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Repurchase agreements, known as repos, play a critical role in the
money markets. They serve to keep the markets highly liquid, which in
turn ensures that there will be a constant supply of buyers for new
money-market instruments.
A repo is a combination of two transactions. In the first, a securities
dealer, such as a bank, sells securities it owns to an investor, agreeing to
repurchase the securities at a specified higher price at a future date. In
the second transaction, days or months later, the repo is unwound as the
dealer buys back the securities from the investor. The amount the
investor lends is less than the market value of the securities, a difference
called the haircut, to ensure that it still has sufficient collateral if the
value of the securities should fall before the dealer repurchases them.
For the investor, the repo offers a profitable short-term use for
unneeded cash. A large investor whose investment is greater than the
amount covered by bank insurance may deem repos safer than bank
deposits, as there is no risk of loss if the bank fails. The investor profits
in two different ways. First, it receives more for reselling the securities
than it paid to purchase them. In effect, it is collecting interest on the
money it advances to the dealer at a rate known as the repo rate.
Second, if it believes the price of the securities will fall, the investor can
sell them and later purchase equivalent securities to return to the dealer
just before the repo must be unwound. The dealer, meanwhile, has
obtained a loan in the cheapest possible way, and can use the proceeds
to purchase yet more securities.
In a reverse repo the roles are switched, with an investor selling
securities to a dealer and subsequently repurchasing them. The benefit
to the investor is the use of cash at an interest rate below that of other
instruments.
Repos and reverse repos allow dealers, such as banks and investment
banks, to maintain large inventories of money-market securities while
preserving their liquidity by lending out the securities in their portfolios.

They have therefore become an important source of financing for deal-
ers in money-market instruments. Many dealers and investors also take

positions in the repo market to profit from anticipated interest-rate
changes, through matched book trading. This might entail arranging a
repo in one security and a reverse repo in another, both to expire on the

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GUIDE TO FINANCIAL MARKETS

same day, in the expectation that the difference in the prices of the two
securities will change.
Investors like repos partly because of their flexibility. The average
maturity of a repo is only a few days, but it is possible to arrange one
for any desired term. An investor can arrange an overnight repo, which
carries the lowest interest rate but must be repaid the following day; a
term repo, which is settled on a specific date usually three to six months

hence and carries a slightly higher rate; or an open repo, which contin-
ues until one or the other party demands its termination at a rate close

to the overnight repo rate. Any type of security can be used, although in

practice the overwhelming majority of repos involve national govern-
ment notes or, in the United States, the notes of federally sponsored

agencies.
The repo market was originally a result of government regulations
limiting the interest banks can pay on short-term deposits. It has grown
rapidly in the United States, the largest single market. The British repo
market was slower to develop, and was not officially recognised by the
Bank of England until January 1996. Since then the market has grown
significantly.
Repos have historically been discouraged in France, where the legal
basis for them was unclear before 1993, and in Germany, where banks
were forced to set aside reserves for repo transactions until 1997, making

such transactions uneconomic. Much trading in repos on German secu-
rities still occurs in London, for legal reasons. The French repo market

has become quite large, but in Italy the market has remained small
because of unfavourable regulations. In Japan, gensaki, repos with
Japanese government bonds, have been traded since 1976. The gensaki

market declined during the 1980s as a result of the increased use of com-
mercial paper and a tax on transactions. By 1998 the average amount of

gensaki outstanding was only about 90 billion. As part of its 1998 finan-
cial-market reform programme the Bank of Japan, the central bank,

announced its intention to revive the Japanese repo market.