A repurchase agreement, or repo, is a form of collateralized lending, while a reverse repurchase agreement, or reverse repo, is a form of collateralized borrowing.
The collateral is most commonly U.S. Treasury securities, but may include other government bonds, agency securities, mortgage-backed securities, corporate bonds or equities. Legal title to the securities passes from the seller to the buyer and vice versa. The amount of collateralization is generally greater than the purchase price of the securities. This is done to mitigate the risk that the counterparty might not be able to return the collateral. Repos and reverse repos are short-term in nature with tenors ranging from overnight to less than one year.
In a repurchase agreement, a dealer sells securities, or collateral, to a counterparty with the agreement to buy back the securities at a higher price at a later date. As part of this agreement, the counterparty gets the use of the securities for the term of the transaction and the dealer earns interest, or the difference between the initial sale price and the buyback price. The dealer also gets a low-risk means to raise short-term funds. Those who enter into repos include money market mutual funds, insurance companies and central banks.
A reverse repurchase agreement is simply a repurchase agreement from the dealer's perspective rather than from the counterparty's perspective. Therefore, if the dealer borrows money, it is a repo. If the dealer lends money, it is a reverse repo. Those who enter into reverse repos are generally seeking cash, and they include hedge funds and other levered accounts.
The Federal Reserve and Repurchase Agreements
Standard and reverse repos are the most commonly used instruments of open market operations for the Federal Reserve. Through these tools, the Fed hopes to reduce the opportunity costs associated with holding bank reserves.
Fed repos operate through a tri-party settlement; another party is brought in to handle the collateral. Reverse repos are executed through a delivery versus payment (DVP) system. In a DVP, securities are moved against simultaneous payment; the Fed sends collateral to the dealer's bank and automatically receives money against the security.
Risks Associated With Repurchase and Reverse Repurchase Agreements
Reverse repurchase agreements carry a similar risk profile as standard securities lending transactions. The difference is that a securities lending transaction is normally managed by a custodian who serves as the lending agent; a reverse repo doesn't have this third party. Instead, a reverse repo takes place directly between the lender and borrower. The exception to this direct relationship is when the Federal Reserve is involved.
Another risk of the fast-and-loose reverse repo market is that the financial strength of the counterparties involved is not typically scrutinized. Old players are allowed to keep playing regardless of their changing financial realities. Some default risk is inherent to this; there is also the chance for securities involved to quickly depreciate before the maturity date, so the lender receives less cash than it initially provided.
When the Federal Reserve is involved in a reverse repurchase agreement, it borrows overnight from cash lenders and, in return, issues securities as collateral. This is designed to drain reserves from the banking system and raise target interest rates in the economy.
Firms that lend to the Fed in these transactions are normally those with large cash-on-hand balances. Since 2011, this is exactly what firms have been doing with the massive amounts of cash reserves left over from the various quantitative easing programs. Some major financial institutions have short-term business models that specifically rely on the overnight reverse repo window at the Fed. If the Fed closed the window suddenly to prevent banks from hiding secured cash with the Fed Bank, many banks (and the financial system) would likely be sent scrambling. This is a bit of a moral hazard risk.
Tax Implications for Repurchase and Reverse Repurchase Agreements
As stated above, a standard repurchase agreement involves the sale of a security where the seller agrees to repurchase the same security at a future date and specified price. The difference in price is normally predicated on a time value of money calculation. Substantively, this is very similar to a collateralized loan.
The reverse repurchase agreement switches the obligation, where the buyer agrees to sell back the security at a later date and specified price. Normally, the buyer earns income from interest, dividends or additional repurchases with the securities prior to selling them back. After the final sale, the buyer can earn a taxable net profit or tax-deductible net loss.
Until the turn of the 21st century, there was some confusion about whether the interest allocation rules (as codified in I.R.C section 864(e)) treated repurchase agreements as net fee income or interest income and interest expense.
In the case of reverse repurchase agreements, it was determined that accumulated interest from reverse repurchases should be treated the same a secured loan with interest income for federal tax purposes. A standard repurchase agreement would create an interest expense.