General Collateral and Special
Any repo trade will fall into one of two categories:
a. The dealer owns securities and lends (repos) them to raise cash. The borrower of security is indifferent as to which specific securities (collateral) it receives, provided they meet pre-agreed quality criteria. This is called a general collateral (GC) trade. The cash, and not the security, is driving the trade.
b. The dealer needs a specific security, and borrows (reverses) it in order to settle its short position. The lender of security lends (repos) the security out against borrowing cash at a rate usually below prevalent money market rates. Since the trade is driven by the need to borrow a specific security, it is known as a 'specials' trade.
The difference between GC and the specials rate is called the repo advantage. The size of the repo advantage generally reflects the imbalance between borrowers and lenders. For certain securities, it is possible for the special rate to be negative. Negative repo rates arise because the fee for borrowing a particular security has risen above prevailing interest rates. But in most markets a combination of psychology and system limitations means that the special rate rarely drops below zero. Thus the potential repo advantage is higher when funding rates themselves are high.
Turning Special
A bond becomes special when it is in unusually high demand, and there are relatively few bondholders willing or able to lend it out. Frequently, special bonds are current benchmark bonds, which because of their liquidity, dealers sell short in order to hedge long inventory positions of similar maturity bonds. Other reasons why individual issues may be specials include the following:
- Failures to deliver
- Issue is deliverable to a futures contract
- An existing issue is to be re-opened
- High liquidity and maintaining benchmark status
- Squeeze in the repo market
- A corporate action on the issue
In repo-ing out a special to a dealer, the bondholder will receive cash for the term of the repo at a below market rate of interest. This cash can then be reinvested at market rates for the same period - in bank deposits, by buying short-term money market instruments, in a reverse GC repo or in some other vehicle. This results in an incremental net cash income at the end of the repo term.
