Often overlooked and easily dismissed as a basic collateralised loan, repos (the short form for repurchase agreement) are much more. In fact, well-functioning (and possibly liquid) repos market is essential for the stability and efficiency of the “proper” securities markets. These is why we have defined them as the invisible gears of the financial markets.
In this article (the first in a series of two) we would like to point out the main features as well as some rather unknown technicalities regarding repos, such as collateral swaps, and introduce the main characteristics of the European credit repo market. In the following part, due to be published in two weeks, we will introduce the reasons and the mechanics of repo failures and we will examine the challenges ahead for the European credit repo market in light of the anticipated CSDR reform and the new mandatory buy-in regime.
What is a Repo
A repurchase agreement (repo) is a form of short-term borrowing in which one party sells financial assets (collateral) to the counterparty and buys them back at a fixed price at a future date. The first party is lending the financial assets and borrowing cash, while the counterparty is borrowing the financial assets and lending cash. For the first party, this is a repo; for the counterparty, this is a reverse repo. The repurchase price embeds the repo rate, i.e. the interest rate charged by the lender of cash to the borrower for this short-term financing. Most repo transactions are overnight but longer tenors are very common as well and they are known as term repo. Term repo allows participants to avoid overnight interest rate risk and the risk arising from changes in the supply and demand for the collateral.
It is important to highlight that the repo seller (the party lending the financial assets and borrowing cash) retains both the economic benefits and the market risk associated to the financial assets. For example, if the bond exchanged in the repo pays a coupon, this cash flow is handed over to the repo seller. So, for instance, a market maker that finances his purchase of securities from the markets (clients) by buying the repo (more on this later) will still be entitled to earn the coupon paid by the bond. Conversely, if he borrows a specific bond in order to sell it to a client, he will need to pass the economic benefits (that is, coupons) to the lender of the bond (which, incidentally, is also borrowing money from the repo buyer, that is, our market maker. In fact, when talking about a repo, one should always bear in mind that the two parties involved in the transaction are simultaneously lenders and borrowers: the one that lends money is also “borrowing” a security whilst the one that borrows money is also lending the security.
Financial institutions enter the repo market for two reasons. The former is to get access to securities they do not own, borrowing them through a reverse repo. The latter is that repos are a form of secured lending since they are collateralized by the financial assets exchanged by the two counterparties. The collateralized nature of repo allows for a wide range of borrowers and lenders to access this market. The resulting breadth and diversification create a deeper and more robust market with reduced systemic risk. Therefore, during a financial crisis, repo markets still work properly while the interbank market (which is a market for unsecured financing) freezes.
Given the collateralized nature of the transaction, the repo market attracts a large and diverse pool of players, as opposed to markets for unsecured lending where the lack of collateral limits the spectrum of potential players only to highly reputational institutions (example: interbank market). The most important lenders in repo market (the buyer’s side of the market, as they buy the financial assets in first place) are very risk-averse cash-rich investors seeking an extra return from secure short-term investments, such as money market mutual funds, international financial institutions, central banks investing foreign currency reserves. After the crisis, due to tighter regulation and higher risk aversion, repo has been attracting all commercial banks and other non-bank financials as such sovereign wealth funds, pension funds, insurance companies, endowments and corporate treasuries. Finally, central banks use Rates repos to conduct monetary policy, injecting liquidity by buying repos and tightening by selling repos.
The repo market is key for market-makers. Consider the case of a market-maker acting as the counterparty of the client who wants to sell a certain security. Rather than draw on the scarce capital of its financial institution for this purpose, the market maker will raise money doing a repo, i.e. selling a repo. In detail, the market maker will sell in a repo contract the security bought from the client, raising money which it uses to pay the client. Ideally, the market maker would offset the client’s sale of the security with another client’s purchase, thus gaining the bid-ask spread. If the buyer does not emerge, the market maker has to roll over its repo. By contrast, when a client wants to buy a certain security, the market maker can either sell him the securities it holds in inventory or, more commonly, doing a reverse repo, i.e. buying the repo. More specifically, the market maker will borrow in a repo contract the security, lending cash to the repo seller. The security thus obtained is handed over to the client in exchange for cash. As in the previous example, the market maker will roll over its reverse repo if a seller does not emerge.
To recap, the market maker will use repo agreements to repo-out (lend) any long positions, and to reverse-in (borrow) bonds against any short positions. Therefore, market makers can be both borrowing and lending cash in the repo market, though, on average, they are net sellers of repo as financing needs prevail.
As we can see from the aforementioned examples, repo help market-makers in two ways. Firstly, repo provide market-makers with financing, thus allowing market-makers to ensure liquidity in the cash market for which they are dedicated liquidity providers. Repo provide a more stable and liquid financing than unsecured funding which has proved more resilient in times of market turbulence. Secondly, market-makers may not necessarily run large inventories of securities (which could be costly in terms of absorption of balance sheet capacity) as they can easily access securities through reverse repo. Therefore, the efficiency of the repo market is an essential prerequisite for the liquidity of the cash market. Without this facility, market makers would only be able to sell the bonds they hold and would be unwilling to buy bonds they already had a sizeable position in, thus drawing liquidity away and widening bid-ask spreads.
It’s not unusual for non-bank lenders of cash (what will be described in the next chapter paragraph as general collateral trade) to charge banks (and potentially other financial institutions) a haircut. Instead, haircuts charged by banks on other banks are rare. Charging a haircut is basically recognising a lower value of the securities posted as collateral compared to the value of the securities. Thus, in order to fully collateralise the position, the buyer of the repo will need to post a total amount of collateral that exceeds the value of the money borrowed via the repo.
These haircuts, that usually lead to overcollateralization of a position, are determined by haircut matrices, with varying degrees of complexity, that not only take into consideration the underlying bond (including characteristics such as credit rating and maturity) as well as the term of the transaction, but also credit considerations with respect to counterparty risk. It is not unusual for haircuts to be in the 5-15% range – commonality is that in general they are not dynamic, i.e. they do no increase or decrease in response to underlying market conditions or changing counterparty risk considerations. Rather, the response is less subtle and more binary, with credit lines being reduced (or even pulled) for certain transactions or counterparties, instead of haircuts being adjusted.
General Collateral Repo vs Special Repo
Lenders in the repo market demand a collateral (high-grade sovereign bonds for Rates repos and other assets for Credit repos) but do not care about which particular securities they receive. These investors trade general collateral (GC), as the buyer in a GC repo is indifferent to which issue, he will receive, among a group of perfect substitutable securities. By contrast, other market participants do care about the specific issues used as collateral. This is especially true when repo is used to short a security.
In this case, the short-seller enters a reverse repo, borrowing the security in the repo market in order to sell it in the cash market. The security used as collateral in the repo is essential: the speculator wants to short the specific security. So special repo is created, i.e. repurchase agreements in which the collateral is a specific security. The high demand for the specific asset in the repo market pushes down the repo rate. In fact, the repo buyer is willing to charge a lower interest rate to the counterparty as long as he gets as a collateral the specific security he wants to short. As a consequence, the special repo rate is lower than the repo rate for General Collateral. Large buy-and-hold investors (such as pension funds and mutual funds) exploit the difference between the special and the General Collateral repo rates to increase their returns. These institutions sell the special repo and buy the General Collateral repo. In so doing, they lend the security that is trading special in the repo market and receive cash. Then they lend cash in the General Collateral repo and borrow the general collateral. Overall, the fund is borrowing at the (low) special repo rate and lending at the (high) General Collateral rate. Moreover, it owns general collateral vs the specific security, which is not an issue as the fund has a long-term investment horizon and the specific securities are for him perfectly substitutable.
With reference to the Rates repo market for US Treasuries, traditionally the most recently issued (on-the-run) Treasury securities trade special in the repo market. These securities, in fact, are the most liquid and so they are the ideal candidates for short positions. The crowded shorts result in these issues trading special in the repo market, as it is clear from the table above showing the low special repo rate of on-the-run bonds. For the sake of clarity: a lower repo rate implies that the seller of the repo is earning less on the money he lends in exchange for the bond; thus, a lower repo rate implies a higher opportunity cost for the one who is borrowing the bond trading special on the repo market and cheaper financing for the one who is lending it.
(Source: Fixed Income Securities, Tools for Today’s Market – Tuckman)
One of the most fascinating aspects of the financial system can be summarized under the statement “if you can think it, you can do it”. And this is really the case when it comes to collateral swaps, also called collateral transformation.
A collateral swap is simply the simultaneous repo and reverse (or loan and borrow) of differently rated (or valued) securities or baskets of securities. Where entity lends out collateral against borrowing higher quality collateral, this is referred to as a ‘collateral upgrade’. The other side of this trade (i.e. a counterparty lending out quality collateral against borrowing lower quality collateral) is referred to as a ‘collateral downgrade’. Usually, the counterparty ‘upgrading’ pays a fee or spread to the counterparty ‘downgrading’, which represents the relative difference in current market repo rates for the respective collateral classes. At this point the reader may ask why on earth would a financial institution pay a fee and “transform” its collateral into a better (higher rated) one. While there may be other different reasons, the main forces behind a collateral swap are regulatory reasons and, less often, desire to short a particular security.
This can be illustrated via an easy example: suppose a (commercial) bank purchases some corporate bonds that seems attractive in terms of risk/return profile. These bonds are held in the balance sheet of the bank; however, because the issuer does not have a sufficiently high credit rating, the bonds are not eligible to be posted as collateral in operations between the commercial bank and the central bank, as the rules of the CB prevents to accept low-quality collateral.
In order to get the eligible collateral needed, the bank could enter a collateral swap and, in exchange for a fee, obtain some securities whose rating is good enough to be used in financing operations with the central bank. The counterparty of this collateral transformation example could be either any financial institution (such as investment fund) looking to increase their return (by earning the fee) on their portfolio or an agent lender.
As mentioned, collateral swaps can be also used to short a given security: instead of entering a “classic” reverse repo, which would lower its available liquidity, the financial institution can lend some of the securities in its balance sheet and borrow the securities that wants to short.
Credit Repo Market
At this point, we would like to introduce some of the peculiarities of the Credit repo market, especially the European one. Corporate bond market-makers are the main users of the credit repo market. In particular, market makers use repo to finance their positions (mostly General Collateral repo are used for this purpose) and trade certain issues they do not have in inventory (Special repo are used here).
As we know, the demand for Special repo is driven primarily by short-selling and Credit repo make no exception. In most recent years, the short selling activity of hedge funds has decreased sharply, particularly in Investment Grade bonds. This is attributed to the spread compression for IG, driven by the low interest rate environment. For this reason, hedge funds are more active in the HY space, where there is still some volatility, which is essential for relative value trading.
As far as General Collateral repo are concerned, their supply is primarily driven by the need to finance dealers’ positions (as dealers receive in their inventory any bond sold to them by investors and need to repo them in order to obtain the cash needed to finance bond purchases from the selling investors). The demand for corporate bond GC primarily comes from short-term cash investors looking for greater returns than those provided by the sovereign GC market. In fact, the General Collateral repo rates for Credit repo are greater than those of General Collateral Rates repo. This results from the higher risk faced by Credit repo lenders due to the, on average, lower creditworthiness of the Credit repo collateral, which is compensated with a higher repo rate, so a higher rate at which they invest their cash.
Banks are the main players in the credit repo market. In fact, they use repos to finance their cash bond credit trading desks that act as market-makers. Alternatively, banks can focus on client funding, i.e. lending funds to their leveraged customers, mainly hedge funds. This activity utilizes the bank balance sheet and absorbs capital.
Making a small step toward understanding the specifics of the European Credit Repo Market, it is important to note that many credit repo desks are exclusively focused on borrowing and lending specifics, whether to service their own trading desks, their clients, or trading with the street, while the financing of long positions tends to be delegated to the GC trading, collateral management, or treasury functions. However, there are also cases of some credit repo desks more focused on trading GC, particularly providing term financing for clients against their long positions (basic translation: on behalf of their client, the desk buys a repo by posting as collateral the securities in which the client wants to have a long position, so that the client obtains money in order to finance the very same purchase of the long position).
Beyond banks, other key players of the credit repo market are investment funds (such as pension and mutual funds) as they are the principal source of supply for corporate bonds. The largest funds act directly in this market, through their proprietary credit repo desk, while others act through a third-party agent. In the so-called triparty repo, the repo buyer and seller agree independently and then notify the agent, who carries out the post-trade processing by paying and settling the transaction, as well as selecting the collateral for GC repo. These agents are usually custodian banks and the leaders in Europe are Clearstream Luxembourg, Euroclear Bank, Bank of New York Mellon and JP Morgan. It is important to highlight that the agent does not participate in the risk of transactions. If one of the parties defaults, the impact still falls entirely on the other party. Triparty repos account for more than 90% of the transactions.
The main source of supply for corporate bond loans and repo is the agent lenders, who are usually the first port of call for the credit repo desks that are looking to cover their inhouse shorts or those of their clients. Instead, this appears to become more difficult with respect to HY, where underlying holders may be less inclined to put their positions into agent lending programs. The supply of corporate bond GC is primarily driven by the need to finance dealers’ positions (or those of their leveraged clients). While non-banks usually finance their long positions on a bilateral basis with their dealer banks, banks tend to use triparty demand for corporate bond GC primarily comes from short-term cash investors looking for greater returns than those provided by the sovereign GC market (usually banks, money-market funds, or even corporate treasuries), or agent lenders either looking to re-invest cash generated from their lending activities or as part of the aforementioned collateral transformation trade (or collateral swap).
When it comes to the pricing of the special corporate bond repos, While the general rule of thumb (and, being it a rule of thumb rule, we recommend to take it with a grain of salt) for pricing special repos seems to be somewhere in the range of 20-35bp through GC rates for Investment Grade bonds, and 50-100bp through General Collateral for High Yield bonds, which is relatively more expensive than sovereign specials (that may only be a few bps through GC), given that most specifics are repo-ed or loaned on an open basis rather than for a fixed term, this allows the possibility for both lenders and borrowers to request a change in the repo rate should it tighten or cheapen (in the interest of the lender in the former case, and the interest of the borrower in the latter).
However, this possibility is used more frequently in the sovereign repo market compared to the credit one. In fact, the credit repo market is not as sensitive as the sovereign repo market when it comes to renegotiating rates spreads that are relatively wide enough to reduce sensitivity, as well as the underlying sizes of transactions being significantly smaller than in the government repo market. Actually, most counterparties tend only to request re-rates when prices move significantly, say in the case of a bond becoming very special.
This is also due to the business economics of the agent lenders: for them, spending time monitoring every single corporate bond loan, and adjusting rates wherever there is a little specialness, is economically inefficient when compared to being on top of their sovereign bond loan book and capturing every additional basis point on these balances.