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Explanator: The Fed has a repo problem. What is that?

By on March 11, 2021 0

(Reuters) – As if the U.S. Federal Reserve didn’t already have enough on its plate for this week’s interest rate meeting, the chaos in the pipes of the U.S. financial system has thrown politicians into an unexpected turn.

The liquidity available to banks for their short-term financing needs practically dried up earlier this week and interest rates in US money markets rose by up to 10% for some overnight loans, more than four times the rate of the US money market. Fed.

This forced the Fed to carry out an emergency injection of more than $ 125 billion in the past two days, its first major market intervention since the financial crisis over a decade ago, to prevent loan costs from escalating further. Although the effort restored some measure of order in the short-term bank lending market, it was not enough to stop the Fed’s benchmark lending rate from rising Tuesday above the expected range of 2.00% to 2. 25%.

The exact cause of the squeeze is a matter of debate, but most market participants agree that two random events on Monday were at least partly to blame. First, companies had to withdraw funds from money market accounts to pay quarterly taxes, and on the same day the banks and investors who bought the $ 78 billion worth of US Treasury bills and bonds sold by Uncle Sam the last week they had to settle down.

Additionally, the reserves that banks park at the Fed and are often made available to other banks overnight are at their lowest since 2011 thanks to the central bank’s tearing down of its vast bond portfolio in recent years.

Taken together, these factors are testing the limits of the $ 2.2 trillion repo market, a gray but essential component of the US financial system.

Whatever the cause, the episode added fuel to the argument that the Fed must take steps to avoid further disruption in the repo market along the way.

(GRAPH – US repo rate:)

WHY IS THE REPO MARKET IMPORTANT?

The repo market underpins much of the US financial system, helping to ensure banks have the liquidity they need to meet their day-to-day operational needs and maintain sufficient reserves.

In a repo operation, Wall Street companies and banks offer US Treasuries and other high-quality securities as collateral to raise money, often overnight, to fund their trading and lending activities. The next day, borrowers repay their loans plus what is typically a nominal interest rate and get their bonds back. In other words, they repurchase, or repo, the bonds.

The system typically buzzes along with the interest rate charged on repurchase agreements hovering close to the Fed’s overnight benchmark rate, which it cut Wednesday to 1.75% to 2.00%, from 2.00 % to 2.25%.

FILE PHOTO: The Federal Reserve Board building on Constitution Avenue is pictured in Washington, USA, March 19, 2019. REUTERS / Leah Millis / File Photo

But when investors are afraid of lending, as seen during the global credit crisis, or when there are not enough reserves or liquidity in the system to lend, the repo rate rises above the Fed Funds rate.

Trading stocks and bonds can get difficult. It can also reduce lending to businesses and consumers, and if the hiatus is prolonged it can become a drag on a US economy that is heavily reliant on credit flow.

WHAT CAUSED THE DECREASE IN BANK RESERVES?

Coming out of the financial crisis, after the Fed cut interest rates to near zero and bought more than $ 3.5 trillion in bonds, banks have accumulated huge reserves held with the Fed.

But that level of bank reserves, which peaked at nearly $ 2.8 trillion, began to decline when the Fed began raising interest rates in late 2015. They fell even faster when the Fed began. to cut the size of its bond portfolio about two years later.

The Fed stopped raising interest rates last year and cut them in July and again on Wednesday. It has now also stopped allowing bonds to come out of its balance sheet.

The question that haunts politicians now is whether these actions are enough to stop the downward drift in reserves, which are a major source of liquidity in funding markets such as repo.

Bank reserves at the Fed stood at $ 1.47 trillion, the lowest level since 2011 and nearly 50% below the peak five years ago.

(GRAPH – Excess bank reserves held at the Fed:)

WHAT CAN THE FED DO TO CALM THE REPO MARKET?

1. PERFORM REPO SPOT OPERATIONS

Through the Federal Reserve Bank of New York, the Fed can conduct occasional repurchase agreements in times of financial stress, allowing banks and dealers to trade their Treasuries and other high-quality securities for cash at a minimal interest rate. . He did this on Tuesday and Wednesday.

2. LOWER INTEREST PAID ON EXCESS RESERVES

By making it less profitable for banks, especially foreign ones, to leave their reserves at the Fed, it could encourage banks to lend to each other on the money markets.

3. CREATE A PERMANENT REPO STRUCTURE

This permanent funding program will allow eligible participants to exchange their bonds for cash at a predetermined interest rate.

The Fed and its staff have considered such a structure, but have not determined who qualifies, what the level of interest paid, and the timeline for a possible launch would be.

4. ACCELERATE THE PURCHASE OF TREASURES

The Fed can replenish the level of bank reserves by slightly increasing its holdings of US public debt. This carries the risk that it may be perceived as a resurrection of quantitative easing rather than a technical adjustment.

WHAT HAS THE FED DONE?

The central bank lowered interest rates on excess reserves by 30 basis points, to 1.80%. The rate is now 20 basis points below the top of the target range, up from 15 basis points previously.

It also set the offer rate in the repurchase agreement market at 1.70%, five basis points below the minimum of the new target range for the policy rate.

Reporting by Richard Leong; Additional reporting by Ann Saphir; Editing by Dan Burns, Richard Borsuk and Chris Reese

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