Repo and Reverse Repo Markets Domain Refresher Training

Agenda REPO Basics Features of the REPO Market Tri Party Repo Role of BNY Mellon 2 2

Section I. REPO Basics

What is a repo agreement? A repo agreement is a contract in which a security is sold with an agreement on the initiation date to repurchase the security at a higher price on a later date specified in the contract. In Figure 5.1, we illustrate a repo transaction. Institution X delivers a Treasury note with a market value of $1,000,000 to Institution Y, which delivers to Institution X $1,000,000 in cash (initial transaction, or the opening leg in the figure). For simplicity, we assume that the Treasury note is selling at par. On the same day, Institution X agrees to buy back from Institution Y the same security on the very next day (overnight) at a price of $1,000,138.89 (closing transaction, which occurs the next day).

Definition of REPO Repurchase agreement (REPO): a contract to sell a security and then repurchase it at a later date for a specified price. We can think of a repo as a collateralized loan, where the collateral is the security. This is because the seller of the security retains the right to receive any interest paid on the security over the term of the repo agreement. Repos are one of the largest sectors of the money market (approximately $1 trillion daily). The repo market provides attractive returns to money market investors, and an inexpensive source of financing for security holders.

Repo transactions

Repo transactions The price at which institution X agrees to buy back was arrive at as follows: The implies interest rate is 5%, and this is determined by the market forces.

What is a reverse repo agreement? A reverse repo agreement is a contract in which a security is borrowed with an agreement on the initiation date to replace the security at a higher price on a later date specified in the contract – flip side of a repo. Figure 5.2 illustrates a reverse repo transaction from the perspective of Institution X. Institution X borrows a Treasury note with a market value of $1,000,000 to Institution Y and delivers to Institution Y $1,000,000 cash (initial transaction in the figure). For simplicity, we assume that the Treasury note is selling at par. On the same day, Institution X agrees to sell back to Institution Y the same security on the very next day at a price of $1,000,138.89 (closing transaction, which occurs the next day).

1. Initial Transaction in Reverse Repo Agreement Treasury Note Institution X Institution Y Cash $1,000,000 2. Closing Transaction in Reverse Repo Agreement Treasury Note Institution X Institution Y Cash $1,000,138.89

Example of repo transaction On August 31, 2007, the 30-year T-bond with a coupon of 5.00% and maturing on May 15, 2037, was quoted at a clean price of 102.50. The general collateral repo rate for a term of one month was 4.775%. A bond dealer receives an order from a client to buy this bond forward in one month’s time. What is the forward price that dealer should quote? Why? How should the dealer hedge the exposure, assuming that the deal is done on August 31, 2007?

Example of repo transaction The dealer will first compute the forward price as follows: Borrow cash to buy the bond in the repo markets for a one-month term on August 31, 2007. Figure out how much has to be paid in the repo markets on September 30, 2007, to retrieve the collateral. This is the forward price at which the dealers will break even. Any additional profit margin would depend on the extent of competition.

Example of a Repo transaction Dealer A owns the security and gets the accrued interest. Dealer A must pay B the repo interest on the cash borrowed. In an upward sloping yield curve, dealer A enjoys a positive carry.

Example of a Repo transaction Dealer A collects the accrued interest when he sells the bond. The transaction is secured by the bond by dealer A.

Example of a Repo transaction Dealer B owns the security and gets the accrued interest. Dealer B must pay A the repo interest on the cash collateral. In an upward sloping yield curve, dealer A faces a negative carry.

Example of a Repo transaction Dealer B collects the accrued interest when he gets the bond. The transaction is secured by cash by dealer A.

Section II. Features of a REPO Market

Participants Participants Why Participate? Commercial banks Commercial banks tend to be net sellers of collateral, that is, cash borrowers.  Corporations Corporations and money market funds tend to be net buyers of collateral, that is, cash lenders. Central banks Central banks enter the repo market to influence interest rates 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. Money market dealers/brokers Money market dealers and brokers will often run matched repo books whereby a repo entered into with one counterparty will be matched with a reverse repo with another counterparty, and vice versa. Other Participants

Dealers Dealers enter into repos for a variety of reasons Inventory: most dealers and traders do not own all the securities in their inventory outright, so the standard practice is to finance holdings by borrowing in the repo market. Short positions: dealers also use the repo market to cover short positions (i.e., they buy the securities to cover the short position and sell them back in a reverse repo). Matched books: dealers buy collateral from one customer (e.g., a thrift) and sell to another (e.g., a money market fund) at lower rate.

Terms of the Loan Overnight repos: one-day transactions Approximately 50% of the market. Open repo is an overnight repo that rolls over automatically. Term repos: transactions beyond one-day (up to one year). Vast majority of repos have maturities of three months or less.

General Collateral Repo Rates In a general collateral repo contract, the lender of cash is willing to accept any security within a class of securities. Sometimes such a contract is referred to as a GC repo contract and the rate on that contract is referred to as the GC repo rate . In a GC repo contract, the lender of cash (such as a mutual fund or fixed-income asset management firm) is primarily interested in earning interest income with limited counterparty credit risk. As long as the class of securities specified in the GC repo contract can be quickly liquidated at a low transaction cost in the market without an adverse price reaction, the lender of cash is comfortable in entering into the GC repo contract. GC repo rates tend to track Effective Fed funds rates

Special Repo Rates In a special collateral repo contract, the lender of funds specifies a particular security as the only acceptable collateral. Such contracts are referred to as special repo contracts and the interest rates on such contracts are referred to as special repo rates. The reason that such contracts might arise is best illustrated with a simple case: Consider a dealer who has a previously established short position in Treasury Note A. The dealer might want to cover his short position by delivering Treasury Note A. To do this, the dealer will lend cash against a specified Treasury Note A (specific security) and use the borrowed security to cover his previously established short position. The special repo rate is typically lower than the GC repo rate in the same security class. In other words, the special rate on a 10-year Treasury note will be lower than the GC repo rate for Treasury securities as a class.

Fails in repo markets Fails occur in repo markets when a security is not delivered (as promised in the contract) on the contractual maturity date. When a fail occurs, counterparty credit exposure results. A very small number of fails occur due to miscommunications or improper and inaccurate documentation in the transactions. Fails can also occur because of an exogenous shock such as the September 11, 2001, attacks. These are idiosyncratic events. Fails that occur when a counterparty is unable to deliver a security may trigger a chain of failures.

Risk Both parties are subject to credit risk and Market Risk The market value of the collateral can change, and one or both party's overall financial position may change for a variety of other reasons.

Illustration Suppose an entity enters into a $10 million 30-day repo with a dealer who is under-capitalized. The dealer delivers the $10 million in T-notes, but is forced into bankruptcy and cannot repurchase them. The entity can sell the collateral in the open market to get its money back. However, if the market price of the T-notes has fallen, then the entity will suffer a loss.

Ways to Reduce Credit Risk Margin: Lenders often require margin to limit their credit exposure (typically 1% to 3%). Example: a customer enters a repo for $10 million with a 2% margin. The dealer delivers $10.2 million worth of securities, receives $10 million, and repurchases the securities on a future date for $10 million plus interest. Marking to market: Collateral is valued at current market levels and the trade is adjusted through a marginal call (dealer sends more collateral) or re-pricing (funds are delivered to customer).

Repurchase Agreement Rates Turn Negative as Fail Penalty Debuts Source: Bloomberg May 1, 2009 Rates in the $7 trillion-a-day market to borrow and lend government debt dipped below zero as a 3 percentage point penalty for failing to meet delivery obligations went into effect for the first time. The old five-year note, the 1.75 percent security maturing in March 2014, traded today at the lowest repurchase, or repo, rate, dipping as low as negative 1 percentage point. The rate closed at negative 0.05 percent, according to GovPX Inc., a unit of ICAP Plc, the world’s largest inter- dealer broker. A negative repo rate means that investors who lend cash in exchange for obtaining Treasuries as collateral actually pay interest instead of receiving it on the money they loan. “Repo rates went negative because we have the new fails fees,” said Joseph Abate, a money-market strategist in New York at Barclays Capital Inc., one of the 16 primary dealers that trade directly with the Federal Reserve.

Repurchase Agreement Rates Turn Negative as Fail Penalty Debuts Source: Bloomberg May 1, 2009 In a repurchase agreement, one party provides securities as collateral to another in exchange for cash; in a reverse repurchase agreement, the opposite takes place. When a security is not delivered as promised, the uncompleted trade is called a fail. The so-called general-collateral repo rate opened today on the bid side of the market, the price quoted for immediate sale, at 0.35 percent, according to GovPX. The federal funds rate opened at 0.21875 percent. The Fed’s official target rate for overnight loans between banks has been at a range of zero to 0.25 percent since December. Securities that can be borrowed in the repo market at interest rates close to the Fed’s target rate are called general collateral. Notes and bonds that are in the highest demand, such as the previously issued five-year note today, are called “special” by traders because rates on loans secured by these securities are lower than the general collateral rate. `

Topic 2b - Conclusions/Main insights Repo and reverse repo markets are used to finance securities and to earn interest on a collateralized basis. These markets allow dealers and hedge funds to take significant leveraged positions with fairly low counterparty credit risk. The Fed engages in repo and reverse repo with primary dealers to execute its open market mandate. GC repo rates refer to collateralized borrowing/lending rates when a class of securities are accepted as collateral. Special repo rates refer to collateralized borrowing/lending rates when only specified securities are accepted as collateral.

Topic 2b - Conclusions/Main insights (continued) GC repo rates tend to track closely other short-term interest rates such as effective Fed funds rates, LIBOR and OIS rates. There are important differences between these short-term interest rates. Fails tend to occur when the GC repo rates are low. This incentive has since been addressed through a “fail penalty” of 300 basis points, allowing Special repo rates to go negative. Forward prices on bonds can be arrived at using term repo rates.

Section III. TRI PARTY REPO

Tri Party Repo Tri-party repo is a transaction for which post-trade processing --- collateral selection, payment and settlement, custody and management during the life of the transaction - -- is outsourced by the parties to a third-party agent. Tri-party agents are custodian banks. Because a tri-party agent is just an agent, use of a tri-party service does not change the relationship between the parties, as the agent does not participate in the risk of transactions. If one of the parties defaults, the impact still falls entirely on the other party. This means that parties to tri-party repo need to continue to sign bilateral written legal agreements such as the GMRA

Overview of Tri-Party Repo A Dealer and an Investor agree on a Tri-Party Repo trade They independently advise Tri-Party Repo Agent-Collateral Manager of the trade The Investor (e.g. money market funds, securities lending agents, insurance companies) sends the cash and the Dealer sends the securities to Tri-Party Repo Agent-Collateral Manager Tri-Party Repo Agent-Collateral Manager send the cash to the Dealer and hold the securities in the Investor’s account Tri-Party Repo Agent-Collateral Manager extends intra-day credit to the Dealer in order for the trade to mature and for the cash principal plus interest to be returned to the Investor. Then return the securities to the Dealer, while immediately debiting the cash principal and interest from the Dealer.

Relevance for us- BNY Mellon Tri-party agents dominate the settlement of US repo, accounting for something in the order of two-thirds of the US market In the US, there are only two: Bank of New York Mellon and JP Morgan.

Advantages of Repos There are a number of advantages of repurchase agreements. Advantages of Repos Parties with a borrowing requirement can achieve lower funding costs through repos than with most 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 collateral and are usually transacted between parties with good credit ratings The cash and securities in a repo transaction can be different currencies For lenders of cash, repos provide an alternative to both the 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 (in terms of contract size and maturity) 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

Uses of Repos Repos are used to: Financing Long Positions finance long positions in different securities provide an alternative source of finance to the unsecured money market provide a method of closing out short positions in a particular security The most important use is to finance long positions. Let's look at this a little closer. Financing Long Positions The unsecured money market is the section of the money market in which the borrower of funds is not required to provide security (collateral) to the lender of funds. Examples of unsecured money market instruments include T-bills, CDs, and commercial paper. Repos are primarily used to finance long positions in (mostly) government securities. To do this, dealers sell these securities at an agreed price and obtain funds at an agreed interest rate in return. They use these funds to finance their purchases of these securities. They also agree to buy back the securities at an agreed price at some specified date in the future.

Calculating Repurchase Agreements 1 Today is June 6. The repo dealer at DEF Bank has been asked to do some funding for the bank. The dealer needs to raise about USD 50 million and has been asked to see what rates can be achieved. As DEF Bank is only looking for liquid money, the dealer is looking at the rates for one-day and open repos. The rates quoted on the screen are: USD 3.10 - 3.15 If the dealer at DEF wants to raise money, which rate will be used? The answer is 3.15. The market is offering to lend money, against collateral, at 3.15% and is looking to pay 3.10% for deposits.

When the dealer looks at the bank's available collateral, he discovers that the bank does not have USD 50 million of US securities on its books to use as collateral. Instead it has the following: USD 30 million US Treasuries 4.5% 11 November 20x6 trading at 100.50 (clean price) EUR 10 million German Bunds 5% 30 April 20X3 trading at 99.89 (clean price) EUR 15 million French OATs 4.75% 31 May 20X6 trading at 99.45 (clean price) What sort of repo structure will enable the bank to use the euro collateral to raise USD? Classic repo Buy/sell back repo Cross currency repo Answer : Cross currency repos have an exchange rate aspect as an additional complication. In practice, its impact on calculation is relatively limited.

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