Repurchase agreement repo

What Is Repurchase Agreement (Repo)?

A repurchase agreement, commonly known as a repo, is a form of short-term financing where one party sells securities to another party with an agreement to repurchase those same securities at a slightly higher price at a specified future date. This transaction effectively functions as a collateralized loan within the money markets. The seller of the securities is essentially borrowing cash, while the buyer is lending cash and receiving the securities as collateral for the loan. The difference between the initial sale price and the repurchase price represents the interest paid on the loan, known as the repo rate. Repos are widely used by financial institutions, including banks, broker-dealers, and central banks, for managing liquidity and short-term funding needs.

History and Origin

The origins of repurchase agreements can be traced back to the early 20th century, with some sources suggesting their use by Federal Reserve banks as early as 1917 to provide credit to member banks.¹⁵ During the 1920s, the Federal Reserve Bank of New York utilized repos with securities dealers to foster the growth of a liquid secondary market for banker's acceptance notes.¹⁴

The widespread adoption and growth of the repo market, however, were significantly influenced by regulatory changes and the general increase in interest rates observed from the mid-1960s. For instance, an amendment to the Federal Reserve Board's Regulation D in 1969 exempted only repos involving government and federal agencies' securities from reserve requirements, thereby encouraging trading in these specific types of securities.¹³ A notable event highlighting the critical role of the repo market occurred in September 2019, when a disruption led to a sharp increase in short-term interest rates, prompting the Federal Reserve to inject billions of dollars into the market to stabilize it.¹⁰, ¹¹, ¹²

Key Takeaways

• A repurchase agreement (repo) is a short-term, secured transaction where securities are sold with an agreement to repurchase them later at a higher price.
• The difference between the sale and repurchase price represents the implicit interest, known as the repo rate.
• Repos are crucial tools for financial institutions to manage short-term liquidity and for central banks to implement monetary policy.
• Treasury securities and other high-quality fixed income assets commonly serve as collateral in repo transactions.
• The repo market is a vital component of the broader money markets, facilitating trillions of dollars in transactions daily.

Formula and Calculation

The implied interest rate, or repo rate, on a repurchase agreement can be calculated using the following formula:

Where:

• Repurchase Price: The price at which the seller agrees to buy back the securities.
• Initial Sale Price: The price at which the seller initially sells the securities.
• Days to Repurchase: The number of days until the securities are repurchased.
• 360: Standard number of days in a financial year for calculating simple interest (can also be 365, depending on market convention).

This formula effectively determines the annualized yield on the short-term loan. The calculation directly reflects the interest rates earned by the cash provider and paid by the cash borrower.

Interpreting the Repurchase Agreement (Repo)

Interpreting a repurchase agreement involves understanding its function as a temporary exchange of cash for securities. For the party selling the securities (the borrower of cash), a repo provides immediate, low-cost funding, as the securities act as collateral, reducing the risk for the lender. For the party buying the securities (the lender of cash), it represents a secure, short-term investment that yields interest. The repo rate is a key indicator, reflecting the cost of overnight or short-term borrowing in the money markets. A low repo rate suggests ample liquidity in the financial system, while a high or volatile rate can signal funding stress or a shortage of available cash among financial participants. For example, a spike in the repo rate in September 2019 indicated a sudden scarcity of reserves in the banking system, prompting Federal Reserve intervention.⁹

Hypothetical Example

Consider a broker-dealer named "Capital Markets Inc." that needs to raise cash for a short period, say overnight. They own $10,000,000 worth of U.S. Treasury securities.

1. Initial Sale: Capital Markets Inc. enters into a repurchase agreement with "CashFlow Fund," a money market mutual fund. Capital Markets Inc. sells the $10,000,000 worth of Treasury securities to CashFlow Fund for an initial sale price of $9,999,000.
2. Overnight Loan: CashFlow Fund provides $9,999,000 to Capital Markets Inc. This effectively serves as an overnight loan to Capital Markets Inc., with the Treasury securities as collateral.
3. Repurchase Agreement: The agreement stipulates that Capital Markets Inc. will repurchase these same securities the next day for a repurchase price of $10,000,000.
4. Completion: The following day, Capital Markets Inc. pays $10,000,000 to CashFlow Fund and receives its Treasury securities back.

In this example, CashFlow Fund earned $1,000 ($10,000,000 - $9,999,000) overnight for lending $9,999,000. Capital Markets Inc. successfully obtained short-term funding using its securities as collateral.

Practical Applications

Repurchase agreements are integral to the daily operations of global financial markets and play a critical role in monetary policy implementation.

• Central Bank Operations: Central banks, such as the U.S. Federal Reserve, actively use repos and reverse repos as a primary tool for open market operations. When the Federal Reserve buys securities from a seller who agrees to repurchase them (a repo), it injects reserves into the banking system, increasing liquidity. Conversely, when it sells securities with an agreement to repurchase (a reverse repo), it drains reserves from the system.⁸ These operations help the Federal Reserve maintain the federal funds rate within its target range, influencing broader interest rates in the economy.⁷ The Federal Reserve's Standing Repo Facility (SRF) and Overnight Reverse Repo Facility (ON RRP) are permanent mechanisms established to support smooth market functioning and effective policy implementation.⁶
• Investment Banking and Trading: Investment banks and broker-dealers frequently use repos to finance their securities holdings, particularly large inventories of fixed income instruments like government bonds. This allows them to maintain substantial trading positions without tying up excessive capital.
• Cash Management for Institutions: Money Market Mutual Funds and other institutional investors with excess cash often engage in repos as a low-risk way to earn a return on their cash, as the agreements are typically collateralized by high-quality assets like Treasury securities.
• Government Securities Dealers: Dealers in government securities heavily rely on repos for short-term financing to facilitate their market-making activities, ensuring a liquid secondary market for these instruments.⁵

Limitations and Criticisms

Despite their utility, repurchase agreements are not without limitations and criticisms, particularly concerning their role in periods of financial instability.

One significant criticism emerged during the 2007-2009 financial crisis. The repo market experienced considerable strain, with funding becoming scarce or prohibitively expensive for certain financial institutions. A disproportionate share of the decline in repo activity during this period was linked to securities dealer's market-making activities in Treasury securities, indicating vulnerabilities even in seemingly safe assets.⁴ The sudden tightening of repo funding contributed to a broader liquidity crisis, demonstrating how disruptions in this market can quickly transmit systemic risk throughout the financial system.³

Regulatory scrutiny has also focused on the transparency and capital requirements associated with repo activities. While repos are generally considered low-risk due to their collateralized nature, issues can arise if the value of the collateral declines rapidly or if counterparty risk becomes a concern. The Securities and Exchange Commission (SEC) has provided guidance on how funds should treat repurchase agreements for compliance with investment diversification rules.² Some critics suggest that increased reliance on central bank intervention in the repo market, such as the Federal Reserve's actions in 2019 and 2020, could create moral hazard or distort market functioning by making private institutions overly dependent on public backstops.¹

Repurchase Agreement (Repo) vs. Reverse Repurchase Agreement (Reverse Repo)

While closely related and often used in tandem, a repurchase agreement (repo) and a reverse repurchase agreement (reverse repo) represent opposite sides of the same transaction. Understanding this distinction is crucial for comprehending their roles in financial markets.

In a repurchase agreement (repo), one party (the seller/borrower) sells securities to another party (the buyer/lender) with an agreement to buy them back at a higher price on a future date. The seller is borrowing cash, using the securities as collateral. This transaction temporarily increases the cash on the seller's balance sheet.

Conversely, a reverse repurchase agreement (reverse repo) is the mirror image. In a reverse repo, one party (the buyer/lender) purchases securities from another party (the seller/borrower) with an agreement to sell them back at a higher price on a future date. The buyer is lending cash, receiving the securities as collateral. This transaction temporarily absorbs cash from the buyer's balance sheet and parks it in a secure, interest-bearing asset.

The confusion often arises because a repo for one party is simultaneously a reverse repo for the counterparty. For example, when the Federal Reserve conducts an operation to inject reserves, it enters into a repurchase agreement (it buys securities with an agreement to resell). From the perspective of the primary dealer on the other side, they are entering into a reverse repurchase agreement (they sell securities with an agreement to repurchase), effectively borrowing cash from the Fed. The Federal Reserve's public statements often describe these transactions from their own viewpoint.

FAQs

What is the primary purpose of a repurchase agreement?

The primary purpose of a repurchase agreement is to provide short-term, secured funding for financial institutions and to allow investors with surplus cash to earn a low-risk return. It's a key tool for managing daily liquidity needs.

Are repurchase agreements risky?

Repurchase agreements are generally considered low-risk because they are collateralized, typically by highly liquid assets like Treasury securities. However, risks can arise if the value of the underlying collateral declines significantly, or in situations of counterparty default, though legal frameworks like Master Repurchase Agreements (MRAs) help mitigate these issues.

How do central banks use repurchase agreements?

Central banks, such as the U.S. Federal Reserve, use repurchase agreements and reverse repurchase agreements as part of their monetary policy tools. They conduct these open market operations to influence the amount of reserves in the banking system, thereby guiding short-term interest rates, particularly the federal funds rate.

What kind of collateral is typically used in a repo?

High-quality, liquid securities are commonly used as collateral in repurchase agreements. These most often include U.S. Treasury securities, government agency debt, and agency mortgage-backed securities. Less liquid or higher-risk securities may also be used but typically require a larger "haircut" or margin.

What is the "repo rate"?

The repo rate is the implicit interest rate on a repurchase agreement. It is derived from the difference between the initial sale price of the securities and the higher price at which they are repurchased. This rate represents the cost of borrowing for the seller and the return earned by the buyer of the securities in the transaction.