While banks can raise funds from deposits and securitizations, they can also access short-term funds through the repo market.
In the repo market, organizations sell securities with an agreement to repurchase them at a higher price in the future (in many cases, they agree to repurchase the securities the next day).
The seller of the securities is known as the repo side, whereas the buyer of the securities is known as the reverse repo side.
The repo side is essentially executing a secured borrowing, while the reverse repo side is lending funds on a short-term basis.
The repo market is usually highly liquid and the cost of borrowing is low. This makes it a popular way to raise short-term funds. The repo term can be for a single trading day or multiple days; in some cases, it doesn’t have a set term.
Single trading day = overnight repo
Multiple trading days= term repo
No set term = open repo
Thus, if a bank has securities (e.g., Treasury bills) but it needs cash today, it can sell the securities with an agreement to repurchase them the next day.
The repo side (the borrower) remains the owner of the security and gets any coupon payments or dividends attributed to the security.
The reverse repo side (the lender) profits by selling the securities back to the repo side at a higher price. The difference between the selling price and the repurchase price is implicit interest:
repurchase price – selling price = interest
The repurchase price (and hence the interest) is determined using the repo rate.
If the repo side can’t come up with the funds to execute the purchase, the reverse repo side can take possession of the securities and liquidate them to ensure repayment. However, there is a risk the securities will have declined in value and the reverse repo side won’t be able to recover the amount they lent. For this reason, the reverse repo side won’t lend the full amount of the securities’ value. The difference between the value of the securities and the amount of cash lent is called a haircut:
cash lent – value of security = haircut
The repo market is used by banks, mutual funds, hedge funds, pension funds, etc.
In the U.S., the repo market is also used by the Federal Reserve as part of its open market operations.
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