Financial Markets Operations Management (48 page)

The loaned securities must be delivered by the borrower to the lender and an appropriate amount of collateral returned by the lender to the borrower, in accordance with the original transaction terms.

The lender can recall a loan at any time and the borrower can return a loan at any time (with an appropriate amount of collateral). A typical reason for a lender recall is that the lender has sold some or all of the securities being lent.

Recalls and returns are covered under Section 8: Delivery of Equivalent Securities of the GMSLA. The lender must give notice of no less than the standard settlement time for the securities. By contrast, the borrower simply has to deliver the securities to the lender.

One risk for the lender is that it might not initiate a recall sufficiently early for the sale transaction to be settled on time. Another risk is that the borrower fails to return the securities to the lender.

Failure to deliver securities or collateral is covered in Section 9 of the GMSLA:

• Para. 9.1: Borrower's failure to deliver equivalent securities
  

  The lender may either continue the loan or terminate the loan.
  

• Para. 9.2: Lender's failure to deliver equivalent collateral
  

  The borrower may either continue the loan or terminate the loan.
  

• Para. 9.3: Failure by either party to deliver
  

  The failing transferor pays all reasonable costs and expenses to the transferee. These can include, for example, interest charges and buy-in costs.
  

The return of securities to the lender is shown in
Figure 12.3
.

When the borrower gives cash, it will demand a return on that cash. This return is known as the
rebate rate
. The lender will reinvest the cash and expect to earn a return, known as the
reinvestment rate
, on that cash. The reinvestment return should be greater than the rebate return and the difference, the
spread
, represents the benefit to the lender.

For loans of securities secured with non-cash collateral, the benefit to the lender is quoted as a lending fee (known as the
non-cash premium
) based on the market value of the loan. (This is in contrast to cash collateral, where the rebate rate and reinvestment rate are calculated on the collateral.)

Fee calculation for non-cash collateral is more straightforward to manage, as the lender (or its agent) does not need to actively manage cash. Instead, both the lender and the borrower know the value of the outstanding loans, know the agreed lending fee and can therefore calculate the daily accrual without any problems.

A repurchase agreement (otherwise known as a classic repo, or simply a repo) is a mature, money market instrument widely used in the USA, Europe and Asia. It enables:

• Companies to borrow and lend cash that is secured against collateral such as bonds;
  
• Market makers to go short in securities (by reversing securities in against cash) and to finance a long securities position (by buying the securities and immediately repoing them out against cash).
  

Unlike securities lending and borrowing, where the securities are the motivator, with repo, both cash and securities are the motivators. Those institutions that are cash-motivated are less concerned about what collateral is taken than they are about making sure that it meets certain quality criteria. This type of collateral is known as
general collateral
(or GC). Securities-motivated repo is known as
special
. The greater the demand for specials, the lower the price (the repo rate) will be.

For a cash borrower, the repo rate is usually lower than bank financing rates. For a cash lender, a repo can provide an attractive yield on what is a short-term, secured transaction in a very liquid market.

Title to the collateral passes from the collateral giver to the collateral taker, although the economic benefits of the collateral remain with the giver.

The motivations for repo buyers and sellers are shown in
Table 12.22
.

Please note that the direction of a repo transaction is from the securities' perspective. If an investor sells a repo, it is selling the securities (i.e. lending the securities).

There are two types of maturity: term and open.

Classic Repo

A classic repo transaction is negotiated between two counterparties where the collateral can either be a basket of securities (general collateral or GC) or a specific security (e.g. ABC 5% bonds due in 2030). Two examples are given in
Tables 12.23
and
12.25
: in Example A, the motivation is cash-driven and in Example B, it is securities-driven.

Background	Investor “A” wants to borrow USD 25,000,000 cash against a specific
Â	security for one month
Counterparty	Dealer “B”	Â
Repo rate	0.22%	1 month
Trade date	Tuesday, 8 July 2014	Â
Settlement date	Friday, 11 July 2014	Â
Termination date	Monday, 11 August 2014	Â
Collateral	EDF 4.60% bonds due on 27 January 2020	Eurobond (30E/360)
Clean price	112.7771	YTM 2.13%
Accrued interest	2.0956	per USD 100 nominal
Dirty price (start)	114.8727	Clean price + accrued interest
Cash amount	USD 25,000,000.00	Cash-driven

Cash amount	USD 24,999,745.70
Repo rate	0.22%
Term (days)	31
Repo interest	USD 4,736.06

Background	Dealer “C” wants to borrow USD 25,000,000 BHP Billiton 2.125% bonds due on 29 November 2018 against cash for three months
Counterparty	Investor “D”	Â
Repo rate	0.21%	3 months
Trade date	Tuesday, 8 July 2014	Â
Settlement date	Friday, 11 July 2014	Â
Termination date	Friday, 10 October 2014	Â
Borrowed security	BHP Billiton 2.125% bonds due on 29 November 2018	Eurobond (30E/360)
Clean price	106.5765	YTM 0.60%
Accrued interest	1.3104	per USD 100 nominal
Dirty price (start)	107.8869	Clean price + accrued interest
Nominal amount	USD 25,000,000	Securities-driven
Cash collateral	USD 26,971,725.00	Â

In Example A, we know the cash amount but not the nominal amount of the EDF bonds. By taking the usual formula for calculating the cash amount of a bond transaction and rearranging it, we can calculate the face value, as shown in
Figure 12.4
.

The exact nominal amount would have been USD 21,763,221.37. However, as the board lot size of the bond is USD 1,000, it would not be possible to deliver this amount. We have therefore rounded the nominal amount down to USD 21,763,000, giving us a cash amount of USD 24,999,745.70 (a small shortfall of USD 254.30). Securities such as government bonds can have a minimum transferable amount of 0.01, enabling a much closer match between the nominal amount and the required cash amount.

On the settlement date, Investor A delivers the bonds to Dealer B against payment of the cash amount. As this is a term repo, the transaction will terminate one month later on Monday, 11 August 2014 when the bonds will be returned and the cash repaid plus interest of USD 4,736.06 (see
Table 12.24
for the calculation).

It should be noted that:

• The dirty price at the start of the transaction remains the same on termination of the transaction.
  
• This transaction was cash-driven. We calculated the amount of collateral using the dirty price. It is more usual to apply a margin to the securities and we will cover this later in this chapter.
  

Example A demonstrated a transaction where cash was the motivating asset, with Investor A wishing to borrow cash. In Example B, we will examine a classic repo transaction where a counterparty (Dealer C) wishes to borrow a particular (specific) security from Investor D (see
Table 12.25
).

On the settlement date, Investor D delivers the bonds to Dealer C against payment of the cash amount. As this is a term repo, the transaction will terminate after three months (91 days) on Friday, 10 October 2014 when the bonds will be returned and the cash repaid plus interest of USD 14,317.49, calculated as shown in
Table 12.26
.

Cash amount	USD 26,971,725.00
Repo rate	0.21%
Term (days)	91
Repo interest	USD 14,317.49

As mentioned above, sell/buy-backs (or buy/sell-backs) are simply two outright transactions, dealt simultaneously, both with the same trade date but with separate settlement dates. The first transaction is therefore a sale at a spot price and a repurchase at a forward price. In Example C (see
Table 12.28
), we will use the same information as in Example B. You will notice that whilst the cash flows are the same, the prices are different.

Please note that the cash flows at the start and at the end are the same as for a classic repo. The difference for a buy/sell-back (or a sell/buy-back) is that the forward price is calculated as a clean price. This is the repayment amount (dirty price) less the accrued interest up to the forward settlement date.

Sell/buy-backs are now mostly documented within the GMRA. Those transactions that are not documented are more risky than those that are. Undocumented transactions contain no provision for variation margin calls, are not subjected to a legal agreement and the seller has no legal right to any coupons.

It is useful to gain some insight into the comparative use of repurchase agreements and sell/buy-back transactions. The ICMA publishes a semi-annual survey on the European repo markets and the surveys can be found on the ICMA website
⁶
(see
Tables 12.29
,
12.30
,
12.31
and
12.32
).