Replacement Transaction

In simple terms, a “Replacement Transaction” is the transaction which exists AFTER it has been ‘adjusted’ pursuant to Paragraph 4(l) of the Global Master Repurchase Agreement.

In practice, “adjustment” of a transaction (whether that transaction is a Repurchase Transaction or a Buy/Sell Back Transaction) is an alternative to making a traditional margin call for a party with either “Transaction Exposure” (with respect to a single transaction) or “Net Exposure” (with respect to multiple transactions).

As is the case when a transaction is “repriced”, the “adjustment” of a transaction also involves the termination of the relevant transaction.  However, whereas in relation to a transaction repricing, the cash leg of the transaction is altered, in a transaction adjustment the cash leg of the transaction is kept static and, instead, the securities leg of the transaction is adjusted.  As such, if the value of the securities has fallen and can no longer support the level of ‘lending’, the Seller will have to provide additional securities by way of ‘top-up collateral’.  Conversely, if the value of the securities has increased, the ‘loan’ is now effectively over-collateralised and some securities will be returned to the Seller.

This method of managing exposure is more frequently used with respect to Buy/Sell-Backs.

More specifically, if a transaction is to be adjusted:

Firstly, the “Original Transaction” is terminated on the date on which the adjustment is to be made (this is known as the “Adjustment Date”) on such terms as the parties may agree.  This will allow the Buyer and the Seller to effectively ‘roll’ the securities underlying the “Original Transaction” straight into the “Replacement Transaction”.

Second, the “Purchased Securities” under the “Replacement Transaction” are such securities as the parties may agree.  However, the market value of the securities underlying the “Replacement Transaction” on the “Adjustment Date” must be substantially equal to the Repurchase Price under the Original Transaction (on the same date) multiplied by the Margin Ratio applicable to the Original Transaction.  In other words:

MV_RT,AD ≈ RP_OT,AD * MR

What does this really mean?  Remember that:

1. The “Repurchase Price” is effectively the amount of the original ‘loan plus interest’.
2. The “Margin Ratio” is essentially an expression of how much excess collateral the Buyer is entitled to in order to cushion itself against the risk of loss which might result from fluctuations in the value of that collateral.
3. The “Market Value of the securities” is really a reference to the value of the ‘collateral’ posted to support the ‘loan’.

In simple terms, this equation is saying that the value of the collateral posted in relation to the “Replacement Transaction” must be basically equal to the total amount of the ‘loan’ made under the original transaction (together with accrued interest) increased by the ‘collateral buffer’ which had been agreed in relation to the original trade.  As mentioned previously, the amount of collateral is adjusted in order to make sure that this equation holds true.

Third, the “Purchase Date” under the Replacement Transaction is agreed as being the “Adjustment Date”.  In other words, the Original Transaction comes to an end at exactly the same time as the Replacement Transaction ‘goes live’ – there is a seamless join between the two.

Fourth, the other terms of the Replacement Transaction are such as the parties may agree.

Finally, the obligations of the parties with respect to (a) payment, and (b) delivery of Securities, on the Adjustment Date under both the Original Transaction and the Replacement Transaction are to be dealt with in accordance with Paragraph 6 of the GMRA.  In simple terms, Paragraph 6(h) and 6(i) of the GMRA allow settlement netting to take place where (a) amounts are payable by the parties in the same currency and on the same day, or (b) fungible securities are to be transferred on the same day.  In other words, the parties can ‘squash the two transactions together’ to the extent possible so as to enable a single adjustment to be made as the “Original Transaction” rolls seamlessly into the “Replacement Transaction”.

An example of adjusting a transaction

Consider the following example:

1. A Seller needs to ‘borrow’ GBP 100.  This would be the “Purchase Price” under a Repurchase Transaction.
2. The Buyer is happy to ‘lend’ GBP 100 to the Seller provided that it receives GBP 104 worth of ‘collateral’.

These facts mean that the “Margin Ratio” (which is equal to the “Market Value” of the Purchased Securities at the time when the Transaction was entered into divided by the Purchase Price (in other words, MV_t=0 / PP)) is equal to 104/100 = 1.04.

Unfortunately (for the Seller), the value of the securities falls to GBP 80 ten days after entry into the Repurchase Transaction.  This creates “Transaction Exposure” for the Buyer as it no longer has sufficient collateral to cover the ‘loan’.

How would the Buyer and the Seller adjust the transaction so as to eliminate the Buyer’s “Transaction Exposure”?

In order to keep things simple, we will ignore the fact that the “Repurchase Price” increases over time (in other words that ‘interest’ accrues on the ‘loan’).  Obviously, this would not happen in reality.

Paragraph 4(l)(ii) of the 2011 GMRA tells us that the market value of the securities underlying the Replacement Transaction on the Adjustment Date must be substantially equal to the Repurchase Price under the Original Transaction (on the same date) multiplied by the Margin Ratio applicable to the Original Transaction.  In other words:

MV_RT,AD ≈ RP_OT,AD * MR_OT

In simple terms, this translates as meaning that the value of the ‘collateral’ posted in relation to the “Replacement Transaction” has to be basically equal to the total amount of the ‘loan’ made under the original transaction (together with accrued interest) increased by the ‘collateral buffer’ which the Buyer and the Seller had agreed in relation to the original trade.  In order to achieve this equilibrium, the parties adjust the amount of securities (i.e. collateral) posted in order to meet the outstanding amount of the loan (plus collateral buffer).

Substituting the values we know into this equation we see that:

MV_RT,AD ≈ RP_OT,AD * MR_OT

MV_RT,AD ≈ 100 * 1.04

MV_RT,AD ≈ £104

Because the value of the collateral is currently only GBP 80, this would mean that the Seller would have to transfer an additional GBP 24 worth of collateral to the Buyer.  In reality, the Seller would have to transfer somewhat more than GBP 24 in order to take account of accrued interest (which would have increased the Repurchase Price) but we have agreed to ignore that for current purposes.

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