Fully Closed Repo - The Trade Every U.S. Treasury Bond Holder Should Know About.

Maximizing Returns: Strategies to Enhance Your U.S. Treasury Portfolio

By Lewis Goldman

Do you know what time it is?  It’s time to learn about “Fully Closed Repo”.  The following pages dissect the steps, attributes, benefits, and risk characteristics of engaging in a decades-old trade known as “Fully Closed Repo”.  This article also compares the stark differences between executing a Fully Closed Repo against the traditional securities lending methodology of U.S. Treasuries. To begin, I pose the following questions: Wouldn’t you like to enhance your U.S. Treasury Portfolio while at the same time engaging in a portfolio strategy that is a safer alternative where the risks justify the rewards compared to securities lending? Where your income enhancement is on 100% of your portfolio and not a fraction of your portfolio?  Where enhancement is guaranteed and paid upfront rather than on a best-efforts basis offered by today’s securities lending firms? Where you’re always in possession of your portfolio and all aspects of U.S. Treasury ownership such as safety and liquidity remain intact? Where there is no possibility of counterparty default or cash collateral reinvestment risk? Where there is no need for indemnification because all securities have been returned in a simultaneous identical offsetting repo transaction closing the repo loop?  The following pages describe how executing Fully Closed Repo transactions offers current short-dated U.S. Treasury owners all of the above.  Portfolio managers have to ask themselves, why am I not aware of this strategy and why am I not executing Fully Closed Repo transaction already?

As stewards entrusted with safeguarding entity assets, it's paramount for treasurers, chief investment officers, portfolio managers, advisors, and securities lending agents to explore avenues that optimize portfolio returns while mitigating risks. Enter Fully Closed Repo transactions – a financial tool that promises substantial benefits without subjecting portfolios to counterparty or cash collateral reinvestment risks or any reduction in safety and liquidity.

AgentLenderPLUS, a leading proprietary trading firm, champions the concept of Fully Closed Repo transactions, presenting them as a lucrative opportunity for portfolio enhancement. The essence of this strategy lies in the simultaneous buying and selling of identical offsetting repurchase agreements, using the same securities and for the same term (see graph below). What distinguishes Fully Closed Repo transactions is their ability to generate significant annual securities lending-like revenue while portfolio managers maintain control over their portfolio absent of the risks found in securities lending transactions.

The allure of Fully Closed Repo transactions is evident in their simplicity and risk-elimination features. Risk officers recognize the stark contrast between the counterparty risks associated with "Open Repo" transactions and the virtually nonexistent risks of “Fully Closed Repo” transactions. While "Open Repo" transactions leave counterparties vulnerable to default and liquidity concerns, “Fully Closed Repo” transactions offer a closed-loop solution, ensuring all responsibilities are fulfilled without exposing portfolios to undue risks.

Let's delve into the mechanics of Fully Closed Repo transactions. At the time of trade settlement, the trade involves executing paired-off identical repo buy and repo sell transactions with AgentLenderPLUS. This simultaneous transaction ensures that all obligations under the repo agreement are satisfied, eliminating the possibility of counterparty default. By engaging in Fully Closed Repo transactions, investors eliminate counterparty risk because all securities are returned due to the identical pair-off nature of the trade. This ensures the portfolio owner retains legal ownership of their portfolio throughout the transaction. Most importantly, no securities or cash move from the custodial account at trade inception or trade termination, ensuring portfolio integrity.

AgentLenderPLUS incentivizes portfolio owners by offering a 12-basis point premium annually for engaging in Fully Closed Repo transactions on U.S. Treasury portfolios maturing under 24 months. This enhancement is received upfront at the time of execution, providing an immediate boost to portfolio returns. This upfront payment serves as compensation for allowing equal yield collateral substitutions that maintain the portfolio's Weighted Average Maturity (WAM) within a 5-day range. Moreover, AgentLenderPLUS assumes all financial and counterparty risks associated with the trade, providing peace of mind to portfolio owners.

Example Trade Mechanics using a $1 billion Treasury portfolio and 12 basis points yield enhancement.

The counterparty receiving 12 basis points yield enhancement simultaneously Sells a $1 billion Treasury repo @ 5.0% and Buys back the same $1 billion Repo from the counterparty paying the yield enhancement @ 5.12%. Because the portfolio sale and buyback are done simultaneously under a repo agreement the trade is “paired off”, so the portfolio owned by the counterparty receiving the 12 basis points yield enhancement doesn’t move. Only the net money difference moves from the counterparty paying yield enhancement to the counterparty receiving yield enhancement.

The graphic below illustrates our $1 billion trade example. The only thing that moves on day one is $100,000 from the counterparty paying yield enhancement to the counterparty receiving yield enhancement which is the first month's prorated amount of 0.12% (12 bps) annual yield enhancement. (0.12% * $1 billion = $1,200,000 annual yield enhancement divided by 12 = $100,000).  In this example, the counterparty receiving yield enhancement will receive $100,000 per month for as long as they continue to participate in this trade.

The counterparty receiving the yield enhancement can terminate at any time and keep the yield enhancement they have earned up until the point of termination.  In our example, if the counterparty receiving the yield enhancement terminated the repo after 3 months, the receiving counterparty would have earned $300,000 (3 x $100,000) in yield enhancement.  If the receiving counterparty continued in the repo for 12 months, then she/he would earn the full yield enhancement of 12 basis points which in this example would be $1,200,000. 

Example of Collateral Substitution:

While investors grant AgentLenderPLUS unlimited rights to make collateral substitutions, these substitutions are strictly regulated to ensure that the WAM of the portfolio remains within a 5-day window. This allows for flexibility while safeguarding the integrity of the portfolio structure. Investors have the flexibility to terminate the yield enhancement trade at any time, allowing them to capture the accrued enhancement up until the point of termination. This flexibility ensures that investors can adapt to changing market conditions or investment strategies as needed.

Terminating the yield enhancement trade:

When the counterparty who is receiving the yield enhancement wants to opt out of the trade, they need to legally own the new portfolio that has been created because of collateral substitutions, keeping in mind, that the WAM of this new portfolio is bound to a plus or minus 5 day differential from the original portfolio WAM. 

Since collateral substitutions are not buys and sells under a repo agreement the counterparty receiving the yield enhancement owns his/her original portfolio and since they received their original bonds back at the inception of the Fully Closed Repo transaction the portfolio can only change with each collateral substitution that takes place.  If at month end the portfolio is different than at trade inception both counterparties will execute one final portfolio trade that gives the counterparty who has been receiving yield enhancement legal ownership of the new portfolio (see illustration of final trade below).

The counterparty who was receiving yield enhancement started with portfolio “A”, and we substituted for portfolio “B”. 

The counterparty who was receiving yield enhancement still owns portfolio “A”, but they are holding “B”.

We must execute a portfolio trade so the counterparty who has been receiving the yield enhancement can legally own portfolio “B”.  Portfolio “B” is substantially the same and functionally equivalent to portfolio “A” because its WAM can only be up to 5 days shorter or longer than the original portfolio “A”.

The counterparty who was paying yield enhancement must sell portfolio “B” to the counterparty who was receiving yield enhancement and the counterparty who was paying the yield enhancement must buy portfolio “A”.

The counterparty who has been receiving the yield enhancement must sell portfolio “A” and buy portfolio “B” at even yield.

The value proposition of Fully Closed Repo transactions lies in its ability to enhance returns, eliminate risk, and provide a seamless and controlled investment process. AgentLenderPLUS's willingness to pay the yield enhancement upfront underscores their confidence in the trade's profitability and benefits for both parties.

Breaking down the steps and logic for current U.S. Treasury securities owners who engage in Fully Closed Repo:

·         By buying and selling identical offsetting repurchase agreements with AgentLenderPLUS, U.S. Treasury owners pick up an additional 12 basis points in annualized yield, find themselves still in possession of all their securities, and due to the paired-off nature of the transaction, their securities and cash remain in their custodial account.

 ·         The above bullet point raises the question as to why AgentLenderPLUS would be willing to pay 12 basis points per annum to execute a trade that puts the U.S. Treasury owner right back where they started.  There are several reasons, but the main reason is that AgentLenderPLUS wants the right to make unlimited collateral substitutions under the repo agreement while not subjecting the U.S. Treasury owner to counterparty risk. Remember, counterparty risk is eliminated by the fact that AgentLenderPLUS returned all the securities to the portfolio owner when they and their counterparty executed back-to-back identical offsetting repos. The only step left, after returning the securities on the settlement date, is whether or not a collateral substitution took place. If none took place, AgentLenderPLUS lost 12 basis points. And conversely, the U.S. Treasury portfolio owner enhanced their holdings by the same 12 basis points.

 ·         AgentLenderPLUS, as a proprietary trading firm, makes their revenue by executing spread trades based on supply and demand factors and they look to take advantage of pricing inefficiencies when they occur. By offering 12 basis points, AgentLenderPLUS locks in a fixed cost to access those securities of yours via collateral substitution without the need or reliance upon dealer firms who post-credit-crisis no longer want to grant access to their balance sheet. Through collateral substitutions (which are non-accounting events) AgentLenderPLUS can set shorts, cover shorts, or set long positions in their portfolio, with the expectation that their spread trading revenue will exceed 12 basis points plus operating expenses.   

·         Many portfolio managers of 2-year or shorter maturity U.S. Treasury securities do not spend their time actively trading their portfolio because they own these securities for safety and liquidity reasons and the time and resources needed to move the yield needle like AgentLenderPLUS does is tedious. AgentLenderPLUS moves the needle for their Fully Closed Repo trade counterparts by paying 12 basis points on 100% of the securities used in the trade. 

·         As mentioned above, AgentLenderPLUS is paying 12 basis points upfront for the right to make collateral substitutions under the repo agreement. However, they can only do so if the WAM differential stays within a plus or minus 5-day window from its original settled WAM. For example, if your U.S. Treasury portfolio WAM is 90-days when the Fully Closed Repo trade is executed, then the minimum and maximum WAM range over the life of the trade is 85 to 95 days respectively (excluding daily time decay). The 5-day WAM differential is de minimus in value and should be viewed as an opportunity cost versus risk. 

·         Portfolio owners who engage in Fully Closed Repo never sacrifice the liquidity or safety of their portfolio as their securities, or substituted securities are always held in the portfolio owners' custodian account and portfolio owners can always terminate their Fully Closed Repo transaction at will.    

Securities Lending and Fully Closed Repo: The transition from traditional securities lending practices to a model that embraces "Fully Closed Repo", addresses many of the concerns that arose in the aftermath of the 2008 financial crisis. The shift is especially pertinent when considering the lending of U.S. Treasury securities, a market that historically offered investors and financial institutions a way to generate additional revenue with perceived low risk. However, the crisis exposed significant flaws in the securities lending ecosystem, leading to a reevaluation of risk and rewards. In this context, comparing the Fully Closed Repo transaction to traditional securities lending practices illuminates the path forward for real cash buyers and holders of U.S. Treasury securities.

Traditional Securities Lending Challenges: The traditional securities lending model was predicated on the notion that lending out securities, such as U.S. Treasuries, could provide additional income with minimal risk. This model, however, faced several issues: 

Risk Mismanagement: The belief that adding income through securities lending was without risk proved dangerously optimistic. The 2008 financial crisis highlighted how practices such as leveraging the portfolio or investing in high-risk securities (e.g., Lehman Brothers paper or toxic derivatives) could lead to significant losses.

Liquidity and Market Impact: The withdrawal of over 80% of Treasury securities from the lending market post-2008 credit crisis indicated a severe reduction in market liquidity and underscored the systemic risks of aggressive securities lending practices.

Service Limitations: The aftermath of the crisis left securities lending agents with diminished capabilities to meet client needs, especially those looking for safe, reliable income from their Treasury holdings without compromising ownership or facing undue risk.

Fully Closed Repo Addresses the Issues: Fully Closed Repo transactions emerge as a solution to these challenges, focusing on the needs of real cash, and buy-and-hold Treasury investors. Fully Closed Repo offers several key features:

Uncompromised Ownership: Ownership of the Treasury securities is never at risk. Ownership of the securities cannot be transferred without a sale and replacement purchase taking place, addressing the primary concern of investors about losing control over their assets.

Zero Leverage: Fully Closed Repo strictly prohibits the use of portfolio leverage, eliminating the risk of amplified losses due to borrowed capital.

Market Value Protection: Fully Closed Repo aims to protect the portfolio from any value erosion, except that which is attributable to normal market fluctuations, thereby offering a safer investment environment.

High Utilization Rate: Despite the conservative approach, Fully Closed Repo maintains a utilization rate of 100% on any Treasury portfolio with securities maturing in less than 2 years, ensuring that they are generating income efficiently.

Meaningful Returns: Fully Closed Repo has no fees associated with the transaction other than the 12 basis points that is received by the portfolio owner.  Fully Closed Repo aims to deliver returns that are significant enough to be attractive to investors while being more predictable and a secure investment strategy.

Predictability and Guarantees: Unlike the traditional securities lending model, which often operates on a "best efforts" basis, Fully Closed Repo offers a more predictable outcome, with guaranteed returns.

Fully Closed Repo represents a paradigm shift in the approach to securities lending, particularly for U.S. Treasury securities. By prioritizing investor control, risk aversion, and predictable returns, it addresses the major shortcomings exposed by the financial crisis. For real cash buyers and long-term holders of Treasuries, Fully Closed Repo should restore confidence generating additional income, without the existential risks that the traditional securities lending models presented. As the financial industry continues to evolve, such innovations will be crucial in balancing the quest for returns with the imperative of risk management.

AgentLenderPLUS addresses common objections related to credit concerns, conservative biases, and an understanding of the trade mechanics. They emphasize that the risk profile of Fully Closed Repo transactions is zero compared to other enhancement options, making it an attractive choice for risk-averse investors.

AgentLenderPLUS's approach to Fully Closed Repo transactions reflects a commitment to innovation and risk elimination. By leveraging proprietary trading strategies and peer-to-peer execution, AgentLenderPLUS circumvents the limitations of traditional banking channels, offering portfolio owners a safer and more efficient alternative for enhancing U.S. Treasury portfolios.

In conclusion: Fully Closed Repo transactions represent a compelling opportunity for portfolio owners seeking to maximize returns while safeguarding against risks. With its transparent and secure framework, AgentLenderPLUS's Fully Closed Repo trade emerges as a prudent choice for U.S. Treasury portfolio enhancement, offering a seamless balance of risk and reward in today's dynamic financial landscape. Fully Closed Repo transactions offer portfolio managers an attractive opportunity to optimize their investment portfolios by enhancing yields while maintaining the same level of safety and liquidity that they had prior to executing Fully Closed Repo. By understanding the mechanics and benefits of Fully Closed Repo transactions, investors can make informed decisions to maximize returns and minimize risks in today's financial landscape.

For additional information regarding “Fully Closed Repo”, please reach out to Lew Goldman at 516-223-3932 or lgoldman@AgentLenderPLUS.com