We bet that you have heard about the 2019 repo crisis. On September 17, 2019, the repo interest rate more than doubled, as the chart below shows. That crash prompted the Fed to pump $500 billion into the repo market since the repo crisis started.
Chart 1: Secured Overnight Financing Rate from January 2019 to January 2020.
But what are repo operations exactly? A repo transaction, or a repurchase agreement, is a short-term agreement to sell securities in order to buy them back at a slightly higher price. There is also, of course, a reverse repurchase agreement, or a reverse repo, which means buying the security and agreeing to sell in the future.
OK, but why would someone sell bonds to buy back later at higher price, often the next day? The key to understand repo transactions it to look at them as collateralized loans, in which the borrower sells a security (typically government bonds) to the lender, with a commitment to buy it back later at a slightly higher price. The difference in price of sale and buy back is the implicit interest rate.
So, as repo operations are used to raise short-term capital, the repo market is an important part of the financial market that redistribute funds between financial institutions, providing liquidity for those who need it. Repos are also a common tool of open market operations conducted by the central banks.
Repo Operations and Gold
What is the link between repo operations and gold? With daily turnover of about $1 trillion, the US repo market’s health is essential for the whole financial market to operate smoothly. Any disruption in this market could be fatal for other segments of the financial market and ultimately for the global economy. We are not exaggerating – the financial crisis of 2007-8 and the resulting Great Recession stemmed from a run on the repo market, in which funding was either unavailable or at very high interest rates. Hence, the precious metals investors should be vitally interested in the developments in the repo market. The tensions in this market may lead to an economic crisis and the increase in the safe-haven demand for gold.