No. Repo is not a derivative.
Accounting treatment
Repos are often deemed to be derivatives, because the sale leg is assumed to remove collateral from the balance sheet, leaving just a revaluation item in respect of the repurchase. The consequential off-balance sheet treatment and the residual revaluation item are characteristic of the accounting treatment of derivatives.
However, such “sales accounting” is not the generally-accepted accounting treatment for repo. For example, International Financing Reporting Standards (IFRS) and US GAAP do not “derecognise” repo collateral from the balance sheet of the seller. This is because the risk on collateral is retained by the seller as a consequence of his commitment to repurchase the collateral at a fixed or determinable price. The continued recognition of collateral on the balance sheet of the seller and the recognition of the cash borrowed by the seller means his balance sheet expands.
Sales accounting of repo can be found in some emerging markets. The motive here is to compensate for the fact that legal frameworks in emerging markets are often unfamiliar with the concept of providing collateral by transferring legal title rather than the traditional method of creating a security interest such as a pledge. Characterising repo as a derivative is seen as reinforcing the claim that collateral has been sold, in order to minimise the risk of a local court re-characterizing repos as secured loans.
Sales accounting has also been seen in developed markets in the past, the attraction having been the capital benefit of off-balance sheet treatment. And the International Accounting Standards Board (IASB) considered the adoption of sales accounting as part of their strategy of promoting mark-to-market accounting. But the IASB proposal was rejected. Where options to allow sales accounting of repo existed (mainly in the US), they were repealed in aftermath of the Global Financial Crisis following Lehman Brothers’ infamous Repo 105/108 scandal and MF Global’s inappropriate use of repo-to-maturities.
Functional analogies
In addition to flawed accounting arguments, it is also frequently argued that repos are derivatives because they are functionally analogous, specifically, that:
- the maturities of repos can be mismatched to create the same forward-forward interest rate positions as deposit futures or forward rate agreements (FRA);
- repos can be used to finance or cover securities positions being used to hedge derivatives;
- repos and total return swaps (TRS) are alternatives.
While repos can be mismatched to create forward-forward interest rate positions and therefore function like derivatives, repos involve transfers of principal and, as explained above, therefore each repo has a gross impact on the balance sheet of the seller. The confusion here arises because different legal structures can be used to achieve the same economic end. The fact that the legal structures are different is not an inconvenient accident. Parties intentionally vary the legal structure of transactions to accommodate differences in the legal framework, capital resources, market liquidity, type of counterparty, margining, settlement and netting.
As regards the use of repo to create hedges for derivatives, it needs to be understood that it is not the repo that is the hedge, but the long or short position in securities that the repo finances or covers. But more importantly, because a cash position is being used to hedge a derivative does not mean that the cash position becomes a derivative. For example, in a cash-and-carry arbitrage, a long bond futures contract is hedged with a short bond position financed in the repo market. To suggest that the bond and repo have become derivatives is without any basis.
The argument that repos are derivatives because they are alternatives to total return swaps (TRS) misunderstands how TRS are used to replicate repos. To replicate a repo, one party must sell a bond to the other and simultaneously agree a TRS which returns the risk on the bond to the seller. In this way, the buyer of the bond lends cash to the seller and the seller retains the risk, which are what in a repo. Simply transacting a TRS in its own does not provide cash to the seller, which is one of the essential functions of a repo. TRS used on their own are unfunded investments. Repo is about providing funding.
The fundamental difference between a repo and a derivative
The real essence of a derivative is not that its price is derived from another instrument (all prices are ultimately derived from other prices). It is that there is never a payment of principal, only ever a payment of profit or loss. Derivatives therefore create an exposure, but do not provide a source of or home for principal. Repo is the temporary exchange of principal for collateral.
Forward repo versus derivatives
It is sometimes argued that, while most repo are not derivatives, forward repo are an exception. There is no precise definition of a forward repo, but it is commonly understood to mean a repo with a value date (Purchase Date) that is later than the most common value date, often weeks or months later. In fact, a forward repo, as the name makes clear, is a forward transaction, which is different from a derivative, although often confused or conflated because they are both off-balance sheet. The difference is that derivatives are instruments which never pay principal, only profit or loss, whereas forwards do pay principal but only in the future. The fact that the payment of principle is in the future means that, before the maturity date, forwards are treated as off-balance sheet, like derivatives. The difference can be starkly illustrated by comparing the credit risk profile over the life of an interest rate swap (a derivative) with that of a currency swap (a forward). The former peaks during the life of the swap and then falls to zero by maturity, while the latter rises until the maturity date, when a payment of principal is due.
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