Classic repo

Repo is essentially a secured loan. The term comes from sale and repurchase agreement however, this is not necessarily the best way to look at it. Although in a classic repo transaction legal title of an asset is transferred from the seller to the buyer during the term of the repo, in the author s opinion this detracts from the essence of the instrument a secured loan of cash. It is therefore a money market instrument. Later we formally define repo and illustrate its use for the moment we need only to think of it as a secured loan. The interest on this loan is the payment made in the repo. 

The classic repo is the instrument encountered in the United States, United Kingdom, and other markets. In a classic repo one party will enter into a contract to sell securities, simultaneously agreeing to purchase them back at a specified future date and price. The securities can be bonds or equities but also money market instruments such as T-bills. The buyer of the securities is handing over cash, which on the termination of the trade will be returned to them and on which they will receive interest. 

The seller in a classic repo is selling or offering stock, and therefore receiving cash, whereas the buyer is buying or bidding for stock, and consequently paying cash. So if the one-week repo interest rate is quoted by a market-making bank as 51 5 4, this means that the market maker will bid for stock, that is, lend the cash, at 5.50% and offers stock or pays interest on borrowed cash at 5.25%. In some markets the quote is reversed. 

EXHIBIT 10.2 Classic Repo Transaction for 100-Worth of Collateral Stock... 

A classic repo transaction is subject to a legal contract signed in advance by both parties. A standard document will suffice it is not necessary to sign a legal agreement prior to each transaction. 

We consider first a classic repo in the United Kingdom gilt market between two market counterparties, in the 5.75% Treasury 2009 gilt stock. The terms of the trade are given in Exhibit 10.3 and illustrated in Exhibit 10.4. Note that the terms of a classic repo trade are identical, irrespective of which market the deal is taking place in. So the basic trade, illustrated in Exhibit 10.3, would be recognisable for bond repo in European and Asian markets. 

Market participants who are familiar with the Bloomberg trading system will use screen RRRA for a classic repo transaction. For this example the relevant screen entries are shown in Exhibit 10.5. This screen is used in conjunction with a specific stock, so in this case it would be called up by entering... 

EXHIBIT 10.5 Bloomberg Screen RRRA for Classic Repo Transaction, Trade Date 5 July 2000... 

If we wanted to use screen RRRA for other securities we would enter the relevant bond ticker, for example T for US Treasuries, B for German Bunds and so on. The principles are the same for classic repo trades whatever the jurisdiction, and the screen may be used for all markets that undertake classic repo. 

EXHimr 10.6 Bloomberg Screen for the Classic Repo Trade Illustrated in Exhibit 10.7... 

We next consider the sell/buyback, which is economically identical to the classic repo but is described under different cash flow terms. 

In addition to classic repo there exists sell/buyback. A sell/buyback is defined as an outright sale of a bond on the value date, and an outright repurchase of that bond for value on a forward date. The cash flows therefore become a sale of the bond at a spot price, followed by repur-... 

A sell/buyback is a spot sale and forward repurchase of bonds transacted simultaneously, and the repo rate is not explicit, but is implied in the forward price. Any coupon payments during the term are paid to the seller however, this is done through incorporation into the forward price, so the seller will not receive it immediately, but on termination. This is a disadvantage when compared to classic repo. However there will be compensation payable if a coupon is not handed over straight away, usually at... 

The Bank of England discourages sell/buybacks in gilt repo and it is unusual, if not unheard of, to observe them in this market. However, we use these terms of trade for comparison purposes with the classic repo example given in the previous section. The procedure and the terms of the trade would be identical in other markets such as Italy and Portugal where sell/buyback trades are the norm. In the Italian market for example, sell/buybacks are actually called repos. ... 

Fundamentally both classic repo and sell/buybacks are money market instruments that are a means by which one party may lend cash to another party, secured against collateral in the form of stocks and bonds. Both transactions are a contract for one party to sell securities, with a simultaneous agreement to repurchase them at a specified future. They also involve ... 

In certain respects however, there are significant differences between the two instruments. A classic repo trade is carried out under formal legal documentation, which sets out the formal position of each counterparty in the event of default. Sell/buybacks have traditionally not been covered by this type of documentation, although this is no longer the case as standard documentation now exists to cater for them. There is no provision for marking-to-market and variation margining in sell/ buybacks, issues we shall look at shortly. 

EXHIBIT 10.11 Summary of Highlights of Classic Repo and Sell/Buyback... 

The term of a stock loan can be fixed, in which case it is known as a term loan, or it can be open. A term loan is economically similar to a classic repo transactions. An open loan is just that there is no fixed maturity term, and the borrower will confirm on the telephone at the start of each day whether it wishes to continue with the loan or will be returning the security. 

As in a classic repo transaction, coupon or dividend payments that become payable on a security or bond during the term of the loan will be to the benefit of the stock lender. In the standard stock loan legal agreement, known as the OSLA agreement,there is no change of beneficial ownership when a security is lent out. The usual arrangement when a coupon is payable is that the payment is automatically returned to the stock lender via its settlement system. Such a coupon payment is known as a manufactured dividend. 

We illustrate a stock loan where the transaction is stock-driven. Let us assume that a securities house has a requirement to borrow a UK gilt, the 5.75% 2009, for a one-week period. This is the stock from our earlier classic repo and sell/buyback examples. We presume the requirement is to cover a short position in the stock, although there are other reasons why the securities house may wish to borrow the stock. The bond that it is offering as collateral is another gilt, the 6.50% Treasury 2003. The stock lender, who we may assume is an institutional investor such as a pension fund, but may as likely be another securities house or a bank, requires a margin of 5% as well as a fee of 20 basis points. The transaction is summarised in Exhibit 10.12. 

A stock loan transaction in which the collateral is in the form of cash is similar in some ways to a classic repo trade. Here we compare the two transactions. Consider the following situation ABC is an entity, perhaps a bank or fund manager, that owns government bond G. Bank XYZ is a bank that requires bond G in order to deliver into a short sale that it has transacted in G. To temporarily acquire bond G to cover the short sale Bank XYZ may enter into either a stock loan or a classic repo. Exhibit 10.13 looks at the similarities between the two and the differences. 

The term delivery repo is sometimes used to refer to a vanilla classic repo transaction where the supplier of cash takes delivery of the collateral, whether in physical form or as a book-entry transfer to its account in the clearing system (or its agent s account). 

On termination, ABC buys back bond G from XYZ at the repurchase price agreed at the trade start. As this is classic repo, the repurchase price is identical to the sale price, but the cash flow includes repo interest. 

A repo-to-maturity is a classic repo where the termination date on the repo matches the maturity date of the bond in the repo. We can discuss this trade by considering the Bloomberg screen used to analyse repo-to-maturity, which is REM. The screen used to analyse a reverse repo-to-maturity is RRM. 

In both classic repo and sell/buyback, any initial margin is given to the supplier of cash in the transaction. This remains true in the case of specific repo. For initial margin the market value of the bond collateral is reduced (or given a haircut ) by the percentage of the initial margin and the nominal value determined from this reduced amount. In a stock loan transaction the lender of stock will ask for margin. 

Investment banks and hedge funds often use TRS contracts to pay for positions in securities that they cannot— for operational, credit, or other reasons—fund using the interbank market or a classic repo. The TRS counterparty that is long the security swaps it with a counterparty that... 

---