For Central Banks, an alternative to buying and selling Treasury bills to control market liquidity, is the use of repurchase agreements (repos).

Repos create a short-term money market between cash investors and securities holders who are looking to take in cash.

The repo instrument is a simple two-leg transaction. The securities holder - the cash taker - sells securities against cash, simultaneously agreeing to repurchase the same or (in the case of the classic or US-style repo) similar securities at a later date. This temporary purchase of securities is effectively like a cash loan but with enhanced protection against counterparty credit risk provided by the creditworthiness of the securities’ issuer.

The maturity date of the transaction is totally flexible - overnight, term or open - as is deal size, so odd amounts can be negotiated by the cash investor to exactly match cash surpluses across any required short term. The investment return is determined by the repurchase rate paid by the cash taker.

The mechanism by which the use of repurchase agreements adds or drains liquidity to the commercial banking system is the same as where a Central Bank buys and sells securities. That is:

• When a Central Bank wants to increase market liquidity it buys T-bills under an agreement to resell them - a so-called reverse repo.       
• When a Central Bank wants to decrease liquidity it sells T-bills under an agreement to repurchase them.

Central Bank use of repos was pioneered by the United States monetary authorities.

In the 1920s the US Federal Reserve provided short-term liquidity by inviting commercial banks to sell Bankers’ Acceptances under an agreement to buy them back from the Fed at a later date.

The US market for repurchase agreements - or repos - has grown in line with the increasing range of debt securities. By the 1960s the Fed could use repos as a powerful tool to add or drain liquidity from the banking sector; and the repo market underpinned the deepening Treasury bond market in the 1980s by enhancing the short-term liquidity of dealers’ inventories.

The use of repos by European Central Banks is a relatively recent phenomenon, however, they are the intended cornerstone of the European Central Bank's open market operation.