What is a 'Reverse Repurchase Agreement'
A reverse repurchase agreement is the purchase of securities with the agreement to sell them at a higher price at a specific future date. 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.
Repos are classified as a money-market instrument, and they are usually used to raise short-term capital.
BREAKING DOWN 'Reverse Repurchase Agreement'
Reverse repurchase agreements (RRPs) are the buyer end of a repurchase agreement. These financial instruments are also called collateralized loans, buy/sell back loans, and sell/buy back loans.
Repos are commonly used by businesses to gain access to short-term capital during cash flow issues. In essence, the business sells a business asset, equipment or even shares in the company for a promise of immediate funding and promises to repurchase the item at a set future time. The RRP is the investor or lending institution that makes the loans to the business in order to impute interest on the item upon repurchase. Short-term RRPs hold smaller collateral risks than long-term RRPs. Over the long term, assets held as collateral can often depreciate in value, causing collateral risk for the RRP buyer.
In a macro example of RRPs, the Federal Reserve Bank (Fed) uses repos and RRPs in order to provide stability in lending markets. 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 in order to maintain long-term monetary policy and ensure capital liquidity levels in the market.
Part of the business of repos and RRPs is growing, as third-party collateral management operators are providing services to develop RRPs on behalf of investors and provide quick funding to businesses in need.
As quality collateral is sometimes difficult to find, businesses are taking advantage of these assets as a quality way to fund expansion and equipment acquisition through the use of triparty repos, resulting in RRP opportunities for investors. This section of the industry is known as collateral management optimization and efficiency.
Components of an RRP
An RRP differs from buy/sell backs in a simple yet clear way. Buy/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, generally the collateral never changes physical location or actual ownership. If the seller defaults against the buyer, the collateral would need to be physically transferred.