Repurchase Agreement (Repo)

What is a repo?

A repurchase agreement (repo) is a short-term transaction in which one party sells securities (commonly government bonds) to another party and agrees to repurchase them at a slightly higher price at a specified future time. The price difference represents an implicit interest rate—the repo rate. Economically, a repo functions like a collateralized short-term loan: the seller is borrowing cash and the buyer is lending cash, with the securities serving as collateral.

How repos work

• Seller (borrower) transfers securities to Buyer (lender) and receives cash.
• At the agreed repurchase date, Seller pays cash plus interest and reclaims the securities.
• If the Seller defaults, the Buyer can sell the collateral to recover the cash.
• Repos are typically overnight but can have longer tenors; they are classified as money-market instruments and are widely used for liquidity management.

Central banks also use repos and reverse repos as monetary-policy tools to manage short-term liquidity and influence interest rates.

Example

A bank needs short-term cash. It sells Treasury bonds to an investor with an agreement to repurchase them the next day for a slightly higher price. The investor earns the implied overnight interest; the bank obtains the cash it needs while temporarily relinquishing the bonds.

Repo vs. Reverse Repo

• Repo: Viewed from the seller’s perspective (selling now, repurchasing later).
• Reverse repo: The same transaction viewed from the buyer’s perspective (buying now, selling later).
  Central banks use repos to inject liquidity and reverse repos to absorb excess liquidity.

Term vs. Open repos

• Term repo: Has a fixed maturity (overnight to weeks). Interest is fixed and paid at maturity.
• Open (on-demand) repo: No fixed maturity; either party can end the agreement with notice. Interest may be repriced periodically and is usually close to the federal funds rate.

Why tenor matters

Longer tenors increase exposure to interest-rate and collateral-price risk. Over longer periods, market conditions can change, affecting collateral value and the borrower’s ability to repurchase. Longer-term repos typically demand higher rates to compensate for added risk.

Common repo types

• Tri-party (third-party) repo: A clearing bank or agent intermediates, holds custody, marks collateral to market, and manages margining. It is the largest segment of the repo market.
• Specialized delivery repo: Involves an additional bond guarantee or specific delivery terms; less common.
• Held-in-custody repo: Seller retains custody of the collateral in a custodial account; uncommon and carries higher counterparty risk.

Near and far legs

A repo has two legs:
– Near/Start leg: initial sale of the security for cash.
– Far/Close leg: repurchase of the security at the agreed later date.
These terms denote the two sides of the same transaction.

The repo rate and its importance

The repo rate (implied by the buyback price) determines the cost of short-term secured funding. Central banks set or influence repo rates to manage money supply:
– Raising repo rates makes borrowing costlier and can help curb inflation.
– Lowering repo rates makes borrowing cheaper and can stimulate economic activity.

Simple implied interest calculation:
Interest rate = [(future value / present value) − 1] × (year / number of days between legs)

Risks and mitigants

Main risks:
– Counterparty risk: Seller may fail to repurchase; buyer must liquidate collateral, which may have declined in value.
– Collateral liquidity risk: Difficulty selling collateral quickly without losses.
– Operational and settlement risks, especially in tri-party arrangements that rely on intraday credit.

Mitigants:
– Over-collateralization and margining (haircuts) to absorb price moves.
– Daily marking to market and margin calls.
– Use of high-quality, liquid securities (e.g., Treasuries, high-grade MBS).

Market developments and systemic considerations

• Repos are central to short-term liquidity and money-market functioning.
• After the 2008 crisis, regulators and central banks focused on repo vulnerabilities (intraday credit reliance, default resolution, risk practices).
• During the COVID-19 pandemic and its aftermath, repo activity surged: central banks (notably the Federal Reserve) expanded repo operations (Standing Repo Facility, Overnight Reverse Repo Facility) to stabilize markets. This increased the Fed’s role as a primary counterparty for a period.
• Subsequent quantitative tightening reduced some central-bank repo activity, prompting a shift back toward private-market participants. The private market’s ability to absorb large volumes remains a focus of systemic risk monitoring.

Who uses repos and what collateral is accepted?

• Borrowers (sellers): banks, broker-dealers, hedge funds, and other institutions needing short-term funding.
• Lenders (buyers): commercial banks, money market funds, asset managers, and central banks.
• Typical collateral: high-quality, liquid securities—Treasuries, agency debt, mortgage-backed securities, and high-grade corporate bonds. Collateral choice hinges on liquidity and predictable valuation.

Bottom line

Repurchase agreements are a fundamental, low-cost way to obtain short-term secured funding and to invest excess cash. They support liquidity across financial markets and are a key tool for monetary policy. While generally considered low-risk due to collateralization and market practices (haircuts, margining), repos can become a source of systemic stress if counterparties, collateral liquidity, or settlement infrastructures are compromised. Understanding repo mechanics, types, and risks is essential for anyone tracking short-term funding markets or monetary policy.