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REPOS: MARKET DEVELOPMENTS
Feature
KEY POINTS
Repos are now used more frequently in relation to asset types, and with maturities not
anticipated, when the industry-standard documentation was first published.
Market participants should carefully consider tailoring their documentation to address
issues associated with changes in the types of asset repo’d and the maturity of those repos.
Author Daniel Franks
Repos: market developments
INTRODUCTION
Today’s repo markets look
considerably different to those
of October 2000, when the most recent
version of the industry-standard crossborder repurchase agreement (the Global
Master Repurchase Agreement (‘GMRA’))
was published. The 2000 version of the
GMRA was itself substantially similar to
its predecessor, published five years earlier.
The form of agreement most commonly
used today to document cross-border repos
therefore largely reflects the repo markets as
they were prior to 1995.
Of course, other agreements can be
(and are) used to document repos, such as
the International Swaps and Derivatives
Association (‘ISDA’) Master Agreement
and the European Master Agreement.
The European Master Agreement is used
primarily in the Eurozone, whereas the ISDA
Master Agreement is used more widely. It
was, for example, used at the inception of the
Australian repo markets in the early 1990s
(subject to specific local law amendments)
This article explores how the repo markets have developed over recent years (in
particular over the past 12 months) and how the industry-standard documentation
should be used only after careful consideration has been given to the issues
associated with those developments.
BACKGROUND
The fi rst developed repo market was
introduced by the US Federal Reserve in
1918, to give effect to the Federal Reserve’s
open market operations. Since then, repo
markets have developed around the world
and can be found in several economies.
These repo markets comprise central
bank schemes, similar to the US open
market operations (for example, the Bank
of England’s open market operations),
together with privately negotiated, or overthe-counter (‘OTC’), repo markets.
In each case, the primary motivation for
entering into a repo is, in economic terms,
to generate secured financing. Of course, as
with any other financial instrument, repos
are used for a number of reasons, including
hedging, speculation and generating leverage
"Repos have traditionally been short-dated
transactions in respect of liquid securities of
low volatility."
and then in South Africa in the mid-1990s.
In each case the market subsequently moved
towards a GMRA-style agreement, but the
ISDA Master Agreement is still used in a
number of jurisdictions to document repos,
even where the GMRA is available. The 2001
ISDA Cross-Agreement Bridge also allows
parties to include repo exposures in an ISDA
Master Agreement while documenting repos
under the GMRA. However, the GMRA
remains the predominant agreement used to
document global cross-border repos. While
many of the issues raised in this article apply
equally to other forms of agreement, this
article focuses on the GMRA.
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(and, in the case of central bank schemes,
removing excess liquidity from the market).
Nonetheless, the most significant portion
of activity in repo markets is for secured
financing.
To explain briefly how repos operate as a
form of secured financing, the principal cash
flows must be examined. A repo comprises
the sale by one party (the seller) to the other
party (the buyer) of securities of a specified
amount for a fi xed price. At the time of
sale, the parties agree that at a future date
the seller will repurchase the securities for
an agreed price. The repurchase price is
typically equal to the purchase price plus an
agreed interest rate (the ‘repo rate’) accrued
for the term of the repo. Since the seller
must repurchase the securities at a fi xed
price, he remains economically exposed to
the value of those securities and does not
(absent a default) pass market risk to the
buyer.
In economic terms, the cash flows are
substantially similar to secured lending:
funds are advanced against the transfer
of assets, and those assets are returned
upon repayment of the funds together
with interest. There are, of course,
differences between the two arrangements,
predominantly because a repo is a title
transfer arrangement, but those differences
are outside the scope of this article.
Repos have traditionally been shortdated transactions in respect of liquid
securities of low volatility, with top-up
collateral being calculated on a daily, or
more frequent, basis. These features of
repos mean that each party’s legal and credit
analyses are perhaps less onerous than they
may otherwise have been: a shorter term
to maturity indicates lower volatility, both
in terms of the value of the repo’d assets
and the counterparty’s credit risk; a repo of
liquid assets means that the buyer (that is,
the cash lender) is easily able to liquidate
his position in the event of a default by the
seller. In each case, the parties may not
require contractual terms that they would
have required in the case of longer term
transactions in respect of more volatile
assets. However, developments in the
market may alter the parties’ perceptions.
DEVELOPMENTS IN THE MARKET
Term to maturity
In the months since July 2007, the
ability of banks and other institutions
Butterworths Journal of International Banking and Financial Law
to borrow in the interbank market has
been severely constrained. This has forced
market participants to turn to repos as an
alternative form of financing. Of course,
repos were an invaluable source of financing
before the events of July 2007, but the
maturity of that financing has changed
significantly.
The International Capital Markets
Association conducts surveys biannually,
the most recently published of which (in
December 2007, as the June 2008 survey has
yet to be published) indicates a proportionate
decline of short-dated repos. That report was
the first such report after the events of July
2007 and shows that, since June 2007, there
has been a sharp decline in the proportion
of repos that have a term to maturity of less
than one week, and a sharp increase in the
proportion that have a term to maturity of
one month to three months. Traditionally,
repos had been used as a source of short-term
(less than one month) financing. Preliminary
indications show that the trend is towards
longer-dated repos.
Type of asset
The types of asset being repo’d have also
changed. Traditionally, repos were entered
into in respect of liquid assets with low
volatility, for example government debt
securities. These types of asset were
acceptable collateral for the repo buyer,
since they are relatively easy to value and
liquidate in the event of a default by the
repo seller. The repo seller would benefit
from the relatively cheap cost of funding
associated with using government debt
securities as collateral. Of course, these
repo markets still thrive today. However,
repos are also entered into in respect of
other types of asset.
Since the events of July 2007, originating
banks and other market participants have
found it increasingly difficult to raise finance
in the asset-backed securities market. There
are fewer investors willing to take long-term
market risk on asset-backed securities.
Originators wishing to use receivables to
generate financing have been unable to do
so through the traditional route of issuing
paper directly into the market.
By originating and then repoing assetbacked securities to an investor, banks are
able to use receivables to generate mid-term
financing (for example, between two and
three years). From the investor’s perspective,
the arrangement is preferable to a direct
investment in the asset-backed securities
themselves for three key reasons: firstly, the
market risk on the securities remains with the
originating bank (in its capacity as repo seller,
for the reasons given above); secondly, the
investor has the added credit enhancement of
contracting with the originator directly (again,
in its capacity as repo seller); and thirdly, the
term of the repo is shorter than the maturity
of the securities, with the result that the
Distributions
Since the seller under a repo remains
economically exposed to the value of the
securities, the seller expects to receive
distributions in respect of interest on those
securities (which reflects the economic
reward associated with that risk). A typical
repo therefore provides for distributions
in respect of income on the securities
to be passed through to the seller as a
manufactured dividend (the seller has
no direct recourse to the issuer for the
distributions).
Parties entering into repos in respect
of asset-backed securities should consider
how, if at all, to address amortisations or
REPOS: MARKET DEVELOPMENTS
Feature
"Repos in respect of asset-backed securities are still
documented under the GMRA."
term of the investor’s potential exposure is
substantially shorter than a long-term holding
in the securities themselves.
In addition, various central banks,
including the European Central Bank, have
extended their open-market operations so
that asset-backed securities are now acceptable
as collateral. The Bank of England’s Special
Liquidity Scheme (technically a securities
lending or asset-swap arrangement, rather
than a repo) has also been designed
specifically to accept asset-backed securities as
collateral. These moves by the central banks
further increase market activity in respect of
repos of asset-backed securities.
IMPACT ON DOCUMENTATION
Apart from repos with a central bank,
which would be documented on that central
bank’s standard terms, repos in respect of
asset-backed securities are still documented
under the GMRA. As mentioned above,
this agreement was developed at a time
when these types of repo were not
anticipated. Market participants should
consider whether any amendments are
required to their standard documentation
to address the issues associated with the
different product type.
Butterworths Journal of International Banking and Financial Law
principal redemptions during the term of
the repo.
Standard practice in the wider repo
markets is for the buyer not to account to
the seller for the return of any principal
until the maturity of the repo. If this were to
apply to the repo of an asset-backed security
and that security were to amortise during
the term of the repo, the buyer would receive
that amortised principal until maturity of
the repo (and would likely earn interest on
it) without having to account to the seller.
The repo rate continues to accrue for the full
principal amount of the repo: the seller pays
interest on the purchase price but does not
receive the corresponding interest payment
in respect of the amortised securities.
Parties to a repo in respect of assetbacked securities should consider addressing
this in their documentation. The most
common methods of addressing this would
be either for the buyer to account to the
seller for principal, as well as interest, at the
time that the distribution is made by the
issuer, or for the amortisation to be treated
as though it were a partial repayment of the
repo and the seller given the opportunity
to ‘top up’ the repo to the original principal
amount.
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REPOS: MARKET DEVELOPMENTS
396
Feature
Haircut
Typically, the value of securities sold by
the seller on the purchase date exceeds the
purchase price by an agreed proportion. In
commercial terms, this discount applied to
the value of the securities is known as the
‘haircut’ and reflects the volatility of the
value of the securities. In essence, the seller
needs to ensure that during the term of the
repo the value of assets transferred (upon
demand) to the buyer is, after application of
the haircut to the repo’d securities, at least
equal to the purchase price plus accrued but
unpaid repo rate.
Since the haircut is designed to reflect
volatility in the value of the securities, it is
likely to be greater in the case of asset-backed
securities, which are considered to be more
volatile than government debt securities or
other types of debt. On the purchase date
the seller therefore receives proportionately
less in cash against the delivery of a specified
amount of asset-backed securities than it
would have received had the repo been in
respect of less volatile securities.
Apart from the commercial effect that
this has on the cost of funding, the seller
should consider other effects of an increase
in the haircut. For example, since a repo is
a title transfer arrangement, the seller is an
unsecured creditor of the buyer to the extent
of any excess collateral (such as the haircut).
If the buyer were to default, the seller would
have no proprietary interest in the repo’d
assets but would simply have a debt claim for
the payment of an amount equal to the value
of any excess. Market participants typically
accept this as the nature of title transfer
arrangements, but it is worth carefully
considering the consequences where the
haircut is significant.
Another consequence that the parties
should consider where the haircut is greater
than normal is how any contractual set-off
rights between the parties would be affected.
For example, the parties may have agreed
(in the repo agreement or elsewhere) that
upon the occurrence of certain events in
respect of the seller the buyer would have
the right to set off amounts owing under
the repo agreement against other amounts
owing between the parties. If the haircut is
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substantial, it is likely that the net amount
owing between the parties under the repo
agreement following a default would be
owed by the buyer to the seller (broadly
equal to the value of the excess collateral).
If the buyer has the right to set this amount
off against another exposure that the buyer
has to the seller, the buyer is economically
able to ‘secure’ other exposures with the
excess collateral. In some cases this may
be accepted as part of the arrangement.
In other cases the seller may require the
repo rate to be adjusted (to reflect the
buyer’s reduced credit exposure) or may
object to a contractual right of set-off
entirely. In any event, the seller should also
consider whether other set-offs exist (such
as insolvency set-off ), that it may not be
possible to contract out of.
Typically in the wider repo market, the
haircut is applied only to the value of the
repo’d securities themselves and not to the
value of any top-up collateral. If asset-backed
securities are accepted as top-up collateral,
the parties should consider whether the
haircut should be extended to apply in all
circumstances.
Valuation
A repo requires a value to be ascertainable
in respect of the repo’d securities for two
reasons: fi rst, to enable the parties to
call for top-up collateral; and second, so
that the parties can calculate the net sum
payable upon a default by either party.
An inability to value the securities would
interfere with two fundamental aspects
of the repurchase agreement, namely
margining and close-out.
Over recent months it has become
increasingly difficult to determine a reliable
value in respect of asset-backed securities.
There has been much discussion as to the
most appropriate method for determining
a value, not simply in the repo market but
also in the wider asset-backed security
market. The repurchase agreement should
reflect the parties’ agreement as to the
method for determining the value of the
particular securities and should also provide
a fallback in the event that the value cannot
be determined. The parties should also
consider including a dispute resolution
mechanism should one party dispute the
value determined by the other party. Such
provisions are typically not included in the
wider repo markets, since the assets are
typically easier to value and the repos are
of such maturities that a sufficiently short
dispute resolution process cannot be agreed.
Events of default
To reflect the fact that repos are typically
short-dated instruments, the events
giving the non-defaulting party the right
to terminate outstanding repos are quite
streamlined. They include events that
parties would typically expect to include
in any bilateral fi nancial agreement,
such as insolvency, failure to pay and
misrepresentation.
The GMRA does not, however, include
events of default which are perhaps
more closely associated with longer-term
exposures. For example, there is no crossdefault clause, which would entitle the
non-defaulting party to terminate the repos
if the defaulting party were to default under
its other financing arrangements. Crossdefault clauses are not necessarily prevalent
in longer-term financings (for example, they
are frequently negotiated out of secured
lending agreements) but they are more often
considered to be ‘on the table’ for negotiation
in those arrangements.
CONCLUSION
The use of industry-standard
documentation such as the GMRA will
protect the parties in a number of respects.
For example, the use of a master netting
agreement should result in a party having
a net credit exposure to its counterparty
(assuming the arrangement is enforceable
upon the insolvency of the counterparty)
rather than gross exposures. It also allows
for ongoing margining and provides a
framework agreement that the parties can
tailor to suit their needs. However, the
parties should ensure that, in tailoring
the agreement, they consider how best
to address the issues associated with
the specific product type that is being
documented under that agreement.
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Butterworths Journal of International Banking and Financial Law