A repo usually involves the sale of bonds in exchange for cash. The borrower is obliged to repurchase the bonds later. The bonds work as collateral for the lender. Securities lending is very similar, but usually involves the transfer of stocks against any type of collateral (not just cash). Securities loans tend to be small, while repos tend to be large and shorter term.
At first glance, both agreements appear similar. But a closer look reveals key differences:
|Sale and repurchase of securities against collateral
|Transfer of ownership against collateral
|Bonds, mainly US treasuries
Keep reading for a more comprehensive answer.
What is Repo
A repurchase agreement (repo) is a short-term collateralized loan.
But it doesn’t work like your traditional bank loan where a bank sends you money and you repay them over time with interest.
Instead, in a repo transaction, the borrower sells bonds to a lender in exchange for cash, and agrees to repurchase the bonds later at a higher price.
The bonds effectively work as collateral for the lender.
So in exchange for giving up cash (the most liquid asset of all), the lender receives bonds.
The borrower will later buy back the bonds for slightly more than the cash (at the time).
This markup is equivalent to interest on a loan.
Say a hedge fund needs cash to make a trade. It will receive cash from investors tomorrow, but needs to open the position today. It has some US treasury bonds sitting around. So, the fund goes up to a bank and proposes a repo agreement.
The hedge fund sells $50M worth (market value at the time) of treasuries to the bank and receives $50M in cash.
Tomorrow, the hedge fund buys back the treasuries at a slightly higher price ($50.1) than what it purchased them for.
This small difference is the implicit overnight interest rate (in this case 50.1/50-1 = 0.2%).
There can also be a haircut:
Instead of paying the $50M in cash, the bank pays only $49M. The purpose of this?
To mitigate the counterparty credit risk for the bank.
Meaning, the risk that the securities lose their market value in the time it takes to sell them in case the hedge fund defaults overnight and can’t repurchase the treasuries tomorrow.
The haircut works as initial margin and it depends on the quality of the collateral (how quickly the bank can sell it on the market to recover its cash).
From the perspective of the bank, the transaction is a reverse repo.
The bank buys securities, which temporarily reduces the cash it has available. Hence, reverse repo is a way to generate returns on excess cash balances.
Banks and other financial institutions also use repo agreements to exchange illiquid assets for cash, as this improves regulatory ratios.
What is SLAB (Securities Lending and Borrowing)
Securities lending and borrowing (SLAB) is also a collateralized loan.
The lender gives cash or securities (the principal) to the borrower in exchange for cash or securities (the collateral). At maturity, they reverse the initial exchange. There can also be no collateral.
And the borrower pays the lender a fee for the loan.
Securities lending is widely used for short-selling.
Say a hedge fund believes the price of a stock will fall over the next week. How can they profit from this?
They borrow the stock from a bank and sell it on the market. In exchange, they give the bank some sort of collateral (which can be cash, other stocks, or bonds).
A week later, they purchase back the stock in the market for less than what they sold it for, and give the stock back to the bank. The bank also returns the collateral to the fund.
The hedge fund profits with the difference between the selling price and the purchase price.
Of course, short sales may not work out as planned—the stock may go up in price.
In this case, the fund will have to buy the stock back at a higher price than the price at which it sold it originally, incurring a loss.
Now, you may be wondering:
Who owns the securities while the SLAB transaction is in place?
When the bank loans the securities, their absolute title passes from the bank (lender, and beneficial owner) to the borrower (hedge fund). The same applies to the collateral.
However, generally, the borrower has to give all economic benefits from the security back to the lender for the duration of the contract. These are cash flows such as dividends from stocks and interest payments from bonds.
Overall, SLAB and repo transactions are very similar, as we’ll see below:
Difference between Repo and SLAB
Both SLAB and repo are securities financing transactions (SFTs).
In a repo transaction, the borrower receives cash from a lender. But not until they give the lender collateral in the form of shares or bonds.
Simultaneously, the borrower agrees to buy the securities later for a higher price (additional implicit interest rate).
Just like a repo, SLAB is a fully collateralized transaction that is reversed at a later date. The borrower pays a fee to the lender for the use of the loaned security.
The difference is mainly in the types of securities exchanged and the legal documents governing the agreements.
The repo market uses mostly bonds and other fixed-income instruments as collateral. In the securities lending market, stocks are common.
Securities lending against cash collateral looks very much like a repo agreement.
In both cases, there’s little to no risk for the lender.
The risk of loss is in the possibility that the borrower defaults before the maturity date, when they have to return the securities.
Nonetheless, the lender can recover its cash by selling the collateral. However, there is also the risk the collateral loses value or the securities gain value. Haircuts protect against this.
A repo is governed by a Global Master Repurchase Agreement (GMRA).
The first paragraph defines a repo transaction in the following way:
From time to time the parties hereto may enter into transactions in which one party, acting through a Designated Office, (“Seller”) agrees to sell to the other, acting through a Designated Office, (“Buyer”) securities or other financial instruments (“Securities”) (subject to paragraph 1(c), other than equities and Net Paying Securities) against the payment of the purchase price by Buyer to Seller, with a simultaneous agreement by Buyer to sell to Seller Securities equivalent to such Securities at a date certain or on demand against the payment of the repurchase price by Seller to Buyer.
A SLAB is governed by a Global Master Securities Lending Agreement (GMSLA).
The first paragraph defines a SLAB transaction in the following way:
From time to time the Parties acting through one or more Designated Offices may enter into transactions in which one party (Lender) will transfer to the other (Borrower) securities and financial instruments (Securities) against the transfer of Collateral (as defined in paragraph 2) with a simultaneous agreement by Borrower to transfer to Lender Securities equivalent to such Securities on a fixed date or on demand against the transfer to Borrower by Lender of assets equivalent to such Collateral.
From a legal perspective, a repo agreement involves an actual sale and repurchase of securities against cash.
Securities lending on the other hand, is a temporary transfer of the ownership of the securities in exchange for collateral.
Nonetheless, they have similar legal foundations.
Hope this helps.
Any questions? Leave them in the comments below!