Repo and reverse repo means repurchase agreement and reverse repurchase agreement respectively. Again, it is a money money market instrument. Repo allows collateralized borrowing and lending through purchase/sale operations in debt instruments. Under repo transactions, the holder of securities the holder of securities sells treasury bills to the buyers with an agreement to repurchase the same at a predetermined date and rate. Thus, under repo, the commercial banks borrow from the RBI against their securities held with the RBI. Accordingly, such borrowings are for short duration like 6 hours, 1 day, 1 night, 1 week etc. The RBI charges interest over such borrowings which is known as repo rate. Subsequently, this repo rate has a great influence in controlling the inflation in the economy. The significant uses of repo rate are-
- When there is inflation in the economy, the RBI increases the repo rate so that commercial banks reduce their borrowings from the RBI. Less borrowing leads to less money with commercial banks for further lending/investment. Hence, it controls excess money supply and also controls inflation in the economy.
- When there is deficit in money supply in the economy, the RBI reduces the repo rate. It encourages the commercial banks for more borrowings from the RBI. Thus commercial banks have available money for lending/investment in the economy.
Types of repo
Under this repo transaction, the RBI actually takes possession of the collateral. The RBI become the owner. The spot buyer/borrower of securities in effect earns the yield on the underlying security plus or minus the difference between this and the repo interest rate.
In this type of repo the start and end prices of the securities are the same and a separate payment of “interest” is made. Classic repo makes it explicit that the securities are only collateral for the loan of the cash .
- Bond borrowing
In this type of repo, the customer lends bonds for an open ended or fixed period in return for a fee. The transaction would be taken care of by an agreement on securities lending and cash or other securities of equal value could be provided as collateral in the transaction.
Under this repo, a common custodian /clearing agency arranges for custody, clearing and settlement of repos transactions. They operate under a standard global master purchase agreement and provide for DVP system, substitution of securities, automatic marking to market, reporting and daily administration by a single agency which takes care of the risk on itself and automatic rollovers while not insisting on disclosing the identities by counterparties.
Reverse repo on the other hand is just the opposite of reverse repo. It is a reverse repurchase agreement. Under reverse repo, the RBI lends money to commercial banks by acquiring their securities with agreement to resell the same at a predetermined date and date. The repo market is an important source of funds for large financial institutions in the non-depository banking sector.