Fixed Income 101: A cursory look at the Repo market in Nigeria

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Repurchase agreement, or ‘repos’ are a silent but important part of the financial systems globally with daily trading anywhere between USD2-4 trillion globally. In Nigeria, using data over the last five years from FMDQ, around NGN160billion (USD430million) worth of repo transactions take place daily basis. What is a repo? A repo is simply a short-term secured loan agreement whereby one party (A) enters a deal to sell a security (usually risk-free government securities) to another party (B) at a particular price with an agreement to buy back the same securities at a higher price at a specified future date.

Figure 1: Annual Repo Market Transactions (NGN’trn)

Source: FMDQ

A classic example of a repo transaction is when Trader A (Lender) who owns a government security agrees to sell it in exchange for cash to Trader B (Borrower) at an agreed price (usually at the current market price) and at the same time, Trader A (Security Lender) agrees to buy back the bond from Trader B (Security Borrower) at an agreed future date and price. Of course, Trader A (The Security Lender) pays for the bond he buys back usually at a lower price. Effectively, he makes money from the difference in the price he sells and buys back. Remember, to make a profit, you buy low and sell high but in a Repo’s case, you sell and then buy it back at a lower price. Usually, the profit earned is meagre because the transaction is low risk to the lender. The ‘loss’ to the borrower is the cost for borrowing the security to trade his view on the market.

The securities essentially serve as collateral and difference between the repurchase price and the initial sales price is the repo rate. Though government securities (FGN bonds and Nigerian T-bills) used for most repo transactions, any security (stocks and corporate bonds) is ‘repo-able’ as long as two parties are able to agree on a price.

There are 4 types of Repos: buy-sell back repo, classic repo, bond borrowing and lending and tripartite repos.

The buy-sell repo transaction is the most common type of repo wherein a security is sold outright and bought back simultaneously for settlement at a predetermined date. The borrower/buyer owns the security and therefore earns the coupon interest due on the bonds. This occurs in Nigeria.

The Classic repo has the same price for the sell and buyback but there is a separate interest charge made as the cost of the transaction. The seller owns the coupon in this case.

Bond borrowing/lending Repo: Here, the seller lends his security for a fee. The fee depends on the particulars of the security – type, size, term and the credit worthiness of the borrower.

In the Tripartite repo, a custodian is responsible for the confidential arrangement of the repo transaction. The custodian agency bears the risk of facilitating the holding, funding, marking to market, reporting and settlement of the repo transactions. They are the middleman/counterparty to the seller and buyer. They provide a marketplace for participants to engage in repo transactions anonymously. This does not occur in Nigeria yet.

Open Buy Back (OBB): Although, this is not an actual type of repo and is uniquely Nigerian. As the name implies, the Buyback (Repurchase) in OBB is Open ended and the security may never be repurchased before maturity. Nigerian Banks use OBB to raise short-term capital among themselves using the Nigerian Treasury Bills as the collateral security. They use it to manage their liquidity (ratio). An OBB transaction happens when Bank A needs cash (Takings) and engages Bank B to loan the cash (Placements) at a rate determined largely by the liquidity in the banking system. The rate usually tracks the interbank borrowing rate and the banks may agree to liquidate at any time or agree to roll-over.

Figure 2: OBB and Overnight Lending Rate

Source: CBN

Repo pricing

We have established that there are 2 sides to a repo transaction that simultaneously occur: The sale of the security which is usually at the current market price considered as the “Near Leg” and the repurchase of the same security as the “Far leg” because of the later date of settlement. Both legs are treated as spot transactions. The repurchase price is what is mutually agreed by the lender and the borrower, and this may depend on some factors.

  1. Short term interest rates: The biggest factor in pricing repo transactions is the rate on short-term or overnight borrowings. This is as the repo rate is effectively the price of immediate liquidity and tends to move in line with where overnight rates are.
  2. Tenor: The period can be from a day to any period agreed by the counterparties. The longer the duration, the lower the repurchase price and vice versa. The repurchase price may be seen as compensating for the accrued interest lost in holding the security for the lender.

Why do financial institutions engage in Repo transactions?

Understand that securities are limited in supply and their price changes. So, financial institutions engage in Repo transactions for the following reasons:

Earn risk free Income: In developed markets, low-risk investors (such as pension funds and insurance firms) who are long-money in that they have the ability and willingness to hold risk-free instruments for long periods (till maturity) can earn small income by lending their securities to those that want to trade the price movements. They are naturally suppliers of collateral for repo transactions.  

Trading a market view: Repos also provide a convenient way for high-risk traders such as hedge funds to trade their view on interest rate direction. Suppose for example that a hedge fund (called HFC) expects interest rates on long dated FGN bonds to rise over the next two weeks (i.e bond prices will fall), to make a profit off this view, HFC can decide to sell long dated FGN bonds (for example the on-the-run FGN 2042 currently trading at c.14.00% yield i.e. price at NGN93.35) now and buy back in the future at a higher yield. The HFC can enter a repo trade that will see it borrow say 500million worth of FGN 2042 from an insurance firm (called Carrot Insurance) with the agreement to sell it back at a later date at a slightly higher yield (say 14.02 i.e 93.21 Price). Upon conclusion of the repo transaction, HFC would immediately sell the bond in the market at the current yield level. Fast forward two weeks and assuming that HFC’s expectations pan out, and interest rates rise by say 100basis points to 15% i.e. price at NGN87.43), then HFC can purchase these bonds in the market now at a cheaper price and return it back to the Carrot Insurance at the pre-agreed price of 14.02 netting off a gain of NGN5.78 on N500m volume (cNGN29m in profits). The trade also works the other way. Essentially repos provide an avenue to trade expectations while improving price discovery and market efficiency for fixed income securities.

Short-term financing: Repos serve as an alternative form of quick short-term financing for financial institutions that sit on securities but require quick cash to fund certain short-term obligations. They do this by covenanting their securities to those that need it in replacement for cash. The cash can be used to earn more returns with less risk as the pledged security will be used as collateral. This is a global norm and applicable in Nigeria looking at Section 318 of the Investment and Securities Act (“ISA”) which classifies Repo as securities lending which is the temporary exchange of securities, generally for cash or other securities of at least an equivalent value, with an obligation to redeliver a like quantity of the same securities on a future date and includes securities loans, repurchase agreements (Repo), and self-buy-back agreements.

Monetary policy execution: Lastly, the Central Bank use repo to redistribute or manage liquidity in the economy. The CBN injects cash into the economy by buying its own securities from Banks and eligible institutions using the Standing Lending Facility (SLF) and Term Repurchase Facility (TRF) with the view of selling it back at a predetermined date. Conversely, to mop-up liquidity, the CBN can arrange to sell its securities to banks with an agreement to repurchase later. Although, not always in use, the CBN can use Repo or reverse repo among other monetary policy tools as a short-term monetary policy aimed at stabilizing the economy.

How are Repos settled in Nigeria?

The Repo market is largely customized. There is no standardized on-screen trading of Repos. Market participants engage in Repo transactions over the counter (OTC) just like any vanilla buying and selling of government securities and the banks or custodians settle these transactions on a CBN Real Time Gross Settlement System (RTGS) and the Scripless Securities Settlement System (also known as S4). The S4 portal is the settlement platform created by the CBN where all government securities – Bills and Bonds – are held. The RTGS on the other hand is a settlement platform for transfer instructions on participants’ accounts with the CBN. It provides a platform for real-time processing and payment settlement.

What are the possible risks around repo transactions?

The main risk in trading repos is counterparty or credit risk which is the risk that a party in a repo transaction will fail to honour the obligation on the return leg. Given the largely OTC nature of repo transactions, the is risk is valid and indeed repo pricing usually incorporates a premium for counterparty risk with a higher rate for less trustworthy counterparties. However, counterparty risk is more manageable as either party has a risk-free collateral or cash which can be used to offset the loss of the security. Another risk though to a lesser extent is liquidity risk which occurs when the underlying collateral is either not a government security or an off-the-run government bond which is not liquid or readily available. For example, in 2021, the DMO halted issuance of the FGN 2045 which created problems for repo transactions as the security immediately became unavailable.

Seyi Dutire is a trader with Krosk Partners.

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