What is Repo Rate and Reverse Repo Rate?

Definition: Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country. It is a monetary policy instrument which can be used to control the money supply in the country.

Answered Sep 23, The significant difference between the Repo Rate and Reverse Repo Rate is that, with an increase in the Repo rate the borrowings of the commercial banks from RBI becomes dearer and as the result, fewer funds are borrowed. Reverse repo rate is rate at which commercial banks lends money to Central Bank in exchange of govt securities. When we need money, we take loans from banks.

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Reverse repo rate Definition: Reverse repo rate is the rate at which the central bank of a country (Reserve Bank of India in case of India) borrows money from commercial banks within the country.

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Marginal standing facility MSF is a window for banks to borrow from the Reserve Bank of India in an emergency situation when inter-bank liquidity dries up completely. Banks borrow from the central bank by pledging government securities at a rate higher than the repo rate under liquidity adjustment facility or LAF in short.

The MSF rate is pegged basis points or a percentage. True cost economics is an economic model that includes the cost of negative externalities associated with goods and services. If the prices of goods and services do not include the cost of negative externalities or the cost of harmful effects they have on the environment, people might misuse them and use them in large quantities without thinking about their ill effects on the env. Choose your reason below and click on the Report button.

This will alert our moderators to take action. Get instant notifications from Economic Times Allow Not now You can switch off notifications anytime using browser settings. Panache Is podcast the latest trend amongst millennials in India? Coupons interest payable to the owner of the securities falling due while the repo buyer owns the securities are, in fact, usually passed directly onto the repo seller.

This might seem counterintuitive, as the legal ownership of the collateral rests with the buyer during the repo agreement. Although the transaction is similar to a loan, and its economic effect is similar to a loan, the terminology differs from that applying to loans: However, a key aspect of repos is that they are legally recognised as a single transaction important in the event of counterparty insolvency and not as a disposal and a repurchase for tax purposes.

Term refers to a repo with a specified end date: Open has no end date which has been fixed at conclusion. Depending on the contract, the maturity is either set until the next business day and the repo matures unless one party renews it for a variable number of business days. Alternatively it has no maturity date — but one or both parties have the option to terminate the transaction within a pre-agreed time frame.

Repo transactions occur in three forms: The third form hold-in-custody is quite rare, particularly in developing markets, primarily due to the risk that the seller will become insolvent prior to maturation of the repo and the buyer will be unable to recover the securities that were posted as collateral to secure the transaction.

The first form—specified delivery—requires the delivery of a prespecified bond at the onset, and at maturity of the contractual period. Tri-party essentially is a basket form of transaction, and allows for a wider range of instruments in the basket or pool. In a tri-party repo transaction a third party clearing agent or bank is interposed between the "seller" and the "buyer".

The third party maintains control of the securities that are the subject of the agreement and processes the payments from the "seller" to the "buyer. In a due bill repo , the collateral pledged by the cash borrower is not actually delivered to the cash lender. Rather, it is placed in an internal account "held in custody" by the borrower, for the lender, throughout the duration of the trade.

This has become less common as the repo market has grown, particularly owing to the creation of centralized counterparties. Due to the high risk to the cash lender, these are generally only transacted with large, financially stable institutions. The distinguishing feature of a tri-party repo is that a custodian bank or international clearing organization , the tri-party agent, acts as an intermediary between the two parties to the repo.

The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market , and substitution of collateral. It is this "eligible collateral profile" that enables the repo buyer to define their risk appetite in respect of the collateral that they are prepared to hold against their cash. For example, a more risk averse repo buyer may wish to only hold "on-the-run" government bonds as collateral.

In the event of a liquidation event of the repo seller the collateral is highly liquid thus enabling the repo buyer to sell the collateral quickly. A less risk averse repo buyer may be prepared to take non investment grade bonds or equities as collateral, which may be less liquid and may suffer a higher price volatility in the event of a repo seller default, making it more difficult for the repo buyer to sell the collateral and recover their cash.

The tri-party agents are able to offer sophisticated collateral eligibility filters which allow the repo buyer to create these "eligible collateral profiles" which can systemically generate collateral pools which reflect the buyer's risk appetite.

Both the lender repo buyer and borrower repo seller of cash enter into these transactions to avoid the administrative burden of bi-lateral repos. In addition, because the collateral is being held by an agent, counterparty risk is reduced.

A tri-party repo may be seen as the outgrowth of the ' due bill repo. A due bill repo is a repo in which the collateral is retained by the Cash borrower and not delivered to the cash provider. There is an increased element of risk when compared to the tri-party repo as collateral on a due bill repo is held within a client custody account at the Cash Borrower rather than a collateral account at a neutral third party.

A whole loan repo is a form of repo where the transaction is collateralized by a loan or other form of obligation e.

The underlying security for many repo transactions is in the form of government or corporate bonds. Equity repos are simply repos on equity securities such as common or ordinary shares.

Some complications can arise because of greater complexity in the tax rules for dividends as opposed to coupons. It is two distinct outright cash market trades, one for forward settlement.

The forward price is set relative to the spot price to yield a market rate of return. There are a number of differences between the two structures.

For this reason there is an associated increase in risk compared to repo. Should the counterparty default, the lack of agreement may lessen legal standing in retrieving collateral. In a repo, the coupon will be passed on immediately to the seller of the security. In securities lending , the purpose is to temporarily obtain the security for other purposes, such as covering short positions or for use in complex financial structures.

Securities are generally lent out for a fee and securities lending trades are governed by different types of legal agreements than repos. Repos have traditionally been used as a form of collateralized loan and have been treated as such for tax purposes. Modern Repo agreements, however, often allow the cash lender to sell the security provided as collateral and substitute an identical security at repurchase.

A reverse repo is simply the same repurchase agreement from the buyer's viewpoint, not the seller's. Hence, the seller executing the transaction would describe it as a "repo", while the buyer in the same transaction would describe it a "reverse repo". So "repo" and "reverse repo" are exactly the same kind of transaction, just being described from opposite viewpoints.

The term "reverse repo and sale" is commonly used to describe the creation of a short position in a debt instrument where the buyer in the repo transaction immediately sells the security provided by the seller on the open market. On the settlement date of the repo, the buyer acquires the relevant security on the open market and delivers it to the seller. In such a short transaction, the buyer is wagering that the relevant security will decline in value between the date of the repo and the settlement date.

For the buyer, a repo is an opportunity to invest cash for a customized period of time other investments typically limit tenures. It is short-term and safer as a secured investment since the investor receives collateral.

Market liquidity for repos is good, and rates are competitive for investors. Money Funds are large buyers of Repurchase Agreements. For traders in trading firms, repos are used to finance long positions, obtain access to cheaper funding costs of other speculative investments, and cover short positions in securities. In addition to using repo as a funding vehicle, repo traders " make markets ".

These traders have been traditionally known as "matched-book repo traders". The concept of a matched-book trade follows closely to that of a broker who takes both sides of an active trade, essentially having no market risk, only credit risk. Currently, matched-book repo traders employ other profit strategies, such as non-matched maturities, collateral swaps, and liquidity management. When transacted by the Federal Open Market Committee of the Federal Reserve in open market operations , repurchase agreements add reserves to the banking system and then after a specified period of time withdraw them; reverse repos initially drain reserves and later add them back.

This tool can also be used to stabilize interest rates, and the Federal Reserve has used it to adjust the Federal funds rate to match the target rate. Under a repurchase agreement, the Federal Reserve Fed buys U. Treasury securities , U. Thus the Fed describes these transactions from the counterparty's viewpoint rather than from their own viewpoint. If the Federal Reserve is one of the transacting parties, the RP is called a "system repo", but if they are trading on behalf of a customer e.

Until the Fed did not use the term "reverse repo"—which it believed implied that it was borrowing money counter to its charter —but used the term "matched sale" instead. The rate at which the RBI lends to commercial banks is called the repo rate. In case of inflation, the RBI may increase the repo rate, thus discouraging banks to borrow and reducing the money supply in the economy. While classic repos are generally credit-risk mitigated instruments, there are residual credit risks.

Though it is essentially a collateralized transaction, the seller may fail to repurchase the securities sold, at the maturity date. In other words, the repo seller defaults on their obligation. Consequently, the buyer may keep the security, and liquidate the security to recover the cash lent.