Wonderful World of Repos as published in Canadian Treasurer (June 2004)

For cash managers, repos provide a useful alternative to short-term market instruments.
By Ana Sainz

A repo is an agreement to sell collateral for cash and buy the same collateral back at a set price, at a specific date in the future.  In it simplest form it is a means of secured borrowing with the financing charge set by a trading desk rather than the commercial banker. 
The repurchase market started as a means for the trading desks at the investment dealers to finance their long inventory of bonds and to borrow in (cover) bonds they had sold short.   Originally started in the US for US treasury bonds, a healthy repo market exists in both Canada and Europe.  There are three basic types of financing agreements:

• the US style or classic repo;
• sell-buy back agreement, and
• securities lending. 

For simplicity we will refer to these all as repos.  All three of these financing agreement may be used as part of a cash management plan and can be used as an alternative to investing in short-term market instruments such as Bankers’ Acceptances, Treasury Bills, or commercial paper. 
Cash lent in a repo is fully collateralized and risk in minimal since the collateral is delivered against payment.  In fact, in a classic repo, the cash lender is over-collateralized.  The margin in Canada is generally 0-2% of every dollar.  The over-collateralization exists to protect the lender from day-to-day price fluctuations in the marketplace.

Repo products offer the corporate treasurer flexibility in respect of:

• size of transaction (odd amounts of cash welcomed);
• period of transaction outstanding (although must be less than 364 days in total length in Canada to fall under standardized legal documents), and
• combination of currency of collateral and cash used.

If the corporation already holds securities as a market investment repos can offer:

• incremental income above the coupon on the bonds;
• immediate access to cash without having to liquidate holdings over a cash crunch;
• potentially less expensive and/or alternative sources of funding, and
• with a mixed currency repo, access to short-term cash in other currencies while using C$ denominated bonds as collateral.

Since legal title of the bonds transfers for the term of the repo, it is wise to review any outstanding debt covenants to ensure the corporation stays aboveboard with its lenders.  Such short-term transactions are typically carved out under negative pledge covenants.   Although legal title does change hands the seller through the repo transaction retains certain attributes of the collateral.

• Any change in the market value of the collateral is attributed back to the seller since the seller buys back the bond at a pre-determined price. 
• Economic benefit from the accrued interest (coupon interest) is attributed to the seller.  Either the buyer (lender of cash) can reduce the financing cost by the carry of the underlying bond so that the seller pays a net amount or the buyer can forward the coupon payment to the seller and request a repricing of the collateral.
• Default risk on the bond is also attributed to the seller.  Under the Investment Dealers Association (IDA) agreement the repo seller must replenish the collateral for the buyer.  The new collateral need not be the same but must be of appropriate credit quality.

Repos are also classified as general collateral (GC) or non-specific collateral.  G.C. repos use any type of collateral as long as they are of a suitable credit rating.   The seller uses the collateral as a means to offset the buyers own corporate credit risk.  In addition, the repo seller may with the buyer’s consent at onset of transaction substitute the collateral with bonds or equal or better credit quality. 

Special repos are different.  They have a higher financing rate because the underlying collateral (bonds) is in great demand by institutional investors.

Repo rates (the financing charge) is determined by the trading desk in close association with other money market rate for high quality market instruments.  Repo rates for each transaction will also be affected by the size and length or repo; the credit quality of counter parties involved, and their collateral. 
The following table briefly outlines the three type of repos:

In order to pursue repo transactions a corporation will need to have the following:

1. Signed repo agreement with the investment dealer(s) of your choice.  In 1991, the IDA standardized the repo agreements into a 2-page document that is relatively easy to understand.  This agreement covers re-pricing availability, margin maintenance provision, and rights in event of default.
2. Properly set up and authorized trading account(s) with the investment dealers:  This will include corporate resolutions to engage in such trading, authorizations identifying the person in the corporation who can issue instructions, banking instructions, etc.  This is an account with the intuitional trading desk, retail brokers will not be able to offer this product directly.
3. Established credit lines for repos:  This means either sending in financial statements to the investment dealer so that they can get credit lines approved or reviewing credit lines with existing lenders and their  trading desks to ensure repos are covered.

The table below shows examples of the three types of repo using the same underlying collateral of C$100 million of the current 10 year Canada bond 5.25% June 2013 priced at $103.45 and the accrued factor of 2.1432 and repo rate of 2.70% (a).  For the securities lending, let us assume a 25 basis point fee quoted and the bonds being delivered 105 % priced at $102.11.

Numeric example of Classic repo and Sell-Buy-back agreements:

Numeric example of Securities Lending repo:

(a) Rates used in example as of October 23, 2003

For more information please contact us at contact@theclaretpartners.com. 

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