Reverse Repo
A Reverse Repurchase Agreement (Reverse Repo) is the mirror transaction of a repo from the cash provider's perspective: the cash provider purchases securities from a counterparty with a simultaneous agreement to resell those same securities at a specified future date and price, effectively making a collateralized short-term loan to the securities seller and earning the repo rate as interest income. Central banks use reverse repos to drain excess reserves from the banking system and manage short-term interest rates, while money market funds and securities dealers use reverse repos as a core tool for deploying cash with collateral protection.
Key takeaways
- In a reverse repo, the party receiving securities and providing cash is the 'buyer' (reverse repo counterparty); this party earns the repo rate as interest and holds the securities as collateral during the term.
- The Federal Reserve's Overnight Reverse Repo Facility (ON RRP) allows eligible counterparties (primarily money market funds and GSEs) to lend excess cash to the Fed overnight at the administered ON RRP rate, providing a floor for short-term rates.
- Dealers use reverse repos to finance short positions: by lending cash against securities they agree to return, they obtain the securities they need for short sale delivery obligations.
- The nob spread (Notes over Bonds) and other yield curve spread trades often involve reverse repo positions in the longer-dated security to fund the carry cost of the spread trade.
- Term reverse repos (longer than overnight) carry greater credit and market risk and typically earn higher rates, reflecting the longer exposure period.
Explanation
The reverse repo occupies the other side of every repo transaction — for every borrower of cash (the repo seller), there is a lender of cash (the reverse repo buyer). The same economic transaction is described as a 'repo' by the cash borrower and a 'reverse repo' by the cash lender, reflecting their respective positions in the transaction. Understanding this duality is essential for interpreting central bank communications, money market fund disclosures, and dealer balance sheets.
The Federal Reserve's Overnight Reverse Repo Program (ON RRP) became one of the most important monetary policy tools in the post-QE environment. As QE flooded the financial system with reserves and reduced the supply of short-term Treasuries available for money market investors, money market funds found themselves with excess cash that earned near-zero rates in the open market. The Fed's ON RRP facility offered a solution: money market funds could lend their excess cash to the Fed overnight, receiving Treasury collateral and earning the administered ON RRP rate (set just below the federal funds target rate range). At its peak in late 2022, the ON RRP facility attracted over $2.5 trillion in daily usage — representing a massive drain of excess liquidity from the private market into the Fed's balance sheet, which helped support the federal funds rate corridor.
For securities dealers, reverse repos are a critical tool for managing short position inventory. When a dealer shorts a bond — borrowing and selling it with the obligation to return it — the dealer needs a continuous supply of that specific bond to deliver against its short sale. By executing reverse repos (lending cash against that specific bond), the dealer obtains the bond it needs while earning a return on its cash. Special repo rates — where a specific bond trades at a lower-than-usual repo rate — reflect the premium that short sellers pay to borrow that specific security, with the lower rate representing the 'specialness' value of having access to the specific collateral.
NOB spread trading (Notes over Bonds) illustrates how reverse repos enable fixed income relative value strategies. A fund implementing a NOB spread — long 10-year Treasury notes and short 30-year Treasury bonds — uses reverse repos to borrow the 30-year bonds needed for the short position. The cost of the reverse repo (the repo rate paid to borrow the bonds) is a key component of the trade's carry calculation, alongside the yield differential between the long and short positions. If the 30-year bond trades 'on special' (low repo rate), the reverse repo is expensive, increasing the cost of maintaining the short and affecting the overall profitability of the spread trade.
Formula
Reverse Repo Return = (Repurchase Price - Purchase Price) / Purchase Price × (360 / Days)
Example
In Q4 2022, with the Fed having raised rates to 4.25–4.50% and the banking system flush with reserves, a large money market fund with $50 billion in cash under management allocates $10 billion daily to the Fed's Overnight Reverse Repo Facility. Each morning, the money market fund lends $10 billion to the Fed, receiving $10 billion of Treasury collateral at the ON RRP rate of 4.30%. The following morning, the Fed returns $10 billion plus $1.19 million in interest (4.30% / 365 × $10B) and receives back the collateral. The money market fund earns a risk-free, secured, overnight return of 4.30% annualized — superior to alternative money market instruments and backed by U.S. Treasury securities, with the implicit credit guarantee of the Federal Reserve System.
Related terms
Amortizing Bond Asset Swap Spread Balance Sheet Bond Central Bank Dirty Price Face Value Federal Funds Rate Liquidity Monetary Policy Nob Spread Premium