On 23 July 2012, the Trinidad and Tobago Securities Exchange Commission (TTSEC) launched its Repo Guidelines. These guidelines were developed with input from the Security Dealers Association of Trinidad and Tobago (SDATT) and are intended to put formal regulation around the growing Repo business. This move by the TTSEC represents a step forward for regulation of the securities industry and seeks to maintain market stability and investor protection. It is also very timely given the financial troubles in some of the world's most developed countries and financial institutions which many can argue were in part a result of gaps in regulations.
What is a Repo?
Before delving into the details of the guidelines, let us briefly review the repo product. A Repo, short for Repurchase Agreement, is a transaction which involves two parties: the Repo Seller and the Repo Buyer (investor). The agreement entails that the Repo Seller will sell specific securities to the Repo Buyer and at the same time the Repo Seller commits to repurchase the securities on a specified future date at a specified price. The price at which the security is repurchased by the Repo Seller is commensurate with the risk of the underlying security and translates into a rate of return for the Repo Buyer (investor). Repos are normally short term instruments but give investors the opportunity to invest/gain exposure to bonds and other fixed income instruments for a short period of time; repos can range from 30 days up to three years while most bonds are typically over 10 years. The repo seller is contractually obligated to buy back the securities on the maturity of the repo contract.
What are the risks associated with Repos?
As with any other investment, repos carry certain types of risk that investors need to be aware of and understand. The main risk is Counterparty Risk which is the risk that the repo seller will be unable to buy back the security as a result of financial problems such as bankruptcy. It is the first and foremost risk that investors must be comfortable with.
In the event that a repo seller cannot repurchase the security the buyer will have to recover their investment through obtaining and selling the underlying instrument themselves. In most cases these instruments are bonds and are also subject to risks such as:
Credit Risk — This is the risk that the issuer of the underlying bond is experiencing financial difficulties and may be unable to pay the interest and principal on the bond.
Interest Rate Risk — this is the risk that the underlying bond could be worth less in the future due to changes in the market interest rates. Fixed rate bonds increase in value if market rates fall and decrease in value as market rates rise.
Liquidity Risk — this is the risk that there may not be a guaranteed market for the underlying instrument. In such a case the investor can opt to sell at a loss in order to dispose of the instrument or hold to maturity or until an opportunity to sell arises. Some bonds such as Government bonds are easier to sell than others.
Credit, interest rate and liquidity risk associated with the underlying instrument arises only if the repo seller cannot fulfill their obligation to repurchase the security from the investor. It should also be noted that repos like many other investment instruments are not covered by the deposit insurance. The fallback for a repo investor is the underlying instrument.
What is in the Repo Guidelines
to safeguard against these risks?
To address some of the risks mentioned above, the TTSEC has instituted the following measures for the protection of non-institutional investors (i.e. investors with net assets less than TT$10m):
1. Restriction on the type of security for non-institutional investors: Repos to individuals can only be done with Government of Trinidad & Tobago (GOTT) or GOTT guaranteed instruments and corporate bonds that are listed on the Exchange. This ensures that if a repo seller defaults the investor will have access to a high quality instrument that can be readily liquidated. Most banks and other financial institutions will buy GOTT bonds and high quality corporate bonds. This also protects against credit risk of the underlying security as GOTT bonds are considered very low risk instruments.
2. Margin requirements: All repos will now require margin to be added, a margin is simply an additional amount of security above what was invested. The margins vary based on the type of instrument i.e. sovereign versus corporate and also based on the tenor. A sovereign security will have a lower margin requirement than a corporate security and the shorter the tenor of the instrument the lower the margin. Just to illustrate how margins work, if an investor purchases a repo for $100 and the margin requirement is 2 per cent based on the type and tenor of the underlying security, the seller must assign $102 worth of securities to the repo. The margin provides the investor with a buffer in the event that the repo seller defaults, the additional coverage will protect against movements in price of the security due to interest rate movements (as described above). Repo sellers are required to revalue securities under repo at least quarterly and assign additional security where values have declined.
3. Independent depository: For all repos done with non-institutional investors the underlying instruments must be transferred to the Trinidad and Tobago Central Depository (TTCD) and pledged to the investor. This ensures that all instruments assigned to repos are held at an independent institution so that in the event of a default by the repo seller, the investor does not have the trouble of trying to acquire the underlying security. This provides a level of protection against the counterparty risk associated with repos.
4. Documentation and disclosures: All repos will now require more documentation and reporting than before; all clients are required to sign a Master Repurchase Agreement (MRA) which outlines all the general terms and conditions that govern repos. In addition, investors must be provided with a term sheet which outlines the specific terms of the repo contract and the underlying security as well as a risk disclosure outlining the key risks associated with the transaction. This ensures that clients are aware of what they are investing in and the terms of the investment. Each repo seller is required to file quarterly reports with the TTSEC showing the value of repos done and the value of securities assigned, if there are any shortfalls, margin maintenance will be required to top up the investors.
These are some of the key highlights from the Repo Guidelines that are aimed at protecting non-institutional investors. While this article covered the key aspects for non-institutional investors, the guidelines cover institutional investors with some more flexibility in certain areas. The implementation of these guidelines will add a high level of confidence to the repo market as a whole and the TTSEC must be commended for the collaborative approach used in the development of the guidelines. Repo investors and sellers alike will benefit from the added safety and confidence that these guidelines will bring to the market.
All information contained in this article has been obtained from sources that First Citizens Investment Services believes to be accurate and reliable. All opinions and estimates constitute the Author's judgment as of the date of the article; however neither its accuracy and completeness nor the opinions based thereon are guaranteed. As such, no warranty, express or implied, as to the accuracy, timeliness or completeness of this article is given or made by First Citizens Investment Services in any form whatsoever.
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