The Central Bank of Nigeria (“CBN”) on April 12, 2021 released new Guidelines for the Conduct of Repurchase Transactions Under its Standing Facilities (“the Guidelines”). This calls for an analysis of the CBN’s core function of controlling monetary bases and velocity of circulation vis-à-vis the effectiveness of repurchase agreements (“repos”) as a monetary policy within the existing legal framework and as a means of providing access to financial institutions who are unable to access funds at the inter-bank market. This paper shall discuss the basis and use of repos by central banks as a monetary instrument as well as highlight the legal framework that supports the repo system; these will be analysed vis-à-vis the CBN’s recently released guidelines.
What is a repo?
A repo is in principle a transaction for the exchange of securities for cash with the agreement to repurchase the securities at a higher rate and at a future date which is usually a short maturity period ranging from overnight to a year. Essentially, the securities serve as a collateral for a cash loan and the cash serves as a collateral for a securities loan thereby making it a sui generis hybrid between a securities sale and a secured loan. In the case of a repo, the lender may have additional rights over the collateral securities such as a right to sell the securities and deliver comparable ones, right to reuse the repo to borrow from another party in the repo market, etc. The price at which the asset is charged is usually lower than its market value; the discount is expressed in percentage terms and referred to as a haircut or margin. Lastly, the collateral may be an identifiable “specific” asset or a “general” one. By way of a simple and practical example, bank A needs to raise cash to cover its operations so it sells its Treasury Bills worth NGN110mil to the XY Ltd at a discounted sum of NGN100mil. When the repo matures, bank A repurchases the Treasury Bills from XY Ltd at NGN100mil plus the margin/ additional interest.
Economic Importance and Monetary Policy of Repos
The economic significance of a repo transaction derives from the fact that they allow one party to temporarily exchange cash for securities and the other to temporarily exchange securities for cash. Financial institutions typically use repos to manage their liquidity, cover short sales, build up leverage or hedge interest rate risks. For central banks, repos have become an important monetary policy instrument for managing liquidity in the money market, supplying the banking system with additional liquidity and keeping banks solvent during the financial crisis on one hand and on the other hand signaling the target interest rate to market participants. It is also attractive to regulators as it carries low credit risk due to the securities, is flexible and does not affect securities prices. Repos may also be used for managing foreign currency reserves as it provides extra returns.
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Legal Framework and Features of Repos Relevant to Central Banks vis-à-vis the Guidelines
The legal framework of repos is dependent on the economic policy for its use in the jurisdiction; that is whether it is for liquidity management purposes, signaling purposes or a combination. It is evident from the CBN’s Guideline that repos in the Nigerian market are for the major purpose of liquidity access as opposed to signaling. This is even more so because as provided in paragraph I.1 of the Guidelines, the rates on the repo facilities are to be set at margins above market rates to ensure that participants first seek interbank market opportunities and have a final recourse to the CBN’s repos, accordingly, no incentive is provided for commercial banks to lower their rates. Although, the 2012 version of the Guidelines did indicate that the aim was to also set an upper limit on rates.
G-10 Countries tend to adopt Standard Repurchase Agreements; the CBN adopts Standard Lending Facility (SLF) and Term Repurchase Facility (TRF), both of which are available only to Deposit Money Banks and other Financial Institutions who have executed the Nigerian Master Repurchase Agreement (NMRA) (II.4 of the Guidelines). The difference being that the SLF spans from one business day to the next and allows the entities square up their positions after inter-bank market trading hours while the TRF is a term facility (see III of the Guideline).
The NMRA is the legal document (master agreement) that governs the CBN’s repos and it defines repos as an agreement to sell securities at an agreed price and buy them back at a future date at an agreed price. The Guidelines are to be read in conjunction with the terms of the NMRA. The eligible securities pursuant to the Guidelines are Nigerian Treasury Bills, Federal Government of Nigeria Bonds, CBN Bills and other securities approved by the CBN (see V.12 of the Guidelines)
There are four major ways in which the economic policy objective shapes the legal framework for a repo and they are as follows:
– Frequency: This tends to be higher for countries that use repos for daily liquidity control as we have in Nigeria. The SLF and TRF are both available on all business days.
– Maturity: Central banks using repos for daily liquidity management tend to have a greater reliance on shorter-maturity rep. The CBN’s SLF spans one business day to the next while the TRF period ranges from 4-90 days.
– Disclosure: Where signaling is the goal, central banks would tend to disclose rates before the tender. With the CBN, the rate for the SLF is the Monetary Policy Rate (MPR) plus it’s upper corridor as set by the Monetary Policy Committee while that of the TRF is the prevailing MPR rate.
– Tender/ Auction System – Tender/ auctions may be chosen where signaling is a core objective. Multiple rates provide a lesser signaling function while fixed rate tenders are an effective signaling tool. CBN’s standing facilities do not tend to adopt such a tender/ auction system. The wider inter-bank market however adopts a retail Dutch auction system.
Additional Legal Framework
It is also important to consider the provisions of the Investment and Securities Act (ISA) as it relates to repos given that the Securities and Exchange Commission’s Regulations (SEC) is the regulator for securities in Nigeria. Section 315 of the ISA defines securities lending to include repos as follows:
The temporary exchange of securities, generally for cash or other securities of at least an equivalent value, with an obligation to redeliver a like quantity of the same securities on a future date and includes securities loans, repurchase agreements (repos) and self buy-back agreements.
SEC’s Rule and Regulation (2013) also provides in 389 (9) that the title of the securities should be temporarily vested in the transferee and the transferees has right to deal with or dispose with the securities in any manner. This fits in with the features of a repo which is essentially an agreement to sell or in this case lend the collateral and then buy back. Furthermore, Rule 389 (10) notes that the obligation on the Buyer in repos is to reconvey equivalent number of securities of the same type and class borrowed, sold and not necessarily the actual securities bought to the seller upon maturity, meaning that a Buyer may choose to dispose or otherwise deal with the securities bought as he so pleases. This emphasizes the point that repos are usually flexible in terms of the additional rights they provide the buyer/ lender.
However, ISA and SEC Rules do not adequately cover for repos because securities lending as envisaged by the Act and Rules is the borrowing of securities upon the provisions of collateral which may be cash, securities or a combination while a repo is outright buying/ transfer of ownership of securities with the addition of an agreement to repurchase.
Key Legal Challenges with Repos
Despite the benefits of repos from an economic standpoint, there are risks faced by market participants including potential for a credit exposure to develop depending on the volatility of the collateral, operational risks, liquidity risks and the fact that the use of leverage can increase credit and liquidity risk. From a legal perspective, the major challenge which may be envisaged or arise with a repo transaction is the enforcement of the agreement. Accordingly, the legal treatment of the collateral is crucial and there must be certainty with respect to rights when a counterparty default, i.e., there should be no unambiguous legal grounds for exercising rights on the securities.
In this regard, paragraphs V. 23 & 24 of the Guidelines provide that with respect to SLF, a default by a counterparty on the next business day would result in the security reverting fully to the CBN at a rediscounted value. With respect to TRF, upon default, a new repo transaction will be deemed to have been entered with the repurchase price as the new purchase price and the new pricing rate set at the applicable rate on the SLF plus 5 percentage points. The new repo will be an SLF and failure to buy same back on the next business day will result in the securities reverting to the CBN at a rediscounted value. SEC’s Rules and Regulation also empower the buyer to liquidate the security (see Rule 289 (17).
Other legal issues which may include force majeure which is to be construed in line with the master agreement as well as complaints management and dispute resolution.
Conclusion
In conclusion, the liquidity benefits repos present for the financial system cannot be overstated. The total request for the SLF granted from January 1–31, 2021 alone was N492.50 billion. From a regulatory standpoint, there is a need for SEC to revisit its provisions on repo transaction. It is advised that repos be treated separately from securities lending and the provisions on same harmonized with CBN’s Guidelines and the NMRA.
This paper has been prepared by Chinonye A. Nnaji, an Associate in the law Firm of Kenna Partners. Chinonye may be reached at [email protected]
