how reverse repurchase agreements rrps work
repos are classified as a money market instrument and they are usually used to raise short term capital reverse repurchase agreements rrps or reverse repos are the seller end of a repurchase agreement these financial instruments are also called collateralized loans buy sell back loans and sell buy back loans reverse repos are commonly used by businesses like lending institutions or investors to access short term capital when facing cash flow issues in essence the borrower sells a business asset equipment or even shares in its company then at a set future time the lender sells the asset back for a higher price the higher price represents the interest to the buyer for loaning money to the seller during the duration of the deal the asset acquired by the buyer acts as collateral against any default risk that it faces from the seller short term rrps hold smaller collateral risks than long term rrps because over the long term assets held as collateral can often depreciate in value causing collateral risk for the buyer in a macro example of rrps the federal reserve bank uses repos and rrps to provide stability in lending markets through open market operations omos the rrp transaction is used less often than a repo by the fed as a repo puts money into the banking system when it is short whereas an rrp borrows money from the system when there is too much liquidity the fed conducts rrps to maintain long term monetary policy and control capital liquidity levels in the market part of the business of repos and rrps is growing with third party collateral management operators providing services to develop rrps to provide quick funding to businesses in need as quality collateral is sometimes difficult to find businesses are taking advantage of their assets as a quality way to fund expansion and equipment acquisition through the use of tri party rrps resulting in repo agreement opportunities for investors this industry is known as collateral management optimization and efficiency reverse repurchase agreements vs buy or sell backsan rrp differs from buy or sell backs in a simple way buy or sell back agreements legally document each transaction separately providing clear separation in each transaction in this way each transaction can legally stand on its own without the enforcement of the other rrps on the other hand have each phase of the agreement legally documented within the same contract and ensure the availability and right to each phase of the agreement lastly in an rrp although collateral is in essence purchased the collateral generally never changes physical location or actual ownership if the seller defaults against the buyer then the collateral would need to be physically transferred repos and reverse repos are two sides of the same coin reflecting the role of each party in the transaction repo refers to the buyer side of a repurchase agreement while reverse repo refers to the seller side example of reverse repurchase agreementslet s say bank abc currently has excess cash reserves and it is looking to put some of that money to work meanwhile bank xyz is facing a reserve shortfall and needs a temporary cash boost bank xyz may enter a reverse repo agreement with bank abc agreeing to sell securities for the other bank to hold overnight before buying them back at a slightly higher price from the perspective of bank abc which buys the securities and agrees to sell them back at a premium the next day the transaction is a repurchase agreement 