SECURITIES LENDING & REPO MARKETS

A CACEIS PRODUCT DEVELOPMENT PUBLICATION - OCTOBER 2010

OVERVIEW OF THE SECURITIES FINANCING MARKETS

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OVERVIEW OF THE SECURITIES FINANCING MARKET

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Definition, characteristics and comparison of main instruments used

The securities financing market encompasses two main types of instruments: Repo and securities loan transactions. Although these instruments may have their own specific le- gal, accounting and regulatory characteristics, as well as different tax treatment, economic considerations are similar. We can distinguish securities-driven transactions, in which parties seek to gain temporary access to specific securities against collateral, from cash-driven transactions, in which parties seek to post securities as collateral to obtain secured cash financing. In general securities loan is more likely to be securities-driven whereas repo is rather cash-driven.

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Repurchase agreements (repos)

Repo is the generic term for repurchase agreement.

It is one of the most widely used securities financing instruments and has become a key source of capital market liquidity, through the lending of securities against cash. Repos are integral components of the banking industry’s treasury, liquidity and assets/liabilities management disciplines. They are also an essential transaction used by central banks for the management of open market operations. A repo transaction involves a short-term sale of securities by a seller (cash-taker) versus a transfer of cash by a buyer (cash-provider), with a simultaneous agreement for the seller to repurchase the same or similar securities at a future date or on demand at an agreed upon price (equal to the original sale price plus a return on the use of the sale proceeds during the term of the repo transaction). The assets temporarily sold in a repo on the purchase date are held as collateral by the counterpart. Thus, the seller is also called collateral-provider, while the buyer is called collateral-taker. These assets held as collateral are a form of protection in the event the seller is not able to return the borrowed cash at the end of the repo agreement. Indeed, if the seller defaults, the buyer can liquidate the collateral in order to recover its cash. In addition, if the issuer of the collateral defaults, the buyer can secure fresh collateral from the seller by making a margin call. Both events of default are possible but are unlikely to occur at the same time, provided the issuer of the collateral and the counterparty are sufficiently independent entities and their credit risks have a low correlation. Settlement of a repo transaction involves the delivery of the securities and the transfer of funds between the buyer and seller. In a classic repo, both legs of trade settle delivery versus payment (DVP). The maturity of a repo can be one day (overnight repo) or a longer term (typically from 2 days to 3 months).

1 Source: Euroclear, “Understanding repo and the repo market”, March 2009

Securities Lending & Repo markets | page 9