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The Fed uses repurchase agreements, also called "RPs" or "repos", to make collateralized loans to primary dealers. In a reverse repo or "RRP, the Fed borrows money from primary dealers. The typical term of these operations is overnight, but the Fed can conduct these operations with terms out to 65 business days.
The Fed uses these two types of transactions to offset temporary swings in bank reserves; a repo temporarily adds reserve balances to the banking system, while reverse repos temporarily drains balances from the system.
Repos and reverse repos are conducted with primary dealers via auction. In a repo, dealers bid on borrowing money versus various types of general collateral. In a reverse repo, dealers offer interest rates at which they would lend money to the Fed versus the Fed's Treasury general collateral, typically Treasury bills.
Among the tools used by the Federal Reserve System to achieve its monetary policy objectives is the temporary addition or subtraction of reserve balances via repurchase and reverse repurchase agreements in the open market. These operations have a short-term, self-reversing effect on bank reserves.
Repurchase agreements are made at the initiative of the trading desk at the New York Fed (the Desk). The Desk implements monetary policy for the Federal Reserve System at the behest of the Federal Open Market Committee (FOMC).
Repos are the most common form of temporary open market operation, and are used to temporarily add balances to those already in the system as a result of securities purchased and held in the SOMA portfolio. The SOMA portfolio is grown via securities purchases, also called permanent open market operations.
RPs and reverse repurchase transactions are particularly useful in offsetting temporary swings in the level of bank reserves caused by such volatile factors as float, currency held by the public and Treasury deposits at Federal Reserve Banks.
While the mechanics of a repo involve buying and then reselling securities at a set price and a set time, at its financial essence, a repo is a collateralized loan. Fed repos can be conducted for terms anywhere from one to 65 business days. They are usually overnight, though rarely longer than 14 days.
There are two main types of settlement methods for repos: triparty and delivery vs payment or DVP. Fed repos are done via triparty settlement, which means that the Fed and the primary dealers use a triparty agent to manage the collateral. In a triparty repo, both parties to the repo must have cash and collateral accounts at the same triparty agent, which is by definition also a clearing bank. The triparty agent will ensure that collateral pledged is sufficient and meets eligibility requirements, and all parties agree to use collateral prices supplied by the triparty agent.
The Desk selects winning propositions on a competitive basis. Each dealer is requested to present the rates they are willing to pay for the agreements versus various types of collateral. The three types of general collateral, or GC, the Fed accepts are marketable U.S. Treasury securities (including STRIPS and TIPS), certain direct U.S. agency obligations, and certain agency pass-throughs (or Mortgage Backed Securities, often called MBS).
The significance of the GC designation on the collateral is that GC collateral is fungible. That is, the Fed is not looking for specific securities; rather it is looking for any of the eligible securities that do not have scarcity value. As such there are a number of securities that would satisfy the requirements, and neither the dealer nor the Fed needs to know which specific security or securities are going to ultimately be pledged to a winning proposition. The Desk establishes relative values across the three collateral types, and then uses these values to select the best bids presented.
The New York Fed makes payment for the securities by crediting the reserve account of the dealer's triparty agent, a commercial bank. This act of crediting the bank's account actually creates reserve balances. When the repo matures, the dealer returns the loan plus interest, and the Fed returns the collateral. The return of funds to the Fed extinguishes the reserves that were originally created by the repo.
The collateral pledged by dealers towards the repo has a haircut applied, which means they are valued at slightly less than market value. This haircut reflects the underlying risk of the collateral and protects the Fed against a change in its value. Haircuts are therefore specific to classes of collateral. For example, a U.S. Treasury bill might have one haircut rate, while an agency coupon might have a different haircut.
Fed reverse repos are settled DVP, where securities are moved against simultaneous payment. In this case, the Fed sends collateral to the dealers clearing bank, which triggers a simultaneous movement of money against the security. At this point, reserve balances are extinguished. When the deal matures, the dealer sends the collateral back to the Fed DVP, which triggers the simultaneous return of the dealers funds. This act re-creates the reserve balances that were extinguished on the front leg of the transaction.
Market participants frequently use repurchase agreements and RRP transactions to acquire funds or put funds to use for short periods. However, transactions not involving the central bank do not affect total reserves in the banking system.