Repo Market – Love Thinking about Finance, Market Microstructure and Money View

By Elham Saeidinezhad

“A person often meets his destiny on the road he took to avoid it.” Jean De La Fontaine

The shift in the provision of financial intermediation away from traditional banks towards the shadow banking system highlights the evolving structure of the financial market. The recent disorder in the short-term repo market has created new openings for money managers. Money managers, such as money market funds and investment funds, are hoarding unusually large amounts of cash in anticipation of the excessive demand for liquidity on December 31st. In doing so, they are planning to serve both as the primary cash providers and the lender of near last resort in the repo market. Traditionally, the latter is the role that the large banks are inclined to have in the repo market. This shift in market structure from banking to shadow banking system seems to be the unintended consequence of the Fed’s tapering and regulatory requirements. It is also no accident that the change in the investment strategy of money managers coincides with the unwillingness of the large banks to borrow from the discount window of the Fed. This reluctance by banks cost the financial system the recent turmoil in the overnight lending market in September. The repo market experiment at the end of December, where money managers are preparing to take over the banks’ role, will be a real-world stress test of this new system.

In this piece, we focus on three factors that derive these changes in the market structure. These forces include Basel III regulatory requirements, Fed’s tapering, and the reluctance of banks to use the discount window to prevent the run on them. Post-crisis macroprudential requirements demand banks to keep a certain level of High-Quality Liquid Assets (HQLA) such as reserves. For example, JPMorgan Chase keeps about $120 billion in reserves at the Fed and will not let it dip below $60 billion on any given day. These requirements reduced banks’ ability to be intermediaries between the Fed and other players. Further, the Fed’s tapering that involved the reduction of the Fed asset purchases reduced the amounts of reserves in the banking system. These factors constrained banks’ ability to provide cash in the repo market during September turbulences. Meanwhile, although the amounts of reserves in the system have shrunk, banks are reluctant to use the Fed’s credit facilities, including the discount window. The Global Financial Crisis has only worsened the stigma attached to using the discount loan for at least two reasons: first, the Dodd-Frank requires the name of the banks that borrow from the discount window to be released. Second, banks are worried that borrowing money from the Fed spur a run on these institutions.

Soon, the resilience of the most critical market for short-term borrowing will be tested when stress hits the system under a new condition. In this unique situation, when there is excessive demand for the cash, both the primary provider of funding liquidity and the lender of near last resort will be shadow banking system, who does not have the Fed’s backstop, rather than the large banks, who do. Perry Mehrling defines shadow banking as the money market funding of capital market lending. In this system, money market funds are primary providers of the funding liquidity. These funds are plotting to seize the new opportunity of becoming the lender of near last resort in December mostly because the large banks did not intervene when the repo rates hiked in September. The main question that remains to be answered is whether this new system will survive extensive pressure. After all, the bolstered role of shadow banking in the repo market is an unintended, rather than planned, consequences of post-crisis macroeconomic and regulatory changes.

Discussion Questions:

Which regulatory requirements have constrained the ability of the banks to lend to the repo market?
What does the lender of near last resort mean?
Who are the main players in the shadow banking system?

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By Elham Saeidinezhad

“The secret of change is to focus all of your energy not on fighting the old, but on building the new” -Socrates

If the Fed’s understanding of the existing problems in the repo market is weak or incomplete, it might attempt to solve the wrong problems, and then implement the wrong solution. Financial participants and the Fed alike are trying to comprehend what triggered the short-term rates in the repo market to rise to 10 percent overnight from nearly 2 percent in September. The “liquidity shortage” that was created by the inaction of large banks to lend cash in the face of the excessive liquidity demands on that day is marked as one of the “triggers.” Since then, the Fed is seeking to tackle the liquidity shortage by lending cash to eligible banks and offering its own repo trades at target rates. Most recently, for example, the Federal Reserve Bank of New York injected $68.343 billion to the financial market on Friday, November 15^th, in the form of repurchase agreements.

These large banks are intermediaries between the Fed and the rest of the system, and the idea is that they will re-lend this money in the repo market. Nonetheless, while the Fed is weighing the recent “triggering” stories, it might be approaching the issue with a wrong perspective. What we saw in the repo market in September has been a tragedy in the making as a result of both the Fed’s own “Tapering” that started in 2013 and the post-Crisis Basel III regulatory framework. The former reduced the number of reserves in the system while the latter put a strain on the balance sheets of the large banks and dampened their ability to lend to the market. Under these conditions, when the liquidity needs are higher than usual, the securities dealers, who are the main demanders of cash in the repo market, face a liquidity crunch. In the process, they put upward pressure on repo rates. The problem is that the Fed tends to overlook the balance sheet constraints that the banks face when examining the current developments in the wholesale money market. Once taking balance sheet restrictions into account, a more structural solution might involve opening the Fed’s balance sheets to the securities dealers.

To elaborate on this point, let us start by understanding the relationship between the interbank lending market and the repo market. The cash-rich lenders in the repo market are mostly hedge funds and other wholesale money managers, while the demanders for cash are securities dealers. The securities dealers use the repo market to finance their securities holdings while providing market-liquidity. Whenever the demand for cash is higher than its supply, banks enter the repo market to fill the gap by expanding their own balance sheet. Before the financial crisis, the banks used to finance these operations by using the Fed’s intraday credit facility and then settle these payments overnight by borrowing from other banks. After the crisis, banks stopped using these credit facilities to avoid being penalized by regulators. Regulatory requirements such as Liquidity Coverage Ratio (LCR), which requires banks to hold high-quality liquid assets, mostly reserves, limits the ability of large banks to engage in such operations due to the higher costs imposed on their balance sheets.

At the same time, the Fed’s Tapering reduced the number of reserves that these large banks are holding as a whole. The combination of these factors reduced banks’ ability to enter the repo market and lend on margin whenever there is a shortage of liquidity. In these circumstances, it should not be surprising that these banks did not seize the arbitrage opportunity when the shock hit the repo market in September even though they seem to be rich in reserves. The Fed’s tendency to discount the balance sheet limitations that the banks face when studying the current events in the repo market might prove to be costly. The Fed’s “taper tantrum” has reduced the number of reserves in the system while the regulations have created balance sheets constraints for large banks, who are the lender of the near-last resort in the repo market. These balance sheet restrictions lead to liquidity problems for the rest of the system and especially the dealers.

In a market-based economy, where the price of capital and collateral depends on the state of market-liquidity, the survival of the financial market depends on well-functioning securities dealers. These dealers create market-liquidity by financing their securities position in the repo market. Therefore, if the securities dealers’ access to the funding-liquidity becomes uncertain or very expensive at times, it might endanger the whole financial system. To sum up, given the recent structural changes in the financial ecosystem and banks’ business models, it might be time for the Fed to think about more structural solutions, such as opening its balance sheet directly to the securities dealers. After all, it is not accidental that the Fed’s continuous liquidity injections have not been entirely successful in stabilizing the repo market considering that the large banks have minimal balance sheet space to channel these reserves.

Discussion Questions:

What was the main source of financing for large banks before the financial crisis? Did it change after the crisis?
Why do Basel III regulatory requirements want banks to hold more liquid assets?

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