What Is a Reverse Repurchase Agreement? How They Work, With Example

Reverse Repurchase Agreement

Investopedia / Jessica Olah

What Is a Reverse Repurchase Agreement (RRP)?

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. A reverse repo refers to the buyer side of a repurchase agreement (RP), or repo. These transactions, which often occur between two banks, are essentially collateralized loans. The difference between the original purchase price and the buyback price, along with the timing of the transaction (often overnight), equates to interest paid by the seller to the buyer. The reverse repo is the final step in the repurchase agreement, closing the contract.

For example, let's say Bank ABC currently has excess cash reserves, and it is looking to put some of that money to work. Meanwhile, Bank XYZ is facing a reserve shortfall and needs a temporary cash boost. Bank ABC may enter a reverse repo agreement with Bank XYZ, agreeing to buy securities and hold them overnight before selling them back for a slight profit. From the perspective of Bank XYZ, which sells the securities and agrees to buy them back at a premium the next day, the transaction is a repurchase agreement.

Notably, Federal Reserve Bank RRPs and repos are labeled based on the viewpoint of the counterparty, not the Fed's viewpoint. In other words, when it comes to dealing with the U.S. central bank, a reverse repo agreement means that the Fed's Open Market Trading Desk sells securities to a counterparty and agrees to buy them back later at a higher price.

Key Takeaways

  • 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, for banks looking to fulfil their reserve requirements.
  • Central banks use repos and reverse repos to add and remove from the money supply via open market operations.

Reverse Repurchase Agreement

How Reverse Repurchase Agreements Work

Repos are classified as a money-market instrument, and they are usually used to raise short-term capital. 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. Then, at a set future time, the buyer 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 because, 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 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.

Notably, the Fed describes these transactions from the viewpoint of the other party, not their own viewpoint. So a Fed RRP or reverse repo agreement is actually an RRP for the other party. In a Fed RRP, the central bank is the one selling securities, and the other party is purchasing the securities.

Part of the business of repos and RRPs is growing, with third-party collateral management operators 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 their assets as a quality way to fund expansion and equipment acquisition through the use of triparty repos, resulting in RRP opportunities for investors. This industry is known as collateral management optimization and efficiency.

RRP vs. Buy or Sell Backs

An RRP differs from buy or sell backs in a simple yet clear way. Buy or 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, the collateral generally never changes physical location or actual ownership. If the seller defaults against the buyer, the collateral would need to be physically transferred.

How Does a Reverse Repurchase Agreement Work?

In a reverse repurchase agreement, a party buys securities from a counterparty with the stipulation that it will sell them back at a slightly higher price. The agreement functions much like a collateralized loan. The original seller (engaging in a repurchase agreement) receives an infusion of cash, while the original buyer (engaging in a reverse repo agreement) essentially provides a loan and earns interest from the higher resale price. In general, the assets that serve as collateral for the transaction do not physically change hands.

What Is the Benefit of a Reverse Repo Agreement?

In a reverse repo agreement, a party with excess cash on hand temporarily buys a business asset, equipment, or even shares in another company, with the stipulation that it will sell the assets back at a profit. Like other types of lenders, the buyer of the assets in a reverse repo earns money for providing a cash boost to the seller, and the underlying collateral reduces the risk of the transaction.

How Does the Fed Use Reverse Repo Agreements?

The Federal Reserve labels repos and reverse repos from the perspective of the counterparty, so a reverse repo means the Fed is initially selling securities and agreeing to buy them back later. In these cases, the Fed is essentially borrowing money from the market, which it may do when there is too much liquidity in the system. Regular repo agreements, in which the Fed plays the role of the lender by buying securities and then selling them back, are more common measures that the central bank uses to inject addition money into the system.

The Bottom Line

A reverse repurchase agreement, or "reverse repo," refers to the buyer side of a repurchase agreement. The party executing the reverse repo buys assets from the other party while agreeing to sell them back later at a slightly higher price. From a practical perspective, a reverse repo agreement is akin to providing a short-term loan, with the underlying assets serving as collateral.

Article Sources
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  1. Federal Reserve Bank of New York. "FAQs: Reverse Repurchase Agreement Operations."

  2. Board of Governors of the Federal Reserve System. "Policy Tools: Overnight Reverse Repurchase Agreement Facility."

  3. The Brookings Institution. "What is the Repo Market, and Why Does It Matter?"

  4. Congressional Research Service. "Repurchase Agreements (Repos): A Primer," Page 1.

  5. PwC. "U.S. Transfers of Financial Assets Guide: 5.5 Repurchase Agreements."

  6. Federal Reserve Bank of New York. "Repo and Reverse Repo Agreements."

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