These last months have been characterized by an increasing importance of the role of the Repurchase Agreements in the financial markets. The rate linked to it has never been this fundamental thus attracting the attention of the entire financial world. Much attention was attributed to the unprecedented spike of Repo rates in September. Market participants are now constantly looking at central bank’s moves and trends in order to understand the wealth of markets. Central banks around the world, and the Federal Reserve (Fed) in particular, planned to double Repo intervention to avoid cash crunch in response to concerns of a jump in short-term borrowing costs. In September 2019, the interest rate for the overnight money market jumped to 10%. Banks were not inclined to lend out capital for the Fed’s target interest rate of 2%. Therefore, the Fed answered to the cash crunch by financing the Repos, which gave the 2% interest on these short-term loans in order to bring the interest rate down and to pump the cash into the market.
- Introduction to the REPO market
The Repo (repurchase agreement) is a money market instrument set by central banks that concerns one party – usually banks – lending out cash in exchange for an equivalent value of securities. This market helps companies which own a lot of securities but are short on cash to cheaply borrow money. More technically, the Repo (Repurchase Agreement) is a type of short-term borrowing for dealers in government securities, which involves a dealer selling government securities to investors, on an overnight basis, and buying them back the following day at a higher price. This requires one party lending out cash in exchange for the same value of securities as collateral. The exchange permits the party that own securities to borrow cheap cash and the other party to earn a small amount of interest while taking negligible risk. The differential in the price is the overnight interest rate (repo rate). The longer the term of the repo, the highest probability that the collateral securities’ value will fluctuate before the repurchase and the business activities will impact the repurchases ability to fulfill the contract. Therefore, the counterparty credit risk is the primary risk involved in repos; in loans the creditor bears the risk that the debtor will not repay the principal, but repos as collateralized debt reduce total debt. These agreements are beneficial for both parties as the repo price is bigger than the value of the collateral.
There are different types of repos. The most common agreement is the third-party repo in which a clearing agent manages the transactions between the buyer and the seller protecting both interests. The clearing banks hold and value the securities and ensures the seller receives the cash and the buyer transfers funds and deliver the securities at maturation. However, the clearing banks do not know act neither as matchmakers nor as brokers. The third-party repos account for more than 90% of the Repo market, which held approximately $1.8 trillion in 2016.
Another type is the specialized delivery repo which requires a bond guarantee at the beginning of the transaction and upon maturity. The last type of repo is the held-in-custody one in which the seller receives cash holding it in a custodial account for the buyer.
Central banks repurchase securities from private banks at a discounted rate which is known as repo rate, which is set by the central banks themselves. This allows governments to control the money supply in the economy managing funds. If repo rates decrease, the banks are encouraged to sell securities to the government in exchange for cash, which in turn increases the money supply, while an increase in the repo rates discourage banks in reselling securities decreasing the money supply in the general economy.
Its increasing importance is given to the fact that the Repo is used to raise short-term capital, facilitates central bank operations and ensures liquidity in the secondary debt market increasing money supply available in the market. Moreover, hedge funds borrow cash in the repo market to fund leveraged investments on a cost-efficient basis and also borrow securities to allow them to take on short positions stopping asset bubbles from developing. This is important for injecting market liquidity and driving price through arbitrage and trading. Investors also borrow securities in the repo market to sell short to hedge their investments against the movements in securities prices.
- REPO rates September spike
If we analyse Repo trading volume from October 2017 to January 2020, we see an increase from $772bn to $1093bn, with a spike in September registering $1196bn total volume traded.
This came in an environment characterised by a decline in the importance of the Repo market, accounting from the 33% of GDP in 2008 to 17% of the GDP in September.
This is primary linked to the demand for cash that went on increasing as liquidity was needed by financial institutions. Demand for cash exceeded supply, and the Fed had to intervene through the expansion of its balance sheet.
In July, the Congress agreed to make the US Treasury borrowing more through the issuance of Treasuries, and consequently the repo market reversed as cash held by US Treasury increased.
Because of the cash crunch affecting markets, in September, Repo rates increased from 1.89% – 1.95% average rate to 10%, which was four times higher than the prior week.
The Federal Reserve responded to the turmoil by expanding its balance sheet and highly injecting liquidity in the repo market. In mid October, the FED increased the overnight repo liquidity disposal from $75bn to $120bn daily. The central banks did not only intervene in the short term but also expanded the two-week liquidity disposal for repo from $35bn to $45bn.
The purpose of this massive unconventional intervention was to backstop against unusual spikes in repo rates thus affecting global markets and cash availability.
Even though some experts saw this move by the FED as a way that could potentially be used also in the future to control interest rates, the American institution warned that this intervention will not be a frequent measure but available when needed.
- Causes of the spike
The sudden increase in rates was due to a cash crunch affecting markets, but the real rationale behind this is still unclear. Many could be the reasons, but the ones more directly related are the quarterly tax payments, the settlement of treasury debt and Liquidity Coverage Ratio rules.
Firstly, on September 16th there was the cut off for quarterly tax payments, where the money was taken from companies’ accounts and deposited in treasuries. At the same time, $78bn of treasury debt settled.
Moreover, reserves balances were lower than normal. After the Fed terminated its quantitative easing program in 2014, it tried to shrink the system’s reserves to a normalized level – minimum level of reserves is estimated to be $1.2-1.3 trillion. According to data from the Fed, total reserves edge closer to these levels.
Lastly, under Basel III Regulation new balance sheet requirement arose, as the LCR Liquidity Coverage Ratio rule – requiring to hold a buffer of liquid assets – keeping either reserves or cash availability high for the central bank at all times in order to keep banks solvent. After the 2008 financial crisis, central banks started to require higher reserves in order to decrease risk of default and avoid Fed intervention.
- Alternative: Foreign exchange derivatives
Even though liquidity has been restored and injected in the market, some experts claim that the FED intervention through repo rates adjustment did not calm the Money Market because some liquidity has been taken from the FX swaps market.
A foreign exchange derivative – also known as FX swap – consists in an exchange of currency between two parties that have long or short positions in different currencies. The agreement consists of swapping principal and interest payments on a loan made in one currency for principal and interest payments of a loan of equal value in another currency. One party borrows currency from a second party as it simultaneously lends another currency to that party. In 2008, the Federal Reserve System made this particular swap available to emerging countries.
In the case of the United States, FX swaps contracts allow a non-US entity to exchange non-dollar cash flows for dollar cash flows. As written by Claudio Borio, Robert McCauley and Patrick McGuire “A key finding is that non-banks outside the US owe large sums of dollars through these instruments. The total is of a size similar to, and probably exceeding, the $10.7tn of on balance-sheet dollar debt.”
FX swaps are technically equivalent to borrowing and lending in the cash market with the difference that they do not appear on the balance sheet and their existence stays unknown by outsiders.
If we look at the numbers, the dollar repo in earlier november was at 190 bps, T-bills at 150 bps and ¥/$ FX swap at 230 bps for a synthetic yen-dollar repo. In this scenario, dealers and brokers have an incentive in terms of return to lend dollars in the FX swap market rather than the domestic money market.
- How FED is going to intervene in the Money Market in the future
The FED tried to increase reserves in the banking system and intervene on liquidity shortages also through $60bn monthly purchases of Treasury bills from mid-October.
The overnight lending facility injection by the FED further expanded in December, as repo rates and volatility in general usually increase at the end of the year. Investors and analysts feared a repetition of the 10% spike of September, but thanks to a massive FED intervention, markets did not panic and rates were under control. On December 31, the US Central Bank provided $25.6bn in overnight funding with maturities throughout January.
This intervention was prompt and successful, the liquidity is still circulating in the markets and this shows that the central bank could effectively manipulate liquidity injections readily available for financial institutions and players when needed.
The Fed is currently trying to decrease its intervention on the repo market but still wants to keep rates low to avoid spikes in rates as happened in September.
At the beginning of February the New York Federal Reserve decreased the marginal cost of funding from 1.60% to 1.59%, it was surprising to see how heavily market participants reacted to this news, showing a highly sensitive demand from market participants that submitted $59bn in bids for the central bank’s offering.
It is known that the demand for short-term funding remains high in the market but the central banks has clear the willingness to cut the size of its interventions. A new plan has been published by the Federal Reserve lowering the overnight lending facility from $120bn to $100bn and the two-week facility from $30bn to $25bn to go back to March 2019 supply levels.
What is coming next? The problem now is that the Repo market has been distorted via the central bank’s interventions and in the future, new rate jumps could happen.
Authors: Elena Paparcone and Arianna Brasiliani