REPOS & SOFTS
create different dynamics and may increase the risk profile of a transaction. Note that a legal opinion is not a substitute for legal advice which, in a transactional context, is likely to be extensive given the numerous issues that can be involved.
Marked-to-market margining allows Buyers to call for additional cash or securities assets from the Seller, and naturally provides the Buyer with a more contemporaneous picture of value. The MPSA can provide the Sugar Company the option to remedy any margin deficit by either providing additional cash or transferring additional sugar quantities that would be reasonably accepted by the Bank. Conversely, if the market value increased above the amount required by the agreed margin of 3%, the Bank can be required to remedy the excess by either transferring cash equal to the amount of the excess or returning a quantity of the sugar to the Sugar Company.
Liquidity Risk A counterparty may not be able
Economically speaking, a repo
transaction may (reasonably) be perceived as a collateralised loan
Risks & Challenges The following are the key risks
and challenges when applying repo structures in soft commodities: Counterparty/Credit Risk Prior to conducting a repo
transaction, the Buyers should determine the financial capacity, risk profile and risk management strategy of the Seller. In the example above, if the Bank sees itself as susceptible to the credit risk of the Sugar Company, the MPSA could be structured such that the amount lent (£3 million) is marginally less than the market value of the sugar used as collateral, thereby providing the Bank with some cushion in the event of a decline in sugar prices (this is known as the repo margin or “haircut”).
Market Risk To mitigate exposure from
changes in market price levels and credit risk, the commodity can be marked to market on a daily basis.
90 September 2011
to settle an obligation for the full value when it is due, but instead settle on some unspecified date thereafter. One way to manage the overall liquidity is through the use of buffer securities or reserve cash. The size of the buffer may be determined partly by the Seller’s willingness to sell, and partly by the participant’s own risk management policy, for example, a higher buffer for less liquid issues. Some Sellers manage their overall liquidity by selling
not more than three days’ worth of the underlying security’s turnover.
Operational Risk A number of operational issues need to be considered at the beginning of the negotiations between the parties, foremost amongst these being the relationship between collateral operations, credit, front office, and each parties’ legal advisors. The timing of margin calls and collateral deliveries should also be clearly identified. The system capabilities of both the Seller and Buyer in capturing all the requirements of the MPSA should be assessed. In order to mitigate these operational issues, the following practices should be adopted: (i) Distinguish duties for trading, operations, accounting, client services, marketing, asset/liability and risk management, legal services and compliance.
(ii) Ensure trades fall within credit limits for counterparties and overall trading limits.
(iii) Ensure that details of any trade confirmation are complete and properly issued and that transactions are accurately recorded in internal systems.
(iv) Apply appropriate haircuts and margin call practices. (v) Emphasise management’s role in measuring, monitoring and controlling credit and market risks.
(vi) Insert appropriate default clauses in the MPSA to ensure that any technical (temporary) inability to deliver securities does not give rise to a formal event of default.
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