchase them very soon at a slight premium the treasury bonds serve as collateral the bank temporarily relinquishes control of the bonds for the cash it needs 6 then at a preset time the bank receives them back by paying back the money it received plus a little extra difference between repurchase and reverse repo agreementsa reverse repo agreement is the inverse of a repurchase agreement every trade has two parties the buyer and the seller whether it s a repo agreement or a reverse repo agreement depends on which side of the trade you are on it s a repo transaction for the party initially selling the security with the agreement to repurchase it for the investor buying the security under the stipulation of selling it back shortly it s a reverse repo agreement in other words a reverse repo is the seller of a repurchase agreement 7reverse repos are commonly used by financial institutions as a form of short term lending and by central banks to reduce the money supply a repo puts money into the banking system a reverse repo meanwhile borrows money from the system when there is too much liquidity 8for example the fed used reverse repos to inject liquidity into the economy in 2020 the height of the covid 19 pandemic and then engaged in reverse repos as part of its quantitative tightening in the years that followed 910term vs open repurchase agreementsthe major difference between a term and an open repo lies in the time between the sale and the repurchase of the securities repos with a specific maturity date usually the following day though it can be up to a week are term repurchase agreements 11 a dealer sells securities to a counterparty who agrees to repurchase them at a higher price on a given date under the agreement the counterparty gets the securities for the transaction term and earns interest through the difference between the initial sale price and the buyback price the interest rate is fixed and is paid at maturity by the dealer a term repo is used to invest cash or finance assets when the parties know how long they need to do so an open repurchase agreement or 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 instead either party can end the trade by giving notice to the other before an agreed upon deadline that arises daily if an open repo is not closed it automatically rolls over into the next day 12 interest is paid monthly and the interest rate is periodically repriced by mutual agreement 13the interest rate on an open repo is generally close to the federal funds rate 1415 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 most open agreements conclude within one to two years 16the significance of the tenorrepos with longer tenors time until maturity are usually considered higher risk a longer tenor means that more can happen which affects the repurchaser s ability to do so also interest rate fluctuations are more likely to influence the value of the repurchased asset this is like those factors that affect bond interest rates under normal credit market conditions a longer duration bond yields higher interest investors buy long term bonds as part of a wager that interest rates won t rise substantially during the term a tail event is more likely to drive interest rates above forecast ranges when there s a longer duration if there is a period of high inflation the interest paid on bonds preceding that period will be worth less in real terms the same principles apply to repos the longer the term of the repo the more likely the collateral securities value will fluctuate before the repurchase and business activities can affect the repurchaser s ability to complete the contract counterparty credit risk is primary in repos as with any loan the creditor bears the risk that the debtor won t repay the principal repos function as collateralized debt which reduces the total risk and because the repo price exceeds the collateral s value these agreements tend to be mutually beneficial 17types of repurchase agreementsthere are three main types of repurchase agreements also known as a tri party repo this is the most common in this arrangement involving three entities a clearing agent or bank conducts the transactions between the buyer and seller and protects the interests of each it holds the securities and ensures that the seller receives cash at the onset that the buyer transfers funds for the benefit of the seller and that the securities are delivered at maturity clearing banks for tri party repos in the u s include jpmorgan chase co jpm and bank of new york mellon bny in addition to taking custody of the securities involved clearing agents also value the securities and ensure that a set margin is applied they settle the transaction on their books and help dealers with collateral 18 however clearing banks don t act as matchmakers they don t find dealers for cash investors or vice versa and they don t broker the deals typically clearing banks begin to settle repos early in the day although they re not technically settled until the end of the day this delay usually means that billions of dollars of intraday credit are extended to dealers daily these agreements are about 80 of the repurchase agreement market which stood at about 3 65 trillion in january 2024 19specialized repos have a bond guarantee at the beginning of the agreement and at maturity along with the collateral this type of agreement is uncommon in this kind of agreement the seller gets cash for the security but holds it in a custodial account for the buyer this type is even less common than specialized delivery repos because there is a risk that the seller may become insolvent and the borrower may not have access to the collateral near and far legslike many parts of the financial world repurchase agreements involve terminology not common elsewhere one common term in the repo space is the leg for instance the part of the repurchase agreement in which the security is initially sold is sometimes called the start leg while the repurchase that follows is the close leg these terms are also sometimes exchanged for near leg and far leg respectively in the near leg of a repo transaction the security is sold in the far leg it is repurchased 16 in the table below we give you a help cheat sheet to check for these and other terms significance of the repo rate