Bank repurchase agreements, also known as repos, are short-term loans used by banks and other financial institutions to access cash quickly. In a repo transaction, a bank sells securities to an investor with an agreement to buy them back at a later date at a slightly higher price.
The basic mechanics of a repo transaction are as follows: an investor, typically a money market fund or other large financial institution, purchases securities, such as Treasury bills or mortgage-backed securities, from a bank. The bank agrees to buy back the securities at a specific date and time, often the next day or within a few days, at a slightly higher price. This higher price represents the interest rate or yield on the loan.
The interest rate on a repo transaction is typically lower than other forms of borrowing, such as bank loans or commercial paper, because the transaction is secured by the underlying securities. If the bank defaults on its obligation to repurchase the securities, the investor can sell the securities to recover its investment.
Repos are commonly used by banks to manage their liquidity needs. Banks use the cash from the repo transaction to meet short-term funding needs, such as to cover daily cash flows or to make loans. Repos also allow banks to earn interest on their securities without selling them outright.
There are two main types of repos: tri-party and bilateral. In a tri-party repo, a third party acts as an intermediary between the bank and investor. The third party, typically a clearinghouse or custodian, takes custody of the securities and cash and manages the transaction. Tri-party repos are used to reduce counterparty risk and increase transparency in the transaction.
In a bilateral repo, the bank and investor negotiate the terms of the transaction directly. Bilateral repos are typically used for larger transactions or for securities that are not eligible for tri-party repos.
Repos are an important part of the financial system and are used by banks, government agencies, and other financial institutions to manage risk and liquidity. While they can be complex, they provide an important source of short-term funding for banks and other financial institutions.