The REPO Market

REPO, short for repurchase agreement, is a short-term secured loan where one party sells securities to another and agrees to repurchase those securities later at a higher price. The securities serve as collateral, and the difference between the securities’ initial price and their repurchase price is the interest paid on the loan, known as the REPO rate.

The REPO market is a foundational component of the U.S. financial system, providing trillions of dollars of daily funding and facilitating liquidity for U.S. Treasuries and other securities. Here are some key points to know about the REPO program in the banking finance sector:

• The REPO market allows financial institutions that own lots of securities, such as banks, broker-dealers, and hedge funds, to borrow cheaply and allows parties with lots of spare cash, such as money market mutual funds, to earn a small return on that cash without much risk, because securities, often U.S. Treasury securities, serve as collateral.
• The Federal Reserve has established repo and reverse repo facilities to support its policy objectives. The Overnight Reverse REPO Facility (ON RRP) helps provide a floor under overnight interest rates by acting as an alternative investment for a broad base of money market investors when rates fall below the interest on reserve balances (IORB) rate. The Standing Repo Facility (SRF) serves as a backstop to dampen upward interest rate pressures that can occasionally emerge in overnight U.S. .
• The REPO market plays a key role in facilitating the flow of cash and securities around the financial system, with benefits to both financial and non-financial firms. A well-functioning repo market also supports liquidity in other markets, thus contributing to the efficient allocation of capital in the real economy. However, excessive use of REPOs can also facilitate the build-up of leverage and encourage reliance on short-term funding3.
• The Fed is considering the creation of a standing REPO facility, a permanent offer to lend a certain amount of cash to REPO borrowers every day. It would put an effective ceiling on the short-term interest rates; no bank would borrow at a higher rate than the one they could get from the Fed directly. However, few observers expect the Fed to start up such a facility soon, as some fundamental questions are yet to be resolved, including the rate at which the Fed would lend, which firms (besides banks and primary dealers) would be eligible to participate, and whether the use of the facility could become stigmatized.
• The REPO market experienced a brief episode of extreme volatility in mid-September 2019, when the level of reserves had been decreasing due to policy normalization. Several factors led to a greater than anticipated need to borrow in the REPO market and to less available funding, including a large amount of Treasury securities coming to the market, money market fund uncertainty about outflows for tax payments, and balance sheet constraints of some large banks.

In conclusion, the REPO program is a crucial part of the U.S. financial system, providing short-term financing to banks, securities dealers, and other financial institutions to fund their liquidity provisions and leveraged investments. The Federal Reserve has established REPO and reverse REPO facilities to support its policy objectives and ensure the smooth functioning of the REPO market. However, excessive use of REPO can also facilitate the build-up of leverage and encourage reliance on short-term funding, which can pose risks to financial stability.

Repo vs reverse repo

REPO and reverse REPO are two sides of the same coin, representing the buyer and seller sides of a repurchase agreement (RP) or a reverse repurchase agreement (RRP). These agreements are short-term borrowing and lending instruments used in the money market, often involving high-quality debt securities as collateral. The main difference between REPO and reverse REPO lies in the perspective of the parties involved in the transaction.

• Repo (RP): In a REPO transaction, the buyer (or the party originally buying the security) temporarily purchases a basket or group of securities for a specified period. The buyer agrees to sell those same assets back to the original owner at a slightly higher price, and the difference between the initial price and the repurchase price represents the interest paid on the loan.
• Reverse Repo (RRP): In a reverse REPO transaction, the seller (or the party originally selling the security) purchases securities and agrees to sell them back for a positive return at a later date, often as soon as the next day. The reverse REPO closes the repurchase contract, and the difference between the original purchase price and the buyback price, along with the timing of the transaction, equates to interest paid by the seller to the buyer.

The Federal Reserve uses REPO and reverse REPO agreements as its most commonly used instruments in open market operations to conduct monetary policy. When the Fed buys securities from a seller who agrees to repurchase them, it injects reserves into the financial system. Conversely, when the Fed sells securities with an agreement to repurchase, it drains reserves from the system.