Central Bank of Egypt 1March, 2014Rami Aboul Naga RepurchaseAgreements

Central Bank of Egypt 2March, 2014Rami Aboul Naga Index I.Repurchase Agreements 1.Definition 2.Advantages of Repos II.Uses of Repos 1.Investment of Cash Balances 2.Incremental income 3.Taking positions 4.Financing positions III.Major Participants and Central Bank role IV.Features of Repurchase Agreement 1.Maturity 2.Margining 3.Risk 4.Collateral V.Types of Repos 1.Classic Repo 2.Sell/Buy Back 3.Cross Currency 4.Security Lending Transaction

Central Bank of Egypt 3March, 2014Rami Aboul Naga Index VI.Delivery Methods 1. Deliver-out repo 2. Hold in custody (HIC) repo 3. Tri-party repo VI.Legal Documentation 1. Global Master Repurchase Agreement 2. Tri-party Agreement VII. Appendix

Central Bank of Egypt 4March, 2014Rami Aboul Naga I. Repurchase Agreements A repurchase agreement (also called a Repo) is a money market instrument whereby a borrower sells securities ( or some other asset) to another party (and thus obtains funds) at a fixed price and agrees to repurchase the securities at an agreed future date and price. A repo is in effect a combination of two simultaneous transactions in one contract. One party sells and buys back the securities (repo), while the counterparty buys and then re-sells (reverse repo). Thus whenever one side does a repo, a reverse repo is transacted by another party. 1.Definition

Central Bank of Egypt 5March, 2014Rami Aboul Naga I. Repurchase Agreements Finally, a repurchase agreement is considered to be a secured borrowing where the securities deposited with the lender for the period of the loan are used as collateral for the loan.

Central Bank of Egypt 6March, 2014Rami Aboul Naga I. Repurchase Agreements FOLLOW THE CASH

Central Bank of Egypt 7March, 2014Rami Aboul Naga I. Repurchase Agreements Parties with a borrowing requirement can achieve lower funding costs through repos than with other money market instruments Holders of securities can increase their overall returns by lending their securities through a repo. Repos are a low risk investment since they are secured by collaterals. The Cash and securities in a repo transaction can be in different currencies 2.Advantages of Repos

Central Bank of Egypt 8March, 2014Rami Aboul Naga I. Repurchase Agreements For lenders of cash, repos provide an alternative to both he unsecured money market and the outright purchase of securities. For lenders of securities, any coupon interest on the securities is retained. For both borrowers and lenders, repos represent a highly flexible and liquid instrument As repos are effectively collateralized loans, they carry a zero risk weighting for capital adequacy purposes, under the Basel II capital framework. Loan/deposit transactions, on the other hand, carry a 20% risk weighting.

Central Bank of Egypt 9March, 2014Rami Aboul Naga II. Uses of Repos There are four types of purposes that Repos can typically achieve: 1. Investment of cash balances: Due to the securitized nature of repurchase agreements, most institutions' risk management departments will allow larger lines of credit for repo transactions that for unsecured deposits. 2. Incremental income: For holders of securities that have "repo value," incremental income can be earned by lending the special bond and investing proceeds at a higher rate in general collateral. This is a popular strategy for central banks.

Central Bank of Egypt 10March, 2014Rami Aboul Naga II. Uses of Repos 3. Taking positions: The repo market allows for views on the shape of the money market curve to be expressed. Additionally, the repo market also facilitates the shorting of bonds. 4. Financing positions: Most securities' houses run large books of positions which need to be funded. The repo market offers a lower cost mechanism than the unsecured inter-bank market. Also, it diversifies the source of funds as more investors are likely to have a credit line for a secured loan. Repo is therefore a vital tool for the broker/dealer community and for hedge funds.

Central Bank of Egypt 11March, 2014Rami Aboul Naga III. Major Participants & Central Banks role The major participants in the repo market are mainly: Commercial Banks Corporations Money market dealers/brokers Central Banks Central Banks can use the repo market as a monetary tool where it can influence interest rates and liquidity in the short term. By buying collateral ( and lending funds), the central bank increases the money supply and drives down interest rates. If, on the other hand, the central bank wishes to reduce the money supply and increase interest rates, it can sell securities on a repo, thus withdrawing money from the financial system.

Central Bank of Egypt 12March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements The majority of repos are issued for one business day (O/N). However there are also repos with a maturity grater than one day. Under this comes: Term Repo: Agreements issued for fixed terms from one day to one year. Open Repos: Agreements where either the borrower or the lender may chosse to cancel at any time. The repo rate on open-ended repos can be renegotiated after a certain period of time has elapsed. 1.Maturity

Central Bank of Egypt 13March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements The fact that the securities in a repo transaction can rise and fall in value means that some form of margin must be built in to protect the lender. Margin is also used to protect against the illiquidity of collateral and counterparty risk. There are two types of margins: Initial margin Variation margin 2.Margining

Central Bank of Egypt 14March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements Initial Margin: Also known as haircut is the percentage by which the market value of the securities ( including accrued interest) in the repo transaction exceeds the cash lent. ( Start proceeds). Margin is usually expressed in terms of the margin ratio: Margin Ratio = Collateral Market Value/ Cash lent

Central Bank of Egypt 15March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements Example: A margin of 2% represents a margin ratio of 102%. Thus, if the collateral is valued at USD 10,000,000/- ( including accrued interest), cash lent will be: Cash Lent= 10,000,000/1.02= USD 9,803, The size of the initial margin is primarily determined by the creditworthiness of both counterparties and the securities used as collateral. Also, a longer repo term and higher collateral duration will lead to a higher initial margin.

Central Bank of Egypt 16March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements Variation Margin: refers to the amount by which the value of the collateralized securities may fluctuate before a margin call will be triggered. A margin call can be met in cash or by additional stock. Variation margin can be expressed in % terms, in absolute cash amount terms, or on a discretionary basis by the counterparties. To reduce the administrative costs of margining, a margin call is usually made only where the change in the market value of the collateral exceeds an agreed amount known as the maintenance margin.

Central Bank of Egypt 17March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements

Central Bank of Egypt 18March, 2014Rami Aboul Naga Example: Counterparty A lends $ 10 MM of the current 2 yrs at a price of 99. The haircut is 2%. Counterparty A receives $ 9,706,415.18/- Market rises and UST is now worth $ 9,600,000/- Counterparty A should restore the margin difference by delivering $106,415.18/- IV. Features of Repurchase Agreements

Central Bank of Egypt 19March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements Repo agreements are low-risk transactions as a consequence of four factors: - fully collateralized loan - provision for margining - daily marking-to-market - ownership of collateral transferred 3.Risk

Central Bank of Egypt 20March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements The fact that repos can be considered as fully collateralized loans, and have provisions for margining and marking-to- market daily, means that they are significantly less risky than unsecured forms of lending. During the term of repo, the ownership of the collateral is legally transferred to the lender, so that in the event of a default by the borrower, the lender can sell off the collateral and so recover the investment.

Central Bank of Egypt 21March, 2014Rami Aboul Naga IV. Features of Repurchase Agreements Collateral take one of the following forms: Specific Collateral General Collateral (GC) Securities used as collateral include: Sovereign Debt, Supernational Debt, Money Market instruments and Eurobonds. The security provider in a repo transaction sometimes has the right to substitute equivalent collateral during the life of the repo. This must be agreed beforehand by the cash lender and the securities must be of the same value and credit quality. 4.Collateral

Central Bank of Egypt 22March, 2014Rami Aboul Naga V. Types of Repurchase Agreements Also referred to as a US-Style repo, involves a cash borrower selling securities to another party with a simultaneous agreement to repurchase them at a future date. The securities are sold and repurchased at the same price, but a repo rate is payable to the buyer of securities. ( the lender of funds). 1.Classic Repos

Central Bank of Egypt 23March, 2014Rami Aboul Naga V. Types of Repurchase Agreements Returns principal + interest Pays cash Sells securities CBE Counterparty AT MATURITY AT INITIATION Returns securities CBE Counterparty REVERSE REPO 1.Classic Repos

Central Bank of Egypt 24March, 2014Rami Aboul Naga Is a simultaneous agreement to sell securities spot and to repurchase them back at a future date. The forward price of the securities is derived from the agreed repo interest rate. ( Implied Repo Rate) V. Types of Repurchase Agreements 2.Sell/Buy Backs Repos:

Central Bank of Egypt 25March, 2014Rami Aboul Naga V. Types of Repurchase Agreements Classic Repo vs. Sell/Buy Backs Repo transactions and sell buy back transactions are very similar. The primary difference between the two is the fact that a sell buy back transaction is not governed by a pre- negotiated global repo agreement—the Global Master Repurchase Agreement (GMRA). The economics of the transaction are the same, but, contrary to classic repos, both deals, though done simultaneously, are treated as two separate legal entities. Another difference lies in the treatment of coupon payments; coupons are not immediately transferred to the seller in a Sell/buy back repo but rather paid back at the end of the repo term, compounded by the repo rate.

Central Bank of Egypt 26March, 2014Rami Aboul Naga Both Classic Repos and Sell/Buy Backs transactions result in cash lender's legal ownership of the securities, the economic ownership of the securities reflects a different reality. The economic ownership of the securities belongs to the cash borrower—the original owner of the securities. This results from the fact that the cash borrower retains the rights to coupons and the fact that the cash borrower is exposed to all financial risk of the securities. The accounting treatment for both repo transactions and sell buy back transactions is the same. The accounting treatment for both transactions reflects the economic nature of the transaction. The securities of the cash borrower remain on the entity's balance sheet to reflect the financial risk borne by the cash borrower. V. Types of Repurchase Agreements

Central Bank of Egypt 27March, 2014Rami Aboul Naga V. Types of Repurchase Agreements Works in the same way as a classic repo, with the exception that the securities and cash are denominated in a different currency. On the start date, the start proceeds are determined by the cash lender in the currency of the collateral. The cash lender then sells these proceeds for the currency required on the foreign exchange market. ( lender’s own currency). The proceeds are transferred to the cash borrower. On the end date, the collateral is returned to the cash borrower against payment of the end proceeds. 3.Cross Currency Repo:

Central Bank of Egypt 28March, 2014Rami Aboul Naga V. Types of Repurchase Agreements Example: A German Hedge Fund wishes to fund a long position in German Bunds against Sterling using a cross currency repo. Tenor: 1Month Nominal Value of collateral (Bunds): EUR 10,000,000/- Dirty price: Market Value of collateral: EUR 10,155,000/- Repo Rate 4.50% ( GBP 1 Mth rate) Basis: ACT/365 Exchange Rate: GBP/EUR 1.45 Required Margin 2.5% The Cash lent (in GBP) against Bund collateral is calculated as follows:

Central Bank of Egypt 29March, 2014Rami Aboul Naga V. Types of Repurchase Agreements Cash lent= Market value of Collateral (in GBP)/ Margin Ratio Cash lent = ( EUR 10,155,000 / 1.45)/1.025 Cash lent = GBP 7,003, / Cash lent = GBP 6,832, Repo interest rate = GBP 6,832,632.46* (0.045*30/365) =GBP 25,271/- The end proceeds are thus: GBP 6,857,903.84/-

Central Bank of Egypt 30March, 2014Rami Aboul Naga V. Types of Repurchase Agreements A transaction in which the owner of securities agrees to lend its securities to a borrower in exchange for collateral consisting of cash or government securities. Borrowers of securities are typically large broker/dealers who use the securities for arbitrage or risk management strategies. Incremental income is generated for the owner/lender by investing the cash collateral in high quality, short term investments. Most lenders authorize an Agent to execute and record- keep its transactions. 4.Security Lending Transaction

Central Bank of Egypt 31March, 2014Rami Aboul Naga VI. Delivery Methods Is a repo transaction where possession of the collateral ( securities) is passed onto the cash lender. If the counterparty simultaneously receives cash in return for the collateral, the transaction is described as being DVP ( delivery vs payment) Deliver-out repos make substitution of collateral more difficult and also increase back office administration 1.Deliver-out Repo

Central Bank of Egypt 32March, 2014Rami Aboul Naga Is also known as a due-bill repo or trust me repo. In this type of transaction, the collateral remains in the possession of the cash borrower, hence avoiding delivery. The Cash borrower is responsible for the marking-to- market of the collateral. HIC repos are used when there is no support operation available and also to minimize clearance costs. HIC repo carry significant counterparty credit risk for the cash lender as they have to trust the repo seller to fully collateralize the loan. VI. Delivery Methods 2.Hold in Custody (HIC) repo

Central Bank of Egypt 33March, 2014Rami Aboul Naga VI. Delivery Methods The cash lender should thus ensure that their counterparty has a high credit rating, and should expect a higher yield on the repo transaction 2.Hold in Custody (HIC) repo

Central Bank of Egypt 34March, 2014Rami Aboul Naga VI. Delivery Methods A tri-party agreement involves a third party ( a clearing house or custodian Bank) acting as intermediary between the cash borrower and the cash lender. The most popular custodian in the non-dollar repo market is Clearstream, Euroclear and Bank of New York. 3.Tri-Party repo

Central Bank of Egypt 35March, 2014Rami Aboul Naga VI. Delivery Methods The Custodian in a tri-party repo is responsible for: Taking delivery of the collateral on the cash lender’s behalf Ensuring that the collateral meets the cash lender’s credit requirements All administration including the daily valuation of the collateral, any marking-to-market of the collateral and issuing statements on a regular basis to both counterparties. The fee charged by the custodian is usually paid by the cash borrower. 3.Tri-Party repo

Central Bank of Egypt 36March, 2014Rami Aboul Naga VI. Delivery Methods Advantages of Tri-party Repos: Clearance costs and time are significantly reduced for both counterparties Settlement risk is reduced No support operation is required All transaction are monitored by the third party 3.Tri-Party repo

Central Bank of Egypt 37March, 2014Rami Aboul Naga VI. Legal Documentation The GMRA is the market standard repo document used as the legal basis for repo in non-USD repo markets, introduced in November The GMRA has been prepared as a standard form and any institution proposing to use it should ascertain that it is suitable for the circumstances in which it is proposed to be used. 1.Global Master Repurchase Agreement

Central Bank of Egypt 38March, 2014Rami Aboul Naga VI. Legal Documentation The GMRA covers a number of key points under which comes the following: Margin Maintenance Payment and Transfer Events of Default Title Transfer Waiver of Immunity

Central Bank of Egypt 39March, 2014Rami Aboul Naga VI. Legal Documentation This agreement sets forth the responsibilities of each of the parties and the custodian Bank and the mechanics of the day to day transactions. 2.Tri-Party Agreement

Central Bank of Egypt 40March, 2014Rami Aboul Naga VII. Appendix

Central Bank of Egypt 41March, 2014Rami Aboul Naga Repos Reverse Repos Investor is borrowing cash Investor is lending cash Remember: Follow the cash! The value of a repo trade depends upon whether you are borrowing cash (lending securities) or lending cash (borrowing securities). VII. Appendix CHEAT SHEET