Repo vs. Reverse RepoShort-term agreements between a buyer and a seller - Everything you need to Know

Written By:
Adiste Mae

Reviewed By:
FundsNet Staff

Overview: Repo Rate & Reverse Repo Rate

Repurchase Agreement (Repo) and Reverse Repo Agreement (RRP) are short-term agreements between a buyer and a seller that deal with a repurchase or buy-back agreement of specific investment securities.

The parties usually involved in this agreement are a business organization (issuer/seller of the securities) and the buyer (financial institution, banks, other credit unions).

The main purpose of this agreement is for the seller to borrow money to use in business operations and for the buyer to serve the purchased securities as an investment to gain interest income from the same.

Both parties play a vital role in this type of transaction, and the usual term is only for a short-term period.

At the end of the term, the seller (original owner) will buy back the securities at a price higher than the original selling price.

Repurchase Agreement (Repo)

A Repurchase Agreement (Repo) is a short-term lending agreement with collateral-based securities to repurchase the same by the seller at the end of the term agreement.

For buyers, the repo agreement benefits them by earning additional income through a form of interest.

Dealers and fund managers of other leveraged accounts such as insurance, or money market mutual funds normally negotiate repo agreements.

Short-term agreements can sometimes mean an overnight transaction or less than a year agreement.

Securing the Repo

Repo can be described as a secured type of borrowing, and the collateral item usually is US Treasury securities.

In a repo transaction, the seller passes the ownership to the buyer.

The buyer will return the ownership of the securities to the seller at the end of the contract term. The most commonly traded securities are treasury shares, but there are cases in which they use government bonds as the object of the contract as well.

Generally, the collateral’s market value is higher than the securities’ purchase price.

In case of any seller’s default in payment, the repurchase agreement will be put on hold until the seller fulfilled the obligation. But every repo transaction corresponds to a repurchase agreement at the end of the contract term.

In some situations, when the securities market value declines, the agreement must include a condition that the seller must fund a margin account to protect the buyer from losses.

How the Fed Uses Repo Agreements

The Federal Reserve often uses the Repo and RRP for open market operations.

Buying treasury bonds by the government to commercial banks positively influences the money supply.

This transaction increases the bank’s cash account and strengthens its reserve rate for the short run.

After the agreed term, the securities will be repurchased by commercial banks.

To control and decrease the money circulation in the market, the Fed resells the securities by repo agreement to the banks.

After some time, they will buy back the sold securities through reverse repo to continue the money circulation.

Disadvantage of Repos

Before entering into a repo agreement, the selling party must consider the willingness of the buying party to take the relative risk carried out by investing in securities.

As such, they are relatively less risky than other types of borrowing as the security itself serves as the collateral and is managed by a third-party custodian.

The other risks of Repos are the lack of time to research the financial standing of the contracting party due to only a short period of transaction involved.

There is also the risk of the lender of a possible impairment of securities over time.

Reverse Repo

A Reverse Repurchase Agreement (RRP) is a manner of selling securities for a short term to repurchase the same upon the expiration of the agreed period.

It is a repurchase agreement on the seller’s side and a reverse repurchase agreement on the buyer’s side.

The final stage that consummates this type of contract is the reverse repo.

A repurchase agreement is a short-term agreement where the seller sells the securities with a sub-agreement of buying back the same when the agreed term ends at a price higher than the selling price.

Sellers have done this practice to raise additional funds for business purposes with a less risky transaction.

The final stage of the contract is to repurchase the sold securities and regain full ownership of the same.

For buyers, the benefit they may receive is temporary ownership of the securities and gaining additional income through interest income.

Special Considerations

The substance of the repo may be like a loan agreement but it is not exactly a loan contract.

A repo agreement involves a transfer of temporary ownership from the seller to the buyer for a short period.

The securities that served as collateral will be transferred back to the issuer when the seller settles the borrowed amount plus interests.

The Repo and RRP are considered collateralized loan agreements with only government bonds, and treasury securities as the qualified collateral items.

These agreements are only for short periods.

And the manner of reporting in financial statements is in debt accounts under liabilities.