The mechanics
In a repo, the borrower (cash taker) sells collateral — typically government bonds — to the lender (cash provider) and simultaneously agrees to buy them back, usually overnight, at a slightly higher price. The difference between the sale price and the repurchase price is the "repo rate" — effectively the interest on a collateralised loan. For the lender, it is a reverse repo: they provide cash and receive securities as collateral. The same transaction, seen from opposite sides.
Who uses repos and why
Repos are the plumbing of the financial system. Banks use repos to fund their securities inventories overnight — buying bonds during the day and financing them in repo at night. Hedge funds use repos to lever their bond positions, borrowing cheap to buy more. Money market funds use reverse repos as safe, short-term investments with government bond collateral. Central banks use repos as their primary tool for open market operations, injecting or draining liquidity to keep the overnight rate at target.
Repo crises: when the plumbing breaks
In September 2019, US repo rates spiked to 10% overnight — five times the Fed Funds rate — because too many dealers needed cash simultaneously and money market funds had pulled back. The Fed had to inject emergency liquidity. In 2008, the collapse of confidence in mortgage-backed securities caused counterparties to refuse to repo them — effectively a bank run on the collateral system. Bear Stearns and Lehman Brothers failed in part because they could not roll their repo funding. When repo markets freeze, even solvent firms can collapse within days.
"Repos are the overnight plumbing of finance — invisible when working, catastrophic when blocked." — A financial stability observation
Haircuts: managing collateral risk
Lenders protect themselves by applying a "haircut" — lending only a fraction of the collateral's market value. A 2% haircut on a £100 government bond means the lender provides only £98 cash. If the borrower defaults, the lender sells the collateral at a small loss and still recovers their capital. Haircuts expand dramatically during crises (from 2% to 20%+ on non-government securities) — which is equivalent to a sudden tightening of credit and can cause forced selling spirals.
What this means for you
Repo rates are a real-time indicator of stress in the short-term funding market. When the repo rate spikes above the Fed Funds rate, it signals collateral or liquidity stress in the banking system. Following the "repo rate vs. policy rate" spread is one of the most useful early-warning indicators for financial professionals monitoring systemic risk.