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By Kevin Cook on 2019-11-14
I remember the first time that I ever came across the term “repo” in the context of finance. It was 2006 and I was structuring a lending transaction for the hedge fund I was working for, when one of our lawyers suggested that we “do it as a repo”. I had no idea what he was talking about and my mind drifted to thoughts of property repossession and Emilio Estevez.
When further informed that, from our perspective as the lender this was actually a “reverse repo”, I was lost; and promptly resolved to educate myself on this peculiarly named financial instrument. More than 13 years later, I am now intimately familiar with the fact that the repo market is one of the most fundamental building blocks of financial markets, yet it remains poorly understood and is still only accessed by a tiny number of institutions.
“Repo” is shorthand for “Repurchase” and a “Reverse Repo” designates a transaction under a “Reverse Repurchase Agreement”. Simple, no?
In fact, the concept of the repo market is much simpler than the terminology might suggest. It runs as follows:
If I am going to lend money to someone then I should take security/collateral for that loan so that if they default, I have an uncorrelated (pool of) asset(s) which I can liquidate to recover my loan amount, rather than relying on my counterparty’s ability to repay. The most ubiquitous real-world example of this principle is mortgage lending.
If someone defaults on a principal or interest payment on a loan then they are likely not in great financial shape, so unsecured recovery rates on the loan at that point probably won’t look pretty.
In general, enforcing security for a loan is a time-consuming, complicated and expensive process.
If you can “own” the assets provided as security (for the term of the loan) then, if your counterparty defaults, you can immediately sell these assets and hence mitigate your loss.
If you can estimate the amount by which that the assets that you “own” by way of security might fall in value over a given period and ask for excess security to be provided to compensate for this “gap” risk, you give yourself a good chance that you can sell the assets, get your money back and not have to worry about whether your borrower can cobble together the cash to repay you. In our mortgage example, this is the LTV or Loan to Value ratio up to which banks will advance funds against the security that they have over your house.
There is an incontrovertible logic to the mechanics of the repo market that leaves one wondering why everybody doesn’t carry out all financing transactions in this way. The answer is that if you are a major global bank and you are lending to another major global bank, you do. The repo market is trillions of dollars deep and forms the bedrock of the largest financing transactions that provide liquidity to the world’s banks every single day.
For the rest of the world however, it is not just the confusing terminology that restricts market access. In order to “do” a repo, you need a huge amount of legal and financial infrastructure in place – commercial relationships, legal agreements, collateral schedules, tri-party infrastructure and middle and back office reporting systems to name just a few. Consequently, the repo market has always been the preserve of the banks, large asset managers and (only relatively recently) a select number of very large insurance companies, pension funds and corporations.
As the years passed, Matthew, James and I became increasingly frustrated that this gold standard of secured loans was shut off to the rest of the world. Why was everybody else taking gigantic positions in unsecured bank risk (whether directly in the form of deposits or indirectly though Prime Money Market Funds) when they could be in so much of a better position if they could do repo?
And then there was the kicker. As we learned more about the repo markets and started to explore the rates that one could earn from lending through it, we realised that firms that were engaging in secured lending were generally getting paid more, often much more, than the firms who were lending to the same cohort of banks on an unsecured basis via deposits. By 2010, the penny had dropped for us that the repo market provided one of those rare “no-brainers” in finance - an opportunity to earn more money whilst taking less risk; and we have been working to bring more firms to that market ever since.
When we created TreasurySpring in 2016, one of the principal challenges that we set ourselves was to deliver access to the repo market for all institutions in a standardised, regulated, digital format - to enable clients to benefit from hundreds of hours of onboarding, hundreds of thousands of pounds of infrastructure spend and decades of market expertise, by simply typing a number into a secure cloud-based portal and joyfully clicking a mouse.
Almost everyone agreed it was a good idea and a laudable aim but most people, both from inside and outside of the market, told us it was “extremely ambitious” (read: impossible). To some extent, they were all right. It was ambitious and it was certainly more complicated and expensive than even we had anticipated. But now we have done it. Forever. And that is pretty cool.