Repo is a generic name for repurchase transactions.
In a repo transaction, one party sells an asset (such as Treasury Bonds) to another party at a set price. The seller commits to repurchase the same assets from the same party at some future date. If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss.
Repos are a way for borrowers to raise short-term funding by agreeing to buy and sell securities over very short timeframes. In practice they function much like a collateralized or secured deposit, and are a vital part of the financial system.
Banks had become increasingly active in the repo market in recent years, lending out some of the surplus money they hold at the Federal Reserve to earn a little extra return in a safe and liquid way.
How is repo rate determined?
The difference between the price paid by the buyer at the start of the repo and the price received at the end is effectively the lending rate on the repo. This is known as the repo rate or repo interest.
Why are repos used?
Repo agreements can serve four primary functions to different institutions:
- They are a safe investment for those with extra cash laying around.
- Borrowing costs are cheap.
- Yields can be enhanced for institutions holding safe assets and by increase their leverage.
- They provide a means for short-selling and short-covering.
It’s safe because the cash is secured by collateral, which is generally safe assets. It also makes it easy for seller of repo to make money back by selling those secured assets if the buyer does default on their payments.
Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.
What is repo with an example?
When an institution or bank needs immediate cash but doesn’t want to sell their securities, they can enter into a repurchase agreement to supply their immediate cash needs.
A repurchase agreement is similar to a loan, and you are using securities as a collateral.
For example, say XYZ Bank Corp. needs to raise cash in order to meet some reserve requirement level. They have plenty of securities on hand, but not enough cash.
In this situation, XYZ Bank Corp. decided to enter into a repurchase agreement with ABC Bank Group.
ABC Bank Group will take on XYZ Bank Corp’s securities and will lend them cash overnight to ensure they are meeting those reserve requirements.
Once the term is up, XYZ Bank Corp will “repurchase” their securities from ABC Bank Group and their debts will consider to be settled.