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The first step is collateral selection. Collateral that is high quality and liquid will be inherently more stable in value. In addition, collateral issued by a party whose credit risk is uncorrelated with that of the repo seller will diversify exposure and avoid so-called wrong-way risk, which is the danger of the collateral value falling as the creditworthiness of the seller deteriorates.

Whatever collateral is accepted, buyers then need to anticipate potential problems in liquidating less liquid collateral in the event of a default, possibly during an episode of market stress, by applying a risk adjustment to its market value in the form of a haircut or initial margin (see question 21).

Once the terms of a repo have been agreed, both parties should revalue the collateral frequently (preferably daily) and as accurately as possible. When the value of collateral falls, the buyer should promptly call for variation margin from the seller to rebalance cash and collateral and vice versa. It is also important for parties to agree deadlines for calling, agreeing and delivering margin and to try to agree what assets will be acceptable as margin. Guidance on efficient variation 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. There is an alternative mechanism to variation margining involving the early termination and replacement of transactions, which was designed for documented buy/sell-backs, that achieves the same result as margining but is not widely used.

In order to minimise the problems that may occur in the aftermath of a default, it is important to have a robust written legal agreement such as the ICMA’s Global Master Repurchase Agreement (GMRA). This protects the rights of the buyer to sell collateral in an event of default, including insolvency, and to net his exposures to the defaulter, as well as providing flexibility in terms of the timing and method of valuation of obligations in order to accommodate less liquid collateral and difficult market conditions.


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