Repo documentation
The performance of repo depends on the buyer’s right to collateral. In order to minimize legal risks, it is prudent to have a written contract in the form of a master agreement. The standard for cross-border repo markets in Europe and elsewhere is the Global Master Repurchase Agreement (GMRA). Such documentation is also important for reinforcing a party’s netting rights in the event of default by a counterparty, and in setting out operational procedures such as margining and manufactured payments. The basic GMRA has been adapted to specialist uses and certain domestic markets through the use of annexes.
In an undocumented buy/sell-back, the rights and obligations of the parties in the event of a default by one of the parties are not clearly established. This is especially true of the right of the non-defaulting party to net obligations with a defaulting counterparty.
Global Master Repo Agreement
In the early days of the European repo market, counterparties drew up their own contracts, but disagreements prompted efforts to produce standard agreements, both for domestic and international repo transactions. The lead in the international market was taken by what is now the International Capital Markets Association (ICMA), through the committee that became the European Repo Council (ERC). In 1992, the ICMA published the first version of the GMRA. This was done in conjunction with the ICMA’s US counterpart, the Securities Industry and Financial Markets Association (SIFMA – formerly called the PSA and then TBMA), whose domestic Master Repurchase Agreement formed the basis of the first GMRA.
In 1995 and 2000, the GMRA was updated to take account of market developments and incorporate improvements suggested by experience. Thus, the GMRA 1995 (the version updated in 1995) incorporated lessons learnt in the Barings crisis of 1995, in particular, the need for more time to liquidate collateral located in other time zones. The GMRA 2000 (the version updated in 2000) reflected the experience of the Long-Term Capital Management (LTCM), Russian and Asian crises of 1997-98, and the additional time needed to liquidate illiquid collateral during a crisis.
The function of legal agreements is two-fold:
To facilitate trading by having counterparties agree as many general terms and conditions as possible, in advance of executing individual transactions. This saves time and helps to avoid misunderstandings at the point of trade.
To set out clearly the rights and obligations of the counterparties during the life of the transaction (e.g. in respect of margin maintenance) and in the event of a problem arising (e.g. failure to deliver collateral or a default by one of the parties). By setting out clearly the intention of the counterparties, it is hoped that courts will uphold the contract in disputes between the counterparties or challenges from third parties.
The specific issues that a repo legal agreement is expected to address include the following:
The transfer to the buyer of absolute legal title to collateral, margins and substitute collateral.
Procedures for marking collateral to market, including price sources.
Procedures for margin maintenance to eliminate material differences between the values of cash and collateral.
The definition of ‘events of default’, and the consequent rights and obligations of the counterparties.
The obligation to fully close out and set off (net) opposing claims between counterparties in the event of default.
The management of coupon and other payments on collateral (i.e. manufactured payments).
The rights and obligations of the counterparties if collateral fails to be delivered.
Procedures to be followed if rights of substitution of collateral are exercised.
The GMRA was designed for repurchase agreements between institutions dealing for their own account (i.e. principals) using fixed-income collateral paying coupons gross of withholding tax. In order to be able to use the agreement to document buy/ sell-backs, repos involving an agent (e.g. a fund manager dealing on behalf of a client), or repos involving other securities, it is necessary to modify the standard agreement by attaching annexes. Annexes have been published by the ICMA to adapt the GMRA to:
buy/sell-backs.
repos between an agent and a principal;
repos of equity;
repos of money market securities; and
repos of net-paying securities
In addition, because the GMRA is governed by English law, it has been necessary to adapt it for use in other jurisdictions (e.g. Australia, Canada and Italy). Annexes have also been published for:
the UK-gilts market by the Bank of England;
the Australian market by the Australian Financial Markets Association (AFMA); and
Japanese securities by the Japanese Securities Dealers Association.
Legal opinions
In addition to publishing and periodically updating the GMRA, the ICMA commissions legal opinions on the enforceability of the GMRA as a whole or, in some cases, just on the enforceability of the netting provisions in different jurisdictions. These are vital in minimizing legal risk and giving confidence to the market and its regulators about the certainty of contracts and the consequences of a default. By 2007, there were legal opinions for over 50 countries. Work is also being undertaken to extend opinions to more countries and, where opinions already exist, to cover insurance companies, hedge funds and mutual funds. The ICMA updates its suite of legal opinions annually.
One of the main legal risks which legal opinions seek to address is so-called ‘re-characterization risk’. This is the possibility that a court may refuse to accept that legal title to collateral has been transferred to the buyer in a repo contract. The risk is often greater for collateral transferred as margin or as a substitute. If a repo is re-characterized, it is possible that it could be re-characterized as a pledge, or even as an unsecured loan.
What happens if a counterparty defaults?
A key chapter of the GMRA deals with default by one of the counterparties. A standard set of events of default is listed in the GMRA. These include acts of insolvency and failure to make cash payments. Failure to deliver collateral is not a standard event of default but, under the GMRA 2000, the counterparties can agree to make it one. In contrast to the ISDA Master Agreements, there are no credit triggers or cross-default clauses (these legal provisions put a counterparty into default if they suffer a credit ratings downgrade or are in default on another master agreement): this is to avoid undermining an institution in difficulty by automatically stopping their funding because of problems in a possibly unrelated market. Counterparties can also add their own events of default to the standard list, but this may create legal complications.
If an event of default occurs, and it is one of two particular acts of insolvency, the party which has committed the act is automatically in default. If any other event of default occurs, a default notice has to be served on the party which has committed the act. Except if the event of default is a ‘failure to perform other obligations’ (in which case, there is a 30-day ‘cure period’), a notice places the counterparty on which it is served in immediate default.
In practice, serving default notices has sometimes proven difficult. Consequently, the GMRA 2000 requires only two reasonable attempts to be made to serve a default notice, after which the non-defaulting entity can certify that an event of default has occurred.
As soon as a counterparty is formally in default and any cure period has expired, the non-defaulting party can close out and set off all the repos it has outstanding with the defaulter that are documented under the same legal agreement. This means that all outstanding repo contracts are terminated (closed out) and their repurchase date accelerated for settlement as soon as possible. The resulting present values of obligations owed by the defaulter are netted (set off) against the present values of obligations owed to the defaulter, leaving a residual net obligation in one currency. Netting may leave the non-defaulter with a small exposure to the defaulter, or none at all.
If a seller defaults, the risk to the buyer is that, between the last margin payment or transfer, and the post-default liquidation of collateral, the value of that collateral has fallen to less than the sum of the purchase price plus the accrued return on the cash loaned. If a buyer defaults, the risk to the seller is that, between margining and the post-default repurchase of his lost collateral in the cash market, the value of that collateral has risen to more than the sum of the purchase price plus the accrued return on the cash borrowed.
Non-defaulters can add reasonable expenses to the obligations of the defaulter, but cannot seek ‘consequential damages’, in other words, all the downstream losses incurred as a result of the default. However, the GMRA 2000 does allow for recovery of the costs of replacement, re-hedging or unwinding hedges.
Agreements such as the GMRA are so-called ‘master agreements’, which means that all repos between the signatories of such agreements fall under the terms of the agreement unless specifically excluded. The consequence is that individual transactions are incorporated into a single contract. This helps to ensure the effectiveness of netting in the event of default by one of the parties.
A key requirement of close out and set off is, of course, the valuation of collateral. The GMRA 2000 offers considerable flexibility to the non-defaulter in the form of a menu of alternative methods, particularly designed to accommodate illiquid collateral. Thus, the non-defaulter has the choice of:
market quotes.
the prices actually realised on the sale of collateral or other holdings of the collateral asset.
its own judgement of ‘fair value’ in cases where quotes are not deemed to be ‘commercially reasonable’.
In order to allow time to get market quotes or dealing prices, the deadline for valuation is five business days after default. However, fair value can be fixed even after this deadline in exceptional circumstances.
The above content is an extract from a book named “Understanding Repo and Repo Markets” published by Euroclear. ICMA and Euroclear are authorities on Repo and Repo markets. To know more about repos, we encourage the readers to download.
