A great job from occupythesec.org:

http://occupythesec.nycga.net/2011/12/15/volcker-rule-round-one-whats-wrong-with-the-repo-exclusion/

Repo lending is best described as the financial equivalent of a visit to the pawnshop.

An asset is deposited with a lender in exchange for cash, with an agreement that at some point in the future a slightly larger amount of cash will be repaid and the initial goods returned. The pawnshop provides a way to exchange a valuable-but-illiquid asset (a grandfather’s watch) for a source of short-term liquidity (next month’s rent).

Repo provides much the same function for banks—except that instead of a watch, one deposits bonds or other securities, and instead of next month’s rent, it is used to fund today’s trading activity.

Repo financing is an integral component in global financial markets. It is the major source of funding for trading positions in global Bond and Derivatives markets. The regulators argue that repos are simply secured-lending arrangements, and that the securities underlying repo transactions should be excluded from the definition of proprietary trading assets.

How to run a Proprietary Trading book with Repo:


1. Shorting: A bank enters a reverse repo with Counterparty X using bonds as collateral. The bank immediately sells the bond, anticipating that the price of the bond will decline. When it is time to return the bonds to X, the bank buys them from the open market, hoping to benefit from price depreciation in the bond. This is essentially a short position on the bond, wrapped up in a repo.

2. Basis Trades: A bank enters a reverse repo with Counterparty X, using securities as collateral. Later, the bank (the repo lender) returns “substantially equivalent” securities instead of the original securities. Since the proposed rule uses the broadly-interpretable ‘stated asset’ in the definition of repo, it seems the rule would allow the bank to return a “similar” asset instead of the original one. The bank is essentially going long the initial security it takes in as collateral, and short the “substantially equivalent” security that it will eventually return to Counterparty X.

3.Put Options: A bank repos some securities in exchange for cash. The repo lender takes the securities. Later, the repo lender fails to return the securities, either due to an outright default or pursuant to an embedded right to refuse delivery. The bank has essentially sold the securities. The CFTC has actually highlighted this possibility. They said: “under new bank capital standards, a sale of securities subject to a repurchase agreement with a unilateral right in the transferee to refuse to return them could be construed to be the granting of a put from the perspective of the original ‘seller.’ This would attract a capital charge.” (http://www.cftc.gov/tm/finseginterp_2-1.htm)

4. Interest Rate trades: A standard repo trade is a rates trade at its core, as the repo rate is effectively the interest on a collateralized loan. Booking a repo looks like three separate trades:

a. a sale of securities
b. a future purchase of the same securities, and
c. a swap, the cashflows of which are the repo rate.

The purchase and the sale of the securities net out, leaving a (proprietary) directional swap.

5. CDS: A bank wants to speculate on the failure of a Counterparty X, so it enters into a repo transaction with X with a significant haircut. The bank lends X some cash, and demands collateral with significantly higher value than the cash. If X defaults, the bank keeps the collateral and locks in a huge profit. (This is functionally a CLN with X, referencing X)


Alongside this menu of desired proprietary exposures that can be smuggled under the rule as basic “repos”, the advent of financial engineering has led to repos that are designed to house many more types of risk. Below is a list of some of the major structured repo categories that contain elements of proprietary trading:

1. Cross Currency Repo: By accepting collateral denominated in a different currency than that of the cash exchanged for it, a bank can embed almost any desired FX exposure into a Repo.

2. Callable Repo: By including an early termination option for the repo lender, any repo swap can be made to include an option on that swap. If rates go up, the repo lender can exercise its option, recall the collateral, and re-repo at a higher rate.

3. Total Return Swap: A more generic way to structure a CDS into a repo, the repo rate in this structure is typically some spread to LIBOR, where the spread is determined primarily by the credit risk of the collateral at the time of the trade. In essence, the Bank is lending money in exchange for collateral AND gaining exposure to the credit risk of the collateral.

It is not difficult to see how banks can package almost any kind of risk into a repo by modifying the conditions of the ‘repo rate’ within them.