What Is a Repurchase Agreement?

What Is a Repurchase Agreement?

Let me explain repurchase agreements, or repos, directly to you. They're short-term borrowing tools in the government securities markets where a dealer sells securities and agrees to buy them back at a higher price soon after. This setup helps financial entities manage liquidity and capital, with the implied interest rate being key. The Federal Reserve has shaped the repo market significantly in recent years.

In a typical repo, a dealer sells government securities to an investor, often overnight, and repurchases them the next day at a slight premium. That price difference acts as an implicit overnight interest rate. You see repos used for raising short-term capital and in central bank operations. In the early 2020s, the Fed's changes boosted repo volumes massively, but they started unwinding that in 2023.

If you're the party selling the security and agreeing to repurchase it, that's a repo for you. The buyer, who agrees to sell it back, is doing a reverse repo. The terminology can get abstract quickly, but these overnight flows are the daily backbone of finance. You should watch this if you're interested in markets, as it's all about the liquidity that keeps our economy running.

Key Takeaways

Here's what you need to know: A repo is a short-term deal to sell securities and buy them back at a higher price. The seller is basically borrowing against those securities, with the price difference as implicit interest. Repos and reverse repos handle short-term borrowing and lending, usually overnight to 48 hours. The repo rate is that implicit interest. The Fed uses these to control money supply and short-term rates, central to their monetary policy.

How Repurchase Agreements Work

The Fed has gotten more involved in repos lately, setting up facilities like the Standing Repo Facility and Overnight Reverse Repo Facility to manage liquidity in short-term funding markets. Repos are safe because they use collateral like Treasury bonds or mortgage-backed securities. They're money market instruments—short-term, collateral-backed loans with interest. The buyer lends short-term, the seller borrows.

Various parties make these agreements. The Fed uses them for money supply and bank reserves. Individuals finance debt purchases with them. Repos are strictly short-term; their maturity is the 'rate,' 'term,' or 'tenor.' Unlike collateralized loans, repos count as purchases, but for tax and accounting, they're loans. In bankruptcy, repo investors can sell collateral, avoiding automatic stays.

Example of a Repurchase Agreement

Suppose a bank needs quick cash. It agrees with an investor to get the money, paying it back soon with interest, and puts up collateral. They use Treasury bonds: the bank sells them to the investor, agreeing to repurchase at a premium. The bonds are collateral; the bank gives up control temporarily, then buys them back with extra payment at the set time.

Repurchase vs. Reverse Repo Agreements: Key Differences

A reverse repo is just the flip side of a repo. Every trade has a buyer and seller, and the label depends on your side. For the initial seller repurchasing, it's a repo; for the buyer reselling, it's a reverse repo. Reverse repos are for short-term lending, used by institutions and central banks to pull money from the system when there's excess liquidity. Repos inject liquidity. The Fed did repos in 2020 for COVID liquidity, then reverse repos for tightening.

Term vs. Open Repurchase Agreements: Understanding the Time Frames

The big difference is timing. Term repos have a set maturity, usually next day to a week. The dealer sells, counterparty buys back at higher price on that date, earning interest via the difference. It's fixed-rate, paid at end. Use it when you know your timeline for investing or financing.

Open repos, or on-demand, work similarly but without a fixed end date. Either party can terminate with daily notice; it rolls over otherwise. Interest pays monthly, rate repriced mutually. Rates stay near federal funds. Use when timelines are uncertain; most wrap up in one to two years.

Why the Tenor Matters in Repurchase Agreements

Longer terms mean more risk—more can go wrong affecting repayment, plus interest rate changes can hit asset values. It's like bonds: longer durations pay higher but risk rate rises. High inflation erodes prior interest value. For repos, longer tenor raises chances of collateral fluctuation and repurchaser issues. Counterparty credit risk is key. But as collateralized debt with repo price over collateral value, they're mutually beneficial and lower total risk.

Different Kinds of Repurchase Agreements Explained

There are three main types. Third-party or tri-party repos are most common, with a clearing bank handling transactions, holding securities, ensuring payments, and applying margins. Banks like JPMorgan and BNY do this. They settle repos, extend intraday credit, but don't match parties. These make up 80% of the $3.65 trillion market as of January 2024.

Specialized delivery repos guarantee specific bonds at start and maturity—uncommon. Held-in-custody repos have the seller hold the security in custody for the buyer, but it's rare due to insolvency risks blocking buyer access.

Understanding Near and Far Legs in Repo Transactions

Repo lingo includes 'leg': the initial sale is the 'near leg' or 'start leg,' the repurchase is the 'far leg' or 'close leg.' You'll see terms like collateral (Treasurys, etc.), counterparty risk (mitigated by collateral), haircut (value buffer), and more in repo discussions.

Why the Repo Rate Is Important in Financial Markets

When the Fed repurchases securities, it's at the repo rate, set by central banks like prime rates. This lets the Fed control money supply by adjusting funds. Higher repo rates mean banks pay more to borrow, squeezing profits, raising public loan rates, cutting spending to fight inflation. Lower rates cheapen borrowing, boosting the economy. To assess a repo, calculate initial cash, repurchase cash, and implied rate using: Interest rate = [(future value/present value) – 1] × year/days between legs. Compare to other sources; repos often offer better terms as secured lending.

Assessing the Risks of Repurchase Agreements

Repos are low-risk, but the seller might fail to repurchase, letting the buyer liquidate collateral. Risk remains if value drops, forcing the buyer to hold or sell at loss. If value rises, the creditor might not return it. Mitigate with over-collateralization and margin calls. Credit risk depends on terms, security liquidity, and parties.

The Financial Crisis: Impact on the Repo Market

Post-2008, focus was on repo 105, speculated in Lehman's hiding of issues. The market shrank but recovered. The Fed addressed risks like intraday credit reliance, default liquidation plans, and risk management. New rules pushed banks to hold safe assets, reducing repo lending. Systemic risks persist, with potential for regulations or central clearing. Repos remain key for short-term borrowing.

Recent Developments in the Repo Market

Post-2008, global repo value dropped from $4 trillion to $2 trillion for a decade. By 2020s, Fed actions offset reserve swings, with volumes peaking at $4.7 trillion in 2023, then under $4 trillion. ON RRP grew from $1 trillion in 2021 to $2.7 trillion by 2022, making Fed central. Pandemic drove safe asset demand; FOMC's SRF smoothed liquidity, becoming key. Fed's bond holdings supported economy, but quantitative tightening from 2022 reduced balance sheet, cutting ON RRP to minimize disruption. Economic uncertainty and changes tripled market size; as Fed pulls back, private sector absorbs, with Q1 2024 showing adjustment, though capacity questions remain.

Who Benefits in a Repurchase Agreement?

All parties benefit: sellers get cash, buyers earn from lending. Sellers include banks, hedge funds, needing short-term cash; buyers are banks, central banks with surpluses. Securities are high-quality like government bonds, easy to sell if needed.

The Bottom Line

A repo lets a dealer sell a security like a Treasury and repurchase at higher price for liquidity. It's a collateral-backed loan with repo rate as interest. Repos provide market liquidity and aid policy. The Fed ramped up in 2020s for stability, now reducing to push private role. They're low-risk but crucial for economic liquidity.