A repo is an agreement between a buyer and seller of securities, whereby the seller agrees to repurchase them at an agreed price and, usually, at a pre-agreed future date. They are widely used as a money market investment vehicle and as an instrument of central bank monetary policy. Repo has been described as “the dominant hydraulic of the money market”.
Where a repo agreement is used as a short-term investment tool, a securities dealer borrows cash from an investor – typically a bank, institutional investor or corporation with excess cash – to finance its inventory, using the securities as collateral. These repos may have a fixed maturity date or be open repos, callable at any time. Rates are negotiated directly between repo buyer and seller. The buyer receives interest on his cash and holds repo’d securities as collateral, while the seller promises to repurchase the bonds at an agreed future date.
The total average daily repo outstandings of US government securities dealers as at 30 June, is estimated at $3.9trn (E3.4trn) (of which around $1.3trn is held in a tri-party environment). This market has grown from $821bn in 1995. The market allows net holders of cash (such as retail banks, insurance companies, mutual/ pension/ money market funds and corporate treasuries) to lend their cash to dealers (such as big securities firms) who in turn need to borrow money in order to finance their securities operations. It is a two-way transaction in which one party borrows funds short-term using securities as collateral.
‘Sale and repurchase agreements’ or ‘repos’ have been actively traded by savvy cash-rich institutions for at least 20 years in the US as short-term, secured cash investment vehicles which allows them to invest their surplus liquidity in a risk-controlled environment, with the additional potential benefits of regulatory capital relief and/or yield enhancement versus. the alternative of placing funds in the unsecured inter-bank market, or outright investments in:
o commercial paper
o certificates of deposit
o sovereign
o corporate debt and
o other short-term financial instruments.
The flexibility of maturities and of overall credit quality also makes repos an ideal place to park funds on an as-needed basis. A repo which uses industry standard UK-law documentation, PSA-ISMA’s General Master Repurchase Agreement (‘GMRA’) gives the repo buyer full legal title to repo’d (ie, ‘purchased’) securities and these securities can therefore be sold on demand without having to first ‘perfect’ any charge or lien over the relevant assets.
The independent ‘bulge-bracket’ broker/dealers have a complementary financing requirement, specifically to reduce the cost of financing their trading inventories, never more so than during recent depressed financial market conditions. Owing to their highly leveraged balance sheets, broker/dealers’ opportunities for unsecured borrowing (eg, by issuing CP/MTN’s) are finite and relatively expensive.
There was a time when repo and stock lending were considered to be routine ‘back-office’ functions. But repo has today come to be recognised as an important profit centre and the pricing of repo has a significant impact on the total returns of financial institutions. Repo is now part of the connected chain of products which includes stock lending, futures, options, swaps, FRA’s and synthetics. None of these products trade without some influence from the relevant repo market(s).
Increased use of collateral: In general, the collateralisation of counterparty exposures can enable unequally rated counterparts to do business with it other, and it can facilitate an increase in both the value and tenor of existing counterparty credit lines. In the aftermath of the stockmarket meltdown of October 1997 ‘Black Monday’, and in the generally increased volatility of global stockmarkets, many large lenders committed resources to building in-house infrastructures to collateralise counterparty exposures. Some ‘bulge bracket’ investment banks set up multi-billion dollar syndicated collateralised ‘revolvers’ (ie, secured liquidity backstop or ‘Armageddon’ facilities) to guarantee liquidity in the event of another global market meltdown. The collateral for these repo-based ‘lifeline’ facilities is usually handled by a tri-party agent (TPAs).
Consolidation in the global financial services industry has raised concerns about concentrations of counterparty risk. And the ongoing global economic malaise and consequent impairment of counterparty credit ratings have also highlighted the need for collateralisation of counterparty exposures.
Until some 15 years ago the use of securities to collateralise credits could not be described as an international market. It was largely consisted of a plethora of national domestic stock loan facilities. Each domestic market had its own idiosyncrasies, and they were usually insular, inefficient and impenetrable to even the most intrepid of foreign organisations. However, the dramatic increase in cross-border investment flows has been accompanied by the availability of sophisticated risk management tools for monitoring and controlling credit exposures, secured or otherwise.
Moving along the collateral curve: The demand for an efficient, deep equity repo market comes from cash hungry securities firms, especially those that also act as prime brokers to hedge funds. These firms have large portfolios of stocks but find their access to cheap financing in the inter-bank market limited. Traditionally, their financing requirements were met internally by their treasury divisions. What has now changed is:
1) the size of their equity inventories has grown
2) Treasury divisions are now regarded as profit centres. Investment banks’ treasuries had to pay higher rates to obtain unsecured funding via CP or MTN issuance, as perceptions of credit risk changed in the wake of the Barings debacle with a consequent increase in the ‘cost of carry’ of non-investment grade or un-rated securities inventories.
Equity divisions are therefore anxious to emulate their firm’s fixed income divisions by putting their long assets to work through repo, and not just repos of diversified pools of prime index equities, but repos of ETFs, and of baskets of sub-investment grade – or unrated – convertibles, warrants and corporate bonds. Repos of lesser rated corporate instruments can reduce dealers’ financing costs and increase their financing lines. But it can also improve yields for their cash investor counterparts, because the volatility and liquidity characteristics of these individual lines of stock make them harder to finance externally. The risk adjusted returns on equity – or convertible bond/ warrant – repo are even more impressive, because these trades can be collateralised by diversified portfolios of securities, drawn from multiple geographies, industries and, of course, issuers, to reflect the risk appetite of individual investors. Individual positions will be smaller and therefore easier to exit. And or course, any securities which cease to conform to these pre-agreed criteria will be automatically replaced by others which do.
Because equities are not publicly rated, investors often lack confidence in their ability to assess the risks of taking equity collateral. Additionally, equities are subject to unpredictable corporate actions (eg, bonus issues, rights issues and takeovers). They are generally repo’d in smaller lots than bonds and subject to longer settlement cycles. Repos assume simultaneous (or at least same day) transfers of cash versus securities – in many equity markets that is not possible.
The in-house collateral management infrastructures developed by even large, sophisticated investors are not generally capable of handling such unrated and/or ‘smaller cap’ issues and/or issues with embedded derivatives, because the credit rating does not tell the full story. It is not that investors are unfamiliar with the necessary tools for handling such instruments; rather, because collateral management is not a core competence for most investors, they generally lack the critical mass to justify the necessary investments in infrastructure and technology to permit such movement along the ‘collateral curve’. These are therefore the instrument types which are more difficult for dealers to finance on a bilateral basis, and this is therefore where tri-party agents can often add the greatest value, by providing the required ‘ruleset’ technology to create collateral pools which automatically conform to an investor’s risk appetite.
Why tri-party repo?
There are broadly three repo operating models: Market or ‘delivery’, Hold-in-Custody (‘HiC’) and Tri-party repo. In the US, tri-party has a 25% share of the repo market, while in Europe the share of tri-party is just 8%, so there is considerable potential for growth. Tri-party collateral management is a service which is designed to simplify the collateralisation process for investors and dealers alike, and to expedite securities transfers between dealers (providers of collateral) and investors (the secured party). The TPA is positioned between dealer and investor to provide an independent, flexible and efficient collateral management service which addresses critical aspects of all traded or structured activities requiring collateralisation for example, securities lending, repo, foreign exchange and derivatives trading – specifically, the independent verification of securities eligibility and value, including the application of haircuts and concentration limits, to ensure that every trade is collateralised strictly in accordance with prescribed eligibility criteria, from inception to maturity. As such, tri-party offers user-friendly solutions to investors who are seeking to optimise investment performance and improve operational efficiency, while simultaneously minimising investments in back-office infrastructure and technology. This out-sourced collateral management service is offered free-of-charge to the investor (the receiver of collateral) ie, the repo seller, pays the TPA’s fees.
In Europe, Alberto Giovannini’s committee was tasked in January 2001 with identifying the sources of inefficiency in EU securities clearing and settlement infrastructure. The Giovannini Report, published in 2001, identified 15 barriers to efficiency, mainly due to the fact that clearing and settlement is dispersed across multiple domestic CSD’s across the EU, with non-synchronous settlement cycles. Paradoxically, these inefficiencies illustrate a key benefit of tri-party collateral management, namely that the TPA is in a position to transfer efficiently collateral from repo seller to buyer on a real-time, book-entry, delivery versus payment basis, thus virtually eliminating the risk of operational fails and enabling participants to operate outside the usual time-zone and market deadlines.
The TPA will only act after matching instructions from both principal counterparts with a view to maintaining sufficient collateralisation. It allocates to each investor’s segregated collateral account only those securities which both parties have prescribed as eligible collateral. The TPA works closely with each dealer to co-ordinate the delivery, receipt and substitution of eligible collateral and to offer a safe, reliable and efficient collateralisation process across multiple time zones. The operational flexibility offered by tri-party complements the bilateral trading relationship between dealer andinvestor enabling the principal counterparts to focus on deal structuring, by delegating all operational duties to an independent expert.
Throughout the term of each transaction, the TPA assesses the eligibility of incoming collateral and safekeeps it, providing the following additional value-added services:
o Daily mark-to-market of collateral versus underlying principal exposure o Application of security and cross-currency haircuts
o Security/geographic/issuer concentration limits
o Margin calls/return of surplus collateral
o Collateral substitutions
o Processing of income and corporate actions
o Transaction and exposure reporting via the internet (secure, encrypted messaging)
Safety: As custodian, the TPA safe-keeps collateral in segregated accounts at each relevant depository or local agent bank within its sub-custodian network. Collateral is marked-to-market daily ensuring that prescribed collateral margins are maintained. Daily securities data feeds are obtained from multiple specialist information vendors.
Efficiency: Tri-party is a more cost-efficient and operationally efficient than the more conventional delivery/market repo. Cost-efficiencies derive from economies of scale, enabling substantial investments in technology, infrastructure and multiple data feeds which facilitate superior risk management, automated control over all collateral movements and accurate, timely confirmation and reporting of collateral settlement, market value, income, corporate actions and substitutions. Operational efficiencies derive from collateral movements occurring on a real-time, fails free, book entry basis on a single integrated platform. Collateral settlement, allocation, segregation and marking-to-market becomes a streamlined process. And there is no charge for book-entry movements.
Balancing risk and reward: Risk is increasingly viewed as fungible across markets, products and time zones. An investor can become a dealer’s preferred counterpart by demonstrating greater collateral flexibility. But if you are going to stretch the ‘collateral envelope’ you need more sophisticated risk management techniques and better (preferably independent) control over collateral, plus of course you need a better understanding of the assets themselves. As such, TPA’s allow dealers to utilise their portfolios more effectively on a truly global basis, because the TPA process delivers:
a) real-time, up front controls
b) minimum asset quality (by enforcing pre-agreed collateral acceptability criteria),
c) portfolio diversification (by enforcing concentration limits by security type, industry and geography) and
d) application of appropriate ‘haircuts’ by collateral class. This combination of factors serves to effectively limit market risk.
Eligibility filters: Fixed income securities can be selected by issuer class (eg, sovereign, government agency, supranational or corporate), type (eg, fixed, floating, asset-backed, convertible, equity), credit rating (higher or lower), tenor, currency, domicile, etc, with percentage of pool or absolute concentration limits. For equity-related instruments, eligibility criteria could also include membership of specified indices, individual named issuers (to include or exclude), as well as proxies for liquidity, such as multiple of average daily traded volume (moving average), percentage of issue size or market capitalisation, etc.
Basel II: The Bank for International Settlement’s soon-to-be-published, revised Capital Adequacy Directive (Basel II) sets out to maintain the overall level of capital in the global banking system, while aligning it more closely with the true economic risks of banks’ activities. Basel II proposes detailed rules for estimating the risk of everything from auto loans and credit card balances to sovereign credits and SPV borrowings. It represents a dramatic departure from today’s simplistic regulatory capital rules (eg, Basel I sorts credit risks into a handful of crude buckets, such as corporates and sovereigns, which bear little relation to their underlying riskiness, because, eg, it does not distinguish between a single-B and triple-A corporate borrower, both of which would require 8% of the loan to be set aside as capital). The new accord attempts to make regulatory capital more representative of the actual commercial risks that banks take, by, for example, basing capital requirements on the credit rating (and therefore the risk of default) of the borrower. Under the revised rules, a loan to a AA counterpart would have a risk weighting of only 20%, while a loan to BB-rated corporate would attract a risk weighting of 100%. The revised accord will also assign a separate capital charge for operational risk.
Since counterparty credit ratings will have a much bigger bearing on capital requirements, it has been observed that Basel II could exacerbate the business cycle by forcing banks to clamp down hard on declining credits during economic slumps but to lend freely during boom times. Continuing the theme of adopting a more pragmatic approach to measuring risk-based capital, but with greater relevance to this article, Basel II also recognises that counterparty credit exposure is reduced by credit default swaps, guarantees and other risk mitigation instruments, including traded securities offered as collateral. Basel II is expected to allow banks to substitute the credit rating of the insurer – or the average rating of the collateral pool – for that of the borrower. As such, all actively traded securities received as collateral (ie, not only OECD sovereign debt, as at present) will reduce the regulatory capital charged against that credit. Some observers feel this does not go far enough, because a bank with a hedged (or collateralised) loan would have to experience a double default – of both the counterpart and the insurer/ collateral – before it loses money. It is therefore argued that banks which can demonstrate that they have the required systems and processes to implement Value-at-Risk techniques for controlling and measuring risk should receive greater regulatory capital relief. Nevertheless, it is generally agreed that Basel II will further curtail the unsecured market and encourage the use of collateral.
Collateralised lending is likely to continue to expand with heightened concerns about counterparty risk. Since investors have finite capacity for ‘clean’ exposures, borrowers are incentivised to offer securities as collateral to facilitate increased credit lines. Tri-party repo is a short-term money management option which can help to diversify risk and increase returns. As tri-party becomes more widely accepted by European investors, especially following the publication of Basel II, we envisage a scenario where investors will compete for repo sellers’ business, not only in terms of price (the repo rate), but also in terms of the collateral they are willing to accept.
Shravan Sood is head of business development, global collateral management, EMEA, at the Bank of New York