An Introduction to Repo Markets

Moorad Choudhry

• Publisher: Wiley
• Year: 2011
• Print ISBN:
  9780470017562
• eBook ISBN:
  9781119995005
• Edition: 3
• Topic: Negocios y empresa
• Subtopic: Finanzas

The Repo markets have grown dramatically in the past few years because of the need to hedge short positions in the capital and derivatives markets. Virtually all major currency markets in the world now have an established repo market, the facility is also increasingly being used in developing currency markets as well.

This book is a practical introduction that focuses on the instruments, applications and risk management techniques essential for this rapidly evolving market. Fully updated to reflect the changes in these markets, the book also includes worked examples and case studies, and new sections on basket and structured finance repo.

Chapter 1

INTRODUCTION TO REPO

The repo market is a vital element of the global capital and money markets. The first repo transactions were initiated by the US Federal Reserve in 1918, since which time repo has become the main instrument of open market operations for virtually all central banks around the world. It is also a major component of the global money markets. The market experienced substantial growth during the 1990s and is now estimated to account for up to 50% of daily settlement activity in non-US Government bonds world-wide; this is a phenomenal figure. Daily outstanding volume in international repo transactions has been estimated at between £440 billion to £450 billion; in the USD domestic market, daily deal volume is over $1,000 billion.

Repo, from ‘sale and repurchase agreement’, is closely linked to other segments of the debt and equity markets. From its use as a financing instrument for market makers to its use in the open market operations of central banks, and its place between the bond markets and the money markets, it integrates the various disparate elements of the marketplace and allows the raising of corporate finance across all sectors.

Repo is an interesting product because, although it is a money market product by dint of the term to maturity of repo trades, the nature of the underlying collateral means that repo dealers must be keenly aware of the assets that they ‘trade’ as well. The assets will be bonds, equity or other collateral of value. This multi-faceted nature of repo is apparent in the way that banks organise their repo trading. In some banks it is part of the money market or Treasury division, while in other banks it will be within the bond trading area. Equity repo is sometimes a back-office activity, as is the longer established stock borrowing desk. However, it is not only commercial and investment banks that engage in repo transactions. Across the world, repo is a well-established investment product, utilised by fund managers, hedge funds, corporate treasuries and local authorities. The practicality and simplicity of repo means that it can be taken up even in capital markets that are still at an ‘emerging’ stage, and by a wide range of participants. It is traded in virtually every country with a debt capital market.

The use of repo enhances the liquidity of bond and equity markets, which reduces costs for issuers of capital, and allows market makers to hedge positions with greater efficiency. Given its size and importance, it is surprising that repo has such a low profile – for example, there is little discussion of it in the financial press. This reflects the simple and straightforward nature of the instrument. Indeed, the fundamental nature of repo is its simplicity: the sale of securities coupled with an agreement to repurchase them at a future date – in other words, a secured loan of cash. It is this simplicity and flexibility that has allowed repo to be used for a variety of purposes, or to meet a range of requirements.

IMPORTANCE OF REPO

Previous literature highlights the importance of the repo market. In Professor Frank Fabozzi’s book Securities Lending and Repurchase Agreements (FJF Associates 1997), Kenneth Miller of Goldman Sachs writes:

The global fixed income markets could not be as large as they are today without the parallel existence of a highly liquid, low credit risk vehicle in which participants can borrow cash and securities. The repurchase agreement (repo) is the foundation for the fixed-income markets. Without repo, the development of a liquid derivatives market, notably swaps and financial futures, would not have been possible. (p. 13)

Robert Sloan of Credit Suisse First Boston writing in the same book states:

If one looks at many fixed income desks, it is easy to see that the repo desk is at the hub of the trading floor... the repo desk is the centre of activity ... the repo desk functions as the spoke in the wheel for almost all fixed income activities: government [bond] auctions, option pricing, corporate bond financing and customer leverage...

The repo desk is also organized to fund the firm’s inventory. This was the original intent of the repo desk. (p. 248)

So we can see that repo is an important product and a vital part of the financial markets. Most market participants will need to be familiar with it, or at least the concept of it, in order to better understand the nature of their own roles.

There are a number of benefits in using repo, which concurrently have been behind its rapid growth. These include the following:

• bank dealers are able to finance their long bond and equity positions at a lower interest cost if they repo out the assets; equally, they are able to cover ‘short’ positions;

• there is greater liquidity in specific individual bond issues;

• greater market liquidity lowers the cost of raising funds for capital market borrowers;

• central banks use repo in their open market operations, which assist in the maintenance of overall money market liquidity;

• repo reduces counterparty risk in money market borrowing and lending, because of the security offered by the collateral given in the loan;

• investors have an added investment option when placing funds;

• institutional investors and other long-term holders of securities are able to enhance their returns by making their inventories available for repo trading.

There is a close relationship between repo and both the bond and money markets. The use of repo has contributed greatly to the liquidity of government, Eurobond and emerging market bond markets. Although it is a separate and individual market itself, operationally repo is straightforward to handle, in that it generally settles through clearing mechanisms used for bonds. As a money market product, repo reduces the stress placed on the unsecured interbank market, and empirical evidence indicates a reduction in overnight interest-rate volatility.

MARKET PARTICIPANTS

The development and use of repo in each country to an extent dictates the nature and range of market participants. In a mature market, repo counterparties include investors and cash-rich institutions, those seeking to finance asset positions and their intermediaries. Some firms will cross over these broad boundaries and engage all aspects of repo trading. The main market parties are:

• Financial institutions – retail and commercial banks, building societies, securities houses and investment banks.

• Investors – fund managers, insurance companies and pension funds, investment funds, hedge funds, local authorities and corporate treasuries.

• Intermediaries – inter-dealer brokers and money brokers. The main brokers are Cantor Fitzgerald, Prebon Yamane, Garban ICAP, Tullett & Tokyo, and Tradition. Indiviual markets also have other brokers.

Repo is perhaps the most important financial instrument in the world, after the basic cash equity and bond product. An understanding of it is vital for all participants in the financial markets, be they students or practitioners.

THE REPO INSTRUMENT

A repo agreement is a transaction in which, legally, one party sells securities to another, and at the same time and as part of the same transaction commits to repurchase identical securities on a specified date in the future at a specified price. The seller delivers securities and receives cash from the buyer. The cash is supplied at a predetermined interest rate – the repo rate – that remains constant during the term of the trade. On maturity the original seller receives back collateral of equivalent type and quality, and returns the cash plus repo interest. One party to the repo requires either the cash or the securities and provides collateral to the other party, as well as some form of compensation for the temporary use of the desired asset. Although legal title to the securities is transferred, the seller/ borrower retains both the economic benefits and the market risk of owning them.

Characteristics of repo

There are a number of repo types in operation in different markets. They differ in detail ...

Table of contents

• The Securities & Investment Institute
• Title Page
• Copyright Page
• Dedication
• Foreword
• PREFACE
• PREFACE TO THE FIRST EDITION
• ABOUT THE AUTHOR
• Chapter 1 - INTRODUCTION TO REPO
• Chapter 2 - MARKET BACKGROUND
• Chapter 3 - THE MECHANICS OF REPO
• Chapter 4 - BASKET REPO, SYNTHETIC REPO AND STRUCTURED FINANCE REPO
• Chapter 5 - THE UK GILT REPO MARKET
• Chapter 6 - OVERVIEW OF REPO TRADING AND THE FUTURES CONTRACT IMPLIED REPO RATE
• Chapter 7 - REPO AND THE YIELD CURVE
• Chapter 8 - THE GLOBAL MASTER REPURCHASE AGREEMENT
• Chapter 9 - ACCOUNTING, TAX AND REGULATORY CAPITAL ISSUES IN REPO
• EXERCISES
• CASE STUDY: ABC BANK plc
• REPO CASE STUDY ANSWERS
• GLOSSARY
• TECHNICAL APPENDICES
• ABBREVIATIONS
• INDEX
• Other titles by the author