EC Repo Quake – A Primer

Chaos in Overnight Funding Markets

Most of you are probably aware that there were recently quite large spikes in repo rates. The events were inter alia chronicled at Zerohedge here and here. The issue is fairly complex, as there are many different drivers at play, but we will try to provide a brief explanation.

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There have been two spikes in the overnight general collateral rate – one at the end of 2018, which was a first warning shot, and the one of last week, which was the biggest such spike on record, exceeding even that seen in the 2008 crisis.

The funding stresses in overnight repo markets were the culmination of a problem that has been simmering in the background for quite some time. It was partly the result of new banking regulations implemented after the GFC (Basel III), the change in money market regulations, the decrease in excess reserves due to QT (as well as for other reasons), a government that is spending like a drunken sailor, and last but not least, assorted yield curve inversions.

In essence, the problem is that there is a surplus of treasury collateral looking for short-term funding, and not enough liquidity. But how did this situation come about?

Relieving a Collateral Shortage

Readers may recall that we have previously discussed the Treasury’s general account at the Fed. When money market fund regulations changed in 2016, one of the problems was that demand for treasury bills was set to soar, as MM funds repatriated money previously invested in commercial paper (mainly issued by European banks) in the euro-dollar market for the yield pick-up.

In other words, the problem at the time was the opposite of that prevailing currently – there was not enough treasury collateral, particularly of the short term variety.The Treasury inter alia over-issued t-bills as a counter-measure. In fact, the situation played into the hands of the Treasury, which wanted to shore up its cash position anyway so as to increase its flexibility during the recurring debt ceiling circus in Washington (when whichever party is not running the administration pretends to care about government debt).

It evidently did so again in early 2018, in response to corporate repatriation flows after the tax reform (US companies repatriated euro-dollars which they had previously lent to non-financial corporations in Europe and as a result, demand for t-bills increased once again).

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US Treasury, general account at the Fed. There were large increases in the Treasury’s cash hoard in 2016 and 2018, which were aligned with the change in MM fund regulations and the repatriation of corporate funds after the tax reform. This was probably not a coincidence.

However, this was not the only thing that happened. In 2015, one year before MM fund regulations changed, banks needed to downsize their balance sheets to comply with the Basel III supplementary leverage ratio (SLR). The Fed supported their effort to shed deposits (and concomitantly, excess reserves) by uncapping the previously capped reverse repo facility for foreign official institutions. This also created an incentive for foreign CBs to get out of treasury debt and deposit cash in the RRP facility instead.

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The Fed’s reverse repurchase facility for foreign official institutions. This is mainly used by foreign central banks wanting to park cash rather than holding treasury debt. The surge in 2015 was reportedly mainly due to Japan (the identities of RRP facility users are not disclosed, but it can be inferred who is doing what by analyzing offsetting entries in the balance sheets of foreign central banks). The 2019 surge had different reasons, which we will discuss further below.

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