Government Bond Market Advisory Services Peer Group Dialogue. Repo: Role in Government Securities Markets

Transcription

1 Government Bond Market Advisory Services Peer Group Dialogue Date: April 28, 2015 Place: Meeting #16: Minutes Repo: Role in Government Securities Markets Conference call led by the Government Bond Market Advisory Services team of the World Bank in DC via WebEx online conferencing tool Time: Attendees: Topic: Objectives: Issues discussed: 8 am- 9:30 am (EST time) Country Participants: Brazil; Colombia; Hungary; India; Malaysia; Mexico; Poland; Turkey World Bank Group Participants: Capital Markets Regulation & Deepening/Insurance, Pensions and Investment Funds (Finance and Markets Global Practice); Financial Advisory and Banking Debt Management (Treasury). Presenters and Speakers: Mr. Mike Williams, Consultant, the World Bank Group Mr. Zsolt Bangó, Head of Treasury Department, Government Debt Management Agency Pte Ltd., Hungary Ms. Indhu Raghavan, Securities Market Specialist, the World Bank Group Repo: Role in Government Securities Markets Introduction of the topic by the World Bank Presentation by Mr. Mike Williams on Repos: Policy and Operational issues arising Presentation by Mr. Zsolt Bangó on Repos: the Experience of AKK (Hungary) Discussion and Q&A Repo policy and operational issues Classic repo - key features: In economic terms, repo is the same as collateralized lending/borrowing. However, unlike a collateralized loan, it involves the transfer of a legal title over a security asset and it is more flexible, as it can be on-sold and allows for margining. Repo interest rate - the difference between the sale and repurchase price - can be fixed or floating (usually fixed). Repo may be with general collateral or on a specific bond. If a coupon is paid during the term of the repo, it should be handed back to the seller, potentially bringing operational

2 complications; thus, markets often avoid collateral with a nearby coupon date. Alternatives to classic repo: Repo is part of a wider family of transactions. Similar transactions are (i) sell/buy-back, which depending on the documentation is likely to have a higher risk in the event of default as collateral is not ring-fenced, and (ii) securities lending, which is often preferred by non-banks/pension funds. Repo variations include held in custody repo, when a security may be retained in a segregated account and not transferred, and tri-party repo, when collateral management services are provided by a third party custodian bank or international CSD (Euroclear/Clearstream). Importance of repo: Repo is used in both money market and bond market and helps to integrate the two sectors. Repo promotes money market development by reducing credit concerns of market participants and serving as a tool for monetary policy operations. It supports debt market development as it facilitates short-selling and market-making, promotes market activity by utilizing the collateral and creates a more continuous yield curve. Repo supports debt and cash management. For debt managers, repo reduces the risk of auction failure, as primary dealers (PDs) use repos as a mechanism for financing their positions. When moving to more active cash management, repo is a convenient and secure tool to invest excess cash balances. Use by DMOs: In debt management, repos are useful to support market making. A DMO can lend a newly created security via repo to relieve a short position of a market maker or remove a distortion if a particular bond is squeezed by a market participant who holds a large proportion of the bond and is unwilling to lend it out. For these purposes, the DMO may charge a slightly penal rate to give the market a chance to find a solution and may enter an offsetting repo to neutralize the cash effect. In cash management, repos help to smooth cash flows across the Treasury Single Account (TSA), which enables the DMO to operate with a lower cash balance and reduces net interest costs. It also helps the central bank (CB), as the fluctuations in the TSA are mirrored by the fluctuations in the banking sector liquidity. Managing risks: (i) Credit risk and market risk: Repo is not without credit risk, as realizing collateral may be cumbersome and may fail to match the value of the loan. Haircuts or margins mitigate the risk that collateral will not realize the full value of the transaction. In more developed markets, the practice is to calculate variation margin during the life of the repo to maintain the value of the collateral. For instance, if the collateral value falls because interest rates have risen during the life of the repo, then more collateral has to be supplied by the borrower and vice versa. With variation margin, the initial margin is usually very little or zero. In more recent adopters of initial margin, it may reach 20-25%, often to avoid computation of variation margin. (ii) Liquidity risk:

3 Collateral may be difficult to sell; hence, governments usually insist on their own (or CB s) securities; (iii) Operational risk: Collateral should have maturity longer than the repo term and should be managed. A collateral manager should be able to value the collateral, perform remargining, and handle all the collateral adjustments and final settlement. Depending on availability of trained staff and systems, the function can be done by the DMO back office, CB, CSD or another agent (tri-party facility); (iv) Legal risk: most countries tend to rely on the Global Master Repo Agreement (GMRA), a well-recognized standard legal arrangement; a local annex may be needed. GMRA ensures legal title over bonds in the event of default, provides for initial and variation margins, enables set-off arrangements, and assigns a coupon payment back to the seller. To avoid fragmentation, the whole market within a country should use the same agreement. Policy decisions and prerequisites: Policy decisions need to be addressed with respect to collateral (eligible securities, initial margin calculation, manager), acceptable counterparties (initially, typically the primary dealers), transaction format (bilateral or auction) and auction procedures. Prior to introduction, DMO needs to sign contracts with all likely counterparties, establish a legal framework (possibly for taxation, insolvency issues, etc.) and ensure internal operational capacity. Transaction process: Repo execution would involve front, middle and back office, with front office doing market monitoring and executing transactions, the middle office putting cash forecasts together on a weekly basis and providing advice to senior management or Cash Coordination Committee (CCC), and back office handling transaction flows, collateral management and settlement for both legs of the repo transaction. The CCC may meet every week and decide what to do with the excess cash or, in case of shortage, delegate borrowing to the officials involved. Issues: (i) Interaction with monetary policy: repo operations should not cut across CB s own monetary policy. DMO and CB need to reach a clear understanding on intentions, timing of transactions and regular information exchange (perhaps, by signing a Memorandum of Understanding); (ii) Accounting treatment: repo transactions are treated as collateralized loans under international accounting best practice. Securities received as collateral are not part of government s balance sheet and changes in their market value have no effect on the balance sheet. When lending via repo, an asset should be recorded in the form of a loan; (iii) Taxation: Preferred treatment is to recognize return on repo as interest, not as capital gains, thus reflecting the substance of the transaction. Coupon payments should be treated as regular dividend payments, not as transfers from the holder of collateral. The GMRA is designed for countries with no withholding tax, and if there is such tax, an amendment to the GMRA may be needed to clarify who pays the tax.

4 Repos vs T-bills - segmentation: Although the credit risk associated with T-bills and short-term repos is very similar, these instruments are not perfect substitutes for each other. The rates on both instruments should normally be close, though some segmentation may arise since T- bills may be sold much more widely outside the wholesale market. Normally, competition for funds between T-bills and repos should not arise, as they serve different purposes: T-bills - for fund raising and repos for fine-tuning. Additionally, DMO has a flexibility to choose whichever is more convenient at a time. Repos vs sell/buy-backs: Sell/buy-backs often coexist with repos, because some participants find them easier to understand and transact, they have a longer history and can be grounded on a mutual relationship of trust between two counterparts. In Hungary, the main reason market participants use sell/buy-backs is because sometimes they prefer an open-ended arrangement and the sell/buyback format is more convenient for this. Effect of repo on market making: As discussed above, stand-by repos facilitate effective market making by enabling PDs to short-sell. Importantly, countries provide such stand-by repo facilities at a penal rate to incentivize them to resort to the market in the first place. Only when there is a distortion in the market or the market is shallow, will the PDs be willing to pay the penal rate and trigger the use of the repo/securities lending facility. Effect of repo on debt balance: When lending out a newly created bond via repo, a DMO does not change its overall public debt balance. Often, an offsetting repo is entered into, so that the transactions are netted-off in all the public debt statistics. Similarly, if the DMO lends a cash surplus, the holding of its own bonds does not reduce its liabilities. Reserve requirements: Under Basel II, short-term repo should be regarded as cash equivalent for liquidity ratio calculation. In general, a consideration is given to the liquidity level of collateral. Repo - the experience of Hungary The Hungarian DMO (AKK) has more than 10 years of experience in repo activities. Repo is important for cash and debt management, and the annual amount of repo trades executed in 2014 accounted for 20% of the Hungarian GDP. AKK has two types of repos: (i) liquidity repo, to finetune the end-of-day liquidity of the TSA; and (ii) stand-by repo facility, to support the market making activity of PDs through securities lending. General practices: Even though sell/buy-backs are popular in the government bond market, AKK executes only classic repos and reverse repos. Eligible counterparties for AKK s repo operations must sign the European Master Agreement (EMA). EMA was introduced in 2003 in

5 the Hungarian language and is governed by Hungarian law as all the executions are done in the forint (HUF). The EMA is consistent with the GMRA. For operational simplicity, bonds with coupon payments during the term of the repo are not accepted as collateral. From an accounting perspective, selling bonds via repo increases the nominal debt figure, while buying-back bonds via repo does not reduce debt in Eurostat statistics. Supposedly, it is to discourage debt managers from artificially reducing the year-end debt figure through repo transactions. Internally, AKK records the actual debt reduction in its books. AKK applies initial margin, but does not apply margin maintenance as it executes only 1- day or 1-week repos. Settlement facilitation: Interestingly, a local clearing house (KELER) can borrow securities via AKK s repos to facilitate intra-day settlements. KELER is subject to the same conditions as PDs; the only difference is a higher series limit, as the main purpose of serving KELER via repo is to help intraday settlement of outstanding issues. For example, the deadline for delivery of securities for trades via MTS Hungary is 2 pm, however, the close of business for OTC operations is 6 pm; so if a trade is received after 2 PM, KELER can provide intraday settlement. Liquidity repo: Liquidity repo is used as one of the fine-tuning tools to manage the liquidity in the TSA (within a HUF 100 billion-wide range above the minimum end-of-day balance). Eligible collateral are HUFdenominated T-bonds/T-bills (no CB notes); eligible counterparties are PDs, local banks and KELER; execution is via Reuters dealing through multiple price auction; and liquidity repo transactions are not conducted at the year-end to avoid artificial influence on debt balance. A decision on liquidity repo tenders is made by the Financing Committee based on the weekly forecast TSA end-of-day balance provided by the CB for every biweekly meeting of the committee. Tenders are held on a daily basis at a standard predefined time: in the morning for tom next (TN), spot next (SN) and spot week (SW) tenders and in the afternoon for overnight (ON) trades, following the receipt of an updated report on the expected end-of-day balance. An ON tender can be announced if the AKK needs extra fund raising to reach the lower band or if expected balance exceeds the upper band. Placement of extra cash (reverse repo) will be announced only if it is profitable, so the upper band is a soft limit for cash management. Stand-by repo: With an average of trades a day, the repo standby facility is the main source of securities lending in the market, as the local investor base is not strong enough to properly support market makers. AKK charges a penalty rate equal to HUFONIA 25 bps. HUFONIA is a one day lending rate in the market which is set by the CB every day. Stand-by repo facility is available during the market making hours. Eligible collateral are quoted HUF-denominated T- bonds/t-bills (with remaining maturity over 90 days); eligible counterparties are PDs and KELER; and execution is via Reuters dealing upon request of a PD at a predefined interest rate. Available tenor is one

6 week and repo cannot be rolled over. The limits for PDs apply to series size, daily repo positions and total stock of repo per dealer. Challenges faced by AKK: (i) IT infrastructure: AKK had to develop some extra functionalities, e.g. following and maintaining the limits for PDs and supporting allocations during the liquidity repo tender. It was important to create the system of daily operations, so participants were ready to use repos as an alternative liquidity management tool. In the beginning, AKK faced a situation of very few/illiquid bids on repos. (ii) Legal framework: It took time to find a common ground among the front office, risk management and legal operations regarding the main points of the EMA and, primarily, to negotiate and sign this agreement with the local banks. Potential effect on market volatility: During market turbulence, to mitigate additional volatility, AKK closely monitors execution of repos. A multi-level trading limit system tracks spikes of trading activity and defers to the Head of Treasury and the Deputy CEO to analyze the source of this activity and grant permission or suspend repo operations at that time. Additionally, market making obligations and the stand-by repo facility may be suspended. AKK s past experience shows increased stand-by repo operations during market turbulence, but not generally for short-sale purposes. Documents discussed: Presentation on the topic by Mike Williams Presentation on the topic by Zsolt Bangó Next steps: Solicit other topics for discussion in future PGD meetings