Global Repo Markets

Instruments and Applications

Moorad Choudhry

• Publisher: Wiley
• Year: 2011
• Print ISBN:
  9780470821275
• Edition: 1
• eBook ISBN:
  9781118178966
• Topic: Business
• Subtopic: Finance
• Index: Business

Repo, from sale and repurchase agreement, is one for the oldest and widely used instruments in global capital markets. It is a vital ingredient in the smooth and efficient running of the financial markets, and is used by all market participants including central banks, commercial banks, fund managers and corporates.

This book is a comprehensive, detailed and authoritative description of the repo instrument. Written by a former repo trader, it covers applications and analysis of the various different instruments used in the repo markets. It also places the repo markets in the overall context of the money markets and banking asset-liability management.

Part I

The Repo Instrument and the Debt Capital Markets

In Part I of this book we introduce sale and repurchase agreements, or repo as they are commonly referred to, as a financial market instrument, and the first three chapters are designed to place repo in the context of the debt capital markets. Repo is an interesting product because, although it is a money market instrument as defined by the term to maturity of a repo trade, the nature of the underlying collateral means that the repo desk must be keenly aware of the bonds that they “trade” as well. This multi-faceted nature of repo is apparent in the way that banks organize their repo trading. In some banks it is part of the money market or treasury division, while in other banks it is 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. In the US dollar market, for example, repo is a well-established investment product utilised by corporate treasuries and local authorities. Fund managers also engage in repo trading. The practicality and simplicity of repo-means that it can even be established in capital markets that are still at an “emerging” stage, and employed by a wide range of participants. If it is not already traded in every country with a debt capital market in the world, then before long it most probably will be.

Chapters 4 and 5 look at the repo instrument and its principal uses and economic functions. There are two main types of repo—the classic repo and the sell/buy-back repo. As markets have developed in their own way and at different paces, they also have slightly different terminology. Wherever possible, this is described and explained. This is followed by a review of the more structured repo-type products, such as total return swaps, and how they form part of the newer market in credit derivatives.

The importance of the financing function undertaken using repo needs to be placed in context, and for this reason we consider bank asset and liability management and basics of trading strategy. These are important areas if one wishes to understand the role that repo transactions play in the capital markets. Once we have considered the instrument generically, we are ready to look at some specific markets. A detailed review is given of the UK gilt repo market, and there are briefer notes on selected other country markets.

CHAPTER 1

Introduction to Repo

The global market in repurchase agreements, or repo, is both large and vitally important to the smooth running of the capital markets. The size of the market is always presented as an estimate, but it is safe to say that markets around the world experienced significant growth during the 1990s and continue to expand. Asset classes that can be subject to repo now include corporate and structured finance Eurobonds in both developed and emerging markets, as well as equities and equity baskets. The growth in repo has been attributed to several factors, which we will review in this and subsequent chapters. However, in essence, the simplicity of repo and the ability to adapt it to any market circumstance is key to its attraction to market participants, whether they are central banks, investment banks, borrowers, investors, or fund managers. 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. Estimates of the size of the repo market vary. The turnover in euro-zone countries and the UK was in excess of US$28 trillion in 2003.1 The US Treasury repo market is estimated at approximately US$2 trillion. Repo generally carries a lower profile than other sectors of the market, but its size is substantial in comparison to them. For example, the turnover through the Euroclear and Clearstream clearing systems alone was US$14 trillion in 2003.2 The introduction of a repo market has an impact other than the straightforward provision of secured lending and borrowing facilities. In the UK, an open market in repo was introduced only in January 1996,3 and it has been interesting to observe the impact of gilt repo on the unsecured money market and on the liquidity and turnover of the gilt market. For instance, data on the sterling average interbank overnight rate, known as SONIA, indicated a substantial reduction in the volume of unsecured overnight borrowing and lending from around US$7 billion at the start of 1996 to under US$4 billion at the start of 2000, as participants started to use repo more heavily. Evidence from the Bank of England also suggested that the volatility of overnight interest rates was reduced.4 These and other issues in the sterling market are investigated in detail in a separate chapter.

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 essence of repo is its simplicity—the sale of securities coupled with an agreement to repurchase them at a future date. It is this simplicity and flexibility that has allowed repo to be used for a variety of purposes, and to meet a range of requirements. The determinants of the growth of repo in Europe are considered in more detail later, although one of the main factors has been the need for investment banks and bond market-makers to secure a lower funding rate for their long positions, and the ability to cover short positions more efficiently. The introduction of the Bund futures contract on London’s LIFFE exchange in 1988 also contributed to the growth of Bund repo, as market participants entered into cash-and-carry or basis trading, arbitraging between the cash and futures market. Such trading is not possible without an open repo market. From around the same time, the increasing use of derivative instruments such as swaps and bond options also contributed to greater use of repo, as banks often used the repo market to manage their hedge positions.

There is a wide range of uses to which repo might be put. Structured transactions that are very similar to repo include total return swaps, and other structured repo trades include floating-rate repo that contains an option to switch to a fixed-rate at a later date. In the equity market, repo is often conducted in a basket of stocks, which might be constituent stocks in an index such as the FTSE100 or CAC40 or other user-specified baskets. Market-makers borrow and lend equities with differing terms to maturity, and generally the credit rating of the institution involved in the repo transaction is of more importance than the quality of the collateral. Central banks’ use of repo also reflects its importance—it is a key instrument in the implementation of monetary policy in many countries. Essentially then, repo markets have vital links and relationships with global money markets, bond markets, futures markets, swap markets and over-the-counter (OTC) interest rate derivatives.

In the remainder of this chapter we set the scene by disc...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Foreword
• Preface
• Part I: The Repo Instrument and the Debt Capital Markets
• Part II: Institutional Treatment of Repo
• Part III: Basis Trading and the Implied Repo Rate
• Glossary
• Author index
• Index