Repurchase agreement

What Is a Repurchase Agreement?

A repurchase agreement, often referred to as a "repo," is a form of secured short-term borrowing within the realm of money market instruments. In a repo transaction, one party sells a security, typically a government bond, to another party with an agreement to repurchase that same security at a slightly higher price on a specified future date or on demand. This difference in price represents the interest rate on the loan. Essentially, it functions as a collateralized loan, where the security acts as collateral to secure the funds. Repurchase agreements are crucial for managing daily liquidity for financial institutions and play a significant role in central bank operations.

History and Origin

Repurchase agreements have been a fundamental part of financial markets for decades, evolving as a flexible tool for short-term financing. Their use became particularly prominent with the growth of government securities markets, providing a liquid and relatively low-risk avenue for cash management. Central banks, notably the Federal Reserve, began utilizing repos extensively as a tool for monetary policy to manage the supply of reserves in the banking system. For instance, the Federal Reserve Bank of New York describes how its Open Market Trading Desk conducts repo and reverse repo transactions to support effective monetary policy and smooth market functioning by helping maintain the federal funds rate within the FOMC's target range.⁸

The significance and vulnerabilities of the repo market became starkly evident during periods of market stress. In 2008, during the global financial crisis, the Federal Reserve employed single-tranche term repurchase agreements to increase the availability of term financing and alleviate strains in financial markets.⁷ More recently, in September 2019, the U.S. repo market experienced an unexpected spike in overnight lending rates. This disruption, where the Secured Overnight Financing Rate (SOFR) jumped significantly, led the Federal Reserve to restart daily repo operations to provide additional reserves and stabilize market conditions.⁶,,⁵

Key Takeaways

• A repurchase agreement is a short-term, collateralized loan where a security is sold and then repurchased at a higher price.
• The difference between the sale and repurchase price implies an interest rate for the loan.
• Repos are a vital tool for financial institutions to manage their short-term liquidity needs.
• Central banks use repurchase agreements as a key mechanism for implementing monetary policy and influencing interbank lending rates.
• Despite their perceived safety due to collateralization, repo markets are susceptible to liquidity crunches and counterparty default risk.

Formula and Calculation

The implicit interest rate (repo rate) on a repurchase agreement can be calculated based on the initial sale price, the repurchase price, and the maturity period.

The formula is as follows:

Where:

• Repurchase Price = The price at which the seller agrees to buy back the security.
• Sale Price = The initial price at which the seller sells the security.
• Days to Maturity = The number of days until the repurchase date. (Using 360 for an annualized rate, common in money markets).

This calculation reveals the effective cost of borrowing for the seller or the effective return for the buyer, over the agreed-upon term.

Interpreting the Repurchase Agreement

A repurchase agreement is interpreted as a financing transaction rather than an outright sale. For the seller of the security (the "borrower" of cash), it's a way to obtain short-term funding, often overnight, using high-quality securities as collateral. For the buyer of the security (the "lender" of cash), it's a secured, short-term investment that provides an immediate return with minimal default risk due to the collateral.

The repo rate reflects the demand and supply for short-term liquidity in the financial system. A higher repo rate indicates tighter liquidity conditions, meaning cash is scarcer, while a lower rate suggests ample liquidity. Institutions regularly analyze these rates to gauge market funding conditions and adjust their cash management strategies, influencing their investment banks operations and other financial activities.

Hypothetical Example

Consider "Company A," a financial institution needing to raise cash overnight. It holds $10,000,000 worth of U.S. Treasury bonds. "Company B," a large money market mutual fund, has excess cash it wants to invest for a short period.

1. Agreement: Company A sells $10,000,000 worth of Treasury bonds to Company B.
2. Repurchase Terms: They agree that Company A will repurchase the exact same bonds the next day for $10,000,050.
3. Cash Transfer: Company B transfers $10,000,000 cash to Company A.
4. Overnight Period: Company A uses the cash for its overnight operational needs. Company B holds the Treasury bonds as collateral.
5. Repurchase: The next day, Company A repays Company B $10,000,050, and Company B returns the Treasury bonds to Company A.

In this scenario, Company A effectively borrowed $10,000,000 from Company B for one day, paying $50 in interest. Company B earned $50 on its overnight cash investment, secured by the Treasury bonds. This demonstrates how a repurchase agreement provides flexible and secured short-term borrowing.

Practical Applications

Repurchase agreements are integral to the functioning of modern financial markets and central banking:

• Central Bank Operations: Central banks, such as the Federal Reserve, routinely use repurchase agreements and reverse repurchase agreements in their open market operations to manage the supply of reserves in the banking system and influence the federal funds rate.⁴ This directly impacts the broader interest rate environment and overall monetary policy.
• Dealer Financing: Securities dealers rely heavily on repos to finance their inventories of bonds and other fixed-income securities. They can quickly borrow against their holdings to fund new purchases or meet short-term obligations, enhancing market liquidity.
• Cash Management for Institutions: Corporate treasuries, money market mutual funds, and other institutional investors use repos to invest excess cash overnight or for short periods, earning a return while maintaining high liquidity and security.
• Regulation and Disclosure: The Securities and Exchange Commission (SEC) has rules regarding how investment companies treat repurchase agreements. For example, Rule 5b-3 under the Investment Company Act of 1940 permits funds to "look through" counterparties to certain repurchase agreements and treat the securities comprising the collateral as investments for specific purposes.³

Limitations and Criticisms

Despite their widespread use, repurchase agreements are not without limitations and criticisms. A primary concern is default risk, particularly if the collateral's value depreciates significantly or the counterparty fails to repurchase the security. While repos are collateralized, the lender might incur losses if the value of the collateral falls below the loan amount, or if there is a " haircut" applied to the collateral value that isn't sufficient to cover market fluctuations.

The complexities and interconnectedness of the repo market also present systemic risks. The unexpected spike in U.S. repo rates in September 2019 highlighted how disruptions in this seemingly esoteric corner of finance can impact broader market stability. Causes for this spike included a temporary shortage of cash available in the financial system due to corporate tax payments and new Treasury security issuances, exacerbated by declining bank reserves and potentially, post-financial crisis liquidity regulations on banks.,²,¹ This event underscored the importance of the repo market for daily funding and prompted increased scrutiny from regulators and central banks regarding market functioning and primary dealers' roles.

Repurchase agreement vs. Reverse Repurchase Agreement

While closely related, a repurchase agreement and a reverse repurchase agreement represent opposite sides of the same transaction.

A repurchase agreement (repo) is initiated by the party seeking to borrow cash. This party sells a security and agrees to buy it back later at a higher price. From the perspective of this party, it is a collateralized loan, a form of short-term borrowing.

Conversely, a reverse repurchase agreement (reverse repo) is initiated by the party with excess cash looking to lend it in a secured manner. This party buys a security with the agreement to sell it back later at a higher price. From this party's perspective, it is a collateralized lending transaction or a short-term investment.

Essentially, if Party A enters into a repo with Party B, Party B simultaneously enters into a reverse repo with Party A. The terms and collateral are identical, but the roles of borrower and lender of cash are reversed. The Federal Reserve often conducts both types of transactions as part of its open market operations.

FAQs

What is the primary purpose of a repurchase agreement?

The primary purpose is to provide short-term, secured funding for financial institutions by allowing them to borrow cash using securities as collateral.

Are repurchase agreements risky?

While generally considered low-risk due to their collateralized nature, they do carry some default risk for the lender if the borrower defaults and the value of the collateral declines. There can also be systemic risks if the broader repo market experiences liquidity issues, as seen during the 2019 events.

How do central banks use repurchase agreements?

Central banks, like the Federal Reserve, use repurchase agreements as a key tool for monetary policy. By conducting repo operations, they can inject liquidity into the banking system, influencing overnight interest rates and managing the supply of reserves.

What kind of collateral is typically used in a repo?

High-quality, liquid securities are typically used as collateral in a repurchase agreement. U.S. Treasury bonds, agency debt, and agency mortgage-backed securities are common examples due to their stability and ease of transfer.