Not just a boring financing tool, repo is showing up in longer-term derivatives transactions. Expect volumes to increase.

By Margaret Elliott

It's official. Repo now has respect. It's now a truly international product, traded on a 24-hour global basis. And the financial markets couldn't function without it. Countries that have allowed unrestricted repo trading in the last few years-the United Kingdom, Germany, Spain, Denmark and Sweden-have witnessed the benefits of bond and derivatives markets that function more efficiently and increased international interest in their securities.

It's not just that new markets are opening up with great alacrity-Japan is due to make its repo markets more attractive to foreigners this year. Repo gained respectability because it has emerged from the short-term financing backwater to take its true place as a product with myriad uses, not least to derivatives players.

Repo defined

Repo, officially the sale of securities with a simultaneous commitment to repurchase them in the future, was traditionally a financing vehicle used by banks to raise money off their bond portfolios. Now, among other things, it greases the wheels of even the most mundane derivatives trades. Mick Chadwick, head of repo for UBS in London, says: "A healthy and liquid repo market goes hand in hand with a healthy derivatives market." Say a trader buys an option and hedges it with the purchase of the underlying bond. A repo would be used to fund the purchase of the bond.

Repo is thought of as a short-term vehicle-overnight repo is the most popular form-but it is possible to extend the repo term to a year and beyond. Within the past year, longer-term repo has taken off in the United States and Europe. According to the head of repo at one U.S. investment bank, "It's possible to detect two separate strands of the business developing-one is the increasing use of the commodity-type repo in both dollar and nondollar forms; the other is the use of structured or term repo in interest-rate derivatives transactions." Structured (the term used in the United States) or term (the European word) repo is used as part of OTC transactions in which customers are trying to implement interest rate views using a combination of swaps, options and repo.

Like all financial transactions, repo attracts a variety of participants. It remains a pivotal financing vehicle for financial institutions, but these days it is even more likely to attract money managers seeking additional yield on bonds that are long-term investments and corporate treasurers in search of higher returns. In a standard repo, the cash borrower puts up a portion of the bond portfolio as collateral and the lender advances cash. For bond-rich investors, repo meets their top-three money market requirements: it's flexible (with time frames from intra-day to three months); it's safe (because it is a collateralized loan); and it often offers the best yields when compared to other alternatives.

These players, though, don't need repo. Sure it enhances yields, but for a money manager or corporate treasurer the mechanics of repo can be too cumbersome for too little return. Cash-rich banks can't get enough of these customers, but they know that they don't drive the market.

Who uses the repo market?

The customers driving the growth in the repo market today are the hedge funds, a loose term that covers sophisticated leveraged investors. As UBS' Chadwick puts it, "Some guys can move the market. They need to do repo to leverage their capital. A large amount of cash business stems from the ability to provide financing."

And what hedge funds want is exotic OTC transactions. A leveraged investor can't do one of these trades without repo. A bank can't run an efficient OTC options desk without a top-flight repo business, because often the pricing on these deals rests on the implied repo rate. So the last year, in particular, has seen symbiotic growth in both businesses for banks across the world.

Conceptually, the repo is used to finance the hedge portion of a complex OTC transaction. And hedges come in all shapes and sizes. That means that in some cases the repo may be done in the currency of the original swap or option. In other cases, in order to pick up more yield or put on a different risk spin, a cross-currency repo could be used. It's a mix-and-match world out there. "Each repo market that comes on stream provides us with new opportunities to structure products," says Chris Welty, head of bond arbitrage at SBC Warburg in London.

Repo markets vary in terms of sophistication and maturity. The U.S. market, the first repo market, is the most developed. The correlation between the treasury bond market and its derivatives is very high. Huge supplies of bonds keep the market liquid. Increasingly, repo is traded not just as a short-term money market instrument, but two or three years out the curve, says Kevin Rodman, head of repo at Morgan Stanley in New York.

Securities houses like Morgan Stanley, Merrill Lynch, Salomon Brothers and Lehman Brothers have set up desks to accommodate this change in direction of the repo market. Called structured repo, these products provide OTC transactions to "customers wishing to implement an interest rate view," says Merrill Lynch repo trader Dennis Ryan.

It could be an investor looking for an option to swap from a floating to a fixed rate on funds he or she has invested some time in the future, depending on his or her view of where rates are going. "In this case," says Ryan, "the investor would purchase this option, using funding from a term repo."

In the opposite scenario, a hedge fund might wish to lock in a bond versus swap spread, which it can do using financing from a term repo that matches the length of time for which it wishes to have the arbitrage play on.

The main difference in these structures is their tenor. Unlike typical short-term repo, these trades are put on for up to five years, with three-year tenors the most common. That changes the nature of the repo as well as the relationship with the counterparty.

The benefits of repo

The reasons for using repo, rather than unsecured financing, in the United States are twofold. One is security. Because repo is collateralized, it is just that bit safer than unsecured financing. And because of the intense compression of spreads in the United States in the last year, repo offers an equally attractive rate with a bit less risk.

Collateral helps mitigate the other key risk in any financing transaction-counterparty risk. These packaged OTC transactions are done on a principal basis by the securities firms, so customers are facing them directly. The market for structured repo is necessarily limited to firms with double-A ratings and above, because of the longer-term nature of the exposure

Keen readers will note a resemblance between structured repo and another somewhat dormant derivative product, structured notes. Structured repo is a not a new product, but one that has reappeared with a new name and several new features recently. According to Debra J. Wloch-Vogt, head of repo marketing in the United States for Merrill Lynch, "Structured repo offers the investor a more aggressive level with a bit more risk. However, because repo is collateralized, there is a certain level of comfort."

In Europe, repo continues to grow in importance as part of OTC derivatives transactions, even if it isn't as well established a trend as it is in the United States. Take for instance an option conversion reversal trade. UBS' Chadwick explains: "Say you want to guarantee that you can buy a bond at a certain price at a certain date in the future. You can do that with European-style options. You buy a call and sell a put. The volume of premium nets off. So no matter where the price goes in the spot market, you will own the bond at the rate you want. Your financing cost in this transaction is the repo rate-the differential between the spot and forward rates on the bond."

It has applications for all types of users. Sophisticated corporates are using term repos for delayed-rate setting trades. If a company issues a bond and wants to lock in a spread over treasuries, but doesn't want to issue bonds for a month, it could enter into a DRS. Their bank hedges with a bond, a swap and a one-month repo. "It moves the bond obligation one month back, which might fit their financing plans better," says SBC Warburg's Welty.

Basis trading also contains a repo component. That's when a trader wants to lock in cash bond versus futures spreads for a

specific period. The underlying concept of this trade is convergence, says UBS' Chadwick. "If you look at this trade on a gross basis, it's often a lay-up trade if rates go the right way. You buy the bond, sell the future and eventually deliver the bond at a profit. But you need to look at it on a net basis, factoring in financing. The implied repo rate is the crucial variable."

As in the United States, a key catalyst for an increase in this activity has been the ability of all kinds of traders to use repo farther out the curve. Longer-term repo isn't as widespread in Europe as it is in the United States, nor is it as popular in nondollar trading as in dollar business. Trades between three months and a year are very common now. And UBS' Chadwick has done repo financing out to five years.

And it isn't just customers that use these products. Repo is an integral part of proprietary trading and market-making within securities firms worldwide. The importance of this tool is often seen when it is absent, as it was in the United Kingdom until the opening of the gilt repo market at the beginning of 1996. A sterling swaps dealer had to price off the gilt market, knowing full well that he couldn't short the cash gilt as a hedge. He would have to put on a synthetic hedge, which would have been cumbersome and more expensive, thus driving up the cost of the original swap.

Building up steam

Now that the gilt repo market is open for business, swaps traders don't have this problem-at least theoretically. Practically, the market has been very slow to develop, as cash-rich U.K. institutions such as insurance companies and pension fund managers, and corporates have been slow to give up their old securities-lending habits and move to repo. According to Julian Beaven, head of repo at Midland Bank, where its subsidiary, HSBC Greenwell is the largest U.K. primary dealer, "It's been a reasonable, but not exciting start. Many more counterparties will be needed before it becomes sufficiently liquid."

The United Kingdom was a late starter in the repo game. France has had a repo market for nearly 20 years and, after the U.S. market, the French repo market is the most developed. Last year, it was one of the toughest markets in which to make money. "Rates were static in France," says Oscar Huettner, head of international repo at BZW. "When money market rates are that low and the economy isn't showing any signs of expansion, repo markets don't move either." The same was true in Germany, where the benchmark rate languished at 3 percent. Low rates and low volatility make for unhappy repo traders.

The two European markets that did help keep repo traders happy in 1996 were Spain and Italy. In both markets, the official interest rates were cut during the course of the year. It's always easier for repo traders trading a matched book to make money when interest rates are dropping, because banks are always long bonds. The Spanish bond market was also volatile, which provides a bit of spice.

It was Italy, however, that provided the most interest. It is one of the most inefficient repo markets in Europe, which until the beginning of this year had an onerous withholding tax on foreigners. Yet shortages in certain bonds occur frequently. And foreign investors are able to finance their positions very cheaply because of a huge retail investor base that is willing to accept sub-LIBOR repo rates.

The character of the market may change this year when the withholding tax regime is changed. As of January 1, foreign investors from countries with dual taxation treaties with Italy will not be subject to the withholding tax. That includes investors from EU countries, but not Swiss or U.S. investors. Nevertheless the market is expected to shift from trading net of tax to gross, as it does in most other countries.

The other repo markets in Europe turned in a mixed performance. Sweden, where interest rates collapsed, proved profitable to many as turnover in the repo market continued to grow substantially. Belgium and Denmark, the other two markets of any maturity, were less active, but marginally profitable.

Japan is the only other truly developed repo market in the world and one of the most frustrating for international repo players. In the middle of last year, the government eliminated a transaction tax that had functionally prohibited onshore repo in Japan. But negotiations are still under way to develop a new and acceptable repo document, so the market remains "maddeningly half-closed," according to one head of repo. "We manage to do what we need to by operating offshore, but it would be so much easier if they would clear up their legal and regulatory problems and let repo happen freely."

It's also been difficult to make money in Japan. Interest rates stayed low all last year. BZW's Huettner says, "The squeeze into September was extremely difficult for many people."

For all of its sophistication, repo has only joined the ranks of electronically traded products. It's a development that some bankers decry. "It changes the character of the relationships we have with some clients. With some it sterilizes the relationship. With others it becomes an essential tool," says Midland's Beaven about the advent of Bloomberg repo screens.

Repo rates are now available across the Bloomberg system. In addition, three investment banks have made proprietary pages available to clients through the system. CS First Boston, through its RepoTrade product, was the first to provide real-time global position management and full trading capability for major markets. Merrill Lynch followed but is only able to offer repo trading, not reverse repo (when the investor lends cash and receives bonds). The Morgan Stanley product went on line in November 1996 and provides full repo market making in th U.S. repo market. "It gives our clients the option of simply trading via the screen if they wish," says Morgan Stanley's Rodman. "I don't anticipate that it will supersede telephone contact, but it gives our customers more options."

The Bloomberg pages are changing the business, but are not necessarily pushing people to electronic trading. "Just having the prices up on the screen has changed the market. Many investors still prefer the phone call, but this will change as banks and investors become more comfortable with committing trades electronically, whether it be Bloomberg, Reuters or the Internet" says Christine Brown-Quinn, head of marketing for SBC Warburg's Short Term Capital Markets.

Outlook

So, what will 1997 bring? International repo traders are focused on one thing: the upheavals that may result in the two-year run-up to the European Monetary Union and the advent of the Euro. Functionally, many elements of the repo won't change. All those bond issues will still be denominated in different currencies-and there will be new issues in Euros. Interest rates may converge, eliminating some of the spreads. But BZW's Huettner is more concerned about the runup. "It could produce a certain amount of volatility as countries try to meet the economic criteria for qualifying. Then there are the convergence trades that traders will be putting on in anticipation of union."