What is a Reverse Repurchase Agreement
A reverse repurchase agreement, or "reverse repo", 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 repurchase agreement (RP) or 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 (RRP) or reverse repo.
Repos are classified as a money-market instrument, and they are usually used to raise short-term capital.
Reverse Repurchase Agreement
How Reverse Repurchase Agreements Work
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.
Reverse repos are commonly used by businesses like lending institutions or investors to lend short-term capital to other businesses during cash flow issues. In essence, the lender buys a business asset, equipment or even shares in the seller's company and at a set future time, sells the asset back for a higher price. The higher price represents the interest to the buyer for loaning money to the seller during the duration of the deal. The asset acquired by the buyer acts as collateral against any default risk it faces from the seller. Short-term RRPs hold smaller collateral risks than long-term RRPs as 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 through open market operations (OMO). 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.
- A reverse repo is a short-term agreement to purchase securities in order to sell them back at a slightly higher price.
- Repos and reverse repos are used for short-term borrowing and lending, often overnight.
- Central banks use reverse repos to add money to the money supply via open market operations
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.