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HMRC internal manual

Corporate Finance Manual

HM Revenue & Customs
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Deemed loan relationships: repos: general collateral repos

General collateral repos

The borrower under a repo is a person who currently owns securities - shares or debt instruments - and sells them for cash. The repurchase price is computed by applying an interest rate to the cash received for the securities in the first leg of the transaction. This rate is known as the repo rate. The rate should theoretically be based on the secured lending rate for a loan equal in term to the length of the repo. However, it will also be affected by factors such as the demand for borrowing of this sort and the quality of the securities sold (collateral).

The repo rate is not dependent on any movement in the market price of the securities during the term of the repo. So the lender is not directly exposed to market risk in relation to the underlying securities-although it could become exposed if it sells them since it will then have to repurchase them at a later date to meet the return leg of the repo.

Since the lender actually owns the securities, it is not exposed to any credit risk and in the event of default can simply sell the securities. As a result the borrower’s own credit rating is not an issue so it will normally benefit from a low interest rate. Like stock loans (CFM74100), a ‘haircut’ is usually required on a repo. In most cases the sale price for the securities in the first leg of the transaction will be a few percent below the market price of those securities. This means that the lender has securities as collateral which are worth more than the amount of the loan, providing an extra degree of protection against default. It should be noted, however, that the repo market came under severe strain from 2007 - see ‘Inter-bank lending’ below.

The collateral position is margined daily. The value of the securities is ascertained and the amount compared with the cash advanced plus accrued repo rate ‘interest’ on the cash. Extra securities may have to transferred, or returned, depending on the result of the comparison.

How general collateral repos are used

Most commercial repo transactions are undertaken as a form of secured lending. See the example at CFM46120. However, there are other possible uses.

  • Repos can be used by hedge funds to finance their investments. A hedge fund manager can purchase securities and then repo them out. In this way the manager only has to find cash upfront equal to the haircut, calculating that the total yield on the securities will exceed the cost of financing them.
  • Arbitrageurs can use repos to take advantage of price anomalies in the futures market. A reverse repo (CFM46130) can be synthesised by the cash purchase of a bond and its future sale under a futures contract. So selling the bond at once under a repo will create a locked-in profit or loss if the difference between the futures price and the sales price under the repo does not equal the repo rate.
  • Financial traders may use repos of differing terms to speculate on forward movements in interest rates. For example, a speculator may repo in a bond over 3 months and immediately repo it out for say 1 month. For the first month the transaction would be broadly cash neutral. But if at the end of 1 month interest rates have fallen the speculator will, by entering into a new two-month repo at that point, pay less interest in respect of its initial cash ‘borrowing’ than it receives under the reverse repo.
  • Lastly, but significantly, repos have been used for tax avoidance. Cases where abuse of the rules is suspected should be referred to CTIAA (Financial Products Team).

Inter-bank lending

Much inter-bank lending is conducted by means of repos. Repos depend on a belief by the lender that the collateral provided by the borrower provides real security for the loan. In 2007, the valuations of securities based on US sub-prime mortgages collapsed. Not only were such securities widely used as collateral in repos, but the resultant concern about the quality of collateral generally led to a freezing of the inter-bank lending market. This was a major cause of the ‘credit crunch.’