What is a Repurchase Agreement?

A repurchase agreement, commonly referred to as a repo, is a type of financial transaction in which a borrower temporarily lends security to a lender, agreeing to buy it back at a set price, usually the next day or within a week.

According to International Monetary Fund (IMF) classifications, a repo is a type of collateralized loan. With a repurchase agreement, the borrower gets temporary cash, although the ownership of the security does not change hands. While most commonly used with short-term government securities, individual investors can choose to purchase repos. 

Read on to understand repurchase agreements and what they can mean for you and the wider financial markets. 

How Does a Repurchase Agreement Work?

The basic concept of a repo transaction is a short-term collateralized loan between a buyer (in this case, the lender) and the seller (the borrower). In most cases, a dealer sells government securities to investors overnight and buys them back the following day or within a week at a slightly higher price. When the buyer acquires securities from the seller and agrees to sell them back at a future date, the securities don't change hands. For that reason, it's considered a loan.

For businesses or governments, repos are primarily used to raise short-term cash that can be used to cover business or operating expenses. Others use repos to gather additional cash to reinvest or restructure existing portfolios. Central banks use repos as a tool for governments to increase or decrease available funds within their economies and control the money supply.

The seller or borrower enters a repo, while the lender or buyer chooses a reverse repurchase agreement or reverse repo. Repos are used for short-term borrowing and lending, often with a duration of just overnight to 48 hours. 

Repos are generally considered a safe or low-risk investment because the security functions as collateral. To increase security, most agreements involve U.S. Treasury bonds, one of the safest investments. With repos, the implicit interest rate, known as the repo rate, offers lenders or investors a risk-free overnight rate.

Types of Repurchase Agreements

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

• Specialized delivery repos are the least common type of repos. These require a bond guarantee at the beginning of the agreement and upon maturity. Specialized delivery repos are also sometimes called securities-driven repos. 
• Held-in-custody repo is another uncommon type of repurchase agreement in which the cash the seller receives is held in a custodial account for the buyer. With this type of repo, buyers face the risk that the seller could become insolvent and the borrower could not access the collateral.
• Third-party repos are the most common type of repurchase agreement. With third-party repos or tri-party repos, a clearing agent or bank conducts the transactions and protects the buyer's and seller's interests. The bank or clearing house holds the securities, ensures that the seller receives cash at the onset and receives the securities at maturation. 

With tri-party repos, collateral is handed over to a third party, such as a bank, and the third party gives substitution collateral, such as bonds. By working to protect both the buyer and the seller, third-party repos offer the lowest risk option. Major clearing banks for tri-party repos include JPMorgan Chase and Bank of New York Mellon.

The Role of Repurchase Agreements in Financial Markets

The significance of repos in ensuring liquidity for market participants is vital. Repo markets facilitate cash flow and securities around the financial system, often providing liquidity to other markets. Repos are used by banks, broker-dealers and other institutional investors to provide efficient short-term funding, stabilize and create a more resilient money market and provide a secure and flexible home for short-term investments. This, in turn, can facilitate central banking operations, finance leveraged investors and cover short investors, support corporate bond investors and ensure liquidity in secondary market debt. 

The role of repos in the overnight lending market is essential to both market liquidity and returns. The repo market facilitates short-term transactions between financial institutions and institutional investors with spare cash. Financial institutions such as banks, hedge funds or brokers can use repos to borrow cheaply. At the same time, institutional investors or other parties with significant spare cash, such as money market mutual funds, use repos to earn a small short-term return without much risk.

Benefits Associated with Repurchase Agreements

The benefits of repos include:

• Flexibility: Repos offer short-term financing solutions for managing liquidity.
• Security: Repos are a type of collateralized lending.
• Low-cost cash: Cheaper and easier funding can lower the cost of financial services provided by intermediaries to investors and issuers.
• Liquidity: Institutional investors can use repo for temporary liquidity requirements without having to liquidate strategic long-term investments.

Risks Associated with Repurchase Agreements

While repurchase agreements are generally considered low-risk, they are not risk-free. Companies and governments work to mitigate risk with collateral. However, the potential risks of repos include:

• Counterparty risk: Especially with longer-term repos, the risk is that the value of the collateral securities will fluctuate prior to the repurchase or below the agreed repurchase price. This and business activities can affect the repurchaser's ability to fulfill the contract. 
• Liquidity risk: The risk of loss resulting from the inability to meet payment obligations in full and on time when they become due for the company. 
• Market risk: There is always a possibility that the market value of the underlying securities will decline. 
• Credit risk: With any repo, there is a possibility that the other party involved will not fulfill its obligation to reverse the transaction at the end of the contract. 

Regulatory Framework and Oversight of Repurchase Agreements

The 2008 financial crisis highlighted the need for additional regulation and oversight in the repo markets. Investors speculated that repos had played a part in Lehman Brothers’ ability to hide its declining financial health. 

Since 2008, the Fed and other international regulators have created new rules to address concerns and weaknesses in the repo markets. Central banks are playing a key role in overseeing repo markets and ensuring stability. For example, Basel III was developed by the Basel Committee on Banking Supervision in response to the financial crisis of 2007-09 with the purpose of strengthening the regulation, supervision and risk management of banks.

Likewise, the Dodd-Frank Wall Street Reform and Consumer Protection Act resulted in the CFTC creating rules to regulate the swaps marketplace.

The Bottom Line on Repurchase Agreements

Repos offer great value to governments and central banks to regulate cash and economies. However, there remain systemic risks to repo markets. Default by a major repo dealer could lead to a fire sale among money funds, which in turn would negatively impact the broader market. Look for evolving regulations to increase security and mitigate risk. However, repurchase agreements offer an important vehicle to facilitate short-term borrowing.

Ready to learn more? Find the best short-term investments, the best short-term stocks and more on long-term vs. short-term investments. 

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