In the U.S. most market participants lend and borrow securities through repurchase agreements. A participant executing a repo sells securities and simultaneously agrees to repurchase the same securities from the buyer at a negotiated price on a future date. A repo transaction is tantamount to borrowing money against a loan of securities. On the money borrowing side, the proceeds of the sale are the principal amount of the borrowing. The excess of the repurchase price over the sale price is the interest paid on the borrowing. On the securities lending side, the securities receiver acquires the ownership of the securities for the trade term and could use the securities for its own trading purposes.
A new repo trading mechanism on Treasury bonds was introduced to China's stock markets late last year. Its Chinese name literally means buy-out repo, emphasizing the fact that a repo constitutes a temporary transfer of a security by its owner to the repo counterparty. Treasury bond repurchase agreements in China (close-end repo in Chinese) essentially money borrowing deals with Treasury bonds pledged as collateral, i.e. a device purely for capital financing. Although the money borrower will pledge the Treasury bonds as collateral, the title of the Treasury bond is not transferred. Currently Treasury bonds in China are effectively non-tradable once they are subject to repo agreements.
Trading Mechanisms In The Trial Period
In April, China's Ministry of Finance, People's Bank and China Securities Regulatory Commission (CSRC) jointly issued The Notice on Developing Buy-out Repo Trading on Treasury Bonds. Consequently, the buy-out repo mechanism was first introduced to China's inter-bank bond market in May, followed by the buy-out repo trading on the Shanghai Stock Exchange (SSE) for investors.
The trial period on the SSE started in early December and the exchange chose one specific seven-year Treasury bond issue for repo trading during the trial period. The repo trading for the trial is on a limited basis: only 48 institutions are qualified to participate (i.e., not available to individual investors as yet) and participants must trade through the large order system at the exchange, which has a large minimum size and specific trading hours. Additionally, the current buy-out repo mechanism does not have certain structural features commonly found in more developed markets, such as securities substitution and early termination.
Unlike the margin maintenance requirements in typical repo transactions, China's buy-out repo applies a performance deposit mechanism. China Securities Depository and Clearing Co. (SD&C), the national securities depository and clearing company for securities traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange, is the central intermediary for buy-out repo trading. On the repo trade date, both counterparties have to make deposits to SD&C as collateral for their performance obligation under the repo agreements.
Performance Deposit & Default Reporting System
When entering a buy-out repo, the lender of funds shall make the initial trade price to the lender of Treasury bonds in an amount equal to (a) the clean price of the Treasury bond at the close one day before executing the trade and (b) accrued and unpaid interests. The performance deposit for both parties is equal to a percentage of the initial trade price, known as the performance deposit rate. At the end of the trade (the repurchase date), lender of funds returns the Treasury bond and receives cash repayment equal to the pre-negotiated repurchase price plus accrued interest. That is:
* Initial Trade Price = Treasury bond closing price the day before the trade plus Accrued Interest
* Performance Deposit = Initial Trade Price * Performance Deposit Rate
* Maturity Settlement Price = Agreed Repurchase Price + Accrued Interest
This counterparty exposure management system differs from typical margin maintenance in two major aspects. First, the performance deposits are not subject to daily mark-to-market based on market price fluctuations during the contract term. Three maturity terms (seven days, 28 days and 91 days) are available for the trial period at the SSE and the performance deposit rates are 1.5%, 3% and 5%, respectively. According to the public education materials from the SSE, the SSE researchers developed these deposit levels through statistical analysis on certain Treasury bonds' price fluctuations within a 12-month span between May 2003 and May 2004. It seems that based on recent historical data, the performance deposits are expected to cover the potential maximum price fluctuations during the trade term.
Second, the SSE's default reporting rule limits both counterparties' contractual liability to the performance deposits. If a repo counterparty is unable or unwilling to perform at the end of the repo trade, the party could simply file a default report with the exchange. Following the default reporting, the non-defaulting party seizes the defaulting party's performance deposit and the defaulting party is freed from any further performance obligation on the repo contract. The rationale for this limited liability setting is apparently to protect trading parties from being squeezed on the short position. In other words, the Treasury bond borrower will not be forced to strictly perform (in contractual law term) the repo contract if he sells the bond short, but could not get the security back easily prior to the repo settlement.
Since the defaulted party is relieved from all obligations under the repo trade after a default reporting, they are not liable for any amount greater than the original performance deposit or for any other losses incurred by the non-defaulting party. This differs from the repo mechanism in many developed markets. For example, in the Global Master Repurchase Agreement (2000 version) by The Bond Market Association (TBMA) and the International Securities Market Association (ISMA), the defaulting party is required to pay the non-defaulting party certain fees, costs and other expenses incurred by the non-defaulting party as a result of the defaulting party's failure.
The performance deposits could potentially be considered as a deposit ("DinJing") for contract performance under China's Security Law. According to China's Supreme Court's interpretation of the Security Law in 2000, contracting parties could terminate a contract by giving up the deposit if such a termination mechanism is provided in the contract and additionally the parties should follow China's Contract Law for liabilities upon contract termination. How this performance deposit and default reporting mechanism under the SSE rule will be treated within the framework of the Security Law and Contract Law remains to be examined by legal authorities.
Conclusion
The new buy-out repo trading in the Shanghai Stock Exchange is a major financial innovation in China's capital markets. Compared to the existing close-end repo, which is tantamount to a Treasury bond pledged cash loan, the buy-out repo transfers Treasury bond ownership between the trading parties. Investors in China have a borrow and short mechanism available for the first time since Treasury bond futures were banned years ago. As China gradually opens its capital markets in line with international standards, short selling mechanisms may become more broadly available for investors and the economic terms and trading behavior of many derivatives products in China may change dramatically.
This week's Learning Curve was written by Winston MaCFA, a financial products structurer in equity capital and derivatives markets at JPMorgan Securitiesin New York.
