Introduction

Central banks implement monetary policy using a variety of financial instruments. These instruments include repurchase transactions, outright transactions, central bank debt certificates, foreign exchange swaps and the collection of fixed-term deposits. Out of these instruments, repurchase transactions are the most important tool used by central banks in the conduct of monetary policy. Currently the Eurosystem alone provides liquidity to the euro banking system through repurchase transactions with a total outstanding value of around half a trillion euro.

Repurchase transactions, also called ‘reverse transactions’ or ‘repos’, consist of the provision of funds against the guarantee of collateral for a limited and pre-specified period of time. The transaction can be divided into two legs, the cash and the collateral leg.

The cash leg is akin to a classical lending operation. The lender transfers an amount of cash to a borrower at the initiation of a transaction. The borrower commits to pay the cash amount lent plus a compensation (i.e. interest) back to the lender at maturity.

By the nature of lending, any lender bears credit risk, namely the risk that the borrower will fail to comply with its commitments to return the borrowed cash and/or provide the required compensation (i.e. interest) at the maturity of the transaction. Several tools are available to the lender to mitigate this risk.

First, counterparty risk can be reduced by conducting operations only with counterparties of a high credit quality, so that the probability of a default is small.