Houston, We Still Have A Repo Problem…

As most readers know, the repo market crashed on 17 September. Ever since then speculation has swirled as to exactly what set it off and why it spun so quickly out of control. Answers to date have failed to get to the heart of the matter. Put another way, everyone knows there is a problem but no one has a handle on what exactly it is – let alone how to fix it.

That point was driven home during a half-day symposium on money markets last week, sponsored by the Bank Policy Institute, a bank trade group and think tank based in Washington DC. Four panels discussed potential causes of the repo flash crash and its implications for year-end:

• Tax and Treasury payments. The first panel pointed to the quarterly corporate tax payments and the fact that heavy Treasury issuance drained cash out of the system and drew down banks’ excess reserves. The panelists pointed to this in combination with other technical factors such as most repo activity occurring early in the day and a general reluctance for banks to risk borrowing from the Fed overnight or running intraday overdrafts. The panel recommended that regulators monitor the Treasury’s General Account at the Fed more closely. Finally, it forecast more volatility in repo and money markets and FX swaps as year-end approaches.

• Regulation impacts use of repo. A second panel discussed how liquidity requirements and supervisory expectations have increased the cost of repo intermediation and discouraged banks from relying on repo. Even though reserves and repo are treated equally for regulatory purposes, regulators themselves express a strong preference for liquidity in the form of reserves. But it was also apparent that there is little will to address what must by now be ‘known knowns’.

• Fed balance sheet. The third panel focused on how the Fed manages its balance sheet, agreeing that its move to increase its balance sheet by buying Treasury bills was helpful. It recommended the Fed pay more attention to the spread between repo rates and interest on excess reserves in order to determine the appropriate level of excess reserves. Further, it expressed skepticism about the Fed-proposed standing repo facility, noting that outright purchases are preferable because repo is costly to banks from a balance sheet perspective. And it also warned of year-end money market volatility.

• New SOFR benchmark issues. The last panel addressed transitioning from LIBOR to SOFR. SOFR is based on repo market transactions. The idea was that it would be transaction-based and hence not as susceptible to manipulation as LIBOR was during and after the financial crisis. The panel failed to discuss whether the technical issues dogging the repo market might make SOFR unsuitable as a benchmark, although it did discuss possible alternatives such as the Bank Yield Index proposed by ICE. The panel agreed that much work needs to be done for SOFR to gain traction with market participants and pointed to the technical and operational challenges of adopting SOFR by 31 December 2021, when LIBOR may no longer be available.

The main thrust of the symposium was that few – if any – have a clear idea of how money markets, QE, and regulation interact with each other in today’s world. The symposium highlighted issues facing markets, but the big takeaway was to expect more volatility.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)