Repurchase Transactions & Soft Commodities: Trends & Issues
As the world’s largest agricultural commodities market outside the US, London has seen an unprecedented rise in the use of repo structures in soft and agricultural commodities transactions. Quite aside from the possible impact such trading may have had on food prices, more widespread trading brings with it a range of other risks and challenges.
By Prajakt Samant & Rashpaul Bahia
2011 HAS WITNESSED an unprecedented escalation in global food prices. On average, the World Bank Food Price Index has remained 33% above the levels recorded in the previous year. Taking wheat as an example, Wheat May futures on Liffe climbed from £153 per tonne in October 2010 to over £222 in April 2011. White sugar futures on NYSE Liffe in London have gained 38% in the past year and raw sugar in New York has gained 48%. The value of sugar, rice, wheat and other staple foods has surged to such a degree that price volatility has eclipsed all other policy debates during France’s G-20 presidency. Questions abound across the academic and
political spheres as to the possible causes of this phenomenon; factors espoused range from climate change and natural disasters to surging demand in emerging economies and rising living standards. However, one thing is certain: there has been a significant shift in regulatory and political focus onto the markets in which soft commodities are traded. Growing investor interest in soft commodities
has met with increased variability in trading and ownership structures. One particular trading method that has proven popular in such investments is that of repurchase (repo) transactions. The United States is the largest repo market in the world, followed by France, whilst the UK (which only introduced a repo market in 1996) has the largest cross border, multi- currency repo market. While repo structures can be applied to almost any security, the most suitable securities are those which provide a high degree of liquidity – such as soft commodities – as their value is more easily realised in the event of default; and most significantly, they can be easily obtained in the open market. In addition to recognising the advantages
repos provide against alternative structures, it is imperative that all parties engaging in these transactions fully appreciate and address potential risks.
Repo Transactions in Commodities Here is an example of how this structure can be used in the commodities markets. On 1st
October 2011, a sugar company (the Sugar Company)
based in Abu Dhabi, decides to sell a quantity of refined white sugar, at a term of 30 days, maturing on 31 October 2011. The agreed repo rate is 7%. In the first instance, the Sugar
Company sells the sugar stock to a bank based in the UK (the Bank), and receives £3 million in return:
A Repo Transaction A repo transaction involves two parties, a Buyer and a
Seller, and two exchanges between these parties. The first exchange occurs at the start of the transaction, wherein the Seller delivers securities or other assets to the Buyer (usually a bank or financial institution), together with a commitment to buy back the securities at a specified later date. Simultaneously, the Buyer will pay cash to the Seller, at an amount equal to the market value of the securities, including any accrued interest:
Title to Securities
Seller Cash The second exchange occurs at maturity, when the
Buyer returns the securities to the Seller. Simultaneously, the Seller repays the original cash amount to the Buyer, plus an agreed sum of interest (known as the repo rate). The interest payment serves to reflect the right of the Seller to use the cash during the period between the first and second exchange:
Title to Securities
Seller
Cash Plus Interest
The opposite of the above scenario (i.e. a purchase and
sell back) also can occur, and this is commonly known as a ‘reverse repo’. In this situation, the transaction involves the sale of an asset for cash, with an agreement to resell at a future date.
September 2011 87 Buyer Buyer
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