Analysis and Evaluation of the Eurex Repo Market Model

Contents

Index of Tables

Index of Illustrations

Abbreviations

1 Introduction

2 The Notion of “Repurchase Agreements”
2.1 Definition and Characteristics of the “Repurchase Agreement”
2.2 Collateral
2.2.1 T-Bonds and T-Notes
2.2.2 T-Bills
2.2.3 Pfandbriefe
2.3 The Pricing of Repos
2.4 The risk associated with repos
2.5 The Advantages of Repos
2.6 Differentiation to other Instruments
2.6.1 Securities Lending and Borrowing
2.6.2 Sell/Buy Back Agreements
2.6.3 Lombard Loan
2.6.4 Interest rate swap

3 The Eurex Market Model
3.1 The Role of Financial Markets and Financial Intermediation
3.1.1 OTC Trade versus Exchanges
3.1.2 The Derivatives Exchange
3.2 The Historical Development of the Eurex
3.3 The Current Market Microstructure
3.3.1 Structural Features
3.3.2 Products
3.3.3 Settlement and Clearing
3.3.3.1 Eurex Clearing AG
3.3.3.2 SIC Swiss Interbank Clearing
3.3.3.3 SIS SegaInterSettle AG
3.3.4 The Eurex Fee and Pricing Model
3.3.5 The Development of the Trading Volume
3.4 International Competition
3.4.1 Europe: Euronext, Newex, Norex
3.4.2 United States: CBoT & CME
3.4.3 The Global Trend

4 The Eurex Repo Market Model
4.1 The Current Market Micro Structure
4.1.1 General Conditions for Participation in Eurex Repo
4.1.2 Requirements for the Use of the Eurex Repo Trading Platform
4.1.3 Rights and Obligations of Participants on Eurex Repo
4.1.4 Trading Hours and Trading Calendar
4.1.5 Trading Procedures
4.1.6 Fees and the Repo Rate
4.1.7 Collateral
4.1.8 Settlement and Clearing
4.2 Legal Foundations for the Eurex Repo System
4.3 Market Surveillance
4.4 Eurex Repo Market Practices
4.5 Critical Factors for the Eurex Repo Market Model
4.6 Future Outlook for the Eurex Repo Market Model

5 Conclusion

6 Appendix

7 Bibliography

Index of Tables

Table 1 Repos and Similar Products

Table 2 Shareholders of Eurex Bonds GmbH (except Eurex Frankfurt AG)

Table 3 Facts and Figures about SIC and euroSIC

Table 4 Clearing License Fee

Table 5 Price of Connection Components

Table 6 Transaction Fees for Eurex Bonds

Table 7 Development of Eurex Turnover Volume

Table 8 Eurex Repo Trading Calendar 2003/04

Table 9 Fees Charged by SIS for CHF Repo Transactions

Table 10 Fees Charged by SIC for Repo Transactions (in EUR excl. VAT)

Table 11 Fees Charged by euroSIC for Repo Transactions (in EUR excl. VAT)

Table 12 Fees Charged for Access to the remoteGATE (in EUR excl. VAT)

Table 13 Euro Market: Clearing Admission Eurex Repo II – Requirements

Index of Illustrations

Fig. 1 Repo Agreement with Combined Purchase and Repurchase

Fig. 2 Development of the Repo Market (June 2001 until December 2003)

Fig. 3 Collateral Divides Repo Market

Fig. 4 Capturing the Repo Dividend

Fig. 5 An Equilibrium Repo Spread

Fig. 6 Eurex Corporate Profile

Fig. 7 The Eurex Clearing System

Fig. 8 Organisation and Company Profile of Eurex Clearing AG

Fig. 9 SwisseuroGATE connections

Fig. 10 Turnover Volume in the Capital Market, Equity and Equity Index Products - Examples for the Continuous Growth of Eurex Products and Turnover

Fig. 11 Turnover p.a. (in Mio. of Contracts)

Fig. 12 Process Flow of a Euro Repo Trade

Fig. 13 Process Flow of a CHF Repo Trade

Fig. 14 Eurex’ Fully Integrated Value Chain

Fig. 15 Daily Margin Adjustment

Abbreviations

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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).

The securities dealers use repos to finance their securities inventories, rolling the repos from one day to the next. Counterparties may be institutions, such as money market funds, that have short-term funds to invest, or they may be parties that wish to briefly obtain use of a particular security. For example, a party may want to sell the security short, or they may need to deliver the security to settle a trade with another party. Accordingly, there are two possible motives for entering into a reverse repo: short term investment of funds, or attainment of temporary use of a particular security (see The Bond Market Association, 2003, pp. 1 f.). Financial institutions such as banks, savings and loan associations, and money market funds often participate in repurchase agreements. In Fig. 1 the typical procedure of a repurchase agreement is visualised.

Fig. 1 Repo Agreement with Combined Purchase and Repurchase

illustration not visible in this excerpt

Source: www.eurexrepo.com/swx/overview_repos_en.html, 30-04-04.

Bank A wants to borrow cash from Bank B for a period from overnight to about one year. This loan is backed with securities. Bank A lends a security to Bank B for the period. At maturity, Bank A pays back the cash amount and the interest based on the repo interest rate. Bank B sends the security back to Bank A. In most cases the security is a government bond. Equity of selected highly capitalized blue chips and corporate bonds may be exchanged too, but government bond repos represent the majority of the market volume.

The securities which are used to secure an obligation are called collateral. Collateral can also take other forms, such as property, inventory, equipment or receivables. In general, repo markets are separated into markets for “general” and “specific” collateral. In the latter case, a piece of specific collateral is identified in the repo contract making it possible to acquire specified securities (see BIS, 1999, p. 5). Of course, there is also risk associated with repo market transactions, which arises mainly from volatility in the value of the collateral. Consequently, credit exposure and the risk of counterparty default may be opened up. To mitigate this risk, cash lenders typically require margin. Accordingly, risk is controlled through margin practices, which involve the setting of initial margins (“haircuts”) and the implementation of margin calls based on an ongoing revaluation of collateral (see Saunders, 2000, pp. 103-114).

The economic significance of repo transactions derives from the fact that they allow one party to temporarily exchange cash for securities and the other to temporarily exchange securities for cash. From a legal point of view, a key feature that makes the repo contract attractive is that the legal transfer of securities for the duration of the contract provides protection against credit risk (see BIS, 1999, pp. 5-7). The economic significance of the repo business can be demonstrated by looking at the outcomes of the ISMA European repo market survey. The survey asked financial entities in a number of European centres for the value of the cash side of repo and reverse repo contracts still outstanding at close of business on Wednesday, December 10, 2003. According to this survey the total value of repo contracts outstanding on the books of the 76 institutions which participated in this survey was EUR 3,788 billion. The aggregate outstanding value of repo contracts at these institutions grew by 22.9% over the year to December 2003. Most of this growth occurred over the first six months (see ISMA, 2004, p. 6).

Besides, repo markets serve as a valuable source of information for central banks on market participants’ near-term expectations regarding monetary policy (see www.worldbank.org/fandd/english/0997/articles/0100997.htm, 14-06-04). Since credit risk is typically low for repos, they give a relatively precise indication of expectations regarding future official rates. They are both a flexible instrument for controlling liquidity in money markets and an effective mechanism for signalling to markets the desired level of interest rates. In the latter case, the upper and lower limit for short-term market interest rates are commonly defined using repo and reverse repo rates (see BIS, 1999, p. 12; Tootell, 2002, pp. 62 f.). The other key determinant of the frequency of central bank repo operations is the existence of minimum reserve requirements, which is the third major monetary policy instrument of the Eurosystem beside standing facilities and open market operations (see Bertraut, 2002, p. 27; Ejerskov et al., 2003, pp. 10 f.). For central banks in countries with reserve requirements and averaging arrangements, daily liquidity fine-tuning is sometimes not necessary and repos are used for the long-term provision of liquidity at less frequent intervals. In absence of reserve requirements repos are conducted on a daily basis to fine-tune liquidity, depending on a rather volatile demand for central bank money (see Kopcke, 2002, pp. 4-5; BIS, 1999, p. 11).

In recent years, the trading of sale and repurchase agreements has spread dramatically from its Anglo-Saxon heartland. The repo market is now also common throughout Europe, where these instruments are used for a variety of purposes. In today’s world repos are the single most important means employed by central banks to carry out open market operations in order to steer liquidity within the financial system, and hence implement their monetary policies. There are also major advantages of repos to commercial banks in terms of minimized credit risk and to security dealers who focus on special repos as an attractive refinancing instrument (see ISMA, 2004, pp. 13-18). The following graph shows the development of the European repo market according to the ISMA European Repo Market Surveys. Since June 2003 the headline number has declined. But some of the changes between surveys represent the entry and exit of institutions into and out of the survey. A representative comparison was made of the returns from the 36 institutions that have participated in all six surveys. The aggregate outstanding value of repo contracts at these institutions grew by 22.9% over the year to December 2003 (see ISMA, 2004, p. 6).

Fig. 2 Development of the Repo Market (June 2001 until December 2003)

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Source: according to ISMA, 2002, p. 5 and ISMA, 2004, p. 6.

Moreover, Appendix 1 shall give an overall impression of the current role of repo transactions in the European market, according to the ISMA European repo market survey 2004.

2.2 Collateral

In general, collateral is assets provided to secure an obligation. Traditionally banks might require corporate borrowers to commit company assets as security for loans. This practice is called secured lending or asset-based lending. A more recent development is collateralisation arrangements used to secure repo, securities lending and derivatives transactions. Under such an arrangement a party who owes an obligation to another party posts collateral, typically consisting of cash or securities, to secure the obligation. In the event that the party defaults on the obligation, the secured party may seize the collateral. In this context, collateral is sometimes called margin (see Bodie et al., 2002, p. 678; Saunders, 2000, p. 220).

In a typical collateral arrangement, the secured obligation is periodically marked-to-market, and the collateral is adjusted to reflect changes in value. The securing party calls for additional collateral when the market value has risen, or removes collateral when it has fallen. The collateral agreement should specify:

- The rating of the collateral: low volatility, no or little negative correlation with the secured obligation are desirable.
- Frequency of margin calls: secured parties prefer to mark-to-market frequently because of changes of the collateral and/or the obligation. They issue a margin call to the securing party for additional collateral when needed.
- Haircuts: in determining the amount of collateral haircuts are applied to the market value of various types of collateral. For example, if a 1% haircut is applied to Treasuries, then Treasuries are valued 99% of their market value (see also Butler/Isaacs, 1993, p. 175).
- Only the value of an obligation above a certain threshold level may be collateralised.
- Close out and termination clauses concerning the circumstances under which the obligation will be terminated.
- Valuation: the methodology for marking both the obligation and the collateral to the market must be agreed upon.

Legal treatment of collateral varies from one jurisdiction to another. In some cases, the secured party takes legal possession of collateral, but is legally bound by how the collateral may be used and the conditions upon which it must be returned. Such transfer of title provides the secured party a high degree of assurance that it may seize the collateral in the event of a default. Transfer of title, however, may be treated as a taxable event in some jurisdictions. In others, the securing party retains ownership of collateral, but the secured party acquires a perfected interest in it (see Madura, 2003, pp. 517 f.).

The motivation to trade a repo is either to borrow cash and lend a security out of a basket (General Collateral repo), or to borrow a specific security against cash (Special repo). The following table gives a general overview illustrating the differences between general and special repo transactions.

Fig. 3 Collateral Divides Repo Market

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Source: www.eurexrepo.com/swx/overview_repos_en.html, 30-04-04.

Under a general collateral repo, the transferred securities serve to secure the loan that has been granted. This is why the parties must not agree on the individual class of securities but on the quality. The securities that have the same qualitative value to the cash provider as collateral are combined in a basket to ensure an efficient and low-cost settlement.

The collateral is normally T-bills, T-notes, T-bonds, mortgage-backed securities (U.S.) or (Jumbo-)Pfandbrief-Baskets (Germany). Their maturities and other features, such as callability and coupons, may be unattractive to the seller of the security. Besides, securities which form part of the general repo basket are highly standardized, whereas the special collateral is traded on an individual basis. Negotiations over the collateral package can delay repo transactions and, thus, make their arrangement more difficult than for simple uncollateralised loans. (see Saunders, 2000, p. 397).

Each repo is defined by an underlying transaction (i.e. by a contract) in which the essential contractual elements are recorded (cash taker, cash provider, purchase date, term etc.). By defining the contract types, the opportunities for shaping the underlying transactions are limited and a more or less standardised repo business is achieved (see Wechsler, 1998, p. 29). The following figure shows the contract types that were used for repos by the SNB in cooperation with SegaIntersettle until 1998.

2.2.1 T-Bonds and T-Notes

In the U.S. and the U.K., in large part government borrows funds by selling T-notes and T-bonds. T-note maturities range up to 10 years, whereas bonds are issued with maturities ranging from 10 to 30 years. Both are fixed-income securities, make semi-annual interest payments, called coupon payments, and repay principal on the maturity date. Aside from their differing maturities at issuance, the only major distinction between T-notes and T-bonds is that T-bonds may be callable during a given period, usually the last five years of the bond’s life (see Elton/Gruber, 2003, pp. 14 f.). In general, treasury instruments are considered to be safe from default, and thus differences in expected returns are due to differences in maturity, differences in liquidity and the presence or absence of a call provision (see Bodie et al., 2002, p. 35).

In the European market T-bonds and T-notes are comparable with European government bonds. They are perceived as having a negligible credit risk and a high degree of liquidity compared to other types of assets. Thus, they perform a “safe haven” role at times of unstable conditions in financial markets. A reduction in the availability of government debt also affects the functioning of bond markets, unless private financial markets develop sizeable and liquid markets for a number of asset classes that enable private securities to assume some of the roles presently fulfilled by government securities. In the late 1990s and 2000, the net supply of government securities in some countries was reduced due to the improved financial position of governments in Europe and the U.S. Financial markets usually adjust to reduced availability of government debt through increased issuance of securities by the private sector, both financial institutions and corporates (see Mastroeni, 2001, p. 44).

2.2.2 T-Bills

Treasury bills are the least risky and the most marketable of all money market instruments. Here the government raises money by selling bills to the public. While most money market instruments are sold in minimum denominations of $100,000, T-bills are sold in minimum denominations of $10,000. New 91- and 182-day T-bills are issued weekly, whereas 52-week T-bills are issued monthly. Principally, sales are conducted via auction, at which investors can submit competitive or non-competitive bids. A competitive bid is an order for a given quantity of bills at a specific offered price. If the bid is high enough to be accepted, the bidder gets the order at the bid price (see Madura, 2003, pp. 135-137). Individuals can purchase T-bills directly at auction or on the secondary market from a government securities dealer. T-bills are sold at a discount from face value (cash payment at maturity) and pay no explicit interest payments. At the bill’s maturity, the holder receives from the government a payment equal to the face value of the bill (see Bodie et al., 2002, pp. 28-31). T-bills are highly liquid, which means that they can easily be converted to cash and sold at low transaction cost with low price risk.

2.2.3 Pfandbriefe

Basing on the U.S. American model of mortgage-backed securities and the U.S. mortgage market, the European bond market has witnessed a very strong development of “Pfandbrief-style” products, in particular the so-called “Jumbo” segment in the last years. This particular instrument seems to offer a very high level of quality for investors due to its built-in characteristics that enhance investor protection. Jumbos obtain an issue rating comparable to those of government bonds and higher than the rating of the individual issuer of this type of asset.

Pfandbriefe are covered bonds obtained through a process of securisation. This can be defined as the technique of converting a credit claim or a pool of claims into negotiable securities, a process that can typically be achieved either “off-balance sheet (“asset-backed”), or “on-balance sheet” (“Pfandbrief-style”), or even through “synthetic securisation” (see Mastroeni, 2001, pp. 45 f.). On-balance sheet securisation consists of the issuance of securities backed by securities that remain on the balance sheet of the issuer. The typical example for this type of securisation is the German Pfandbrief.

For traditional Pfandbriefe the level of standardization is relatively low, whereas Jumbos are highly standardised and very transparent to the investors. In general, Pfandbrief-style products have built-in mechanisms in order to ensure “bankruptcy remoteness”, i.e. ensuring repayment of the bondholder in the event of default either of the bank issuing the Pfandbrief, or of the underlying issuer of collateral. They are guaranteed by the whole amount of mortgage or public loans issued by the bank (see Woll, 1992, p. 543).

Jumbo-type products that are currently issued in the euro area are the German Pfandbrief the French obligation foncière, the Spanish cédula hipotecaria, the Luxembourg lettre de gage and since 2001 also the Irish Pfandbrief (see Mastroeni, 2001, pp. 47-50). It was only with the launch of the Jumbo Pfandbrief by the German mortgage banks in mid-1995 that domestic covered bonds crossed domestic boundaries to become a better known instrument internationally. The move of the German banks has been followed by the French, Spanish and Luxembourg regulatory authorities, which have revised and updated their existing legislation on covered bonds (see Mastroeni, 2001, p. 53). In Switzerland the Pfandbriefe (lettres de gage) and mortgage bonds deviate quite materially from the Franco-German model (see www.eubfn.com/arts/DePfa.htm, 13-06-04).

2.3 The Pricing of Repos

Pricing in repo markets depends on whether the transaction involves general or specific collateral. In general repo transactions, the repo rate is roughly comparable to other short-term market interest rates and is only slightly higher than the T-bill rate. In a specific repo transaction, the repo rate reflects the value of the collateral in the securities loan (see Hull, 1997, p. 50).

For specific collateral, the repo rate is generally below the repo rate for general collateral. In a special repo transaction, the borrower of securities is willing to accept a lower return in order to obtain specific collateral. The spread between the general repo rate and the specific repo rate can be thought of as a borrowing fee for specific securities and is sometimes referred to as the repo spread or “specialness spread” (see Wechsler, 1998, p. 52). This repo spread allows the holder of the collateral to earn a repo dividend.

Fig. 4 Capturing the Repo Dividend

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A dealer can capture the repo dividend by repo-ing out the specific collateral that is on special and simultaneously reversing in general collateral. The dealer nets (r-R) times the value of the specific collateral financed in the repo market. Source: Fisher, 2002, p. 33.

Arbitrage, market-making and speculative activity of market intermediaries have a major impact by facilitating price discovery and providing liquidity. This often takes the form of direct trading of the repo rate itself, a practice called matched-book trading. Thereby, paired repo and reverse trades base on the same underlying collateral, perhaps mismatched in maturity (see Fisher, 2002, p. 28). Securities or cash are borrowed through the repo market with the intention of re-lending the cash or securities at more favourable rates in the same market. This trading earns market–makers or dealers a small spread and facilitates price discovery. Thus, customers are enabled to obtain funding or securities on more favourable terms. Since this type of trading is usually conducted in high volume, it can have a large balance-sheet impact and thus tends to be sensitive to features of the regulatory regime (see Bodie et al., 2002, pp. 10f).

Sometimes participants transact even at negative specific repo rates, which means that the lender of money receives less money at maturity than the amount loaned. Negative repo rates arise simply because the fee for borrowing a particular security has risen above prevailing interest rates (see BIS, 1999, p. 6). The following question arises: Why would anyone put extra value on some specific collateral? Why are other similar bonds not sufficiently close substitutes? The answer is simple: Anyone who sold that specific collateral short must deliver that bond and not some other bond. In other words, traders with short positions are willing to pay a repo dividend (see Fisher, 2002, p. 32).

Fig. 5 An Equilibrium Repo Spread

illustration not visible in this excerpt

Source: Fisher, 2002, p. 33.

Supply and demand for repos may meet either via over-the-phone trading, or in the electronic repo market, which is a growing sector in today’s trading environment, enhancing transparency and liquidity. Firstly, the market participant bilaterally determines all relevant repo parameters and then issues a statement of interest, which is an advice to all or individual market participants (see The Bond Market Association, 2003, p. 8). In this non-binding statement the sender states his interest in a specific transaction. The recipient of a statement of interest may supplement or overwrite this with his offered quantity and his price and address it as an addressed offer to the sender of the statement of interest. The recipient of the addressed offer can accept or reject the offer by phone call or via “mouse click” – in electronic markets. A market participant may also use an addressed offer to suggest his potential counterparties a binding transaction without notifying them beforehand by means of a statement of interest. In the electronic repo market, participants in the repo market place an electronic settlement order as contract confirmation with a repo triparty service provider. Both the cash taker and the cash provider must place an order within certain deadlines (see also Nyborg et al., 2002, p. 11).

The price differential, which is the difference between the repurchase price and the purchase price is payable throughout the term, commencing with the purchase date (included) and ending with the repurchase date (excluded). Participants may bilaterally agree on one of the following calculation formulae: actual/360, actual/365, actual/actual The price differential is computed on a daily basis, also in the case of intraday repos in which the cash is available to the cash taker only for several hours (see Wechsler, 1998, p. 32).

Interest on general collateral repo is paid at maturity but, in addition, there are daily accrued interest and mark-to-market payments associated with reversals. These payments protect the financial interests of both borrowers and lenders. They are, therefore, a crucial aspect of GC repo. In order to justify the return of a borrower’s collateral against payment of only the original principal amount of the borrower’s repo, the borrower must pay accrued interest on its borrowing and make (or receive) a mark-to-market payment to account for the decline (or rise) in the market value of its contract due to changes in general collateral repo rates since the contract was negotiated. To preserve the convention that interest on general collateral repo is paid in full at maturity, both of the foregoing payments are returned the following day with interest at the overnight repo rate. (see Fleming/Garbade, 2003, p. 6).

2.4 The risk associated with repos

The most important types of risk regarding repo transactions are credit risk, liquidity risk, operational risk (settlement risk) and interest rate risk.

Although repo transactions are collateralised, certain embedded credit risk remains. The potential for a credit exposure to develop depends on the volatility of the price of collateral (see Wechsler, 1999, p. 17). A decline in the market value of the securities held as collateral creates a credit exposure as the cash loan is now only partially collateralised since, in the event of counterparty failure, the collateral will have to be liquidated at the prevailing (lower) market price. Conversely, if prices move in the other direction, the cash lender will be over-collateralised. This implies that the securities lender runs a credit risk for the difference between the market value of the collateral and the cash leg. Exposures can also develop if securities are not properly segregated or transferred, and if margin call practices are inadequate, such as the failure to re-establish haircuts after a change in collateral values (see Fleming/Garbade, 2003, p. 6).

Highly creditworthy borrowers in the repo market sometimes borrow money with a low haircut using more volatile securities as collateral. In doing so, they are using their strong credit standing to borrow funds more cheaply. Those lending to them must recognise that (uncollateralised) credit has been extended and manage the risk accordingly (see Saunders, 2000, pp. 107 f.). Interest rate risk can be considered as non-existing, as the repo transaction is backed by collateral, and the general collateral rate can be compared to the risk-free rate of a bond (see Fisher, 2002, p. 32)

Just as for any other financial product, activity in repo markets entails operational risks. Although repos involve a bundle of relatively simple transactions, some of the associated transaction structures (settlement systems, legal procedures etc.) may be quite complex and can give rise to increased operational risk. Technological innovation has been a major concern in recent years. In the 1980s and 1990s, banks, insurance companies and investment companies all sought to improve operational efficiency with major investments in internal and external communications, computers and an expanded technological infrastructure (see Saunders, 2000, pp. 109 f. and pp. 202-210.). The objective of technological expansion is to lower operating costs, increase profits and capture new markets, which can be achieved by exploiting economies of scale and economies of scope. Economies of scale imply lower average costs of operations by expanding output of financial services. Economies of scope imply that cost synergies may be generated by producing more than one output with the same inputs. Indeed, the attempt to better exploit such economies of scope lies behind the currently existing mega-mergers (see Andersen, 1998, pp. 95-112).

Additionally, there are two types of liquidity risk associated with refinancing difficulties and with counterparty default. The first can arise from over-reliance on very short-term funding sources, where an institution experiencing unexpected financial distress may find it difficult to roll over maturing repos (see The Bond Market Association, 2003, p. 17). This risk could rise in countries where only the short-term segment of the repo market has been developed, leading to a very short maturity structure for debt at institutions that rely heavily on repos for funding. Another source of liquidity risk is associated with the liquidation of collateral, for example in the event of default of a counterparty. Clearly, if securities markets are rather illiquid (or become illiquid at times of market stress), the exposure may be under-collateralised if the collateral can only be liquidated at a discount. To limit this risk market participants need to carefully consider the liquidity of the markets for the securities used as collateral when setting haircuts and credit lines (see Saunders, 2000, p. 114).

The use of leverage can increase credit and liquidity risk, which may be of particular concern to repo market participants, since repos are regarded as a cost-effective source of leverage. Leverage is vital to the financial market activities of market participants and facilitates the effective use of a scarce resource – capital. However, it also entails risks and thus needs to be set at an appropriate level. Policies on initial haircuts and margin practices that are well formulated and consistently applied help to limit leverage. Furthermore, repo markets may have implications for systemic risk due to the linkages of repo markets with other short-term financial markets and securities markets. Systemic risk consists of the following components: the probability of a shock occurring, the channels through which shocks are transmitted and the impact that these shocks tend to have (see BIS, 1999, p. 27).

2.5 The Advantages of Repos

Repo transactions offer a number of advantages in contrast to other comparable instruments (see Wechsler, 1998, p. 10 f.; Fleming/Garbade, 2003, p. 6).

- In a repo, the credit risk of the cash provider is transferred form the counterparty to the issuer of the securities serving as collateral. Even participants who would usually not be granted credit lines in an unsecured money market can enter into repurchase agreements. Consequently, repo transactions usually offer a broad range of investment opportunities and credit facilities.
- In contrast to an unsecured loan, the cash taker benefits from more attractive interest rate conditions. For example, the deposit interest rate in Switzerland has exceeded the repo rate curve since 1998.
- A liquid repo market practically exists in all usual currencies. The terms vary between one day and one year which implies higher flexibility for the participants.
- The broad range of securities available in the repo market offers a competitive return on invested capital depending on the creditworthiness of the counterparty or the issuer and the selected settlement form.
- Financial institutions can not only channel their capital resources more efficiently, but they benefit also from an attractive return on their invested capital. Provisions such as the capital adequacy rules in the EU require banks to provide adequate capital for that part of the loan which is not covered. Consequently, it is only evident that almost no capital resources are required in the repo business, because all repos are secured.
- To satisfy monetary obligations arising from repos with banks, cover is only to be provided for the difference between the value of the obligation and the value of the collateral.
- A centralised risk management facility ensures that collaterals are permanently monitored on conclusion of a tri-party repo and provides for the immediate transfer of margin securities. Thus, repo transactions are associated with high security.

2.6 Differentiation to other Instruments

2.6.1 Securities Lending and Borrowing

In the event of a securities lending, the lender lends out securities and receives a lending fee from the borrower. In the case of art. 312 OR (Swiss Code of Obligations) the borrower becomes the legal owner of the securities. In the standard form, the borrower becomes contractually obliged to redeliver a like quantity of the same securities, or to return precisely the same securities. The lender is to be compensated by the borrower for any income earned during the term of the lending. If securities lending is combined with a cash lending of the equivalent amount, the economic features of a repurchase agreement can be reproduced (see BIS, 1999, p. 39).

2.6.2 Sell/Buy Back Agreements

A sell/buy back operation consists, as a repo transaction, of a sale of securities linked to a concurrent forward purchase. The forward price is set relative to the spot price to yield a market rate of return. In contrast to repo and securities lending transactions, price fluctuations are not balanced out by means of margin calls, marking-to-market (see BIS, 1999, p. 38). The market participants therefore expose themselves to a larger counterparty risk than those of repos or securities lending. Since the buyer becomes the beneficial owner, any income earned must not be transferred to the seller. Instead, the seller may buy the securities back at a reduced price (see Wechsler, 1998, p. 12; ISMA, 2004, p. 16).

2.6.3 Lombard Loan

The lombard rate is the rate of interest at which central banks lend to commercial banks, usually 1% above the discount rate. A Lombard loan is defined as a fixed credit of a certain amount of money, which is granted to commercial banks against the pledging of movables and/or rights. The pledge-object may be movables as jewellery or precious metal, securities, bills, rarely endowments or goods. The advantage of lombard loans can be seen in the fact that no sale of securities of movables is necessary in order to obtain short-term liquidity (see Graefer et al., 1994, p. 204). The following table highlights the differences between the mentioned products:

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