A "repo," short for repurchase agreement, is a form of short-term borrowing, primarily in government securities.
In a repo transaction, one party sells government securities to another party with an agreement to repurchase the same securities at a later date at a predetermined price.
The repurchase price includes an interest payment, making the transaction effectively a loan, with the securities serving as collateral.
How Repos Work
Initiation of the Transaction: The borrower (often a securities dealer) sells government bonds or other high-quality securities to a lender (which could be another dealer, a money market fund, or another type of financial entity) for cash, agreeing to buy back the securities at a future date.
Interest Rate: The difference between the sale price and the repurchase price of the securities implies an interest rate for the loan, often referred to as the "repo rate".
Term: Repos can be overnight or term agreements. Overnight repos are typically for one day, while term repos can last for several days, weeks, or even months.
Use of Proceeds: Dealers use repos to finance their inventories of bonds, while money funds and other institutional investors use them as a safe place to invest cash on a short-term basis, often with better returns than bank deposits.
Risks: While generally considered safe due to the collateral involved, repos carry risks such as counterparty risk (the risk that the other party will not fulfill their obligations) and liquidity risk, particularly with longer-term repos.
Types of Repos
- Overnight Repo: An agreement to repurchase the securities the following day.
- Term Repo: An agreement where the repurchase date is beyond the next day.
- Open Repo: An agreement with no fixed end date, which can be terminated by either party at any time.
- Reverse Repo: The opposite of a repo, where the dealer buys securities with an agreement to sell them back at a future date. It's essentially the lender's perspective in a repo transaction.
Repos play a crucial role in the financial system by providing liquidity, helping manage interest rates, and supporting the smooth functioning of financial markets.