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9. What is a ‘special’ in the repo market?
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A special is an issue of securities that is subject to exceptional demand in the repo and cash markets compared with very similar issues. Competition to buy or borrow a special causes potential buyers in the repo market to offer cheap cash in exchange. A special is therefore identified by a repo rate that is distinctly lower than the GC repo rate (see question 8). The demand for some specials can become so strong that the repo rate on that particular issue falls to zero or even goes negative in an otherwise positive interest rate environment. The repo market is the only financial market in which, historically, a negative rate of return has not been unusual.

Specialness is driven by an excess of demand for a particular issue of securities over its supply. For this reason, special repos are sometimes described as securities-driven repo. As a special repo rate is unique to a particular issue of securities, it is uncorrelated with the GC repo rate or other money market interest rates.

The spread between the GC repo rate and a special repo rate represents the return which the buyer of that security is willing to give up on the cash he pays for that security. In other words, this specialness spread is an implicit securities’ borrowing fee and special repo can be seen as another form of securities lending and borrowing.

The specialness spread can also be seen as a convenience yield, which is a reduction in the rate of return on an asset reflecting the non-pecuniary benefits to investors of holding that asset (in the case of specials, because of its value as collateral).

Because the buyer in a special repo is only interested in one particular security, the choice of collateral is the buyer’s and is made at the start of a negotiation, in contrast to a GC repo, in which the collateral is selected by the seller at the end of the negotiation.

Bonds trading special in the repo market will also be in demand in the cash market.* Indeed, demand in the cash market is usually the reason why securities trade special in the repo market. Market-makers and other dealers will use the repo market to borrow securities that are in strong demand in the cash market (and therefore difficult or very expensive to buy immediately) in order to fulfil delivery commitments on sales of those securities in the cash market. The premium in the price of a special in the cash market means that, in theory, it should not be impossible to buy a special in the cash market and repo it out for cheap cash in order to reap an arbitrage profit by reinvesting the cheap cash in GC repo. There is evidence that a no-arbitrage condition prevails in the overnight repo market for US Treasuries but academic studies have found that the term repo spread tends to overestimate future special repo rates.

The excess demand that creates specials tends to arise because an issue is very liquid, often because it is a benchmark or on-the-run issue, and therefore routinely in demand. For this reason, the specialness spread is sometimes described as a liquidity premium. It is often argued that deeper liquidity is valued by investors because it allows them to sell off the security more easily if they wish to switch into cash, for example, at an expected market turning point or in a crisis. However, an alternative argument is that liquidity is valued by short-sellers, both speculators and hedgers, as it makes it easier to open and close out a short position.

One of the most common reasons for an issue of securities to go special is when that issue becomes the cheapest-to-deliver in the futures market for that bond. Some futures sellers will have difficulty buying what they need to deliver to the futures clearing house. As failure to deliver to a clearing house would incur serious penalties, these parties will be forced to borrow the issue in the repo market and may have to bid aggressively to secure it, including sometimes offering negative repo rates.

The term ‘special’ is often incorrectly used to describe any particular issue of securities that the seller and buyer in a repo agree in advance to use as collateral, as opposed to issues selected from a GC basket after the other terms of the repo have been settled. A special is identified only by the fact that its repo rate is below the GC repo rate. Not all issues of securities specifically agreed in advance as collateral trade at repo rates below the GC repo rate. Such issues could be called specifics but should not be called ‘specials’. The latter form a subset of the former.

* The ‘cash’ market in a security is that segment of trading in which the security is bought outright or sold outright. The term is used to distinguish outright buying and selling from repo trading in the same security.

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