CFM17175 - Repos: commercial background: examples of uses of general collateral repos

How general collateral repos are used

The vast majority of commercial repo transactions are undertaken as a form of secured lending. However, there are other possible uses:

Repos can be used by hedge funds to finance their investments. A hedge fund manager can purchase securities and then repo them out. In this way the manager only has to find cash upfront equal to the haircut, calculating that the total yield on the securities will exceed the cost of financing them.

Abritrageurs can use repos to take advantage of price anomalies in the futures market. A reverse repo ( CFM17180) can be synthesised by the cash purchase of a bond and its future sale under a futures contract. So selling the bond at once under a repo will create a locked-in profit or loss if the difference between the futures price and the sales price under the repo does not equal the repo rate.

Financial traders may use repos of differing terms to speculate on forward movements in interest rates. For example, a speculator may repo in a bond over 3 months and immediately repo it out for say 1 month. For the first month the transaction would be broadly cash neutral. But if at the end of 1 month interest rates have fallen the speculator will, by entering into a new two-month repo at that point, pay less interest in respect of its initial cash “borrowing” than it receives under the reverse repo.

Lastly, but significantly, repos can be used for tax avoidance. There has been extensive exploitation of the tax rules in recent years, with very substantial tax at stake. It is hoped that the introduction of the manufactured payments unallowable purpose rule ( CFM17330) will curtail this. But cases where abuse of the rules is suspected should be referred at once to CT&VAT Products and Processes..