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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?
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    $\begingroup$ I'll respond to the case where the bond is an MBS Derivative (an Inverse IO, for example). It is not necessarily the case that both the purchase and the repo have to be done with the same party although the market has definitely moved in that direction over the past few years because of broker-dealer balance sheet constraints. In the past, every now and then, there would be some firm that would be particularly focused on the security lending business and would repo entire portfolios of bonds. I'll end here since it seems like your focus is on the simultaneous aspect. $\endgroup$ – Sharad Nov 26 '20 at 18:00
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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.

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  • $\begingroup$ Thank you. I am aware of haircuts, choice of collateral for GC repos, etc. So I am abstracting from this. My question is really more on the operational side. So you say both transactions might be done with the same custodian, that should certainly facilitate crossing the transactions and doing them in a simultaneous fashion. Is it also possible that the settlement lag helps this? For example, if the bond purchase settles at t+2bd and the repo settles at t+1bd, then by the time you settle the outright purchase you've already received the necessary cash from the repo (which settled yesterday). $\endgroup$ – Daneel Olivaw Nov 27 '20 at 10:02
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    $\begingroup$ The custodian is merely holding the accounts and receiving and delivering assets and cash at the end of settlement date. The trader is the most important link here. They would have to trade both legs of the trade simultaneously to avoid slippage on the bond price of both legs. If they do that with the same counterparty it would be easier as it would be part of a package and the dealers sales guy would coordinate between the two desks that trade these assets. With different counterparties, your trader will have to coordinate between the two different dealers trading the individual legs. $\endgroup$ – AlRacoon Nov 27 '20 at 15:41
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    $\begingroup$ And yes settlement dates do matter. The cash/assets must be in the custodial account to settle any trade. You would have to have the bond in the account to settle the repo or you will fail for a day and be assessed fail charges. Your trader can also negotiate settlement dates as part of the negotiation so that the settlement dates are the same. Most asset managers will have cash and other assets in this account as well to make margin or recieve margin, and not just these assets. $\endgroup$ – AlRacoon Nov 27 '20 at 15:44

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