Repurchase Agreement (Repo)

A repurchase agreement, commonly called a repo, is a transaction in which one party sells securities to another for cash and simultaneously agrees to buy them back at a specified later date and a slightly higher price. Economically it is a short-term loan secured by collateral: the seller of the securities is the borrower, the buyer is the lender, the securities are the collateral, and the difference between the sale price and the repurchase price is the interest. From the lender's side the same trade is called a reverse repo.

Repos are among the largest and most important funding markets in the world. Banks, broker-dealers, money market funds, hedge funds and central banks use them to borrow and lend cash overnight or for short terms, mostly against government bonds. The repo market is also the channel through which central banks implement much of their monetary policy.

A repo has two legs. In the opening leg, the borrower delivers securities and receives cash. In the closing leg, the borrower returns the cash plus interest and receives the securities back. Title to the securities passes to the lender during the trade, which is why repo is documented as a sale and repurchase rather than a pledge. This gives the lender a strong position if the borrower defaults: it can sell the collateral without going through insolvency proceedings, subject to the governing legal agreement, typically the Global Master Repurchase Agreement in international markets.

The lender usually advances less than the market value of the collateral. The difference is the haircut, which protects the lender against a fall in the collateral's price. During the trade the collateral is revalued daily, and a fall in value triggers a call for more collateral or cash, similar to a margin call.

A dealer needs USD 100 million overnight. It sells US Treasury securities with a market value of USD 102 million to a money market fund for USD 100 million, a 2% haircut, and agrees to buy them back the next day. If the repo rate is 5.00% a year on an actual/360 basis, the overnight interest is 100,000,000 x 5.00% x 1/360, or about USD 13,889. The next day the dealer pays USD 100,013,889 and receives its Treasuries back.

• Bilateral repo: the two parties settle directly with each other, choosing and delivering specific collateral.
• Tri-party repo: a third-party agent, in the United States a clearing bank, holds the collateral, allocates it, values it daily and manages substitutions. Money market funds lend large amounts this way.
• Cleared repo: trades are novated to a central counterparty, which stands between buyer and seller and allows positions to be netted.
• General collateral and specials: in general collateral repo, any security from an agreed class is acceptable; in a "special", lenders want a specific bond and accept a lower rate to get it.
• Term and open repo: repos can run overnight, for a fixed term, or open-ended until either party ends them.

Central banks lend to and borrow from banks through repo operations to steer short-term interest rates and supply liquidity. The US Federal Reserve runs a Standing Repo Facility established in 2021 and an overnight reverse repo facility that absorbs cash from money market funds; the Bank of England and European Central Bank run comparable operations. Repo rates are closely tied to policy rates such as the federal funds rate.

The repo market also anchors key benchmarks. SOFR, the Secured Overnight Financing Rate that replaced US dollar LIBOR, is calculated from overnight repo transactions in Treasury securities. Money market funds are among the largest cash lenders in this market.

Repo funds long-term securities with very short-term borrowing, a form of maturity transformation, so it can amplify stress. In 2007 and 2008, lenders raised haircuts and refused some collateral, cutting off funding to investment banks and contributing to the failures and rescues of the 2008 financial crisis. Lehman Brothers' "Repo 105" transactions, which treated certain repos as sales to reduce reported leverage, became a well-known accounting controversy. In September 2019, US overnight repo rates spiked sharply when reserves became scarce, prompting the Federal Reserve to inject liquidity. These episodes are why regulators monitor repo closely as part of shadow banking and why the US has moved toward central clearing of Treasury repo.

An FX swap works in a similar way but exchanges one currency for another rather than securities for cash, and a gold swap uses gold as the collateral. Securities lending is closely related: it is motivated by the need to borrow a specific security rather than cash.

• Federal Reserve Bank of New York