A repurchase agreement (repo) is a short-term lending arrangement widely used by banks, investment funds, and other financial institutions to manage cash flow efficiently. In a typical repo transaction, the borrower sells high-quality securities—often U.S. Treasury bonds—to a lender with an agreement to buy them back at a predetermined future date for a slightly higher price. The price difference reflects the interest paid on the loan, known as the repo rate.
This arrangement functions like a collateralized loan: the securities serve as collateral, securing the lender’s cash. This reduces credit risk and allows the borrower to quickly obtain liquidity without permanently selling assets.
Repos are critical to the financial system’s smooth operation by providing short-term funding and helping central banks, like the Federal Reserve, manage monetary policy. By adjusting repo operations, central banks influence short-term interest rates and liquidity.
Key Participants:
- Borrowers (Sellers of securities): Typically commercial banks, investment banks, and hedge funds seeking short-term financing.
- Lenders (Buyers of securities): Money market funds, large corporations, and central banks providing low-risk returns on idle cash.
Common Types of Repos:
- Overnight repos: Mature the next business day, used for daily liquidity needs.
- Term repos: Have a fixed term longer than a day for specific funding periods.
- Open repos: No fixed maturity; can be terminated anytime by either party.
Risks: Though repos are low-risk due to collateral, they carry some counterparty risk if the borrower fails to repurchase, and collateral risk if the security’s market value falls. To mitigate this, lenders apply a “haircut,” lending slightly less than the collateral’s market value.
For individual consumers, the repo market ensures banks have the liquidity needed to lend for mortgages and business loans. Disruptions here can lead to broader credit shortages.
For further details, visit the Federal Reserve Bank of New York’s repo market overview.