Repo Market: What It Is and Recent Developments Within
An oft-overlooked cornerstone of the financial system, the repo market, is in fact largely responsible for financial market stability and accounts for more than a trillion dollars in transactions daily. Given its important cornerstone status in the market, observers should be concerned to see the repo market manifesting red flags.
The repo market, repo being short for repurchase, allows big investors such as financial institutions to gain access to short-term loans. For example, a mutual fund such as Fidelity Investments may be sitting on a huge pile of cash and looking for a way to invest it. On the other hand, a hedge fund is sitting on government securities and needs a fair chunk of change rather quickly. The hedge fund would enter into a repurchase agreement whereby they would offer Fidelity treasury securities as collateral and Fidelity would extend them the cash (Adrian, Begalle, Copeland, & Martin, 2013). Ultimately though, the hedge fund will need to rebuy their securities at a higher price and typically within a day. The compensation for the party lending the cash is based on the federal funds rate which is the rate at which banks lend reserve balances to one another in the short-term, typically overnight. This process happens daily, and usually without a hitch. The last time the repo market faced trouble was in the days leading up to the 2008 crisis. The ensuing subprime credit crunch brought the repo market to a screeching halt due to apprehension towards the collateralization of loans with mortgages (Gorton & Metrick, 2009). As we will see later, the federal funds rate can be very high sometimes. For this reason, repo agreements are not always the best way to secure short-term liquidity.
As mentioned earlier, treasury securities are involved in a repo transaction. Therefore, it shouldn’t surprise you that the Federal Reserve has a presence in the repo market. However, most don’t know just how prevalent that presence is. In fact, the Federal Reserve utilizes monetary policy as a mechanism for manipulating the federal funds rate when necessary, thus affecting the repo market. Recently, this interest rate skyrocketed past the desired rate of 2%-2.25%, up to roughly 10%. The Fed has been steadily increasing the size of their balance sheet since the financial crisis, but up until a few years ago, they began to downsize it. As it turns out, they sold more bonds than they probably should have and reduced the amount of excess reserves that banking institutions have. Typically, if the Federal Reserve is selling bonds, it is a sign of confidence and economic strength. In this case though, it created a problem within the repo market because excess reserves, which is the cash that is lent out, fell below a sustainable level making short-term loans expensive.
To resolve the liquidity squeeze and to lower interest rates, the Fed elected to temporarily inject cash to the tune of hundreds of billions of dollars into the banking sector to allow business to proceed as usual. There are concerns that should short term interest rates rise when the health of the financial system is not as strong as it is today, the effects may be more dramatic. The reason for this is the following: multiple large lending institutions, such as JP Morgan Chase & Co. and Bank of America Corp., have an obligation to cooperate with the Federal Reserve when they wish to conduct open market operations. In the most recent case, the recent cash injection by the Federal Reserve is expected to be distributed by these lending institutions in order to quench the thirst of repo market participants. Due to the nature of the system, smaller firms seeking short term loans are at the mercy of larger institutions. A potential risk at hand is that, in times of market turmoil, these large institutions can potentially serve their own needs with the additional cash provided first before attempting to help others. This would inevitably cause short-term interest rates to rise, which could place smaller businesses at risk.
As of late, the Federal Reserve has been exploring their options for preventing another credit crunch. The immediate issue is to prevent short-term rates from skyrocketing suddenly as they did on September 19th. Initially, the Fed injected capital into the financial sector, as well as lowered the interest earned on excess reserves to incentivize banking institutions to lend out cash. This was not enough to mitigate the risk, therefore the Fed has recently decided to expand their balance sheet through open market operations. Thinking long-term, the Fed is considering how to best reduce the chance of credit crunch in the future without needing to interfere. The most popular option, which is referred to as a standing overnight repo facility, is to designate a specific amount of cash that will be lent out to market participants at a set interest rate. In the event that demand exceeds supply again, it is important that a plan is in place.
Interestingly enough, turmoil within the repo markets have once again raised the question of how regulated financial institutions should be. After the 2008 financial crisis, regulators enacted the Basel III accord which mandated that financial institutions maintain a certain level of liquidity which would act as a buffer during times of economic distress. While these liquidity constraints were put in place as a safeguard, they arguably prevented some major players who have the means, and in this case a vested interest as well, to stifle the surge in short-term rates.
Citations:
https://www.nytimes.com/2019/09/18/business/fed-repo-rates.html
https://www.wsj.com/articles/big-banks-loom-over-fed-repo-efforts-11569490202
Repo and Securities Lending: Tobias Adrian, Brian Begalle, Adam Copeland, and Antoine Martin Federal Reserve Bank of New York Staff Reports, no. 529 December 2011; revised February 2013 JEL classification: G10, G20
Gary B. Gorton & Andrew Metrick, 2009. "Securitized Banking and the Run on Repo," NBER Working Papers 15223, National Bureau of Economic Research, Inc.
