Repo vs. Reverse Repo: An Overview
A repurchase agreement, or repo for short, is a form of short-term lending used in the money markets. It is a form of collateralized lending.
- A repurchase agreement is a short-term loan. The seller sells a Treasury bill or other government security with the promise to buy it back at a specific date at a price that includes an interest payment.
- A reverse repurchase agreement is simply a matter of perspective. To the party selling the security with the agreement to buy it back, it is a repurchase agreement. To the party buying the security and agreeing to sell it back, it is a reverse repurchase agreement.
Dealers who buy repos are generally raising cash for a short-term purpose. Managers of hedge funds and other leveraged accounts, insurance companies, and money market mutual funds are among those active in such transactions.
Notably, the repo and the reverse repo are key tools used by the Federal Reserve Bank as a means of controlling the overall supply of money.
A repurchase agreement involves a sale of assets. However, for tax and accounting purposes it is treated as a loan.
How the Repo Works
The repo is a form of collateralized lending. The securities used are the collateral for the loan. Legal title to the securities passes from the seller to the buyer and back again.
The collateral most commonly used in this market consists of U.S. Treasury securities. However, any government bonds, agency securities, mortgage-backed securities, corporate bonds, or even equities may be used in a repurchase agreement.
The value of the collateral is generally greater than the purchase price of the securities. This difference in prices reduces the risk that the counterparty might fail to return the collateral.
Repurchase agreements are short-term transactions in nature, often literally overnight. Some repos are open, meaning they have no set maturity date, but the reverse transaction usually occurs within a year.
The Benefit to Each Party
In a repurchase agreement, a dealer sells securities to a counterparty with the agreement to buy them back at a higher price at a later date. The dealer is raising short-term funds at a favorable interest rate with little risk of loss.
The counterparty earns interest on the transaction in the form of the higher price of selling the securities back to the dealer. The buyer also gets the temporary use of the securities.
How the Federal Reserve Uses Repos
Standard and reverse repurchase agreements are the most commonly used instruments of open market operations for the Federal Reserve.
The Central Bank can boost the overall money supply by buying Treasury bonds or other government debt instruments from commercial banks, thus increasing its reserves of cash in the short term before selling them back. When the Central Bank wants to tighten the money supply, it sells the bonds to the commercial banks and then buys them back in a reverse repo.
The Risks of Repos and Reverse Repos
Repo agreements carry a risk profile similar to any securities lending transaction. That is, they are relatively safe transactions as they are collateralized loans, generally using a third party as a custodian.
The real risk of repo transactions is that the marketplace for them has the reputation of sometimes operating on a fast-and-loose basis without much scrutiny of the financial strength of the counterparties involved. Some default risk is inherent in this.
There also is the risk that the securities involved will depreciate before the maturity date, in which case the lender may lose money on the transaction. This risk of time is why the shortest transactions in repurchases carry the most favorable returns.
Tax Implications for Repos and Reverse Repos
The purpose of the repo is to borrow money, yet it is not technically a loan. Ownership of the securities involved actually passes back and forth between the parties involved.
Nevertheless, they are very short-term transactions with a guarantee of repurchase. Thus, for tax and accounting purposes repos are generally treated as loans.
- The repurchase agreement is a form of short-term borrowing used in the money markets.
- Although it is considered a loan, the repurchase agreement involves the sale of an asset that is held as collateral until it the seller repurchases it at a premium.
- The seller is making a repurchase agreement. In money markets lingo, the buyer is making a reverse repurchase agreement.