Let’s cut to the quick: there are currently no true repo markets in East Africa!
In Kenya, Rwanda, Tanzania and Uganda, there is an interbank instrument called a ‘horizontal repo’ (as opposed to the ‘vertical repo’, which is an instrument between commercial banks and the central bank in each of those countries). In Burundi, there is the ‘pension livrée’ (the French name for repo). In Ethiopia and Malawi, there is nothing as yet.
However, neither horizontal repo nor pension livrée are true repos, that is, neither is secured by the transfer of title to collateral by means of a true sale. Horizontal repo appear to be secured by a pledge, under which possession of collateral is given to the collateral-taker/cash lender but legal ownership remains with the collateral-giver/cash borrower. As there is no sale of collateral in a pledge, horizontal repos do not allow the collateral-taker/cash lender to re-use the collateral. And any coupons, dividends or other income on the collateral are paid directly to the collateral-givers/cash borrowers.
Most central banks in East Africa have published or plan to publish master repurchase agreements (MRAs) for their horizontal repo markets. These are based on the cross-border Global Master Repurchase Agreement or GMRA (Kenya), the domestic US Master Repurchase Agreement or MRA (Burundi, Malawi and Uganda) or both (Tanzania).
However, the GMRA is designed to document title transfer repo. It is therefore not suitable for pledge-based horizontal repo.
The MRA may look more appropriate, given that US repo is also pledge-based. However, US repo only works because solutions have been implemented to overcome the key shortcomings of pledging as a means of giving collateral, namely, stays on enforcement and no automatic use of collateral unless and until the collateral-giver/cash borrower defaults. A stay on enforcement is a delay imposed by bankruptcy law on the ability of a collateral-taker/cash lender to dispose of collateral following the insolvency of the collateral-giver/cash borrower. It means the collateral-taker/cash lender has to be able to ride out the loss from a default. The restriction which prevents a collateral-taker/cash lender from automatically selling his collateral means that the collateral-taker/cash lender cannot re-sell the collateral to refinance himself during the term of a transaction in the event of an unexpected liquidity need or to cover a short position.
In the US, the shortcomings of pledging have been overcome by: (1) a statutory exemption from the Bankruptcy Code (called a ‘safe harbor’) for repo and other instruments; and (2) a special contractual provision in the MRA which gives the collateral-taker/cash lender the right to re-use collateral. Such remedies are absent in East Africa, which means that the MRA is no more suitable as a template for the documentation of East African horizontal repo than the GMRA.
Consequently, all the master agreements that have been published or proposed in East Africa are inconsistent with the instruments they are supposed to be documenting. It is possible therefore that a court would reject the documents as shams and set aside collateral-takers/cash lenders’ claims to collateral.
The answer for East Africa is not to change the documentation. Rather, it is the instrument that needs to be changed. Loans secured by pledges should be replaced by title transfer repos. Title transfer is a much more desirable way of conveying collateral. Ownership gives the collateral-taker/cash lender full control over his collateral, as well as the ability to re-sell the collateral at any time during a transaction. Title transfer collateral therefore provides a stronger hedge against credit risk than pledging and also hedges liquidity risk. The superiority of title transfer transactions such as repo over secured loans is recognised under the Basel regime by more favourable capital treatment. The size of risk-weighted assets (RWA) is a direct function of the transaction type. Traditional Credit Products such as secured loans have RWAs which are many multiples of Repo-Style products.
Title transfer is also simpler. In a pledge, collateral-takers have to ‘perfect’ their security interest in the collateral in order that their right will be recognised by an insolvency court. Perfection requires the performance of a range of often intricate formalities. Getting perfection wrong means the loss of collateral. The only formality required for title transfer is delivery.
Moreover, laws on security interests and perfection requirements differ between jurisdictions, which makes cross-border pledging riskier. In contrast, title transfer is a uniform means of conveying collateral, making it a surer basis for the regional financial integration to which East Africa aspires.
Pledging is also subject to doubts about the feasibility of netting offsetting obligations. A master agreement for title transfer repo transactions is a single contract, which reinforces the right to net mutual obligations documented under the agreement. But pledges tend to be separate agreements (eg the Chinese NAFMII master agreement), in order to avoid the need to perfect existing pledges every time a new one is executed or extinguished , something which would introduce more uncertainty.
Unfortunately, title transfer is not a free option and would require some investment. While title transfer is generally a better legal basis for conveying collateral than pledging, the fact that true repos are combinations of immediate and future transfers of title can cause legal confusion. The problem stems from the fact that, by committing to repurchase collateral in the future at a fixed price, the seller takes back the risk and return on collateral (eg if the price of collateral falls during a repo, the seller is committed to repurchase at a price fixed at the start of the transaction, so he would suffer the loss, even though the buyer is the legal owner). This means a repo functions like a secured loan. But this might lead an inexperienced court to conclude that repo not only had the economic character of a secured loan but also the legal character, In this case, the buyer’s rights to the collateral would then probably be set aside due to the fact he had not perfected his rights.
This ‘re-characterisation risk’ to repo is higher in jurisdictions with under-developed financial law and even more so where the legal framework is restricted by out-dated civil codes. It can also be increased by the use of repurchase transactions. This type of repo employs margining and manufactured payments and envisage the possibility of substitution of collateral. Margining can make repo look like a pledge-based margin loan. And, where a civil code only expressly envisages collateral-giving by pledge, it may be that margins, being free-of-payment, would be judged to be pledges, which may colour the court’s view of the nature of the underlying repo. Manufactured payments could be taken to imply that income on collateral is being passed to the seller, which would mean he was the owner. And any substitution of collateral could be seen as incompatible with the idea of a sale of title.
The adoption of true repo in East African countries therefore needs to be investigated by seeking legal opinions in each country about the degree of re-characterisation risk. Should these raise any doubt about title transfer, a repo law might be needed. Or it might be possible to circumvent the problems caused by margining, manufactured payments and substitution by using documented sell/buy-backs. This type of repo replaces margining and substitution with an early termination and replacement mechanism, and manufactured payments with deduction from the repurchase price.
The legal certainty of repo would also be enhanced by robust written contracts setting out, in clear and unambiguous language, the terms and conditions of transactions, and the rights and obligations of the parties. Use of the GMRA would also help lay the foundations for the regional and global integration of local markets in East Africa, and would benefit from some thirty year’s of experience.
But, even if the fact that repo involves a sale and repurchase does not cause problems in law or can be overcome using documented sell/buy-backs and robust legal agreements, there is another potential obstacle to true repo that needs to be anticipated. Will the sale and repurchase legs of a repo be treated as disposals for the purpose of capital gains tax (possibly a problem in Kenya, Rwanda and Uganda)? And would manufactured payments be taxed as normal income? Both types of tax would kill the repo market at birth by making transactions uneconomic.
There is also the question of whether netting would work after the insolvency of a repo counterparty. Legal uncertainties exist in all countries in the region, reflecting their under-developed financial law frameworks. Netting is essential, both for individual repos (to set off cash lent to a defaulter against collateral received, and vice versa) and across repo books (to set off the net exposures of individual repos against each other). The problem is that netting can be seen as giving preference to parties such as banks, who tend to have lots of two-way obligations, at the expense of other creditors who don’t, whereas bankruptcy laws try to ensure equal treatment for all creditors. Netting is therefore another issue to considered in legal opinions.
Finally, there are some cultural issues. Currently, in East Africa (but also in other regions), collateral is stigmatized. It is seen as a sign of weakness to borrow against collateral. For this reason, repo rates are often higher than unsecured deposit rates (eg Burundi, Kenya, Tanzania and Uganda). To normalise the role of collateral, it is essential that repos receive preferential capital treatment from local regulators in line with Basel.