Repo Market

It has been said of Quantitative Easing (QE) that every move by the Fed was priced into the markets, with reaction predicted and contained. Recent events might cast doubt on the predictability claim with financial markets mechanics maybe not functioning as well as some thought.

This post will discuss contributory factors and consider how the presence of shadow banking characteristics in the repo market could make attempts to resolve the repo crisis more difficult.
Recently Zoltan Pozsar currently at Credit Suisse and ex-senior adviser to the US Department of the Treasury, outlined three points that could have set the scene to current stress in the Repo market. These points were outlined on two separate editions of the Odd Lots podcast.

To begin, Foreign Investors like Life Insurers and pension funds seek to avoid negative interest rates in home economies and purchase US assets with attractive yields. Foreign Investors utilise the FX Swap market to hedge back to their local currency to manage FX risk and off-set costs. In 2015 when the Treasury curve was steep Foreign Investors could buy 10 Year Treasuries for 2½ %, spend 1% to hedge FX component and make a profit of 1½ %. However, in 2017 when the Fed hiked interest rates, the 10-year Treasury Yield Curve flattened reducing the 10-year yield thereby removing the ability of Foreign Investors to buy US Treasuries on a hedged basis & make positive spread.

The reduced demand for US Treasuries occurred alongside the Fed’s $600 bn taper of QE, which took reserves away from banks balance sheets. Pozsar points out it is dealers in the repo market that have difficulties with liquidity. Financial entities go to the Repo market because they cannot make payments that day. Basel III regulations require banks to maintain a Liquidity Coverage Ratio (LCR) to cover 30 days of outflows.

If Foreign Investors find hedging costs high and reduce purchase of Treasuries, dealers get backed up with Treasuries and need to lean on large banks (HQLA) portfolios. This becomes problematic if banks cannot lend as they have reached their LCR limit. It is questionable if is sustainable for only one or two large banks to be in a position to help the Repo market clear, when these banks reach their LCR, this can show as repo rates spiking at 10%.

One reason the Repo market has grown massively, is due to a new phenomenon known as Sponsored Repo, which has grown in size to $300 bn. Banks such as JP Morgan of the Fixed Income Clearing Corporation (FICC) sponsor in money funds or hedge funds and let them face off against each other through a matched book provided by the bank which can then net these positions and not use their balance sheet.

Treasury collateral coming into the system has mostly been funded through sponsored repo but this can only happen overnight as term trades are not available yet in Sponsored Repo. So Relative Value funds that need to roll their positions they can only do so overnight.

However, at the Year-end when banks have a snap shot taken of their balance sheets, no one has balance sheet to enable reserves to move around. Once dealers cannot intermediate between banks and the system there is no mechanism to inject liquidity into the repo market.
However, this isn’t to say that altering regulations is a solution. Of more relevance, is a consideration that it is the accumulation of actions and practices by the Fed, and financial markets, that have combined to create the tricky situation we have today with the repo market.

Additionally, the inability of the system to adapt and fund itself makes resolution of events such as Year-End Turn problematic if you also consider a link between the repo market and shadow banking.
The concept of shadow banking refers to an intricate system of financial interaction that occurs outside traditional banks’ balance sheets away from regulatory gaze of monitoring authorities (Palan, Nesvetailova, 2013).

It has been said collateral exchanged in the repo market can become a form of privately created money, potentially a critical part of the shadow banking system. Collateral is sold to a financial entity, which agrees to purchase the assets at a future date at an increased price. The selling entity ‘borrows’ the money, with the price difference being the same as the interest rate.

Collateral can also pass between institutions, in a chain. A repo transaction provides one institution with cash and another with securities. The institution that gets the securities, reprocesses these assets as collateral to access their own repo loans. The next repo lender can then re-use these same assets to access collateral on a loan themselves. This process is known as rehypothecation.

The process described could be said to illustrate the description of shadow banking which involves credit intermediation in networks that function as complex webs without recognised institutional structures.

Should this type of structure exist in the repo market, if concern arises about the leverage of a non-bank entity this could be problematic, as it could be difficult to identify a single source of risk or plug a funding gap without causing wider contagion. Concern is expressed by the DiMartino Booth, Chief Strategist at Quill Intelligence about a future credit event. DiMartino Booth says until the Fed is faced with such a credit event, it will claim it is just solving technical glitches in the Repo market.

Therefore the Feds continuing market interventions to counter spikes in the repo market or continuing purchase of US Treasuries to build up reserves, could obscure hidden fault lines and connections. This concept borrows from Normal Accident Theory which claims if parts in a machine are altered, adjustments become problematic as machine function cannot accommodate the modified nodes. The accumulation of actions by the Fed and the actions of entities in financial markets may require a more in-depth approach instead of the outside looking in approach adopted by Central banks so far with QE.