A repurchase agreement is a form of short-term lending. Under Repo, a primary dealer will sell a government security to an investor with an agreement to buy it back, often the next day, at a slightly higher price. This is the cheapest form of borrowing there is.
Since it is short-term, the maturity is from overnight to 1 year. This is known as "term" repo. Anything that goes further than a year doesn't have a maturity date and is known as "open".
The difference in price on the overnight is the implicit interest rate. This is also known as the Repo Rate.
To clarify, the seller of the security is the borrower, trying to get a hold of cash. The buyer is considered the lender, since that is the financial institution coming to the table with money. In this scenario, the security acts as collateral. This makes Repo a secured loan.
Repo Market
The repurchase market is the largest and most actively traded sectors of all short term credit markets. It is a vital source of liquidity for money market funds.
As of August 2023, the repo market did $4.7 trillion in daily volume according to the Federal Reserve Bank of New York.
This market brings large institutions together. Each will bring different assets which are swapped based upon needs.
Why Repo Market Exists
There are two primary reasons for the Repo Market.
-Institutions that hold a large number of securities are able to use them as collateral for cash. Examples of these are:
- hedge funds
- pension funds
- insurance companies
- banks
- broker-dealers
Holding cash is something these entities avoid since it has a cost due to the fact it doesn't pay interest or generate a return. They do have to meet daily expenses requiring the money to operate.
The securities can be posted as collateral on a short term (usually overnight) loan providing the liquidity required.
Large cash holders, such as money market funds, can gain earn a small amount of interest by providing the liquidity to the market. These funds act as lenders with the others institutions effectively being the borrower.
-The Federal Reserve uses the Repo Market to implement monetary policy.
When the Fed buys securities from a seller who agrees to repurchase them, it is injecting reserves into the financial system. Conversely, when the Fed sells securities with an agreement to repurchase, it is draining reserves from the system.
Many watch this as an indicator of the liquidity in the financial system.
Central bank reserves can only be on the balance sheet of member institutions who have a master account with the Fed. The primary-dealers are the ones who can warehouse the securities. The reserves are used during Quantitative Easing (QE) as a way to stimulate the economy.
During Quantitative Tightening (QT) the reverse is undertaken as the Fed reduces its balance sheet.
Reverse Repo
A reverse repurchase agreement (reverse repo) is the mirror of a repo transaction. In a reverse repo, one party purchases securities and agrees to sell them back for a positive return at a later date, often as soon as the next day.