china's repo markets: the structure and safeguards of china's
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Chinas repo marketsThe structure and safeguards of Chinas largest, most liquid money market instruments
FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLYNOT FOR RETAIL USE OR DISTRIBUTION
J.P. MORGAN GLOBAL LIQUIDITY
J.P. Morgan Global Liquidity believes in creating long-term, strategic relationships with
our clients. We bring value to these relationships through extensive liquidity management
capabilities, which are global in reach, comprehensive in solutions and relentless in risk
control. J.P. Morgan Global Liquidity is one of the largest managers of institutional money
market funds in the world, with dedicated investment management professionals around
the globe. This positions us to offer best-in-class investment solutions spanning a range
of currencies, risk levels and durations, designed to suit our clients specific operating,
reserve and strategic cash management needs.
A B O U T
T A B L E O F C O N T E N T S
1 E X E C U T I V E S U M M A R Y
2 I N T R O D U C T I O N
3 W H AT I S R E P O : T E R M S A N D D E F I N I T I O N S
7 I N T E R B A N K R E P O : O P E R AT I O N S , Y I E L D A N D V O L U M E
8 I N T E R B A N K R E P O : C O L L AT E R A L A N D C O U N T E R PA R T Y R I S K
9 S TO C K E XC H A N G E R E P O : O P E R AT I O N S , Y I E L D A N D VO LU M E
10 S TO C K E XC H A N G E R E P O : C O L L AT E R A L A N D C O U N T E R PA R T Y R I S K
13 R E P O F O R M O N E Y M A R K E T F U N D S
15 C O N C L U S I O N
16 A P P E N D I X : R E P O R E G U L AT O R S , M A R K E T S A N D FA C I L I TAT O R S
4 LONG-TERM CAPITAL MARKET RETURN ASSUMPTIONS
J .P. MORGAN ASSET MANAGEMENT 1
REPURCHASE AGREEMENTS (REPOS) are a crucial component of global financial markets, increasing market efficiency and liquidity. In Western markets, long and widespread use of repo, combined with strong legal status under bankruptcy laws and the clarity provided by a master agreement for repo transactions, offers transparency and reassurance to investors and participants.
Chinese repo markets also follow standardized policies and procedures. However, the lack of clarity regarding collateral and counterparty risk, as well as confusion about how repo markets operate, has created uncertainty and concern, especially among Western investors.
There are two types of Chinese repo: interbank and stock exchange. RMB money market funds (MMF) favor stock exchange repo, which provides quasi-sovereign counterparty risk and more timely settlement than interbank repo, albeit with greater volatility. Because it offers uniform counterparty risk, real-time monitoring and genuine market-driven dynamics, stock exchange repo is widely recognized as the most accurate measure of funding costs, liquidity conditions and market stresses in Chinese financial markets.
Repo is an important investment option for RMB money market funds. Their ability to offer higher, market-driven interest returns helped spur the growth of MMF assets in China to a record CNY 2.5 trillion as of April 2015. Essential to this success has been the ability to invest in repo.
Once they understand the organization, mechanics and structure of Chinese repo markets, cash investors will be able to appreciate how repo has helped RMB money market funds provide relatively attractive returns with flexible liquidity.
Aidan Shevlin, CFAManaging DirectorHead of Asia Pacific Liquidity Fund ManagementJ.P. Morgan Asset Management
Andy Chang, CFAVice PresidentAsia Pacific Liquidity Fund ManagementJ.P. Morgan Asset Management
E X E C U T I V E S U M M A R Y
2 CHINAS REPO MARKETS
I N T R O D U C T I O N
INTEREST RATE LIBERALIZATION, a key element in Chinas financial sector reform, is now under way. As it progresses and the governments market presence recedes, interest rates will become more market-driven. Investors will then be required to develop a heightened awareness of risk as the range of investment options increases.
However, Chinese interest rates have not yet fully liberalized. As a result, there is a limited range of suitable, market-driven investment instruments available to investors. As the largest, most liquid money market instrument in Chinese markets, repo is a major holding for RMB money market funds.
Still, some RMB money market fund investors are concerned about repo market operations, collateral quality and counterparty risk. In the following pages, we explain the markets structure, safeguards and benefits, addressing and allaying those concerns, and making clear how and why repo has become such a critical component of RMB money market funds.
J .P. MORGAN ASSET MANAGEMENT 3
What is repo: terms and definitionsA repurchase agreement, or repo, is a contract for the sale of a security with a commitment by the seller to buy the same security back from the buyer at a specified price on a designated future date.1
A counterparty (the repo seller, often a broker/dealer) is borrowing money and providing collateral for the loan while the second party (the repo buyer, often a money market fund) is lending money and accepting securities as collateral for the loan. The seller gains access to funds at lower funding costs than are typically available elsewhere. The buyer obtains an attractive yield on a short-term, secured, liquid investment.
Repo collateral typically comprises government bonds but can also include money market instruments, agency securities and asset- and mortgage-backed securities. The decision on which collateral to use is negotiable between the repo counterparties and will impact the interest rate offered and the haircuts required.
Repo is effectively a short-term, interest-bearing loan against a pool of collateral, but while repos resemble collateralized loans, their treatment under bankruptcy law is more beneficial to the buyer. That is because a buyer can sell the collateral quickly in the event of a counterparty default.2
1 Source: Frank J. Fabozzi, The Global Money Markets (Wiley Finance, July 2002). 2 According to market convention, repo refers to a transaction in which a dealer acts as a sellerborrowing money and providing securities as collateral. In reverse repo, a dealer acts as a buyerborrowing securities and lending money.
Repo variables Details
Transaction size Based on the cash size of the trade
Collateral The securities offered by the seller; the characteristics and quality of the collateral impact the size of the haircut
Haircut/margin Difference between the value of the cash and the value of the collateral (as a percentage)
Maturity date Repurchase date for the repo
Counterparties The buyer and seller; the creditworthiness of the seller also impacts the size of the haircut
Interest rate/repo yield Paid by the seller; affected by market rates, collateral, tenor and counterparty
Source: J.P. Morgan Asset Management; as of May 31, 2015.
Every repo trade consists of six negotiable variables
EXHIBIT 1: KEY REPO VARIABLES
4 CHINAS REPO MARKETS
Across global money markets, repos provide an efficient mechanism for financing bond positions, enabling market makers to take long and short positions, and providing short-term investors with a relatively low-risk investment opportunity. A liquid repo market is a key element of a liquid bond market and is especially important to market participants that rely on wholesale funding or face restrictions on unsecured lines of credit. The terms and definitions we have described apply to both Western and Chinese repo markets, but there are significant differences between the two.
AN OVERVIEW OF WESTERN REPO MARKETS
In Western markets, two repo structures have evolved: bilateral and tri-party, both of which are traded in over-the-counter markets (EXHIBIT 2). A bilateral repo involves two parties, the buyer and the seller. A tri-party repo involves a tri-party agent (TPA) as well as the two parties. The agent takes on the administrative functions of receiving, reporting, settling and delivering the repo securitiessimplifying the operational complexities for both counterparties.
Western repo market participants use the global master repurchase agreement (GMRA).3 It outlines the terms and conditions of the repo contract, including rules concerning margin maintenance and procedures in the event of default.
While both counterparties are exposed to credit and default risk in a repo transaction, the buyer is usually in the more vulnerable position. Therefore, careful counterparty and collateral selection is important to minimize counterparty default risk, collateral default risk and collateral impairment.
Counterparty default risk can be reduced by using internal credit analysis and nationally recognized statistical rating organization (NSRO) ratings to identify higher quality counterparties. Collateral default and impairment risk are mitigated by ensuring that collateral is high-quality, liquid and uncorrelated with the seller.
Repo transactions are normally over-collateralized. That is, the value of the collateral exceeds the value of the cash exchanged. The excess collateral is known as a haircut, or margin. Haircuts are based on historical volatility, market convention and collateral quality.
If the market value of the collateral falls below the repo transaction size (margin deficit), the seller is required to commit additional cash or acceptable