A repurchase agreement or “repo” is the sale of securities combined with an agreement for the seller to buy them back from the buyer at a higher price on a future date. The difference between the sale price and the future repurchase price represents interest, with the buyer of the securities effectively providing a secured loan to the seller for a specified period, with the securities used as collateral to secure the loan. The rate of interest is referred to as the repo rate and any income earned on the securities during the period of the repo is passed back to the original seller, even though they no longer own the securities.
Reverse repos are the same as repos except they are used to describe the other side of the repo transaction, where a party buys securities and then must sell them back at a higher price at the end of the (reverse) repo term. The reverse repo is therefore economically equivalent to a secured “term” deposit or advance.
How it works in a snapshot
Repos are typically only provided over highly liquid securities, which can be readily sold in the event that the seller of the securities fails to buy them back on the maturity date. Most repo transactions are performed over high-grade fixed income securities such as AAA-rated government bonds. Repos can therefore be used to finance the purchases of bonds, much like a margin loan can be used to finance the purchase of shares. Reverse repos can be used to short-sell bonds (like a stock loan) if the view is that the bond price is likely to fall. In this case the buyer of the securities at the start of the reverse repo on-sells them into the bond market, rather than holding them, and buys them back just before expiry of the reverse repo.
What are the different types of repos?
There are three types of repos – overnight, fixed term and open-dated repos which are “at call” with no fixed maturity. Most repos are short term, but some can have a maturity of up to two years.
Repos have many benefits; for the buyers of the securities they can invest cash for a customised period of time – compared to the overnight, 30, 60 and 90-day options that may be on offer from banks or in money market instruments. Secondly, repo loans are secured by very high quality, liquid securities so they are relatively secure.
Market liquidity for repo transaction is also very good and repo rates are attractive for investors, which is why many money market funds invest in repos. For banks and securities trading firms, repos offer a lower cost funding alternative than if the bank or trading firm sought to borrow in its own right, because the loan is fully collateralised by highly-rated securities. Repos also add liquidity to bond markets and allow arbitrage opportunities between the cash bond market and the futures market.
Central banks, such as the US Federal Reserve, European Central Bank and RBA are actively involved in the repo market and allow banks to sell them securities deemed “eligible” collateral under short term repos. They use the repo market as part of their open market operations to control short-term interest rates and manage liquidity and reserves in the banking system. Buying eligible securities from banks through reverse repos adds reserves and liquidity, and selling securities to banks through repos drains reserves and liquidity from the banking system. In Australia, the RBA estimates that the repo market is around A$110 billion in size, however, in Europe it is approximately €5.5 trillion and US$4.6 trillion in the US.
Repos are not riskless as there is some credit risk that the securities will not be repurchased on the maturity date and, in order to recoup their investment, the lender will need to sell the securities. If the securities have lost value due to a fall in price (e.g. Greek government bonds) then the repo lender may lose money. For this reason, repos are often marked-to-market and, if there is a fall in the price of the bonds, the borrower has to provide additional cash or collateral to the lender.