Repurchase Agreement - Repo

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What is a 'Repurchase Agreement - Repo'

A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day.

For the party selling the security, and agreeing to repurchase it in the future, it is a repo; for the party on the other end of the transaction, buying the security and agreeing to sell in the future, it is a reverse repurchase agreement.

BREAKING DOWN 'Repurchase Agreement - Repo'

Repos are classified as a money-market instrument. Usually used to raise short-term capital, think of a repurchase agreement as having the same effect as a short-term, collateral-backed, interest-bearing loan. The buyer acts as a short-term lender, the seller acts as a short-term borrower, and the security is the collateral. Thus the goals of both parties, secured funding and liquidity, are met.

Repurchase agreements are generally considered safe investments because the security in question functions as collateral, which is why most agreements involve U.S. Treasury bonds. The Federal Reserve enters into repurchase agreements to regulate the money supply and bank reserves. Individuals normally use these agreements to finance the purchase of debt securities. Repurchase agreements are strictly short-term investments, and the maturity period is called the rate or term.

Despite the similarities to short-term, interest-bearing loans, repurchase agreements are actual purchases. However, since the buyer only has temporary ownership of the security, these agreements are often treated as loans for tax and accounting purposes. Agreements that have a specified maturity date are term agreements. Most agreements mature the following day or week. Some agreements are referred to as open because they have no maturity date specified. Either the buyer or seller may fulfill and renew the agreement or terminate it, but nearly all open agreements conclude within one or two years.

Types of Repurchase Agreements

There are three types of repurchase agreements. In a specialized delivery repo, the transaction requires a bond guarantee at the beginning of the agreement and upon maturity. This type of agreement is not very common.

In a held-in-custody repo, the seller receives cash for the sale of the security but holds it in a custody account for the buyer. This type of agreement is even less common since there is a risk the seller may become insolvent and the borrower may not have access to the collateral.

The third and most common type of repurchase agreement is a third-party repurchase agreement. In this arrangement, 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 the seller receives cash at the onset of the agreement and the buyer transfers funds for the benefit of the seller and delivers the securities at maturation. These agreements constitute over 90% of the repurchase agreement market, which holds approximately $1.8 trillion as of 2016.

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  5. What risks does the dealer (lender) in a reverse repurchase agreement take on?

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