ANALYSIS AND EVALUATION
OF THE
EUREX REPO MARKET MODEL

Diplomarbeit

zur Erlangung des akademischen Grades
einer Magistra der Sozial- und Wirtschaftswissenschaften

eingereicht
Institut für Betriebliche Finanzwirtschaft
Sozial- und Wirtschaftswissenschaftliche Fakultät der
Leopold-Franzens-Universität Innsbruck

von 

Monika Gruber

Innsbruck, August 2004

Contents

CONTENTS  ... I
INDEX OF TABLES   ... III
INDEX OF ILLUSTRATIONS   ... IV
ABBREVIATIONS   ... V

1 INTRODUCTION  ... 1

2 THE NOTION OF “REPURCHASE AGREEMENTS”   ... 3
2.1 DEFINITION AND CHARACTERISTICS OF THE “REPURCHASE AGREEMENT”   ... 3
2.2 COLLATERAL   ... 7
2.2.1 T-Bonds and T-Notes   ... 9
2.2.2 T-Bills  ... 10
2.2.3 Pfandbriefe  ... 10
2.3 THE PRICING OF REPOS   ... 12
2.4 THE RISK ASSOCIATED WITH REPOS  ... 15
2.5 THE ADVANTAGES OF REPOS  ... 17
2.6 DIFFERENTIATION TO OTHER INSTRUMENTS  ... 18
2.6.1 Securities Lending and Borrowing   ... 18
2.6.2 Sell/Buy Back Agreements  ... 18
2.6.3 Lombard Loan  ... 18
2.6.4 Interest rate swap  ... 19

3 THE EUREX MARKET MODEL  ... 20
3.1 THE ROLE OF FINANCIAL MARKETS AND FINANCIAL INTERMEDIATION   ... 20
3.1.1 OTC Trade versus Exchanges  ... 22
3.1.2 The Derivatives Exchange  ... 23
3.2 THE HISTORICAL DEVELOPMENT OF THE EUREX   ... 26
3.3 THE CURRENT MARKET MICROSTRUCTURE  ... 29
3.3.1 Structural Features   ... 29
3.3.2 Products   ... 32
3.3.3 Settlement and Clearing  ... 32
3.3.3.1 Eurex Clearing AG  ... 32
3.3.3.2 SIC Swiss Interbank Clearing   ... 35
3.3.3.3 SIS SegaInterSettle AG  ... 38
3.3.4 The Eurex Fee and Pricing Model  ... 39
3.3.5 The Development of the Trading Volume  ... 41
3.4 INTERNATIONAL COMPETITION  ... 42
3.4.1 Europe: Euronext, Newex, Norex  ... 42
3.4.2 United States: CBoT & CME   ... 44
3.4.3 The Global Trend   ... 44

4 THE EUREX REPO MARKET MODEL  ... 46
4.1 THE CURRENT MARKET MICRO STRUCTURE   ... 47
4.1.1 General Conditions for Participation in Eurex Repo   ... 47
4.1.2 Requirements for the Use of the Eurex Repo Trading Platform   ... 48
4.1.3 Rights and Obligations of Participants on Eurex Repo  ... 49
4.1.4 Trading Hours and Trading Calendar  ... 50
4.1.5 Trading Procedures   ... 51
4.1.6 Fees and the Repo Rate  ... 56
4.1.7 Collateral   ... 60
4.1.8 Settlement and Clearing  ... 62
4.2 LEGAL FOUNDATIONS FOR THE EUREX REPO SYSTEM   ... 64
4.3 MARKET SURVEILLANCE   ... 66
4.4 EUREX REPO MARKET PRACTICES   ... 67
4.5 CRITICAL FACTORS FOR THE EUREX REPO MARKET MODEL   ... 69
4.6 FUTURE OUTLOOK FOR THE EUREX REPO MARKET MODEL   ... 73

5 CONCLUSION  ... 77

6 APPENDIX  ... 79

7 BIBLIOGRAPHY  ... 93

Index of Tables
Table 1 Repos and Similar Products   ... 19
Table 2 Shareholders of Eurex Bonds GmbH (except Eurex Frankfurt AG)   ... 31
Table 3 Facts and Figures about SIC and euroSIC   ... 37
Table 4 Clearing License Fee  ... 39
Table 5 Price of Connection Components   ... 39
Table 6 Transaction Fees for Eurex Bonds   ... 40
Table 7 Development of Eurex Turnover Volume   ... 41
Table 8 Eurex Repo Trading Calendar 2003/04   ... 51
Table 9 Fees Charged by SIS for CHF Repo Transactions  ... 57
Table 10 Fees Charged by SIC for Repo Transactions (in EUR excl. VAT)   ... 58
Table 11 Fees Charged by euroSIC for Repo Transactions (in EUR excl. VAT)   ... 58
Table 12 Fees Charged for Access to the remoteGATE (in EUR excl. VAT)   ... 58
Table 13 Euro Market: Clearing Admission Eurex Repo II – Requirements   ... 63

Index of Illustrations
Fig. 1 Repo Agreement with Combined Purchase and Repurchase  ... 4
Fig. 2 Development of the Repo Market (June 2001 until December 2003)   ... 6
Fig. 3 Collateral Divides Repo Market   ... 8
Fig. 4 Capturing the Repo Dividend   ... 12
Fig. 5 An Equilibrium Repo Spread  ... 13
Fig. 6 Eurex Corporate Profile  ... 30
Fig. 7 The Eurex Clearing System   ... 33
Fig. 8 Organisation and Company Profile of Eurex Clearing AG   ... 35
Fig. 9 SwisseuroGATE connections   ... 36
Fig. 10 Turnover Volume in the Capital Market, Equity and Equity Index Products - Examples for the Continuous Growth of Eurex Products and Turnover   ... 42
Fig. 11 Turnover p.a. (in Mio. of Contracts)   ... 45
Fig. 12 Process Flow of a Euro Repo Trade   ... 55
Fig. 13 Process Flow of a CHF Repo Trade   ... 55
Fig. 14 Eurex’ Fully Integrated Value Chain  ... 62
Fig. 15 Daily Margin Adjustment   ... 68

Abbreviations
AGB Allgemeine Geschaeftsbedingungen
AMEX American Stock Exchange
ATS Automated Trading System
BIS Bank for International Settlement
BTEX BrokerTec Futures Exchange
CAES Corporate Actions Enhancement Services
CBoT Chicago Board of Trade
CCP Central Counterparty
CESR Committee for European Securities Regulators
CFTC Commodity Futures Trading Commission (U.S.)
CME Chicago Mercantile Exchange
CPSS Committee on Payment and Settlement Systems
CSD (ICSD) (International) Central Securities Depository
DCM Direct Clearing Member
DTA Datentraegeraustausch (data media exchange facility)
DTB Deutsche Terminboerse
DTCC Depository Trust and Clearing Corporation
ECN Electronic Communication Network
ECSDA European Central Securities Depositories Association
EMA Eurpean Master Agreement
EMU European Monetary Union
EUWAX European Warrant Exchange
FESE Federation for European Securities Exchanges
FSG Swiss Financial Services Group
FTD Financial Times Deutschland
FWB Frankfurter Wertpapierboerse
GAAP Generally Accepted Accounting Principles
GC General collateral
GCM General Clearing Member
GMSLA Global Master Securities Lending Agreement
GRMA General Repo Market Agreement
HEX Helsinki Exchange
IAS International Accounting Standards
i.e. in explanation
ISE Irish Stock Exchange
ISMA International Securities Market Association
KFW Kreditanstalt fuer Wiederaufbau
LCH London Clearing House
LIFFE London International Financial Futures and Options Exchange
LSE London Stock Exchange
LSV Lastschriftenverfahren (direct debit facility)
MTS Mercato dei Titoli di Stato (Market for government bonds)
NASDAQ National Association of Securities Dealers Automated Quotation System (U.S.)
NCM Non-Clearing Member
NYSE New York Stock Exchange
NZZ Neue Züricher Zeitung
OSLA Overseas Securities Lending Agreement
OTC Over the counter
RTGS Real-time Gross Settlement
SC Special collateral
SECB Swiss Euro Clearing Bank
SECOM SEGA Communication Systems
SIC Swiss Interbank Clearing (RTGS)
SIS Swiss SegaInterSettle AG
SMI Swiss Market Index
SNB Swiss National Bank
SOFFEX Swiss Options and Financial Futures Exchange
SOFFEX Swiss Options and Financial Futures Exchange
SWX Swiss Stock Exchange
TARGET Trans-European Automated Real-Time Gross Settlement Express System
TARGET Automated Real-time Gross Settlement Express Transfer
TBMA The Bond Market Association
VAT Value Added Tax
vs. versus
XETRA Exchange Electronic Trading

1 Introduction

Europe is a leading world centre for financial markets alongside North America and the Far East. European securities exchanges play a vital role in these markets by providing companies with the opportunity to raise capital and by giving both private and institutional investors the opportunity to invest.

There have been three major developments that characterise the changes in the European Exchange landscape over the past twenty years: the globalisation of financial markets, the revolutionary developments of technology, and European regulation. A growing number of companies and banks wish to raise capital in more than one country. Investors too are looking at integrated or interconnected international markets in order to maximise their return and spread their capital risk. Long term developments such as the introduction of the euro, the spread of privatisation, the growing number of pan-European mergers and the rise of the retail investor have encouraged closer cooperation and, in some cases, the integration of Europe’s formerly diverse and separate equity markets. At the same time, over the past decade, every European exchange membership has undergone a major transformation. Most have opened up to foreign-owned intermediaries. Trading is executed electronically, often from overseas.

European securities exchanges have risen to these challenges in a number of ways. Several exchanges increased the number of hours during which trading can take place to enhance access. They also introduced market-making and block-trading to increase liquidity. Additionally, order handling and execution systems were refined in order to boost efficiency and to reduce settlement times. Most exchanges also improved information systems to increase transparency and access. By developing new and imaginative investment instruments investment options have been enhanced. Thus, the European exchanges of today rightly present themselves as modern, high-tech enterprises. In several European countries, whole securities market services groups have grown around the traditional exchanges. With very few exceptions, the national derivatives markets are generally found today under the same roof as the national cash markets. Some of these groups even integrated their national clearing and settlement institutions, their IT provider, information distribution services and others. Following the internal concentration process in almost all European countries, the European exchanges started different forms of international cooperation. “Practical” alliances now provide cross-membership and cross- access facilities, harmonised listing requirements and cross-listings of products, most notably on derivatives markets.

The first cross-border merger of exchanges in Europe, in 1999, happened even across the borders of the EU when the national derivatives markets of Germany and Switzerland created Eurex. In 2000, Euronext, the second big merger project, became reality. The Exchanges of Amsterdam, Paris and Brussels created a new joint platform with corporate structure. Norex, Virt-X, Newex are further merger projects. During the last decade, not only the institutional framework of exchanges has changed, but also the popularity of different products that are traded on the new platforms. Currently the derivatives market, in particular the trading with repurchase agreements, experiences major growth in Europe as well as in the U.S. The Eurex Repo platform observes a steady increase of outstanding volume, due to the fact that Eurex Repo is the only electronic market that offers repo transactions with the shortest possible term of just one night (overnight repo transaction). 

The goal of this paper is to analyse and to critically assess the Eurex Repo market model mentioned above, which is currently treated as the most efficient and successful trading platform for derivatives, with a specific focus on repurchase agreements.

Chapter 2 aims to give answers to the following questions: What is a repurchase agreement? Which are the characteristics of repo markets in general? Which risks are associated with repos and how does the pricing of repos work? Which other instruments for liquidity management do exist for banks?

The purpose of Chapter 3 is to give an overview of the derivatives market in general, past business methods, the intermediating role of banks and exchanges, and the dynamic development of the derivatives market. In addition, the Eurex market model will be described, as well as competing market players in Europe and the U.S.

In Chapter 4, the main focus is put on the examination and evaluation of the Eurex Repo market model in order to investigate the key drivers in this model. Considering Eurex’ expansion to the U.S., where the originally European exchange is competing with the major North American exchange CBoT since February 2004, and the advance of Eurex’ main competitor Euronext, the future perspectives for the Eurex Repo market model will be explored.

2 The Notion of “Repurchase Agreements”

2.1 Definition and Characteristics of the “Repurchase Agreement”

Repurchase agreements play a crucial role in the efficient allocation of capital in financial markets. „With a repurchase agreement (repo, RP), one party sells securities to another for cash with an agreement to repurchase the securities at a specified date and price. In essence, the repo transaction represents a loan backed by the securities” (Madura, 2003, p.142).

The lender has claim to the securities, in the case that the borrower defaults on the loan. Most repos are overnight transactions, with the sale taking place one day and being reversed the next day. Long-term repos can extend for a month or even up to one year. A reverse repo refers to the purchase of securities by one party from another with an agreement to sell them. The term is used to describe the opposite side of a repo transaction. Thus, a repo and a reverse repo can refer to the same transaction but from different perspectives (see Wechsler, 1998, p. 9).

While a repo is legally the sale and subsequent repurchase of a security, its economic effect is that of a secured loan. Economically, the party purchasing the security makes funds available to the seller and holds the security as collateral. If the security pays a dividend, coupon or partial redemptions during the repo, this is returned to the original owner. The difference between the sale and repurchase prices paid for the security represents interest on the loan. Indeed, repos are quoted as interest rates (see Hull, 1997, p. 50). The dealer thus takes out a one-day loan from the investor and the securities serve as collateral. Repos are considered very safe in terms of credit risk because, in general, the loans are backed by government securities.

Repurchase agreements originated in arrangements between the U.S. Federal Reserve Bank and the money market, but are now widely used by large companies and banks in the U.S as well as in Europe. Today in general, repos transactions are negotiated through telecommunications networks. The electronic exchange of information is a critical step in straight through processing, as it provides improvement in data consistency and accuracy (see Butler/Isaacs, 1993, p. 249).

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