Reverse repurchase agreement meaning

A reverse repurchase agreement, usually referred to as a “reverse repo”, represents the purchase of securities with the agreement to sell them at a higher price at a specified date in future. 

Actually, from a seller’s perspective, it is the same as a repurchase agreement or repo. However, the one who buys the security and agrees to sell it in the future, considers it as a reverse repurchase agreement. 

Repurchase agreements are known as money-market instruments often used to gain short-term capital. 

How reverse repurchase agreements work 

As we have mentioned, repurchase agreements and reverse repurchase agreements are exactly the same kind of transaction, just seen from different perspectives. 

Reverse repurchase agreements are also known as collateralised loans, sell/buy back loans and buy/sell back loans.

Investors or lending institutions usually use reverse repurchase agreements to lend short-term capital to businesses experiencing cash flow issues. 

In practice, the lender purchases a business asset, shares or equipment in the seller’s company and at a predefined time in future sells the asset back to the seller for a higher price.

Loaning money to the seller by purchasing the asset for a higher price guarantees that the buyer will get his interest from the reverse repurchase agreement. The purchased asset represents the collateral against any risk it faces from the seller’s side. 

Short-term reverse repurchase agreements bear smaller collateral risks than longer-term reverse repurchase agreements as assets held as collateral can depreciate in value over time.

Types of reverse repurchase agreements

Repo transactions have three major types: tri-party, specified delivery and held in custody, in which the seller holds the security during the term of the reverse repurchase agreement. The third type is used rarely, mainly because of the risk that the seller will default and the buyer will be unable to recover the purchased securities used as collateral.

The specified delivery type presupposes the delivery of a specified bond at the onset and at maturity of the agreed period. Meanwhile the tri-party represents a basket form of transaction and includes a wider range of assets. It involves a third party – a bank or a clearing agent – between the buyer and the seller. The third party manages the securities that represent the subject of the reverse repurchase agreement and processes all the payments between the seller and the buyer.