Understanding Reverse Repurchase Agreements (RRPs): Definition & Examples

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A reverse repurchase agreement (RRP, or reverse repo) is a short-term transaction in which one party buys securities from another and agrees to sell them back at a set, slightly higher price on a set future date. Economically, it is a collateralized loan. The buyer lends cash, the securities serve as collateral, and the difference between the purchase price and the resale price is the interest the lender earns.

The same trade is a repo (repurchase agreement) from the other side, where a party sells securities and promises to repurchase them. Which name applies depends on whose perspective the trade is described from.

How a reverse repo works

Every repo-style trade has two legs written into one contract:

1. Opening leg: Party A sells securities to Party B for cash.
2. Closing leg: On the agreed date, Party A buys the same (or equivalent) securities back from Party B at a higher, pre-agreed price.

Party A has borrowed cash against collateral; Party B has lent cash and held the securities as protection. If Party A fails to repurchase, Party B keeps the securities and can sell them to recover its money. If Party B fails to return the securities, Party A keeps the cash.

Repos are money market instruments. Banks, broker-dealers, money market funds, hedge funds and government-sponsored enterprises use them to fund securities positions, park surplus cash for short periods, or meet reserve needs. Related structures include sell/buy-backs and buy/sell-backs, which have a distinct legal form covered below.

Who is doing the “reverse”?

Under the dealer convention used in U.S. and international markets:

Some definitions describe the reverse repo as the seller’s side, the opposite of standard dealer usage. The Federal Reserve names its operations from its counterparties’ perspective. In a Fed “reverse repo,” the Fed sells securities and agrees to buy them back, so the Fed borrows cash while the money market fund or bank on the other side lends it. In any source, identify who sells first and who lends cash. Those two facts settle the meaning regardless of the label, and misreading the direction changes who is exposed to which risk.

Collateral, haircuts and tri-party settlement

The lender usually advances less cash than the market value of the collateral. That gap, called a haircut, protects the lender if the securities fall in value before the closing leg. Lower-quality or longer-maturity collateral generally carries a larger haircut, because its price can move further over the life of the trade.

Many trades settle through a tri-party arrangement, in which a clearing bank acts as agent. It holds the collateral in custody accounts, values it daily, applies the agreed haircuts and moves cash and securities between the parties. In bilateral trades, the two parties handle delivery and valuation themselves.

Formula and worked example

The interest on a reverse repo is the price difference between the two legs. It is annualized here with the actual/360 day count common in U.S. money markets:

Repo interest = Repurchase price − Purchase price

Repo rate = (Repurchase price − Purchase price) ÷ Purchase price × (360 ÷ days in the term)

Hypothetical example. Bank ABC has surplus cash it wants to put to work overnight. Bank XYZ is short of reserves for one day and holds Treasury securities with a market value of $10,200,000.

• Bank ABC buys the securities from Bank XYZ for $10,000,000. The roughly 2% haircut keeps the collateral value above the cash lent.
• The next day, Bank XYZ repurchases them for $10,001,250.
• Interest earned by Bank ABC: $10,001,250 − $10,000,000 = $1,250.
• Annualized rate: $1,250 ÷ $10,000,000 × 360 ÷ 1 = 4.5%.

Bank ABC has done a reverse repo: it lent cash secured by Treasuries. Bank XYZ has done a repo: it borrowed cash. The figures are illustrative and do not reflect any current market rate. For a 7-day or 30-day term, only the day count in the annualization changes.

If a coupon is paid on the Treasury during the term, a classic repo contract typically requires Bank ABC to pass that payment back to Bank XYZ. Bank XYZ keeps the economic exposure to the security throughout. This is why accounting standards generally treat a repo as a secured borrowing rather than a true sale.

Reverse repo vs. buy/sell-back

A buy/sell-back reaches a similar economic result through a different legal structure. It consists of two separately documented transactions: a spot purchase and a forward sale. Each leg stands on its own. Income on the collateral during the term is usually built into the forward price rather than passed through separately.

In a classic repo or reverse repo, both legs sit in a single, jointly enforceable contract. It is usually written under a master agreement such as the SIFMA Master Repurchase Agreement in the U.S. or the Global Master Repurchase Agreement internationally. The master agreement also carries terms that buy/sell-backs historically lacked, such as margin calls when collateral values move, substitution rights and close-out procedures on default.

How the Federal Reserve uses reverse repos

The Fed uses repo-type operations as part of open market operations to influence the quantity of reserves and the level of short-term rates:

• Repo operations (including the Standing Repo Facility created in 2021) add reserves. The Fed buys securities and lends cash for a short term.
• Reverse repo operations drain reserves. The Fed sells securities and borrows cash, temporarily pulling it out of the system.

The overnight reverse repurchase agreement facility (ON RRP) lets eligible counterparties, including money market funds, banks, primary dealers and government-sponsored enterprises, lend cash to the Fed overnight against Treasury collateral at the ON RRP offering rate set by the Federal Open Market Committee. Few eligible institutions would lend overnight in the private market for less than they can earn risk-free at the Fed. The facility therefore sets a floor under overnight rates and helps keep the federal funds rate within the FOMC’s target range. The Federal Reserve Bank of New York runs the operations, and daily usage is widely tracked as a gauge of excess cash among money market funds.

Why reverse repos matter

For the cash lender, a reverse repo earns a return on idle cash for as little as one night, secured by collateral rather than an unsecured promise. For the borrower, it provides cheaper funding than unsecured borrowing because the lender is protected. For the financial system, the repo market links cash-rich institutions with those that hold securities and need financing. That role makes it central to Treasury market functioning and to how central bank policy reaches interest rates.

Limitations and risks

• Counterparty risk: If the borrower defaults, the lender must sell the collateral. In a falling market, the sale may not cover the cash lent even after the haircut.
• Collateral risk: Longer terms and lower-quality collateral widen the possible gap between collateral value and the loan.
• Rollover risk: Borrowers that fund long-term assets with overnight repo must renew the funding daily. During the 2008 financial crisis, lenders pulled back or demanded bigger haircuts, and firms that relied heavily on repo funding, including Bear Stearns and Lehman Brothers, came under severe pressure.
• Rate spikes: Repo rates can jump when cash is scarce, as in September 2019, when overnight repo rates surged and the Fed stepped in with repo operations.

FAQs

The Bottom Line

Reverse repos matter to cash-rich institutions that want a secured return for as little as one night, and to anyone reading Fed operations or money market data. Before relying on the label, check who sells securities first and who lends cash, since sources and the Fed use opposite naming. Collateral quality, haircut size and rollover dependence determine how much risk each side really carries.