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Current Issues in Economics and Finance
The Repurchase Agreement Refined: GCF Repo®
|June 2003 Volume 9, Number 6||
|JEL classification: G19, G29||View PDF version|
|7 pages / 127 kb|
One of the largest and most important of the money markets is the market for repurchase agreements. In a repurchase agreement, a borrower of money effectively agrees to provide securities as collateral to the lender to mitigate credit risk. GCF Repo is a recent innovation in this market that reduces transaction costs, enhances liquidity, and facilitates the efficient use of collateral.
Repurchase agreements (repos or RPs) play a crucial role in the efficient allocation of capital in financial markets. They are widely used by dealers to finance their market-making and risk-management activities and they provide a safe and low-cost way for mutual funds, depository institutions, and others to lend surplus funds. The importance of the repo market is suggested by its immense size: dealers with a trading relationship with the Federal Reserve Bank of New Yorkso-called primary dealersreported financing $2.48 trillion in Treasury, agency, mortgage-backed, and corporate securities at the end of 2002 with RPs.1
GCF (General Collateral Finance) Repo was introduced in 1998 by the Fixed Income Clearing Corporation (FICC) and two large dealer clearing banks, JPMorgan Chase Bank (JPMC) and Bank of New York (BoNY), to reduce transaction costs and enhance liquidity in the repo market.2 Its success in achieving these objectives is suggested by its rapid growth and current market share. Average daily net settlement volume in GCF Repo rose from $11.3 billion in 2000 to $101.3 billion in 2002, and GCF Repo was recently estimated to account for 54 percent of inter-dealer repo transactions on Treasury collateral (Bockian 2002).3
This edition of Current Issues explores why GCF Repo has become so popular. We start by describing conventional repurchase agreements and identifying the transaction costs that limit liquidity in the conventional repo market. We then explain how GCF Repo works and how it reduces transaction costs by allowing for netting in the settlement process and by facilitating the efficient use of collateral.
Repurchase Agreements Defined
A general collateral RP is a repurchase agreement in which the lender of funds is willing to accept any of a variety of Treasury and other related securities as collateral. The class of acceptable collateral might be limited to Treasury securities maturing in less than ten years or it might include all Treasury and agency securities. The lender is concerned primarily with earning interest on its money and having possession of assets that can be sold quickly with minimal transaction costs in the event of a default by the borrower.
Direct Trading and Settlement
Trading and Settlement in the Inter-Dealer
Settlement of an RP that is arranged
by a broker between two FICC members differs from the textbook
description of a repo settlement in two important respects.
First, the broker is involved in the settlement at the start
of the repo. As shown in the top panel of Figure 2,
the borrowing dealer delivers its securities to the broker,
rather than directly to the lender, against payment of the
principal amount of the borrowing. The broker then redelivers
the securities to the lender against payment of the same principal
amount. This more costly, two-step settlement process is necessary
to preserve the anonymity of the borrower and lender.7
Second, the settlement at the end
of the RP goes through FICC. FICC nets the settlement obligations
of each of the three partiesthe borrower, the lender,
and the brokerwith other obligations of each of those
parties to receive and deliver the same securities on the
termination date of the RP. If, for example, the lender (dealer B
in Figure 2)
happens to be a buyer (from another FICC member) of $7 million
principal amount of the same series of Treasury notes, it
would have a net obligation to deliver only $3 million
of the notes ($3 million = $10 million of notes
due to be returned to dealer A, less $7 million of the
notes due to be received in settlement of its purchase). The
broker always drops out of the settlement process because
it has offsetting obligations to receive $10 million
of the notes from dealer B and to deliver $10 million
of the notes to dealer A.
In the simple case in which the borrower and lender have no other obligations to receive or deliver the same securities on the same day, the lender delivers the securities that collateralized the RP to FICC against payment by FICC of the principal and interest on the borrowing, and FICC delivers the securities to the borrower against payment of the same sum. This is shown in the lower panel of Figure 2. When the borrower and lender do have other obligations, settling the closing leg of the RP through FICC is cheaper and more efficient than settling through the broker because of the efficiencies of net settlement (described in Fleming and Garbade ). The starting leg of the RP is not settled through FICC because, outside of the GCF Repo facility described below, FICC does not provide for net settlement of transactions that settle on the day they are negotiated.
Transaction Costs of Inter-Dealer Trading
A second transaction cost is the
relatively early (in the day) loss of the borrowers
option to deliver any of a variety of securities. A dealer
borrowing funds on a general collateral RP has to identify
by about 11 a.m. the securities that it intends to deliver.
As soon as it does so, it becomes obligated to deliver those
specific securities. If the dealer identifies securities that
it expects to receive later in the day but that ultimately
fail to arrive, the dealer has to go back to the lender and
request that it agree to accept different securities. The
possibility that repo settlements may have to be renegotiated
adds to the costs of making a two-way market in general collateral
A third transaction cost is the
cost to a lender of accommodating a borrowers request
to substitute collateral on a term, or multiple-day, repo.
A dealer that borrows money on a term RP will sometimes request
that it be allowed to provide different collateral if it identifies
an opportunity to sell outright some or all of its original
collateral at a favorable price. Collateral substitution requires
two settlements, one when the lender delivers the original
collateral back to the borrower against payment, and the second
when the borrower delivers the new collateral to the lender,
also against payment. A dealer lending money on a general
collateral RP bears additional expenses whenever a borrower
Trading in GCF Repo
Settlement of GCF Repo
Settlement of GCF Repo is also
designed to preserve for as long as possible the borrowers
option to choose what collateral to deliver. A dealer that
clears through JPMC and is a net borrower on GCF Repo on all
Treasury issues has until 4:30 p.m. to deliver Treasury
bills, notes, and/or bonds of its choosing to an FICC account
at JPMC against payment of the principal amount of its net
JPMC is responsible for verifying that the securities are
in fact Treasury securities and that they have a market value
(including any accrued interest) at least as large as the
principal amount of the dealers net borrowing. The borrower
does not have to give any advance notification of the specific
collateral that it plans to deliver, so its option to choose
which securities to deliver survives well past the time when
collateral is assigned for conventional repos.
The securities transferred to FICCs
account are redelivered to other dealers that also clear through
JPMC and that are net lenders against payment of the principal
amounts of their respective net loans. The transfers of securities
from net borrowers to FICCs account at JPMC, and the
transfers of securities from FICCs account to net lenders,
occur entirely on the books of JPMC and do not require any
Fedwire transfers. The aggregate net borrowing of all of the
dealers that are net borrowers and clear through JPMC is identical
to the aggregate net loan of all of the dealers that are net
lenders and clear through JPMC because every GCF Repo transaction
involves a borrowing and a loan of identical size by parties
that clear through the same bank. Thus, the total payments
received by FICC in its JPMC account equal the total payments
disbursed by FICC from its JPMC account.10
Morning Reversal and Afternoon Recollateralization
The morning reversals are important
to dealers borrowing on continuing term RPs because they restore
a borrowers control over its collateral, giving it access
to securities that might be needed to settle unrelated sales.
The morning reversals eliminate the costs of requesting and
effecting specific collateral substitutions because borrowers
regain control over all of their collateral through
securities and funds transfers that take place entirely on
the books of their clearing bank.
Of course, if a dealer committed
to borrow on a term RP that is not terminating, its borrowing
must be renewed, that is, the morning reversal must itself
be reversed. Similarly, if a dealer committed itself to lend
on a continuing RP, its loan must be renewed. Thus, FICC reinstates
all continuing borrowing and lending commitments immediately
following each morning reversal. Any additional commitments
negotiated during the day are combined with the reinstated
commitments in the 3:45 p.m. calculation of each dealers
net obligation to borrow or lend that day.
If the dealer is a net borrower
at 3:45 p.m., it is obligated to deliver Treasury collateral
to FICC against payment of the aggregate principal amount
of its net borrowing. It does not, however, have to deliver
the same securities that it received in the morning (assuming
it had been a net borrower on the preceding day). If it needed
some of those securities to settle unrelated sales, it can
continue its borrowing using other securities as substitute
collateral. In this way, GCF Repo makes collateral substitution
an entirely transparent process.
Accrued Interest and Mark-to-Market Payments
In order to justify the return
of a borrowers collateral against payment of only the
original principal amount of the borrowers RP, FICC
requires that the borrower pay accrued interest on its borrowing
and make (or receive) a mark-to-market payment to account
for the decline (or rise) in the market value of its contract
due to changes in GCF Repo rates since the contract was negotiated.
To preserve the convention that interest on GCF Repo is paid
in full at maturity, both of the foregoing payments are returned
the following day with interest at the overnight repo rate.
presents a numerical example.
GCF Repo Compared with Conventional Repo
|About the Authors
Michael J. Fleming is a research officer and Kenneth D. Garbade a vice president in the Capital Markets Function of the Research and Market Analysis Group.
1. Federal Reserve Bulletin 89 (April
2003), p. A27, Table 1.43, U.S. Government
Securities Dealers, Positions and Financing. The repo
financing is the sum of lines 33 and 34 for the column headed
December 25, 2002.
Ingber (2003) recounts the development of GCF Repo; see
(1998) and Government
Securities Clearing Corporation (1997, 1998). FICC is
a wholly owned subsidiary of the Depository Trust & Clearing
Corporation (DTCC), which also owns the Depository Trust Company.
The Government Securities Division of FICC is the successor
to the Government Securities Clearing Corporation (GSCC),
which was acquired by DTCC in January 2002.
3. The figures double count the actual
volume of transfers of funds and securities because they include
the sum of daily net borrowings and daily net loans.
4. The Bond
Market Association (1998) recommends that borrowers advise
lenders by 11 a.m. of the collateral they will be delivering.
and Garbade (2002) describe the details of delivery and
payment through Fedwire.
6. Dealers actually quote bid rates for (borrowing)
collateral against lending money and offer rates for (lending)
collateral against borrowing money. We reverse the bid and
offer conventions for expositional clarity.
7. The brokers role in settling the starting leg of an RP was made possible by GSCCs decision in mid-1996 to guarantee broker payment and delivery obligations. This guarantee, as well as other aspects of repo settlements, is discussed in Fleming and Garbade (2002).
8. For reasons that will become evident shortly,
dealers that clear through JPMC can trade GCF Repo only with
other dealers that trade through JPMC. Dealers that clear
through BoNY can trade only with other dealers that clear
through BoNY. FICC sponsors GCF Repo trading in four other
classes of collateral: (1) Treasury bills, notes, and
bonds with less than ten years remaining to maturity, (2) fixed-rate
unsubordinated non-mortgage-backed securities of the Federal
Farm Credit Banks, the Federal Home Loan Banks, the Federal
National Mortgage Association (Fannie Mae), and
the Federal Home Loan Mortgage Corporation (Freddie
Mac), (3) fixed-rate mortgage-backed securities
issued by the Government National Mortgage Association, and
(4) fixed-rate mortgage-backed securities issued by Fannie
Mae and Freddie Mac.
9. A net borrower can deliver securities after
4:30 p.m. but it is then subject to penalties that escalate
the later it makes delivery.
10. Between June 1999 and March 2003,
FICC sponsored trading in GCF Repo that combined dealers that
clear through JPMC with dealers that clear through BoNY (see
 and Government Securities Clearing Corporation
Important Notice 051.99, Implementation of the
Interbank Phase of the GCF Repo Service, June 2,
1999, posted at <http://www.ficc.com/gov/notices/GOV051.99.htm?NC-query=>.
Settlement problems led to the separation of the two dealer
groups in March 2003 (see Fixed Income Clearing Corporation
Important Notice GOV025.03, Status of the GCF Repo
Service, March 5, 2003, posted at <http://www.ficc.com/gov/notices/GOV025.03.htm?NS-query=>,
Jones Newswire , and Wall
Street Journal ).
Bond Market Association. 1998. Repo Trading
Practices Guidelines,Update No. 98-4, November 2. <http://www.bondmarkets.com/Market/repoupdate98-4.shtml>
Dow Jones Newswire. 2003. Risks
Force Limitations on Popular Repo Market Product, March 12.
Fleming, Michael J., and Kenneth D. Garbade.
When the Back Office Moved to the Front Burner: Settlement
Fails in the Treasury Market after 9/11. Federal
Reserve Bank of New York Economic Policy Review 8,
no. 2 (November): 35-57.
Government Securities Clearing Corporation.
1997. General Collateral Finance (GCF) Repo. New
Service Bulletin, July 25. (June 2003).
_____. 1998. General Collateral Finance
(GCF) Repo Service. New Service Bulletin, June 1.
Ingber, Jeffrey. 2003. Gets Confusing
Fast: A Review of the GCF Repo Service. RMA Journal 85,
no. 8 (May): 46-51.
Taylor, Ellen. 1998. Repurchase Agreements:
Good Bye to Collateral? Global Custodian, spring:
Wall Street Journal. 2003. Repo Market Is Hit by Limits on a Top Product, March 17, p. C13.
Settlement of a Brokered Repurchase Agreement
between Two FICC Members