The Repo Market’s a Mess. (What’s the Repo Market?)

(Bloomberg) -- When plumbing works well, you don’t need to think about it. That’s usually the case with a vital but obscure part of the financial system known as the repo market, where vast amounts of cash and collateral are swapped every day. But when it springs a leak, as it did in mid-September, it rivets the attention of the U.S. Federal Reserve, the nation’s largest banks, money-market funds, corporations and other big investors. It even gets airtime on National Public Radio. The Fed calmed things down by pumping in billions of dollars, but it may have a lot more work to do on the pipes -- and a lot more money to lay out.

1. What’s the repo market?

It’s where piles of cash and pools of securities meet, resulting in more than $3 trillion in debt being financed each day. Repo is short for repurchase agreements, transactions that amount to collateralized short-term loans, often made overnight. Repo deals let big investors -- such as mutual funds -- make money by briefly lending cash that might otherwise sit idle, and enable banks and broker-dealers to get needed financing by loaning out securities they hold in return. A healthy repo market is more than the world’s biggest pawn shop: It helps a wide range of other transactions go more smoothly -- including trading in the over $16 trillion U.S. Treasury market.

2. How is the Fed involved in it?

In a number of ways. For years, central banks around the globe have used their own repo markets to temporarily extend credit in tight markets, stabilize financing costs and guide interest rates. Many things have changed in the repo market since it melted down in September 2008, a crucial part of that year’s financial panic. Since then, the Fed has worked with other regulators to curb risk-taking and bolster liquidity requirements as a way of preventing a recurrence. And since 2013, the Fed has entered the repo market on a large scale, using transactions there to put a floor under rates.

3. What happened?

In the week of Sept. 16, a lot of cash flowed out of the repo pipes just as more securities were flowing in -- meaning that suddenly there wasn’t enough cash for those who needed it. That mismatch drove overnight repo rates to 10% on Sept. 17, from about 2% the week before. More alarming for the Fed was the way volatility in the repo market pushed the effective federal funds rate to 2.30%, above the 2.25% upper limit of the Fed’s target range -- just as the Fed was preparing to drop that ceiling to 2%.

4. Why did that all happen?

In one view, different events that acted as catalysts just happened to land at the same time and push in the same direction. A big swath of new Treasury debt settled into the marketplace, landing on dealers’ balance sheets just as cash was being sucked out by quarterly tax payments companies needed to send to the government. Many also say the weight of post-crisis regulations served to slow banks from adding more cash by jumping in to grab the windfall of higher repo rates. Researchers at the Bank for International Settlements, a kind of central bank for central banks, suggest there are deeper structural issues related to the concentration of repo activity among the top four U.S. banks and the fact that their portfolios of high-quality liquid assets are skewed more toward Treasuries relative to reserves. Analysts also pointed to the increasing use of the Treasury repo market by hedge funds.

5. What did the Fed do?

In its first direct injection of cash to the banking sector since the financial crisis, it laid out as much as $75 billion a day in temporary cash over four days to quell the funding crunch and push the effective fed funds rate down. In what are known as overnight system repos, the Fed lent cash to primary dealers against Treasury securities or other collateral.

6. Was that enough?

It did calm the markets, eventually bringing the rates down around 2% by Sept. 19. The following week, the Federal Reserve Bank of New York began extending these temporary loans for beyond one day, in what is known as a term operations, and provided a set schedule of their future repo plans. It has since beefed up its overnight operations and continued to offer swaths of longer-term repo funding. The central bank went on in October to buy Treasury bills from the marketplace, as a method to more permanently add reserves to the banking system. Those actions have quelled the mayhem yet market participants are wary issues will reappear at year-end and other key times when banks curtail repo lending due to regulatory-related balance sheet constraints. To prevent trouble around Dec. 31, 2019, the Fed is willing to inject up to half a trillion dollars of liquidity. But many strategists, economists and some former Fed officials have voiced the belief that the turmoil is a sign of larger problems that may require regulatory changes.

7. What do they think is wrong?

To some, one factor is that the rules regulators imposed to make the market safer led dealers to pull back on their involvement, reducing overall liquidity. And many think these distortions will continue as long as government spending and Treasury’s debt issuance continues to rise. But the broadest view is that the financial system has run low on bank reserves -- excess money that banks park at the Fed -- and that the current repo turmoil is a sign that the banking system lacks the buffers markets need in times of stress.

8. What does that mean?

It could mean that bank reserves, which top $1 trillion, still don’t amount to having enough money in the system. The Fed has been buying $60 billion of Treasury bills per month and has said that they will continue “at least into the second quarter” of 2020. Chairman Jerome Powell has repeatedly maintained these purchases of securities are not a resumption of quantitative easing, meant to support the broader economy, but are just to better control its policy rate.

9. And what does that mean?

As with any corporation, the Fed’s assets and liabilities must balance. As well as bank reserves, its main liabilities come in the form of currency in circulation, which has been growing in step with the economy. To prevent that growth from squeezing reserves going forward, some strategists predict the Fed will need to keep buying Treasuries.

10. What else can the Fed do?

It did one thing at its September meeting, and other steps are being discussed. The Federal Open Market Committee has reduced the interest rate it pays on so-called excess reserves -- the cash banks park at the Fed beyond what’s needed to meet regulatory requirements -- by more than their main interest rate to help quell the money-market stresses. Lowering the IOER rate gives banks an incentive to lend out more of their money, which would keep repo under control and the effective federal funds rate within the Fed’s target range.

11. What else might the Fed do?

Many market participants want the Fed to activate a new tool, called a standing overnight repo facility, that it’s been considering. The facility would amount to a standing offer to lend a certain amount of cash to repo borrowers every day. St. Louis Fed President James Bullard says the launch of this facility would be a sensible “endgame” to prevent more bouts of extreme volatility in money markets and keep the federal funds rate in its target range.

The Reference Shelf

• QuickTakes on the repo market, Jamie Dimon’s gripe about it and the interest on excess reserves rate.
• A Bloomberg News article on warnings of a shortage of bank reserves.
• A Federal Reserve Bank of St. Louis paper, “Interest Rate Control Is More Complicated Than You Thought.”
• The BIS linked the repo blow up to big banks and hedge funds.

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net;Alexandra Harris in New York at aharris48@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, John O'Neil, Nick Baker

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