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.
Repos are typically used to raise short-term capital.
BREAKING DOWN Repurchase Agreement - Repo
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 or other investments. Repurchase agreements are strictly short-term investments, and their maturity period is called the "rate," the "term" or the "tenor."
Classified as a money-market instrument, a repurchase agreement functions in 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 securities being sold are the collateral. Thus the goals of both parties, secured funding and liquidity, are met.
Despite the similarities to collateralized loans, repos 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.
Term vs. Open Repurchase Agreements
The major difference between a term and an open repo lies in the amount of time between the sale and the repurchase of the securities.
Repos that have a specified maturity date (usually the following day or week) are term repurchase agreements. A dealer sells securities to a counterparty with the agreement that he will buy them back at a higher price on a specific date. In this agreement, the counterparty gets the use of the securities for the term of the transaction, and will earn interest stated as the difference between the initial sale price and the buyback price. The interest rate is fixed, and interest will be paid at maturity by the dealer. A term repo is used to invest cash or finance assets when the parties know how long they will need to do so.
An open repurchase agreement (also known as on-demand repo) works the same way as a term repo except that the dealer and the counterparty agree to the transaction without setting the maturity date. Rather, the trade can be terminated by either party by giving notice to the other party prior to an agreed-upon daily deadline. If an open repo is not terminated, it automatically rolls over each day. Interest is paid monthly, and the interest rate is periodically repriced by mutual agreement. The interest rate on an open repo is generally close to the federal funds rate. An open repo is used to invest cash or finance assets when the parties do not know how long they will need to do so. But nearly all open agreements conclude within one or two years.
The Significance of the Tenor
Repos with longer tenors are usually considered higher risk. During a longer tenor, more factors can affect repurchaser creditworthiness, and interest rate fluctuations are more likely to have an impact on the value of the repurchased asset.
It's similar to the factors that affect bond interest rates. In normal credit market conditions, a longer-duration bond yields higher interest. Long-term bond purchases are bets that interest rates will not rise substantially during the life of the bond. Over a longer duration, it is more likely that a tail event will occur, driving interest rates above forecasted ranges. If there is a period of high inflation, the interest paid on bonds preceding that period will be worth less in real terms.
This same principle applies to repos. The longer the term of the repo, the more likely that the value of the collateral securities will fluctuate prior to the repurchase, and business activities will affect the repurchaser's ability to fulfill the contract. In fact, counterparty credit risk is the primary risk involved in repos. As with any loan, the creditor bears the risk that the debtor will be unable to repay the principal. Repos function as collateralized debt, which reduces the total risk. And because the repo price exceeds the value of collateral, these agreements remain mutually beneficial to buyers and sellers.
Types of Repurchase Agreements
There are three types of repurchase agreements.
- The most common type is a third-party repo. 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 that the seller receives cash at the onset of the agreement and that the buyer transfers funds for the benefit of the seller and delivers the securities at maturation. These agreements constitute more than 90% of the repurchase agreement market, which held approximately $1.8 trillion as of 2016.
- 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 custodial account for the buyer. This type of agreement is even less common because there is a risk the seller may become insolvent and the borrower may not have access to the collateral.
The Significance of the Repo Rate
When government central banks repurchase securities from private banks, they do so at a discounted rate, known as the repo rate. Like prime rates, repo rates are set by central banks.The repo rate system allows governments to control the money supply within economies by increasing or decreasing available funds. A decrease in repo rates encourages banks to sell securities back to the government in return for cash. This increases the money supply available to the general economy. Conversely, by increasing repo rates, central banks can effectively decrease the money supply by discouraging banks from reselling these securities.