Repurchase Agreement (Repo): Definition, Examples, and Risks

A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. For a repo, a dealer sells government securities to an investor, usually overnight, and buys them back the following day at a slightly higher price. The small price difference is an implicit overnight interest rate. Repos are typically used to raise short-term capital. They are also commonly used in central bank open market operations. During the early 2020s, the Federal Reserve instituted changes that massively increased the volume of repos traded, a trend it began to unwind in 2023.

Those involved in the agreement are in different stances: the party selling the security and agreeing to repurchase it later is involved in a repo. Meanwhile, the party buying the security and agreeing to sell it back is engaged in a reverse repurchase agreement.

Understanding Repurchase Agreements

Repurchase agreements are generally safe investments because the securities involved, typically Treasury bonds, serve as collateral. Classified as a money market instrument, a repo is thus a short-term, collateral-backed, interest-bearing loan. The buyer acts as a short-term lender, while the seller is a short-term borrower. The securities sold are the collateral.

Repurchase agreements are made between a variety of parties. The Federal Reserve uses repos to regulate the money supply and bank reserves. Individuals typically use them to finance the purchase of debt securities or other investments. Repurchase agreements are strictly short-term investments, and their maturity period is called the "rate," the "term," or the "tenor."

Despite the similarities with collateralized loans, repos count as purchases. However, because the buyer only temporarily owns the security, these agreements are usually treated as loans for tax and accounting purposes. When there's a bankruptcy, repo investors can generally sell their collateral. This distinguishes repos and collateralized loans; for most collateralized loans, bankrupt investors would be subject to an automatic stay.

Repurchase Agreement Example

Suppose a bank needs a quick cash injection. It agrees with an investor, who offers to give it the money it needs so long as it pays it back quickly with interest. In the meantime, the bank also provides collateral for peace of mind.

At issue in the agreement are Treasury bonds. The bank sells them to the investor with a deal that it will repurchase them very soon at a slight premium. The Treasury bonds serve as collateral: the bank temporarily relinquishes control of the bonds for the cash it needs. Then, at a predetermined time in the near future, the bank receives them back by paying back the money it received for them plus a little extra.

Term vs. Open Repurchase Agreements

The major difference between a term and an open repo lies in the time between the sale and the repurchase of the securities.

Repos with a specified maturity date (usually the following day, though it can be up to a week) are term repurchase agreements. A dealer sells securities to a counterparty who agrees to repurchase them at a higher price on a given date. Under the agreement, the counterparty gets the securities for the transaction term and earns interest through the difference between the initial sale price and the buyback price. The interest rate is fixed and is paid at maturity by the dealer. A term repo is used to invest cash or finance assets when the parties know how long they need to do so.

An open repurchase agreement or "on-demand repo" works the same way as a term repo, except that the dealer and the counterparty agree to the transaction without setting the maturity date. Instead, either party can end the trade by giving notice to the other before an agreed-upon deadline that arises daily. If an open repo is not closed, it automatically rolls over into the next day. Interest is paid monthly, and the interest rate is periodically re-priced by mutual agreement.

The interest rate on an open repo is generally close to the federal funds rate. An open repo is used to invest cash or finance assets when the parties do not know how long they will need to do so. But almost all open agreements conclude within one to two years.

The Significance of the Tenor

Repos with longer tenors are usually considered higher risk. A longer tenor means that more can happen that affects the repurchaser's ability to do so. Also, interest rate fluctuations are more likely to influence the value of the repurchased asset.

It's like the factors that affect bond interest rates. Under normal credit market conditions, a longer-duration bond yields higher interest. Investors buy long-term bonds as part of a wager that interest rates will not rise substantially during its term. A tail event is more likely to drive interest rates above forecast ranges when there's a longer duration. If there is a period of high inflation, the interest paid on bonds preceding that period will be worth less in real terms.

The same principles apply to repos. The longer the term of the repo, the more likely the collateral securities' value will fluctuate before the repurchase, and business activities can affect the repurchaser's ability to complete the contract. Counterparty credit risk is primary in repos.

As with any loan, the creditor bears the risk that the debtor will be unable to repay the principal. Repos function as collateralized debt, which reduces the total risk. And because the repo price exceeds the collateral's value, these agreements mutually benefit buyers and sellers.

Types of Repurchase Agreements

There are three main types of repurchase agreements:

Third-party repos

Also known as a tri-party repo, this is the most common. In this arrangement involving three entities, a clearing agent or bank conducts the transactions between the buyer and seller and protects the interests of each. It holds the securities and ensures that the seller receives cash at the onset, that the buyer transfers funds for the benefit of the seller, and that the securities are delivered at maturity. Clearing banks for tri-party repos in the U.S. have included JPMorgan Chase & Co. and Bank of New York Mellon.

In addition to taking custody of the securities involved, clearing agents also value the securities and ensure that a set margin is applied. They settle the transaction on their books and help dealers with collateral. However, clearing banks don't act as matchmakers: they don't find dealers for cash investors or vice versa, and they do not act as brokers.

Typically, clearing banks begin to settle repos early in the day, although they're not technically settled until the end of the day. This delay usually means that billions of dollars of intraday credit are extended to dealers daily. These agreements constitute about 80% of the repurchase agreement market, which was approximately $3.65 trillion in January 2024.

Specialized delivery repo

Specialized repos have a bond guarantee at the beginning of the agreement and at maturity, along with the collateral. This type of agreement is uncommon.

Held-in-custody repo

In this kind of agreement, the seller gets cash for the security but holds it in a custodial account for the buyer. This type is even less common than specialized delivery repos because there is a risk that the seller may become insolvent and the borrower may not have access to the collateral.

Near and Far Legs

Like many parts of the financial world, repurchase agreements involve terminology not common elsewhere. One common term in the repo space is the “leg.” For instance, the part of the repurchase agreement in which the security is initially sold is sometimes called the “start leg,” while the repurchase that follows is the “close leg.”

These terms are also sometimes exchanged for “near leg” and “far leg,” respectively. In the near leg of a repo transaction, the security is sold. In the far leg, it is repurchased.

Significance of the Repo Rate

When central banks repurchase securities from private banks, they do so at a discounted rate, known as the repo rate. Like prime rates, repo rates are set by central banks. The repo rate system allows governments to control the money supply by increasing or decreasing available funds.

An increase in repo rates means banks pay more for the money they borrow from the central bank. This squeezes lenders' profits and increases interest rates on loans made to the public. This generally discourages people and businesses from taking out loans, which can cut consumer spending, business investment, and the amount of money circulating in the economy. This might be necessary if the central bank is attempting to tackle inflation.

A decrease in the repo rates has the opposite effect. It makes borrowing cheaper, resulting in more money being spent and swirling around the economy. This can be helpful when central banks want to stimulate the economy.

To determine the costs and benefits of a repurchase agreement, a buyer or seller should make three different calculations:

1. Cash paid in the initial security sale
2. Cash to be paid for the repurchase of the security
3. Implied interest rate

The cash paid for the initial security sale and the money paid for the repurchase will depend on the value and type of security involved in the repo. In the case of a bond, for instance, both will derive from the clean price and the value of the accrued interest for the bond.

A crucial calculation for any repo agreement is the implied rate of interest. If the interest rate is unfavorable, a repo agreement may not be the most efficient way to access short-term cash. A formula that can be used to calculate the real rate of interest is below:

Interest rate = [(future value/present value) – 1] x year/number of days between consecutive legs

Once the real interest rate has been calculated, comparing the rate against other funding sources should reveal whether the repurchase agreement is a good deal. Generally, as a secured form of lending, repurchase agreements offer better terms than money market cash lending agreements. From the perspective of a reverse repo participant, the agreement can also produce extra income on excess cash reserves.

Risks of Repo

Repurchase agreements are generally seen as low risk. The largest risk in a repo is that the seller may fail to repurchase the securities at the maturity date. When this happens, the security buyer may liquidate the security to recover the cash it paid.

This still constitutes a risk since the security value may decline after the initial sale, and the buyer may have few options other than to hold onto the security, which it never wanted for this purpose, or sell it for a loss. The borrower also faces some risk: if the security value rises above the agreed-upon terms, the creditor may not return the security.

There are ways to mitigate these risks in repurchase agreements. For instance, many repos are over-collateralized. In these cases, if the collateral falls in value, a margin call will require the borrower to amend the securities offered. If it seems likely that the security value may rise and the creditor may not sell it back to the borrower, under-collateralization can be utilized to mitigate this risk.

Generally, credit risk for repurchase agreements depends on many factors, including the terms of the transaction, the liquidity of the security, and the needs of the counterparties involved.

The Financial Crisis and the Repo Market

After the 2008 financial crisis, investors focused on a particular type of repo known as repo 105. There was speculation that these repos played a part in Lehman Brothers’ attempts at hiding its declining financial health leading up to the crisis. During this time, the repo market in the U.S. and abroad shrunk significantly, though it has since recovered and continues to grow.

The crisis revealed problems with the repo market in general. Since then, the Federal Reserve has stepped in to analyze and mitigate systemic risk. The Fed identified at least three areas of concern:

1. The tri-party repo market’s reliance on the intraday credit that the clearing banks provide
2. A lack of effective plans to help liquidate collateral when a dealer defaults
3. A shortage of viable risk management practices

Starting in late 2008, the Fed and other regulators established new rules to address these and other concerns. The new regulations increased pressure on banks to maintain their safest assets, such as Treasurys, giving them incentives not to lend them through repos.

Despite these and other regulatory changes over the last decade, there are still systemic risks within the repo space. The Fed continues to worry that a default by a major repo dealer could inspire a fire sale among money funds, which would then negatively affect the broader market. The future of the repo space may involve continuing regulations that limit the actions of these transactors, or it may involve a shift toward a centralized clearinghouse system. For the time being, though, repurchase agreements remain an important means of facilitating short-term borrowing.

Recent Changes in the Repo Market

The results from the Fed's post-2008 actions were significant: up through late 2008, the estimated value of global securities lent this way was close to $4 trillion. That figure hovered near $2 trillion for much of the next decade. By the 2020s, the Fed was progressively entering into repurchase (or reverse repurchase) agreements to offset temporary swings in bank reserves. The major jump comes from 2021 to 2023, when there was a major boost in the estimated value of repos traded, peaking at about $4.7 trillion in June 2023 before settling back under $4.0 trillion by the end of that year. Until 2021, the Fed was a relatively minor player in repo transactions when its role expanded considerably, with Overnight Reverse Repurchase (ON RRP ) agreements growing just above $1 trillion in the spring of 2021 to $2.7 trillion in assets by December 2022 for its part of the overall repo market. By 2023, the repo market was about three times larger than at the beginning of 2021, with the Fed serving as the critical counterparty for most of these transactions.

The significant rise in repo volumes can be attributed to several prominent changes within the market and the broader economy. The pandemic set off a rush for safe assets, driven by the period's extensive economic uncertainties. In July 2021, the Federal Open Market Committee (FOMC) established the Standing Repo Facility (SRF) as a backstop in the money markets. The SRF was intended to smooth liquidity in the repo market further and provide a dependable source of cash in exchange for safe investments like government bonds. It soon became a crucial part of how major financial institutions across the U.S. managed their short-term liquidity needs. Under the SRF, eligible institutions could borrow money overnight from the Federal Reserve, using securities such as Treasury bonds as collateral. The interest rate on these loans, known as the repo rate, is set by the FOMC and is generally above the market rate, ensuring the SRF is used as a backstop rather than a primary funding source. Concurrently, the Fed's increase in bond holdings, a measure to improve market liquidity, was part of its broader monetary policy to stabilize and support the economy.

However, from mid-2022 through 2023, the Fed was winding down these holdings under a policy known as "quantitative tightening," marking a shift from its earlier expansionary monetary stance. Pulling back its efforts to support the economy (by this time, inflation was becoming a critical worry), the Fed sought to decrease the size of its balance sheet. Reducing the Fed's balance sheet mainly involves cuts in three crucial areas of Federal Reserve liabilities: deposits of the U.S. Treasury at the Fed, deposits of banks at the Fed (known as reserves), and deposits of money market funds at the Fed through the ON RRP. The size of its part in the repo market would be easier to cut, given that the Fed has less control over the other two.

As the Fed sought to decrease its balance sheet, ON RRP made the most sense to pull back. Although bank reserves were to play a key role in future cuts to the Fed's balance sheet, scaling back the ON RRP is generally regarded as less disruptive to the monetary system than cuts to bank reserves. Changes in the ON RRP should cause a move away from the Fed as a primary counterparty toward the private sector. However, the capacity of the private repo market to handle much higher volumes is in some doubt. The Fed's active participation has significantly increased the repo market's size, and it's unknown if the private sector could adjust to step in for the Fed's increased part in the repo market.

The Bottom Line

A repurchase agreement, or repo, is a short-term lending instrument that involves a bank selling securities, usually government bonds or other debt instruments with steady values, to an investor and then repurchasing them a short time later at a slightly higher price. Repos essentially act as short-term, collateral-backed, interest-bearing loans, with the buyer playing the role of lender, the seller as the borrower, and the security as the collateral.