THE GLOBAL REPO MARKETS: Instruments & Applications

THE GLOBAL REPO MARKETS: Instruments & Applications

THE GLOBAL REPO MARKETS: Instruments & Applications Moorad Choudhry John Wiley & Sons (Asia) Pte Ltd

Copyright 2004 Moorad Choudhry Published in 2004 by John Wiley & Sons (Asia) Pte Ltd 2 Clementi Loop, #02-01, Singapore 129809 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop, #02-01, Singapore 129809, tel: +65-4632400, fax: +65-4634605, e-mail: enquiry@wiley.com.sg. This Publication is designed to provide general information in regard to the subject matter and it is sold with the understanding that neither the Publisher or Author are engaged in providing financial, investment, legal, accounting, taxation or other professional advice or services and do not in any way warranty the accuracy, completeness, suitability or appropriateness of any of the information formulae or instructions discussed in the Publication nor provide any warranty that uses of any of the information, formulae or instructions may not cause injury, illness, loss or any other financial or other damage to the user. Readers should seek appropriate advice from suitable qualified professional advisers and obtain independent advice or verification of the relevance and appropriateness of the use of any fo. rmula or instructions prior to the use of these in any way whatsoever. The views in this book represent those of Moorad Choudhry in a private capacity, and should not be taken to be representative of KEC Financial Products or KEC Bank N.Y., or of Moorad Choudhry as a representative, officer or employee of KEC Financial Products or KEC Bank N.V. Other Wiley Editorial Offices John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ, 07030, USA John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester P019 8SQ, England John Wiley & Sons (Canada) Ltd, 22 Worcester Road, Rexdale, Ontario M9W 1 L 1, Canada John Wiley & Sons Australia Ltd, 33 Park Road (PO Box 1226), Milton, Queensland 4064, Australia Wiley-VCH, Pappelallee 3, 69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data ISBN 0470-82127-2 Typeset in 10/13 points, Times by Cepha Imaging Pvt, Ltd Printed in Singapore by Saik Wah Press Pte Ltd 10987654321

Table of Contents Foreword Preface vii ix Part I Chapter 1: Chapter 2: Chapter 3: Chapter 4: Chapter 5: The Repo Instrument and the Debt Capital Markets.... Introduction to Repo..... Market Background: The Bond Markets.... Market Background: The Money Markets..... The Repo Instrument..... The Uses and Economic Functions of Repo.... 1 3 11 51 83 133 Chapter 6: Chapter 7: Chapter 8: Chapter 9: Chapter 10: Repo and Structured Financial Products............... 151 An Introduction to Money Market Trading and Hedging 175 An Introduction to Banking Asset and Liability Management CALM)....................... 199 The United Kingdom Gilt Repo Market............... 231 Selected Country Repo Markets...................... 265 Part II Chapter 11: Institutional Treatment of Repo..... 295 Repo Dealing Risks................................. 297

vi The Global Repo Markets Chapter 12: Chapter 13: Chapter 14: Chapter 15: Accounting, Tax and Capital Issues.... 313 Legal and Documentation Issues... 335 Repo Netting and Electronic Trading.... 347 Equity Repo..... 361 Part III Chapter 16: Chapter 17: Chapter 18: Basis Trading and the Implied Repo Rate............................... 375 Basis Trading and the Implied Repo Rate: Part I....... 377 Basis Trading and the Implied Repo Rate: Part II....... 421 An Introduction to the Fundamentals of Basis Trading.. 437 Glossary............................................................ 453 Author Index....................................................... 469 Index............................................................... 471

Foreword Fixed income products are among the fastest growing and most sophisticated within the financial markets. This market is also one that still remains very challenging for most academics and practitioners; hence the continuing calls for accessible user guides in this area. This comprehensive and highly specialised book explains and clarifies an essential part of the capital markets, that of sale and repurchase agreements or repo. The book covers the key building blocks in the pricing and risk analysis of the repo market. It provides application-oriented examples drawn from the author's own trading experience among the world's major financial institutions. The Global Repo Markets: Instruments and Applications provides an integrated, self-contained analysis of the repo and synthetic repo markets. In addition, it has an extensive treatment of the individual products and their application for funding positions using contemporary Bloomberg analytics. The Global Repo Markets: Instruments and Applications discusses the development of the repo market, the various market type players in these markets and the different motives for transacting in these instruments. It presents a clear and detailed analysis of various repo types including hedging analysis. This is an excellent, one-stop-shop book for a specialised area within the fixed income markets and appeals to various audiences including practitioners, academics, students and newcomers to the subject. Moorad Choudhry is one of the most prolific authors in the fixed income market today. What distinguishes him from other authors is his clarity of style, his ability to write concisely and with focus, his extensive market knowledge, and his consistency for providing detailed analyses throughout the book. He appears to be

viii The Global Repo Markets tireless, not to mention thoroughly committed to improving knowledge transfer and learning within the market. He has a great gift for teaching, both through his books and the live presentations at major financial market events and conferences. I thoroughly recommend this book to anyone with an interest in repo, the money markets, and asset-liability management. Abukar Mohamed Ali Research Partner, YieldCurve.com March 2004

Preface This book is a revised edition of Moorad Choudhry's earlier book about the repo instrument and how it is used in the global money markets. That is, it is about the instruments used in the world's repo markets, the mechanics of the instruments themselves, and the markets in which they are used. Repo, from "sale and repurchase agreement", is closely linked to other segments of the debt and equity markets, so the book does not look at repo in isolation, but rather its use in the context of the global capital markets. These are comprised of the debt and equity capital markets, and although equity repo is increasingly important, it is government bond repo that is absolutely vital to the smooth running of the global debt markets. From its use as a financing instrument for market-makers to its use in the open market operations of central banks, and its place between the bond markets and the money markets, repo integrates the various disparate elements of the financial marketplace and allows the raising of corporate finance across all sectors. Although used in bond and equity markets, this book concentrates on bond repo. The repo market is a vital element of the global capital and money markets. The first repo transactions were initiated by the US Federal Reserve in 1918. Since this time, repo transactions have become the main instrument of open market operations for many major central banks around the world. The repo market is also a major component of the global money market. The repo market experienced substantial growth during the 1990s and is now estimated to account for up to 50% of daily settlement activity in non-us government bonds worldwide-a phenomenal figure. Daily outstanding volume in international repo transactions has been estimated at anything between 420 to 450 billion, depending on the source.

x The Global Repo Markets The rapid growth in the use of repo worldwide has been attributed to several factors including the rise in non-bank funding and disintermediation, the expansion in public debt, the liquidity of the instrument itself and the high quality of collateral used-which is government debt in a majority of the transactions. Additional factors that have led to greater use of repo include the need for liquidity as marketmakers have sought to cover short positions, a greater awareness of counterparty risk, and not least the more advantageous capital treatment that repo transactions receive compared to unsecured transactions. The flexibility of repo transactions has resulted in them being used by a wide variety of market players, from securities houses and investment banks to fund managers, corporate treasurers and local authorities. All major markets in the world now have an established repo market and the facility is also increasingly being used in developing currency markets as well. Changes in this book from the earlier edition include a more succinct discussion of the futures basis as well as more detail on tri-party repo transactions. There is also a new section on basket repo transactions, and synthetic repo trades used for funding purposes in the form of Total Return Swaps. Chapter 3 on money markets also introduces the overnight-index swap. As before, the book is aimed at those with little or no previous understanding of, or exposure to, the repo markets, however, it also investigates the markets in sufficient depth to be of use to the more experienced practitioner. It is primarily aimed at front, middle and back office banking and fund management staff who are involved to any extent in the repo markets. Others, including corporate and local authority treasurers and risk management and legal department staff, may also find the contents useful. Structure of the Book This book is organised into three parts. Part I deals with the repo instrument, but also seeks to place the repo in the context of the wider debt capital markets. Repo market practitioners may prefer to go straight to Chapter 4, which discusses the market and instruments. Chapters 2 and 3 describe the bond and money markets, which may be useful for newcomers to the industry. However these chapters are not necessary for an understanding of repo. In addition to covering the basic repo instrument, its uses and economic functions, we also cover repo-like transactions such as total return swaps. There is also a chapter each on elementary trading strategy, and asset and liability management. Brief coverage is presented of a number of selected country markets, whilst Chapter 9 looks at the United Kingdom gilt repo market in detail.

Preface xi Part II of the book considers the institutional treatment of repo, including chapters on risk, accounting, tax and legal issues. There is also a chapter on equity repo, which may more logically sit in Part I, but it is the opinion of the author that Part I is best utilised concentrating on bond repo. Part III is a detailed treatment of some of the most exciting areas of the marketthe government bond basis, implied repo rate and basis trading. This includes a detailed look at the UK gilt bond basis. Basis trading is a form of arbitrage trading, and it is a form of trading that does not reap dividends unless carried out with precision, but there is considerable confusion about it in the market. The chapters in Part III are designed to demystify the subject to some extent. A glossary concludes the book. Acknowledgements My first book on repo was a long time in the making. It would not have been completed without the help and influence, directly or indirectly, of a number of people. Their help and guidance was greatly appreciated. This book which is a revised edition of the earlier book has also benefited from external help. A very, very big thank you to Mr Derek Taylor, who is not only a money market expert but also a good chum, now with King & Shaxson Bond Brokers Limited, for his continued assistance, and all his help in the past, starting when I was at Hoare Govett Securities Limited. Thanks for everything Del-Boy, and all the best. Thank you to Abukar Ali for the very nice Foreword. I am especially grateful for the endorsements provided for this book, all by people who are experts in their field. A big thank you to Remi Bola, Aaron Nematnejad and Suleman Baig. Thanks to Mike Hartnett at Lehman Brothers and Bill Foley at ABN Amro. Nice to be back in the market dealing with you chaps! Thanks to Rupert, Jeff and Serj at KBC Financial Products for letting me fund their very high-quality ABS book in Repo! Finally a big thanks to Malar, Pauline and Nick at Wiley Asia, always a pleasure! Bibliography and References All reference to previous research and published material is detailed in a bibliography at the end of each relevant chapter. We also list recommended texts and articles, which the author thinks that readers will find interesting and/or benefit from looking at. A more comprehensive list of references and recommended readings on the subject of the global debt capital markets can be found at the end of

xii The Global Repo Markets each chapter in Choudhry (2001). The Blake (2000) and Fabozzi (1993) references listed below are excellent reading for newcomers to the financial markets. Blake, D., Financial Market Analysis, Ff Prentice Hall, 2000. Choudhry, M., Bond Market Securities, Ff Prentice Hall, 2001. Fabozzi, F., Bond Markets: Analysis and Strategies, 2nd edition, Prentice Hall, 1993. About the Author Moorad Choudhry is Head of Treasury at KBC Financial Products in London. He previously traded gilt repo at ABN Amro Hoare Govett Sterling Bonds Limited, and gilt and sterling Eurobond repo at Hambros Bank Limited. He also worked in structured finance at JPMorgan Chase Bank. Moorad is a Visiting Professor at the Department of Economics, London Metropolitan University, and a senior Fellow at the Center for Mathematical Trading and Finance, CASS Business School, London.

Part I The Repo Instrument and the Debt Capital Markets In Part I of this book we introduce sale and repurchase agreements, or repo as they are commonly referred to, as a financial market instrument, and the first three chapters are designed to place repo in the context of the debt capital markets. Repo is an interesting product because, although it is a money market instrument as defined by the term to maturity of a repo trade, the nature of the underlying collateral means that the repo desk must be keenly aware of the bonds that they "trade" as well. This multi-faceted nature of repo is apparent in the way that banks organize their repo trading. In some banks it is part of the money market or treasury division, while in other banks it is within the bond trading area. Equity repo is sometimes a back office activity, as is the longer-established stock-borrowing desk. However, it is not only commercial and investment banks that engage in repo transactions. In the US dollar market, for example, repo is a well-established investment product utilised by corporate treasuries and local authorities. Fund managers also engage in repo trading. The practicality and simplicity of repo-means that it can even be established in capital markets that are still at an "emerging" stage, and employed by a wide range of participants. If it is not already traded in every country with a debt capital market in the world, then before long it most probably will be. Chapters 4 and 5 look at the repo instrument and its principal uses and economic functions. There are two main types of repo-the classic repo and the sell/buy-back repo. As markets have developed in their own way and at different paces, they also have slightly different terminology. Wherever possible, this is described and