What is reverse repo and how does it affect me?

A reverse repurchase agreement, or reverse repo, is effectively a short-term loan between two financial institutions.

What is reverse repo and how does it affect me?

The parties in a repurchase agreement benefit by accessing cash or earning a return on cash, depending on what side of the transaction they're on. TommL/Getty Insider's experts choose the best products and services to help make smart decisions with your money (here's how). In some cases, we receive a commission from our partners, however, our opinions are our own.

Terms apply to offers listed on this page. When you hear the term repo, you might think of the bank taking back your car due to missed payments. But this term is also used in the financial sector to refer to repurchase agreements and reverse repurchase agreements, which are essentially two sides of the same coin.While the average individual tends not to directly engage in repo or reverse repo, these transactions play important roles in the functioning of financial markets. What is reverse repo?A reverse repurchase agreement, known as reverse repo, is a transaction that involves a short-term (often overnight) purchase of securities.

The securities are then sold back to the initial party at a higher price.In effect, repo and reverse repo are mechanisms for short-term loans. This could happen directly between two financial institutions, or it might involve an intermediary, such as a clearing bank, in what's known as tri-party repo.In 2013, the Federal Reserve started an overnight reverse repo facility, where financial institutions such as banks and money market mutual funds can engage in these transactions with the Fed as their counterparty. "The Reverse Repo Program is one of many tools the Fed uses to implement and sustain its monetary policy goals.

Practically, it creates a floor for overnight interest rates," says Andrea Pfenning, chief operating officer of clearance and collateral management at BNY Mellon.In turn, repo and reverse repo rates can ultimately influence other types of interest rates, like rates on mortgages or business loans."Repo rates serve as relatively risk-free rates which are used to value other fixed-income assets across the maturity and risk spectrum," explains Matthew Nest, global head of active fixed income at State Street Global Advisors.Note: Tools like reverse repo help prevent financial institutions from setting rates too low in relation to Fed policy. If an entity can get a higher return via the Fed's reverse repo facility then there's little incentive to go through other channels for the same type of loan, thus putting upward pressure on interest rates.Reverse repo vs. repoReverse repo and repo are two parts of the same transaction.

The party engaging in repo effectively borrows cash, while the party engaging in reverse repo acts as the cash lender.More specifically, the repo party sells securities, receives cash, and then repurchases the securities for a higher price than they were initially sold.  The party engaging in reverse repo first buys the securities, which serve as collateral for the cash they're sending to the other party, and then they ultimately receive a return on that cash when the transaction is unwound, known as the repo rate.How does reverse repo work?A financial institution can engage in reverse repo by purchasing securities from another institution that agrees to repurchase them and pay a return at a specified date. Treasuries are the most common form of securities purchased in these transactions because of their relatively high liquidity. Treasuries have several critical uses, like financing the federal government, as well as providing a low-risk investment and hedging tool, explains Pfenning.

"The US Treasury repo market facilitates the movement of cash and securities amongst financial institutions, ensuring the liquidity of this important asset class, which is foundational to the broader stability of global financial markets," she says. The function of the Fed's Reverse Repo Program is a bit different. When the Fed engages in a reverse repo transaction, it sits on the repo side of the equation, meaning it sells securities to later repurchase them at a higher price, while the other party — for example, a mutual fund — takes on the reverse repo role of buying the securities and later reselling them for a return.

In doing so, the Fed temporarily absorbs cash from financial institutions. "It's a tool for the Federal Reserve to drain excess liquidity in the system," says David Page, head of macroeconomic research at AXA Investment Managers. As of January 2023, the Fed was pulling in over $2 trillion daily through reverse repo. It then provides a return to these lenders."With the Federal Reserve tightening policy so aggressively … money market funds had an incentive to keep the duration of their assets relatively short," Page says.

"And one of the ways they could invest but with very short duration was via parking [cash] at the Federal Reserve and earning the overnight rate from reverse repo." Reverse repo can take place to match a party that has excess cash with a party that has securities to lend. A money market fund, for example, holds a lot of cash from customer deposits. So, a money market fund might use reverse repo, where they purchase securities from a bank or hedge fund that needs cash temporarily.

That allows the money market fund to earn a return on its cash after the other party buys back the securities for a higher price.Who benefits from reverse repo?Reverse repo, and repo markets as a whole, are part of the plumbing that makes financial markets work well, explains Nest. "The liquidity provided through repo allows markets like those for US Treasuries, mortgages, or equities to function smoothly," he says.The transacting parties gain benefits like accessing cash or earning a return on cash, depending on what side of the transaction they're on. That might not seem like it matters much to someone who doesn't work in finance, but it can make a difference to ordinary savers and investors."A more direct relevance for individual investors is as an important investment option for USD money market funds, which allow investors to earn a safe and profitable short return on cash investments," Pfenning says.However, reverse repo can also potentially have downsides for some investors.

For example, the high usage of the Fed's reverse repo facility potentially depresses other assets that financial institutions might have otherwise invested in, if not for the attractive returns provided by the Fed. Personal Finance Insider PFI Reference PFI Freelance