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Special Report

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Welcome to 'Repoland'

Saheed Awan goes on a quick tour of the repo & reverse markets

Ten years ago a handful of the London based subsidiaries of US investment banks began putting their sizeable bond inventories out to work. By repoing" them out these investment banks, denied access to the interbank market because of their subsidiary status, began to cost effectively finance their securities inventories. Few at that time would have had the foresight to believe that this infant market would grow to the mind boggling size it has.

Cedel Bank's estimates are that repo turnover last year in Europe was over $97trn. The turnover in the US is double the European number. We estimate that the average amount in outstanding transactions was approximately $1.3trn in Europe and approximately $2.4trn in the US. In the 1990s repo became the world's fastest growing capital markets instrument.

The market's growth has yet to peak as regulators and governments the world over begin to recognise that there can be no efficient capital market without an underlying repo market. Governments are also beginning to open up their domestic repo markets to reduce the cost of financing treasury deficits or use the repo structure to create a more secure lending environment where an efficient and stable banking system is non-existent. In developed economies, repo has become a major, if not the central instrument, of monetary policy. It will act in this capacity for the European Central Bank. Thus, from next year, we will all be touched, directly or indirectly, by this product.

Characteristics

l In a typical transaction, the Cash Taker (the seller) gives securities as collateral against the cash loan, simultaneously agreeing to repurchase the same or similar securities at a later date. The price of the cash loan is the repo interest rate.

l For additional security and exposure cover, the Cash Provider (the buyer) can receive a margin (or "haircut") and the securities collateral are marked-to-market daily.

l The title of the securities passes to the cash provider but the cash taker retains beneficial rights.

l The cash taker may also be given permission by the buyer to substitute the pledged securities with pieces of similar quality and value.

l A standard contract governs the rights and obligations of the the two parties, including carefully crafted clauses on counterpart default. In Europe the launch and circulation of the ISMA/PSA Master Repurchase Agreement in 1992 has been one of the factors for the growth of the classic repo with the flexibility and security outlined above.

Why Repo?

There are a number of reasons in answer to this question? There are, however, two primary reasons: repo as a financing technique and as a cash management tool.

Dealer financing

Every bond-trading operation has to finance its inventory of bonds. Long positions can amount to billions of dollars for big traders. When a big position is assembled, the bonds bought have to be paid for. Now, the dealers are reluctant to use up valuable and sometimes scarce equity capital on such a nuts-and-bolts job, so they have looked to the repo market for overnight and term funding of their positions. Depending on the quality of the collateral, the dealer's credit rating, transaction size and maturity, a repo desk can trim off between one-eighth to three-quarters of a percentage point off their financing costs by putting their inventory out to work daily with customers or other dealers.

The issue of financing is most pressing for securities houses which lack a banking parent because they are unlikely to have access to short-term bank loans at preferential rates. But it is increasingly being recognised as the financier of first preference for the securities arms of, for example, European universal banks. They too are leveraged operations, even if their primary source of funding is the group bank. And often, that bank is subject to very strict limits on how much risk it is willing to take, even with a related company.

For a dealer's finance desk, a major reason for them to lend cash themselves (ie engage in a reverse repo) is to cover short positions. The cost of carrying a deliberate short position can wipe out the paper profits from the trade. Dealers are therefore increasingly using their finance desks as the first port of call to borrow bonds for delivery against a short position by doing a reverse. In return, the securities holder can receive incremental income on the temporary loan of the security.

A cash management product

A product which has its roots in dealer financing is now marketed increasingly as a secure and flexible short term cash investment alternative to other money market instruments such as certificates of deposit (CDs), call money, the deposit market and commercial paper.

Even more important for cash investors is the competitive yields that repo investments can bring. Repo rates can be generally better than deposit rates and repo transactions offer security. In principle, repo should yield less than deposits because it is collateralised. But when bond-trading desks have a large inventory to finance, repo will trade over deposits as dealers compete for the limited amount of cash available.

Above all else is the additional security that a repo brings. In general, a cash provider's concerns about shaky bank credit worthiness should be allayed not only by actual or effective ownership of the collateral in a repo agreement but also by the high credit quality of the bonds that serve as collateral. The risk in a repo transaction can be effectively transferred from counterparty risk to government risk. Additional safety is provided by the fact that the collateral is marked-to-market daily.

The other major benefit of repo is the flexibility it gives in managing short term liquid assets. Much of this flexibility stems from the variety of maturity options available. These make repo the only money market instrument that can be tailor-made to match any maturity profile required:

Overnight Repo: The trade matures in one business day

Open Repo: The counterparties agree that the cash lender will lend the money for an indefinite term. The arrangement may be terminated by either party on any day. Collateral may be substituted. The interest rate may change from day to day subject to market conditions.

Term Repo: Repos with a maturity of greater than one day. The amount loaned and the maturity are fixed.

These options allow the cash investor to specify amount, maturity and interest rate, giving him a precise position on the yield curve.

Classic repo transactions can be classified by the three different varieties of settlement and deal administration methods used. These are:

1. Delivery (or 2-party) Repo

2. Hold-in Custody (or "Trust me") Repo

3. Triparty Repo

The advantages and disadvantages of each type are summarised in the table (right).

The triparty function gives the security of delivery repo for the investor and the convenience of hold-in-custody repo for the dealer.

As in delivery repo:

l the credit structure does not change

l the delivery aspect does not change

l the standard PSA/ISMA repo agreement does not change

l the multi-currency capabilities

do not change

What is different though is that the third party agent undertakes to manage, maintain and monitor the repo transaction from the time a new deal is executed. The two parties to a repo transaction basically outsource the settlement and back-office operations to the triparty agent. This is by far the easiest, simplest and cheapest method for a pension or a money market fund to enter to start repo.

Emu and repo

Collateralisation is the buzz-word now as banks and broker dealers prepare for the single currency. More precisely, "sweating" your assets, be they cash or securities, held in Europe wide depositories, is going to be an important attribute of the successful players in the new environment. The demand for collateral will increase as financial institutions seek out assets to collateralise payments for Target, for bond borrowing to prevent expensive fails, to collateralise short term loans like repo to reduce capital adequacy charges, or to collateralise exposures from derivative transactions. The opportunities abound for asset holders to squeeze the maximum out of their portfolios for all types of financing transactions. And for investors long of cash, the Emu will increase the size of the "general collateral" market in Europe consisting mainly of EU government debt.

Saheed Awan is the senior manager for collateral & asset management at Cedel Bank in London"

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