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18. Why is it important to document repo?
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The purpose of collateralisation is to secure a lender (ie mitigate his credit risk) by giving him the right to liquidate collateral provided by the borrower in the event that the borrower becomes insolvent or defaults in another way. In traditional secured lending, this right is established as a pledge or other type of security interest on the collateral. In repo, security is established (outside the US --- see question 9) by a transfer of legal title to the collateral. In order to ensure that courts will enforce a lender’s right to collateral, it is usually mandatory (in the case of pledges) or prudent (in the case of transfer of title) to provide a written agreement as evidence of the intentions of the parties to give the lender the right to liquidate the collateral.

In the case of repo, the evidence provided by a written agreement should help to ensure that a court will not invalidate the transfer of title to the collateral and re-characterise 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 nor would they have performed any of the formalities normally required to establish a pledge. The lender would therefore find himself an unsecured creditor.

Other legal reasons for having a written agreement are:
  • To set out the procedure to be followed in the event of a default by one of the parties. This is essential in minimising the disruption that a default can cause to the business of non-defaulting parties as well as to the rest of the market.
  • To reinforce the right, in a default, 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 netting rights can eliminate or dramatically reduce the loss caused by the default of a counterparty. There needs to be sufficient flexibility in terms of timing and method of valuation to accommodate less liquid collateral and difficult market conditions.
  • To set out how 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 agreement and its margining provisions are the minimum regulatory conditions for recognition of the risk mitigation impact of collateral in the calculation of regulatory risk capital requirements under Basel III.

Written agreements for financial transactions such as repo frequently take the form of a master agreement, such as the 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 each transaction 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.
  • 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 payments and collateral transfer netting.
  • 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 harmonisation of market practice.
Written agreements also allow the terms of a repo to be varied, 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.

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 the GMRA each year in over 60 jurisdictions for transactions with banks and other companies, and in many countries, various types of non-bank financial institution.

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