Everything is not awesome
04 Febuary 2020
After much-unwanted drama last year, can the US repo market stay out of the spotlight in 2020?
Image: Shutterstock
The US repo market shook up Wall Street last September and since then market participants, regulators and even politicians have rushed to zero-in on the causes of the problem and produce solutions more nuanced than simply throwing money at it.
The interest rate spike – which lasted several days and peaked briefly at around 9 percent on 17 September 2019 – was a rude awakening for the New York Federal Reserve. The Fed was accused of miscalculating the consequences of the Basel III’s rules on banks’ ability to lend to each other, especially when combined with other market events, and then not acting quickly enough cap the spikes as they intensified each day in the lead-up to the end of Q3.
Once the Fed did turn on the hoses and drench the smouldering engine room of the financial markets with much-needed cash, the issues quickly died away, but concerns remained as to how the market would function at year-end, which is traditionally more volatile than a quarter-end.
The Fed’s answer was to simply stay in the market. It continued to offer cash injections in the lead-up to and over year-end to the tune of $75 billion in daily repos in September and then $35 billion in long-term repo twice per week from then on.
According to the International Capital Market Association (ICMA) report, published earlier this month, the Fed’s continued presence was successful in avoiding anything near a repeat of September over year-end.
In its report, ICMA states that the Fed’s attempts to keep bank reserves comfortably above the $1.5 trillion mark through its open market operations and bill purchases, has proved successful in stabilising money rates, and was further aided by an injection of increased liquidity over year-end.
“This also seems to have prompted a transfer of balance sheet by US banks from their European business to the US,” it notes.
With the threat of year-end now over, all those involved must now answer the questions of what the future of repo will look like and whether the traditionally out-of-sight-out-of-mind funding market will be able to stay out of the spotlight in 2020.
So far, discussions around relaxing certain bank regulations and reducing the Fed’s involvement in the overnight funding market are all being debated, even as opinions conflict over what caused the disaster in the first place and what the best course of action going forward should be.
“You don’t really want the central bank propping up the repo market,” argues Andrew Hill, senior director at ICMA. “When there is a great demand for cash in the repo market, you take it out of the central bank and you will get a better return. But there’s a point, which we found in September, where the banks stopped doing that and they leave their money at the Federal Reserve.” But why?
Jeff Kidwell, former-Morgan Stanley executive director and market commentator, explains: “The bottom line is that the repo market globally has fundamentally changed or moved on. The hundreds of new regulations imposed by global regulators, inspired by the 2007/08 financial crisis, have changed the way that businesses who use the repo market look at the use of capital and the return they require on that capital.”
Although many welcomed the Fed’s enlarged operations at the time, questions are now being raised as to the long-term viability of such activities, according to Michael Cyrus, head of short term products, equity finance and foreign exchange at Deka Investment, a Frankfurt-based investment manager.
“There are many implications with recent central bank interventions and most recently even the European Central Bank admitted that there are negative impacts with some aspect of how central banks interact with current markets,” he explains.
“Central banks are an important player in the money markets and money markets are an essential part of the monetary transmission mechanism for central banks. Hence, it is hardly comprehensible to imagine money markets without central banks. However, in our view central banks have to (re-) learn that there should be some degree of volatility, some dispersion of prices and more granular pricing for risky assets.”
Cyrus suggests that the actions of central banks are simply “papering over all kinds of risk nuisances in the market and are distorting market prices”.
“Whether this is a price to be paid for financial stability or whether this makes markets inefficient to the extent that these inefficiencies become a threat to the market is an open question that needs to be looked into,” he concludes.
ICMA’s Hill predicts that whatever comes next, increased volatility is the new normal. “Volatility in the repo market should respond to demand and supply to have a functioning market, but it is these dislocations and panic to find cash and panic to place cash and the lack of access to markets,” he says.
What’s to be done?
Hill states that unless the market can address some of the imbalance or come up with a more proportionate regulatory framework that balances the importance that banks conduct, (plus having a safe resilient banking system), banks are going to have to get used to what happened in September.
There has been talk about the Federal Open Market Committee including a standing repo facility as part of the new framework for banks, this tool would allow banks that owned risk-free Treasurys to hand them in to the Fed on demand in exchange for fast liquidity in the form of bank reserves.
To this Hill says that there is a solid case for a standing repo facility. “As it becomes more difficult to estimate the ‘sweet spot’ for reserve balances as a result of prudential regulation, this would help get around the reliance on primary dealers to intermediate liquidity injections and provide a pressure valve for the money-markets”.
However, Kidwell is of the opinion that a standing repo facility would harken back to the several standing repo facilities that the Fed had to employ during the financial crisis, which was an extraordinary measure and might make the public and the market think that we were on the verge of another crisis”.
Despite animated discussions by those that felt the main most acutely in September, market consensus is that the Fed is unlikely to commit itself to create such a facility in the near future. Moreover, despite the overt perception from the Trump administration that an axe would be taken to the carefully constructed post-crisis regulations, significant reforms are unlikely given the distraction of the upcoming election.
Year-end may have passed uneventfully, but the first quarter-end of 2020 is already on the horizon and it’s unclear how many more body blows the market will be able to take before a permanent solution is found.
The interest rate spike – which lasted several days and peaked briefly at around 9 percent on 17 September 2019 – was a rude awakening for the New York Federal Reserve. The Fed was accused of miscalculating the consequences of the Basel III’s rules on banks’ ability to lend to each other, especially when combined with other market events, and then not acting quickly enough cap the spikes as they intensified each day in the lead-up to the end of Q3.
Once the Fed did turn on the hoses and drench the smouldering engine room of the financial markets with much-needed cash, the issues quickly died away, but concerns remained as to how the market would function at year-end, which is traditionally more volatile than a quarter-end.
The Fed’s answer was to simply stay in the market. It continued to offer cash injections in the lead-up to and over year-end to the tune of $75 billion in daily repos in September and then $35 billion in long-term repo twice per week from then on.
According to the International Capital Market Association (ICMA) report, published earlier this month, the Fed’s continued presence was successful in avoiding anything near a repeat of September over year-end.
In its report, ICMA states that the Fed’s attempts to keep bank reserves comfortably above the $1.5 trillion mark through its open market operations and bill purchases, has proved successful in stabilising money rates, and was further aided by an injection of increased liquidity over year-end.
“This also seems to have prompted a transfer of balance sheet by US banks from their European business to the US,” it notes.
With the threat of year-end now over, all those involved must now answer the questions of what the future of repo will look like and whether the traditionally out-of-sight-out-of-mind funding market will be able to stay out of the spotlight in 2020.
So far, discussions around relaxing certain bank regulations and reducing the Fed’s involvement in the overnight funding market are all being debated, even as opinions conflict over what caused the disaster in the first place and what the best course of action going forward should be.
“You don’t really want the central bank propping up the repo market,” argues Andrew Hill, senior director at ICMA. “When there is a great demand for cash in the repo market, you take it out of the central bank and you will get a better return. But there’s a point, which we found in September, where the banks stopped doing that and they leave their money at the Federal Reserve.” But why?
Jeff Kidwell, former-Morgan Stanley executive director and market commentator, explains: “The bottom line is that the repo market globally has fundamentally changed or moved on. The hundreds of new regulations imposed by global regulators, inspired by the 2007/08 financial crisis, have changed the way that businesses who use the repo market look at the use of capital and the return they require on that capital.”
Although many welcomed the Fed’s enlarged operations at the time, questions are now being raised as to the long-term viability of such activities, according to Michael Cyrus, head of short term products, equity finance and foreign exchange at Deka Investment, a Frankfurt-based investment manager.
“There are many implications with recent central bank interventions and most recently even the European Central Bank admitted that there are negative impacts with some aspect of how central banks interact with current markets,” he explains.
“Central banks are an important player in the money markets and money markets are an essential part of the monetary transmission mechanism for central banks. Hence, it is hardly comprehensible to imagine money markets without central banks. However, in our view central banks have to (re-) learn that there should be some degree of volatility, some dispersion of prices and more granular pricing for risky assets.”
Cyrus suggests that the actions of central banks are simply “papering over all kinds of risk nuisances in the market and are distorting market prices”.
“Whether this is a price to be paid for financial stability or whether this makes markets inefficient to the extent that these inefficiencies become a threat to the market is an open question that needs to be looked into,” he concludes.
ICMA’s Hill predicts that whatever comes next, increased volatility is the new normal. “Volatility in the repo market should respond to demand and supply to have a functioning market, but it is these dislocations and panic to find cash and panic to place cash and the lack of access to markets,” he says.
What’s to be done?
Hill states that unless the market can address some of the imbalance or come up with a more proportionate regulatory framework that balances the importance that banks conduct, (plus having a safe resilient banking system), banks are going to have to get used to what happened in September.
There has been talk about the Federal Open Market Committee including a standing repo facility as part of the new framework for banks, this tool would allow banks that owned risk-free Treasurys to hand them in to the Fed on demand in exchange for fast liquidity in the form of bank reserves.
To this Hill says that there is a solid case for a standing repo facility. “As it becomes more difficult to estimate the ‘sweet spot’ for reserve balances as a result of prudential regulation, this would help get around the reliance on primary dealers to intermediate liquidity injections and provide a pressure valve for the money-markets”.
However, Kidwell is of the opinion that a standing repo facility would harken back to the several standing repo facilities that the Fed had to employ during the financial crisis, which was an extraordinary measure and might make the public and the market think that we were on the verge of another crisis”.
Despite animated discussions by those that felt the main most acutely in September, market consensus is that the Fed is unlikely to commit itself to create such a facility in the near future. Moreover, despite the overt perception from the Trump administration that an axe would be taken to the carefully constructed post-crisis regulations, significant reforms are unlikely given the distraction of the upcoming election.
Year-end may have passed uneventfully, but the first quarter-end of 2020 is already on the horizon and it’s unclear how many more body blows the market will be able to take before a permanent solution is found.
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