Repurchase Agreement: Definition, How It Works

What is a Repurchase Agreement?

A repurchase agreement is a type of financial transaction or contract, also known as a repo, RP or sale and repurchase agreement, that provides short-term borrowing in government securities between a dealer and an investor. The terms are typically outlined in a legal document. The dealer sells underlying security to investors and buys them back shortly afterwards at a higher price by agreement between the parties involved.

Repurchase agreements are also known as a repo for the party selling the security and agreeing to repurchase it in the future, and as a reverse repurchase agreement for the party buying the security and agreeing to sell it in the future.

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Purpose of a Repurchase Agreement

Repurchase agreements are considered relatively safe investments because the security functions as collateral. However, the safety of a repurchase agreement also depends on the creditworthiness and reliability of the parties involved. Repurchase agreements function like a short-term interest-bearing loan that has collateral-backing. This type of short-term lending allows both parties to meet their goal of secured funding as well as liquidity. While repurchase agreements are similar to collateral-backed loans, they are actual purchases. However, due to their short term and temporary ownership, they are treated as short term loans for tax and accounting purposes.

For traders, a repurchase agreement also provides a way to finance long positions, or a positive amount, in securities that are posed as collateral to obtain access to cheaper funding costs for long positions in other investments or to cover short positions, or a negative amount, in securities through a reverse repo and sale.

Repurchases contribute to facilitating cash and security flow in a financial system. They create opportunities for low risk investments of cash and management of liquidity and collateral by financial or non-financial firms. For instance, the federal reserve enters into repurchase agreements to regulate the supply of money and bank reserves. Individuals can also use repurchase agreements to finance debt-security purchase or make other investments.

There are a few disadvantages of a repurchase agreement:

• Risk of default: Repurchase agreements carry similar risks to any other security lending transaction. However, because of their short-term nature, they operate without much assessment of the financial strength of the parties involved and thus carry a risk of default.
• Risk of depreciation: Repurchase agreements carry the risk of depreciation of the value of the security before its maturity date. The lender can lose money on such transactions. The risk of depreciation is mitigated by the fact that the repurchase price is agreed upon in advance and usually includes interest or a premium to compensate for potential depreciation.

Here is more on reverse repo and sale.

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How Repurchase Agreements Work

When a company needs to raise immediate cash without selling long-term securities, they can use a repurchase agreement. There are a few components of a repurchase agreement:

• Selling securities: The business offers certificates of deposit, stocks and bonds for sale to a financial institution with the promise to buy it back in the future at a higher price.
• Buying back the security: The financial institution that the securities are sold to cannot resell it to a third party under a repurchase agreement. Therefore, the business or individual must buy it back in time.
• Repo rate: The repo rate refers to the percentage paid to buy back securities. For instance, the business or individual might have to pay a 10% higher price at the repurchase time. One can think of this as interest.
• Margin payments: If the value of securities drops before you repurchase it, you will have to make margin payments to the entity holding your securities.

There are also two types of repurchase agreements: term and open repurchase agreements. Repos with a fixed maturity date are called term repurchase agreements whereas ones with no set maturity date are called open repurchase agreements.

• Term repurchase agreement: In a term repurchase agreement, the interest rate is fixed and is paid at maturity. The buyer can use the securities for the term and will earn an interest over the term.
• Open repurchase agreement: An open repo can be terminated by either party after giving a notice to the other before an agreed-upon daily deadline. If this notice is not provided, the repo rolls over to the next day automatically. The interest rate in an open repurchase agreement is close to the federal funds rate. It is often used to invest cash or assets when parties are unsure about the time needed to do so.

You can read more on components of a repurchase agreement.

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Examples of When You Use a Repurchase Agreement

Repurchase agreements are widely used by banks and financial institutions to regulate cash flow. Individuals can also use it for short term borrowing, but keep in mind they not treated as short-term loans for tax purposes. Here are some examples of when repurchase agreements are used.

United States Federal Reserve:

Repurchase agreements are used by the US federal reserve in open market operations to crease reserves in the banking system and withdraw them after a certain time period. This is used to temporarily drain reserves and add them back later. It can be used to stabilize interest rates. The federal reserve uses it to adjust the federal funds rate to match the target rate. Through a repurchase agreement, the federal reserve buys securities from a dealer who agrees to buy them back. When the federal reserve is a transacting party, the repurchase agreement is called a system repo. When the federal reserve is trading on behalf of a foreign bank, it is called customer repo.

Reserve Bank of India:

The reserve bank of India uses repo and reverse repo to regulate money supply in the economy. The rate at which the reserve bank of India lends to commercial banks is called the repo rate. When there is an inflation, the RBI can increase the repo rate and reduce the supply of money in the economy.

Individuals:

Traders use repos to loan securities over a short term and buy them back at a higher price. Short-term loans through a repurchase agreement can provide a low-risk option for buyers or investors, rather than taking out a short-term loan from a bank. Keep in mind that a repurchase agreement for a short-term loan is treated differently for tax and accounting purposes. Generally, they are treated as sales and purchases of securities.

You can read more on repurchase agreements and their uses.

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