What is Reverse Repurchase Agreement?
The term “reverse repurchase agreement” refers to the buying of securities with the promise of selling them back at a higher price on a specified future date. It is also popularly known as the “reverse repo” agreement. Effectively, the reverse repurchase agreement (reverse repo) from a buyer’s perspective is similar to the repurchase agreement (repo) from a seller’s perspective.In the US, the most common type of reverse repurchase agreement is the tri-party agreement.
A transaction is considered a reverse repurchase agreement when a buyer purchases securities from a seller in exchange for cash and with the promise to sell them back to the seller at a higher rate on a specified date in the future. In short, the seller is executing a repo transaction, while the buyer is executing a reverse repo transaction. Both repo and reverse repo are like short-term collateralized loans.
Purpose of Reverse Repurchase Agreement
It is very popular among financial institutions as it is easy and safe. The leading financial institutions, such as banks, hedge funds and securities dealers, don’t prefer to maintain large amounts of cash on hand and thus, they intend to invest all their funds in the market. So, when they have excess cash, they invest it in reverse repurchase agreements, and when they are in need of cash, they raise money using repurchase agreements. This is why financial institutions actively participate in the repo market.
How does Reverse Repurchase Agreement Work?
Businesses like investors or lending institutions usually use reverse repurchase agreements to lend short-term loans to other businesses when they are in need of funds. Effectively, the lender purchases equipment, business asset or shares of the borrower with the agreement to sell them back to the borrower for a higher price on a set future date. The difference between the buying price and the higher selling price represents the lender’s interest in the deal. The asset purchased by the lender (or buyer) acts as the collateral to cover the default risk. Interestingly, there is no physical exchange of the collateral between the lender and the borrower until the borrower defaults.
Examples of Reverse Repurchase Agreement
Following are the example are given below:
Let us assume that a buyer bought securities at $950with collateral coverage of $1,200 in the transaction’s first leg. In the second leg, the buyer will sell the securities back to the seller at $1,000 and return the securities worth $1,200. Determine the interest earned by the buyer in this transaction.
In this transaction, the buyer earned $50 (= $1,000 – $950) in exchange for lending the money.
Let us assume that the central bank has fixed the US’s reverse repo rate at 6% per annum. Determine the selling price of the securities that a commercial bank purchased for $950 for 28 days.
The interest to be earned in the agreement is $4.37 (= 6% * 28/365 * $950). So, the selling price will be $954.37 (= $950 + $4.37).
Components of Reverse Repurchase Agreement
The reverse repurchase agreement has all the legs of the agreement legally documented within the same contract. The first leg is the purchase of the underlying business asset by the lender (buyer), and the second leg involves selling the asset back to the borrower (seller). Further, the underlying asset serves as the collateral for the lending operation. However, there is no actual change of location or ownership of the collateral unless the borrower defaults, in which case the collateral has to be physically transferred to the lender.
Some of the major advantages of RRA are as follows:
- It helps the commercial banks in earning an additional return on their excess cash, which can be handy in times of high levels of inflation in the economy.
- It is a very important tool for the central banks for controlling the money supply in the economy. For instance, a high reverse repo rate helps in injecting liquidity into the economy.
- It is one of the safest avenues to hold investment as the borrowers are usually the central banks, who enjoy the support of the government. Effectively, the banks earn profit by parking the excess cash with the central banks. However, the chances of default still exist, and it can’t be completely written off.
Some of the major disadvantages of RRA are as follows:
- If the reverse repurchase transactions are executed on a larger scale, then it may result in major banking disintermediation.
- Typically, there is no proper establishment of the reverse repurchase agreement with the entity’s counterparty.
- There is neither any judicial checking of the borrower’s financial health and the seller nor any assessment of the value of the collateral. Actually, the collateral may lose value owing to market volatility or changes in the market scenario.
So, it can be seen that the reverse repurchase agreement is a useful method to inject liquidity into a market. In essence, it ensures that businesses don’t need to liquidate their investments due to unforeseen cash flow crisis. It is also effectively used for managing cash. The central banks usually use the reverse repurchase agreement to control the money supply in the economy. Given that it primarily involves buying and selling treasury securities, it is considered to be one of the safest forms of investment.
This is a guide to Reverse Repurchase Agreement. Here we also discuss the introduction and how does reverse repurchase agreement work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –