THE UNITED KINGDOM GILT REPO MARKET - Global Money Markets

Trading in UK gilt repo market began on January 2, 1996. Prior to this,securities lending in the gilt market was available only to gilt-edged Market Makers(GEMMs), dealing through approved intermediaries,the Stock Exchange Money Brokers (SEMBs). The introduction of Gilt Repo allowed all market participants to borrow and lend gilts. The market reforms also liberalized gilt securities lending by removing the restrictions on who could borrow and lend securities,thus ensuring a“level playing field” between the two types of transaction.

The market grew to about £50 billion of repos and securities lending outstanding in the first two months, further growth took it to nearly £95 billion by February1997, of which £70 billion was in repos. This figure fell to about £75 billion by November 1998, compared with £100 billion for sterling certificates of deposit (CDs). Data collected on turnover in the market suggest that average daily turnover in gilt repo was around £16 billion through 1999.

Gilt Repo

Gilt repo has developed along side growth in the existing unsecured money markets.There has been a visible shift in short-term money market trading patterns from unsecured to secured money. According to the Bank of England, market participants estimate that gilt repo now accounts for about half of all overnight transactions in the sterling money markets. The repo generalcollateral (GC) rate tends to trade below the interbank rate, on average about10–15 basis points below, reflecting it sstatus as government credit. The gap is less obvious at very short maturities,due to the lower value of such creditover the short term and also reflecting the higher demand for short-term funding through repo by securities houses that may not have access to unsecured money.

The sterling CD market has grown substantially, partly because the growth of the gilt repo and securities lending market has contributed to demand for CDs for use as collateral. One effect of gilt repo on the moneymarket is a possible association with a reduction in the volatility of overnight unsecured rates.Fluctuations in the overnight unsecured market have been reduced since the start of an open repo market, although the evidence is not conclusive. This may be due to repo providing an alternative funding method for market participants, which may have reduced pressure on the unsecured market in overnight funds. It may also have enhanced the ability of financial intermediaries to distribute liquidity

Bloomberg Security Description Screen of a UK Gilt

Bloomberg Security Description Screen of a UK Gilt

To illustrate a gilt repurchase agreement, let us consider a UK gilt dealer who purchases a 7.5% coupon gilt stock (in the UK bonds are referred to as stocks)and needs financing overnight. Figure above presents a Bloomberg SecurityDescription screen for this security. As before, we will use Bloomberg’s RRRA screen to illustrate the transactionin Figure below. Suppose the face amount ofthe position is $1 million and the note’s full price (i.e., flat price plus accrued interest) is £1,163,491.80. Suppose the haircut is 2%. Accordingly, the collateral is 102% of the amount being lent. This percentage appears in the boxlabeled “COLLATERAL” in the upper right-hand corner of the screen.Accordingly, to determine the amount being lent, we divide the note’sfull price of £1,163,491.80 by 1.02 to obtain £1,140,678.04 which is labeled “SETTLEMENT MONEY” located on the right-hand side ofthe screen.Suppose the repo rate in this transaction is 3.9063%. Then,the dealer would agree to deliver the gilt stocks for £1,140,678.24 and repurchase the same securities for £1,140,800.32 the next day. The £122.08 difference between the“WIRED AMOUNT” of £1,140,678.24 and the “TERMINATION MONEY” of £1,140,800.32 is the sterling interest on the financing. Using a repo rate of 3.9063% and a repoterm of 1 day, the sterling interest is calculated as shown below:

Bloomberg Repo/Reverse Repo Analysis Screen of a UK Gilt Repo

Bloomberg Repo/Reverse Repo Analysis Screen of a UK Gilt Repo

£122.08= £1,140,678.24 × 0.039063 × (1/365)

This calculation agrees with repo interest as calculated in the upperright-handcorner of Figure above Note that the day count convention in the UK moneymarkets is Actual/365.

Market Structure

The UK market structure comprises both gilt repo and gilt securities lending. Some institutions will trade in one activity although of course many firms will engage in both. Although there are institutions which undertake only one type of activity, there are many institutions trading actively in both areas. Forexample, an institution that is short a particular gilt may cover its short position (which could result from an either an outright sale or a repo) im either the gilt repo or the securities lending market. Certain institutions prefer to use repo because they feel that the value of a special bond is more rapidly and more accurately reflected inthe repo than the stock lending market.

Some firms have preferred to remain in securities lending because their existing systems and control procedures can accommodate stock lending more readily than repo. For example, a firm may have no cash re nvestment facility or experience of managing interest rate risk. Such a firm will prefer to receive collateral against a bond loan for a fee, rather than interest bearing cash in a repo. They may also feel that their business does not need or cannot justify the costs of setting up a repo trading facility.

Inaddition, securities lending has benefited from securities houses and banks who trade in both it and repo; for example, borrowing abond in the lending market,repoing this and then investing the cash insay, the CD market. Other firms have embraced repo due, for instanceto the perception that value from a bond on special is more readily obtained in the repo market than in the lending market.

Market Participants

Virtually from the start of the market, some firms have provided what is in effect a market making function in gilt repo. Typical of these are the former SEMBs and banks that run large matched books. According to the Bank of England, during1999 there were approximately 20 firms,mostly banks and securities houses,which quoted two-way repo rateson request, for GC (general collateral),specifics and specials, up to three months. Longer maturities are also readily quoted. Examples of marketmaking firms include former SEMBs such as Lazards,Cater Allen (part of the Abbey National group), and Rowe & Pitman (part ofthe UBS group), and banks such as RBS Financial Markets, HSBC, Deutsche Bank,and Barclays Capital. Some firms will quote only to their own clients.Many of the market making firms quote indicative repo rates onscreen services such as Reuters and Bloomberg. Figure below presents a Bloomberg screen of repo rates in UK markets on November 13, 2001for various maturities out to one year.

A number of sterling broking houses are active in gilt repo. Counter parties still require signed legal documentation to be in place with each other, along with credit lines, before trading can take place, which is not the case in the interbank broking market. A gilt repo agreement is not required with the broker, although firms will certainly have counterparty agreements in place with them. Typical of the firms providing broking services are Garban ICAP, Tullet& Tokyo, andKing &Shaxson Bond Brokers Limited, part of Old Mutual plc. Brokers tend to specialize in different aspects of the gilt market. For example, some concentrate on GCrepo, and others on specials and specifics; some on very short maturity transactions, and others on longer term trades. Brokerage is usually 1 basis point of the total nominal amount of the bond transferred for GC,and 2basis points for specific and special repo. Brokerage is paid by bothsides to agilt repo.

Bloomberg Screen of UK Repo Rates

Bloomberg Screen of UK Repo Rates

The range of participants has grown as the market has expanded. The overall client base now includes banks, building societies, overseas banks and securities houses, hedge funds, fund managers (such as Standard Life,Scottish Amicable,and others), insurance companies, and overseas central banks. Certain corporateshave also begun to undertake gilt repotransactions. The slow start in the useof tri-party repo in the UK markethas probably constrained certain corporatesand smaller financial institutions from entering the market. Tri-party repo would be attractive to such institutions because of the lower administrative burden of having an external custodian. The largest users of gilt repo will remain banks and building societies, who are required to hold gilts as part of their Bank of England liquidity requirements.

Bank of England OpenMarket Operations

The Bank of England introduced gilt repo into its open market operations in April1997. The Bank aims to meet the banking system’s liquidity needs each day viaits open market operations. Almost invariably the market’s position is one of a shortage of liquidity, which the Bank generally relieves via open market operations conducted at a fixed official interest rate. The Bank’s repo operation in this case is actually a reverse repo. The Bank will reverse in gilts and eligible Bills. The reason central banks choose repo as the money market instrument to relieve shortagesis because it provides a combination of security (government debt as collateral)and liquidity to trade in large size.


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