UNDERSTANDING REPURCHASE TRANSACTIONS A PRCIS BY OLUBUKOLA THOMAS

Recently, the Central Bank of Nigeria (CBN) included Asset Management Corporation of Nigeria (AMCON) Bonds as eligible securities for repurchase transactions under its standing facilities. However, apart from investment bankers and perhaps securities and finance savvy individuals, everyone else would probably require a basic understanding of repurchase transactions to perhaps appreciate the intent of the apex bank with this inclusion. Ordinarily, a banks general lending funds comprise deposits from customers and loans from other financial institutions through the interbank market. On the one hand, where the bank funds itself from the deposits of its customers, it is expected that the deposits will be used for short-term lending and the depositor will earn a return on his/her money. On the other hand, where the bank funds its lending with a deposit from the interbank market, it obtains deposit in the same currency, for the same amount and for the same period as the amount it is due to lend or has lent to its borrower. However it is not unlikely that a financial institution will also decide to source funding for its short-term lending through repurchase transactions. Simply put, a repurchase transaction, also known as a sale and repurchase agreement (repo), is a lending transaction where a party agrees to sell securities (e.g. bonds) to another party in exchange for a transfer of funds upon an agreement that the seller will buy back the securities at a later date. For clarity, let us assume a lending bank (the borrower) intends to get funds from another party (the lender). The borrower will usually get the cash in exchange for providing some securities in exchange. In other words, the party that buys the securities effectively acts as a lender and the seller acts as a borrower, using those securities as collateral for the loan at a fixed rate of interest. Security (ies) is used here loosely to describe stocks, bonds and other capital market investment instruments. Indeed it may be argued that a repurchase agreement is economically similar to a secured loan because the buyer (the lender) receives securities as collateral to protect him against default by the seller (the borrower). However, unlike a secured loan, where legal title in the collateral does not pass from the borrower to the seller when the interest is created, in a repo, legal title to the securities passes from the seller to the buyer at the point of sale and purchase so that the former can freely sell, transfer, pledge or hypothecate it. It is also instructive to note that almost any security may be offered as collateral in these transactions. However, highly liquid securities are preferred as they are easier to dispose in the event of default by the borrower. Consequently, Treasury or Government Bills, corporate and Treasury/Government bonds and stocks form a large part of securities offered in exchange for cash in such transactions. One major feature of a repo transaction is that it usually arises from another agreement between the buyer and the seller called a master agreement. Examples of this agreement are

the Global Master Repo Agreement; the standard agreement used for international repo transactions and the Nigerian version called the Nigerian Master Repurchase Agreement. Another significant feature of repos is the tenor of the transactions. Most repos are overnight transactions, with the sale taking place one day and being reversed the next day. However, long-term reposcalled term reposcan extend for a month or more. Perhaps it is also important to highlight the boilerplate clauses in a typical master repo agreement. It is expected that a master repo agreement will include the following clauses amongst others: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Capacity of the parties, either as agents or principals; Authority of the parties to purchase or sell securities; Absolute transfer of legal title; Market risk management such as mark to market; Margin percentages; Substitution or re-pricing; Arrangements for delivery/receipt of securities; Treatment of dividends payments and timing of payments; Default procedures and the consequential rights and obligations of the counterparties, including rights of set-off; Governing law of the agreement.

With the benefit of the foregoing, a simple explanation of the intent of the CBN would be that the inclusion of AMCON Bonds as eligible securities for accessing CBNs Standing Lending Facility and Term Repurchase Facility will primarily achieve two things. First, increase the portfolio of eligible securities which before now comprised Treasury Bills, Federal Government Bonds and CBN Bills only. Second, improve the viability of AMCON bonds as liquid securities for trading purposes. In other words, acquisition of AMCON Bonds will become more attractive to financial institutions and discount houses as it would now be easier to transfer them in the interbank money market or trade them in for credit from the apex bank if funds are not available in the former. Finally, although as stated earlier, financial institutions raise short-term funds through these transactions, central banks are also an important customer base for repo transactions. However, central banks all over the world use repo as a tool of monetary policy to control liquidity in domestic money market, hence perhaps the inclusion of AMCON Bonds as an eligible security for CBN Lending Facilities. A typical central bank repo transaction would be a reverse repo. That is, the CBN would buy eligible securities (typically domestic government bonds) and lend cash to an eligible counterparty (usually a financial institution). The overall effect would be a short term injection of liquidity into the money market.