1. A repurchase agreement or a repo is a contract whereby the seller of securities agrees to buy them back at a specified future date and price usually on a short-term basis. The difference between the original price and the repurchase price implies the cost of the repo otherwise known as the repo rate. This transaction is generally used for securities financing or securities short covering and is an alternative to securities lending and borrowing. In jurisdictions such as the United States where legislation, like the Glass-Steagal act, prohibits investment banks from performing commercial banking transactions, the repo becomes essential in the financing of capital market activities.
2. Beyond its financing function, repos are an essential component in developing and deepening a debt market. An active repo market allows for market makers to consistently provide two way prices for traded securities, thus providing more depth and liquidity.
3. Many studies have been commissioned to look into the challenge of deepening emerging debt markets. Initiatives are currently on-going within the region as sponsored by the ADB. The consultants engaged by the ADB to study how to deepen the Philippine Bond Markets agree that there could be no discussion on deepening bond markets without the development of a true repo market. The publication by the BIS Committee on the Global Financial on how to design deep government securities markets identifies the development of a repo as part of its 5th policy recommendation. It cites the need to develop repo markets to “enable dealers to finance long positions and cover short positions, allowing them to respond to customers’ needs quickly.”
4. Developed capital markets generally have some mechanism in place to allow short-selling of securities usually in the form of repos or securities lending and borrowing. Either mode provides an infrastructure that supports an active two-way market. More importantly, it provides an effective mechanism for professional market players to hedge their risks
Background on the Development of the Repo in the Philippines
5. In the Philippines, a repo market developed in the 80s primarily between banks and their retail customers. Being a capital markets transaction, the repo proved to be an efficient tool for the banks to finance their balance sheets while providing their customers better returns as opposed to regular deposits. It also provided better security for the customers due to the collateralized nature of the transaction. This however posed problems for the monetary authorities as the repo weakened the effectiveness of monetary tools for controlling monetary aggregates. In particular, the repos allowed for the faster creation of credit as it was not subject to reserve requirements given that the transaction happened off balance sheet as a deposit substitute. The Central Bank of the Philippines eventually applied reserve requirements on these deposit substitutes which spelled the end of the product.
6. Unfortunately what happened consequently created a worse problem as it drove the market underground. An undocumented repo market emerged where only the spot legs of the transaction where reported as outright sales. The contingent repurchase was not documented and was instead evidenced by unofficial side letters. This clearly created a significant problem for regulators as proper reporting and documentary proof were non-existent yet a significant amount of contingent liabilities existed in the banking sector which absolutely nobody could quantify. Worse is that the Central Bank monetary management continued to suffer a leak while customer protection diminished.
Philippine Bond Markets
7. In the mean time, the development of a true repo market ceased to progress to the detriment of the nascent debt capital market. Informal data as of mid 2011 suggests that bond market turnover in the Philippines lags considerably compared to its peers in the region.
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8. Significant programs have been put in the past years to hasten the deepening of the local debt markets. Among these programs, the reissuance process and debt consolidation program have been the most effective and notable in bringing about more liquid bond issues. These 2 programs could best be credited for the surge in bond activity in the last decade which has trimmed average bid-offer spreads from 50bps to 5bps today. However much still needs to be done to ensure the consistency of these metrics, not just on the bid-offer spreads, but on the constant availability of prices too. Making markets remains a significant challenge for local market participants given that there is no effective mechanism to short positions. This will become more apparent as the market opens up to foreign flows as global customers demand this consistency in pricing and liquidity. This is an identified gap in the current state of the local debt market.
9. Anent to the deepening of the bond market, a repo market will also address the lack of a real interbank money market. Being a market driven financing transaction on the other hand, the repo is essentially a true money market instrument that can supplant the use of FX swaps for financing purposes. It then has the additional value of providing a new market determined short term benchmark to complete the gaps in our current yield curve. Eventually, an interest rate swap (IRS) market that fixes on the repo rate can be developed to supplement the current IRS market which fixes on the implied yields derived from the FX forwards.
The MART Proposal
10. What is being proposed is the creation of an inter-professional Buy/Sellback repo market which will be recognized as a derivative under Philippine regulations and governed by the use of the Global Master Repurchase Agreement (GMRA). After much analysis the proposed form is seen to best suit current market conditions and regulations. As such it is believed that the proposed form has the greatest chance of succeeding.
a. Bilateral and Inter-professional. The proposed transaction is being envisioned initially only for the interbank market. This eliminates concerns from the monetary perspective as transactions will be between and amongst BSP regulated financial institutions. Being interbank transactions, there are no applicable reserve requirements on the transactions as well. There being no public involvement, there is no public that needs to be protected. The main purpose of the product is to provide a hedging mechanism for banks as well as a liquidity mechanism for bond portfolios.
b. Buy / Sellback Repo. There are various forms of repurchase agreements. The most basic form is the collateralized lending transaction which for all intents is a loan. The other form is the classic repo which in essence is a true repurchase transaction but is recorded as a cash transaction. Bonds sold under repo are not necessarily derecognized in the books of the bank but are rather reclassified as bonds under repo with a corresponding adjustment to the cash balances. The proposed transaction, referred to as the Buy/Sellback repo, is similar to the classic repo in essence but is instead recorded as a securities transaction. Here a true sale of securities is recorded and derecognized from the balance sheet. A forward purchase is then subsequently booked in the contingent accounts. Being a true sale transaction, there are no legal impediments to holding the bonds in the event of counterparty default as the transfer of title is perfected at inception. Only the forward leg is subject to an event of default which is covered and defined under the GMRA.
c. GMRA. The Global Master Repurchase Agreement is the de facto global standard for repurchase transactions developed by the International Capital Markets Association (ICMA) in conjunction with the Securities and Financial Markets Association (SIFMA). It is easily the most recognizable and accepted master document that sets out the terms and conditions for repo transactions and is essentially the gold standard. ICMA regularly updates opinions globally in various legal jurisdictions to ensure the contracts applicability. The GMRA is fully enforceable in the Philippines without revisions and is thus an applicable jurisdiction.
d. Derivative. Under Philippine laws and regulations, a repo is a derivative. It is similar in nature to the FX swap transaction. Being a derivative, the transaction is free from any withholding taxes or DST. The income derived by the bank from the overlying transaction is however subject to income tax and GRT consistent with current tax laws.
e. True sale. As earlier mentioned, the form of the proposed repo is that of a true sale transaction. As such, collateralization of the financing transaction is perfected.
f. Eligible Securities. Only identified liquid government bonds are contemplated to be eligible as underlying instruments.
g. Conventions, Trade Capture, and Reporting. The transactions shall be governed by the GMRA, the MART Code of Ethics and the relevant trading conventions to be developed. Transactions are to be captured through the Bloomberg B/SB facility which shall also record, consolidate, and make available the transactions for record keeping, transparency and surveillance.