Understanding Repo - SCB

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Understanding Repo

22 nd April 2010

Tanweer KhanGlobal Head – Repo & Collateralized Financing

Standard Chartered Bank



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Presentation Outline

n Introduction to Repo

n Balance Sheet Treatment

n Risks in Repo Transactions

n Contact Information



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Introduction to Repo



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Introduction to Repo

The age of innocence – when banks lent to each otherunsecured for three months or longer at only a small premium

to expected policy rates – will not quickly,if ever, return.

Mervyn King – Governor of The Bank of England

“

”



Question

“Would you rather buy a 6 month ‘AA’ rated time deposit

or

invest money in a repo with a ‘A’ counterparty and get ‘B’

collateral? ”



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What is Repo?

n Definition of a Repo Transactionn A repurchase (or “repo”) transaction involves a purchase or sale of securities

with a simultaneous agreement to reverse the transaction at an agreed date andprice in the future. This effectively is a “collateralized” cash loan, with securitiesbeing used as collateral

n Benefits of a Repo Transactionn Cheaper way to finance inventory

n Facilitates market making activity

n Benefit from inherent value in collateral





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Product Types – Repo and Reverse Repo

n Repo/Reverse Repo Trade Structure

Seller Cash Borrower

Buyer Cash Lender

Repo Interest Payment

Start CollateralStart Cash

End CashEnd Collateral



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Product Types – Buy Sellback/Sell Buybackand Cross-Currency Repo

n Buy Sellback (BSB)/Sell Buyback (SBB)n Similar trade structure as a repon Same economic impact as a repo

– Except that on maturity date the end cash takes into account of any bond couponsreceived by the cash lender and includes these in the maturing cash (the end cashreturned to the cash lender will be reduced by the bond coupon amount)

n Cross-Currency Repon Similar trade structure as a repo

– Except that the underlying collateral is denominated in a different currency compared tothe cash lent (e.g., USD cash lent vs. SGD denominated government bonds ascollateral)



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Product Types – Tri-Party Repo

n

Tri-Party Repon A repo where the underlying collateral is not specified but is allocated by a tri-party agent

based upon a pre-defined set of rules and criteria agreed by both counterparties – The Tri-party agent acts as custodian for the collateral – The underlying collateral is delivered by the seller to a tri-party agent and held in a separate account by the tri-party

agent on the buyer’s behalf

n Tri-Party Repo Trade Structure

Buyer Cash Lender

Seller Cash Borrower

Agree on termsof Transaction

Tri-Party AgentCustodian Bank

Notification of Trade Notification of Trade

Cash Cash

Collateral

Buyer’s Account



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Product Types – Securities Lending

n Securities Lendingn Pure Borrow/Loan vs. Fee

– A loan of a security from a counterparty to another on a fee basis, who is obliged to return the same security onmaturity

n Borrow/Loan vs. Cash – Similar trade structure and economic impact as a repo

n

Trade Structure

ClientStandardCharteredCollateral securities or cash collateral

Securities that Standard Charteredwants to borrow

Clients (e.g.,pension funds,sovereigns,mutual funds,Insurance funds)

Clients(Internal and External)

Fee for lending securities



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Securities Lending –Rationale for Lenders & Borrowers

n Allow clients to earn income bylending their securities

n Provides extra security throughcollateralization

n Offsets custody fees

n Requires minimal effort

n Facilitates borrower’s tradingstrategies

n Balance Sheet relief

n Liquidity creating mechanism

n Revenue generating opportunity

Rationale for Lenders Rationale for Borrowers



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Benefits of Repo (1/3)

n Firm Financingn Borrowing securities to cover an outright short position in the

cash marketn Financing long securities position by lending them out via repo

n Lower Financing Costsn Secured cost of funds is lower than unsecured money market funds for

financing security portfolios

n Yield Enhancementn Able to extract extra yield from lending bonds that are currently trading

special via repo trading strategies



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n Leveragen By leveraging up their portfolio via repo, investors can enhance their

portfolio returnsn Numeric Example:

– A hedge fund started with USD 10mio capital – 2 Portfolios:

Unleveraged Portfolio and a Leveraged Portfolio (10 x capital) – Purchases a 5 year State Bank of India (SBI) bond yielding Libor + 2.25%

Assume Libor = 5 year mid swap rate and is at 2.25%

Unleveraged Portfolio Leveraged Portfolio

Amount 10,000,000 100,000,000

Haircut (10% of Portfolio) – 10,000,000

Financing Required – 90,000,000

Return on SBI Bond Libor + 2.25% Libor + 2.25%

Repo Rate Financing – Libor + 0.50%

Spread Earned via Repo Financing – 1.75%

Return on Portfolio 4.5% 20.25%



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n Increase Return on Risk Weighted Assetsn Reduced counterparty default risk compared to unsecured

cash lending due to taking collateral

n Default Risk Exposure is further mitigated by: – Taking an upfront initial haircut on the collateral at start of trade

– Daily marking to market the collateral and making margin calls

n Due to reduced credit risks, lower capital needs to be setaside for repo transaction compared to unsecured cashlending

– Results in higher return on risk weighted assets



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Market Participants

External SellersInsurance CosHedge Funds

Money ManagersMutual FundsBanks/Brokers

Financial SponsorsCentral BanksPrivate Clients

BuyersGovts & Agencies

BanksInsurance CosHedge Funds

Money ManagersMutual Funds

BrokersPrivate Clients

REPOREPODESKDESK

Collateral Collateral

CashCash



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Types of Underlying Collateral

n Asian participants have traditionally done repo on governmentbondsn US Treasuries, US Agencies, etc

n European Sovereign Bonds

n Asian Sovereign Bonds

n Currently seeing institutions evolve down the credit curven Corporate Bonds (Investment Grade and High Yield)

n Structured Repos

n Equity Collateraln Domestic and Foreign Equities,

n Exchange Traded Funds and Convertibles





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Balance Sheet – Repo Transactions

Balance Sheet Treatment Under IAS/US GAAP

RepoTransactions*

Repo Seller Repo Buyer

n Securities remain on theBalance Sheet

n –

n

Debit Asset Account (e.g., cash) n

Credit Asset Account (e.g., cash)

n Booking of Accounts Payable (liability) n Booking of Account Receivable

n Difference between the selling and therepurchase price is booked as aninterest expense (in the IncomeStatement)

n Difference between the selling and therepurchase price is booked as an interestincome (in the Income Statement)

= Balance Sheet lengthens = Switching on the Asset Side

* There is no difference in the Accounting treatment under IAS and US GAAP for secured Repos



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Balance Sheet – SecuritiesLending Transactions

Securities Lending Transactions

SecuritiesLending

Transactions*

Securities Lender Securities Borrower

n Securities remain on the BalanceSheet (e.g., no de-recognition)

n No impact from the transferred securities(e.g., no recognition)

n The Securities Lending Transaction

must be shown in the FinancialStatement Notes

n Securities Lending Transactions must beincluded in the Notes to the Balance Sheet

n The treatment of the securities in theBalance Sheet and Income Statementdepends if they have been classifiedas being "Available for Sale" or “Heldfor Trading"

n –

n The lending rate is treated as interestincome

n The borrowing rate is treated asinterest expense

= Balance Sheet Neutral = Balance Sheet Neutral

* This only applies for unsecured lending or when securities are received as collateral



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Risks in Repo Transactions



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Legal Risks – Default Scenarios

n Default under GMRA 2000n Non Defaulting Party will Serve a Default Notice to the Defaulting Party

n All repo transactions between the counterparties are accelerated

n All repo transactions are netted and set off against each other and onlythe balance shall be payable

n Market Values of underlying collateral will be determined by the NonDefaulting Party

– Non Defaulting Party will gather market quotes from dealers on underlying collateral

– The average price of the dealers will be the market value of the underlying collateral

*** For detailed default remedies, please refer to GMRA 2000 and consult legal counsel



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Counterparty Credit Risks

n Counterparty Credit Riskn Prudent to evaluate counterparty risk and choose your counterparty

carefully

– 1st recourse in a repo transaction is always to the counterparty

– 2nd recourse in a repo transaction is to the underlying collateral

– 3 rd recourse in a repo transaction is an unsecured claim to the counterparty to recoverany residual exposure after liquidating the underlying collateral



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Collateral and Risks

n Collateral Riskn Quality of Collateral

– Taking into consideration the credit worthiness of the counterparty, one must alsoconsider the quality of the underlying collateral

n Market Risk – To minimize credit exposure due to price volatility of the underlying collateral, repo

collateral is marked to market on a daily basis

– Margin calls are made by the cash lender if the value of the underlying collateral falls bya pre-agreed amount by both counterparties and vice versa



Question (revisited)

“Would you rather buy a 6 month ‘AA’ rated time deposit

or

invest money in a repo with a ‘A’ counterparty and get ‘B’

collateral? ”



Answer

n Ques tion : “Would you ra ther buy a 6 mon th ‘AA’ ra ted t ime depos i t o rinves t money in a repo w i th a ‘A’ counte rpar ty and ge t “B” co l late ra l?”

– If you purchase an unsecured ‘AA’ credit quality asset, you have a 0.003% probability of the ‘AA’ defaulting over a 6-month period. This would result in loss ofyour principal investment. (1 in 33,333)

– On the other hand if you entered into a repo transaction with a ‘A’ counterpart andreversed in ‘B’ collateral, you would only lose your principal investment if both ‘A’ counterpart and ‘B’ collateral defaulted simultaneously. The probability of thishappening over a 6-month period is 0.0008%. (1 in 125,000)

(The above numbers are based on S&P and Moody’s data 1983-2002)



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Contact Information



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Contact Information

Tanweer KhanGlobal Head - Repo & Collateralized FinancingTel: + 65 6407 2065E-mail: [email protected]

mailto:[email protected]

mailto:[email protected]



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Disclaimer

This communication is made by Standard Chartered Bank (SCB), a firm authorised and regulated by the United Kingdom’sFinancial Services Authority. It is not directed at Retail Clients in the European Economic Area as defined by Directive

2004/39/EC neither has it been prepared in accordance with legal requirements designed to promote the independence ofinvestment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. It is forinformation and discussion purposes only and does not constitute either an offer to sell or the solicitation of an offer to buy anysecurity or any financial instrument or enter into any transaction or recommendation to acquire or dispose of any investment. Theinformation herein may not be applicable or suitable to the specific investment objectives, financial situation or particular needs ofrecipients and should not be used in substitution for the exercise of independent judgment.

Information contained herein, which is subject to change at any time without notice, has been obtained from sources believed tobe reliable. While all reasonable care has been taken in preparing this communication, no responsibility or liability is accepted forany errors of fact, omission or for any opinion expressed herein. SCB may not have the necessary licenses to provide services or

offer products in all countries or such provision of services or offering of products may be subject to the regulatory requirementsof each jurisdiction and you should check with your relationship manager or usual contact. You are advised to exercise your ownindependent judgment (with the advice of your professional advisers as necessary) with respect to the risks and consequences ofany matter contained herein. We expressly disclaim any liability and responsibility for any losses arising from any uses to whichthis communication is put and for any errors or omissions in this communication.

© Copyright 2010 Standard Chartered Bank. All rights reserved. All copyrights subsist ing and arising out of these materials belong to Standard Chartered Bank and may not be reproduced,distributed, amended, modified, adapted, transmitted in any form, or translated in any way without the prior written consent of Standard Chartered Bank.

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Understanding Repo - SCB