A repurchase agreement, or repo, is a contract between two parties whereby one party temporarily lends a security to the other for cash and agrees to buy it back later at a specified price (typically one that’s slightly higher). A repo is similar to a short-term secured loan, with the security serving as collateral.
The repo market is an important source of liquidity for financial institutions, as well as a key monetary policy tool for the Federal Reserve. In this article, we’ll cover these complex and relatively obscure transactions and the role they play in financial markets.
What is a repurchase agreement (repo)?
Repurchase agreements are financial contracts whereby one party sells a financial security to another party and agrees to pay it back at a specific price in the near future. The implied interest rate is the difference between the sale and repurchase prices.
The securities used are usually low-risk government debt instruments, like UK Gilts or agency mortgage-backed securities. However, even corporate bonds and equity can be used as collateral.
Essentially, the entity that temporarily sells the security is borrowing money. The entity that agrees to buy the security and sell it back later is the lender. The securities are collateral that protects the lender in case the borrower fails to pay back the cash it received.
How do repo agreements work?
In a repo agreement, lenders typically require over-collateralization to protect themselves against the risk that the securities will drop in value. As a result, assets pledged as collateral are discounted, which is often referred to as a haircut. The difference between the initial price of the securities and their repurchase price is known as the repo rate.
In the US, most repos are tri-party repo agreements, which means they’re settled through a third-party clearing bank. About 80% of daily traded volume on the tri-party repo market consists of overnight repos or contracts that mature the next day.
But some repo agreements are known as open or on-demand repos, which means they have no maturity date. In an open repo, the contract rolls over from day to day, but either party can terminate the agreement at any time. The length of the agreement is known as its tenor; the tenor is similar to a bond’s maturity date. Generally, a longer tenor is associated with greater risk.