Repurchase agreement

A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is a form of secured short-term borrowing, usually, though not always, using government securities as collateral. A contracting party sells a security to a lender and, by agreement between the two parties, repurchases the security back shortly afterwards, at a slightly higher contracted price. The difference in the prices and the time interval between sale and repurchase creates an effective interest rate on the loan. The mirror transaction, a "reverse repurchase agreement," is a form of secured contracted lending in which a party buys a security along with a concurrent commitment to sell the security back in the future at a specified time and price. Because this form of funding is often used by dealers, the convention is to reference the dealer's position in a transaction with a counterparty. Central banks also use repo and reverse repo transactions to manage banking system reserves. When the Federal Reserve borrows funds to drain reserves, it can do so by selling a government security from its inventory with a commitment to buy it back in the future; it calls the transaction a reverse repo because the dealer counterparty to the Fed is lending money. Similarly, when the Federal Reserve wishes to add to banking reserves, it can buy a government security with a forward commitment to sell it back. It calls this transaction a repo because the Fed counterparty is borrowing money. The repo market is an important source of funds for large financial institutions in the non-depository banking sector, which has grown to rival the traditional depository banking sector in size. Large institutional investors such as money market mutual funds lend money to financial institutions such as investment banks, in exchange for (or secured by) collateral, such as...