Repurchase Agreements Securities Lending

1. SEACEN Conference December 4-7, 2007 Siem Reap, Cambodia Repurchase Agreements Securities Lending Nilakanta Venky Venkatesh, CFA Principal Financial Officer Sovereign Investments Partnerships World Bank Treasury nvenkatesh@worldbank.org Richard V. Williams, CFA Senior Financial Officer Sovereign Investments Partnerships World Bank Treasury rwilliams1@worldbank.org

2. Road Map for this Presentation • What is a repurchase agreement (repo/resale)? • Why would you use repos? • What are the risks and requirements for trading repos in-house? • What is securities lending? • What are the benefits of securities lending? • What are the risks and how do you mitigate them? • Comparison of repos vs. securities lending

3. Central Bank borrows cash Central Bank Repo REPURCHASE AGREEMENTS (Repos) • Money market transactions supported by a legal framework • Securities (collateral) are sold (on a temporary basis) to a counterpart against cash while agreeing to repurchase those same securities at a specific price on a specific forward date • Beneficial ownership of securities remain with lender of securities (principal and interest payments) • In repo, interest is paid on the amount of cash borrowed

4. REPO EXAMPLE Cash received depends upon price of bond 30 day Repo quotes Dealer A = 0.62% Dealer B = 0.60% Dealer C = 0.62% U.S. Treasury: 100mm T 3.375% 10/15/09 @ 100.25 Repo borrowing cost 0.60%  Borrowing cost using repo trade (100,000,000*1.0025) * 0.0060 * (30/360) = $ 50,125.00 Fed Funds borrowing cost 2% Borrowing cost using FF market (100,025,000) * 0.02 * (30/360) = $ 166,708.33

5. REVERSE REPURCHASE AGREEMENTS (Resales) • Securities (collateral) are purchased from a counterpart on a temporary basis for cash while agreeing to sell those same securities back at a specific price on a specific forward date • Interest is earned on the cash lent • A Resale for a central bank (CB) isa Repo for a dealer (and vice versa) Central Bank is lending cash Central Bank Resale

6. REVERSE REPO (Resale) EXAMPLE 7 day Resale rates Dealer A = 1.97% Dealer B = 1.94% Dealer C = 1.98% General collateral with a market value that equals 100 million notional Resale investment rate 1.98%  Interest earned using resale trade 100,000,000 * 0.0198 * (7/360) = $38,500.00 Fed Funds deposit rate 1.95%  Interest earned using FF trade 100,000,000 * 0.01 * (7/360) = $37,916.67

7. Borrowing or Lending Cash Investoris borrowing cash Repos Reverse Repos Investor is lending cash Remember:Follow the cash! The value of a repo trade depends upon whether you are borrowing cash (lending securities) or lending cash (borrowing securities).

8. VALUE DETERMINANTS IN REPO General Collateral are generic securities used to either finance the position of a security or as a guarantee for the cash received on a deposit • Why General? • Supply/Demand 30yr Treasury Repo rate= 1.72% Specials are specific pieces of collateral used to cover short positions of the borrower. These trade at a premium to ‘general’ collateral in the repo market • Why Special? • Supply/Demand • Cheapest to Deliver • Hedging Vehicle 5yr Treasury Repo rate = .60%

9. General CollateralVersus Special issues • Repo rates depend on whether collateral is considered “general” or “special” • General collateral (GC) meets counterpart’s general requirements • Special issues (Specials) meets counterpart’s specific requirements • Dealer reversing in general UST collateral will accept any bills, notes or bonds • Dealer looking for special issue collateral will only accept specific issue

10. “Specials” Repo and Resale Rates • Specials market is driven by supply of, and demand for, a specific security at a given point in time • Factors which drive “specialness” of securities, e.g. • Dealers setting “shorts” ahead of Treasury auction • Size of available issue (supply and demand) • Bond Futures “cheapest to deliver” • Repo “ squeezes” by dealer community • High demand for current issues (e.g. hedge fund activity)

11. GC Repo and Resale Rates • Repo rates are determined by dynamic market forces • Factors influencing overnight GC Repo rates • Benchmark rate (Fed Funds in US or Libor non US markets) • General supply of money and repo collateral • Method of delivery • Size of transaction • Creditworthiness of counterpart • Factors influencing term GC Repo rates • Shape of yield curve • Rights of substitution • Yields on competing money market instruments • Seasonal influences • Interest rate forecasts

12. TRADING STRATEGIES : REPO & RESALES Repos Yield enhancement for bond portfolios Finance Long positions Resales Liquidity Management (Yield Enhancement) Cover short positions Repo / Resales Repo Arbitrage

13. Calculation of Profit / Loss on a Repo Spread [101] x [1.15[7/360] = 22,584.72 REPO ARBITRAGE Cash received depends upon price of bond Repo rates Dealer A = 0.82% Dealer B = 0.80% Dealer C = 0.82% Deposit rate = 1.95% Investor reinvests in Deposits 101mm (Cash raised from market value of lent collateral) U.S. Treasury = 100mm 3.25 8/07@ 101 (1.95%-.80%)

14. Calculation of Interest Earned on a Reverse Repo [100] x [1.98[7/360] = 38,500.00 REVERSE REPO TRANSACTION Resale rates Merrill = 1.96% Lehman = 1.98% Goldman = 1.96% Deposit rate = 1.95% General collateral with a market value that equals 100 notional

15. Repo - Margin and Pricing • Margin - Excess collateral provided to cash lender • Protects cash lender against adverse change in price of securities between time of default and subsequent liquidation of collateral • When providing margin, securities pledged as collateral are priced at full accrual market value minus a “haircut” • Size of haircut depends on the maturity of collateral, price volatility, term of repo and credit standing of the cash borrower

16. Margin and Pricing Example • Dealer repos $10mn face amount of UST trading at price 100 to central bank (CB) overnight • Assume dealer gives 1% margin to CB • Assume zero accrued coupon interest on UST • Assume overnight repo rate is 1% • $10mn UST returned to dealer the next morning and funds are wired back to CB with interest of 1% • Interest received by CB $9,900,990*0.01*1 /360 = $275 $ amount of Repo = (market price + accrued coupon interest) * face value / margin % = (1.00+0) * 10 million / 1.01 = $9,900,990

17. Special issues Example Example • CB owns current 2 year UST • CB wants to borrow cash for 4 days • Bid for GC is 1% • Fed Funds borrowing cost is 1.05% • Bid for 2 year UST is 0.5% (trading “special”) • CB pays 0.5% on cash borrowing for 4 days • Cash borrowing cost using special issue resale:- • 50 basis points less than GC cost of funds • 55 basis points below Fed Funds borrowing cost

18. Repo Pricing Screen without Margin

19. Repo Pricing Screen with Margin

20. Money Due at Settlement Screen

21. Collateral Mark-to-Market • Margin is maintained to protect the cash lender from loss should the market value of the securities pledged as collateral fall below the $ value of the initial repo transaction • Achieved through marking-to-market (MTM) the collateral to reflect price movements in underlying securities • If the market value of securities declines so that the agreed Repo margin is not maintained, lender of securities must give cash lender additional cash or securities to restore margin

22. Collateral Mark-to-Market Example Example • CB delivers $9,690,000 par of UST of value $10,100,000 to Dealer • Receives $10,000,000 cash (1% margin given to Dealer) • Market drops and UST is now worth $9,950,000 • Margin restored to 101% of cash loan • CB delivers additional collateral with current market value of $150,000 to Dealer

23. Repos - Risks • Credit Risk • Counterparty exposure • Inaccurate pricing of collateral • Market Risk • Mismatch between repo transaction and investment of repo proceeds • Leverage

24. Repos - Risks • Operational risk • Trading and delivery deadlines • DVP monitoring (cash vs securities receipt) • Messaging • Coupon and redemption handling • Handling of fails • Repricing and Margin calls

25. Mitigating Risks • MTM of Collateral • Netting of transactions with the same counterpart • Specify permissible investments using cash raised • Prohibit leverage

26. REPO DELIVERY METHODS • Delivery Versus Payment (DVP) • Cash lender takes possession of collateral in a bank account established, maintained and paid for by the cash lender • Tri-Party Deliverable Repos • Dealer, cash lender, and third party custodian bank enter into tri-party agreement in which custodian bank acts as intermediary in the Repo transaction Tri-party repo reduces operational risks associated with margin calls, repricing, collateral movements, delivery risks

27. Repo Process Flow

28. Market Agreements for Repo Transactions • Master Repurchase Agreement (TBMA 1996 version) • intended for US$ repo market • governed by New York law • Global Master Repurchase Agreement (TBMA/ISMA 2000 version) • intended for “London market” -- international use • Governed by English law

29. Requirements for Trading Repos • Experienced repo traders • Credit limits • Accurate pricing capability • IT system to keep track of securities positions and repos against them • Legal agreements • Accounting Procedures

30. Alternatives to Repo • Some market participants may be not be permitted to engage in Repurchase transactions because, e.g., • Regulatory or tax restrictions • Accounting and system limitations • Inability to administer mark-to-market • Alternatives to Repo • Buy and Sell back transactions • Custodian Securities Lending Programs

31. Buy and Sell Back transactions • Can be governed by legal agreement • Master Securities Forward Transaction Agreement (US) • Legal Agreement in accordance with Capital Adequacy Directive • Transactions are booked as 2 separate trades • Both sale and buy are entered into at the same time • An investment rate is used to derive the forward price • Excess margin is generally not provided • The cash lender receives title to the securities • Accrued interest / coupon paymentsbelong to cash lender

32. Repos – Key Messages • Repo transaction raises cash by lending (selling and buying back) a security • Repos/resales are used for yield enhancement, finance long positions or cover short positions • Margins are posted to cover erosion in market value of the collateral • Repo pricing depends on whether the collateral is general (GC) or special • Legal agreements and other provisions (such as netting) will mitigate the risks

33. Securities Lending

34. Securities LendingMain Features • Who borrows ? • Low cost option for client • Income sharing • Rebate to borrowers • Can you sell securities that have been borrowed ? • Substitution • Accounting for securities lending activity (custodian versus client) • Indemnification • Collateral investment guidelines • Transparency (reporting, income calculations) • Utilization rate, spread expectations

35. Securities LendingMore on Accounting….. • Available Reporting from Custodian: • Cash Collateral Report • Securities-on-Loan Report • Monthly credit of income earned

36. Securities Lending Risks The above is not intended to be a comprehensive listing of all risks in a securities lending program.

37. Securities Lending Less internal infrastructure needed Less internal operational risk – trade may fail if security is out on loan and required for settlement No additional staffing requirements Earnings shared with custodian – can be used for fee negotiation In-House Repo Trading Robust internal infrastructure needed – IT and Settlements Higher operational risk due to tight deadlines for trading, settlement confirmation & dispatching of messages More staffing may be required due to time difference between local and investment markets Spread will not be shared with custodian Securities Lending Vs. In-House Repo Trading