Repo and Reverse Repo Roles in Liquidity Management
Summary
A repo is a secured borrowing from the perspective of the party selling a security and agreeing to repurchase it; the other party calls the same transaction a reverse repo. The difference between the sale price and repurchase price represents the borrowing cost. The labels therefore describe opposite sides of one trade, rather than distinct transaction types for each counterparty.
The explanation applies this distinction to central bank liquidity operations: a central bank can supply funds by lending against securities in a repo, or absorb funds by borrowing cash through a reverse repo, depending on the central bank’s perspective and market convention. It also notes that higher borrowing rates tend to discourage secured borrowing. The source is a conceptual answer, not an empirical analysis, and operational terminology can depend on whose perspective is being described. It does not explain every channel through which policy rates affect broad money supply.
Key ideas
- A repo is secured borrowing for the party that sells securities and agrees to repurchase them.
- The counterparty to a repo describes the same transaction as a reverse repo.
- The difference between the initial sale price and repurchase price is the financing cost.
- Higher borrowing rates generally discourage borrowing, while lower rates encourage it.
- Central bank repo operations can add liquidity, while reverse repo operations can absorb it, from the central bank’s perspective.
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Full text
# Repo vs Reverse Repo terminology # Repo vs Reverse Repo terminology This might be a basic question. But I am still confused about the terms. Please kindly suggest about my understanding of repo vs reverse repo and repo rate vs reverse repo rate with their applications for money supply. Here is my understanding: - Repurchase Agreement is when Banks sell securities to Fed in order to buy back at a higher price. - Reverse Agreement is when Fed buys securities from Banks and resell them to Banks at a higher price. - Repo rate is the rate applied from the Bank’s perspective when the Bank has to pay Fed when buying back securities. (In this case, the Bank is on the Repurchase agreement and Fed is on the Reverse repurchase agreement) - Reverse repo rate is the rate applied from the Bank’s perspective when the Bank buys securities from Fed in order to get paid by Fed when the Bank resell securities to Fed at a later date. (In this case, the Bank is on the Reverse repurchase agreement and Fed is on the Repurchase agreement) When Fed wants to increase money supply, it will lower repo rate. On the other hands, if Fed wants to decrease money supply, it will increase repo rate. When Fed wants to decrease money supply, it will increase reverse repo rate. On the other hands, if Fed wants to increase money supply, it will decrease reverse repo rate. Q: Is my understanding correct? I’ve been reading on articles and internet resources but still can’t wrap my head around. Please kindly suggest. Thank you in advance. ## Answer by AlRacoon (score 4, accepted) https://quant.stackexchange.com/a/51453 A repo transaction and a reverse repo transaction are opposite sides of the same transaction. A capital market participant enters into a "repo" with a counterparty, who is in a "reverse repo". A repo is repurchase agreement. The counterparty (liquidity taker) is effectively borrowing funds from the capital market participant (liquidity provider) on a secured basis. They sell the security to the capital market participant and simultaneously agrees to repurchase the same security. The difference between the price sold (lower) and the agree upon price to repurchase the same security represents the interest paid on the secured loan. Higher interest rates discourage borrowing (lower interest rates encourage borrowing) in that higher interest rates increase the cost of borrowing money. While the Fed and Banks are major participants in the repo market, the repo market has many participants (money market funds, mutual funds, institutional investors, etc). The consistency is that the borrower or liquidity taker enters into a "repo", and the lender or liquidity provider enters the same trade as a "reverse repo". When the Fed is looking to inject liquidity (increase funds or money supply) into the market, they are engaging in a "reverse repo" transaction. When the Fed is looking to take liquidity out of the market (reduce funds or money supply), they are engaging in a "repo" transaction.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.