A repurchase agreement (RP), commonly referred to as a repo or sale and repurchase agreement, is a type of short-term borrowing primarily involving government securities. Repos generally consist of two parties: the borrower, who requires short-term liquidity, and the lender, who possesses surplus cash to invest. In this arrangement, one party sells securities to another and commits to repurchase those securities later at a higher price.

What is a Repo? A repo, or repurchase agreement, is a short-term transaction in which a financial institution sells government securities to another entity, typically the Federal Reserve or another financial institution, with a commitment to repurchase them at a predetermined date and price. The securities act as collateral. The difference between the initial price of the securities and their repurchase price constitutes the interest paid on the loan, known as the repo rate. Essentially, a repo functions as a collateralized loan, where the borrower (the financial institution) temporarily exchanges government securities for cash, agreeing to buy back the securities at a later date.

Repurchase agreements are usually short-term transactions, often occurring overnight. However, some contracts may be open-ended with no fixed maturity date, although the reverse transaction typically takes place within a year. For the buyer, a repo presents an opportunity to invest cash for a tailored duration. It is a short-term and safer investment since the investor receives collateral.

What are repos used for? Buyers of repo contracts generally seek to raise cash for short-term needs. Repos are commonly utilized by banks to finance their daily operations. Other financial institutions, such as hedge funds and money market funds, also use repos to manage their cash flow. For instance, money market funds are significant purchasers of repos. Traders in trading firms use repos to finance long positions (in the securities they post as collateral), access cheaper funding costs for long positions in other speculative investments, and cover short positions in securities (through a “reverse repo and sale”). The Federal Reserve also employs repo and reverse repo agreements as a means to regulate the money supply.

Why are repos important? Repos are a crucial yet often overlooked financial instrument that facilitates the smooth operation of financial markets. They are essential for ensuring that financial institutions have access to short-term liquidity and that the Federal Reserve can effectively manage short-term interest rates. The repo market is significant for several reasons:

• Providing short-term liquidity: The repo market enables financial institutions that hold substantial securities (such as banks, broker-dealers, and hedge funds) to borrow at low costs, while parties with excess cash (like money market mutual funds) can earn a modest return on that cash with minimal risk, as securities, often U.S. Treasury securities, serve as collateral. Financial institutions prefer not to hold cash due to its cost and lack of interest. For example, hedge funds may possess numerous assets but require funds for daily trades, so they borrow from money market funds with ample cash, which can earn a return with minimal risk.
• Creating a low-risk investment option: For lenders, repos provide a low-risk, short-term investment opportunity. Since the transactions are secured by government securities, the risk of default is minimal. This security makes repos an appealing choice for investors seeking short-term, low-risk investments.
• Supporting the Federal Reserve’s monetary policy: The Federal Reserve utilizes repos and reverse repos to implement monetary policy. When the Fed purchases securities from a seller who agrees to repurchase them, it injects reserves into the financial system. Conversely, when the Fed sells securities with a repurchase agreement, it withdraws reserves from the system. Since the financial crisis, reverse repos have gained new significance as a monetary policy tool. Reserves refer to the cash banks hold—either in their vaults or on deposit at the Fed. The Fed establishes a minimum reserve level; any amount above this is termed “excess reserves.” Banks can and often do lend excess reserves in the repo market.

How a Repo Works: A repo is a form of collateralized lending. A collection of securities serves as the underlying collateral for the loan. The legal title to the securities transfers from the seller to the buyer and reverts to the original owner upon contract completion. The collateral typically consists of U.S. Treasury securities, but any government bonds, agency securities, mortgage-backed securities, corporate bonds, or even equities may be utilized in a repurchase agreement. The value of the collateral is generally higher than the purchase price of the securities. The buyer agrees not to sell the collateral unless the seller defaults on the agreement. At the specified contract date, the seller must repurchase the securities, including the agreed-upon interest or repo rate. While the purpose of the repo is to borrow money, it is not technically a loan: ownership of the involved securities actually shifts back and forth between the parties. Nevertheless, these are very short-term transactions with a guarantee of repurchase.

How the Fed Uses Repos: The Federal Reserve employs repo transactions as a mechanism for executing its monetary policy. By engaging in repo operations, the Fed can inject liquidity into the financial system, which helps maintain its target short-term interest rate range. The central bank can increase the overall money supply by purchasing Treasury bonds or other government debt instruments from commercial banks. This action provides the banks with cash and boosts their reserves in the short term. The Federal Reserve will subsequently resell the securities back to the banks. When the Fed aims to tighten the money supply—removing money from circulation—it sells bonds to commercial banks using a repurchase agreement, or repo for short. Later, they will buy back the securities through a reverse repo, returning money to the system.

Repo vs. Reverse Repo: Repos and reverse repos represent the same transaction but are labeled differently depending on the party's perspective. For the party initially selling the security (and agreeing to repurchase it later), it is a repurchase agreement (RP) or repo. For the party initially buying the security (and agreeing to sell it in the future), it is a reverse repurchase agreement (RRP) or reverse repo.