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Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital.
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A repurchase agreement (repo) is a short-term sale between financial institutions in exchange for government securities. The two parties agree to reverse the sale in the future for a small fee. Most repos are overnight, but some can remain open for weeks. They are used by businesses to raise cash quickly. They are also used by central banks.
Repos are sales transactions that function like short-term collateralized loans.
Repos are popular because they are easy and safe. Financial institutions such as banks, securities dealers, and hedge funds don't like to have large amounts of cash on hand. They prefer to put all their money to work. When they need cash in a hurry, they can turn to the repo market. Money market funds, on the other hand, have lots of cash. They are happy to lend funds overnight to the financial institution for a small fee.
The U.S. repo market is between $2 trillion and $4 trillion. Europe's repo market is more than double that, at $9 trillion.
A repurchase agreement is when the buyers purchase securities from the seller in exchange for cash and agree to reverse the transaction on a specified date. It functions like a short-term collateralized loan.
In the United States, the most common type of repo is the tri-party agreement. A big commercial bank acts as the middle-man. It brokers a deal between a financial institution that needs cash, typically a securities dealer or hedge fund, and another with excess to lend, such as a money market fund.
The parties agree to reverse the transaction, commonly the next day. That transaction is called a reverse repurchase agreement, or reverse repo.
The securities dealer posts short-term government securities like U.S. Treasury bills as collateral. The value of the collateral is about 2%-3% greater than the cash it receives. That's the profit to the money market fund for "lending" its cash. That percentage difference is known as the repo rate.
Alternate Name: Repo, buy/sell-backs
The Federal Reserve uses in repo and reverse repo transactions to manage interest rates. Specifically, it keeps the federal funds rate in the target range set by the Federal Open Market Committee (FOMC). The Federal Reserve Bank of New York executes the transactions.
The New York Fed conducts repos with just primary dealers. These are large New York banks that agree to participate in the Fed's daily transactions. The Fed purchases Treasurys, mortgage-backed securities, or other debt from the bank. In this way, it adds credit to the banks' reserves. This gives banks more money to lend, thus lowering interest rates.
The Fed conducts reverse repos with primary dealers and other banks, government-sponsored enterprises, and money market funds. It sells Treasurys and other securities to the banks. This lowers the amount of lendable funds that the banks have on hand, thus raising interest rates.
The Federal Reserve started issuing reverse repos as a test program in 2013. This was while it was purchasing long-term bank securities as part of its quantitative easing (QE) program. QE added massive quantities of credit to financial markets to combat the 2008 financial crisis. The Fed could use reverse repos to make adjustments to the short-term securities market.
Many investment banks, like Bear Stearns and Lehman Brothers, relied too heavily on cash from short-term repos to fund their long-term investments. When too many lenders called for their debt at the same time, it was like an old-fashioned run on the bank.
First, Bear Stearns and later Lehman couldn't sell enough repos to pay these lenders. Soon, no one wanted to lend to them. It got to the point where Lehman didn't even have enough cash on hand to make payroll. Before the crisis, these investment banks and hedge funds weren't regulated at all.
Some researchers disagree. A Stanford Business School study found that 90% of the repos were backed by ultra-safe U.S. Treasurys. Furthermore, repos only made up $400 billion of the $2.3 trillion in money market fund assets. The researchers concluded that the cash crunch occurred in the asset-backed commercial paper market. When the underlying assets lost value, the banks were left with paper no one wanted. It drained their capital, causing the financial crisis.
