Reverse Repo and the Differences from the Conventional
On the face of it, the definition for a reverse repo would appear simple. It is a normal repurchase agreement. However, the repurchasing party does not do the reverse repo agreement, but the party from whom the securities are repurchased executes the agreement. As such, the receiver of the cash would conduct the transaction as a repo one, while the provider of the cash would view it as reverse repo. In essence, repo and reverse repo mean the same transaction, but from different viewpoints.
In equity markets, a spot sale and a forward repurchase of a security is termed as sell/buy back transaction. On the other hand, the equivalent of a reverse repo is a buy/sell back transaction. Though reverse repo transactions do take place in stock markets, they are mainly used by the central banks of the respective countries.
U.S. Federal Reserve operations
In the United States, the U.S. Federal Reserve operates repo and reverse repo transaction mainly to offset or create temporary changes in bank reserves. Repos are used to increase the reserves in the banking system initially and later withdraw them. The increase in bank reserves will increase their liquidity, leading to higher lending. Thus, cash in injected into the economy, which results in higher spending by the consumers. Consequently, production and overall economic growth get a boost. These transactions are termed RP agreements.
On the contrary, the Federal Reserve uses the reverse repo to withdraw bank reserves from the system initially and then pump them back. The squeeze in bank reserves would create a cash crunch for the banks. They would reduce their lending. Money would become tight in the market. Spending would shrink. Production and economic growth would slow down. This process is initiated by the Federal Reserve mainly to fight inflationary conditions. Such transactions by the Federal Reserve with the banks are called RRP agreements.
Repurchase agreements by the Federal Reserve might be from overnight to 65 business days between delivery and maturity dates. The lowest rate accepted is the stop out rate for repo agreements. For reverse repo transactions, the highest rate accepted is the stop out rate. The Federal Reserve fixed the overnight stop out rates on January 22, 2007 at 5.21% for treasury notes, at 5.23% for agency notes, and at 5.25% for mortgage-backed securities.
