Starting in mid-June, APG will be trading repo transactions through the Frankfurt-based trading platform Eurex. But what exactly are repo transactions, and what is their purpose? We asked Jan Mark van Mill, Head of Treasury & Trading at APG.
An investor needs money in the short term for short-term obligations, such as collateral and payment obligations arising from interest rate and currency hedging, for example. For this purpose, the investor holds cash. This cash buffer cannot be held with one bank and is therefore invested in the market on a daily basis. To manage this, APG uses various instruments on behalf of its pension fund clients, including deposits and short-term bonds. The most important instrument, however, is the repo transaction.
Repo stands for repurchase agreement, Van Mill explains. “In a repo transaction, we provide cash on behalf of one of our pension fund clients to a counterparty, usually a bank. In return, we receive collateral from the bank in the form of a government bond. At the end of the transaction term, we get the cash back, the government bond is returned to the bank, and the interest due is settled.” Because the bank provides collateral on the loan, there is less risk for the counterparty from which the loan is outstanding.
A repo transaction comes in different guises. “Until now we only did bilateral repo transactions, where the direct counterparty is always a bank. The transactions we will be doing through Eurex starting in mid-June are so-called cleared repo transactions. That means that there is a trading platform, or clearing house, between our pension fund client and the bank. In this case Eurex. On the trading platform, we agree on a price with the bank, after which we offer the transaction to Eurex. The latter checks whether the pension fund and the bank have met all their obligations. If so, the transaction is concluded between the pension fund and Eurex on the one hand, and between Eurex and the bank on the other.”
Eurex is sometimes called a central counterparty, or a CCP, which stands for central (clearing) counterparty. “This regulates all transactions and is therefore the spider in the web of the financial market. The advantage of this form of repo transactions, i.e. with a CCP, is that we no longer have a bank as a counterparty, with the risk that the bank will collapse. Think of Lehman Brothers at the beginning of the credit crisis, for example. In contrast, the probability of a CCP going bankrupt is virtually zero.” In addition to the advantage that a pension fund has less risk, the rates for repo transactions through a CCP are also more attractive than for interbank repo transactions. Furthermore, APG benefits as an executor because the transactions through Eurex are fully automated. This makes them more efficient and there are fewer operational risks.
Every day, APG does dozens of repo transactions for all its pension fund clients combined, Van Mill said. Their term is usually one day, with a maximum of a week. In total, APG manages between 15 and 25 billion euros in liquidity for its pension fund clients. “Repo transactions are a very important element in the asset management of a pension fund. You could call it the lubrication function because everything comes together in liquidity management: all the funds’ cash flows but also the pension payments and rights management. In this perspective, participation in Eurex represents an expansion of our palette of instruments for managing cash flows. This is also necessary because it is becoming more and more difficult to put money away in the market. This is because banks are becoming increasingly cautious when it comes to repo transactions. Their regulator is critical of the risk that banks run in these transactions. It is attractive for them to continue to accept money from us if it goes through a party like Eurex, which is then taking the risk.”
Traditionally, the market for cleared repos was open only to banks. “For several years now, the market has been opened up to other parties, such as pension funds, insurers and municipalities. This means that through our participation in Eurex, we have access to a wide range of parties that are either looking for cash or want to invest somewhere. That is a major advantage, especially since we are facing stricter capital requirements for banks as a result of new legislation and regulations. It is therefore important that we have a wide and diverse range of instruments and liquidity counterparties at our disposal.”
See also the Eurex press release.