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What is a Repurchase Agreement?
A repurchase agreement is a legal document, also known as a repo, RP or sale and repurchase agreement, that provides short-term borrowing in government securities between a dealer and an investor. The dealer sells underlying security to investors and buys them back shortly afterwards at a higher price by agreement between the parties involved.
Repurchase agreements are also known as a repo for the party selling the security and agreeing to repurchase it in the future, and as a reverse repurchase agreement for the party buying the security and agreeing to sell it in the future.
You can read more on repurchase agreement here.
Purpose of a Repurchase Agreement
Repurchase agreements are considered safe investments because the security functions as a collateral. In effect, repurchase agreements function like a short-term interest-bearing loan that has collateral-backing. This type of short-term lending allows both parties to meet their goal of secured funding as well as liquidity. While repurchase agreements are similar to collateral-backed loans, they are actual purchases. However, due to their short term and temporary ownership, they are treated as short term loans for tax and accounting purposes.
For traders, a repurchase agreement also provides a way to finance long positions, or a positive amount, in securities that are posed as collateral to obtain access to cheaper funding costs for long positions in other investments or to cover short positions, or a negative amount, in securities through a reverse repo and sale.
Repurchases can play a key role in facilitating cash and security flow in a financial system. They create opportunities for low risk investments of cash and management of liquidity and collateral by financial or non-financial firms. For instance, the federal reserve enters into repurchase agreements to regulate the supply of money and bank reserves. Individuals can also use repurchase agreements to finance debt-security purchase or make other investments.
There are a few disadvantages of a repurchase agreement:
- Risk of default : Repurchase agreements carry similar risks to any other security lending transaction. However, because of their short-term nature, they operate without much assessment of the financial strength of the parties involved and thus carry a risk of default.
- Risk of depreciation : Repurchase agreements carry the risk of depreciation of the value of the security before its maturity date. The lender can lose money on such transactions.
Here is more on reverse repo and sale.
How Repurchase Agreements Work
When a company needs to raise immediate cash without selling long-term securities, they can use a repurchase agreement. There are a few components of a repurchase agreement:
- Selling securities: The business offers certificates of deposit, stocks and bonds for sale to a financial institution with the promise to buy it back in the future at a higher price.
- Buying back the security : The financial institution that the securities are sold to cannot resell it to a third party under a repurchase agreement. Therefore, the business or individual must buy it back in time.
- Repo rate : The repo rate refers to the percentage paid to buy back securities. For instance, the business or individual might have to pay a 10% higher price at the repurchase time. One can think of this as interest.
- Margin payments : If the value of securities drops before you repurchase it, you will have to make margin payments to the entity holding your securities.
There are also two types of repurchase agreements: term and open repurchase agreements. Repos with a fixed maturity date are called term repurchase agreements whereas ones with no set maturity date are called open repurchase agreements.
- Term repurchase agreement : In a term repurchase agreement, the interest rate is fixed and is paid at maturity. The buyer can use the securities for the term and will earn an interest over the term.
- Open repurchase agreement : An open repo can be terminated by either party after giving a notice to the other before an agreed-upon daily deadline. If this notice is not provided, the repo rolls over to the next day automatically. The interest rate in an open repurchase agreement is close to the federal funds rate. It is often used to invest cash or assets when parties are unsure about the time needed to do so.
You can read more on components of a repurchase agreement.
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Examples of When You Use a Repurchase Agreement
Repurchase agreements are widely used by banks and financial institutions to regulate cash flow. Individuals can also use it for short term borrowing. Here are some examples of when repurchase agreements are used.
United States Federal Reserve:
Repurchase agreements are used by the US federal reserve in open market operations to crease reserves in the banking system and withdraw them after a certain time period. This is used to temporarily drain reserves and add them back later. It can be used to stabilize interest rates. The federal reserve uses it to adjust the federal funds rate to match the target rate. Through a repurchase agreement, the federal reserve buys securities from a dealer who agrees to buy them back. When the federal reserve is a transacting party, the repurchase agreement is called a system repo. When the federal reserve is trading on behalf of a foreign bank, it is called customer repo.
Reserve Bank of India:
The reserve bank of India uses repo and reverse repo to regulate money supply in the economy. The rate at which the reserve bank of India lends to commercial banks is called the repo rate. When there is an inflation, the RBI can increase the repo rate and reduce the supply of money in the economy.
Traders use repos to loan securities over a short term and buy them back at a higher price. Short-term loans through a repurchase agreement can provide a low-risk option for buyers or investors, rather than taking out a short-term loan from a bank.
You can read more on repurchase agreements and their uses.
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Firm rated best ADR firm for Wisconsin and won an award for cultural innovation in dispute resolution from acquisition international magazine in 2016 and it was rated "Best of Brookfield" by Best Businesses in 2015. Attorney Maxwell C. Livingston was rated 10 best in Labor & Employment Law by American Institute of Legal Counsel and 40 Under 40 by American Society of Legal Advocates for 2016; he also won 10 Best by American Institute of Family Law Attorneys. He is licensed in Wisconsin in all state and federal courts, and in the 7th Circuit Court of Appeals, wherein he won a landmark decision in McCray v. Wielke.
Richard is a wizard at taking on bureaucracies and simply getting the job done. His clients value his straight-forward counsel and his ability to leverage a top-notch legal staff for efficient and effective results. Richard is a professional engineer, professor of law, and has been named among the top 2.5% of attorneys in Texas by the Super Lawyers®. When he is not driving results for his clients, Richard can be found with his small herd on his Texas homestead.
Experienced attorney and tax analyst with a history of working in the government and private industry. Skilled in Public Speaking, Contract Law, Corporate Governance, and Contract Negotiation. Strong professional graduate from Penn State Law.
I am an attorney admitted in NY, with over 6 years of experience drafting, reviewing and negotiating a wide array of contracts and agreements. I have experience in Sports and Entertainment, Real Estate, Healthcare, Estate Planning and with Startup Companies. I am confident I can assist you with all of your legal needs.
Rishma D. Eckert, Esq. is a business law attorney who primarily represents domestic and international companies and entrepreneurs. A native of both Belize and Guyana, she remains engaged with the Caribbean community in South Florida: as a Board Member and General Counsel for the Belize American Chamber of Commerce of Florida, and Member of the Guyanese American Chamber of Commerce. She holds a Bachelor of Laws degree (LL.B.) from the University of Guyana in South America, a Master’s degree in International and Comparative Law (LL.M.) from Stetson University College of Law in Gulfport, Florida, and earned a Juris Doctor degree (J.D.) from St. Thomas University School of Law in Miami, Florida. Licensed to practice in the State of Florida and the Federal Court in the Southern District of Florida, Mrs. Eckert focuses her passion and practice on domestic and international corporate structuring and incorporation, corporate governance, contract negotiation and drafting, and trademark and copyright registrations.
Mark A. Addington focuses his practice primarily on employment litigation, including contractual disputes, restrictive covenants (such as non-competition, non-solicitation, or confidential information restrictions), defense of wage and hour, harassment, retaliatory discharge, disability, age, religion, race, and sex discrimination.
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