COVID-19 cash shortage highlights need for classic repo

8 October 2020

2020 has been a turbulent year for financial markets worldwide. The COVID-19 pandemic has caused unforeseen price volatility in the South African market with large swings in mark-to-market positions increasing demand for cash – cash which could usually be raised through repurchase transactions (repos).

There are some limitations to the buy/sell back repo transactions that dominate the South African market – and the pandemic-led demand for cash has highlighted this.

Some of the constraints of buy/sell back repos can be alleviated by adding classic repos as an alternative tool that can expand trading and funding opportunities. Yet the South African market has been slow to adopt classic repos despite the global trend in this direction.

A repo is simply a collateralised loan where one party borrows cash and promises to return it at a pre-specified date with interest, and puts up securities as collateral.

For years repos have been used in the financial markets as a contractual sale with a promise to repurchase at an agreed future date, and to obtain and utilise cash at favourable rates under the internationally recognised Global Master Repurchase Agreement (GMRA). Typically, there are two types of repo transactions that can be structured under a GMRA: the classic repo and the buy/sell back. The South African market predominantly operates within the buy/sell back market with this market legacy built on simplicity and convenience, in times before COVID-19.

Buy/sell backs do not require variation margin to be exchanged between parties, nor do they allow for security substitutions. Any capital events are priced into the transactions upfront. While these terms simplify the transaction, they may also generate unintended consequences for the market, including:

In the absence of variation margin, the cash provider may stipulate higher funding rates, placing extra pressure on a cash strained market
Higher cash rates could price players out of the market, forcing them to sell stock in the open market to raise cash for obligations such as margin for derivative positions
In times of stress, the supply of stock to honour lending positions or on-market trades can prove to be challenging. Given that buy/sell backs do not facilitate substitutions, this in effect can “lock up” stock within a buy/sell back until term or early termination
Without the ability to substitute stock when required, traders may be forced to source required stock from alternative avenues, quite possibly at a premium
Lastly, upfront deal pricing, without the ability to margin, adds risk in turbulent times

Classic repos could alleviate some of the intended consequences of buy/sell backs. Classic repos, which are automatically covered under standard GMRAs, differ from buy/sell backs in the following ways:

The exchange of variation margin which limits risks associated with daily price fluctuations
Substitutions are allowed under classic repo meaning that alternative, acceptable collateral may be swopped with placed collateral, under the consideration of the collateral receiver/cash provider
Any capital event payments are processed independently and passed through to the collateral giver/cash receiver on the payment date of the event and are not priced in upfront. This allows the collateral giver to potentially earn a better return than if it was priced into the repurchase consideration

Simply put, it can be difficult to realise the benefits of the classic repo without efficient processes in place to execute substitutions and daily margin calls. In view of this, the global trend is to outsource the administration of classic repo transactions to a third party provider who can generate margin calls as well as instruct and facilitate security collateral substitutions, while still monitoring custody.

Strate Collateral Services serves the South African financial market as a third party collateral management provider that facilitates the automation of the administration of classic repo transactions. Please contact Strate Collateral Services for more information collateralmanagement@strate.co.za