Re­pos de­fined

Financial Mirror (Cyprus) - - FRONT PAGE -

Re­pos (re­pur­chase agree­ments) may be de­fined as the sale of a se­cu­rity cou­pled with an agree­ment to re­pur­chase it at a higher price at a fixed fu­ture date. How­ever, in prac­ti­cal terms, the sale is not a real sale, but a loan, col­lat­er­alised by the se­cu­rity.

As such, a repo is trans­lated into re­ceiv­ing fi­nanc­ing against col­lat­eral which could be fixed in­come or eq­ui­ties alike. The liq­uid­ity and the credit risk of the un­der­ly­ing in­stru­ment de­ter­mine the fi­nanc­ing which can be sourced against it, also known as the “hair­cut”. The an­nu­alised fi­nanc­ing rate is fixed ir­re­spec­tive of the un­der­ly­ing col­lat­eral type and it is usu­ally set by the fi­nan­cial in­sti­tu­tion will­ing to un­der­take the repo trans­ac­tion.

As an ex­am­ple, US trea­suries carry a ‘ AAA’ S&P rat­ing and trade with very nar­row spreads; the bid and ask dif­fer­ence be­ing in­dica­tive of the liq­uid­ity of the un­der­ly­ing. Th­ese bonds re­quire a much lower hair­cut than Rus­sian Fed­er­a­tion bonds of par ma­tu­rity which carry a ‘ BBB’ S&P rat­ing and have much wider bid and ask spreads (the hair­cut stands at an in­dica­tive 10% vs. 30%). So, an in­vestor that puts up US$ 1 mln worth of US Trea­suries as col­lat­eral would ob­tain $900,000 as fi­nanc­ing at a fixed an­nual in­ter­est rate ver­sus $700,000 fi­nanc­ing against a col­lat­eral of Rus­sian Fed­er­a­tion bonds of equal worth. The same vari­ants for fi­nanc­ing ap­ply in the in­stance of eq­ui­ties where blue chip stocks are in­her­ently more liq­uid and have lower hair­cuts than stocks with lower credit rat­ings.

A re­verse repo is de­fined as ex­actly the same op­er­a­tion but the swap is per­formed from the per­spec­tive of the buyer rather than the seller. As the la­bel­ing of the di­rec­tion of the repo is seen from the side of the dealer, typ­i­cally, if the dealer bor­rows money it’s a repo while if the dealer lends money it’s a re­verse repo.

Tight­en­ing reg­u­la­tory changes have made the repo business less at­trac­tive for banks. Dur­ing the sub­prime cri­sis of 2007-08, nu­mer­ous banks cut credit lines with each other amid a sen­ti­ment of high risk aver­sion, which re­sulted to a credit crunch. Con­se­quently, fi­nan­cial reg­u­la­tors had to ad­just reg­u­la­tory mea­sures so that they could have more con­trol of liq­uid­ity. Ad­just­ments of two par­tic­u­lar ra­tios, the net sta­ble fund­ing ra­tio (pro­por­tion of long-term as­sets funded by longterm fund­ing) and the sup­ple­men­tary lever­age ra­tio (mea­sures abil­ity to meet fi­nanc­ing obli­ga­tions) make it less at­trac­tive for banks to en­gage in repo ac­tiv­ity as it be­came much less at­trac­tive and pos­si­ble to own short-term debt. This may trig­ger fur­ther set­tle­ment is­sues as lower liq­uid­ity and fewer, avail­able short-term debt make it dif­fi­cult to get hold of sought after, more liq­uid pa­per which can lead to failed trades. Although this un­der­mines the Fed’s goals of fi­nan­cial sta­bil­ity, reg­u­la­tors con­sider the fi­nan­cial sys­tem stronger over­all once the con­stituent play­ers are less re­liant on short-term fund­ing like repo. Due to the above dy­nam­ics, the Fed formed a foothold in the repo business equipped with a port­fo­lio of more than $4.3 trln bonds pur­chased while en­act­ing its QE mon­e­tary pol­icy op­er­a­tions. It utilises re­verse repo op­er­a­tions (RRP) to raise short term fi­nanc­ing from money mar­ket funds, a trade which in a more flex­i­ble era was en­acted much more so by banks. The grow­ing pres­ence of the Fed in re­pos por­trays its pur­suit to for­mu­late new meth­ods to reg­u­late short-term in­ter­est rates once it starts ta­per­ing its QE. Once mon­e­tary pol­icy is re­versed and short-term rates are hiked, the Fed may utilise RRP to squeeze cash out of the fi­nan­cial mar­kets. By con­trol­ling the short-term loans of Trea­suries of its huge bal­ance sheet it may man­age the liq­uid­ity pumped back into the cap­i­tal mar­kets, es­pe­cially as banks’ cur­rent role in the repo mar­ket is less sig­nif­i­cant.

More­over, as banks shift to longer-term fi­nanc­ing, non-bank en­ti­ties such as hedge funds and in par­tic­u­lar REITS (Real Es­tate In­vest­ment Trusts) are gain­ing mar­ket share in the $4.2 trln mar­ket. Such play­ers turn to re­pos to boost re­turns given the cur­rent eco­nomic en­vi­ron­ment of low rates. By us­ing more bor­rowed money, or lever­age, REITS and hedge funds can take larger po­si­tions to op­ti­mise re­turns, a strat­egy which works in sta­ble mar­kets; of course, if the mar­ket re­verses, lever­aged po­si­tions trans­late into larger losses.

Lastly, repo fi­nanc­ing is also play­ing a new role in the mar­ket­ing of CLOs (Col­lat­er­alised Loan Obli­ga­tions) which are bonds backed by loans to com­pa­nies. They con­sist of tranches, whereby highly rated se­nior slices of­fer lower yields ver­sus the riski­est slices. As in­vestors are in pur­suit of higher yields they ei­ther invest in the riskier slices or invest in the most se­nior slices by lever­ag­ing the re­spec­tive po­si­tion. Banks are in­volved in the lat­ter by of­fer­ing repo fi­nanc­ing to buy­ers of the more se­nior tranches. The cur­rent, stricter bank­ing reg­u­la­tory en­vi­ron­ment where banks can’t hold CLOs as as­sets “on­bal­ance sheet”, en­cour­ages lend­ing against them and mak­ing re­turns in this man­ner.

The main risk with con­duct­ing repo trans­ac­tions re­lates to col­lat­eral man­age­ment fol­low­ing sharp fi­nan­cial mar­ket swings. For in­stance, in a repo trans­ac­tion where the dealer bor­rows money against col­lat­eral, a sharp mar­ket down­swing in the un­der­ly­ing po­si­tion would trans­late into mar­ket value losses be­low the se­cured hair­cut, i.e. the bor­rower’s po­si­tion not be­ing col­lat­er­alised enough. The dealer would then face a mar­gin call. The op­po­site would oc­cur in the in­stance of a re­verse repo sit­u­a­tion.

The main ben­e­fit of such trans­ac­tions is fa­cil­i­tat­ing fi­nanc­ing by util­is­ing idle pa­per or se­cu­ri­ties and it is a form of liq­uid­ity that is eas­ily ac­ces­si­ble also to re­tail in­vestors that wish to cap­i­talise on buy and hold po­si­tions held in their re­spec­tive port­fo­lios. In­stead of un­der­go­ing vo­lu­mi­nous due dili­gence pro­ce­dures on prospec­tive business projects and col­lat­er­al­is­ing fixed as­sets such as real es­tate to raise fi­nanc­ing, em­ploy­ing repo trans­ac­tions for liq­uid­ity is a swifter and more flex­i­ble al­ter­na­tive.

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