1 Short Term USD Product Overnight Repo Shane Lawlor Global Treasury 21 March 2012

2 Introduction Every business day, money markets funds, municipalities, corporations, etc. are seeking investments for their overnight cash. A wide range of products are available including: bank CDs, corporate CP, money market funds and repurchase agreements, etc. Overnight repurchase agreements can satisfy the demands of investors especially in today’s environment where liquidity and safety are of paramount importance. (The tri- party repo market is currently $1.7 trillion market (Source: FT 2/15/12)). What is a Repurchase Agreement? Repo is the generic industry term for repurchase agreements. These are financial vehicles that are generally used by securities dealers and other financial firms to fund the purchase and therefore their long term holding of various securities. A repo is a sale of securities with an agreement to repurchase the same securities at a price on a later date. In some cases the repo can be term or ‘open’ with an evergreen maturity. The other side of the repo trade presents certain investors with an opportunity to invest their short term cash in a collateralized investment product.

3 Repo Counterparties The Seller / Collateral Provider: Managing the Balance Sheet A typical repo trade starts with a repo seller, e.g. a broker/bank, who buys a security. In order to finance the security the repo seller enters into the repo market and sells the very security that they just bought. The proceeds from the repo sale are then used to pay for the security in the first place. However, as part of the repo agreement, the dealer not only sells the asset but simultaneously commits to buying it back from the repo counterparty at an agreed price at a future date. The fixed repurchase price means that, although the asset has been sold, any change in value of the security during the term of repo trade will be a born by the repo seller, as the repo seller will have to buy it back at the price agreed to at the start of the repo. Repo is generally viewed as less risky and regulations such as the Basel Accords require institutions lending through repo to hold less regulatory risk capital than unsecured lending.

4 Repo Counterparties The Buyer / Cash Provider: Short term cash investors The repo counterparty has temporarily bought the asset and holds them as collateral. Because repo is a safer way to lend cash, repo buyers may be willing to lend more. As a cash provider the added safety of receiving collateral is seen as a relatively secure overnight investment and is not subject to the daily market price risk if cash provider had actually bought securities overnight, e.g. T Bills, Additional margin/haircut provides added safety in the even of a volatile market.. Different type of collateral are available depending on risk appetite of the cash provider.

5 Repo – Example of Operational Flows (Starting Leg) Cash Provider Custodian Security Provider Deliverable Cash Securities Cash Provider Security Provider Tri-party Custodian Custodian Securities at 102% Securities at 105%

6 Types of Repo Tri-party versus Deliverable Deliverable repo is when the cash provider delivers the security into the general custody account against a simultaneous transfer of cash to the counterpart provider. A deliverable repo is more labor-intensive and time-consuming than tri-party repo. The main distinguishing feature of a tri-party repo versus a deliverable repo is that a custodian bank is "the tri-party agent" and acts as an intermediary between the two counterparties to the repo. An investor places its money with the tri-party custodian bank, which in turn lends it to another institution. Assets are then pledged as collateral for the loan. The tri-party agent is responsible for the administration of the transaction including collateral allocation, marking to market, and substitution of collateral. Tri-party agents each administer US$ trillions of collateral. Therefore, the tri-party agent have the scale to subscribe to multiple data feeds to maximize the universe of coverage. As part of a tri-party agreement, the three parties to the agreement - the tri-party agent, the repo buyer and the repo seller agree to a collateral management service agreement which includes an "eligible collateral profile". (Source: r3po). Cash providers generally receive a slightly higher rate on tri-party repos due to added trade flexibility and settlement costs.

7 Collateral and Margin / Haircut Requirements Repo collateral is generally fixed income securities, e.g. treasury, agencies and mortgages. The repo rate and haircuts are impacted by the collateral type. The price at which a security is initially sold in a repo is usually the same as the market price. Any concerns about the liquidity of a security or the creditworthiness of the repo counterparty generally results in the repo buyer paying less than market value by deducting a discount called an initial margin (haircut). Collateral is continuously revalued and, if its value falls, then extra collateral is required from the repo seller (a process called margin call). This operational burden has driven the growth of outsourcing the management of their collateral to agents, this repo is called tri- party repo. The type of collateral drives the rate and margin. Generally repo is undertaken at 102% (repo buyer receives 2% more securities in value than the seller cash amount) and increases to 105% and above depending on the collateral type. Haircuts are generally more correlated with counterparty credit worthiness and the price volatility of the underlying securities than anything else.

8 Repo Rate The price at which a security is repurchased in a repo is equal to the price at which it was sold plus an amount of interest for the use of the cash. The amount of interest is calculated from a market determined rate called the overnight repo rate. Repo rates are generally lower than bank deposit rates like Fed Funds/Libor because lending cash through a repo is, by virtue of the collateral, less risky than making an unsecured loan. If an asset is strongly in demand, dealers may be willing to offer cheap cash to get hold of it in the repo market (repo rates can fall to zero or even go negative). When this happens to an asset, it is said to be special. In contrast, the normal repo rate is called the GC (general collateral rate). Overnight repo rates have traded in a wide range over the last year. A number of factors impact rates including: the supply and demand of securities, FDIC insurance, the number of counterparties, the counterparty balance sheet constraints, etc.

9 USD Overnight Rates 2005-Current

10 USD Overnight Rates Q Current

11 Central Banks Actions Most major central banks use repo as one of their tools to control the level of short-term interest rates. However, these periodic official operations are not part of the repo market and while the central bank repo rate provides a benchmark, market repo rates are determined between private institutions. In addition, the Fed with QE1 and QE2 and ‘ Operation Twist’ has impacted the availability and type of securities that need repo funding and the overnight repo rates. The Fed is currently testing reverse repo transactions as a matter of advanced planning for the possible reduction in their monetary easing stance.

12 Legal Documents  This requires legally enforceable documentation. In the U.S. market, this is provided by the Master Repurchase Agreement (MRA). Source is the International Capital Market Association ( ICMA) Repo In the rapidly expanding cross-border repo market ICMA has been an active force in standardizing documentation, hence the MRA or GMRA, GMRA is the standard master repurchase agreement for cross-border repo transactions.  MRA covers  In the event of a default by their counterparty, they can sell the collateral without hindrance from other creditors of the defaulter  The exposure to the defaulter can be reduced by ‘netting’ debts owed by the defaulter against debts owed to the defaulter.

13 Government Investment Officers Association. Doesn’t overnight Repo assist with two of these missions ? GIOA mission is to assist GIO with their responsibilities. Government Investment Officers are guardians of taxpayers monies. Pursuant to that duty, the mission of the GIOA is the education and training of Government Investment Officers to assist them in their responsibilities, which are as follows: Ensure safety of principal through suitable investments Maintain sufficient portfolio liquidity Optimize and measure investment performance Communicate portfolio policy and plan to the governing board and public Source: GIOA.US Website.

14 Upcoming Industry Topics Impacting the Repo Market Expiration of FDIC Insurance Ongoing Regulatory Reforms including; –SEC reform proposed from MMF –Tri-party reform –Dodd Frank reform –Basel Federal Reserve Repo Program

15 Thank You