Repo and reverse repo transactions
The repurchase agreement (repo or RP) and the reverse repo agreement (RRP) are key tools used by many large financial institutions, banks, and some businesses. These short-term agreements provide temporary lending opportunities that help to fund ongoing operations. The Federal Reserve also uses the repo and reverse repo agreements as a method to control the money supply.
In short, a repo is an agreement between parties where the buyer agrees to temporarily purchase a basket or group of securities for a specified period. The buyer agrees to sell those same assets back to the original owner at a slightly higher price using a reverse repo agreement.
A repurchase agreement (RP) is a short-term loan where both parties agree to the sale and future repurchase of assets within a specified contract period. The seller sells a Treasury bill or other government security with a promise to buy it back at a specific date and at a price that includes an interest payment.
Repurchase agreements are typically short-term transactions, often literally overnight. However, some contracts are open and have no set maturity date, but the reverse transaction usually occurs within a year.
Dealers who buy repo contracts are generally raising cash for short-term purposes. Managers of hedge funds and other leveraged accounts, insurance companies, and money market mutual funds are among those active in such transactions.
The repo is a form of collateralized lending. A basket of securities acts as the underlying collateral for the loan. Legal title to the securities passes from the seller to the buyer and returns to the original owner at the completion of the contract. However, any government bonds, agency securities, mortgage-backed securities, corporate bonds, or even equities may be used in a repurchase agreement.
The value of the collateral is generally greater than the purchase price of the securities. The buyer agrees not to sell the collateral unless the seller defaults on their part of the agreement. At the contract specified date, the seller must repurchase the securities including the agreed upon interest or repo rate.
In some cases, the underlying collateral may lose market value during the period of the repo agreement. The buyer may require the seller to fund a margin account where the difference in price is made up.
Repo agreements carry a risk profile similar to any securities lending transaction. That is, they are relatively safe transactions as they are collateralized loans, generally using a third party as a custodian.
The real risk of repo transactions is that the marketplace for them has the reputation of sometimes operating on a fast-and-loose basis without much scrutiny of the financial strength of the counterparties involved, so, some default risk is inherent.
There also is the risk that the securities involved will depreciate before the maturity date, in which case the lender may lose money on the transaction. This risk of time is why the shortest transactions in repurchases carry the most favorable returns.
A reverse repurchase agreement (RRP) is an act of buying securities with the intention of returning—reselling—those same assets back in the future at a profit. This process is the opposite side of the coin to the repurchase agreement and is simply a matter of perspective. To the party selling the security with the agreement to buy it back, it is a repurchase agreement. To the party buying the security and agreeing to sell it back, it is a reverse repurchase agreement. The reverse repo is the final step in the repurchase agreement closing the contract.
In a repurchase agreement, a dealer sells securities to a counterparty with the agreement to buy them back at a higher price at a later date. The dealer is raising short-term funds at a favorable interest rate with little risk of loss. The transaction is completed with a reverse repo. That is, the counterparty has sold them back to the dealer as agreed.
The counterparty earns interest on the transaction in the form of the higher price of selling the securities back to the dealer. The counterparty also gets the temporary use of the securities.
The purpose of the repo is to borrow money, yet it is not technically a loan. Ownership of the securities involved actually passes back and forth between the parties involved. Nevertheless, they are very short-term transactions with a guarantee of repurchase. Thus, for tax and accounting purposes repo agreements are generally treated as loans.