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Central Bank of Egypt Repurchase Agreements Rami Aboul Naga March, 2014 Rami Aboul Naga Central Bank of Egypt Repurchase Agreements Rami Aboul Naga March, 2014 Rami Aboul Naga 1

Index Central Bank of Egypt I. Repurchase Agreements 1. Definition 2. Advantages of Repos Index Central Bank of Egypt I. Repurchase Agreements 1. Definition 2. Advantages of Repos II. Uses of Repos 1. Investment of Cash Balances 2. Incremental income 3. Taking positions 4. Financing positions III. Major Participants and Central Bank role IV. Features of Repurchase Agreement 1. Maturity 2. Margining 3. Risk 4. Collateral V. Types of Repos 1. Classic Repo 2. Sell/Buy Back 3. Cross Currency 4. Security Lending Transaction March, 2014 Rami Aboul Naga 2

Central Bank of Egypt Index VI. Delivery Methods 1. Deliver-out repo 2. Hold in Central Bank of Egypt Index VI. Delivery Methods 1. Deliver-out repo 2. Hold in custody (HIC) repo 3. Tri-party repo VI. Legal Documentation VII. 1. Global Master Repurchase Agreement VIII. 2. Tri-party Agreement IX. VII. Appendix X. March, 2014 Rami Aboul Naga 3

Central Bank of Egypt I. Repurchase Agreements 1. Definition ü A repurchase agreement (also Central Bank of Egypt I. Repurchase Agreements 1. Definition ü A repurchase agreement (also called a Repo) is a money market instrument whereby a borrower sells securities ( or some other asset) to another party (and thus obtains funds) at a fixed price and agrees to repurchase the securities at an agreed future date and price. ü A repo is in effect a combination of two simultaneous transactions in one contract. One party sells and buys back the securities (repo), while the counterparty buys and then re-sells (reverse repo). Thus whenever one side does a repo, a reverse repo is transacted by another party. March, 2014 Rami Aboul Naga 4

Central Bank of Egypt I. Repurchase Agreements ü Finally, a repurchase agreement is considered Central Bank of Egypt I. Repurchase Agreements ü Finally, a repurchase agreement is considered to be a secured borrowing where the securities deposited with the lender for the period of the loan are used as collateral for the loan. March, 2014 Rami Aboul Naga 5

Central Bank of Egypt I. Repurchase Agreements FOLLOW THE CASH March, 2014 Rami Aboul Central Bank of Egypt I. Repurchase Agreements FOLLOW THE CASH March, 2014 Rami Aboul Naga 6

Central Bank of Egypt I. Repurchase Agreements 2. Advantages of Repos ü Parties with Central Bank of Egypt I. Repurchase Agreements 2. Advantages of Repos ü Parties with a borrowing requirement can achieve lower funding costs through repos than with other money market instruments ü Holders of securities can increase their overall returns by lending their securities through a repo. ü Repos are a low risk investment since they are secured by collaterals. ü The Cash and securities in a repo transaction can be in different currencies March, 2014 Rami Aboul Naga 7

Central Bank of Egypt I. Repurchase Agreements ü For lenders of cash, repos provide Central Bank of Egypt I. Repurchase Agreements ü For lenders of cash, repos provide an alternative to both he unsecured money market and the outright purchase of securities. ü For lenders of securities, any coupon interest on the securities is retained. ü For both borrowers and lenders, repos represent a highly flexible and liquid instrument ü 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. March, 2014 Rami Aboul Naga 8

Central Bank of Egypt II. Uses of Repos There are four types of purposes Central Bank of Egypt II. Uses of Repos There are four types of purposes that Repos can typically achieve: 1. Investment of cash balances: Due to the securitized nature of repurchase agreements, most institutions' risk management departments will allow larger lines of credit for repo transactions that for unsecured deposits. 2. Incremental income: For holders of securities that have "repo value, " incremental income can be earned by lending the special bond and investing proceeds at a higher rate in general collateral. This is a popular strategy for central banks. March, 2014 Rami Aboul Naga 9

Central Bank of Egypt II. Uses of Repos 3. Taking positions: The repo market Central Bank of Egypt II. Uses of Repos 3. Taking positions: The repo market allows for views on the shape of the money market curve to be expressed. Additionally, the repo market also facilitates the shorting of bonds. 4. Financing positions: Most securities' houses run large books of positions which need to be funded. The repo market offers a lower cost mechanism than the unsecured inter-bank market. Also, it diversifies the source of funds as more investors are likely to have a credit line for a secured loan. Repo is therefore a vital tool for the broker/dealer community and for hedge funds. March, 2014 Rami Aboul Naga 10

Central Bank of Egypt III. Major Participants & Central Banks role The major participants Central Bank of Egypt III. Major Participants & Central Banks role The major participants in the repo market are mainly: ü Commercial Banks ü Corporations ü Money market dealers/brokers ü Central Banks can use the repo market as a monetary tool where it can influence interest rates and liquidity 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. March, 2014 Rami Aboul Naga 11

Central Bank of Egypt IV. Features of Repurchase Agreements 1. Maturity ü The majority Central Bank of Egypt IV. Features of Repurchase Agreements 1. Maturity ü The majority of repos are issued for one business day (O/N). ü However there also repos with a maturity grater than one day. Under this comes: ü Term Repo: Agreements issued for fixed terms from one day to one year. ü Open Repos: Agreements where either the borrower or the lender may chosse to cancel at any time. The repo rate on open-ended repos can be renegotiated after a certain period of time has elapsed. March, 2014 Rami Aboul Naga 12

Central Bank of Egypt IV. Features of Repurchase Agreements 2. Margining ü The fact Central Bank of Egypt IV. Features of Repurchase Agreements 2. Margining ü The fact that the securities in a repo transaction can rise and fall in value means that some form of margin must be built in to protect the lender. ü Margin is also used to protect against the illiquidity of collateral and counterparty risk. There are two types of margins: • Initial margin • Variation margin March, 2014 Rami Aboul Naga 13

Central Bank of Egypt IV. Features of Repurchase Agreements ü Initial Margin: Also known Central Bank of Egypt IV. Features of Repurchase Agreements ü Initial Margin: Also known as haircut is the percentage by which the market value of the securities ( including accrued interest) in the repo transaction exceeds the cash lent. ( Start proceeds). Margin is usually expressed in terms of the margin ratio: ü Margin Ratio = Collateral Market Value/ Cash lent March, 2014 Rami Aboul Naga 14

Central Bank of Egypt IV. Features of Repurchase Agreements ü Example: A margin of Central Bank of Egypt IV. Features of Repurchase Agreements ü Example: A margin of 2% represents a margin ratio of 102%. Thus, if the collateral is valued at USD 10, 000/( including accrued interest), cash lent will be: ü Cash Lent= 10, 000/1. 02= USD 9, 803, 921. 57 ü The size of the initial margin is primarily determined by the creditworthiness of both counterparties and the securities used as collateral. ü Also, a longer repo term and higher collateral duration will lead to a higher initial margin. March, 2014 Rami Aboul Naga 15

Central Bank of Egypt IV. Features of Repurchase Agreements Variation Margin: refers to the Central Bank of Egypt IV. Features of Repurchase Agreements Variation Margin: refers to the amount by which the value of the collateralized securities may fluctuate before a margin call will be triggered. ü A margin call can be met in cash or by additional stock. ü Variation margin can be expressed in % terms, in absolute cash amount terms, or on a discretionary basis by the counterparties. ü To reduce the administrative costs of margining, a margin call is usually made only where the change in the market value of the collateral exceeds an agreed amount known as the maintenance margin. March, 2014 Rami Aboul Naga 16

Central Bank of Egypt IV. Features of Repurchase Agreements March, 2014 Rami Aboul Naga Central Bank of Egypt IV. Features of Repurchase Agreements March, 2014 Rami Aboul Naga 17

Central Bank of Egypt IV. Features of Repurchase Agreements Example: ü Counterparty A lends Central Bank of Egypt IV. Features of Repurchase Agreements Example: ü Counterparty A lends $ 10 MM of the current 2 yrs at a price of 99. The haircut is 2%. ü Counterparty A receives $ 9, 706, 415. 18/ü Market rises and UST is now worth $ 9, 600, 000/ü Counterparty A should restore the margin difference by delivering $106, 415. 18/- March, 2014 Rami Aboul Naga 18

Central Bank of Egypt IV. Features of Repurchase Agreements 3. Risk Repo agreements are Central Bank of Egypt IV. Features of Repurchase Agreements 3. Risk Repo agreements are low-risk transactions as a consequence of four factors: ü - fully collateralized loan ü - provision for margining ü - daily marking-to-market ü - ownership of collateral transferred March, 2014 Rami Aboul Naga 19

Central Bank of Egypt IV. Features of Repurchase Agreements ü The fact that repos Central Bank of Egypt IV. Features of Repurchase Agreements ü The fact that repos can be considered as fully collateralized loans, and have provisions for margining and marking-tomarket daily, means that they are significantly less risky than unsecured forms of lending. ü During the term of repo, the ownership of the collateral is legally transferred to the lender, so that in the event of a default by the borrower, the lender can sell off the collateral and so recover the investment. March, 2014 Rami Aboul Naga 20

Central Bank of Egypt IV. Features of Repurchase Agreements 4. Collateral take one of Central Bank of Egypt IV. Features of Repurchase Agreements 4. Collateral take one of the following forms: ü Specific Collateral ü General Collateral (GC) ü Securities used as collateral include: Sovereign Debt, Supernational Debt, Money Market instruments and Eurobonds. ü The security provider in a repo transaction sometimes has the right to substitute equivalent collateral during the life of the repo. This must be agreed beforehand by the cash lender and the securities must be of the same value and credit quality. March, 2014 Rami Aboul Naga 21

Central Bank of Egypt V. Types of Repurchase Agreements 1. Classic Repos ü ü Central Bank of Egypt V. Types of Repurchase Agreements 1. Classic Repos ü ü Also referred to as a US-Style repo, involves a cash borrower selling securities to another party with a simultaneous agreement to repurchase them at a future date. The securities are sold and repurchased at the same price, but a repo rate is payable to the buyer of securities. ( the lender of funds). March, 2014 Rami Aboul Naga 22

Central Bank of Egypt V. Types of Repurchase Agreements 1. Classic Repos REVERSE REPO Central Bank of Egypt V. Types of Repurchase Agreements 1. Classic Repos REVERSE REPO AT INITIATION CBE Pays cash Sells securities Counterparty AT MATURITY CBE March, 2014 Returns securities Returns principal + interest Rami Aboul Naga Counterparty 23

Central Bank of Egypt V. Types of Repurchase Agreements 2. Sell/Buy Backs Repos: ü Central Bank of Egypt V. Types of Repurchase Agreements 2. Sell/Buy Backs Repos: ü Is a simultaneous agreement to sell securities spot and to repurchase them back at a future date. ü The forward price of the securities is derived from the agreed repo interest rate. ( Implied Repo Rate) March, 2014 Rami Aboul Naga 24

Central Bank of Egypt V. Types of Repurchase Agreements Classic Repo vs. Sell/Buy Backs Central Bank of Egypt V. Types of Repurchase Agreements Classic Repo vs. Sell/Buy Backs ü Repo transactions and sell buy back transactions are very similar. The primary difference between the two is the fact that a sell buy back transaction is not governed by a prenegotiated global repo agreement—the Global Master Repurchase Agreement (GMRA). ü The economics of the transaction are the same, but, contrary to classic repos, both deals, though done simultaneously, are treated as two separate legal entities. ü Another difference lies in the treatment of coupon payments; coupons are not immediately transferred to the seller in a Sell/buy back repo but rather paid back at the end of the repo term, compounded by the repo rate. March, 2014 Rami Aboul Naga 25

Central Bank of Egypt V. Types of Repurchase Agreements ü Both Classic Repos and Central Bank of Egypt V. Types of Repurchase Agreements ü Both Classic Repos and Sell/Buy Backs transactions result in cash lender's legal ownership of the securities, the economic ownership of the securities reflects a different reality. The economic ownership of the securities belongs to the cash borrower—the original owner of the securities. ü This results from the fact that the cash borrower retains the rights to coupons and the fact that the cash borrower is exposed to all financial risk of the securities. ü The accounting treatment for both repo transactions and sell buy back transactions is the same. ü The accounting treatment for both transactions reflects the economic nature of the transaction. ü The securities of the cash borrower remain on the entity's balance sheet to reflect the financial risk borne by the cash borrower. March, 2014 Rami Aboul Naga 26

Central Bank of Egypt V. Types of Repurchase Agreements 3. Cross Currency Repo: ü Central Bank of Egypt V. Types of Repurchase Agreements 3. Cross Currency Repo: ü Works in the same way as a classic repo, with the exception that the securities and cash are denominated in a different currency. ü On the start date, the start proceeds are determined by the cash lender in the currency of the collateral. The cash lender then sells these proceeds for the currency required on the foreign exchange market. ( lender’s own currency). The proceeds are transferred to the cash borrower. ü On the end date, the collateral is returned to the cash borrower against payment of the end proceeds. March, 2014 Rami Aboul Naga 27

Central Bank of Egypt V. Types of Repurchase Agreements Example: A German Hedge Fund Central Bank of Egypt V. Types of Repurchase Agreements Example: A German Hedge Fund wishes to fund a long position in German Bunds against Sterling using a cross currency repo. ü Tenor: 1 Month ü Nominal Value of collateral (Bunds): EUR 10, 000/ü Dirty price: 101. 55 ü Market Value of collateral: EUR 10, 155, 000/ü Repo Rate 4. 50% ( GBP 1 Mth rate) ü Basis: ACT/365 ü Exchange Rate: GBP/EUR 1. 45 ü Required Margin 2. 5% ü The Cash lent (in GBP) against Bund collateral is calculated as follows: March, 2014 Rami Aboul Naga 28

Central Bank of Egypt V. Types of Repurchase Agreements ü Cash lent= Market value Central Bank of Egypt V. Types of Repurchase Agreements ü Cash lent= Market value of Collateral (in GBP)/ Margin Ratio ü Cash lent = ( EUR 10, 155, 000 / 1. 45)/1. 025 ü Cash lent = GBP 7, 003, 448. 276 / 1. 025 ü Cash lent = GBP 6, 832, 632. 46 Repo interest rate = GBP 6, 832, 632. 46* (0. 045*30/365) =GBP 25, 271/The end proceeds are thus: GBP 6, 857, 903. 84/- March, 2014 Rami Aboul Naga 29

Central Bank of Egypt V. Types of Repurchase Agreements 4. Security Lending Transaction ü Central Bank of Egypt V. Types of Repurchase Agreements 4. Security Lending Transaction ü A transaction in which the owner of securities agrees to lend its securities to a borrower in exchange for collateral consisting of cash or government securities. ü Borrowers of securities are typically large broker/dealers who use the securities for arbitrage or risk management strategies. ü Incremental income is generated for the owner/lender by investing the cash collateral in high quality, short term investments. ü Most lenders authorize an Agent to execute and record-keep its transactions. March, 2014 Rami Aboul Naga 30

Central Bank of Egypt VI. Delivery Methods 1. Deliver-out Repo ü Is a repo Central Bank of Egypt VI. Delivery Methods 1. Deliver-out Repo ü Is a repo transaction where possession of the collateral ( securities) is passed onto the cash lender. ü If the counterparty simultaneously receives cash in return for the collateral, the transaction is described as being DVP ( delivery vs payment) ü Deliver-out repos make substitution of collateral more difficult and also increase back office administration March, 2014 Rami Aboul Naga 31

Central Bank of Egypt VI. Delivery Methods 2. Hold in Custody (HIC) repo ü Central Bank of Egypt VI. Delivery Methods 2. Hold in Custody (HIC) repo ü Is also known as a due-bill repo or trust me repo. ü In this type of transaction, the collateral remains in the possession of the cash borrower, hence avoiding delivery. ü The Cash borrower is responsible for the marking-tomarket of the collateral. ü HIC repos are used when there is no support operation available and also to minimize clearance costs. ü HIC repo carry significant counterparty credit risk for the cash lender as they have to trust the repo seller to fully collateralize the loan. March, 2014 Rami Aboul Naga 32

Central Bank of Egypt VI. Delivery Methods 2. Hold in Custody (HIC) repo ü Central Bank of Egypt VI. Delivery Methods 2. Hold in Custody (HIC) repo ü The cash lender should thus ensure that their counterparty has a high credit rating, and should expect a higher yield on the repo transaction March, 2014 Rami Aboul Naga 33

Central Bank of Egypt VI. Delivery Methods 3. Tri-Party repo ü A tri-party agreement Central Bank of Egypt VI. Delivery Methods 3. Tri-Party repo ü A tri-party agreement involves a third party ( a clearing house or custodian Bank) acting as intermediary between the cash borrower and the cash lender. ü The most popular custodian in the non-dollar repo market is Clearstream, Euroclear and Bank of New York. March, 2014 Rami Aboul Naga 34

Central Bank of Egypt VI. Delivery Methods 3. Tri-Party repo The Custodian in a Central Bank of Egypt VI. Delivery Methods 3. Tri-Party repo The Custodian in a tri-party repo is responsible for: ü Taking delivery of the collateral on the cash lender’s behalf ü Ensuring that the collateral meets the cash lender’s credit requirements ü All administration including the daily valuation of the collateral, any marking-to-market of the collateral and issuing statements on a regular basis to both counterparties. ü The fee charged by the custodian is usually paid by the cash borrower. March, 2014 Rami Aboul Naga 35

Central Bank of Egypt VI. Delivery Methods 3. Tri-Party repo Advantages of Tri-party Repos: Central Bank of Egypt VI. Delivery Methods 3. Tri-Party repo Advantages of Tri-party Repos: ü Clearance costs and time are significantly reduced for both counterparties ü Settlement risk is reduced ü No support operation is required ü All transaction are monitored by the third party March, 2014 Rami Aboul Naga 36

Central Bank of Egypt VI. Legal Documentation 1. Global Master Repurchase Agreement ü The Central Bank of Egypt VI. Legal Documentation 1. Global Master Repurchase Agreement ü The GMRA is the market standard repo document used as the legal basis for repo in non-USD repo markets, introduced in November 1992. ü The GMRA has been prepared as a standard form and any institution proposing to use it should ascertain that it is suitable for the circumstances in which it is proposed to be used. March, 2014 Rami Aboul Naga 37

Central Bank of Egypt VI. Legal Documentation ü The GMRA covers a number of Central Bank of Egypt VI. Legal Documentation ü The GMRA covers a number of key points under which comes the following: ü Margin Maintenance ü Payment and Transfer ü Events of Default ü Title Transfer ü Waiver of Immunity March, 2014 Rami Aboul Naga 38

Central Bank of Egypt VI. Legal Documentation 2. Tri-Party Agreement ü This agreement sets Central Bank of Egypt VI. Legal Documentation 2. Tri-Party Agreement ü This agreement sets forth the responsibilities of each of the parties and the custodian Bank and the mechanics of the day to day transactions. March, 2014 Rami Aboul Naga 39

Central Bank of Egypt VII. Appendix March, 2014 Rami Aboul Naga 40 Central Bank of Egypt VII. Appendix March, 2014 Rami Aboul Naga 40

Central Bank of Egypt VII. Appendix CHEAT SHEET Repos Investor is borrowing cash Reverse Central Bank of Egypt VII. Appendix CHEAT SHEET Repos Investor is borrowing cash Reverse Repos Investor is lending cash Remember: Follow the cash! The value of a repo trade depends upon whether you are borrowing cash (lending securities) or lending cash (borrowing securities). March, 2014 Rami Aboul Naga 41