What is a Repurchase Agreement (Repo)?

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Definition:

A repurchase agreement (repo) is a short-term borrowing tool that an entity, often a government, might use to raise short-term funds.

🤔 Understanding a repurchase agreement (repo)

A repurchase agreement (repo) acts as a short-term loan. Financial institutions often sell them on behalf of another organization (such as the federal government). They are a money market instrument with a short maturity date — Usually overnight. The investor purchases the security, and the seller is promising to repurchase it the next day with interest. The interest rate on repurchase agreements is often higher than other investment opportunities because of the short maturity date. An organization might use these agreements when they need to raise short-term capital. The security they sell the investor acts as the collateral on a short-term loan.

Example

Suppose that an investment bank needs some quick cash. They might sell U.S. Treasury bills to investors with a maturity date of the next morning. The investment bank gets the fast cash they need, and the investor receives a higher-than-normal interest rate. The deal is really a short-term loan for the bank, but they’re giving the investor the U.S. Treasury bills to hold as collateral.

Takeaway

A repurchase agreement is like asking a friend to cover your $20 bar tab, and promising to pay them back tomorrow...

Then when you run into your friend the next day, you give them $25 instead of just the $20 you owe them. You threw in the extra $5 because they helped you out when you were in a pinch. That’s how repurchase agreements work — The seller needs capital quickly, so they pay investors back at a higher interest rate.

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How do repurchase agreements work?

A repurchase agreement (aka repo) is a secured short-term loan that one party (often a financial institution) sells to another. The deal is a sale of securities that act as the collateral on the loan.

When the seller sells the repurchase agreement to the buyer, they’re promising to repurchase the securities after a short amount of time. Often repurchase agreements have a maturity of just one day, but they could last longer.

A repurchase agreement comes with a higher interest rate than many securities deals because of the short timeline. This interest is the price that the seller pays to the buyer for a short-term loan.

These agreements are beneficial to both parties. First, they allow the seller to raise the short-term funds they need. They’re also advantageous to the buyer because they will enable them to make a profit in a short amount of time.

Repurchase agreements are a part of the money market, and the securities changing hands as a part of these agreements are often government-backed securities such as U.S. Treasury bills or bonds.

In addition to the institutions who often use these agreements to raise short-term capital, the Federal Reserve (aka the fed) may also use repurchase agreements to regulate the supply of money. They might do this to increase the amount of money in circulation for borrowing.

What is the repo market?

The repo market is the financial system where repurchase agreements are bought and sold. The repo market is responsible for the sale of more than $3T of debt securities every day.

How does the repo market work?

The lenders for repurchase agreements are often hedge funds and broker-dealers who manage large amounts of money. The buyers of these agreements are often money market funds — So you might be involved in the repo market without even knowing if you have cash in the money market.

What is the repo rate?

The repo rate is the current rate of return that investors are able to get for overnight repurchase agreements. The rate is published by the New York Fed in cooperation with the U.S. Office of Financial Research. They publish these rates with the hopes of increasing transparency in the repo market.

The New York Fed publishes three different rates:

  • Secured overnight financing rate: This rate is a general measurement of the cost of overnight securities.
  • Broad general collateral rate: This rate measures rates on overnight Treasury GC (general collateral) repo transactions.
  • Tri-party general collateral rate: This rate is a measure of rates on tri-party repurchase agreements. It comes from data collected by the Bank of New York Mellon.

What is the difference between a term and an open repurchase agreement?

A repurchase agreement could either be classified as a term or open agreement depending on the amount of time that passes from when the seller sells the securities to when they repurchase them.

A term repurchase agreement (aka term repo) is one that has a particular maturity date. The transaction usually occurs with a one-day or one-week maturity. One party sells the securities to another party, promising to repurchase them at the maturity date for a higher price. This type of repurchase agreement is a fixed-income security, meaning the rate is predetermined and does not change.

Open repurchase agreements (aka open repo) have a longer time until maturity than the term agreements. Usually, the buyer and seller don’t agree to a maturity date at the time of the sale. Instead, either party can end the deal at any time by giving the other party notice. Any day that one of the parties doesn’t put an end to the trade, it rolls over to the next day.

Unlike the term repurchase agreements that have a fixed interest rate, these open agreements have variable rates. The rate is often tied to the federal funds rate, which is the rate that banks charge each other for overnight loans. These agreements can last for a year or two, and the seller pays interest to the other party monthly.

Open repurchase agreements, and more extended maturity agreements, in general, tend to have a higher level of risk associated with them. There’s a lot that can change throughout a longer-term deal, including interest rates and the value of the security being traded as a part of the deal. There’s also a risk for the buyer of the agreement. They face the possibility of the other party defaulting on the deal and not being able to repurchase the securities as promised.

What are the different types of repurchase agreements?

There are three primary types of repurchase agreements on the market: third-party repo, held-in-custody repo, and specialized delivery repo.

Third-party repo

A third-party repo (aka tri-party repo) is a repurchase agreement where a third entity facilitates the transaction to protect the interests of both the buyer and the seller. This type of repurchase agreement is the most common. The third-party in this type of arrangement is often a bank — JPMorgan Chase and Bank of New York Mellon are two of the primary banks that facilitate these repo transactions. They often hold onto the securities and help to make sure that each party gets the funds the other has promised them.

Though these clearing banks might help act as the intermediary for these agreements, they don’t take on the role of finding buyers and sellers to match together — They are not brokers.

Held-in-custody repo

In the case of a held-in-custody repo, the buyer of the securities doesn’t receive the securities. The buyer hands over the money for the deal, but the seller holds onto the securities in a custodial account at a financial institution. This type of repurchase agreement is not very common.

There’s a high level of risk for the buyer since the seller maintains possession of both the securities and the money for the transaction. The buyer has to trust that the seller will hold up their end of the bargain with few assurances on their end.

Specialized delivery repo

The final type of repurchase agreement is a specialized delivery repo. Like the held-in-custody repo, this type is not very common. This type of transaction uses a bond guarantee, which is when a third party guarantees the interest and principal payments of the bond. This guarantee occurs both at the time of the initial sale and at the maturity of the agreement.

What is the difference between a repurchase agreement and a reverse repurchase agreement?

While a repurchase agreement is where one party sells a security with the promise to repurchase it at a later date, a reverse repurchase agreement is just the opposite. A reverse repurchase agreement (reverse repo) is when one party buys a security with the promise to sell it back later for a higher price.

The difference in the terms comes down to a difference in which party you’re talking about. From the perspective of the initial seller, the deal is a repurchase agreement. From the standpoint of the initial buyer, the transaction is a reverse repurchase agreement.

When someone enters into a reverse repurchase agreement, they are signing up to give a short-term loan to another party (often a financial institution). The seller might be running into cash flow problems and needs to raise some short-term capital.

These types of deals are beneficial for the buying party because they aren’t out their cash very long, but they get to make a profit off the short-term loan. The primary risk for the buyer is that the seller will default on the deal. However, the securities act as collateral on the loan to minimize that risk. And the short maturity date reduces the risk of the seller not following through on their end of the bargain.

Similar to how the central bank might use a repurchase agreement to increase the money supply temporarily, they might also use a reverse repurchase agreement to do the opposite. They might use this type of transaction if they want to reduce the supply of money temporarily.

What are the near and far legs in a repurchase agreement?

‘Leg’ is a term that is commonly used in reference to repurchase agreements. The near leg of the deal is the start of the agreement, when one party sells the security to the other. The far leg of the deal is the maturity date, when the seller repurchases the security. The near and far legs are also referred to as the start and close legs, respectively.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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