Important note: While, once a firm is short more than a given threshold of a companys stock it is legally obliged to disclose as much, this does not to my knowledge apply to the bond markets. I also doubt the practice of short-squeezing to create positive fails in the bond markets is a defunct practice, irrespective of any regulatory deterrents. It is just a matter of how it gets done. While therefore the procedures and principles covered in this chapter still apply, readers should satisfy themselves with regard to current rules on both short selling, and buy-ins; going into the open market to buy securities because a seller has failed to deliver, and passing on the costs to the seller. And also with respect to recent changes designed to improve the efficiency of the repo markets. All that said the following remains a clear guide to financing positions and the repo markets. NOTE: Cedel merged in 2000 with Deutsche Borse Clearing to become Clearstream.

From Mastering the Euromarkets.

Financing Positions

The value of a firms inventory changes daily, and is generally multiples of its capital. A house with US$3 billion in capital could have trading positions with a total value in excess of US$100 billion! Street firms therefore, need to borrow money every day and in many different currencies. Finance departments are responsible for doing much of this, by raising money at the cheapest possible cost to support their employers trading activities. They also take care of borrowing securities to satisfy the short sales of trading colleagues. The borrowing and lending of securities is often done via the repo market (which is discussed later). This chapter looks at financing from a bond traders perspective.

The normal settlement 1 of international securities is three business days following the trade date. When a trader buys a bond, he must borrow money to pay for it. Interest charges on money borrowed will be partially, or fully, offset by the coupon income of the security purchased.

When a trader sells a bond that he does not have in inventory, it will have to be borrowed, so as to be delivered on the settlement date. If a bond cannot be borrowed, the trader will incur the coupon cost for each day it is not delivered.

For the following examples an overnight financing rate of eight per cent is used, which is equivalent to 8.11 per cent on a eurobond basis. 2 This is the rate at which the majority of traders can borrow money to finance their positions, i.e. pay for purchases of securities.

Financing long positions

On long Eurobond positions the trader:

LOSES financing rate x amount borrowed (principal x A/I)

This example involves a straightforward borrowing of cash to pay for a purchase of bonds, although long positions in liquid, top quality securities, can also be financed via the repo market. This is discussed later.

Failing to deliver

The following example shows how much money can be lost when a trader fails to deliver a security.

EXAMPLE

Friday, 8 December 1995

A trader sells short 1mm of a US dollar-denominated eurobond with a 9 per cent coupon at a price of 99 per cent, for regular settlement on Wednesday 13 December 1995. Proceeds of this transaction are:

Principal                               990,000 (1mm x 99 %)

280 days A/I                          70,000 (1mm x .09 x 280 / 360)

Total proceeds                   1,060,000

Monday, 11 December 1995

Even if the trader covers his short today, he will fail to deliver for one day. This is because normal settlement is three days, and a trade done today will not settle until Thursday.   The trader will therefore lose $250, being one days accrued interest.   To compensate, he must now buy his bonds back at 98.975 per cent.   To calculate the cost of failing to deliver a security for one day, take the nominal amount x the coupon / 360, e.g. for this bond 1mm x .09 / 360 = 250.

Tuesday, 12 December 1995

The market is unchanged and the trader can buy his Eurobonds back at 99 1/16 per cent but decides not to. Consequently, he will now fail over the weekend and lose two more days accrued interest, because his next opportunity to trade will be on Wednesday for settlement the following Monday.   To compensate, he must now buy the Eurobonds back at 98.925 per cent.

Wednesday, 13 December, 1995

Trader covers his short at 99 per cent for regular settlement on Monday 18 December. Proceeds:

Principal                                990,000 (1mm x 99 %)

280 days A/I                          71,250 (1mm x .09 x 285 / 360)

Total proceeds                   1,061,250

This trader lost $1,250 as a result of failing to deliver for five days.   Had he decided to pay the higher price of 99 1/16 per cent to cover his short on Tuesday, the proceeds would have been:

Principal                                990,625 (1mm x 99 1/16 %)

280 days A/I                          70,500 (1mm x .09 x 282 / 360)

Total proceeds                   1,061,125

Although Tuesdays offer price of 99 1/6 per cent was higher than where the trader originally sold bonds short, it would still have been cheaper overall to buy the bonds back then, at that price, as this would have prevented a fail over the weekend.

When a trader fails to deliver a bond, he loses the coupon interest per day, multiplied by the number of days the bond is not delivered.   As the majority of transactions are settled on a delivery versus payment basis, when a trader fails to deliver a security, he cannot gain access to the sale proceeds and, as a result, he also loses the financing rate on that money, as you will see further on.

The moral of the story is that unless you are confident of being able to buy bonds back at a cheaper price than where you short them, a price that fully reflects the costs of being short in addition to some principal gain, do not go short.   Also bear in mind that a security may be trading very expensively for the very reason that there are no bonds available to either buy or to borrow.

A fail can be avoided if bonds can be borrowed.

Borrowing securities

By lending out securities, you can earn additional income without any additional market risk.   By borrowing securities, whilst you will pay a borrowing fee, you can reduce your overall costs of being short.

Never assume, however, that you can borrow bonds.   Always ask your finance division/settlements department, whether a security is available (for borrowing) before you go short.

Borrowing costs are calculated on the market value of a security, plus accrued interest not the redemption amount.   If a coupon payment date falls while a security is out on loan, the borrower of the securities must immediately make the appropriate coupon payment to the lender.

In the previous example, had the trader been able to borrow the Eurobonds at a rate of say, 3 1/2 per cent the first day that he went short, although he would have paid $515.27 borrowing costs (3 1/2 per cent for five days on principal + A/I of $1,060,000) he would at least have had access to the sale proceeds of $1,060,000.   His borrowing requirements for overnight funds would have then been reduced by this amount, thereby saving one days interest at the financing rate.   Alternatively, he could have used the sale proceeds to buy other securities on which coupon interest could have been earned.

The borrowing and lending of securities is a highly-lucrative, low-risk activity.   A lot of money can be made from acting as the intermediary between borrowers and lenders.   This is why many of the larger Street firms now operate their own schemes, as well as trade short and long positions via the repo market.

The repo market

The repo market offers an alternative way to borrow and lend both securities and cash.   The repo market in Europe grew in the late 1980s in an effort to reduce what was regarded as the exorbitant cost of borrowing securities through the clearing agents.   A few firms started borrowing and lending among themselves, via the sale and repurchase of securities (repo agreements), and their purchase and re-sale (reverse repo agreements). A repo is therefore a way to lend bonds and borrow money, while a reverse repo is a way to borrow bonds and lend money.

The following is an example involving 10 million of the current US Government long bond which, at the time of writing, is the 7 5/8 percent 15 February 2025, currently trading at a price of 111 8/32 per cent, i.e. 111.25.

EXAMPLE

You lend (repo) 10 million of this security to another party for one week at a repo rate of 5.6 per cent.   Repo interest is calculated actual/360 on the full price, i.e. the quoted net price plus accrued interest.

Interest on US Treasuries is paid on an actual/actual semi-annual basis.   The number of days in a semi-annual period can vary between 181 and 184.

There are 181 days in the current interest period, and 154 days accrued interest as of the start date (the initial settlement date) of the agreement.

On the initial settlement, or start date of the agreement, you (the lender of the securities) will receive proceeds of US$11,449,378.45:

Principal                                              11,125,000.00

280 days accrued interest                   324,378.45 (10,000,000 x 0.038125/ 181 x 154)

Total proceeds                                   11,449,378.45

There will be repo interest of US$12,467.10 due on this transaction (11,449,378.45 x 0.056 x 7 / 360 = 12,467.100.   At the end of the agreement therefore, when you repurchase the securities, you will pay 11,461,845.55 (11,449,378.45 + 12,467.10).

A repo agreement contains an agreement by the buyer (borrower) of securities to waive all rights to any coupon payment in favour of the seller (lender) of the securities.   Thus, when a coupon payment occurs part-way through a repo agreement, it has the effect of leaving the buyer (borrower) under-collateralized.   This is because he would originally have loaned the seller (lender) an amount of money equal to the market price of the security, plus accrued interest.   The problem is usually solved by the seller (lender) repaying the buyer (borrower) the accrued interest portion of the funds advanced at the beginning of the agreement.   This is effected through what is known in the trade as a call for difference.   Such requests come from the buyer (borrower) and are usually made in sufficient time for funds to be repaid when the seller (lender) receives the coupon payment.

In the earlier example, you borrowed money and pledged securities as collateral, and paid interest of 5.6 per cent.   Thus, you could have purchased these securities and then lent them out on repo, using the resulting money borrowed to pay for them.   This is how many traders finance their inventory.   Whereas in the first example on financing long positions, we said the trader gains the coupon income, but loses the financing rate multiplied by the amount borrowed, if he uses the repo market, he gains the coupon income but loses the repo rate multiplied by the amount borrowed.

It is important to remember, however, that the quality of collateral will determine the repo rate.   In this example, we used US government securities, which represent the highest quality collateral.   If you wanted to repo out one million of a Eurobond issued by a bank or corporate borrower, it could be difficult given the credit and liquidity risk and small amount involved.   These risks would be reflected in the repo rate; you may have to pledge more collateral and/or pay a much higher rate.   When financing long Eurobond positions therefore, the traditional approach may prove the cheapest.

Financing short positions

On short Eurobond positions where bonds are available for borrow, the trader:

LOSES coupon income x par amount

LOSES borrowing costs x amount borrowed (principal + A/I)

GAINS financing rate x proceeds (from short sale)

EXAMPLE

A trader sells short one million of a Eurobond with an 8 3/4 per cent coupon at a price of 101 per cent.   There is 314 days accrued interest on this bond as at the settlement date.   The borrowing rate, i.e. the cost of borrowing bonds from Euroclear or Cedel, is 3 1/2 per cent.

Loss per day: 0.0875 x 1mm / 360                              = 243.05 Loss

Loss per day: 0.035 x 1,086,319.44 * / 360                = 105.61 Loss

Gain per day: 0.0811 x 1,086,319.44 / 360               = 244.72 Gain

Positive/Negative carry                                                   103.94 Negative

* Principal of 1,010,000.00 plus 76,319.44 (314 days A/I ) = 1,086,319.44

As with long positions, a trader can also finance short positions in the repo market by borrowing bonds via a reverse repo agreement.   He would use the bonds he borrows to make delivery on his short sale, and lend (pledge) the resulting proceeds of his short sale to the repo desk as collateral.   He would then receive interest income from the repo desk, on the money pledged as collateral.   If, therefore, the reverse repo rate was 6 per cent the trader would:

LOSE coupon income x par amount (on his short sale)

GAIN reverse repo rate x amount loaned (principal + A/I from short sale)

Going back to the last example, while the trader would still lose 243.05 per day in coupon income, he would gain 181.05 from his reverse repo (0.06 x 1,086,319.44 / 360 = 181.05) resulting in a net loss per day of 62 instead of 103.94.

Therefore, when financing short positions via the repo market, the traders net loss or gain is the difference between the coupon on the bond he sells short, and the reverse repo rate.   His net loss or gain on long positions, is the difference between the coupon on the bond he owns, and the repo rate.

Although in the US government bond example a period of one week is used, repos are often done for just a few days, and trades involving 50 or 100 million bonds and more, are quite common.   In fact, a key advantage of the repo market is that bonds can be borrowed for a fixed period, and there is no limit on transaction size.   The main clearing agents only lend or borrow on an overnight basis, and also limit the lending of securities to 10 per cent of an issue, regardless of whether there are holders willing to lend more. They impose this restriction as their priority is to help create liquidity rather than restrict it, which could occur if one party controlled too many bonds of one issue.

Repos and reverse repos in effect, resemble collateralized loans.   Investors can earn additional income from lending (repo-ing) securities held in their portfolio, while organizations with surplus cash can lend these funds on a collateralized basis using a reverse repo.

Tri -party repo agreements

Tri-party repos provide another way for Street firms to borrow money to finance their inventories, and a way for organizations to lend money safely.   It also enables organizations with a lot of money, but inadequate clearance systems and/or an insufficient number of settlements staff, to participate in the market.

The first tri-party repo agreement in Europe was executed in October 1992 between the EBRD, Swiss Bank Corporation, and Cedel.

The concept originated in the US but many adaptations were required for the non-US government and international markets, given the different currencies, settlement procedures, and associated legal considerations.

The tri-party repo structure involves a third-party acting as clearing agent and custodian, as well as a sort of policeman.   At the present time Cedel, Euroclear or the Bank of New York can act as tri-party custodians.

The custodians role is to clear all transactions, monitor and control the quantity and quality of collateral, and ensure that all margin calls are met.   If, therefore, 100 million Bunds (German government bonds) are on repo at a market price of 100 per cent, but then the market falls by, say, two points, the custodian is responsible for ensuring that additional securities are pledged.   This is to ensure that the organization which has borrowed those bonds has collateral equal to the market price paid at the start of the agreement.   In the same way, when securities pledged as collateral are downgraded, the custodian is responsible for ensuring that securities of acceptable quality are immediately substituted.   The level of collateralization required is not always 100 per cent.   Some central banks for example, require 101 per cent, which means they will lend DM100,000,000 but will want securities as collateral that are worth DM101,000,000.

The tri-party repo structure allows for unlimited rights of substitution.   In both of the above situations, therefore, different securities could be used either as a substitute or to make up any shortfall.   A dealer that pledges securities under a tri-party structure, can therefore actively trade them, knowing that if he sells the securities, and needs them to make good delivery, he can simply substitute.

Custodians fees are paid by the trading house, and reflected in the traders quoted rate, which must still, of course, be competitive to attract the business.

Tri-party repos provide the Street with access to pools of money they may not otherwise be able to borrow directly.   Their structure enables organizations to participate in the repo market safely, and with minimum administrative hassle.

Matched-book trading

A finance department that has good repo traders can generate significant revenue from actively trading the repo market via what they call their matched book.   Matched-book trading is a bit of a misnomer, in that it involves anticipating which securities and currencies will be in demand, and taking positions accordingly.   Profits come from accurately predicting the direction of interest rates in various currencies and the supply of, and demand for, specific securities.

For example, when a government trader goes short, he will usually look to borrow bonds from his repo desk which, if running a matched book, may already have some in position.   If the repo desk accurately predicted that the security in question would be in short supply, then they will have borrowed bonds ahead of time.

Some firms have computer programs which measure the probability of fails in different securities.   If the repo trader has bonds in position, he will lend them to the government trader at the prevailing repo rate thereby earning the difference between his initial cost and the repo rate.   If the repo trader does not run a matched book, or does not have the security in position, he would have to go into the market to borrow it at that time.   However, if the government trader was taken short because he quoted a price, and someone bought bonds on his offer and he did not therefore choose to be short, the security could well be unavailable for borrowing.   Matched-book trading can provide considerable additional liquidity to a firms trading divisions.

Finance activities have become very sophisticated, and finance desks are increasingly being measured like any other trading desk (except of course, that profit is a function of money saved as well as money earned).   This is not to say that individual trading divisions are treated as clients of the finance division when borrowing money to finance their inventories.   Money borrowed to finance in-house trading activities may be passed to the relevant trading divisions at cost, with each division paying a portion of the finance desks operating costs.   You should find out how your firm works in this regard.

Houses with the highest credit-rating, and the most capital, are in the best position to develop sophisticated repo operations.   Banks and other financial institutions will extend credit to them at the lowest rates, and investors will be happy to lend their securities to them.   By the same token, to ensure their standing is maintained, any firm active in the repo market must be extremely thorough when assessing the creditworthiness of all counterparties with whom it deals.   It must also have strict criteria for assessing the quality and value of collateral and, given the sheer volumes and short-term nature of repo agreements, first-class technological support to both settle trades, and monitor accurately the inherent risks.

Value date mistakes

Settlement procedures vary between markets.   It is therefore essential to confirm the value (settlement) date of a trade at the time of execution, so as to ensure that it is a good business day according to the prescribed criteria.   A seemingly trivial mistake can cost a lot of money and administrative hassle.   For more than 30 years, normal/regular settlement of international securities was seven calendar days. On 1 June 1995, it changed to three business days following the trade date, providing that both clearing agents are open for business (Euroclear and Cedel usually open all year round except for Christmas day).   Additionally, the cash market for the underlying currency in which transfers are to be made, must also be open for business.

This change reduces risk, in that the less time between trade date and settlement date, the less likely a counterparty could go bankrupt in the interim.   It also brings the Eurobond markets more in line with the foreign exchange and government markets, where settlement usually takes place one or two days following trade date.   It is now easier for investors to switch between Eurobonds and government securities denominated in different currencies.

That said, a seemingly inconsequential oversight with regard to settlement details can impact on a series of transactions, which can cost money, and adversely affect relationships.   Clients, in particular, do not like settlement mistakes.   For example, let us say that you are a client and sell a eurobond on a Monday for normal settlement the following Thursday, three days later.   You then find out, after the trade is done, that the Thursday is a holiday in the US (where the cash market for US dollars is based).   In this situation you would not receive the proceeds of your sale until the Friday.   Although there would be an adjustment of accrued interest, problems can still arise.   What if, for example, having traded on the assumption that your sale would settle on the Thursday, you had entered into a foreign exchange agreement to convert your US dollar proceeds into French francs in order to pay for a purchase of French frank government bonds due to settle on the same day?

Time spent unravelling a settlements error is time that could be spent making money.   Misunderstandings about value dates can easily occur.   Always confirm the value date of a transaction at the time of execution.

Positive fails

As the average size of a eurobond issue is much greater now than it was ten years ago, you would have to have the capacity to buy and own a lot of bonds to successfully create a positive fail.   Your firms capital, and your time, could perhaps be better used elsewhere.   However, the economic rewards of positive fails can be considerable and so they do still occur.

Creating a positive fail involves picking a security in which there is little supply, buying sufficient amounts of it so as to take the market short, and then refusing to lend out your bonds.

In this situation, the trader would earn the coupon, and use of the money to be set aside to pay for the bonds, which will sit in his account until bonds are delivered.   He could then use this money to educe his overnight cash borrowings and therefore his financing costs.

A positive fail can be left to run for as long as the trader wants.   Unless short-sellers manage to find bonds to deliver, they are at the traders mercy.   If and when he decides to end their misery, he could make even more money by offering bonds back to them at a very high price.   If their only alternative is to continue failing, they have little choice but to pay up.

In the repo market, a bond that is trading expensively because it is scare and unavailable for borrow, is known as a special.   A repo trader could therefore work in conjunction with his eurobond traders to create specials.

Positive fails can generate a lot of revenue.   Be alert to the possibility that you could find yourself caught in one if you fail in your due diligence as a trader 1.   In fact, in the 1980s, some firms indulged in the practice of selling short new issues in which they had no known sources of supply.   Some positive fails were thus created and a few firms lost a small fortune.

Avoiding fails on sales

Other than when buying and selling identical amounts 2 when you sell a large amount of one particular bond, it is prudent to split the ticket.   If you sell 20 million bonds to the same institution, split the ticket into four separate trades of five million. If you request this at the time of execution, your counterparty should be happy to oblige.   If they are not, then ask yourself why.   Even if you own a lot of bonds, unless you are certain that all bonds purchased have been delivered, a fail could occur if the securities are sold in one piece.

EXAMPLE

A trader buys 5mm of a bond on a Monday, from three different sources: two lots of 2mm and one lot of 1mm.   He then sells all 5mm in one piece.   He then finds that, of the 5mm bonds purchased, only 2mm have been received.   His buyers delivery instructions however, are to receive one piece of 5mm.   This trade will not settle unless the buyer accepts a partial delivery, which is unlikely for reasons explained below.   The seller will, therefore, fail on the whole amount.

A buyer of a block of bonds is in effect provided with free financing if he refuses to accept a partial delivery.   If the seller cannot deliver all the bonds, the buyer does not have to pay for them.   This money will therefore remain in the buyers account until such time as all the bonds are delivered.   While it cannot be removed, it can be used to reduce overnight borrowings, on which interest would have to be paid at the financing rate.

Conversely and consequently, the seller will have to finance any partial amount of securities in his account, but will not earn the coupon, as it belong to the buyer from the settlement date. Unless the partial amount was sufficiently large and of good credit quality, it is unlikely the seller could even repo the bonds out on an overnight basis to reduce financing costs.   When selling a large amount of bonds, you should therefore split the ticket.

1 See Trading in Chapter 6

2 When buying and selling identical amounts, it could have the effect of zero on your credit line if transactions are netted out.   If this is the case, were you to buy 50 million of a security, and then sell 50 million — but split the ticket into five lots of 10 million, the trade will not be netted out.   This is to your disadvantage as it will use up 50 million of your credit line.   If you have a limited credit line, and are running big overall positions, do not split tickets.   Try instead to match purchase and sale amounts wherever possible.