By Jack McCabe and Alison Touhey
The repo market experienced increased volatility last week. Borrowing costs jumped, starting Monday, Sept. 16, indicating that there was more demand for cash than participants were willing to lend. The repo rate typically sits within the federal funds rate target range, but it spiked to over 7 percent. Consequently, this led to the effective federal funds rate breaching the upper end of the target range on Tuesday, Sept. 17. This article provides background on the repo market and explains what last week’s market turmoil means for banks.
What is a repurchase agreement?
A repurchase agreement is an overnight transaction in which one party simultaneously sells a security and agrees to repurchase the security at a fixed price on a specific future date. The security is exchanged for cash, plus interest paid when the transaction is unwound. Repos are used to source both cash and securities. Typically, “repo” describes the transaction from the cash borrower’s perspective, while a “reverse repo” describes the transaction from the cash lender’s perspective. Because repos are secured, they are considered relatively low-risk. Accordingly, they are often less expensive than other money market instruments.
Why is the repo market important?
The repo market is a key piece of financial plumbing, facilitating the flow of cash and securities around the global financial system. For cash holders (e.g., money market funds, insurers and pension funds) repos offer a safe place to park their cash and earn interest. For cash borrowers (e.g., hedge funds, banks and broker-dealers) the repo market offers a source of cash. Broker-dealers finance their securities portfolios with repos and act as intermediaries so they are both cash lenders and cash borrowers.
What caused the recent imbalance?
Uncertain, and explanations are still preliminary. There are many complex and varied drivers of the repo market, including the global demand for cash, the supply/demand for safe-haven assets, foreign exchange market dynamics, and the foreign demand for dollars.
How do the post-crisis regulatory framework and monetary policy affect the repo markets?
Post-crisis liquidity and capital regulations have made it more expensive for banking organizations to engage in repos. Additionally, banking organization balance sheets are less flexible, so they are less able to step in and act as intermediaries between cash lenders and cash borrowers.
The liquidity coverage ratio requires that banks hold high quality liquid assets against expected liquidity needs during stress periods. A significant amount of HQLA is held as reserves on the Fed’s balance sheet, taking money out of the market and limiting the Fed’s ability to reduce its balance sheet (reserves are liabilities on the Fed’s books, for which it must have corresponding assets).
Repos are one of several options for investing cash overnight. The cost and return of a repo transaction is relative to the cost and return of other overnight investments, including the fed funds rate and interest on excess reserves paid by the Fed to banks, which are key monetary policy tools used by the Fed. The Federal Reserve was in the process of shrinking its balance sheet, which puts treasury securities into the market and absorbs cash, thereby shrinking reserves.
Did these rules affect banks’ ability to meet cash demands?
A confluence of market events increased the demand for cash. Sept. 15 was a deadline for paying corporate taxes, leading to $35 billion being pulled out of money market funds, while Treasury deposited tax receipts in its account at the Fed, further draining reserves (Treasury’s general account and reserves are both liabilities on the Fed’s balance sheet, so the increase in the TGA decreases reserves all else being equal).
The settlement of Treasury securities—$54 billion—increased the demand for cash in the repo market from primary dealers. Meanwhile, analysts also noted that Saudi Arabia repatriated billions of dollars to support rebuilding efforts to their oil infrastructure, contributing to the repo market turbulence.
Banks did not step in to meet the increased demand, in part because they are constrained by the level of reserves and other HQLA they need to hold to be in compliance with the LCR. Additionally, the capital rules—such as the leverage ratio and the GSIB surcharge—mean that they have limited balance sheet space to hold additional Treasury securities.
What was the Fed’s response?
The Fed acted to respond to the tight market by injecting cash through the repo market. The New York Fed, which conducts open market operations, intervened in money markets for the first time in a decade by offering up to $75 billion in overnight funding. Banks and investors used $53 billion of the short-term cash on Tuesday, $75 billion on Wednesday (requests totaled over $80 billion, greater than the $75 billion max the New York Fed placed on offer), $75 billion on Thursday, and $75 billion again on Friday. These actions helped the repo rate come back down to within the fed funds rate target range, settling around 1.95 percent, while the effective fed funds rate sat at 1.90 percent on Sept. 19. The Fed announced that it would continue to offer up to $75 billion in overnight funding daily through October 10.
At the Federal Open Market Committee meeting on Sept. 18, the committee voted to lower the interest paid on required reserves and excess reserves to 1.80 percent, aiming to add more cash to the markets by incentivizing banks to lend in overnight market.
What happens from here?
There may not be a crunch as severe as what occurred this week, but because of the limits on liquidity, this may continue to be a problem. The Fed has a few options on the table:
- Modify the capital and liquidity requirements to allow banks and affiliated broker dealers to step in as intermediaries in times of stress.
- Continue to provide support to money markets in the manner it has done so this week, particularly in anticipation of tax payments, quarter end cash needs and government debt financing. Prior to 2008, this was standard practice for the Fed as it operated a corridor (reserve-scarce) system. The Bank of Canada currently operates this way.
- Further lower the interest rate paid on excess reserves to help prevent the fed funds rate from moving outside the target range.
- Begin to grow its balance sheet again in an organic (non-Quantitative Easing) fashion, which would increase the amount of reserves available in the system.
- Provide a longer-term fix in the form of a standing repo facility, where the Fed would lend against Treasuries or other securities at a rate above the market and the fed funds target. This would ensure the money markets have the funding they need and prevent rates from moving upward. The Fed has recently been discussing this option.
Jack McCabe is an economic research specialist at ABA. Alison Touhey is VP for bank funding policy at ABA.