How Repurchase Agreements Work

Image attribution: FreeDigitialPhotos.net; standard royalty free license

Repurchase agreements are short-term financial transactions between traders of government securities; often financial institutions and government agents, but also private parties. These transactions typically involve large amounts of money and require the seller of financial instruments to repurchase them in the future. The cost of 'repos' varies with the financial security, and the market conditions surrounding the transaction; it is referred to as either the general collateral rate or in the case of discounted repurchase agreements, special collateral rates.

The Government Finance Officers Association (GFOA) states repurchase agreements are primarily used to assist with the financing of organizational cash-flow needs. In a broader sense, and in the case of repurchase agreements involving the Federal Reserve Bank, the agreements are also intended to assist with the implementation of monetary policy according to the New York Federal Reserve Bank. An example of how repurchase agreements can help implement monetary policy is given by the Inter-American Development Bank that claims a strong 'repo market' is key in facilitating bond market and secondary market liquidity.

The types of government securities traded in repurchase agreements include Treasuries such as Treasury Bills, but also include other securities such as home loan bank bonds per the GFOA. The term of a repurchase agreements generally does not exceed two months in the case of Federal Reserve Bank "repos". The transactions may also involve three parties where the third party or bank acts as the financial intermediary between the two parties engaged in the repurchase agreement. In some cases a second sale of repurchased assets can also occur when multiple transactions by a dealer have been pre-arranged. 

The repurchase agreement market can be influenced by demand for short-term financing via repurchase agreements and Treasury auctions according to an article by Bradford and Susan Jordan in the Journal of Finance. Specifically, in the case of Treasury auctions, when demand is high, the demand for repurchase agreements can also rise leading to a reduction of financing cost for sellers of securities in repurchase agreements. Moreover, if a significant amount of buyers at the auction fail to acquire enough treasuries that have already been pre-sold, resulting higher competition for repurchase agreements can lead to special rates for the sellers of Treasuries.

The risk associated with repurchase agreements is more dependent on the credibility of the transaction than the quality of the financial instrument, especially in the case of high grade treasury securities. In other words, it is more likely an investor will be left holding a security beyond the extent of the repurchase agreement than it is the Treasury Bill or other government security will lose a great deal of value. However, the Inter-American Development Bank points out that repurchase agreements involving assets that do not sell easily do present a liquidity risk.