Repo vs. Reverse Repo
Before having our first morning coffee, some of us will grab our phones, scroll through the news, and will sometimes stumble across headlines involving the words repos or reverse repos. We pause, and without further ado, we continue scrolling in hopes of finding something more appealing for our eyes.
But what are repos and reverse repos? We hope to shed some light on this topic through this blog.
The word repo is simply the short form of repurchase agreement. A repo is a type of money market instrument which involves the short-term borrowing of high-quality debt securities. A reverse repo is simply the other side of the coin.
When it comes to the duration of these loans, there are two main types: fixed and open tenor. The fixed tenor, as its name suggests, has a fixed start and end date, and can vary from overnight (the most common), to 1 – 3 months, or 1 – 2 years. Open tenor refers to repurchase agreements that do not have a set duration and can be terminated by either the seller or buyer on any business day as long as there is sufficient notice by either party.
Depending on the collateral involved, repurchase agreements can fall into two categories, traditional and non-traditional.
Traditional agreements involve government debt securities as collateral. These can include US Treasuries, agency-debt, and agency mortgage-backed securities.
Non-traditional agreements may include non-government debt securities as collateral. These can include corporate investment grade and non-investment grade debt, and sometimes equity securities.
Before diving further, it would be helpful to first focus on the repurchase agreement transaction. As in many financial transactions, repurchase agreements usually involve a seller, a buyer, and sometimes a third party, which could either be a custodian bank or a clearing organization. These institutions serve as the intermediary between the buyer and seller.
The applicability of the term repo or reverse repo will depend on the side you are taking in the repurchase agreement transaction, and whether one of the parties is the central bank or not.
For simplicity, let’s first talk about transactions in which the Fed is not a party. In this case, you are either the seller of the security or the buyer. From the seller’s perspective, it is a repo, and from the buyer’s perspective it is a reverse repo. In the case of a repo, a party is selling the security and agreeing to purchase it back later, usually overnight, and at a higher price. This party is essentially the borrower, seeking a short-term loan. In the case of a reverse repo, a party is purchasing the security and agreeing to selling it back later for a higher price. This party is essentially lending and holding the security as the collateral.
Visualizing this transaction can be helpful:
Source: Blackrock. “Understanding repurchase agreements”
The dynamic is a bit different when a central bank is involved in the transaction. In this scenario, the Fed would be on one end and on the other the banking system. For the Fed, a repo is used to lend money to the banking system. When it does so, it is essentially putting money into the banking system when it is short by buying the securities from the system. On the other hand, when there is too much liquidity in the banking system, the Fed will sell securities to the banking system, thus reducing the money supply. In this case, the Fed is essentially borrowing from the system, and the transaction is known as reverse repo. The Fed commonly uses repos rather than reverse repos.
Repos and reverse repos are money market instruments used to raise or lend short-term capital. Users can include:
Source: Corporate Finance Institute, May 2022. “ Repurchase Agreement (Repo)”
As you may know, the Fed, just as other central banks, has a variety of tools at its disposal to maintain monetary policy. Through open market operations, the Fed uses repos and reverse repos to provide stability in the lending markets and implement monetary policy, regulating money supply and bank reserves. If the Fed desires to tighten money supply, it can remove money from the banking system via reverse repo, selling securities to banking institutions.
When it comes to investors and financial institutions, these agreements can be used to invest excess funds on a short-term basis, and to manage liquidity and finance inventories.
To simplify repos and reverse repos, they are two sides of the same coin. These repurchase agreements are money market instruments used for borrowing and lending purposes in very short time frames. Repo and reverse repo agreements are the Fed’s most commonly used instruments in open market operations. If the Fed desires to tighten the money supply, it can remove money from the banking system via reverse repo, selling securities to banking institutions. Due to their short-term duration and collateralization, repurchase agreements, in general, are considered to be of low-risk nature.
- Investopedia, December 2020. “Reverse Repurchase Agreement”
- Investopedia, December 2021. “Repo vs. Reverse Repo: What’s the difference?”
- Corporate Finance Institute, May 2022. “ Repurchase Agreement (Repo)”
- Blackrock. “Understanding repurchase agreements”
- Federal Reserve Bank of New York. “Repo and Reverse Repo Agreements”
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