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15. Is repo riskless?
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There is no such thing as a riskless financial instrument. But repo can achieve a substantial reduction in the credit and liquidity risks of lending, if managed prudently. The degree to which repo can mitigate risk depends upon the careful selection of counterparties, the use of high quality and liquid collateral, the operational ability to mobilise collateral across clearing and settlement systems, efficient collateral management (particularly margining) and legal certainty about ownership of collateral.
  • Careful selection of counterparties is vital to the performance of repo. This is because the value of even the best assets will fluctuate and the liquidation of collateral in response to an event of default can be delayed by unexpected operational and legal problems. Moreover, collateralisation does not change the probability of default of a counterparty, so collateral taken from risky counterparties is likely to be tested by a default and may turn out to be worth less than expected. Consequently, collateral should be treated only as insurance against the default of the seller, not as a substitute for his credit risk. This means that the primary exposure in a repo remains counterparty credit risk. Consequently, repo does not replace conventional credit risk management and does not allow lending to parties deemed unsuitable for unsecured lending. Rather, repo is intended to reduce the risk of lending to existing counterparties and make more efficient use of the capital supporting such lending.
  • Although counterparty credit risk is the primary exposure in a repo, the choice of collateral is still very important. First, the credit risk on the collateral should have a minimal correlation with the credit risk on the repo counterparty, in order to diversify credit exposure as much as possible. Second, collateral should have minimal credit and liquidity risks in order to maximise certainty about its value and ease of liquidation in the event of a default. Government bonds have traditionally provided collateral that meets both criteria. However, the sources of high-quality and liquid collateral have recently been reduced by the sovereign debt crisis, although possible alternatives are being investigated by the market, including covered bonds and bank loans.
  • Even the best asset is no good as collateral if it cannot be easily and securely transferred to a counterparty. This is straightforward in an integrated market such as the US but more complicated in Europe, which has a fragmented securities clearing and settlement infrastructure. Great strides have been made in integrating the European infrastructure but barriers to the efficient mobilisation of collateral persist, particularly between some domestic CSDs and the ICSDs that are used by most cross-border investors.
  • Efficient collateral management is mainly about frequent and accurate calling for margin to compensate for fluctuations in the value of collateral (see question 20). It may also be helpful to adjust the initial market value for some types of collateral by applying a haircut or initial margin (see question 21), in order to cover the gaps between margining and take account of the potential cost of liquidation following a default. Guidance on efficient margining is set out in the Guide to Best Practice in the European Repo Market published by the European Repo and Collateral Council (ERCC) of the ICMA.
  • Legal certainty about a buyer’s right to collateral and the right of a non-defaulting party to net mutual obligations in the event of a default depend on robust contractual documentation such as the ICMA’s Global Master Repurchase Agreement (GMRA) (see questions 18 and 19). This functioned well during the Lehman Brothers and other recent defaults.

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