(LifeWire) - In the financial markets, one of the core components is the "repo." The repo, in this case, refers to repurchase agreements, not repossession.
Repurchase agreements are short-term transfers of securities in exchange for cash. They're commonly used by the government, securities dealers, banks and companies, either to make productive use of securities sitting on a balance sheet or to quickly obtain securities for investment purposes.
Despite the tightening of credit in 2007 and 2008, the market for repos remains robust. In the first quarter of 2007, the volume of repurchase agreements grew 31% from the previous quarter, to a value of $14.8 trillion, according to Xtrakter, a provider of capital-market data. And the number of repo transactions rose by about 17%.
How Repurchase Agreements Work
Just as someone with a red convertible might lend it to a friend for the weekend while he's out of town, the owner of a bond or stock that's sitting idly in an account might transfer it to someone else for a brief period of time.
Why? The securities owner may need cash for a day or two, or a week or more. Instead of taking out a short-term loan, he can sell the bond or stock to someone and promise to buy it back at a higher price. The crucial distinction between using a repurchase agreement and letting a friend borrow a car is that the repo is, for legal purposes, a sale of a security and an agreement to buy it back. So the security becomes the possession of the buyer for the term of the repurchase agreement.
Why would anyone want to own a security for such a short time? Consider a money-market fund with excess cash that it needs to keep safe and provide a decent return on. Its managers may be willing to transfer some of the cash for a short time in exchange for a higher-yielding security, such as a Treasury bond.
It's possible you may be an unwitting repo man (or woman) yourself, if you have any cash in a money-market fund or account. These funds can only invest in short-term instruments, such as certificates of deposits and Treasury bills. They can find even shorter-term instruments with repurchase agreements.
Who Else Uses Repurchase Agreements
Central banks use repurchase agreements to increase or reduce the money supply - a basic function of monetary policy. By offering to buy securities in exchange for cash, the Federal Reserve can inject money into the economy. This is one of the common open-market operations the Fed uses to implement its monetary goals.
Companies, especially banks, may participate in repo markets to make productive use of cash on their balance sheets. Repos are considered to be particularly safe, because the loan comes with collateral; if the counterparty doesn't buy back the security, the new owner can generally sell it.
Traders may need to raise cash quickly to purchase another investment; to do so, they may transfer another security in a repo transaction as a source of short-term financing.
Risks of Repurchase Agreements
Even though a repurchase agreement comes with collateral, risks remain. If the seller of a repo defaults, meaning that he or she doesn't buy back the security, the buyer may keep the security as collateral and sell it to recoup his cash. However, the security might have declined in value in the meantime.
