Repos

"A repo man spends his life getting into tense situations."
--Bud (Repo Man)

Repurchase agreements, or 'repos,' are contracts where party A (the seller) sells securities to party B (the buyer) with the promise to buy those securities back at some future date. The time frame for this agreement is short term and often overnight. B, who buys then sells, is said to be engaging in a 'reverse repo' agreement.

What is going on here? A wants or needs cash for a project. B essentially lends A the money, and accepts the securities, usually liquid short term instruments like US T-bills, as collateral. When A buys back the securities, it is usually at a higher price. The difference between the initial sale price and the buyback price constitutes what is often called the 'repo rate.' Essentially, B is being paid interest for a short term loan.

Although repos resemble secured loans, they are legally different. Unlike loans, A legally repurchases the securities at the end of the term. This has regulatory and tax consequences that differ from loans.

Collateral reduces but does not eliminate risk with repos. A may fail to repurchase the securities at the maturity date, resulting in a default. B can sell the securities to recover the lost cash, but the securities may have lost value due to market movement. B may also fail to sell back the securities if their value increases during the term of the agreement.

An important thing to remember is that repos put more leverage into the system. If prices move in the wrong direction for leveraged parties, then repos can drive big increases in market volatility as investors move to unwind risk.