Repo markets are extremely important. They are large and highly liquid. In the US, for example, the daily average outstanding amount is some US$4.5 trillion , while in Europe, the total value of repos is over €6 trillion .
This high liquidity reflects the vital role repo plays as a lubricant for the financial system. It is used by central banks to manage liquidity, by brokers and dealers to provide short-term financing for their everyday operations, and by investors and corporates to manage cash.
Repo Basics
To understand how repo can help corporates manage cash and risk, it is necessary to understand how the market works and some of the issues that have an impact. These include operational difficulties and regulation.
For example, the markets have contracted since the financial crisis under the weight of new regulation and deleveraging by banks and dealers. Basel III and Europe’s Financial Transaction Tax (FTT) might further affect them.
Repo is short for repurchase agreement. An organisation sells financial assets, such as gilts, bonds and mortgage-backed securities for cash. As it does so, it makes a promise to buy back those assets on an agreed date and for the same price plus interest from the buyer of the assets.
Because sellers are offering collateral for cash, they are called borrowers, while buyers are lenders.
If the borrowers are unable to buy back the assets at the agreed time and price, then lenders can sell them elsewhere to recover their cash. Borrowers and lenders take on their respective burdens of the transaction. A repo deal is effectively a collateralised loan.
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Historically, repo developed as a cost effective way for dealers to finance inventory – especially fixed-income securities – and their short-term financing needs. However, corporates can lend cash to dealers or even banks, in return for acceptable collateral and, often make a better return for lower risk than depositing the money in a bank.
Repo gained a new prominence during the liquidity crisis that preceded the full-blown implosion of the financial system in 2008 as investors became aware of the credit risks associated with banks.
While deposits are essentially an unsecured loan to a bank, a repo transaction is effectively a collateralised loan to a market player. The creditworthiness of the collateral can greatly mitigate counterparty credit risks, provided the collateral is priced correctly and up-to-date.
A wide range of asset classes can be used as collateral. The most popular tend to be highly liquid, carry strong credit ratings and are traded in open and transparent markets where up-to-date mark to market prices can be readily obtained. Assets whose legal titles can be transferred easily and traded electronically are also preferred.
Government and agency securities, mortgage-backed securities, corporate bonds and money market instruments are the most common collateral.
High-quality collateral, such as government bonds, can command rates much lower than Libor. Among the most popular at the moment are AAA-rated European government bonds and US Treasury securities.
Repo Relevance for Treasurers
Despite this, repo is a viable alternative for corporate treasurers to investing in short-term government bonds, such as US Treasury Bills because it is a big and liquid market and, more importantly, offers credit protection to buyers and sellers without sacrificing yield.
There are other advantages, particularly to those providing the liquidity. They have the flexibility with regards to the term of their investment. The most popular maturities range from overnight to three months, although deals can be struck for up to a year.
More flexibility is provided by the use of ‘open repos’, where overnight transactions are allowed to roll over until terminated unilaterally by one of the parties, and ‘evergreen’ repos. These are term repos that are rolled over until the lender terminates the extension. In this case, the loan will mature when the next term is up.
Lenders can also decide on what assets they would like to accept based on criteria such as credit risk and yields. The hair cut, or margin, on the collateral depends on factors such as ratings, price volatility and the counterparty’s credit risk.
Repo Risks to Consider
There are risks. Lenders need to watch out for ‘Wrong Way Risk’, when the credit risk of the collateral is highly correlated with that of the borrower. For example, if a dealer uses real-estate loans in its inventory as the basis for an investment-grade commercial paper, and then uses that commercial paper as collateral for a repo deal, the lender might not get the protection it thinks it is.
Another issue that has deterred investors and corporates from making more use of the repo markets has been the administrative and operational burdens associated with transacting a deal. Over the years, the documentation has become more standardised. The two most common documents are the Master Repurchase Agreement and the Global Master Repurchase Agreement. One master agreement can cover all subsequent repo transactions conducted by the two parties.
The way in which a repo deal is transacted can also make a difference to the operational problems faced by a corporate wanting to use the markets.
The most burdensome method is called bilateral repo. This involves collateral, usually comprising a number of different securities, delivered from the custodian bank of the borrower to that of the lender. Settlement instructions for each security have to be conveyed to both custodian banks. It is no wonder that many potential lenders have been deterred from participating in the market.
However, these issues are addressed by an alternative way of transacting repo. Tri-party repos are where a borrower and lender agree on a common custodian bank. They then negotiate what securities and associated haircuts are acceptable as part of the collateral. Once the bank knows the collateral delivered by the borrower is suitable, it releases the cash and holds the collateral until maturity. The borrower typically pays the bank’s fees.
Tri-party transactions also make it easier for lenders to know that collateral is being accurately priced. If there is insufficient collateral, the bank can simply move more into the lender’s account.
Recent Regulatory Impact
The liquidity crisis of 2007 exposed the potential shortcomings in the market and showed that repo can be a double-edged sword if not used properly. Then a collapse in the US housing market caused a catastrophic loss of confidence in the mortgage-backed securities used widely as collateral for repo. The markets froze until the Fed stepped in to provide liquidity to the dealers.
Brokers, dealers and regulators have combined to resolve some the concerns around the market and provide better protection for lenders. For example, the introduction of negative interest rates has greatly reduced the number of settlement failures in the repo markets.
Regulation is also addressing some of the problems the market experienced around the mismatch between assets and liabilities by the dealers. In a normal yield curve, the shorter the tenor, the lower the rate paid. From a borrower’s point of view, this means it is always cheapest to use short-term financing. Taking this to an extreme implies every security should be financed using overnight repo.
In theory, repo can also be used to achieve unlimited leverage: a borrower can use a security to raise funds, which can then be used to buy more securities to raise funds … and so on.
The leverage and capital rules being introduced with Basel III will establish a framework for reducing systemic risk, but perhaps at the expense of some liquidity.
Some of the rules pose a more dangerous threat to the market. A flat tax on the market value of collateral, regardless of the terms of repo, as proposed in the Financial Transaction Tax (FTT), will greatly shrink the repo market. The FTT is designed to discourage banks from risky activities while also raising government revenues. However, it will drive up funding costs for banks, especially for very short-term repo trades where rates – and margins – are thin.
As repo is actually a low-risk funding source for banks, then the rules will have to be modified, perhaps by exempting the repo markets altogether.
This would also affect the value of the markets to corporates who should, nonetheless, consider using it as an invaluable way of managing their cash.
[1] Source: Securities Industry and Financial Markets
Association.
[2] Source: European Repo Council of the International
Capital Market Association’s latest survey of 65 institutions at close of
business on 12 June 2013.