What are repos and why do they matter?
By: Tim Bennett
A sudden spike in the “repo rate” in September triggered a short-term panic across financial markets. Tim Bennett shines a light on what went wrong.

What are repos and why do they matter?

The repo market is huge and yet most equity investors will not have heard much about it. So, this week I look at why a problem in this dark corner of the investment world can cause big ripples elsewhere.


Banks around the world engage in repos and reverse repos all the time. These core transactions are so frequent and so important that they are often referred to as the financial system’s plumbing. The question for equity investors is, therefore, how important is their proper functioning to what happens in other parts of the market and what does a problem in the repo market signal?

Repo basics

The word repo is short for repurchase, which itself is one half of the “sale and repurchase” agreement that this part of the market is built on. It takes two parties to make these work – one doing a repo and the other a reverse repo. To understand why they would enter such a deal, it is helpful to think of repos as secured loans that use bonds as collateral.

How it works

The next slide illustrates the basic mechanism. Party A is seeking to borrow cash short-term (typically overnight) and Party B is willing to lend it, taking bonds (IOUs) as security. The cash loaned will come with an interest charge but to keep the admin side of things simple, this is factored into the price at which the same bonds are rebought by Party A – the difference is known as the repo rate.

What is the point?

The repo market serves several functions but the key motivations for entering these deals is either as a way of borrowing at short notice or lending out securities for a fee. However, its participation in this market also allows the Federal Reserve to influence short term lending and borrowing rates by making more, or less, liquidity available to its participants.

How so?

In essence, the price of money is set by supply and demand, as it is for any other asset. If large institutions, such as commercial banks, need more liquidity to meet their regulatory requirements regarding minimum capital (to give just one example), then central banks such as the Fed can manage this by making more liquidity available.

Does this matter to investors?

The only time most investors will encounter repos is when something goes wrong, as it did in September this year. The repo rate is normally very low and does not move very much. Last month however it spiked sharply and suddenly. Ever since, market participants have been trying to work out why.
The explanation may be largely innocent and built around a number of what are known as technical factors – a mismatch in the timing of tax receipts, for example, may have caused a short-term problem.
However, if the repo rate spike was a function of the bigger players in this market failing to lend their reserves at the usual rate, it may signal something more significant. Ever since the financial crisis of 2007-2009, the Fed has been on a cash lending spree via QE. This latest incident may suggest that unwinding this, via QT, is proving harder than they expected and is putting a bigger squeeze on the main players (i.e. banks) than is generally realised. Which explanation is the more likely will only become apparent as and when we see more volatility in a normally quiet part of the markets.