Mini Chapter Two
Repo vs SLB
Comparison between ‘Standard’ Market Repos and Securities Lending/Borrowing (can be used interchangeably with Collateralised Lending/Borrowing)
| Salient Features | Repo | Securities Lending/Borrowing |
|---|---|---|
| Master Agreements | Global Master Repurchase Agreement (GMRA), but contracts can be structured under ISDA too (refer to TRS later) | Global Master Securities Lending Agreement (GMSLA) |
| Funding Yield (contractual difference) | Fixed Rate as normally short dated in tenor | Fixed/Floating as customised in the contract |
| Title Transfer | Full transfer of ownership | Varying degrees of transfer ranging from Charge/Lien on the asset to full ownership |
| Time of Title Transfer | At the start of contract | On a credit event in case of a Charge/Lien but immediate in case of full ownership |
| Intermediate Cash Flows | Goes to purchaser of the repo/borrower of the asset | Remains with the original owner of the asset |
| Standard exchange | Typical repo as in the fixed income world consists of an exchange of securities/bond for cash | Is an exchange of securities/bonds |
| Unwind of contract | Needs agreement of both the borrower and lender unless a credit event triggers an unwind | As this was an equities product at its genesis, title transfer of the security also transferred the voting rights/corporate actions on it. Securities Lender is free to execute a unilateral unwind to exercise a voting right/corporate action event. |
| Accounting Treatment | Fair Value option accounting for mark to market | Accrual based |
Source: Pandemonium.
Other considerations for repo pricing:
- Initial Margin – Is the overcollateralization of the underlying as a percentage of the loan value. Generally market repo on sovereign bonds does not have daily top-ups (or daily margining) based on the price movement of the underlying hence the margin charged at the beginning of the contract needs to account for the underlying asset price volatility and or credit risk. You can say it’s similar to the initial margin on a bilateral interest rate swap. For example a 3 month repo on an IG (Investment Grade) rated Government bond and an IG rated Corporate Bond may have the same repo rate but a vastly different margins; 3-5% for sovereigns and 15-25% for IG Bonds. A higher Margin amount would therefore imply a higher effective total cost of funding which in most cases would be above the repo rate.
- Title transfer and its implication on pricing –Â At the start of the repo trade the borrower of the security (repo purchaser) gets the legal ownership of the security i.e. claims all intermediate cash flows on it. But it is important to note they do not get the price risk on it – mark to market swings on the security do not belong to the repo purchaser. When we think about the repo rate cash flows being charged on the lent amount against the security it would be adjusted for all intermediate cash flows on it and for any discount/premium (to the general collateral repo rate) depending on the relative demand/supply of the security.
- Trivia
Korea happens to be an exception in the region where despite the title transfer the intermediate bond cash flows belong to the original holder of the bond. The KRX Clearing House redirects the coupon cash flows to the ultimate beneficial owner of the bond. Hence repo rate is a funding rate payable on the cash borrowed instead of being implied in the sale and repurchase price of the underlying bond.
- Availability of comparable instrument/Liquidity of the underlying – Repo cost would importantly be affected by availability of the asset that one wants to borrow and or the specific tenor (often odd dated/customised) for lending cash.  Â
- Accounting requirements – higher quality assets that form part of regulatory ratios (mandatory Statutory Liquidity Ratio, High Quality Liquid Asset buying) of financial institutions have a higher refinancing value; recall repo/reverse repo on sovereign bonds/bills. Need for such assets let’s say for HQLA and LCR (Liquidity coverage ratio) requirements of banks around certain times of the year impact repo pricing as well especially if one wishes to temporarily borrow without taking market risk of the underlying. This pushes repo rates on them below market/General Collateral rates.
- Special on repo – An excessive demand to borrow a bond owing to a massive short position on it can push the repo rate significantly below the general collateral (GC) market repo rate. In such cases the bond is termed as trading ‘Special-on-Repo’ and the borrower needs to pay carry to be able to maintain the short position. As an example: a 10 year bond trading special on repo at -3% annualised while GC trading at +3% is deemed to have negative carry of 6% implying a loss of 50bps per month to run a short position on the bond.
Securities Lending/Borrowing
(For the sake of completion and not repetition I’ll cover this product in its most primitive format) – is a one sided borrowing/lending of securities without any exchange of cash; the table earlier is an updated description of the product as it trades today. The security borrower can use the borrowed security to either short the same or repo with another counterparty to generate cash. The security lender gets an additional spread over and above the current market yield to compensate them for the unsecured credit exposure of the securities borrower. Hence these (uncollateralised) trades were restricted to only financial intermediaries that have very sound credit.
Pricing of Securities borrowing/lending
Given the unsecured credit risk of this instrument the security borrower’s unsecured funding cost effectively works as a guide for pricing along with the repo rate of the underlying security. In case the security goes special in repo, the lending spread (to reflect the unsecured risk) over the security’s repo yield should increase. To sum up then – the opportunity cost of lending the security would be akin to repoing it and investing the cash generated into the unsecured loan of the borrower.
Given the risks associated with the clean lending exposure of the security borrower, these markets have evolved into a collateralised format as discussed earlier.
