Reverse Repurchase Agreement

Reverse Repurchase Agreement (Reverse Repo)

A reverse repurchase agreement (reverse repo or RRP) is the seller’s side of a repurchase agreement. In a reverse repo, one party sells securities to another with a contractual promise to repurchase those securities at a higher price on a specified future date. Economically, it functions as a short-term, collateralized loan: the seller receives cash now, and the buyer provides cash and earns interest equal to the price difference.

Key takeaways

• A reverse repo is effectively a collateralized short-term loan where the seller agrees to buy back sold securities at a higher price.
• Buyers earn interest from the price difference and hold the securities as collateral.
• Financial institutions use reverse repos to manage short-term liquidity; central banks use them to drain excess system liquidity.
• Reverse repos typically document the entire transaction in one contract (unlike some buy/sell-back structures).
• Collateral usually does not change physical possession; ownership transfers only on default or per contract terms.

How reverse repos work (step by step)

1. Seller (needs cash) sells securities to Buyer and agrees to repurchase them at a specified future date and price.
2. Buyer pays cash to Seller and holds the securities as collateral.
3. On the repurchase date the Seller pays the agreed higher price; the price difference equals the implied interest.
4. If the Seller defaults, the Buyer can keep or liquidate the collateral per the agreement.

Notes:
* Transactions are usually short-term (overnight or a few days), reducing collateral deterioration risk.
Documentation commonly consolidates all phases in a single repo/reverse repo contract.
Physical transfer of securities often does not occur; bookkeeping entries reflect the trade.

Uses and participants

• Banks and broker-dealers use reverse repos to invest excess cash or provide short-term funding to counterparties.
• Institutional investors and money market funds use reverse repos to earn a low-risk return on cash.
• Central banks (e.g., the Federal Reserve) use reverse repos as an open market operation to remove excess liquidity from the banking system, helping control short-term interest rates.

Collateral management and tri‑party arrangements

Third-party collateral managers and tri‑party custodians facilitate many repo/RRP transactions by:
* Safekeeping collateral, performing valuation and margining, and managing settlement.
* Enabling firms with illiquid or diverse assets to optimize collateral usage and obtain funding more efficiently.

Reverse repos vs. buy/sell-back agreements

• Reverse repo: entire transaction (sell now, repurchase later) is documented in a single contract, making all phases jointly enforceable.
• Buy/sell-back: the sell and buy transactions are documented separately and are legally independent.
  Practically, both structures achieve similar economic outcomes, but legal and operational differences affect enforceability and settlement procedures.

Example

Bank ABC has excess cash and Bank XYZ needs overnight funding. Bank XYZ sells Treasury securities to Bank ABC with an agreement to repurchase them the next day at a slightly higher price. From Bank ABC’s perspective this is a repo (it provides cash and will be sold the securities back); from Bank XYZ’s perspective it is a reverse repo (it receives cash now and will repurchase later).

Benefits and risks

Benefits:
* Provides predictable short-term funding or investment for cash management.
Collateral reduces credit exposure compared with unsecured lending.
Flexible maturity and frequently used in money markets.

Risks:
* Counterparty credit risk if the seller defaults and collateral value falls.
Market risk if collateral prices decline (especially for longer maturities).
Operational and legal risk tied to documentation, settlement and custody arrangements.
* Liquidity risk if the collateral cannot be sold quickly at expected value.

Conclusion

Reverse repurchase agreements are a core money-market mechanism for short-term liquidity management. They let sellers obtain temporary funding against securities while giving buyers a collateralized, short-duration claim that earns a modest return. Central banks also use RRPs as a policy tool to absorb excess liquidity from the financial system.