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18. Why is it important to document repo?
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The key purpose of collateralisation is to secure a cash lender (ie mitigate his credit risk) by giving him the right to liquidate the collateral provided by the cash borrower in the event that the borrower becomes insolvent or defaults in some other way. In traditional secured lending, the right to liquidate is established under a pledge attached to or other type of security interest in the collateral in favour of the cash lender. In repo, security is established (outside the US --- see question 14) by a transfer of legal title to the collateral. In order to ensure that courts will enforce a lender’s rights to liquidate collateral, it is prudent to provide a written contract as evidence of the original intentions of the parties to create this right for the non-defaulting party and to ensure that a court will not re-characterize the repo as a secured loan. In many jurisdictions, such re-characterisation would deprive the holder of any rights to the collateral, as the parties would not have originally intended to make a pledge so would not have performed any of the formalities normally required to create a valid pledge. The lender could therefore find himself relegated to the position of an unsecured creditor.

Other legal reasons for having a written contract are:
  • To reinforce the right, if one of the parties becomes insolvent and defaults, of the non-defaulting party to offset the value of cash and securities owed to the defaulting party against the value of cash and securities owed by the defaulting party, both within individual transactions and between separate repos. These close-out netting rights can eliminate or dramatically reduce the loss caused by the default of a counterparty. In this respect, it is also helpful to have sufficient flexibility in terms of the timing and method of valuation of obligations to accommodate less liquid collateral and time zone differences and to cope with difficult market conditions.
  • To set out how variation margining and other risk mitigation measures should be implemented by the parties.
  • To set out how to deal with problems which do not necessarily constitute an event of default (eg failure to deliver collateral).
Use of an enforceable written contract and its variation margining provisions are the minimum regulatory conditions for recognition of the risk mitigation impact of collateral and close-out netting in the calculation of regulatory capital requirements and large exposure monitoring. In some jurisdictions, the use of master agreements is a requirement for close-out netting.

Written contracts also allow the terms of a repo to be varied in order to create useful structured transactions, such as open and forward repos. Such variations are only possible if the parties have somewhere to record how the structures will operate, eg how much notice is required to terminate an open repo and how forward repo will be margined.

Written contracts for financial transactions such as repo frequently take the form of a master agreement, such as the ICMA's Global Master Repurchase Agreement (GMRA) (see question 19). A master agreement sets out the general terms and conditions of the business relationship between the parties, and consolidates all outstanding transactions within one contract. This not only legally underpins transactions but also offers important operational benefits:
  • Enhancing the operational efficiency of individual transactions by allowing the negotiation of transactions to be limited to the specific commercial terms of each transaction, rather than repeating the general terms and conditions of the relationship between two parties. For this reason, master agreements are called ‘framework agreements’.
  • Enhancing the operational efficiency of individual transactions by setting out agreed procedures for managing repos post trade (eg dealing with income payments on the collateral).
  • Consolidation of all outstanding transactions within one contract allows operational efficiencies such as the netting of payments and collateral deliveries.
  • Where standard master agreements, such as the GMRA, are adopted across the market, the operational efficiency of the market as a whole is improved through harmonization of market practice.
In addition to documenting repos in a master agreement, it is essential that the enforceability of the master agreement is regularly re-assessed. Accordingly, the ICMA commissions legal opinions on behalf of its members on the GMRA each year in over 65 jurisdictions for transactions with commercial banks, securities dealers and other companies, and in many countries, various types of non-bank financial institution.


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