The repo market – from “sale and repurchase” agreement – was introduced by the US Federal Reserve in 1918 as the main tool of the Federal Reserve’s Money Market Operations. Repos were used to drain liquidity from the US banking system and to add liquidity as required. The size of the Repo Market: Gross amounts outstanding at year end 2007 of roughly $10 trillion (double counting of repos and reverse repos) in the US (70% of US GDP) and €6 trillion in the Euro Repo Markets (65% of Euro-area GDP) and another $1 trillion in the UK Repo Market (Hordal and King, 2008).
The Euro Repo market has grown in size to reach €6 trillion Euros. Two thirds of the collateral is Central Government bonds from Euro area countries. In terms of country of issuance, Germany makes up ¼ of the market followed by Italy at 13%, France at 11% and other Euro area at 15%. Two thirds of repos have a maturity of one month or shorter with the rest up to one year (ECB, 2010). US Primary Dealers are the most active participants in the US market and have used repos to finance most of the growth of their balance sheets, creating pro-cyclical leverage and an exposure to refinancing risk.
In particular the top US Investment banks funded roughly half of their assets using repo markets. While the US repo market is dominated by trading in US Treasuries, there are also active markets in bonds issued by US government sponsored agencies (agencies), agency mortgage backed securities and corporate bonds (Please note that the argument by Gorton 2009, of declining haircuts on Repo transactions related only to structured products). Prior to the crisis, non-governmental collateral contributed significantly to the growth of the market.
Primary dealers are the primary suppliers of collateral in the Repo market. Other suppliers include hedge funds and institutional investors with long investment horizons e. g. pension funds etc.. e. g. in the tri-party repo market in the US (which accounts for $2. 3trillion, the top 5 collateral providers from July 2008- Jan 2010, accounted for 57% of borrowing (Copeland et al, 2010). Copeland et al (2010) provide reasons for why dealers (as in primary dealers) hold securities e. g.
Dealers provide cash to their clients, such as hedge funds, usually through a bilateral repo transaction in which the client is the collateral provider. Dealers can also rehypothecate the collateral to a cash investor through a tri-party repo and make money on the different interest rates. If the hair cut on the tri-party repo is less than on the bilateral repo, then they can make money on the extra cash obtained (Copeland et al, 2010:5). They also give the example of how dealers use repos to finance their securities purchase, enabling them to economise on the use of their capital.
An alternative way of funding for these dealers is bilateral repos. However these are not considered to be as flexible and are considered to be too costly. Unsecured funding, using Commercial Paper or Medium Term Notes also became less attractive as it was thought to be less stable and more affected by market sentiment than repos (Copeland et al, 2010). Cash investors or lenders of cash include financial intermediaries, money market mutual funds etc. They are willing to lend for short durations. They are more numerous than the collateral providers.
An important group here are securities lenders, who use the repo market to invest the cash that they receive when they lend securities. Cash providers, may provide cash for short periods because they need cash at short notice e. g. money market funds need cash to accommodate redemption requests. Some cash investors may use DvP (bilateral repos). However they require the investor to take possession of the collateral and to perform other functions that the clearing banks provide in the tri-party repo. Cash investors can also invest in unsecured instruments such as CP or certificates of deposits Copeland et al, 2010). For a good outline of the Tri-Party Repo market in the US, please see Copeland et al, 2010. For a review of the Repo market in the Euro area please see the ECB Monthly Bulletin, Feb 2010. Note: Agencies: Includes Federal agencies, which are fully owned by the US government and have been authorised to issue securities in the marketplace. Interest income on securities issued by federally related institutions is exempt from State and Local Income Tax. Also includes Government Sponsored Agencies, which are privately owned, publicly chartered entities.
A government-sponsored enterprise is a shareholder-owned company created by Congress to serve a public purpose (i. e. farmers, homeowners and students). Examples include Freddie Mac and Fannie Mae. What is a Repo Transaction? A repo agreement is a transaction in which one party sells securities to another (Sale) and at the same time and as part of the same transaction, commits to repurchase securities on a specified date and at a specified price (Repurchase). A typical repo leads to an outflow of collateral and an inflow of cash. A Reverse Repo leads to an inflow of collateral and an outflow of cash. Central Banks view such transactions from the point of view of their banker/dealer counterparties with repos temporarily adding reserve balances to the banking system while reverse repos temporarily draining balances from the system. ]
There are 2 parties to a repo trade. Bank A is the “seller” of the securities (Repo Seller or Cash Borrower) and Bank B is the “buyer” of the securities (Repo Buyer or Cash Lender). On the trade date the 2 banks enter into an agreement whereby on a set date, the settlement date Bank A will sell to Bank B a nominal amount of ecurities in exchange for cash. The price paid for the securities will be linked to the settlement price of the stock on the trade date. The agreement also demands that on the termination or maturity date Bank B will sell identical stock back to Bank A at the previously agreed price, and consequently Bank B will have its cash returned with interest at the agreed repo rate. |Example 1: | |On 6th September, Bank A agrees to sell £1m nominal of UK gilts which is trading at a dirty price of 104. 3. The agreement will| |begin on the value date, the 7th September.
The term of the trade is 30 days so the termination date is 7 October 2007 and the| |agreed repo rate is 6. 75%. On the 7th September Bank B receives £1m nominal UK gilts, which has a settlement value of | |£1,043,000. On the 7th October, Bank A receives back the specific gilts and returns the original cash amount of £1,043,000 | |along with repo interest of £5786. 50. | | | |The repo interest rate in the example is based on a 30 day repo rate of 6. 75% and a 365 day count basis which is the | |convention in the sterling markets.
If the repo had been conducted for the US dollar bond, the interest would have been | |calculated on a 360 day basis. Repos are agreed at the time of the trade and are quoted, like all interest rates on an | |annualised basis. | | | |[pic] | | | |The settlement price (dirty price) is used because it is the market value of the bonds on a particular trade date and | |indicates the cash value of the gilts. The object is to minimise the credit exposure by equating the value of the cash with | |the collateral. |
The main elements of a repo are maturity, the nominal amount, the interest rate, the collateral: i) Maturity: Most Repos have a fixed maturity, which can range from one day to one year. There are 3 types of repos with a maturity of one day: Overnight Repos: Traded and Settled on the same day and mature the day after. (This type of repos and their weaknesses are discussed by Copeland et al, 2010. ) Tomorrow/Next Repos: Settled one day after the trade and mature 2 days after the trade Spot/ Next Repos:
Settled 2 days after the trade and mature 3 days after the trade i) Interest rate: The repo rate is the interest rate that determines the interest payment made by the cash borrower at the end of the repo (the % of the nominal amount that is to be paid out as interest). The majority of repos have a fixed repo rate. iii) Collateral: Parties may agree on a specific type of collateral (ISN Code) for the transaction (Special Repos) or may specify a basket of assets (General Collateral Repo). The cash borrower decides on which type of asset to actually provide. General Collateral Repos are cash driven. Special Repos are Securities driven.
The Repo rate on Specials may be below the General Collateral Repo rate because there is a high demand for them. In this case repo traders say that the security is “on special”. In a Repo Transaction, the collateral is legally transferred from the borrower to the lender. If the cash borrower defaults, then the cash lender (Repo Buyer) can sell the security immediately (i. e. does not have to wait for insolvency). To ensure that both parties are protected against default, the collateral value and the cash value of the repo should be close to each other.
If the former is less than the latter, then the Repo Buyer (cash lender) loses if the borrower defaults. Hence the collateral is valued at the dirty price (i. e. including interest accrued) mid-market price. However it may not be possible to sell the asset at that price hence the need for a “margin” or a “haircut”. In principle either the cash or the collateral provider may have to post margin (See Copeland et al, 2010:78 for a discussion on this). What types of Collateral are accepted: In most cases only the most liquid forms of collateral are accepted.
Less Liquid assets such as Corporate Bonds and Asset Backed securities are not used as much. Reasons: They provide a lower level of protection to the cash lender because they are more difficult to mark to market and the liquidation value may be less than the previous market value. A way around this would be to impose a larger haircut. However borrowers may not be willing to accept a large haircut. Why? Because the lender may also default and not repay back the collateral. Where the value of the collateral is valued higher than the loan, the borrower will keep the cash but will still have a net claim on the lender, which may be lost.
The expected net claim and the potential losses will be larger when haircuts are larger. Thus there will be a larger expected loss associated with large haircuts. So the lender will accept illiquid assets but with a large haircut whereas the borrower will not be willing to accept a large haircut. So the assets that will be accepted first are highly liquid assets with small haircuts. The assumption here is that the lender could default which makes the borrower willing to accept larger haircuts. So borrowers may be willing to use less liquid assets as collateral in a repo transaction with the ECB as the latter will not default.
Also it enables then to use the more liquid assets in the private repo market (ECB, 2010). iv) The market value of the collateral may change over the life of the repo. To adjust for the asset price changes, variation margin is used and the collateral is marked to market on a daily basis and additional deposits (or collateral) is provided or subtracted. See Copeland et al, 2010:12-16 for a description of the mechanics of a tri-party repo during the global crisis and some of the difficulties involved in this market. Use of Repos: Repo as a Financing Transaction
To finance a long position, money can be borrowed unsecured in the interbank market. However a collateralised loan will invariably be offered at a lower rate. Money market investors (with cash) finance bond traders by lending out cash in a repo. They receive general collateral in return for the cash. It is a secured loan. The cash investor receives the repo rate of interest for making the loan. The advantages of a repo transaction for a cash investor are: ? It is a secured investment ? The returns are competitive with bank deposits and occasionally higher ? It is a diversification from bank risk
If cash is the desired asset, the compensation for its use is simply the repo rate of interest paid on it. In a financing transaction, the dealer is paying the repo rate on the investor’s cash. The General Collateral rate (in which a basket of collateral can be supplied as long as it is the required type and credit quality) would be below LIBOR reflecting its role as a secured loan. GC Repos are always cash driven. A bond trader will enter into a reverse repo when he requires a specific issue (“specials”) to deliver in a short sale. In this case the trader is orrowing bonds and putting up cash as collateral. The bond trader receives the repo rate on his cash. If the bond is particularly sought after the repo rate that he receives may be significantly below a general collateral rate – it may be zero or even negative. By convention whether the transaction is called a repo or a reverse repo is determined by viewing the transaction from the dealer’s perspective. If the dealer is borrowing money from a customer and providing securities as collateral, the transaction is called a Repo (Sale and Repurchase Agreement).
If the dealer is borrowing securities (which serve as collateral), and lends money to a customer, the transaction is called a reverse repo. When someone lends securities in order to receive cash (i. e. borrow money), that party is said to be “reversing out” securities. Correspondingly a party that lends money with the security as collateral for the loan is said to be “reversing in” securities. When a dealer says that he is going “to repo securities”, this means that he is going to finance securities using the securities as collateral. To do repo” means that the investor is going to invest in a repo as a money market instrument – finance some else’s securities.
Risks in the Repo Transaction: Repos are subject to various types of Risk: i) Counterparty Credit Risk: Although the legal title of the security is transferred to the cash provider, the seller retains both the economic benefits and the market risk of owning them. The cash provider can sell the security in the event of default. The nature of the collateral is important – a repo against a basket of non-specific government securities (known as a general collateral repo) is associated with the lowest level of risk. i) Market risk: This is the risk of a change in the value of an asset due to movement in market prices. The main risk in a repo transaction is market risk. What happens if the collateral declines in value? The loan is greater than the value of the collateral therefore the loan is under-collateralised. To allow for this, repos feature an initial “margin/haircut” where the quantity of cash (or securities) delivered is adjusted to ensure over-collateralisation, typically in favour of the cash provider. The collateral is marked to market every morning.
The size of the “haircut” reflects the market risk of the collateral, with longer maturity bonds and lower rate securities requiring higher margin due to their higher price volatility. Copeland et al (2010) find that some dealers in tri-party repos face higher haircuts than others even on the same collateral. iii) Funding/Liquidity Risk: The cash lender receives collateral. However what is important here is how liquid this collateral is – can it be converted into cash.
The less liquid this is, the higher the funding liquidity risk premium. v) Operational Risk: Relates to the transfer and management of the collateral. Settlement is typically delivery versus payment where cash is delivered against the receipt of collateral simultaneously (Is there a mismatch in timing – Daylight Risk Exposure). Either party to a security can fail to deliver. A “Fail” to deliver a security is a situation in which a trade involving a security does not settle on schedule. Another operational risk is who holds the collateral. Bilateral Repo: The collateral is held on the balance sheet of the cash provider, granting immediate access in the event of default on the loan.
However it may be too expensive to deliver the collateral especially if is overnight. The risk of not actually taking possession of the collateral is that the borrower may sell the collateral or use the same security as collateral for a repo with another counterparty. Tri-party Repo: The clearing bank provides intermediation services to the cash investor and the collateral provider. In the US market there are 2 clearing banks – JP Morgan Chase and the bank of New York Mellon. This is popular because of the efficiency gains associated with the intermediation role of the clearing bank.
The clearing bank takes custody of the collateral, they value the securities and decides on the number of securities that need to be placed as collateral for a fixed amount. They update the prices of the securities on a daily basis and undertake to confirm each day to the investor that their cash remains fully collateralised – carries out daily marking to market and a substitution of collateral if required. Therefore it reduces the cost for the end- investor. By taking custody of the collateral, the clearing banks provide a guarantee that the collateral is available in case of default of the collateral provider.
This reduces the legal risk facing the cash investor. The cash investors and the collateral providers hold balances and securities accounts on the books of the clearing bank. Illiquid assets are more important for tri-party repos than for other repos. This is because they specialise in pricing these assets. However the share of these in tri-party’s would have fallen during the Financial Crisis. Hold in Custody Repo: In a Hold in Custody Repo – the security lender continues to hold the bond on their own balance sheet in a segregated account, raising the risk to the cash provider.
Why might they do that? If the dealer needs to substitute collateral once or twice during the deal, the settlement costs involved may make the deal unworkable. Therefore the dealer may offer to hold the securities himself against the investor’s cash. The advantage is that no settlement charges are incurred as the securities do not physically move. However it is risky for the investor because he only has the dealer’s word that their cash is fully collateralised. What can affect Repo Rates? There is no one single repo rate.
It depends on the maturity, the quality of the collateral, delivery requirement, availability of the collateral and the underlying interest rate. A dealer can run a matched book by simultaneously entering into a repo and a reverse repo for the same collateral and for the same period. It does so to capture the spread. For example where Repo rates are lower than Reverse Repo rates a dealer enters into a term repo for one month with a money market mutual fund (cash rich). The dealer is a Repo Seller and cash borrower.
At the same time it enters into a reverse repo transaction as a Repo Buyer or cash lender. Given the data on rates above, the reverse repo rates are higher than the repo rates and the dealer is locking in this spread. However traders will deliberately mismatch their books to take advantage of the short-term yield curve e. g. Borrow funds short term and lend them long term. The more difficult it is to obtain the collateral, the lower the repo rate will be. If a “special” is required, then a lower rate will be charged for funds lent.
Financial crisis will also have an impact on the “specialness” of a bond, which is defined as the spread between the general collateral rate and the repo rate of a particular security. However the money market rates generally will determine the cost of a repo. In general repo rates will be lower because they are secured. In the “special” repo market high demand for a particular security can exert substantial downward pressure on repo rates for transactions involving that security as it becomes increasingly scarce. This funding can then be lent out as either secured funding (in a repo) or as unsecured lending.
In times of severe market turbulence, surging demand for safe government securities (they have become special) and a general unwillingness to repo them can result in a downward pressure on rates for the GC repo market as a whole. Repo Fails: In a fail, a seller does not deliver the securities it promised to a buyer on the scheduled settlement date. The convention is to reschedule delivery for the next day at an unchanged price. During the financial crisis, there was a large increase in the number of Treasury fails due to the scarcity of US treasuries.
The very low interest rates at that time increased the problem by reducing the cost of fails. If the seller does not have the securities, it generally would enter into a reverse repo and borrow the security. Remember that if he/she borrows the security, he/she is a cash investor. In the case of specials, there is a “specials” rate for a security. If the demand to borrow a security is strong or the supply of the security is limited, the specials rate for a security may be materially below the general collateral rate and the specialness spread is correspondingly very large.
The “specialness spread” will depend on the demand for borrowing the security with the availability of the supply of the security for lending. A larger spread will result in greater supply because it offers a greater reward to those lending specials (and borrowing money in that market) and relending that cash in the GC market. A larger spread also reduces the demand for borrowing the special security. A particular security is usually borrowed to finance a short position in that security. An increasing spread, increases the cost of financing a short position and reduces the attractiveness of being short.
As the specials rate for a security approaches zero, those with short positions may select to fail on their delivery. Why lend money at negligible rates (or zero rate) when you could instead fail to deliver? The convention that has emerged over time in the market is that of allowing the failing seller to make delivery the next business day at an unchanged invoice price. But settlement fails are not costless. The most significant cost is the money that could have been lent out on the Federal Funds or general collateral markets. This is a significant cost for the seller.
The incentive for a seller to borrow securities to avoid or cure a fail declines with the specials rate for the security. When the specials rate is near zero, a seller has little to gain lending money (at nearly no interest) to borrow the needed securities. These fails can be costly for the market as a whole. (i) They increase counterparty credit risk (ii) fails generate increased administrative and legal costs and may worsen relations between different counterparties (iii) reduce market liquidity as those in the market prefer to withdraw (Fleming and Garbade (2010)).