The Plumbing of the Financial Sector: How Does the Repo Market Work?

“Repo” is short for “repurchase agreement.” In layman’s terms, repos are a type of short-term borrowing and lending transaction between financial institutions. The basic principle of a repurchase agreement is simple: Party A sells securities to Party B and at the same time pledges to buy them back at a later point in time at a specific (usually slightly higher) price. The maturity date and repurchase price are predetermined at the outset of the repo transaction. The securities act as collateral, with the ownership title to them transferring to the buyer for the duration of the contract term. This means that if Party A becomes insolvent before the repo contract expires and is unable to buy back the securities at the pre-agreed price, Party B has the right to liquidate the securities.

The difference between the initial sale price and the buyback price is the implicit rate of interest, or repo rate. Repo transactions usually have a relatively short term to maturity. The most common ones used are overnight repos, an arrangement under which the securities are bought back the following day. The securities involved usually are government bonds or other fixed-income products that have the most price stability. More volatile investment vehicles like stocks, for example, are not suitable collateral for repo transactions because their prices can fluctuate considerably within a short time frame.

But for what purpose do financial institutions make such short-term loans to each other? Most repos are used to make liquidity available for a short period of time. Commercial banks are legally obligated to hold a certain amount of liquidity at all times to meet regulatory requirements. If a bank is short on liquidity, an overnight repo can help it to nonetheless stay in compliance with regulatory requirements. Or it can cover the need for short-term capital to make investments.

There is a lot of demand for repos mostly because commercial banks do not like to hold large amounts of cash. That’s because cash in an account earns them no money, or at least less of a return than investments in securities do. For lenders, on the other hand, repos are a safe and efficient investment opportunity for earning quick profits.

Repos are also one of the most important monetary-policy tools for central banks. If a central bank purchases a lot of securities, that increases the supply of money in the economy at the same time. If a central bank sells a lot of securities, that shrinks the money supply. A central bank thus can inject or drain liquidity through repo transactions to actively enforce its monetary policy.

The difference between the sale price and the buyback price in a repo transaction determines the repo rate, which is tremendously important for the economy. The higher the interest that banks pay for their money, the higher all other interest rates – for businesses and private individuals. Switzerland’s SARON reference interest rate is calculated on the basis of the Swiss repo market. An average of 110 interest rates per day from the CO:RE repo platform flow into the calculation of SARON, which is computed and published every ten minutes by SIX. SARON is of fundamental importance for Switzerland’s economy. It acts as a baseline for interest rates on loans, savings deposits, and mortgages. Although the repo market operates largely behind the curtains of large financial markets, it is vital to the liquidity and stability of the financial system and lays the foundation for a well-functioning market.