Hi All,
More than happy to join you!
I am a new member of this awesome forum, currently working as a Trade Support since graduated master study in 2014. Before coming to US in 2013, I worked in Asia on a FX Spot desk.
Regarding to the subject:
As far as I know, repo/Security Lending facilitates liquidity, price discovery as well as short selling.
However, I am quite confused about the key decisive factor for this type of trading desk to generate profit.
Could any of you tell me what's this type of traders' profit pattern?
Are they simply generating profit via the rate spreads by following the securities lending cycle?
Or they actually need to take risks, such as Reverse repo side can sell the collateral then buy back on maturity, profit via the decline in the collateral's marketprice?
I am really confused. Thank you very much in advanced!
interested
It's just like any trading...
If you're very junior and/or risk-averse, you collect the spread, et voila. If you're senior and/or confident, you can take risk.
I'll try to explain without going into too much detail... repo trading can be divided into cash driven and collateral driven. You can think of cash driven as basically funding the firm (GCF). Based on what you wrote, it seems like you're interested in hearing more about collateral driven (specials) trading so I'll talk a little about that. I'm going to assume you know what it means when something is trading "special".
I'd say there are two ways to make money in this type of trading...
You cover your firms shorts (reverse in) and lend out its longs (repo) at a better level than the market. For example if something is trading GCF (not special), and you're able to lend it out at a special level, then you'll make that spread, vice versa.
Like Martinghoul said, any other type of trading .You want to buy in cheap (reverse) and sell rich (repo). For example, If you think the on-the-run 10yr will trade more special tomorrow, then you might want to take a position by reversing it in before it does. Let's say you think that there will be less supply and short demand will increase for some reason. Then tomorrow when it does trade more special, you lend it out. Again, you make the spread but this time you're handling more risk. If your view is wrong, all of a sudden your stuck with the 10yr at an awful rate which would hit your P&L. You anticipate what you think the supply and demand of a security will be, just like anything else.
This is an awesome explanation!!
Yes. I am quite excited about trading repo/securities lending based on my market sense of the underlying collateral's demand. some further questions I'd like to discuss?:
1) For those collateral driven repo, traders profit from the spread in market-making borrowing rate and lending rate. this is for sure. However, a number of banks they have a specific portfolio created for lending, thus reduce the repo traders' borrowing cost. Does this type of portfolio's P+L belong to the repo trader's book? or This type of portfolio is usually hedged perfectly... I m lacking of hands on experience.... tks!!
2) Second question about the potential to be a top repo trader. I was wondering what kind of market sense should they have compared to the trader on a specific fixed income desk (eg. RMBS)' Does repo traders actually must know more about the market demands on a wider range of securities? but not focused on the quantitative pricing? Is the RMBS traders' work much more quantitative? more volatility betting? thus more profit/loss potential??
Much appreciate it!
1) Not sure what you mean by specific portfolio, but viewed as a Treasury function the repo desk's primary goal is to lend collateral to borrow cash cheaply, i.e. borrow cash against collateral at as low of a rate as possible. One strategy is to purchase term GC collateral at relatively high rates and lend collateral at relatively low overnight rates. P+L from such activities is generally attributed to the repo desk.
2) Govt repo traders generally do not need to know market demands on a wider range of securities. Obviously knowledge of the Treasury bond market is helpful when trading Treasury repo, but a rudimentary understanding probably suffices. The key point is that the supply/demand for US Treasury collateral is not the same as supply/demand for US Treasury notes/bonds. For every buyer of a bond, there is a seller - roughly speaking, what is crucial to the collateral (repo) market is how many bond buyers need to fund longs (supply in repo) and how many bond sellers need to cover shorts (demand in repo). This usually means that technical factors, rather than fundamental factors, are crucial in driving cash market to repo market relationships. This is especially important for specials trading, which to a large degree follow the auction cycle closely.
Repo pricing is not that quantitative, it's a linear product. Simple breakeven analysis (most of which you can do in your head) usually suffices for many trades.
MBS is generally much more quantitative, it's a nonlinear and more complicated product. Part of this is due to embedded optionality, which is usually modeled separately. This embedded vol is often important for valuation, but for trading purposes can be tied to more useful forms, e.g. OAS. That said funding is a crucial part of MBS trading as well - most directly, structures such as dollar roll or inverse floaters are economically very similar to a repo transaction.
Regarding profitability, it depends partly on the environment, but buying GC term collateral and funding overnights is a well-known consistently profitable strategy (this however depends critically on access to cheap funding, e.g. via money funds), whereas specials trading can really be hit or miss. For one, it's a bit unnatural to completely divorce the two activities, since the goal in both is the same, and any specific issues that don't really trade special are presumably funded via GC. But that's exactly the problem, most issues don't trade special; in fact, most Treasury on-the-runs haven't traded that special this year. Unless you're trading Treasury repo at 10 AM (it's well known the market dives in liquidity/dept after the first 1-2 hours), bid-offers for on-the-runs have been fairly narrow this year, and o/n vol has been low. Thus, selling to the refunding date and covering short in o/n has been the better strategy, but the risk/reward isn't considerably attractive. I won't elaborate much on why this is the case, but some of the same factors that have pushed interdealer GC above unsecured funding rates have probably also weighed in on specific issues. 2014 was a much different environment, and a good specials trader could've made a good chunk of change (actually you just had to realize the market was not internalizing the depth of the short-base, especially in the front-end).
I think specials trading, if done properly, can teach you a reasonable amount about how basic carry trades work. It also exposes you to basic relative value in the cash market. But it's also a rather narrow area. To me, a firm understanding of how GC is priced and how GC relates to other short-term interest rates, ultimately goes a longer way in understanding the role of repo in the context of fixed-income markets (which, if you use that knowledge correctly, makes you a better trader).
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