REPOS & SOFTS
On 31st October, the Bank returns
the sugar to the Sugar Company, and the Sugar Company pays over the original monies plus repo interest of £210,000:
Why Use Repos in Softs? 1. Security of Investment
Generally, the world’s most
resource-rich countries, and thus the Sellers with whom Buyers would wish to trade in soft commodities, tend to be located in some of the world’s less secure jurisdictions, such as Russia or
Sugar Company £3 Million
Kazakhstan. With the application of a repo structure to the transaction, the Buyer has the benefit of a secured investment. In the example above, the Bank effectively acts as a lender,
£3 Million + £210,000 Interest
Sugar Company
Sugar Stock
In the example above, a Collateral Monitoring Agreement
could be signed between the Sugar Company, the Bank and a surveillance company. During the term of the MPSA, the sugar stock could be stored in the Sugar Company’s storage facility. It may be agreed that the storage facility is (at all times) under the disposition and surveillance of the surveillance company, which has overall control over the storage facility. The Bank would consequently bear no responsibility whatsoever for the storage of the sugar, and would not be liable for any damage caused to it. The Bank and Sugar Company can then set out an agreed fee
for the storage of the sugar stock. In addition, during the 30- day term of the MPSA, the Sugar Company may seek the right to drawdown quantities of the sugar from the storage facility, as required in the course of its business. Before a drawdown can take place, however, the MPSA can
require the Sugar Company to issue the Bank with a drawdown request, and this drawdown quantity of sugar may only be released from the storage facility with the written consent of the surveillance company (acting on the instructions of the Bank). Accordingly, a Collateral Monitoring Agreement would
enable the Bank to leverage the expertise of a surveillance company to minimise the operational, settlement and market risks which are intrinsic to the transaction.
88 September 2011 Bank
Sugar Stock
Bank
and takes ownership of the sugar stock. The Sugar Company acts as a borrower and uses the sugar stock as collateral for a secured cash loan from the Bank, at the fixed repo rate of 7%. The application of a repo structure to the transaction therefore provides leverage; the Sugar Company is able to receive a financial return from the sugar stock without having to expend
... there has been a significant shift in
regulatory and political focus onto the markets in which soft commodities are traded
the purchase price of £3 million. The Sugar Company thereby earns on the sugar stock, and, consequently, is able to finance many more securities as compared to an outright purchase. In the event that the Sugar Company defaults on its repayment of £3 million (plus interest), collateralisation in the form of the sugar stock provides the Bank with a good level of security. This offers the Bank the possibility of liquidating the sugar stock in order to offset any default. The sale of the sugar would be possible where the legal transfer of that collateral from the Sugar Company to the Bank is acceptable.
2. Lower Costs The only charge to the Seller is the repo rate that is mutually
agreed between the parties, and is usually a fraction of the LIBOR rate of the equivalent maturity. This, obviously, is a preferable option for the Seller.
3. Diversification of Risk / Hedging Strategies Perhaps more pressing in the current financial climate is
the opportunity that a repo transaction provides for parties to diversify away from bank risk. Through careful assessment of (i) the creditworthiness of a counterparty and (ii) the quality of the collateral and delivery mechanism, parties are able to structure an investment which exactly matches their needs. Through the exercise of a repo structure, the Bank has greater leverage in the hedging markets. The bank may also enter into physical transactions, e.g. an exchange for physical (EFP) on an exchange such as Euronext Liffe, whereby an equivalent number of bought futures are exchanged for an equivalent number of sold futures.
4. Regulatory Considerations The European Community Capital Adequacy Directive (CAD)
and Basel II have influenced the capital requirements that money market participants must abide by. Due to the collateralisation in the form of soft commodities, the participant in a repo transaction requires almost no capital resources. This means that a repo is a much more capital efficient instrument that enables participants to leverage their capital more effectively.
5. Flexibility Repo transactions are attractive to market participants because
they provide a high degree of flexibility when compared to other market instruments. A liquid repo market exists in most major currencies for maturities ranging from one day to one year. This allows investors to trade with relatively bespoke maturities and investment amounts.
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