The Tri-party Repo: The Latest Short-Term Investment Option
Developing and maintaining an efficient liquidity management strategy is a challenge, considering the abundance of short-term investment and account management products and services. Management is faced with many choices including banking partners, concentration methods, benchmarking options, cash forecasting packages, and money market investment instruments. Through an efficient liquidity allocation procedure (centralizing the firm’s account structure, concentrating balances, maintaining an updated investment policy, forecasting cash balances, and allocating capital across money market instruments), investment options are evaluated and filtered, leaving management with a concise list of appropriate investment vehicles from which to choose. The benefits of an efficient liquidity allocation procedure are two-fold. First, the process enables decision-makers to more easily identify the investment options that meet the firm’s objectives on a risk-adjusted return basis. Second, the procedure provides management with a tool to evaluate money market investment options introduced and modified by financial solutions providers.
A repurchase agreement (repo) is a money market instrument that offers yield enhancement opportunities to the repo buyer (investor) with terms that vary from overnight to longer maturities. Repo deals can be negotiated in various currencies, providing firms with a tool for short-term foreign exchange management. Overnight repo transactions also provide investors with a way to manage daily liquidity. A firm can diversify the short-term investment portfolio by allocating liquidity across repo and other money market investments to reduce concentration risk and achieve an efficient short-term investment portfolio, characterized by maximized risk-adjusted return. Because rates are negotiated on a frequent basis, repo deals can outperform other money market instruments in a rising rate environment.
Although the repo market offers benefits to investors that are seeking short-term investment solutions, investment barriers prevent widespread use of this money market instrument. Repo deals are reserved for investors with significant cash balances (typically US$100m or higher), which results in an exclusivity barrier where firms with smaller cash balances are unable to participate in the repo market. Investment policies may reject repo transactions due to the existence of counterparty risk. The required reporting and administration of repo deals can make these transactions less lucrative due to the costs incurred by investing in required staff and technology. Collateral management and safekeeping also result in complications that can bar repo investments.
Tri-party repo is a lesser-known money market instrument that is available for short-term investment allocation. Market innovation and advances in technology are enabling firms to bypass the repo market barriers through the use of tri-party repo, which provides investors with a way around the repo market barriers through intermediation while overcoming exclusivity, counterparty risk, and operational complications that are inherent in classic repo. The result is a solution that enables a wider range of investors to access the repo market, and positions this investment option in the short-term investment portfolio.
The key difference between classic repo and tri-party repo is the addition of a deal intermediary in the tri-party repo setup. In a traditional repo, buyers (investors) deal directly with sellers (cash borrowers), while collateral, term, cash amount, and rate are negotiated. Tri-party repo involves an intermediary that is responsible for pooling investment amounts, administering the flow of capital and collateral, safekeeping, reporting, and collateral management, thereby bypassing the investment barriers to the repo market, as shown in Figure 1.
Tri-party repo bypasses the exclusivity barrier of classic repo. Firms with balances that do not meet the required cash level in classic repo transactions can pool their cash balance with other investors, resulting in an overall aggregate balance that meets the minimum cash amount required in classic repo. Tri-party repo participants subsequently receive a pro rata share of the overall return. This pooling feature allows smaller investors to realize the yield enhancement opportunities in classic repo without the additional liquidity that is typically required.
Figure 1 shows the operational flow of a typical tri-party repo deal where buyers’ balances are transferred to the intermediary that aggregates individual positions and transfers the aggregate amount to the counterparty. The intermediary also values and places the collateral in safekeeping, and then reverses the deal at the end of the term.
Tri-party repo also eliminates the administrative, counterparty risk, and collateral management investment barriers through deal intermediation. An intermediary handles the reporting and coordination of the security and cash flow between the deal parties, as shown in Figure 1. The intermediary also manages collateral by testing the value of the securities to confirm that the dollar amount pledged by the investor is fully collateralized and meets the requirements of the investor. Counterparty risk is avoided by ensuring that enough collateral is in safekeeping for liquidation in the case of counterparty default. In cases where the term of the deal extends beyond overnight, the collateral is marked to market and levels are adjusted accordingly to ensure that the invested balance remains fully collateralized throughout the term of the arrangement. These intermediation tasks allow the investor to focus on return and other core competencies without the burden of operational and administrative duties.
Beyond avoiding investment barriers through deal intermediation, tri-party repo offers additional benefits that should be considered when managing the firm’s short-term investment portfolio. The Basel II Accord encourages collateralization, diversification, and efficiency; and by meeting these criteria, tri-party repo arrangements may be treated favorably in terms of capital relief. Tri-party repo transactions provide investors with greater control over portfolio return by allowing buyers to choose the underlying collateral. Investors can enhance yield by moving from risk free collateral (US Treasuries) to riskier collateral (agencies). Firms can realize diversification benefits by including multiple investment instruments in the short-term investment portfolio. Typically, repo market participants have mid-morning investment cutoffs; however, tri-party repo deal investment cutoffs can be extended to later in the day. The liquid nature of repo deals and the ability to determine the term of the deal give investors the access to potentially higher rates of return without the capital lockup inherent in other short-term investment instruments, such as auction rate securities (ARS), and certificates of deposit (CDs).
Investors can receive additional benefits in cases where the firm’s concentration bank is also the intermediating custodian in the tri-party deal due to account management efficiencies. Clients can realize the competitive rate of return while also receiving additional account management services, such as account sweeping, managing and pooling multiple accounts, and maintaining a custody account with the same service provider. These operational efficiencies provide management with the tools to manage balances across the account structure while actively engaging in short-term investment activities that enhance yield and reduce risk.
To enhance risk-adjusted return on a firm’s liquidity position, management must develop and maintain an efficient and diversified short-term investment portfolio. Tri-party repo is a money market instrument that provides the benefits of traditional repo products while circumventing barriers to investment for market participants. Value-added services through intermediation provide additional benefits to investors beyond the opportunity for yield enhancement, and these benefits are further amplified when the concentration bank is also the intermediary in the tri-party deal. Management must therefore consider the yield enhancement potential along with the value-added benefits of tri-party repo when defining the firm’s liquidity allocation procedure.