In a reverse purchase agreement or reverse repo, a buyer agrees to buy assets (normally securities) from a seller on the condition that seller will buy them back on a predetermined future date.
The assets act as collateral in that the buyer can keep them if the seller is unable to repurchase them at the agreed time.
Reverse purchase agreements are typically used by interested parties, such as shareholders, to provide a company or other entity with liquidity for a specific period of time.
They are widely used by central banks in order to control the flow of base money in circulation. In this arrangement, a central bank buys assets (such as bank bonds or other securities) from a commercial bank and pays the commercial bank with base money. The base money is used by the commercial bank for commercial banking activities, thereby increasing the amount of base money in circulation during the agreed term. On the predetermined date, the central bank sells the assets back to the commercial bank, recovering the base money and thus taking it back out of circulation.
Example of a reverse purchase agreement in business:
A shareholder of a company which is experiencing temporary cash flow problems agrees to buy additional shares in that company for a one-month period. The injection of money allows the company to manage its cash flow issues and thus avoid a devaluation of its stock.
At the end of the month, the shareholder sells the bonds back to the company as agreed. If the company was not able to repurchase the shares at the predetermined time as per the agreement, they would remain in the possession of the shareholder who bought them – compensating the shareholder for the loss.
See also: repurchase agreement