Explaining the Repo Market and Its Mess
To begin with, repo is short for repurchase agreements, meaning agreements to obtain short-term lending from other parties. By short-term, this usually means overnight transactions, i.e. when you get a loan today to finance some short-term lack of liquidity, and you repay it tomorrow. Naturally, repos do not necessarily have to be overnight, even if most are. Still, almost 99% of the repo market uses maturities of less than a month.
The repo market does not rely only on bona fide. Most of these loans are collateralized, meaning that the loan-takers offer some sort of guarantee for the loan they seek to obtain. This collateral is usually Treasury bills, even though other types of assets are also used. Repo deals let big investors - such as investment funds - make money by briefly lending cash, and enable banks and broker-dealers to get needed financing by loaning out securities they hold in return.
Naturally, in such a big market, central banks are also key players. This is especially true for the US, where the Fed uses the repo market to stabilize financing costs and guide interest rates, by either purchasing or selling. Back in 2015, the Fed actually removed the daily limit on aggregate borrowings through its overnight reverse repurchase facility, previously set at $300 billion, in a step designed to make sure the benchmark interest rate stays inside its new target range.
While the repo market usually behaves as it supposed to do, In the week of September 16, a lot of cash flowed out of the repo market, as more securities were flowing in. In other words, people were very willing to offer their holdings as collateral, but there wasn’t enough cash to cover their needs. That mismatch drove overnight repo rates to 10% on September 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%.
To ease the pressures, the Fed laid out as much as $75 billion a day in temporary loans over four days, in order to 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. The move calmed the repo market and 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.
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. To prevent trouble around Dec. 31, 2019, the Fed is willing to inject up to half a trillion dollars of liquidity. As the figure below shows, total support from the Fed rose to more than $300 billion in December.
The big question is what has caused this shortage in short-term cash and the subsequent spike in repo rates? Some believe that the level of excess reserves in the banking sector appears to be low; however, it still remains at very high levels, standing at $1.4 trillion in November. By comparison, excess reserves stood at just $5 billion until 2008, and the repo market functioned quite smoothly. Another potential explanation is that investors are more willing to hold onto bonds instead of moving to riskier investments which deprives them of liquidity in exchange for (at least some) return. Furthermore, the constant increase in US government debt adds increases the supply of bonds in the repo market.
A more intriguing reason for the repo lack of liquidity would be the liquidity regulations imposed on banks after the 2008 crisis. According to JP Morgan's CEO Jamie Dimon, the bank was unable to deploy cash to calm the market due to these regulations. At the moment, the Fed is considering how to create a standing repo facility where eligible banks would be able to convert Treasuries into reserves on demand. Also, the lack of "daylight overdrafts", i.e. being forced to close gaps with the Fed as these occur and not at the end of the day as it used to be, could also be linked to more pronounced swings in their reserves during the day. Still, as critics comment, the big banks still have a lot of space to maneuver before they get worried about liquidity. Furthermore, had banks wished, they could have also used the reverse repo facility at the Fed.
So what is the reason? Apparently, nobody has any idea yet. It could be a c