MORGAN STANLEY DEAN WITTER
GLOBAL HIGH YIELD
September, 1997
Emerging Market Repo
Emerging Market Repo and Securities Lending Market
I.Background and Evolution
A. What is a repo?
B. Repo in Emerging Markets
11.Growth and Attributes of Emerging Market Repo
A. Participants
1. Customers
2. Brokers and Dealers
3. Volumes
B. Rates
C. Margin
D. Dealer Matchbook
Ill. Risk of Emerging Market Repo
A. Counterparty Risk
B. Documentation and Legal Risk
C. Custody Risk
D. Settlement Risk
E. Liquidity Risk
IV. Mechanics of Repo and Securities Lending
A. Repo and Reverse Repo
B. Borrow Versus Cash and Borrow Versus Pledge
C. Sell/Buyback and Buy/Sellback
V. Characteristics of Repo Securities Lending
A. Maturity
B. Delivery
This memorandum is based on information available to the public. No representation is made that it is accurate or complete. This memorandum is not an offer to buy or sell or a solicitation of an offer to buy or sell the securities or instruments or to participate in any particular trading strategy mentioned. Please refer to the notes at the end of this report. Additional information on recommended securities is available on request.
Background and Evolution
A repurchase transaction (a "repo") is the secured financing effected through a shortterm sale of securities to a cash provider with the commitment to repurchase the same or similar securities at an agreed upon price in the future. Similarly, a reverse repurchase transaction (a "reverse repo") is the shortterm purchase of securities from a cash borrower with the commitment to resell the same or similar securities at an agreedupon price in the future. The difference between the price at the start of the transaction and the price at the end of the transaction reflects the rate charged, in the repo market, to borrow cash approximately equal to the market value of the securities transferred.
Repo In Emerging Markets
Repos on emerging market instruments started in the early 1990's with cash investors in search of superior returns on investments to those that were offered in the domestic markets and Latin American banks looking to finance their inventory of USD Brady Bonds. American and European investment banks active in outright trading of Brady Bonds saw this supply/demand imbalance and acted as credit intermediaries between the cash investors and the Latin banks.
Against the banks' Brady Bond positions, dealers would lend cash to the Latin banks equal to the market value of the securities minus a "haircut" and charge a spread over Libor. The haircut is the difference between the market value of the securities and cash lent against the transfer of the securities. Through these transactions Latin banks were able to obtain financing using their Brady Bond holdings at rates much better than borrowing in the unsecured USD market or by issuing commercial paper. The dealer would then use the securities to do a repo with the cash investors. The returns to the cash investor were greater than those of a repo secured by OECD paper to reflect the risk involved in holding below investment grade debt as collateral. The use of repos added liquidity to the market and provided Latin banks with a cheaper source of financing.
The Mexican Peso crisis in December of 1994 saw a decline in all trading of emerging markets instruments, including cash, options and repos. As the decline subsided in mid1995, local emerging market customers needed to raise cash and repo dealers, albeit cautious, were there to provide it.
Growth and Attributes Of Emerging Market Repo
Participants
Volumes in emerging market repo are up significantly, as would be expected with a growing market. In 1994, daily repo turnover of $500 million$I billion was typical. Today values of $23 billion and higher are normal. The acceptance of emerging market debt as a necessary part of a bond fund's portfolio and the improving credit fundamentals in many of the emerging market countries have brought new classes of investors into this repo market.
In 1994, the primary customers of emerging market debt were Latin banks. Today, along with Latin banks, there are global money managers and hedge funds, relative value books, high net worth individuals, global asset managers, regional developmental banks, options desk, and derivatives desks.
Through screen trading, there is a robust brokered inter-dealer market for emerging market debt. Broker screens, although not directly available to nondealer counter-parties, have affected customer price expectations and have helped accelerate a trend toward greater pricing parity between counter-parties of different credit quality.
Today, emerging market repo is commonly used by customers to finance new purchases of securities and is the key to relativevalue trading. As relative value trading grows, its effectiveness depends on whether the bonds can be borrowed at a reasonable rate. Relativevalue trading has also increased the volume of term repo, that is, repo with a fixed term of three to six months or more, in order to reduce the risk that the bonds will get very difficult, or in some cases, impossible to borrow.
Options dealers also base the prices of their trades on the cost of carry to hedge options trades with the underlying collateral. Repos have facilitated the entry of hedge funds into the emerging markets by providing leverage consistent with their liquidity needs. In addition, emerging market repo is used to cover short sales as dealers become more sensitive to the cost of carry on the trades, to cover a counter-party's failure to deliver bonds on settlement date reducing operational costs, and to obtain financing through a dealer's inventory, which lowers the firm's need to borrow funds through the more costly unsecured USD market.
Rates
Rates charged to borrow cash through repos against emerging market debt vary based on market conditions, including whether the bond is trading "special." A bond trades special when there is excess demand for the bond in the market. Repo rates just prior to the Mexican peso crisis were around USD libor + 100 to 150 basis points for nonspecial issues. At the onset of the crisis rates spiked to libor+ 200 to 250 basis points. Today, for non-special issues, rates can range from libor+25 to libor flat. A bond trading special can command rates of libor500 basis points.
Margin
Margin, commonly known as the "haircut," is the amount of overcollateralization required by the cash lender to protect itself from the price volatility of the underlying security and the possibility that a counter-party might walk away from the trade. The haircut amount varies with the size and term of the transaction, and the type and maturity of the securities and the creditworthiness of the counter-party. Haircuts for lesser capitalized counter-parties just prior to the Mexican Peso crisis in 1994 were 2040% and reached 2550%. Today haircuts have moved back down to 020%.
Dealer Matched Book
Emerging market repo is also viewed as a profit center in itself A dealer can generate profit by running a matchbook, whereby the dealer reverses in collateral from one customer and repos it to another customer at a lower rate. Although the dealer could run a perfectly matched book, thereby eliminating rate risk, in practice dealers mismatch maturities to profit from anticipated market conditions. A dealer may also position bonds to take advantage of specials. Dealers must take a view on shortterm rates and actively fund their term collateral as these trades become bigger in size and longer in duration. A dealer must have indepth knowledge of local customers and their creditworthiness, with more established and bettercapitalized counter-parties commanding less risk premium in the market than some of the newer entries.
Counterparty Risk
Because a repo is essentially an extension of credit, the creditworthiness of the counterparty is relevant. Better counterparty credits command lower haircuts. The more accurate the dealer's information on the counterparty, the more accurate the pricing of the trade to reflect the credit risk. An understanding of the local markets is key to weighing the risk associated with the collateral and to managing the risk/return tradeoff in a repo.
The willingness of some dealers to overlook the risk/return payoff in extending credit to lesser capitalized counterparties in order to capture market share and establish themselves in the emerging market business has led to socalled "franchise trades." In these trades dealers will use repo as a loss leaders to gain access or secure other emerging market business.
Documentation and Legal Risk
Most bilateral repo agreements are based on the PSA/ISMA Global Master Repurchase Agreement (GMRA). When dealing with local emerging market counterparties or instruments, one must keep in mind restrictions imposed by local laws. For instance, in Mexico, certain types of counterparties are not permitted under local law to marktomarket the underlying collateral. Marktomarket provisions are taken for granted by OECD traders and customers.
In the case of most local market instruments, local law will govern whether the party reversing in the securities is "perfected," or in other words, whether they are legally able to sell those securities upon a counterparty default in order to make themselves whole. The ability of borrowers to freely deal with those securities may be in question in some countries. The borrower's rights upon the insolvency of a local counterparty may be determined by the local jurisdiction, which may disregard rights provided in the PSA/ISMA (GMRA) such as termination and netting of transactions. Taxes, stamp duties, transfer levies and other fees and expenses may also have to be addressed in the documentation.
Custody Risk
Most emerging market securities trade in U.S. dollars or other G7 currencies and clear through Euroclear/Cedel or DTC. Custody problems are few in these systems but do arise in the local market instruments. These are securities that cannot leave the country of issuance and trade in local settlement systems, some of which are not well developed or totally independent from local traders and dealers.
Settlement Risk
With most of the volume cleared through Euroclear and Cedel, settlement risk resides in local market transactions. Since local market U.S. dollardenominated securities cannot leave the country of issuance, settlement and payment do not happen simultaneously. This requires global operational coordination to make sure bonds and money move simultaneously. This coordination has to take place across different time zones with custody operations that may not be highly developed. As expected, the fail risks are high as are the fail costs.
Liquidity Risk
There are a number of factors which affect the liquidity of emerging market repo. Dealers must closely monitor events that could affect the supply of bonds. It is not uncommon for arbitragers to take short positions that could effectively drive the repo rate on that issue below I%. If emerging market bonds are placed into a vehicle issuing collateralized bond obligations (CBO), those bonds are taken out of market until maturity. Also in today's favorable interest rate environment sovereign issuers have been exchanging older Brady Bonds, which are in some cases backed by U.S. Treasuries for Eurobonds with no U.S. Treasury backing. With the announcement of an exchange offer, bonds trading as general collateral in the repo market prior to the exchange can trade very special after the exchange.
Mechanics of Repo/Securities Lending
The emerging market repo market actually encompasses three basic types of products: repos (repurchase and reverse repurchase transactions), securities lending transactions and, less commonly in this market, sell/buybacks. Although each of these transactions has its own specific legal, accounting and regulatory characteristics, the economic considerations are similar.
Repo
A repo involves the sale of securities versus a transfer of cash with a simultaneous agreement to repurchase the securities at a future date. The securities, which are delivered to the cash investor, are valued at the current market price plus accrued interest to date. The securities can be delivered to the customer or its agent, or they can be safekept by Morgan Stanley. Upon termination of the repo, the securities are returned to the original seller and the cash investor receives back the original principal plus the financing interest charged by the cash investor. Any coupon paid during the term of the transaction is passed through to the original owner of the securities. The holder of emerging markets fixed income securities can use the repo market to reduce funding cost or increase portfolio yield by lending or repoing securities.
Reverse Repo
Reverse repo is the mirror image of a repo. It involves the purchase of securities versus a transfer of cash, with a simultaneous agreement to resell the securities at a future date. Dealers will utilize reverse repo to borrow specific securities in order to cover short positions. Clients may use the reverse repo to finance a new purchase or meet shortterm cash needs. Reverse repos give institutions access to funds without having to liquidate inventory.
Securities Lending
Securities lending is a loan of securities secured by one of two forms of collateral: Cash or other securities. In both forms of securities lending, the borrower of the bonds receives all rights of ownership associated with owning the bonds (e.g. ability to use and vote bonds) but must pass through to the lender all distributions, if any, paid during the term of the trade.
A separate "Securities Lending Agreement" outlining the terms and conditions of these transactions should be executed prior to entering into this type of transaction.
Borrow Versus Cash
The mechanics of a borrow versus cash are identical to those of a reverse repo transaction. The dealer borrows securities and pledges cash as collateral and charges the lender an interest rate. This is known as the rebate rate, which is paid at the termination of the loan.
Borrow Versus Pledge (Bonds Borrow)
In this transaction the borrower reverses a specific issue they need from a securities lender and simultaneously delivers out another security of equal worth to the lender. The borrower pays a fee to the lender for the specific issue. The fee is paid upon termination of the transaction and is calculated based on the original market value of the borrowed securities.
Sell/Buyback
A sell/buyback is a sale of securities with the simultaneous agreement to buy back the same securities at an agreed upon price at some future date, calculated to reflect an implied rate of return (repo rate). Sell/buyback agreements are particularly useful where there are withholding tax considerations since no coupon is passed through during the term of the transaction, as in the case of repo.
The securities are priced at the outset of the transaction at the current market price plus full accrued interest to date. The purchaser owns the securities and the coupon for the term of the trade. At the buyback date, the bonds are redelivered to the original owner, at original price plus an "implied repo rate" (i.e. borrowing cost) for the period as well as the loss of coupon for the term of the trade. (i.e. accrued interest). A buy/sellback is the mirror image of a sell/buyback.
Characteristics of Repo and Securities Lending
Maturity of the Repo
With regard to maturity there are generally two types of transactions: Open and term. Open transactions refer to repos with no predetermined end date. The transaction is openended or continuous until the client of dealer takes positive action to close it. The rate paid on funds is based on prevailing LIBOR rates and can be fixed or floating. The interest accrues daily for the life of the agreement and is not paid until the actual termination date of the trade. The trade can be terminated by the borrower or lender with at least two business days notice.
A term transaction refers to any trade executed for a fixed period longer that one day. The repo rate can be floating or fixed, but the duration of the trade and quantity of securities are fixed and are agreed upon at the initiation of the trade. Interest is paid at the end of the term.
Delivery
Delivery can be effected in one of three ways: Outright delivery through separate agents, safekeeping and triparty. In most cases delivery is versus payment but in many local market funds move separate from bonds. In an outright delivery Morgan Stanley moves securities to the customer's account at the customer's clearing agent and receives payment. Delivery can be made through Euroclear/Cedel or a domestic agent.
For the customer who does not wish to receive delivery, securities can be moved into a customer account at one of Morgan Stanley's clearing agents. The securities would be segregated from Morgan Stanley's proprietary positions and is know as safekeeping. In this type of transaction the cash to be invested is paid to Morgan Stanley's agent bank and the securities are moved into a segregated account and held on Morgan Stanley's books and records on the customer's behalf.
A variation of safekeeping repo is letter repo. In this type of transaction the customer receives a single letter detailing the basket of securities that has been moved into a segregated account on the customer's behalf. Securities my substituted daily by Morgan Stanley; each substitution generates a new confirmation.
For the customer who desires the security of delivery repo without the operational requirements, triparty repo is the ideal product. It involves the use of a third party custodian who receives the cash directly from the customer and then, on the customer's behalf, monitors the movement of cash and collateral between the customer's account and Morgan Stanley's account to ensure compliance with the terms of the agreement. Letter repo and triparty repo are generally designed for the customer that has money to invest in repo rather than securities to loan.