5 Things You Need To Know About The Recent Repo Market
November 11, 2019
Written by Linda Richardson
“Turmoil in the repo market…”
Probably, news somehow like this has hit the headlines in our country! But what exactly is the repo market?
Well, repo is the short term for repurchase agreements. A repo means when one party lends out cash in exchange for the approximate value of securities, usually Treasury notes. A repo market refers to the transactions that amount to short-term collateralized loans, usually at midnight! The Wall Street companies and banks offer US Treasuries and other high-quality securities as collateral to raise cash to finance their trading and lending activities. The repo market holds up much of the financial system of our country. Thereby, it helps the banks of our country to have sufficient liquidity to meet their day-to-day operational needs and maintain appropriate reserves.
And it has been working fine! You might be surprised to know that more than about $3 trillion in debt being financed every day.
Repo allows big investments like mutual funds to make money by briefly lending cash that would have otherwise sit idle. The benefits of compound interest enable banks and broker-dealers to get needed financing by loaning out securities they hold in return.
But there was chaos in the repo market in September 2019. Here are some of the important things you need to know:
Last month, the repo market hit a pothole with a big shortage of cash. The Federal Reserve had to intervene with an immediate $75 billion liquidity injection. A Bank of America estimate shows that the Fed will have to undertake $400 billion more bailout by purchasing bonds from the banks over the next year.
In case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back at a slightly higher price. That small difference in the price is known as the implicit overnight interest rate. You might know that repos are usually used to raise short-term capital. They are also a common tool of central bank open market operations.
But as the Fed sought to tighten monetary policy, its post-crisis balance sheet required reverse repos and paying interest on excess reserves to manage the increase in short-term rates.
But what is reverse repo?
It is the purchase of the securities with an agreement to sell them off at a higher price on a specific date in the future. So, for the party who is selling the security, it is a repo. And for the party on the other end of the transaction, it is reverse repo.
Federal Reserve Chair Jerome Powell said that the central bank would use temporary open market repo operations for the foreseeable future. But he declined to say whether or not a permanent standing repo facility would be deployed in the future to backstop the market.
No doubt, the cash injection by the Fed calmed the markets. And eventually, it brought down the rates around 2% by September 2019. The following week, the New York Federal Reserve Bank started extending these temporary loans for more than one day. This was made by the “term operations” and provided a schedule of their future repo plans through October 2019.
What happened during the financial crisis of 2008 was that most big banks were gambling with high amounts of subprime mortgage bonds and credit default swaps. These toxic assets were used as collateral for repo loans. At that time 2.0% was the target FFR (Fractional Flow Reserve) or what financial companies were supposed to charge each other for overnight lending in the repo market. The intraday repo rates ranged from 0.01% to 7% on September 15th, 2008, showing that the repo market was not just broken, but shattered. On the contrary, on September 17th, 2019, the effective FFR (repo rate) closed that day at 2.3%! And it’s 5 basis points above the Fed’s target range. For a very short time, the intraday repo rate hit as high as 4%. But the Fed stepped in with $75 billion in bond buying from financial institutions, to stabilize the repo market which settled down the next day.
For the time being people should expect future moments of strain in repo markets. The slight rate difference might edge the banks to rethink their reserves policy. And the Fed may have to intervene with injections of liquidity, as it did recently.
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Written by Linda Richardson