David Little, who heads Rule Financial’s Securities Finance and Payments divisions, is convinced that the market has only scratched the surface of its potential as the sector continues to grow. Qualified as an engineer and trained as a geophysicist, he was an oil prospector in the Sahara desert before joining ICL and moving on to a career in IT with UBS and then Deutsche Bank, where he first encountered Rule Financial.

“As a business consultant in the Securities Finance sector for the past decade, I’ve found myself dealing with some of the most creative thinkers in the City. But however far they stretch the envelope, the market follows and the hunt is quickly on for the next big idea. At Rulenot only do we  have to keep up, but we have to take the lead when it’s needed - and we do.”

Developing a Repo System

A Rule consultant reports on an expanding area of our Securities Finance business.

By volume and value of transactions, the repo market is one of the largest. Just about every bank has a repo desk, using the product to cover short securities positions and to raise the cash required for the day-to-day business. This is the bread-and-butter financing function carried out by virtually every repo desk. It’s the oil in the wheels and, without it, banks couldn’t run in the way they do; they would quickly contract. Many houses also have a matched book, trading repo to make profit by taking on credit and interest rate risk.

This is a mature market and yet many banks don’t have systems in place providing full support. Why is this? Why such a tough nut to crack?

A repo is a straightforward transaction: you are simply borrowing or lending money and giving or taking securities as collateral. Very easy to understand compared to many products traded today, yet it seems to place quite a burden on core systems. The reason lies in the chameleon nature of the repo product. A repo transaction (the same repo transaction) can look very different depending on why it was traded and who is viewing it.

in the front office…
The firm financing trader has borrowed money against a piece of inventory. He’s managing the firm’s cash and inventory balances, and needs to see the effect of the deal on the value-dated projection of each of these. He‘s not managing risk so has no need of further positional data.

The same deal done by a matched book trader requires a different treatment. He is borrowing and lending money against his own inventory. He’s mismatching maturities, creating and managing interest rate and credit risk and he needs to see the effect of the deal on the risk position.

in settlements…
Settlements don’t care whether a repo is firm financing or matched book; the deal will settle the same way regardless. A repo settles as two outright trades; a spot sale of securities and a forward purchase of the same securities. Each leg settles on the due date, delivery versus payment, securities exchanged for cash just like an outright cash trade – and that’s the point. To settlements, a repo is not a single instrument with a term, a start date and an end date: it’s two unconnected cash trades settling independently…indistinguishable from the real cash trades.

in accounts…
Accounts don’t even see the deal as two trades. To them, a repo is a single instrument with a term, an interest (repo) rate, a start date and an end date. It’s accounted for exactly like a simple cash loan or deposit…the principal as asset or liability and the interest accrued straight line over the term of the transaction. The security side of the transaction (which bond is involved, and for how much) is irrelevant to the accounting. When one bank repo’s a bond over to another, the second bank takes both legal title and physical possession but the bond does not move on to its balance sheet; it stays on the balance sheet of the first under the “substance over form” principle. This says that the accounting treatment of any transaction should flow from the commercial substance rather than the strict legal form. In the case of a repo, the legal form is a sale and repurchase of securities but the commercial substance is that of a collateralised deposit.

The purpose of the deal is, however, crucial to accounts. A firm financing repo must be linked back to the correct underlying long security position. The interest expense is then accrued as the cost of carrying that position in the book of the relevant trader. A matched book repo does not usually form part of the cost of carry because there is no underlying firm position to which it relates.

in credit…
Credit are concerned with comparing the credit risk created by the deal against the limits which are preset for each counterparty. The credit exposure in a repo is the difference between the amount of the cash lent and the value of the collateral taken; this difference on day one of the deal is the haircut. For these purposes, it does not matter whether the deal is firm financing or matched book because the impact on the firm’s exposure is the same. The direction of the deal (repo or reverse) does matter, however. So, very importantly, does the question of whether the exposure can be netted against other outstanding deals with the same counterparty.

in conclusion:
It’s the challenge posed by these factors, not a lack of investment, which usually causes a repo project to fail. For such a project to succeed, it’s imperative to take a holistic approach. The design of the system must be driven by the business flow throughout the bank, and not by the views (valid though they are) of either front, middle or back office. Ideally, the system should incorporate a single database of transactions, yet allow each transaction to be viewed in a way that suits the user. As explained above, this view will vary in the different user areas.

Rule Financial has developed a strong specialisation in the area of repo systems development. Whatever the size and shape of your repo project, we can provide the insight and expertise to make sure it succeeds.