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25. What happens if a party fails to deliver collateral in a repo?
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There are two occasions when this might happen: at the start of a repo, if the seller fails to deliver; or at the end of a repo, if there is a failure to deliver by the buyer.

In the event of a failure by a seller to deliver collateral to the buyer at the start of a repo, if the parties have signed a GMRA, one of the following will happen:
  • If the parties have agreed, when they negotiated their agreement, to treat a failure to deliver collateral as an event of default, the buyer could place the seller in default. However, putting a counterparty into default is a very serious step. It is important to be sure that his failure to deliver reflects credit problems and not temporary operational problems, infrastructure frictions or market illiquidity, which are all beyond the seller’s control.
  • The contract remains in force but the buyer withholds cash from the seller. This option allows the seller to deliver the collateral at any time during the remaining life of the contract. Only if and when delivery eventually takes places will the buyer pay the seller. But whether or not the seller ever delivers the collateral, at the end of the repo, the seller will be obliged to pay to the buyer the repo interest for the full intended term of the transaction. This means that the seller is penalised for failing to deliver and the buyer is compensated.
  • The buyer terminates the failed transaction (he can do this at any time). If he does, the seller will be obliged to pay whatever repo interest has accrued up to the date of termination.
In the event of a failure by the buyer to deliver collateral to the seller at the end of a repo, if the parties have signed a GMRA, one of the following will happen:
  • If the parties have agreed, when they negotiated their agreement, to treat a failure to deliver collateral as an event of default, the seller could place the buyer in default.
  • The seller could call a mini close-out, which means he terminates the failed transaction (but no others), values the collateral in that transaction using the methodology set out in the GMRA for defaults (see question 26), offsets this against the cash he owes the buyer and settles any difference. However, mini close-outs can prove to be very expensive for parties failing to deliver. In repo markets, such as those for government bonds, which trade at narrow spreads, it is felt that the threat of mini close-outs would drive many banks out of the market and fatally damage its liquidity, so mini close-outs are in practice restricted to fails in types of collateral such as corporate bonds. Note that the mini close-out mechanism works differently from the ‘buy-in’ procedure used in the cash market when the seller fails to deliver to the buyer in an outright transaction.
  • The parties could negotiate a solution. Until then, the repo would continue, with the seller holding cash which will be interest-free after the repurchase date.
In the event of a failure by the seller to deliver collateral at the start of a repo or by the buyer to deliver at the end, if the other party has paid cash to the failing counterparty before discovering that there has been a failure to deliver, he can require the failing counterparty to immediately repay the cash or he can make a cash margin call. If the failing counterparty does not promptly return the cash, he risks being placed into default.


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