SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

At the beginning of a transaction, securities are valued and sold at the prevailing “dirty” market price (including any coupon that has accrued), also called “all in price”. Between the sale and the repurchase:

> The seller gets the use of the cash proceeds of the sale of the assets.

> The buyer gets legal title to the assets received in exchange for the cash it has paid. If the seller defaults on the repurchase, the buyer can liquidate the assets to recover some or all of its cash. In addition, as the buyer owns the collateral assets, he can re-use them during the term of the repo by selling the assets outright, “repoing” them or pledging them to a third party. The buyer must buy back the assets by the end of the repo in order to be able to sell them back to the seller. > Any coupon or dividend paid to the buyer during the term of the transaction is immediate- ly passed through to the original owner of the securities (i.e. the seller). This equivalent payment made by the buyer to the seller is called manufactured payment or manufac- tured dividend. Upon termination of the repo, the securities are returned to the initial seller and the cash investor receives back the original sale price plus a previously agreed upon interest rate (the repo rate), as illustrated by figure 1. The repo rate can be fixed or floating (e.g. indexed to EONIA).

Figure 1: Illustration of a standard repo transaction

REPO TRADE INITIATION

Both parties agree to a repo rate Party A sells €50M worth of securities to Party B against the transfer of €50M in cash from Party B

Securities (€50M worth)

Party A SELLER/CASH-TAKER

Party B BUYER/CASH-PROVIDER

Cash (€50M)

Repotransaction characteristics Trade date Settlement date

Seller identity Buyer identity Maturity Collateral name and ID Nominal value Repo rate Settlement instructions

REPO TRADE TERMINATION

Party B returns the securities to Party A against the payment of the original €50M in cash + the repo interest earned for the period

Securities

Party A

Party B

Cash (€50M + repo interest)

Copyright CACEIS, 2010

In securities-driven transactions (where the motivation is not simply financing) the repo rate is typically set at a lower rate than prevailing money market rates to reward the “lend- er” who will invest the funds in the money markets and thereby seek a return. The “lender” often receives a margin by pricing the securities above their market level. In cash-driven transactions, the repurchase price will typically be agreed at a level close to current money market yields, as this is a financing rather than a security specific transac- tion. The right to substitute “repoed” securities as collateral is agreed by the parties at the outset. A margin is often provided to the cash “lender” by reducing the value of the trans- ferred securities by an agreed “haircut” or discount.

page 10 | Securities Lending & Repo markets