The Repo Market
Over here are investors with cash that’s not doing anything profitable at the moment. Over there are banks with tons of bonds and a need for ready money. The so-called repo market is where the two sides meet. Repurchase agreements make up an essential, if esoteric, piece of financial plumbing. By providing a place where assets can be pawned for short-term loans, a healthy repo market helps a wide range of other transactions go more smoothly. But a repo meltdown was a crucial part of the financial panic in September 2008, and the U.S. Federal Reserve and other regulators are still working on ways to reduce the dangers. To many market participants, the changes may be creating new pitfalls. At the same time, the Fed entered the repo market on a massive scale, using it as a tool to guide interest rates higher. A lot is riding on how well the plumbing works.
The new regulations have put pressure on banks to hold onto their safest assets, like Treasuries, rather than lend them out. That’s left money-market mutual funds and other repo investors struggling at times to find enough borrowers for their cash. The size of the global repo market has fallen by 49 percent since its peak in 2008. That means the Fed, which has purchased $2.5 trillion worth of Treasuries since the financial crisis, will likely become the U.S. market’s dominant player, at least temporarily. Unlike banks, it didn’t jump in because it needed overnight cash. Its goal is to drive up interest rates that have stood close to zero since 2008. Those years of easy money have left so much cash sloshing around that the Fed’s traditional interest-rate tools aren’t likely to work by themselves. So it has begun wading into the repo market daily, offering to borrow cash from money-market funds and other big investors at a higher rate than banks have been paying. Banks that want to borrow from the money-market funds will have to pay more in interest to compete. The central bank, which started testing this so-called reverse repo program in 2013, hopes that rising interest rates on the repo market will ripple through the entire financial system.
Repo and reverse repo transactions are formally purchases but function as collateralized loans. One party buys an asset from another, who promises to buy it back at a higher price, often the next day; the markup is equivalent to the interest rate on the loan. (Reverse just means that the transaction is initiated by the bond-holder rather than the investor with cash.) The repo market in the U.S. dates from 1917, but has grown significantly since the 1980s. Central banks around the globe have used their own repo markets to extend credit in tight markets, stabilize financing costs and guide interest rates. Repo deals let investors make money on cash that might otherwise sit idle, and enable banks and broker dealers to put the securities they hold to work without having to sell them. The free flow of what amounts to temporary ownership of collateral makes markets more liquid, as the bonds that change hands in repo deals can then be used to facilitate other transactions. For years, repo seemed safe, because every transaction was backed by collateral. Then Lehman Brothers went under when repo investors, worried that it might become insolvent, stopped rolling over its loans.
That kind of systemic risk still worries Fed officials, since a default by a repo dealer might force money funds to dump securities quickly in a so-called fire sale that could drag down markets more broadly. In addition to bolstering capital requirements, some policy makers think the ultimate solution could be a move to a central clearinghouse system. Some market participants respond that the squeeze on repos has contributed to the outsized swings in debt markets seen in the summer and fall of 2015, while Citigroup reported its most profitable year in recent memory in the repo market. Others say the Fed’s repo program amounts to a giveaway to money-market funds and hedge funds. There are also worries that the Fed program could make market drops worse by giving investors a safe alternative to lending to banks in times of stress.
The Reference Shelf
- An overview of the U.S. repo market by the Federal Reserve Bank of New York.
- The International Capital Markets Association has a FAQ on the repo market.
- A Brookings Institution explainer on how the Fed plans to make interest rates go up, include its use of reverse repo.
- An in-depth feature by the New York Times on the same subject.
- And Bloomberg’s Tracy Alloway contributes a musical analysis with The Ballad of the Repo Trader.
First published Nov. 12, 2015
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John O'Neil at firstname.lastname@example.org