Repurchase Agreements Explainer
A repurchase agreement, or repo, is a transaction in which one party sells securities and agrees to repurchase them later at a higher price. Economically, it functions much like a secured loan: the seller receives cash, the buyer holds collateral, and the price difference represents financing cost.
From the cash borrower’s perspective the trade is a repo; from the cash lender’s perspective it is a reverse repo. Most transactions are short term. A haircut means the cash advanced is less than the collateral’s market value, providing protection against price changes and liquidation costs.
Collateral is valued and may be margined as prices move. Tri-party agents can handle settlement, custody, and valuation, while bilateral trades leave more operations directly between counterparties. General collateral trades primarily obtain cash; a security trading special is particularly desired and may finance at a lower rate.
Repo supports dealer inventories, market liquidity, and monetary-policy implementation, but it creates counterparty, collateral, liquidity, settlement, and rollover risk. A lender may face losses if the borrower defaults and collateral falls or cannot be sold. Documentation, eligible collateral, haircuts, netting, and operational controls are essential.
Securities move to the cash lender with an agreement to reverse the trade.
The price difference implies interest.
Haircuts and margin help absorb price changes.
They do not remove liquidation risk.
The cash borrower calls it repo; the cash lender calls it reverse repo.
Both sides still face operational and counterparty risks.
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