A repo, short for repurchase agreement, is a short-term secured funding instrument that makes it possible for dealers in different debt instruments to either loan or be loaned securities over days or hours. Repo trading allows banks to lend/borrow their security holdings in exchange for money and receive or grant liquidity as a result.
A repo is essentially a contract for the sale and future repurchase of a financial asset, most often Treasury securities. On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds. Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan against collateral.
The U.S. Federal Reserve system uses repurchase agreements to make collateralized loans to primary dealers. In a reverse repo, the Fed borrows money from primary dealers. The Fed uses these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drain balances from the system.
The European Central Bank (ECB) and the majority of national European central banks also use repo transactions to control money supply.
The annualized rate of interest paid on the loan is known as the repo rate. Repos can be of any duration but are most commonly overnight loans. Repos for longer than overnight are known as term repos. There are also open repos that can be terminated by either side on a day’s notice. In common parlance, the seller of securities does a repo and the lender of funds does a reverse. Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent depending on maturity.
Every night, about $2.5 trillion turns over in the repo market.