What it means
In economic substance a repo is secured borrowing. The seller gets cash immediately and the buyer holds the securities as protection, so if the seller fails to buy them back the buyer can sell the collateral to recover the money.
The same trade has two names depending on which side you are on. If you are handing over securities and receiving cash you have entered a repurchase agreement, and if you are handing over cash and receiving securities you have entered a reverse repurchase agreement.
Both parties are describing one transaction. Collateral is almost always government bonds or other very liquid securities, and the lender protects itself with a haircut, meaning it lends less than the market value of the collateral.
A 2% haircut on $50,000,000 of bonds means only $49,000,000 of cash changes hands, leaving a cushion if bond prices fall before the trade unwinds. Repos matter well beyond banking because they set the price of very short-term money in the financial system.
Central banks use them as a main tool for adding or draining cash from the market, and stress in the repo market is watched closely as an early sign of funding pressure. For a corporate treasurer, a reverse repo is a way of earning a return on surplus cash for a few days while holding government bonds as security, which is safer than an unsecured deposit with a single bank.
The trade-off is administrative complexity and the need for proper documentation and valuation of the collateral.
In practice
Real-world examples
Example 1
A money market fund with $400,000,000 of cash to place overnight enters reverse repos with several dealers against government bonds. It earns a modest overnight return while holding collateral, which suits a fund whose first duty is protecting capital.
Example 2
A securities dealer holds a large bond inventory it does not want to sell. It finances that position through rolling one-week repos, using the bonds themselves as collateral rather than borrowing unsecured from a bank.
Example 3
A central bank wants to add cash to the banking system for a fortnight ahead of a tax payment date. It runs a repo operation, buying bonds from banks with an agreement to sell them back, injecting cash temporarily without permanently changing the size of its bond holdings.
Think of it
Imagine you need fifty pounds for the weekend. You leave your expensive bicycle with your neighbour as security and take their cash. On Monday, you return with fifty-one pounds, give back their cash, and take your bicycle home. That is a repurchase agreement.
Formula
Calculation
Cash lent = Collateral market value x (1 - haircut); Repo interest = Cash lent x repo rate x (days / 360)
A dealer needs cash for eight days and pledges government bonds with a market value of $50,000,000. The lender applies a 2% haircut, so the cash advanced is $50,000,000 x 0.98 = $49,000,000. The agreed repo rate is 4.5% on a 360-day convention, so annual interest on the cash would be $49,000,000 x 0.045 = $2,205,000. For eight days the interest is $2,205,000 x 8 / 360 = $49,000. The dealer therefore repurchases the bonds for $49,000,000 + $49,000 = $49,049,000, and the lender has earned $49,000 for eight days while holding collateral worth $1,000,000 more than the cash it advanced.Case study
Seen in the real world
Marlow Bridge Capital is an illustrative and entirely fictional bond fund created to show how repo funding behaves under pressure. It financed a $300,000,000 bond portfolio with rolling seven-day repos at a 2% haircut, meaning it only had to fund a small slice of the position with its own capital.
When bond prices fell sharply over a fortnight, its lenders raised the haircut from 2% to 8%. That single change meant Marlow Bridge had to find roughly $18,000,000 of extra cash to keep the same portfolio financed, at exactly the moment its assets were worth less.
The illustrative lesson is not that repos are dangerous but that funding terms can tighten precisely when a borrower can least afford it. After the episode the fictional fund capped the share of its portfolio financed by short-dated repo and held a standby credit line for haircut increases.
Watch out
Common mistakes
- Reading a repo as a genuine sale of securities, when in substance it is a secured loan and is usually accounted for as borrowing.
- Ignoring the haircut when working out how much cash a portfolio can actually raise against its bonds.
- Assuming repo funding will always roll over on the same terms, when rates and haircuts can change sharply during market stress.
Questions
People also ask
What is the difference between a repo and a reverse repo?
They are the same trade seen from opposite sides: the cash borrower has a repo, the cash lender has a reverse repo.
Who owns the securities during a repo?
Legal title usually passes to the cash lender, but the economic risks and rewards stay with the borrower, which is why the borrower keeps them on its balance sheet.
Why do companies use repos instead of bank deposits?
Because a reverse repo is secured by high-quality collateral, which reduces the risk of losing cash if the counterparty fails.