REPO Structure and terminology

Question Posted / shinoj.k.s.

REPO Structure and terminology..

Answer / shinoj.k.s.

A repo is economically similar to a secured loan, with the

buyer (effectively the lender or investor) receiving

securities as collateral to protect against default of the

seller (effectively the borrower). Almost any security may

be employed in a repo, though practically speaking highly

liquid securities are preferred because they are more

easily disposed of in the event of a default and, more

importantly, they can be easily secured in the open market

where the buyer has created a short position in the repo

security through a reverse repo and market sale; by the

same token, illiquid securities are discouraged. Treasury

or Government bills, corporate and Treasury/Government

bonds, and stocks may all be used as "collateral" in a repo

transaction. Unlike a secured loan, however, legal title to

the securities clearly passes from the seller to the buyer.

Coupons (installment payments that are payable to the owner

of the securities) which are paid while the repo buyer owns

the securities are, in fact, usually passed directly onto

the repo seller. This might seem counterintuitive, as the

ownership of the collateral technically rests with the

buyer during the repo agreement. It is possible to instead

pass on the coupon by altering the cash paid at the end of

the agreement, though this is more typical of Sell/Buy

Backs.

Although the underlying nature of the transaction is that

of a loan, the terminology differs from that used when

talking of loans because the seller does actually

repurchase the legal ownership of the securities from the

buyer at the end of the agreement. So, although the actual

effect of the whole transaction is identical to a cash

loan, in using the "repurchase" terminology, the emphasis

is placed upon the current legal ownership of the

collateral securities by the respective parties.

The following table summarizes the terminology:

Repo Reverse repo

Participant Borrower

Seller

Cash receiver Lender

Buyer

Cash provider

Near leg Sells securities Buys securities

Far leg Buys securities Sells securities

Types of repo and related products

There are three types of repo maturities: overnight, term,

and open repo. Overnight refers to a one-day maturity

transaction. Term refers to a repo with a specified end

date. Open simply has no end date. Although repos are

typically short-term, it is not unusual to see repos with a

maturity as long as two years.

Repo transactions occur in three forms: specified delivery,

Tri-party, and held in custody. The third form is quite

rare in developing markets primarily due to risks. The

first form requires the delivery of a prespecified bond at

the onset, and at maturity of the contractual period. Tri-

party essentially is a basket form of transaction, and

allows for a wider range of instruments in the basket or

pool. Tri-party utilizes a tri-party clearing agent or bank

and is a more efficient form of repo transaction.

Due bill/hold in-custody repo

In a due bill repo, the collateral pledged by the (cash)

borrower is not actually delivered to the cash lender.

Rather, it is placed in an internal account ("held in

custody") by the borrower, for the lender, throughout the

duration of the trade. This has become less common as the

repo market has grown, particularly owing to the creation

of centralized counterparties. Due to the high risk to the

cash lender, these are generally only transacted with

large, financially stable institutions.

Tri-party repo

The distinguishing feature of a tri-party repo is that a

custodian bank or international clearing organization, the

tri-party agent, acts as an intermediary between the two

parties to the repo. The tri-party agent is responsible for

the administration of the transaction including collateral

allocation, marking to market, and substitution of

collateral. Tri-party agents administer US$ trillions of

collateral. They therefore have the scale to subscribe to

multiple data feeds to maximise the universe of coverage.

As part of a tri-party agreement the three parties to the

agreement, the tri-party agent, the repo buyer and the repo

seller agree to a collateral management service agreement

which includes an "eligible collateral profile". It is

this "eligible collateral profile" that enables the repo

buyer to define their risk appetite in respect of the

collateral that they are prepared to hold against their

cash. For example a more risk averse repo buyer may wish to

only hold non-financial, primary market, equity as

collateral. In the event of a liquidation event of the repo

seller the collateral is highly liquid thus enabling the

repo buyer to sell the collateral quickly. A less risk

averse repo buyer may be prepared to take non investment

grade bonds as collateral, these may be less liquid and may

suffer a higher price volatility in the event of a repo

seller default, making it more difficult for the repo buyer

to sell the collateral and recover their cash. The tri-

party agents are able to offer sophisticated collateral

eligibility filters which allow the repo buyer to create

these "eligibile collateral profiles" which can

systemically generate collateral pools which reflect the

buyer's risk appetite.[clarification needed] Collateral

eligibility criteria could include asset type, issuer,

currency, domicile, credit rating, maturity, index, issue

size, average daily traded volume, etc. Both the lender

(repo buyer) and borrower (repo seller) of cash enter into

these transactions to avoid the administrative burden of bi-

lateral repos. In addition, because the collateral is being

held by an agent, counterparty risk is reduced. A tri-party

repo may be seen as the outgrowth of the due bill repo, in

which the collateral is held by a neutral third party.

Whole loan repo

A whole loan repo is a form of repo where the transaction

is collateralized by a loan or other form of obligation

(e.g. mortgage receivables) rather than a security.

Equity repo

The underlying security for most repo transactions is in

the form of government or corporate bonds. Equity repos are

simply repos on equity securities such as common (or

ordinary) shares. Some complications can arise because of

greater complexity in the tax rules for dividends as

opposed to coupons.

Sell/buy backs and buy/sell backs

A sell/buy back is the spot sale and a forward repurchase

of a security. It is two distinct outright cash market

trades, one for forward settlement. The forward price is

set relative to the spot price to yield a market rate of

return. The basic motivation of sell/buy backs is generally

the same as for a classic repo, i.e. attempting to benefit

from the lower financing rates generally available for

collateralized as opposed to non-secured borrowing. The

economics of the transaction are also similar with the

interest on the cash borrowed through the sell/buy back

being implicit in the difference between the sale price and

the purchase price.

There are a number of differences between the two

structures. A repo is technically a single transaction

whereas a sell/buy back is a pair of transactions (a sell

and a buy). A sell/buy back does not require any special

legal documentation while a repo generally requires a

master agreement to be in place between the buyer and

seller (typically the SIFMA/ICMA commissioned Global Master

Repo Agreement (GMRA)). For this reason there is an

associated increase in risk compared to repo. Should the

counterparty default, the lack of agreement may lessen

legal standing in retrieving collateral. Any coupon payment

on the underlying security during the life of the sell/buy

back will generally be passed back to the seller of the

security by adjusting the cash paid at the termination of

the sell/buy back. In a repo, the coupon will be passed on

immediately to the seller of the security.

A buy/sell back is the equivalent of a "reverse repo".

Securities lending

The general motivation for repos is the borrowing or

lending of cash. In securities lending, the purpose is to

temporarily obtain the security for other purposes, such as

covering short positions or for use in complex financial

structures. Securities are generally lent out for a fee.

Securities lending trades are governed by different types

of legal agreements than repos.

Reverse Repo

A reverse repo is simply the same repurchase agreement from

the buyer's viewpoint, not the seller's. Hence, the seller

executing the transaction would describe it as a "repo",

while the buyer in the same transaction would describe it

a "reverse repo". So "repo" and "reverse repo" are exactly

the same kind of transaction, just described from opposite

viewpoints. The term "reverse repo and sale" is commonly

used to describe the creation of a short position in a debt

instrument where the buyer in the repo transaction

immediately sells the security provided by the seller on

the open market. On the settlement date of the repo, the

buyer acquires the relevant security on the open market and

delivers it to the seller. In such a short transaction the

seller is wagering that the relevant security will decline

in value between the date of the repo and the settlement

date.

Reverse Repo Rate

3.50% (w.e.f. (19/03/2010) Increased from 3.25%, which was

continuing since 21/04/2009.

Uses For the buyer, a repo is an opportunity to invest cash

for a customized period of time (other investments

typically limit tenures). It is short-term and safer as a

secured investment since the investor receives collateral.

Market liquidity for repos is good, and rates are

competitive for investors. Money Funds are large buyers of

Repurchase Agreements.

For traders in trading firms, repos are used to finance

long positions, obtain access to cheaper funding costs of

other speculative investments, and cover short positions in

securities.

In addition to using repo as a funding vehicle, repo

traders "make markets". These traders have been

traditionally known as "matched-book repo traders". The

concept of a matched-book trade follows closely to that of

a broker who takes both sides of an active trade,

essentially having no market risk, only credit risk.

Elementary matched-book traders engage in both the repo and

a reverse repo within a short period of time, capturing the

profits from the bid/ask spread between the reverse repo

and repo rates. Presently, matched-book repo traders employ

other profit strategies, such as non-matched maturities,

collateral swaps, and liquidity management

Is This Answer Correct ?

3 Yes

1 No

Post New Answer