The Hindu Business Line : Driven by a need for cheap financing

Like many, if you are clueless about what `reverse repo' and repo rate' are about, Moorad Choudhry's The Global Repo Markets, could make for interesting reading. Simple in style and full of helpful mini-problems with worked out solutions, the book, says D. Murali, takes the reader through the maze of repo, step by step.

THIS week, the air has been thick with repo and reverse repo happenings. The RBI Governor raised repo and reverse repo rates by 25 basis points, saying growth is fine but inflation a worry. The Finance Minister described the hike as a measured step towards moderate monetary tightening. And FICCI said that the move to up the reverse repo rate is as per industry expectations.

Like the many, you could be clueless about what the word `repo' is all about. You may have found some help in those parenthesised explanations in news copies: "reverse repo rate (price at which the RBI absorbs excess bank funds) and repo rate (the price at which the RBI lends money to banks)". If you are hungry for more, choose for this weekend's reading Moorad Choudhry's, The Global Repo Markets, from Wiley (www.wiley.com).

There is one more reason that makes a discussion on repo apt; for, the day marks the completion of one year since the meaning of repo and reverse repo swapped places here, undergoing a reversal to fall in line with international usage. "Till October 28, 2004, repo indicated absorption of liquidity whereas reverse repo meant injection of liquidity by the Reserve Bank," chronicles http://rbidocs.rbi.org.in. Thus, now, repo means injection of liquidity; and reverse repo is the opposite, that is, absorption.

Repo is closely linked to other segments of the debt and equity markets, writes Choudhry, reasoning why one should look at repo not in isolation but in the context of the global capital markets. "From its use as a financing instrument for market-makers to its use in the open market operations of central banks, and its place between the bond markets and the money markets, repo integrates the various disparate elements of the financial marketplace," he explains.

Repo (a.k.a. RP, repurchase agreement, and buyback) means a contract in which the seller of securities, such as Treasury Bills, agrees to buy them back at a specified time and price, defines www.investorwords.com. The first repo transactions were initiated by the US Federal Reserve in 1918, informs the book. "The repo market experienced substantial growth during the 1990s and is now estimated to account for up to 50 per cent of daily settlement activity in non-US government bonds worldwide," highlights the author. "Daily outstanding volume in international repo transactions has been estimated at anything between £420-450 billion."

Big enough to merit attention, you would agree. And this statistic on www.answers.com would affirm: "The US Federal Reserve and the European Repo Council (a body of the International Securities Market Association) both try to estimate the size of their respective repo markets. At the end of 2004, the US repo market reached $5 trillion and the European one passed euro 5 trillion in outstandings. Both are growing at two-digit pace." Estimates vary, concedes the book, citing ISMA numbers that the turnover of euro-zone countries and the UK was in excess of $28 trillion in 2003.

According to RBI Bulletin (October 17), `net of overnight repo' stood at Rs 25,780 crore at the end of August, as a positive number indicating absorption of liquidity. "Surplus liquidity conditions resulted in the reverse repo volumes tendered under the LAF (Liquidity Adjustment Facility) increasing from an average of Rs 29,809 crore in March to Rs 34,832 crore in August before declining to Rs 21,128 crore in October," is from what the RBI Governor told us on October 25.

Why is repo popular? Choudhry attributes the growth of repo to factors such as public debt expansion, rise in non-bank funding and disintermediation, high quality of collateral, flexibility and liquidity of the instrument. Additional factors that the author lists are: "The need for liquidity as market makers have sought to cover short positions, a greater awareness of counterparty risk, and the more advantageous capital treatment that repo transactions receive compared to unsecured transactions." Yet, repo has `such a low profile', with `little discussion of it in the financial press', observes Choudhry. This, according to him, is due to the simple and straightforward nature of the instrument.

Simplicity, again, is what you would find in the author's style. He takes the reader through the maze of repo step by step. For instance, he explains the key features of repo thus: "The maturity of the majority of repo transactions is between overnight and three months, although trades of six months and one year are not uncommon... Because of the nature of the collateral, repo market participants must keep a close eye on the market of the asset collateral."

Wherever jargon is introduced, Choudhry pauses to demystify the same, as in the case of trades being `stock-driven' or `cash-driven'. For the latter, the author gives the example of a corporate treasurer who invests cash while receiving some form of security; and "a market-maker that wishes to cover a short position in a particular stock, against which they lend cash, is entering into a stock-driven trade". Similarly, `tom next' is not about somebody next-door, but "the overnight interest rate starting tomorrow); and `spot next' means `the overnight rate starting two days forward'.

Another useful feature of the book is the use of many mini-problems with worked out solutions. For example, in the discussion on present value of money, meet Nasser who is `saving for a trip around the world after university'. He needs £1,000 in three years. How much does he have to invest now if "he can invest in a bank fixed-rate bank account at 7 per cent guaranteed fixed rate for three years"?

After advising Nasser to invest £816.30 `today', you can move on to advanced problems such as: A company knows that it will need to borrow £1 million in three months' time for a 12-month period. It can borrow funds today at LIBOR + 50 basis points... The treasurer decides to buy a 3 x 15 (`threes-fifteens') FRA to cover the 12-month period beginning 3 months from now."

If `yield' is what has been bothering you, Choudhry offers this crisp line: "The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the initial cost (price) of the investment." This internal rate of return (IRR) is taken to be the bond's YTM or yield to maturity or redemption yield; an important yield measure, this is, used in the markets "to estimate the return generated from holding a bond", instructs the author. A basic lesson is that — in a market that has bonds with different issuers, coupons and terms to maturity — you need to compare yields, not prices.

Repo, the otherwise `most plain-vanilla sector of the global financial sectors' has not been immune to `the application of financial engineering techniques,' writes Choudhry in a Chapter titled `Repo and structured financial products'.

An example is `callable repo' where the lender of cash has the right `to terminate the repo early, or call back a portion of the cash'. Another is `whole loan repo' that has developed `from the securitisation of residential and commercial mortgages'; this structure originated in the US market "as a response to investor demand for higher yields in a falling interest rate environment," states the author.

Then, TRS — not the name of a political party, but total return swap — where two parties agree to exchange the total return from a financial asset between them, thus transferring credit risk from one to the other. Though a credit derivative, this has many economic similarities with repo deals, says the author.

Get a ringside view of how trading and hedging are done at a repo desk in a Chapter that takes you through many screenshots, find out in another Chapter how ALM or asset and liability management can be done in a bank `to minimise exposure to market risk and liquidity risk', and learn about the UK gilt repo market that the author describes as `an example of an efficient and liquid repo market'.

Choudhry offers a tour of `selected country repo markets', covering Spain, France, Germany, Italy, and the US. If you hear of "T-bills known as Letras, bonds of between three and five years maturity (Bonos) and bonds of 10-15 years maturity (Obligaciones)," know that you are in Spain. And Germany is where they'd talk of Pfandbriefe repo and bund market!

An exotic development is the `emerging market' repo, writes Choudhry. "The term has at various times grouped relatively developed markets such as Taiwan and Singapore along with true capital market minnows such as those in Jordan and Zambia, and the whole range of countries in between." Emerging markets cooled after the 1997 East Asian crisis.

"However, one of the main reasons behind the initial enthusiasm for emerging markets, namely the requirement by investment managers for higher yields, remains in tact and this has seen renewed growth in investment in these markets," notes the author.

In one of Dr Y. V. Reddy's articles, posted on www.bis.org, he narrates how the development of the repo market "on sound lines with transparency and DvP (delivery versus payment), facilitated the introduction of the LAF in 2000.

"It has become the most important tool for management of short-term liquidity, and facilitating the transmission mechanism from the short end of the term structure to the longer end and to other debt instruments, which use the short-term rates as a benchmark. The replacement of the RBI's standing facilities with assured rates by using the LAF for absorbing/injecting short-term liquidity will further ensure the efficacy of targeting short term interest rates," adds Dr Reddy. No wonder, therefore, that repo rates and spreads get more attention than prime lending rate.

With no reversals in sight for repos, the topic may worth a detailed study, with Choudhry's able guidance.

Economics@TheHindu.co.in

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