Repurchase Agreements and Reverse Repos

Why This Topic Matters

Repurchase agreements (repos) are one of the largest and most liquid short-term funding and investment markets in the world, with trillions of dollars transacted daily in the United States alone. For the Certified Treasury Professional (CTP) exam, repos sit squarely within the Corporate Liquidity Management domain because they are a core tool for investing excess cash on a short-term, collateralized basis. Treasury professionals need to understand repos for three practical reasons: (1) corporate treasurers routinely place overnight cash in repos through bank sweep accounts and dealer relationships, (2) money market funds in which companies invest hold large repo positions, and (3) the Secured Overnight Financing Rate (SOFR), the benchmark that replaced USD LIBOR, is derived from Treasury repo transactions. On the exam, you can expect questions that test definitions, the perspective of each party, collateral mechanics, risk mitigation, and simple interest calculations.

What Is a Repurchase Agreement?

A repurchase agreement (repo) is a transaction in which one party sells securities to another party and simultaneously agrees to repurchase those same securities at a specified future date and at a specified (higher) price. Although it is legally structured as a sale and a repurchase, economically a repo is a collateralized short-term loan. The seller of the securities is the borrower of cash; the buyer of the securities is the lender of cash. The securities serve as collateral, and the difference between the sale price and the repurchase price represents the interest on the loan, known as the repo rate.

A reverse repurchase agreement (reverse repo) is the identical transaction viewed from the other side. The party that buys the securities and agrees to resell them later is doing a reverse repo. In other words, every repo is a reverse repo for the counterparty. The label depends entirely on whose perspective you take.

Key Terminology

Repo rate: the annualized interest rate implied by the difference between the initial sale price and the repurchase price. Quoted on an actual/360 money market basis in US dollars.
Collateral: the securities sold and repurchased. Most common are US Treasury securities, agency securities, and agency mortgage-backed securities. Lower-quality collateral (corporate bonds, equities) carries higher repo rates and larger haircuts.
Haircut (margin): the amount by which the market value of the collateral exceeds the cash lent. A 2% haircut means $10,000,000 of collateral supports a $9,800,000 loan. The haircut protects the cash lender against a decline in collateral value.
Overnight repo: matures the next business day. The most common tenor.
Term repo: has a fixed maturity longer than one day, often one week to several months.
Open repo: has no fixed maturity; either party can terminate daily, and the rate resets daily.
Bilateral repo: the two parties deal directly with each other and the collateral is delivered to the cash lender or its custodian.
Tri-party repo: a third-party clearing bank or custodian holds the collateral, values it, applies the haircut, and settles the cash. This reduces operational burden and is the structure most corporate investors use.
Hold-in-custody repo: the dealer keeps the collateral in its own custody rather than delivering it. This is cheaper but exposes the investor to the risk that collateral is not properly segregated or is pledged to multiple lenders. Treasury policies often prohibit or restrict this structure.
General collateral (GC) repo: the lender accepts any security within a defined class (for example, any US Treasury). The rate reflects the cost of cash, not demand for a specific bond.
Special collateral repo: the lender wants a specific security (often to cover a short position) and accepts a lower repo rate, sometimes near zero or negative, to obtain it.
Master Repurchase Agreement (MRA): the standardized legal contract, published by SIFMA, that governs repo transactions between two parties. It establishes margin rights, default procedures, and netting.

How a Repo Works: Step by Step

Consider a securities dealer that holds $10,000,000 face value of Treasury notes and needs overnight cash. A corporation has $9,800,000 of excess cash to invest overnight.

Step 1 - Agreement. The dealer and the corporation agree on the collateral (Treasury notes), the cash amount ($9,800,000), the haircut (2%), the repo rate (say 5.00%), and the term (overnight).
Step 2 - Initial leg (settlement). The dealer delivers the Treasury notes to the corporation (or to a tri-party custodian) and receives $9,800,000 in cash.
Step 3 - Interest accrual. Interest is calculated as: Principal x Repo Rate x (Days / 360). Here: $9,800,000 x 0.05 x (1/360) = $1,361.11.
Step 4 - Closing leg (repurchase). The next day, the dealer pays $9,801,361.11 to the corporation and receives its Treasury notes back.

From the dealer's point of view, this is a repo: it sold securities and agreed to repurchase them, effectively borrowing cash. From the corporation's point of view, this is a reverse repo: it bought securities and agreed to resell them, effectively lending cash on a secured basis. In everyday treasury language, however, corporations often say they invested in repo, which is why the exam demands careful attention to who is selling and who is buying.

Why Repos Are Treated as Secured Loans

Even though legal title to the collateral transfers, accounting standards (ASC 860 in US GAAP) treat a typical repo as a secured borrowing, not a sale, because the seller retains effective control through the obligation to repurchase. Consequences:
- The securities remain on the seller's (borrower's) balance sheet.
- The cash received is recorded as a liability (repo payable) by the seller.
- The buyer (cash lender) records a receivable or short-term investment, not ownership of the securities.
- Coupon or interest payments made on the collateral during the repo term belong economically to the original owner (the seller) and are passed back.

Legally, however, the transfer of title is critical. Because the cash lender owns the collateral, it can sell the securities immediately if the counterparty defaults. US bankruptcy law provides a safe harbor that exempts repos from the automatic stay, allowing the non-defaulting party to liquidate collateral without waiting for court approval. This legal certainty is a major reason repos are considered low-risk instruments.

Risks and Mitigants

Counterparty (credit) risk: the risk that the seller fails to repurchase the securities. Mitigated by collateral, haircuts, daily mark-to-market, and dealing only with approved, creditworthy counterparties.
Collateral (market) risk: the risk that the collateral falls in value below the cash lent. Mitigated by haircuts and margin calls when value declines. Larger haircuts apply to longer-duration or lower-quality collateral.
Operational and custody risk: the risk that collateral is not actually delivered or segregated, particularly in hold-in-custody repos. Mitigated by using tri-party or delivery-versus-payment structures.
Legal risk: the risk that documentation is unenforceable. Mitigated by executing a Master Repurchase Agreement before trading.
Reinvestment and rollover risk: for overnight investors, the rate resets daily, so income fluctuates with market rates. For borrowers, there is a risk that lenders refuse to roll funding, as occurred during the 2008 financial crisis.
Liquidity risk: generally very low for Treasury-collateralized repos, but can spike during market stress, such as the September 2019 repo rate spike when overnight rates briefly exceeded 10%.

Repos in Corporate Liquidity Management

Corporate treasurers primarily encounter repos as a short-term investment vehicle for operating cash. Key attributes that make repos attractive:
- Safety: collateralized by high-quality government securities with a haircut.
- Liquidity: overnight maturity means cash is available the next business day.
- Flexibility: amounts can be sized exactly to the daily cash position, unlike T-bills that trade in fixed sizes.
- Yield: repo rates track overnight benchmarks such as the federal funds rate and SOFR, and are typically competitive with or slightly below unsecured overnight rates because the loan is secured.

Common access points include bank sweep accounts that automatically move end-of-day balances into overnight repo, direct dealer relationships for larger companies, and indirect exposure through government money market funds, which hold substantial repo positions.

Repos are typically not FDIC insured and are not SEC-registered securities, which is why investment policies address them separately, often specifying acceptable collateral types, minimum haircuts, approved counterparties, maximum tenor, and a prohibition on hold-in-custody structures.

The Federal Reserve and Repos

The Fed uses repos and reverse repos as monetary policy tools. When the Fed conducts a repo, it buys securities from dealers with an agreement to resell, temporarily adding reserves to the banking system. When the Fed conducts a reverse repo (through its Overnight Reverse Repo Facility, ON RRP), it sells securities with an agreement to repurchase, temporarily draining reserves. Note that the Fed names the transaction from its own perspective, which can feel reversed relative to a dealer-centric description. The ON RRP rate also acts as a floor for short-term money market rates, which directly affects the yields corporate treasurers earn on cash.

Essential Calculations

1. Repo interest: Interest = Cash Principal x Repo Rate x (Days / 360).
Example: $25,000,000 for 7 days at 4.80%: $25,000,000 x 0.048 x (7/360) = $23,333.33.

2. Repurchase price: Repurchase Price = Initial Cash + Interest.
Example: $25,000,000 + $23,333.33 = $25,023,333.33.

3. Implied repo rate from prices: Repo Rate = [(Repurchase Price - Sale Price) / Sale Price] x (360 / Days).
Example: sale $50,000,000, repurchase $50,069,444.44, 10 days: (69,444.44 / 50,000,000) x 36 = 0.05 = 5.00%.

4. Haircut and collateral required: Collateral Market Value = Cash Lent / (1 - Haircut).
Example: $9,800,000 cash with a 2% haircut requires $9,800,000 / 0.98 = $10,000,000 of collateral.
Alternatively: Cash Lent = Collateral Value x (1 - Haircut).

5. Margin call: if collateral value falls so that Collateral Value x (1 - Haircut) is less than Cash Lent, the borrower must deliver additional collateral or return cash.

Always use 360 days for US dollar repos unless the question explicitly states otherwise.

Comparison With Other Short-Term Instruments

Treasury bills: direct government obligation, no counterparty risk, but fixed maturities and sizes; repos offer more flexibility and the ability to invest odd amounts overnight.
Commercial paper: unsecured corporate obligation with higher yield but higher credit risk; repos are secured.
Certificates of deposit: bank deposit with FDIC coverage only up to the insured limit; repos rely on collateral instead of insurance.
Fed funds: unsecured interbank lending, generally unavailable to corporations; repos are the secured equivalent accessible to non-banks.
Money market funds: pooled, diversified, same-day liquidity, but hold repos among their assets, so a corporate investor gets indirect repo exposure.

Exam Tips: Answering Questions on Repurchase Agreements and Reverse Repos

Tip 1 - Identify the perspective first. The single most tested concept is who is doing the repo versus the reverse repo. Ask: who is selling securities now and buying them back later? That party is doing a repo and is borrowing cash. The other party is doing a reverse repo and is lending cash. If the question says a corporation invests excess cash with a dealer by purchasing securities and agreeing to resell them, the corporation is in a reverse repo. If the question simply says the company invested in a repo, treat the company as the cash lender.

Tip 2 - Remember the economic substance. When a question asks what a repo is economically, the answer is a collateralized or secured short-term loan, not a sale of securities. When it asks about accounting treatment, the answer is secured borrowing; the collateral stays on the seller's balance sheet.

Tip 3 - Know the purpose of the haircut. A haircut protects the cash lender against a decline in collateral value and against counterparty default. It does not protect the borrower, and it is not a fee. If asked who bears the haircut, the answer is the securities seller (borrower), who must post more collateral than cash received.

Tip 4 - Use the 360-day convention. US repo interest uses actual days / 360. If an answer choice differs from your calculation only slightly, check whether you used 365 by mistake.

Tip 5 - Match collateral quality to rate and haircut. Higher-quality, shorter-duration collateral means a lower repo rate and a smaller haircut. Lower-quality or more volatile collateral means a higher rate and a larger haircut. Special collateral trades at a lower rate than general collateral because the lender wants the specific security.

Tip 6 - Distinguish the structures. Tri-party repo uses a custodian bank to hold collateral and is the safest operationally. Bilateral repo involves direct delivery. Hold-in-custody repo leaves collateral with the dealer and is the riskiest for the investor. Questions about reducing operational or custody risk point to tri-party or delivery-versus-payment.

Tip 7 - Watch for Fed perspective questions. A Fed repo adds reserves (Fed buys securities temporarily). A Fed reverse repo drains reserves (Fed sells securities temporarily). The ON RRP facility sets a floor under short-term rates.

Tip 8 - Link repos to SOFR. SOFR is calculated from overnight Treasury repo transactions. If a question asks which benchmark is based on secured overnight transactions, the answer is SOFR, not fed funds or LIBOR.

Tip 9 - Recall the legal protections. The Master Repurchase Agreement governs the relationship and provides netting and default rights. Repos enjoy bankruptcy safe harbor, allowing immediate liquidation of collateral on default. Treasury investment policies should require an executed MRA before trading.

Tip 10 - Eliminate distractors about insurance and registration. Repos are not FDIC insured and are not registered securities. Safety comes from collateral and haircuts, not from government guarantees.

Common Exam Traps

- Confusing the repo party with the reverse repo party when the question describes the corporation's actions rather than the dealer's.
- Treating the repurchase price difference as a capital gain rather than interest.
- Calculating the haircut as a percentage of cash rather than of collateral value (Cash = Collateral x (1 - Haircut)).
- Assuming coupon payments on collateral belong to the cash lender; they are passed back to the original owner.
- Assuming term repos are riskier for the cash lender only because of maturity; the real added risks are longer exposure to collateral price moves and counterparty deterioration, which is why term repos carry larger haircuts and higher rates.
- Selecting hold-in-custody repo as a risk-reducing choice; it increases risk.

Quick Recap

A repo is the sale of securities with a simultaneous agreement to repurchase at a higher price; economically a secured loan where the seller borrows cash. A reverse repo is the same trade from the buyer's side; the buyer lends cash and holds collateral. Haircuts, daily marking to market, tri-party custody, and the Master Repurchase Agreement manage risk. Corporations use repos, usually as the cash lender, to invest excess liquidity overnight with high safety and flexibility. Interest is computed on an actual/360 basis. On the exam, always determine who is selling securities, remember substance over form, and apply the standard formulas carefully.