eli5 What is the reverse repo market and why is it important
In: Economics
The simplest example of a repo agreement (also known as a repurchase agreement) is as follows.
Joe has 20 pieces of gold. He also has a paycheck coming in tomorrow for $100. Joe wants a concert ticket that goes on sale today for $95. However, the website doesn’t accept gold as a valid payment method.
Jessica has $200. She isn’t planning on spending it today (or anytime soon). She wants to earn a little extra money.
Joe enters into a repo agreement with Jessica. He will sell her a single gold piece for $95, and promises to purchase the gold piece back for $100 tomorrow. If Joe doesn’t pay for the gold piece tomorrow, Jessica gets to keep it. This works out great for Joe, because he gets the money he needs today. It also works out great for Jessica, because tomorrow she will have made $5 with no risk (because even if Joe doesn’t pay, she can sell the gold piece and recoup her money).
The federal repo market is exactly the situation above, except with Treasury notes. These are essentially gold due to the stability of the US government. The repo market allows companies with securities (like Joe and his gold) to raise capital quickly and at super low interest rates (because the risk on these loans is so low). By contrast, companies with lots of cash (like Jessica) have the ability to make a small profit on that cash with little to no risk.
If the reverse repo rate is high, this means that the Federal Reserve is issuing more Treasury bonds in an effort to get banks to purchase them. This decreases monetary supply (as the Federal Reserve then has the cash), which can help to combat inflation.
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