To wit, the IMF has estimated that the same collateral was reused 2.2 times in 2018, which means both the original owner plus 2.2 subsequent re-users believe they own the same collateral (often a US Treasury security). Now the repo-market turmoil has given an answer—and it is far higher than the Fed expected. Collectively, America’s commercial banks now hold $1.3trn of … The event doesn’t mean another financial meltdown is necessarily imminent—just that the risk of one is heightened—since the brush fire can be doused either by the Fed, or by the banks raising more equity capital. All Rights Reserved, This is a BETA experience. Multiple parties report that they own the very same asset, when only one of them truly does. Overnight lending rates topped at an annualized rate of 10% last week, four times higher than the prior week. The repo market is a critical resource for large businesses to get the overnight financing they need to pay taxes, make payroll, fund operations, etc. the risk-free rate); and Post was not sent - check your email addresses! The Fed has gone out of its way to say that this is not another round of quantitative easing (QE). What happened then? I can sum up why this happened in two words: central banks. But the Fed didn’t know for sure the minimum level of reserves that were “ample,” and surveys over the past year suggested reserves wouldn’t grow scarce until they fell to less than $1.2 trillion. On September 16 and 17, bid-ask spreads were higher than usual and the fed funds distribution became more dispersed as shown in Figure 3. On the flip side, the better question is why banks weren’t willing to lend against “risk-free” collateral for an 8% “risk-free” gain? That’s not the Fed’s intention this time. Now the repo-market turmoil has given an answer—and it is far higher than the Fed expected. The repo rate spiked in mid-September 2019, rising to as high as 10 percent intra-day and, … For years, IMF economist Dr. Manmohan Singh has done terrific work estimating it (see examples here, here, here, here, here, here and here). But repo rates spiked way above unsecured lending rates last week, even for “risk-free” collateral such as US Treasuries. However, it provides a “teachable moment” regarding systemic fragility and anti-fragility. As demand exceeded supply, the repo rate rose sharply. Liquidity Coverage Ratio (LCR) and Bank Internal Stress Tests. Interest rates have betrayed common sense—interest rates in the repo market should be lower than rates in unsecured markets, for example, because repos are secured by assets and thus supposedly lower-risk. Opinions expressed by Forbes Contributors are their own. Here’s what the books of three parties show when a transferee (Party A) sells pledged collateral to a third party (Party C): If you add up the positions of all parties, economically there’s no problem because the net of the two longs and one short position add up to $100. A crucial but little-known market that ordinarily hums steadily along, this week we saw a shortage of cash cause a massive spike in repo rates. What happened last week? Stepping back, it reveals two big things about financial markets: first, US Treasuries are not truly “risk-free” assets, as most consider them to be, and second, big banks are significantly undercapitalized. In light of the traditional financial system’s instability, despite all of Bitcoin’s drawbacks, I find that a powerful concept. Why is state and local employment falling faster than revenues? That trade lost someone a whopping 8% (annualized) overnight, but presumably the trade allowed the bank to stay in business for another day. But the run on repo can be stalled in one of two ways: (1) banks raise new equity capital, or (2) the Fed injects more dollars into the system. By the end of July, the repo problems made their way into the Fed’s meeting, as we learned when the minutes of that meeting were released in August. Before coronavirus turmoil hit the market, the Fed was offering $100 billion in overnight repo and $20 billion in two-week repo. That’s the fairy tale to keep everyone calm while the central banks scramble to figure out what happened. “The repo market is the market where people running leveraged positions borrow,” Stanley told MarketWatch in an interview. Bitcoin’s price is highly volatile, but as a system it is more stable. The good news is that while what happened in the repo market may sound alarming, there’s no need to worry. They recognize that what appears to be an 8% risk-free arbitrage is anything but risk-free. This was made more confusing by the complexities of the market itself. At the end of each year, international regulators measure the factors that make up the systemic score for a global systemically important bank (G-SIB), that in turn determines the G-SIB’s capital surcharge, the extra capital required above what other banks are required to hold. Federal Reserve Chair Jerome Powell and New York Fed President John Williams, in a letter to Rep. Patrick McHenry (R-NC), said the Fed will continue to review a wide range of factors, including supervisory expectations regarding internal liquidity stress tests. But how does the market for repurchase agreements actually work, and what’s going on with it? When interest rates in the overnight lending market (known as the repo market) spiked in September, there was a real fear that it was a sign of something far worse. Hutchins Center on Fiscal & Monetary Policy, The Brookings Institution. What Happened in the Fed Funds Market? I’m a 22-year Wall Street veteran who has been active in bitcoin since 2012, and whose passion is a fair and stable financial system. I jumped to blockchain to try to fix these problems, and from 2016-2018 I was chairman and president of Symbiont, an enterprise blockchain company, where I jointly spearheaded blockchain delivery of index data to Vanguard. The $1 trillion "repo market" allows banks and other financial institutions to borrow and lend from one another, usually overnight. It is now on a weekly basis offering repo at much longer terms: $500 billion for one-month repo and $500 billion for three months. banks, broker-dealers, hedge funds) to borrow cheaply and allows parties with lots of spare cash (e.g. But, as usual, the Fed will almost certainly do what it always does—stem the run by injecting cash into the system in various ways, thereby socializing losses among all US dollar holders. Given that short-term interest rates are closely linked, volatility in the repo market can easily spillover into the federal funds rate. When that same bond is reused again and again and again in similar transactions, the magnitude of double counting within the financial system builds in a manner that no one can accurately measure. An anti-fragile system is one that becomes stronger and more resilient as a result of shocks, not weaker. Bitcoin is no one’s IOU. The repo market can be split into two main segments: Bilateral Repo – The bilateral repo market has investors and collateral providers directly exchange money and securities, absent a clearing bank. In an October 2019 call with analysts, he said, “[C]ash, we believe, is required under resolution and recovery and liquidity stress testing. The LCR requires that banks hold enough liquid assets to back short-term, runnable liabilities. This is why the FT’s interview with Williams was so extraordinary. First of all, what is the Repo Market? Some fundamental questions are yet to be resolved, including the rate at which the Fed would lend, which firms (besides banks and primary dealers) would be eligible to participate, and whether the use of the facility could become stigmatized. Rather, I’m referring to the practice in the repo market that allows more people to believe they own US Treasuries than actually do. When the Fed first intervened in September 2019, it offered at least $75 billion in daily repos and $35 billion in long-term repo twice per week. What happened? Financial regulators can’t publicly admit to this, but big banks know it’s true—and that’s why they hunker down (and stop lending) when they sense one of their kin is in trouble. The financial system is fragile. Why was someone willing to borrow cash at a 10% interest rate last Tuesday, in exchange for pledging US Treasury collateral that yields only 2% or less? A new facility would “likely provide substantial assurance of control over the federal funds rate,” Fed staff told officials, whereas temporary operations would offer less precise control over short-term rates. Subsequently, it increased the size of its daily lending to $120 billion and lowered its long-term lending. There are two ways in which these purchases are different from QE: The Fed has also been conducting daily and long-term repo operations. Together, these developments suggest that digesting the increased supply of Treasuries will be a continuing challenge, with potential ramifications for both Fed balance sheet and regulatory policies.”. They found that, before the market contracted, money market funds held $2.3 trillion in assets, and about $400 billion in repos. But then they reversed course, cut rates three times, and also re … Post-crisis rules require that banks prepare recovery and resolution plans, or living wills, to describe the institutions’ strategy for an orderly resolution if they fail. That’s nonsense. He’s saying that the repo market passed through the eye of a storm due to quarterly corporate tax payments, which was the excuse for SOFR spiking over 10% on Sept. 17. The Fed has cut interest rates to near zero, is re-starting quantitative easing like it did in the 2008 Financial Crisis, and it’s actively trading in something commonly referred to as the “repo market.” But this isn’t the first time in the last year that the Fed has been working in the Repo Market. Then, on March 12, the Fed announced a huge expansion. That’s the layman’s explanation of what’s happening. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points). In a reverse repo, one party purchases securities and agrees to sell them back for a positive return at a later date, often as soon as the next day. It’s as close as a regulator will come to admitting the reality that the system doesn’t work the way most of us think it does and that the Fed may not even understand critical things about it. Holding a lot of reserves won’t push a bank over the threshold that triggers a higher surcharge; lending those reserves for Treasuries in the repo market could. The Bank for International Settlements said this month that growing reliance on the biggest U.S. banks to keep the repo market functioning may have been a big factor in September’s cash squeeze. Like for the LCR, the regulations treat reserves and Treasuries as identical for meeting liquidity needs. The repo market disruption: What happened, why, and should something be done about it? Everyone knows someone will eventually lose. The repo market is an important component of short-term funding markets and the source of financing for dealers’ holdings of Treasury bonds. Yet few observers expect the Fed to start up such a facility soon. Banks tried to hold just the minimum amount of reserves, borrowing in the federal funds market when they were a bit short and lending when they had a bit extra. “The repo market is the market where people running leveraged positions borrow,” Stanley told MarketWatch in an interview. What started in the repo market last week isn’t new—it’s actually the fourth such episode since 2008. Last week the financial system ran out of cash. The Fed said that these liquidity operations aimed to “address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.” In short, the Fed is now willing to loan what is essentially an unlimited amount of money to the markets, and uptake has fallen well below amounts offered. This is the real reason why the repo market periodically seizes up. The ‘repo market’ is a critical market within the financial system of an economy as it signals important information: about the cost of borrowing secured credit across an economy (i.e. This crisis was a sign of the endemic fragility of the interbank markets, which in reality have never recovered from the financial crisis of 2008-2009. So what really happened in September 2019 in the repo market? Specifically, the Fed’s focus on the fed funds market is misplaced because the real action is in the much bigger, much more global repo market; the Fed shouldn’t have allowed America’s big banks to pay dividends or buy back stock when they’re so capital-constrained that they can’t even pick up an 8% “risk-free” arbitrage; the Fed’s proclamation that “the financial system remains resilient,” when it released the results of the most recent bank stress tests in June 2019, strains credulity; a staggering amount of US dollar liabilities have been issued offshore in recent decades and the Fed not only doesn’t control them but can’t measure them with any degree of accuracy; and banks’ financial statements don’t accurately reflect their financial health. I bring you bitcoin/blockchain thru a 22-year Wall St. veteran's lens, EY & Citi On The Importance Of Resilience And Innovation, Impact 50: Investors Seeking Profit — And Pushing For Change, Michigan Economic Development Corporation With Forbes Insights. And most of the public doesn’t really know much about it. The whole thing is very dull and predictable. Until the last couple of years, the Fed was buying Treasury bonds under its QE monetary policy. What has the Fed done in response to the COVID-19 crisis? Auditors can’t help here, and the accounting profession bears some of the blame for this problem. The Fed’s target for the fed funds rate at the time was between 2 percent and 2.25 percent; volatility in the repo market pushed the effective federal funds rate above its target range to 2.30 percent. The closest I’ve heard a financial regulator speak publicly of this is former CFTC Chairman Chris Giancarlo, to his credit, when he answered a question after a 2016 speech: “At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another. This shift means that those purchases will likely need to be financed, at least until end investors acquire the Treasuries, and perhaps longer. Two events coincided in mid-September 2019 to increase the demand for cash: quarterly corporate taxes were due, and it was the settlement date for previously-auctioned Treasury securities. The market sprung a leak last week. The TGA has become more volatile since 2015, reflecting a decision by the Treasury to keep only enough cash to cover one week of outflows. The additional debt leaves primary dealers—Wall Street middlemen who buy the securities from the government and sell them to investors—with increasing amounts of collateral to use in the repo market. The lenders of … Prior to the global financial crisis, the Fed operated within what’s known as a “scarce reserves” framework. The repo market has nothing to do with cars or other purchases getting repossessed, but it is a crucial part of the financial system. The repurchase agreement, or “repo,” market is an obscure but important part of the financial system that has drawn increasing attention lately. And I think it’s up to the regulators to decide they want to recalibrate the kind of liquidity they expect us to keep in that account.”. The repo market blew out in mid-September. What exactly happened? I’m a 22-year Wall Street veteran who has been active in bitcoin since 2012, and whose passion is a fair and stable financial system. That money is used to pay for the … On Tuesday, September 17th and Wednesday, September 18th, the REPO market in New York experienced a short but violent crisis. It would put an effective ceiling on the short-term interest rates; no bank would borrow at a higher rate than the one they could get from the Fed directly. A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. Banks also say that government supervisors sometimes express a preference that banks hold reserves instead of Treasuries by questioning assumptions bank make when they say they could quickly sell Treasuries without a large discount at a moment of stress. The Repo market is a short term lending facility for banks, hedge funds, and other Wall Street firms. Collectively, America’s commercial banks now hold $1.3trn of … It’s unstable. This was made more confusing by the complexities of the market itself. As a result, the pre-crisis framework no longer worked, so the Fed shifted to an “ample reserves” framework with new tools – interest on excess reserves (IOER) and overnight reverse repos (ONRRP), both interest rates that the Fed sets itself – to control its key short-term interest rate. Many analysts do too. But former and current regulators point out that the LCR probably didn’t contribute to the repo market volatility because Treasury securities and reserves are treated identically for the definition of high-quality liquid assets in the regulation. Banks have some preference for reserves to Treasuries because reserves can meet significant intra-day liabilities that Treasuries cannot. The banks that need cash borrow it in the repo market from other banks at rates that are usually just a little above the Fed’s policy rate. Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”. the financial system is. This has made it harder for the Fed to estimate demand for reserves. The repo market is an important component of short-term funding markets and the source of financing for dealers’ holdings of Treasury bonds. Singh has been recommending for years that regulators’ financial stability assessments of big banks be adjusted to back out “pledged collateral, or the associated reuse of such assets.” Financial regulators should have followed his advice years ago! Jamie Dimon, chairman and chief executive of J.P. Morgan Chase, points to these restrictions as an issue. Given the crucial importance of the REPO market, it has created a real shock for the financial markets and served as an important warning for financial institutions. QE can have a powerful signaling effect, reinforcing the Fed’s words. Fed officials concluded that the dysfunction in very-short-term lending markets may have resulted from allowing its balance sheet to shrink too much and responded by announcing plans to buy about $60 billion in short-term Treasury securities per month for at least six months, essentially increasing the supply of reserves in the system. In addition, the marginal purchaser of the increased supply of Treasuries has changed. It ramped up the operations on March 9, offering $175 billion in overnight and $45 billion in two-week repo. In the repo market, financial institutions such as hedge funds and investment banks borrow cheap money from large investors such as mutual banks to fund their operations. Sorry, your blog cannot share posts by email. The borrower (hedge fund) or the dealer sells securities such as the U.S. Treasury bills as a … Shockingly, the Fed admitted to asking itself this same question, as revealed in an extraordinary interview on Friday with New York Fed President John Williams in the\Financial Times. This describes Bitcoin, whose network security grows as the system’s processing power grows. The problem arises when you aggregate the three US GAAP financial statements. I saw inaccuracies in Wall Street’s. When the Fed started to shrink its balance sheet in 2017, reserves fell faster. And therefore, we could not redeploy it into repo market, which we would’ve been happy to do. Since these increased deficits are not the result of countercyclical policies, one can anticipate continued high supply of Treasuries, absent a significant shift in fiscal policy. money market mutual funds) to earn a small return on that cash without much risk, because securities, often U.S. Treasury securities, serve as collateral. The regulatory authority responsible for the markets, the Federal Reserve of New York (FRoNY), had to stage a … In stark contrast to the traditional financial system, Bitcoin is not a debt-based system that periodically experiences bank run-like instability. Instead, it is buying assets for the sole purpose of injecting liquidity into the banking system. Far from it. The balance sheets balance because Party B records a liability, so auditors don’t catch the problem. As a result, when the Treasury receives payments, such as from corporate taxes, it is draining reserves from the banking system. US Treasuries are the core asset used by every financial institution to satisfy its capital and liquidity requirements—which means that no one really knows how big the hole is at a system-wide level. The market sprung a leak last week. What Happened Last Week in Repo? It turned out banks wanted (or felt compelled) to hold more reserves than the Fed anticipated and were unwilling to lend those reserves in the repo market, where there were a lot of people with Treasuries who wanted to use them as collateral for cash. hosted by the Hutchins Center on Fiscal & Monetary Policy on December 5, 2019. Furthermore, since the crisis, the Treasury has kept funds in the Treasury General Account (TGA) at the Federal Reserve rather than at private banks. The Fed apparently miscalculated, in part based on banks’ responses to Fed surveys. The Fed’s facility makes cash available to the primary dealers in exchange for Treasury and other government-backed securities. A repurchase agreement (repo) is a short-term secured loan: one party sells securities to another and agrees to repurchase those securities later at a higher price. This resulted in a large transfer of reserves from the financial market to the government, which created a mismatch in the demand and supply for reserves. In this regard, Bitcoin is an insurance policy against financial market instability. At a systemic level, the traditional financial system is as fragile as Bitcoin is anti-fragile. What happened? Bitcoin Value Tops Half A Trillion Dollars—Is The Bitcoin Price About To Smash $30,000? Most repos are overnight, though they can be longer. However, at the Hutchins Center event, Tarullo noted that reserves and Treasuries “are not treated as fungible in resolution planning or to meet liquidity stress tests.” As part of the post-crisis framework, banks are required to conduct their own internal liquidity stress tests, the Comprehensive Liquidity Analysis and Review (CLAR), which are subject to review by the supervisors. A significant amount of cash (supply) flowed out of the repo market just as more securities (demand) were flowing in. Join the conversation on Twitter using #RepoMarket In September, a disruption in the market in which banks and others lend and borrow for very short periods of time, the repo market… As former Fed governor Daniel Tarullo put it at the Hutchins Center event: “With the budget deficit having increased by about 50 percent in the last two years, the supply of new Treasuries that need to be absorbed by debt markets has grown enormously. But the Fed has signaled that it wants to wind down the intervention: Federal Reserve Vice Chair Richard Clarida said, “It may be appropriate to gradually transition away from active repo operations this year,” as the Fed increases the amount of money in the system via purchases of Treasury bills. So why aren’t banks falling over themselves to rake in such easy, “risk-free” profits? In January 2019, the Federal Open Market Committee – the Fed’s policy committee – confirmed that it “intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.” When the Fed stopped its asset purchasing program in 2014, the supply of excess reserves in the banking system began to shrink. Heading toward the end of the year, the demand for cash by these financial institutions increases, primarily to balance their books in order to comply with federal regulations. In the case of a repo, a dealer sells government securities to … That … The securities serve as collateral. For example, hedge funds hold a lot of assets but may need money to finance day-to-day trades, so they borrow from money market funds with lots of cash, which can earn a return without taking much risk. On average, $2 trillion to $4 trillion in repurchase agreements – collateralized short-term loans – are traded each day. Last fall, another far-less-noticed crisis occurred in that market that led the Federal Reserve to intervene. Most financial regulators baffle us with jargon when they discuss this issue, making it barely intelligible to regular folks (cloaking it in such terms as “clogged transmission mechanisms,” “length of collateral chains”). It has no lender of last resort because it doesn’t need one. The core function of the repo market is exchanging Treasury securities — in other words, government debt — for cash. Strains in the repo market that emerged on the morning of September 16 quickly spilled over to the fed funds market later that day. So what really happened in September 2019 in the repo market? The repo market is where high-quality securities are swapped daily for trillions of dollars of cash, making a wide range of transactions easier. counting of US Treasuries takes place. These rules may have led banks to hold on to reserves instead of lending them in the repo market in exchange for Treasury securities. Somebody—probably a big bank—needs cash so badly that it has been willing to pay a shockingly high cost to obtain it. The financial panic of 2007-8 stemmed from a run on the repurchase or "repo" market -- the primary source of funds for the securitized banking system -- rather than a run on monetary deposits as in earlier banking panics, according to a recent study by Gary Gorton and Andrew Metrick. An increase in the systemic score that pushes a bank into the next higher bucket would result in an increase in the capital surcharge of 50 basis points. The Repo Market. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points). … What started in the repo market last week isn’t new—it’s actually the fourth such episode since 2008. But almost no one is talking about the elephant in the room. Between 2008 and 2014, the Fed engaged in Quantitative Easing (QE) to stimulate the economy. It’s not surprising that the volume of Treasury-backed repo transactions has increased substantially in the last year and a half. Recovery and Resolution planning. This spike was unusual because the repo rate typically trades in line with the Federal Reserve’s benchmark federal funds rate at which banks lend reserves to each other overnight. Party B borrows it, showing a liability of $100 ($100 of securities sold, not yet purchased). Global SIFI surcharge. It had already briefly blown out at the end of 2018, then settled back down. Keep in mind that the repo market conducts about $1 Trillion daily in repo transactions. Banks are supposedly healthy and flush with cash, right? What does this mean for markets in the short-term? This brings us to the market on September 16, 2019. QE was designed, in part, to reduce long-term interest rates in order to encourage borrowing and economic growth and to spur more risk-taking, by driving investors into stocks and private bonds. Why does this facility exist? Amazon and Walmart have raked in billions in additional profits during the pandemic, and shared almost none of it with their workers, How misinformation is distorting COVID policies and behaviors. I hold degrees from Harvard Law School (JD, 1994), the Kennedy School of Government (MPP, 1994) and the University of Wyoming (BA, 1990). No one knows, but I doubt this is “the big one.” Sure, the repo market is flashing red sirens. When interest rates in the overnight lending market (known as the repo market) spiked in September, there was a real fear that it was a sign of something far worse. Some in financial markets are skeptical, however, because QE eased monetary policy by expanding the balance sheet, and the new purchases have the same effect. What it all means is that, while each bank’s financial statements show the bank is solvent, the financial system as a whole isn’t. Financial institutions do not want to hold cash because it is expensive—it doesn’t pay interest. What happened in the repo market in September 2019? Party A owns a particular US Treasury Bond, showing an asset of $100. It always has been. Here I distinguish between price volatility and systemic volatility. The $1 trillion "repo market" allows banks and other financial institutions to borrow and lend from one another, usually overnight. 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