The major function of the money market is to provide liquidity. To achieve this function and to even out liquidity changes, the Reserve Bank uses repos. Repo is a useful money market instrument enabling the smooth adjustment of short term liquidity among varied market participants such as banks, financial institutions, and so on.
Repo refers to a transaction in which a participant acquires immediate funds by selling securities and simultaneously agrees to the repurchase of the same or similar securities after a specified time at a specified price. In other words, it enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments. It is a temporary sale of debt involving full transfer of ownership of the securities, that is, the assignment of voting and financial rights. Repo is also referred to as a ready forward transaction as it is means of funding by selling a security held on a spot basis and repurchasing the same on a forward basis.
Reverse repo is exactly the opposite of repo – a party buys a security from another party with a commitment to sell it back to the latter at a specified time and price. In other words, while for one party the transaction is repo, for another party it is reverse repo. A reverse repo is undertaken to earn additional income on idle cash. In India, repo transactions are basically fund management/SLR management devices used by banks.
The different between the price at which the securities are bought and sold is the lender’s profit or interest earned for lending the money. The transaction combines elements of both securities purchase/sale operation and also a money market borrowing/lending operation. It signifies lending on a collateral basis. It is also a good hedge tool because the repurchase price is locked in at the time of the sale itself. The terms of contract are in terms of a ‘repo rate’, representing the money market borrowing/lending rate. Repo rate is the annual interest rate for the funds transferred by the lender to the borrower. The repo rate is usually lower than that offered on unsecured inter-bank rate as it is fully collateralized. The factors which affect the repo rate are the creditworthiness of the borrower, liquidity of the collateral, and comparable rates of other money market instruments.
Importance of repos: Repos are safer than pure call/notice/term money and inter-corporate deposit markets which are non-collateralized; repos are backed by securities and are fully collateralized. Thus, the counter party risks are minimum. Since repos are market based instruments, they can be utilized by central banks as an indirect instrument of monetary control for absorbing or injecting short term liquidity. Repos help maintain an equilibrium between demand and supply of short term funds. The repos market serves as equilibrium between the money market and securities market and provides liquidity and depth to both the markets. Monetary authorities can transmit policy signals through repos to the money market which has a significant influence on the government securities market and foreign exchange market. Hence, internationally it is versatile and the most popular money market instrument. In India, too, it was a rapidly developing and thriving market until the scam of 1992-93 where this facility was grossly misused.
Two types of repos are currently in operation – inter-bank repos and RBI repos. Inter bank repos: The Reserve Bank itself, allowed it resort to repo transactions among themselves and with DFHI, and STCI. Inter bank repos were popular in 1991-92 as banks did not wish to buy the securities outright because of the risk of depreciation. Moreover, since there were not many money market instruments of different maturities repos served as a hedge for interest rate fluctuations.
The reserve repos: The Reserve Bank also undertakes repo/reverse repo operation with primary dealers and scheduled commercial banks as part of its open market operations. The Reserve Bank introduced repo operations (selling government securities to repurchase later) on December 10, 1992 to influence short term liquidity. The Reserve Bank provides liquidity support to primary dealers, and 100 percent gilt mutual funds in the form of reverse repo facility. The Reserve bank indirectly interferes in the market through reverse repo operations to ease undue pressure on overnight call money rates. This also enables the repo market to forge close links between the money market and securities market.