Operational aspects of repo funding trades

Question

It is widely known that repurchase agreements ("repos") are regularly used by market participants as a mean to fund long/short positions in a certain asset, in particular for derivative hedging purposes. For example, in page 16 of their white paper Understanding repos and the repo market (2009), Euroclear explains how a dealer can fund a long position in a bond:

1. A dealer buys a bond in an outright purchase from the cash market. [...]

2. The dealer offers the bond as collateral to the repo market and uses the cash proceeds to pay for the outright purchase of the bond in the cash market.

My question is about the operational aspects of such a transaction, in particular its simultaneous aspect:

• Is this particular operation only possible when both the purchase and the repo are done with the same party?
• Are these kind of operations executed through some custodian agent that settles both cash and repo transactions, hence allowing it to cross-settle this kind of operation?
• Do settlement lags enable this sort of operation, in that outright purchases take more time to settle than repos, thus allowing to receive the repo's cash in the meantime?
• Or is the above merely an "illustrative description", and in practice this kind of operations amounts to margin trading?

Answer 1

I believe the example is merely for illustrative purposes. You shouldn't be able to fully fund a position in real life.

The funding of (repo) and the bond purchase need not be with the same counterparty, nor does it have to be simultaneous. In fact, the bond purchased need not be the same collateral that is part of the repo trade and often isn't.

A repo trade is at its essence a form of collateralized lending. The collateral (in this case the bond purchased) is sold to the lender and simultaneously agreed to be re-purchased (hence repo--repurchase agreement) at a certain point in time. The difference in the two prices representing the interest of the loan.

In order to fully fund the purchase price of the bond, one would have to post more collateral than the price of the bond. The lender would want to have some cushion should they need to liquidate the collateral in the event the borrower defaults on "re-purchasing" the bond, or fails to post additional collateral margin. In overnight bond repo, this cushion is approximately 2% of the loan amount.

Here is where the closer in timing of the bond purchase and repo trade are, the better. If one is using the same bond purchased as collateral in the repo trade, the closer in timing of the two trades, the higher the likelihood the repo counterparty (the lender) would buy the collateral at the same purchase price of the bond and hence the position could be fully funded. Nevertheless, there would have to be the 2% haircut and proceeds will be less than the total amount needed to fully fund the purchase of the bond. Consequently, there would have to be other assets that are posted (cash margin, or additional assets repo'd) to fully fund the position. Additionally, the margin account will need to be maintained.

Both the bond purchased and the repo would most likely be held at the same custodial (or prime brokerage) account that would facilitate the settlement of both trades, and the posting of additional collateral.