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Economy

Repurchase agreements hold strong potential for Asian economies

The development of Asian markets for repos would help deepen the region's capital markets and benefit its real economy. Repos, or repurchase agreements, are essentially loans secured by collateral such as high-quality sovereign bonds. The repo seller gets an immediate infusion of cash while committing to repurchase the asset at a higher price in the future, with the difference representing implied interest.

     Repos have historically played a much smaller role in Asian financial markets than in Europe or the U.S. However, policymakers have gradually realized the importance of repo markets and elevated them as part of financial regulatory reforms following the global financial crisis. This coincided with the wider shift from unsecured to secured forms of financing that had been underway in markets for some years and helped encourage the collateralization of risk.

     It is essential to develop Asia's repo markets to facilitate the efficient functioning of regional financial markets. The pool of available financial instruments can be expanded by using repos. This in turn would promote the cross-border mobility of assets and increase access to funding pools across the region.

     Repos can also help investors to access bond markets and transact in local currencies, facilitating the pricing and valuation of securities. Through this process, primary and secondary market liquidity can be deepened and investor demand broadened.

     Many other benefits stand to flow from integrating bond and repo markets in Asia, including: improving access to finance and allowing companies to reduce their reliance on traditional bank lending; supporting the development of bond markets and bond futures markets as well as over-the-counter derivatives markets; and improving the ability of repo holders to transfer ownership and use the securities across multiple jurisdictions to help adjust to the impact of regulatory changes that have raised requirements for financial institutions' liabilities to be secured.

     Repos can also be an effective hedging tool for risk management by banks and other financial institutions. In the open market operations of central banks, repos are an important instrument, integral to the transmission of monetary policy.

Obstacles to market development

The Asian repo market environment is fragmented, and many markets lack a consistent legal architecture, contract enforceability or a clear legal basis for holders in a default to set off their claims against those of sellers or vice versa. The absence of explicit legal protections safeguarding creditors' rights in repo agreements has prevented investors from building confidence in repo transactions in Asia. This in turn has sometimes given rise to perceptions of repos as risky financial instruments.

     Standard repo documentation such as the Global Master Repurchase Agreement, a model legal agreement for repo transactions, is not universally recognized in markets here. Regional repo markets suffer from a lack of benchmark yield curves, especially for longer terms, a lack of liquidity, barriers against investor access and adverse tax treatment.

     In many Asian jurisdictions, stamp duties and transaction taxes adversely impact repo market development by raising the cost of transactions and reducing demand for government securities. The levying of withholding taxes on non-resident investors has curtailed foreign participation in the secondary market in many Asia countries, dampening market liquidity.

     In jurisdictions including China, "pledge repos" dominate the local market. Pledge agreements do not include the full transfer of ownership of underlying assets; this can lead to problems such as a repo seller pledging the collateral security to multiple counterparties without their knowledge.

     Pledge repos also eliminate the ability of buyers to reduce counterparty credit risk and liquidity risk, since they do not include the explicit right to liquidate collateral assets or set-off claims in the event of a seller's default. As a consequence, there is no ability to extend collateral chains and deepen secondary market liquidity. This is a genuine concern at a time when there is a shortage of high-quality collateral globally.

     While repo markets in the U.S. and Europe represent approximately between 40-50% of gross domestic product, the Hong Kong Monetary Authority estimated that as of 2013, the overall size of repo markets for Asia, outside Japan, equated to less than 1.8% of GDP.

Overcoming the challenges

There is much Asian policymakers could do to facilitate the growth of regional repo markets.

     The development of underlying bond markets would support the growth of repo markets. The relationship between efficient repo markets and bond markets is self-reinforcing and mutually beneficial: efficient repo markets depend on the liquidity provided by robust government bond markets, while the development of repo markets can assist the further development of bond markets by deepening secondary market liquidity, improving price discovery mechanisms and inducing broader investor participation in local currency bond markets. In relation to this, market access for foreign investors to domestic bond and repo markets should be improved.

     Providing legal certainty is also important. Legal certainty can be reinforced when domestic law explicitly recognizes that a repo contract or master repo agreement is enforceable in bankruptcy proceedings. As such, master agreements -- which stipulate payment protocols, netting and close-out rights -- must be soundly established in law to induce market practitioners to engage in these types of agreements. Thus, wide recognition of repo documentation in domestic law and bankruptcy frameworks is essential to protect creditors' rights in insolvency cases and to assure investors of the enforceability of repo contracts.

     Asian policymakers should also move towards a true sale repo market by adopting the framework of "classic" repo transactions, as opposed to pledge repos. This would improve creditors' rights to liquidate collateral securities and to net off or set off in the event of counterparty default. Also, neutralizing the tax treatment of repo transactions could remove barriers to further market development.

     It is important to strengthen connectivity across the financial market infrastructure of Asia's markets to improve efficiency and reduce the cost of trading, improve price discovery, and enhance risk management in cross-border markets. Improving the interoperability of financial market infrastructure, such as linking onshore and offshore repo markets at central securities depositories, could promote the cross-border mobility of assets.

     At the industry level, establishing best practices in the region will be essential for developing the Asian repo market. The Asia Securities Industry & Financial Markets Association has offered suggestions in a newly published guide.

     Looking ahead, regulatory and market incentives stand to help realize the great potential for growth in Asian repo markets.

Patrick Pang is managing director and head of fixed income and compliance for the Asia Securities Industry & Financial Markets Association

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