Flights-To-Quality

oktober 24, 2014 in Columns-Artikelen by onze redactie

What happened? The Dow Jones Industrial Average dropped from 17,200 at the end of September to a low of 15,900 last week. The Treasury 10-Year note rallied from 2.50% on September 29 to 2.15% on October 15. It was an incredible rally for the 10-Year note in just one day. At one point, it even hit an intraday low of 1.87%. Call it a correction, but there was definitely some sort of panic involved. Some say it was related to Ebola, slow growth, or even another round of QE. Overall, it was very reminiscent of a flight-to-quality (FTQ), but there was one market that acted completely different: the Repo market.

What Causes A FTQ?

A FTQ is caused by fear, plain and simple. Market participants prefer safety to yield. In other words, they will do anything to NOT to lose money. Over the past 20 years, there have been several flights-to-quality which include: a terrorist attack, a hedge fund collapse, a major country default, a liquidity crisis of over-leverage, and the big-daddy of them all, The Financial Crisis.

What Happens During A FTQ?

Remember, a panic is not based on fundamentals. Yes, some are pricing interest rates lower to reflect the increased chances of a Fed rate cut, however, most of the distorted prices and rates are based on fear. When investors are worried they won’t get their money back, they’ll pay almost anything for an ultra-safe financial instrument. As a consequence, Treasury bills and short-term Treasurys rally considerably, stocks sell-off. To some extent, investors are gauging whether real economic activity will decline after the crisis. Of course, if the panic conditions continue, there will be less economic activity and the panic becomes the reality. However, over the past 20 years, only one FTQ was a prelude to a recession (The Financial Crisis). Otherwise, the distorted markets are generally short-lived and normal markets soon resume.

The Repo Market

In the Repo market, it’s all about supply and demand. There’s more demand for high-grade securities, like U.S. Treasurys, and there’s less supply available in the market. Investors who were normally enjoying higher yields in uncollateralized lending, like bank deposits, CDs, and CP, move their cash out of those instruments and into Treasurys and Treasury Repo. Bank CD, CP, and deposit rates move higher as there’s less investor cash in those markets. Treasury collateral trades at a wider premium below fed funds. Because many end-user customers do not loan their securities, it increases the borrowing premium for specials and leads to increased fails.

LTCM Collapse And The Russian Default Crisis: October 1998

In August 1998, Russia defaulted on its debt and the hedge fund Long Term Capital Management (LTCM) collapsed in October. During the crisis, the Street cut back on financing activity and many predicted a pending financial markets recession. The Dow dropped from 8,024 on September 15 to 7,726 on October 4, a decline of 3.7% The U.S. Treasury 10-Year note rallied from 4.90% to 4.16%, a rally of 74 basis points. At the height of the crisis, general collateral was trading 45 basis points below fed funds and there were shortages in every on-the-run Treasury.* However, the market mostly returned to normal by the end of November.

September 11, 2001

Following the terrorist attacks of September 11, the financial markets were effectively frozen for a week. This crisis was unique in one way: it was more an infrastructure crisis than anything else. The Bank of New York’s clearing function was effectively closed, so the entire settlements system was frozen. One month Treasury bills rallied from 3.40% on September 10 to a low of 2.00% on September 19. The Dow dropped from 9,605 to a low of 8,235 on September 21, a decline of 14.2%. The Treasury 10-Year note rallied from 4.84% to 4.50% on October 3, a rally of 34 basis points. In the Repo market, there was a very unique response. The market fixed inter-dealer Repo rates for a week at a 50 basis point spread. General collateral was fixed at 3.50% and specials at 3.00%. Though there was increased demand for Treasury collateral, one would expect significant Repo specials. It was the case in some issues but not in all. There wasn’t a significant widening of the spread between GC and fed funds because the situation was mostly due to the collapse in infrastructure. By November, all of the fails had cleared up and the Repo market was mostly back to normal.

The Liquidity Crisis: August 2007

After the collapse of Bear Stearns Asset Management in June 2007, two BNP Paribas funds and July, and Sentinel Capital Management in August, the market was caught in a drastic period of deleveraging. Market participants didn’t know who was holding illiquid securities, like CDOs, so there was a perceived increase in counterparty risk. Investors didn’t want to lend to banks and banks didn’t want to lend to leveraged funds. The period became known as “The Liquidity Crisis of August 2007.” Fear of insolvent banks was so great that the bank CD market all but shutdown. A massive amount of cash moved out of banks and into Treasury securities. The Dow declined from 13,362 on August 1 to 12,845 on August 16, a drop of 3.8%. The 10-Year note rallied from 4.76% to 4.60%, and one month Treasury bills went from 5.05% to a startling 2.47% on August 20 – a move of 258 basis points. Repo rates followed the bill market, trading 277 basis points below fed funds for a few days. The depth of the crisis was over by mid-September, but the period was marked by an unprecedented premium for high-quality assets.

The Financial Crisis: September And October 2008

No one can fully explain The Financial Crisis in just one paragraph. Overall, financial institutions collapsed, stocks declined, the CD market shutdown, Treasurys disappeared, and there was a massive amount of Treasury fails. Investors pulled out of the financial markets for fear of the next collapse. From September 12 to the beginning of October, the Dow dropped from 11,421 to 8,451, a decline of 26%. One month bills rallied from 1.37% down to 0.13% on September 24, yet the Treasury 10-Year note barely budged, only rallying from 3.74% to 3.48%, a total of 26 basis points. In the Repo market, GC traded 500 basis points below funds on September 30, 2008. The specials situation in 2008 was somewhat unique. The Fed was rapidly cutting overnight rates and there was no Fail Charge at the time. Though demand for Treasurys and settlement fails were astronomical, it wasn’t fully reflected in Repo rates because GC rates were so close to zero anyway.

Last Week’s Mini FTQ: October 2014

During last week’s bond market “flash crash,” the Dow sold-off 8% at its low, and the 10-Year rallied 35 basis points, though it moved as much as 63 basis points based on its intraday low. Both in the ballpark of a flight-to-quality. However, Repo rates actually moved higher during the panic; the exact opposite of a normal FTQ. For one day, GC traded 11 basis points above fed funds. In the past, when GC rates traded above fed funds, it either meant the Street was extremely long the market, bank’s had balance sheet restrictions that prevented them from arbitraging the two markets, or the Treasury was over-issuing debt. None of those factors were really true for that one day.

Was there a FTQ last week that was different from others in the past? Perhaps last week’s FTQ was minor and not a full blown panic, but still the 10-Year note rallied like there was no tomorrow. Perhaps there’s been a fundamental change in the market due to something like QE, new bank regulations, and less bank intermediation. Does last week’s bond market “flash crash” represent a growing dysfunctional market? There’s clearly some fundamental changes occurring in the market, I can’t explain them now but expect more confusing Repo market trends in the near future.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

The Assault On Liquidation Rights

oktober 24, 2014 in Columns-Artikelen by onze redactie

There is an assault brewing on the liquidation rights for swaps contracts. Banks were recently asked to give up some of their rights under the law when 18 of the largest U.S., European, and Japanese banks met in Washington DC after several months of discussions. Regulators want to delay termination rights of swaps contracts for 48 hours for troubled financial institutions. The banks agreed, and the new protocol will take effect on January 1, 2015.

The goal is a noble one. It’s an attempt to limit “fire-sales” during the worse part of a financial crisis. There’s a good case to be made for waiting 48 hours to have a counterparty that’s recapitalized and backed by the government. Just waiting these two days can prevent the entire liquidation process. On the other hand, those 18 banks are giving up liquidation rights that exist under current law. When an important foundation of a market is altered, even in a minor way, there will be consequences. Not surprising, asset managers and hedge funds are resisting the change. Since those entities are not under the same regulatory umbrella as the banks, regulators will have to compel them to comply with the new rules.

But here’s the part I’m concerned about: included in the 48 hour delay is a hold on margin collateral. That means they’re getting into the realm of the Repo market. If swaps are pushed along this route, Repo could be next.

Defaults

When a company declares bankruptcy, its assets are frozen and the company is either liquidated or reorganized. Either way, no one can touch the assets, except those which are legally exempt like Repo and swaps. Officially, they’re both exempt from the “automatic stay” provision of the bankruptcy code. Repo and swaps counterparties have the right to immediately liquidate all of their outstanding trades with the defaulted entity.

The idea behind the 48 hour delay is to prevent these liquidations and the market distorting fire-sales that result. When counterparties liquidate contracts, it makes a market crisis all the more chaotic. In a way, over the past 30 years, liquidations may have increased market volatility. Lehman Brothers is a good example. They had billions of dollars of swaps trades outstanding and within five weeks of their bankruptcy, 80% of their swaps contracts had been liquidated. It was good to get Lehman as a counterparty off of your books, but the Lehman trustee spent years in the legal system with many of these counterparties trying to claw-back collateral. Avoiding a repeat of the Lehman legal mess is one goal behind the 48 hour delay.

Dodd-Frank

Regulators were give new powers under Dodd-Frank in 2010 to seize a failing bank and keep its units operating. But in order to make it work, you can’t have their counterparties trying to liquidating their positions at the same time. Thus the 48 hour delay in termination rights. Basically, regulators need time to transfer the defaulted entity into a “bridge” holding company. As long as the new entity is well-capitalized and government backed, the swaps counterparties are giving up a bad counterparty for good a good counterparty. And there’s no need to liquidate the swaps contracts. Sounds like a win-win? But again, how much market efficiency and liquidity in normal times is being given up to limit financial market stress during bad times?

Repo Property Rights Established

Repo liquidation rights were originally established after Drysdale, then passed along to municipalities after Orange County. Swaps currently enjoy those same liquidation rights. It’s a system that made Repo and swaps markets highly liquid and highly efficient.

Back in 1982 after Drysdale defaulted, there were no bankruptcy laws on the books nor any court cases to establish the legal status of Repo in a default. No one was sure exactly how the outstanding Repo trades would be treated in a bankruptcy. If Repo was legally a “collateralized loan,” then securities held by a creditor would be stuck in the bankrupt entity. If a Repo was a sale and a repurchase transaction, then the securities could be immediately liquidated. It was a major issue that would have ramifications going forward.

Though Chase Manhattan Bank covered Drysdale’s loss and took over Drysdale to liquidate them, there was no immediate resolution of the Repo liquidation rights issue. The issue came up again just three months later when another firm, Lombard-Wall, collapsed in August 1982. In September 1982, one month later, the Federal Bankruptcy Court of New York ruled that a Repo was a sale and repurchase transaction, making it two separate transactions and thus not a single collateralized loan. The court recognized that allowing prompt liquidation was necessary to continue the orderly functioning of the markets. Two years later, in 1984, Congress passed an extension of the Federal Bankruptcy laws so that Repo on Treasurys, Federal Agencys, CDs and BAs were exempt from automatic stays in a bankruptcy by law. The Repo market was off and running, but one aspect of the bankruptcy code was overlooked – municipalities.

Repo Property Rights In Orange County

On December 6, 1994 Credit Suisse First Boston demanded repayment of $2 billion of the Repo trades that they had executed with Robert Citron, the Treasurer of Orange County, California and they immediately seized $1.25 billion of Orange County’s securities. Later that day, Orange County declared bankruptcy, making it the largest municipal bankruptcy in the history of the United States up until that time.

When the county declared Chapter 9 bankruptcy to seek protection, they thought they were preventing a run on their investment portfolio and they’d prevent their Repo counterparties from liquidating their securities. Chapter 9 bankruptcy is a specific type of reorganization reserved solely for municipalities. When the Bankruptcy Act came into being in 1934, a part of it was called Chapter 9 and it allowed specifically for bankruptcy protection to municipalities. A very important feature of Chapter 9 is that the law specifically did not include Section 559 of the larger bankruptcy code. Section 559 allows a repo counterparty to liquidate repurchase agreements in order to recoup their money. In other words, whereas the whole Repo market was set up so that a creditor can sell the collateral in the event of default, Chapter 9 bankruptcy prohibited – or at least didn’t explicitly allow – it to happen. It was, at the time, an untested loophole in the law. Orange County officials were pinning their hopes that by declaring Chapter 9, their Repo counterparties would have their hands tied and wouldn’t be able to liquidate the securities.

Ironically – and perhaps predictably – when Orange County filed for bankruptcy, the result was the exact opposite. The Wall Street firms interpreted the bankruptcy filing as a default, which it was, and began to enforce the terms of the Repo agreements. That meant they all began liquidating Orange County’s positions.

Merrill was the next one to launch a liquidation salvo, selling off all of $800 million in securities that they were holding . The firm contented that they were legally allowed to sell off the securities, because the Repo legal agreement allowed for liquidation in the event of a default. The Orange County Board of Supervisors begged to differ and they authorized their lawyers to begin filing lawsuits against any Wall Street firm that liquidated securities. They alleged that selling collateral was illegal under the Chapter 9 because there was no mention of Repo agreements in the law. Banks were, therefore, legally obligated to return the securities to Orange County. Their argument, though legally clever, fell on deaf ears and the other liquidations proceeded.

Repo Consequences

All of the same arguments used to suspend swaps liquidation rights could be used to suspend Repo liquidation rights. In the near future, we could see regulators asking Repo counterparties to wait 48 hours before liquidating securities financing transactions. The problem is: Repo is fundamentally different from swaps. In swaps, the two parties agreed to pay the differential (say fixed versus floating) on the notional amount of the trade. It’s all about cash flow. In Repo, the two counterparties actually exchange the notional amount; that is, they exchange cash and securities. If the Repo market were asked to suspend its liquidation rights for 48 hours, the counterparties would be giving up their rights for their cash or their securities for that period of time. It’s a larger issue than waiting for a differential on cash flow for 48 hours.

If the 48 hour waiting period is extended to the Repo market, I’m worried about the unintended consequences. What helps during a market crisis, might hurt the market the other 99.9% of the time. If a bank is teetering on the brink of collapse and their Repo counterparties know their liquidation rights will be suspended for two days, they may pull their funding faster. During that 48 hour waiting period, there will be market distortions. Uncertainty will drive counterparties to panic and act in unexpected ways.

Overall, suspending the liquidation rights for swaps for 48 hours will help address the fire-sale issue, but I’m worried the tradeoff will have unintended consequences. Does market stability during a one week period justify market distortions for the 10 to 20 years in between? That’s a crucial question. I’m not sure the correct answer, but I am certain there are tradeoffs.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Roundup: September (Quarter-End, Fails, Regulation)

oktober 2, 2014 in Columns-Artikelen by onze redactie

The big story this week is quarter-end. Not because securities became extraordinarily scarce or overnight rates were extraordinarily volatile, but because the market planned to use the Fed’s Fixed-Rate Reverse-Repo facility (FRRP) for a large amount of window dressing. Those plans were foiled by the FOMC two weeks ago.

Since the facility’s creation once year ago, banks were using the FRRP to have the Fed as a 0% risk-weighting counterparty on their books for quarter-end in order to reduce Basel III regulatory capital charges. On June 30 quarter-end, a record $339 billion flowed into the FRRP. This quarter-end, it was estimated that banks were going to place between $400 billion to $500 billion at the FRRP. However, after the Fed announced the new $300 billion limit on the program, banks were scrambling to find other assets to fulfill their window dressing needs. With a limit on the facility, hundreds of billions of dollars began looking for a regulatory risk-free home and U.S. Treasury bills yields dipped into the negatives.

Today, GC averaged at -.015% (-1.5 basis points) and federal funds at .05%. A total of $407 billion in cash was submitted to the FRRP, but only $300 billion was accepted. This is the first time I’ve ever seen GC average negative on quarter-end.

Fails

The Fed published an analysis* about the puzzling increase in U.S. Treasury fails which occurred in June. All total, there were $1.2 trillion fails for the month, including $627 billion in on-the-run issues, like the current 2-Year, 5-Year, and 10-Year Notes, but, most interesting, $470 billion of those fails were in off-the-run issues, those defined as issued more than 6 months prior.

Fails in the on-the-run issues, like the 2-Year, 5-Year, 10-Year Notes are all pretty standard – the kind of gossip that’s always flying around the Repo market. The main reason for fails is that there’s a short-base in the market and there’s not enough supply for all of the shorts to get covered; thus resulting in fails. For the 10-Year Note, it was all deemed a part of the auction cycle. I’ve described this phenomena many times before: When a new 10-Year Note is first issued, it’s only a single issue. The previous 10-Year Note is a triple-issue, having been re-opened twice already. As the potentially massive amount of shorts that can be contained in a triple-issue roll into a single-issue, it often creates a shortage. The 5-Year Note failed from June 20 to 26, and then again on June 30. June 30 was clearly related to quarter-end and probably a deep short-base in the 5-Year Note explained the June 20 to 26 period. However, the 2-Year Note is interesting. There was one single day when $71 billion 2-Year Notes failed and then cleared up next day. The fail was not related to the auction cycle, instead, it was a one day event when a significant amount of supply disappeared from the market. Was it a single large trade changing hands or did a large customer choose not to loan their position that day?

The explanation of the off-the-run fails is even more interesting. Perhaps, it’s a sign of a fundamental change occurring in the Repo market. Overall, the off-the-run fails were small in size, frequent, and widespread across many Treasury issues. That’s a bad sign. There was no flight-to-quality, frequent operational errors, or a dealer squeeze which helped create the fails. It basically means there was less intermediation by banks; less market-making in the Repo market.

If there’s less intermediation in the Repo market, it means there is less supply of securities getting from end-owner to end-borrower to cover shorts; especially on month-end and quarter-end. Basically, when there’s a supply shortage, there are fewer dealer banks willing to get supply from the end-user portfolios to cover the shorts in the market. It is a result of banks managing their balance sheets more actively; they’re trying to reduce their regulatory capital changes. Here’s an example: suppose it’s month-end and there’s a security which becomes very special in the early afternoon. One bank knows a customer who owns security and they can borrow the security from that customer and then loan it to the entity who’s short. However, if regulatory capital charges are being calculated that day, there’s a significant marginal cost to the trade. It’s the cost of capital for the bank for 30 days versus the revenue on an overnight Repo trade. Yes, even if the bank makes the 300 basis points (3%) overnight on the fail charge, the trade is still not economical. Therefore, the trade doesn’t get done and the result is a supply shortage in the market.

In the past, fails were generally the result of dealers purposely holding supply out of the market. Now, it appears, the fails are increasing due to less dealer intermediation (market-making) in the Repo market. And all of this will kick-in even more as more of the new regulations are fully implemented.

Regulation Update

Liquidity Coverage Ratio (LCR)

The Liquidity Coverage Ratio was approved by the Fed and FDIC on September 3rd. It requires banks to hold enough high-grade securities (like Treasurys) that can be sold during a crisis and provide funding for the bank for 30 days. It’s estimated that banks have already added $200 billion in high-quality assets to their balance sheets and are expected to hold as much as $2 trillion once the new rule is fully in effect. In the Repo market, it’s expected the LCR will push Treasury Repo rates lower by creating a permanent premium for Treasury collateral in the market. Of course, that’s assuming the securities are not actively loaned into the market. If a bank can loan the securities into the Repo market, there won’t be as much of a market distortion.

Net Stable Funding Ratio (NSFR)

This month, a group of banks sent a letter to the Basel Committee about the NSFR, saying they believe it will make short-selling stocks 5 times more expensive for Basel III banks. They concluded it will “significantly increase transaction costs across equity markets.”

New Regulation Timeline

  • The LCR implementation was postponed until July 1, 2015 for many banks and January 1, 2016 for the largest banks.
  • Leverage Ratios – The Basel III Leverage Ratio is to be fully implemented by 2018; the Dodd-Frank Leverage Ratio by January 1, 2015 for U.S. banks, and foreign banks have until January 1, 2016.
  • NSFR is not a final rule yet, it’s only a draft. If it is implemented, it’s not binding until January 1, 2018

* Liberty Street Economics; September 19, 2014; “What Explains the June Spike in Treasury Settlement Fails”

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Fixed-Rate Reverse-Repo: One Year Later

september 26, 2014 in Columns-Artikelen by onze redactie

Over the past year, the Fixed-Rate Reverse-Repo (FRRP) program was clearly a success. In the beginning, it set a floor in overnight rates and eliminated the chance of a collateral shortage. During the height of the Fed’s QE program, it protected the general collateral (GC) market from flat-lining at 0% or dipping into negative rates. In addition, it’s helping with tri-party reform and will become an essential part of monetary policy going forward as the lower rate band of the federal funds target range.

Surprisingly however, the Fed has turned somewhat negative on the FRRP recently. First, they realized it became a window dressing tool for banks to reduce regulatory capital usage on month-end and quarter-end. The Fed also pointed out that during a period of financial stress – like a flight-to-quality – the FRRP might provide cash investors with an alternative to funding banks. If there is stress in the banking system, it’s better to have the Fed as counterparty. The Fed also noted that the FRRP might be expanding the Fed’s role in financial intermediation. With the creation of the FRRP, the Fed has basically become a market participant – instead of a referee on the sideline.

What Sparked The Program?
The official “reason d’être” of the FRRP program was to help manage interest rates and I suspect that will be its long-term role. However, given the Fed was not expected to begin tightening until two years after the program was announced, I believe the immediate reason was to keep GC from dropping to 0% or below. Clearly, the Fed was worried about the impact of QE purchases on the Repo market. Throughout June and July of 2013, GC was trending straight toward 0%. Had the program not started when it did, there was the possibility of market distortions and, no doubt, the Fed was conscious of preventing a collateral shortage.

Details of The Program

All total, there are 139 banks, foreign banks, broker-dealers and money funds who participate in the program. About 75% of the daily volume comes from the money funds. The participants provide the cash and the Fed lends them U.S. Treasurys from the SOMA portfolio in return; the securities which were accumulated through QE purchases. There’s an auction each day between 12:45 pm and 1:15 pm and the rate of the program has varied; right now it’s set at 5 basis points. Just last week, the Fed upped the individual counterparty limit to $30 billion and set an overall limit to the entire program of $300 billion.

Window Dressing

Since the FRRP rate was moved to 5 basis points on February 26, the average daily volume was $130.6 billion. More significant, the average volume on month-end is $199.7 billion and it’s $290.8 billion on quarter-end. In fact, the largest volume spike occurred on June 30 quarter-end when participants took over $339 billion in Treasurys from the Fed. The volume spikes in the graph [above] mark each quarter-end pretty clearly.

Back last year, right after September 30 quarter-end, I mentioned that the facility would be used for bank window dressing. That day, a total of $58.2 billion of cash went into the Fed, which seemed like a considerable amount at the time. It makes sense that banks and other financial institutions want the Federal Reserve as a Repo counterparty for accounting statement periods. Not only do banks prefer a 0% risk-weighting counterparty on their books to minimize their capital requirements, but the Fed is a desirable name to show on the financial statements. In fact, the FRRP program happens to be the best “window dressing” facility ever created. But that’s all about to change, realizing participants tendency to abuse of the program on quarter-end, the Fed has set a limit of $300 billion at the facility.

Where Does the Money Coming From?

Here’s a question: How can $339 billion flow out of the Repo market on quarter-end with little disruption to other money markets? The answer is that it does. According to Fitch Ratings, when the FRRP month-end and quarter-end volume spikes, that cash is generally being removed from European short-term assets. These assets including CDs, term deposits, and direct Repo trading with banks. Fitch concluded that the cash inflows into the FRRP program approximately matches cash outflows from Europe. Naturally, these financial institutions are trying to avoid Basel III regulatory capital charges on month-end and quarter-end. I assume it’s mainly European banks moving their cash into FRRP, given that European banks have more experience working under Basel.

How Do Market Repo Rates Affect FRRP Volume

I would expect that higher GC Repo rates would leave less volume at the FRRP facility. I took rate and volume data going back to February 26, when the FRRP rate moved up to 5 basis points. With higher market Repo rates, there is less volume at the FRRP, but it’s not so crystal clear. I had expected FRRP volume to trail-off considerably when market rates were 5 basis points higher than the FRRP rate, but it’s not the case. Cash investors are willing to lose 5+ basis points on a regular basis just to have the Federal Reserve as a counterparty – and it’s not just on month-end and quarter-end ! FRRP volume also stays at a minimum of $50 billion no matter what.

The Future of The FRRP

We started getting hints from the Fed as to the future of the FRRP program with the release of the June FOMC minutes. They said the FRRP “could play a supporting role” in draining reserves and tightening interest rates. Of course, Fed Chair Yellen noted that “we do have concerns about allowing that facility to become too large or play too prominent a role.” But still the Fed decided to make the FRRP rate the lower rate band for the federal funds target range going forward. In that respect, it appears the FRRP program is here to stay, but at the same time, Fed governors “agreed that the ON RRP facility should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose.” So maybe it lasts only through the current tightening cycle. We’ll see.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Roundup August: Rates, Specials, FOMC Minutes, Regulation

september 2, 2014 in Columns-Artikelen by onze redactie

General Collateral rates have been quiet for most of the summer, excluding of course, quarter-end. Since the beginning of July, GC averaged 9.3 basis points, which is two basis points higher than its 7.3 basis point average since the beginning of the year. For most of July and August, rates were trading on top of fed funds.

By the end of this week, I expect rates to spike higher due to a combination of month-end and new issuance. All total, between August 28 and September 4, $68 billion* in net new Treasurys will be issued into the market. Over the next few months, I still contend that Repo rates are on their way upward, with the combination of QE winding down and Treasury issuance still running about $50 billion a month. QE is now at $25 billion a month and moving down to zero within three FOMC meetings. Then, with no Fed program to soak up Treasury issuance, Repo rates will, ultimately, trend higher.

Specials

There’s a good short-base in this market. The 2 Year, 3 Year, 5 Year and 10 Year have all traded below -2.25% over the past two months. Remember though, Repo rates are a function of supply and demand for the specific securities in the Repo market. When demand increases (more shorts) rates move lower. No doubt, there are directional shorts (expecting a sell-off in the overall market) and hedging shorts (hedging their long positions in other securities). In addition, the current 10 Year Note is now a single issue with a good short-base and September is arriving very soon. Historically, there’s a lot of market activity in September and a quarter-end at the end of it, both factors which should push a single issue 10 Year Note deep into negative territory.

Once again, there’s no surprise there are more fails when there’s more short-selling. When short-selling demand for a Treasury is greater than the available supply and all of the shorts can’t get covered, the issue fails. Fails in the Treasury market remain relatively high and I expect that to continue. Fails-To-Deliver are running at $128.9 billion in regular Treasurys and $7.1 billion in TIPS. I understand why there are so many Repo specials failing, but the high fails number in TIPS is somewhat of a mystery.

June And July FOMC Minutes

IOER (Interest On Excess Reserves) And Federal Funds

Back in June, the FOMC hinted they would stick with the federal funds rate as the policy target rate and that the IOER “should play a central role” in tightening. Then, they followed up in July stating that “it would be appropriate to retain the federal funds rate as the key policy rate” and “the IOER rate would be the primary tool used to move the federal funds rate into its target range.” It’s pretty clear now – U.S. monetary will remain based on the federal funds rate and the IOER will be the primary tool for draining reserves.

FRRP (Fixed-Rate Reverse-Repo Facility)

Where does that leave the FRRP facility? Well, back in June the FOMC stated the FRRP “could play a supporting role” in draining reserves, but in July they indicated a sunset for the facility, “that the ON RRP facility should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose” Perhaps, reports about banks using the FRRP for window dressing is starting to bother the Fed.

Rate Band

But here’s even bigger news and a fundamental change in Fed policy – they’re going to keeping the fed funds target rate as a rate band and not just a specific target rate. In the July minutes, “they supported continuing to target a range of 25 basis points.” The rate band will be such that “the IOER rate would be set at the top of the target range for the federal funds rate, and the ON RRP rate would be set at the bottom of the federal funds target range.” Interesting – technically, right now the fed funds target range is .25% to 0.0% and the FRRP is set a .05%, or 5 basis points above the lower band.

Before December 2008, the last time the Fed used a federal funds target range was June 1989 when the range was set between 9 1/2% and 9 5/8% Perhaps the Fed is really just getting back to its roots; for much of the 1980s, the fed funds target alternated between a target rate and a target range. Keep in mind, in the 1980s, Fed had a harder job fine tuning rates. The Repo market was less developed and nominal rates were much higher, which made miscalculations in reserves more apparent. If overnight rates moved 10% off of the rate target, it meant a swing of 90 basis points in 1989 verses 1 to 2 basis points today.

The Changing Repo Market

New regulation is driving changes in the Repo market. Because of the Leverage Ratios, Basel III, Dodd-Frank, and Tri-Paty Reform, many banks have reduced their Repo books. Since the beginning of the year, Goldman Sachs cut $56 billion of assets from their balance sheet which included $42 billion in Repo. Barclays cut their Repo book down $25 billion, BofA down $11.4 billion, and Citi cut theirs $8 billion. The reasons? For Goldman, it was to increase their Leverage Ratio to 4.5% from 4.3% and get closer to the 5% minimum that regulators mandated.

According to Jeff Kidwell at AVM after conversations with clients, “the supply of O/N collateral, particularly US Treasuries and Agency MBS at the broker/dealers, has dried up.”** If four large banks have cut $86 billion from their Repo books this year, that doesn’t even include about 40 other banks intermediating in the Repo market. It doesn’t end there, banks are also moving out of Treasury Repo and into higher spread collateral, which includes: corporates, equities, private label MBS.

During the year, banks have told hedge-fund clients that regulations have forced them to set aside more capital and that’s affecting the profits of their prime-brokerage business.*** Banks are even urging customers not to leave cash in their accounts and they’re charging clients for cash balances and imposing monthly fees.

It seems pretty clear, the Repo market is beginning to experience dislocation. With fewer banks making-markets, shorts are becoming harder to cover, specials trade at lower rates with more rate volatility, there are rate spikes on quarter-end, and a significant increase in the amount of fails.

* ICAP Wrightson; “Money Market Observer”; August 25, 2014
** Courtesy of Jeff Kidwell at AVM
*** WSJ; “Goldman Sachs Dumps Weaker Hedge-Fund Clients”; August 5, 2014

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

The Anxiety of Fails

juli 22, 2014 in Columns-Artikelen by onze redactie

There’s a lot of discussion about fails in the Treasury market, including a variety of armageddon theories about why fails have increased, but rest assured, fails are a normal part of the market. That’s not to say I take the increased fails lightly, but it’s not a threat to humanity. The recent spike in fails might seem significant, but it isn’t.

What’s A Fail?

Fails come in two forms: A fail-to-deliver and a fail-to-receive. They’re both the same in a way, one person’s fail-to-deliver is another person’s fail-to-receive. Here’s how it happens: When someone sells a security to someone else, the buyer expects the security to be delivered. Now, suppose the seller didn’t actually own the security and they must go into the Repo market and borrow it. But now, suppose they can’t borrow it. Without the security, they’re unable to deliver anything and it becomes a fail-to-deliver. Naturally, for the buyer, it’s a fail-to-receive. Market participants can fail for a variety of reasons, recently, it’s because there’s more demand.

The Cost of Fails

Without the Fail Charge, the cost of a fail is the equivalent of investing cash at a 0% rate, which is the same as not covering (borrowing) the security at all. Here’s how it works: Someone who’s short borrows the security via a reverse-repo trade to cover their short. They borrow the security and simultaneously lend cash at the same time (delivery versus payment). A “Special” is when someone is willing to accept below market interest rates on their cash in order to receive a specific security. The larger the premium (spread) below general collateral (GC), the more that security is in demand. For example, if GC is trading at 0.25% and a specific Treasury is trading at 0.0%, that issue is trading 25 basis points below GC. Thus, the borrower is willing to invest their cash at 0.0% instead of 0.25% in order to receive that specific security.

Before there was a fail charge, some market participants wouldn’t even cover their shorts when rates got close to zero. Perhaps they didn’t want to show the market the size of their short, or pay brokerage, or maybe even pay the ticket charge and processing fees. In any event, those costs exceeded the cost of not covering the security at all.

Not covering shorts was actually quite common in the past for periods of time when there were protracted shortages. It all came to a head in October 2008 when securities were pulled from the market, the Fed dropped overnight rates down to near 0.0%, and counterparties stopped trading with each other. It was the perfect storm in the repo market and fails shot up to an all-time record high of $5.06 trillion on October 15, 2008. People realized there needed to be a cost of failing in the Fed’s new 0.0% interest rate environment. About 7 months later, the Fail charge was introduced. At 0.0% rates, the Fail Charge is 300 basis points which makes the break-even cost for not covering a short the equivalent of -3.00%. These days, when repo rates get near or below -3.00%, dealers will not cover their shorts. It’s also why you rarely see repo rates below -3.00%

Supply And Demand

Think of the repo market like any market, it’s the meeting place between supply and demand. Demand in the specials market comes from the shorts. Traders might be outright short the market, they might feel the short-end of the curve will back-up more than the long-end, and traders are just more likely to hedge when they expect rising rates. Basically, when there are more shorts in the market, the demand for securities increases.

Supply comes from the available supply in the market – dealer inventories, securities lenders, prime brokerage accounts, and in general, any portfolio which lends it’s securities into the market. Supply leaves the market when securities are sold to “retail accounts” and portfolios which do not lend their securities. Supply is also a function of which securities the Fed is holding. Currently, the Fed owns about 20 percent of all U.S. Treasuries, a total of $2.39 trillion. The more the Fed owns of specific Treasurys, the more supply can get channeled back into the repo market via the Fed’s securities lending program.

Historical Standards

Let’s put the current situation in perspective. A Fail Charge of -3.00% basis points is expensive by post 2008 standards, but not by historical standards. In 2007 overnight rates were set around 5.00%. Back then if someone failed, there was a 500 basis point cost. It’s a matter of mindset. The Fail Charge was never guaranteed to eliminate fails, it set up to make them more expensive when overnight rates were at 0.0%.

2013 Vs. 2014

Last year, around this time, there was concern about 10 Year Note fails. Beginning in 2013, there was a large short-base in 10 Year Note which culminated in June 2013 and led to a spike in fail volume. The shorts were on target, Bernanke’s “tapering” hint in May 2013 backed-up the Treasury market considerably.

This year, as it turns out, other Treasury issues are special, including the 2 Year Note, 5 Year Note, and 10 Year Note, plus a little bit in the 3 Year Note. Just like last year, there’s an imbalance between supply and demand and that imbalance will be corrected as new securities are issued. More supply in the 2 year and 5 year sectors arrived on June 30 and supply arrived in the 10 Year Note on June 15.

Doomsday Theories

That brings us to the doomsday theories about the spike in fails. Some say the fails are an indication of “stress in the financial system.” That the increased fails are a reflection of the lack of high quality collateral. There won’t be sufficient short-term paper to handle the amount of shorts generated from a round of Fed tightening. That won’t be the case. In June, the fails were concentrated in on-the-run issues: the 2 Year Note, 5 Year Note and 10 Year Note. When on-the-run issues become too expensive in the repo market, shorts move into other issues or instruments, like old issues, double-old issues, futures, swaps, etc.

Another outlet blamed the increase in fails on QE. I can assure you, QE is not causing the fails, and let’s be clear, I’d be one of the first to criticize QE if it did. Remember, the Fed has a securities lending program, so the securities it purchases in the market are still available in the repo market. However, I did read one interesting point. Under Operation Twist, the Fed sold their short-term securities and purchased long-term securities and the Fed does not own any securities that mature until 2016. Operation Twist skewed the Fed’s holdings away from the short-end. Thus, potentially less supply in the short-end of the market.

Then, someone even suggested that the increase in fails was a result of quarter-end. Now, quarter-end does contribute to increased fails, but this fail discussion appeared well before June 30.

Natural Market Mechanism

All in all, the existence of fails is an indication of an imbalance between supply and demand in the repo market. Normally, there’s an abundance of securities (supply) in the market – plenty of securities to fill all of the shorts. When demand increases considerably (more shorts) and that demand exceeds supply, fails are the result. But don’t worry, it’s a normal part of the repo market. Once there’s a shortage, securities become more expensive in both the outright and repo markets. Then, many of the shorts roll out of the expensive issues, portfolios sell their long positions and it brings securities back into the market. Fails were a pretty common occurrence just several years ago. These days, people are a little panicky because they haven’t see as many shortages since the end of the financial crisis.

For more discussion on fails, see my commentary from June 11, 2013

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Roundup: June (Higher Rates, Repo-To-Maturity, MSRB Rule)

juni 25, 2014 in Columns-Artikelen by onze redactie

The seasonal collateral shortage officially ended two weeks ago when about $55 billion in net new securities settled between May 28 to June 2. On Wednesday, the FOMC is expected to trim its QE purchases from $45 billion to $35 billion a month. At the same time, the U.S. budget deficit is still running at $872 billion annualized for FY 2014. On a monthly basis, that means there’s approximately $72 billion net new U.S. Treasurys being issued each month. Why mention the end of the collateral shortage, QE tapering, and Treasury issuance all in one paragraph? They all lead to higher GC Repo rates.

GC/Fed Funds

Over the past 18 months, excessive Treasury issuance was checked by QE purchases. Without the purchases, GC rates would have traded much higher relative to fed funds. In fact, the last time there was no QE program running, GC was averaged 14.1 basis points above fed funds for the month of September 2012 [see graph below]. Coincidentally, that’s when the Fed began its QE3 program – market pundits called it an additional form of stimulus, I called it a way for the Fed to hide the negative consequences of excessive Treasury issuance. With the help of QE3 and QE4, GC has traded below fed funds and at relatively normal spreads, but by July of 2013 and after almost 2 years of QE purchases and over $4 trillion spent, there were so many Treasurys taken out of the market that there was concern that GC would drop to 0% or even dip into the negatives. I believe the immediate reason for the creation of the Fixed-Rate Reverse-Repo program was to prevent GC from flat-lining at 0%. Since then, the FRRP has been successful, it has served as an effective rate floor in the Repo market.

Those were the Repo market fundamentals a year ago, but they’re not the same fundamentals today. This month, the seasonal collateral shortage is over, QE is winding down, and Treasury issuance is still relatively large. GC rates will continue to move higher relative to fed funds, and within a year, I expect GC and fed funds to be trading at the high end of the target range of .25% to 0%.

Specials

The 10 Year Note is special once again and trading at the “fail rate” of -3.00%. Back in May 2009 the Treasury Market Practices Group (TMPG) instituted a “fail charge” for U.S. Treasury securities of 300 basis points based on where rates are today. All in all, when there’s a shortage of a particular Treasury, -3.00% becomes the new 0%. It means there’s a cost to fail a security of 300 basis points. When there’s not enough supply in the market to cover all of the shorts, the Repo rate will drop down to -3.00%

Now, fast forward to early 2013 when we had a series of 10 Year Notes trading very special – during the first two weeks of March 2013 and during the first two weeks of June 2013. Why? Because between February 15 and March 15, and from May 15 to June 15, the on-the-run 10 Year Note is a single issue. That is, it hasn’t been reopened yet, so there’s a limited amount of supply available in the Repo market. Picture a large amount of shorts safely hiding in a triple Treasury issue moving into a single issue of only $21 billion outstanding. When there are a lot of shorts in the market, there’s historically a shortage with only a single 10 Year Note issue outstanding. Like we had recently.

Now, fast forward again to 2014 and the outright 10 Year yield had rallied from 3.00% at the beginning of this year down to a low of around 2.40%. A 60 basis point rally is bound to generate some short sales. Definitely enough shorts for a single 10 Year Note issue to trade special. The good news is that on Monday, June 16th, a new $21 billion in 10 Year Note supply settled and that’s why rates loosened up so much.

Fixed-Rate Reverse-Repo (FRRP)

General collateral rates have averaged 11.2 basis points since June 1st, which is 6.2 basis points above the FRRP floor rate of .05%, yet still there’s a large volume trading each day at the Fed. Assuming the “customers” who have access to the FRRP are seeing a rate of .09% each day (GC minus 2 basis points), that means there’s about $100 billion in cash which would rather get 5 basis points at the Fed than an additional 4 basis points in the open Repo market. Giving up 4 basis points on $100 billion is the equivalent of $111,000 a day, or $40.5 million annually. Then with GC at .15% yesterday, there was still over $50 billion in FRRP booked with the Fed. A hefty amount of cash will give up revenue just for the privilege of trading with the Fed. It will be interesting to see what happens when Repo rates get to .25% or .30%. Will there still be volume at the FRRP?

Overall, it means a certain amount of FRRP volume is price inelastic. Meaning, having the Fed as a counterparty is worth something to “customers” and not just on month-end or quarter-end when they’re printing a financial statement and possibly paying a regulatory capital charge.

FASB Updates Repo-To-Maturity (RTM)

The Financial Accounting Standards Board (FASB) recently published Update No. 2014-10, which revised accounting for repo-to-maturity trades. Technically, RTM will no longer be considered a sale with a forward purchase, and instead, the whole transaction will be considered a “secured borrowing.” In the past, when there was a forward purchase, a repo-to-maturity could be netted with the security’s maturity and considered a risk-free netted transaction. Thus, the RTM transaction qualified as a “true sale” and it allowed banks to remove the securities from their balance sheet.

MF Global had taken this trade one step, actually let’s say two steps further. They entered RTM trades with non-risk-free securities, like the sovereign bonds of Italy, Spain, Portugal, Ireland and Belgium. Second, since LCH.Clearnet did not allow Repo trades to mature on the day the underlying collateral matured, MF Global settled the Repo trades two days before maturity. Technically not risk-free transactions and not exactly repo-to-maturity.

Personally, I don’t see that FASB is revising the rules and closing an accounting loophole. A risk-free security like a US Treasury that’s truly repo’d-to-maturity should be a “true sale” and remain off balance-sheet. It’s a risk-free transaction. However, in light of MF Global and the negative publicity, the new rule is that RTM is no longer off balance-sheet as of December 15, 2014.

MSRB Rule

There’s an unintended consequence of Dodd-Frank about to hit the Repo market. This came to me via Jeff Kidwell at AVM in Florida. The crux of the new rule is whether municipalities should be receiving “advice by a municipal advisor” when dealing with a Repo desk. If that’s the case, then personnel on a Repo desk will be required to register as a Municipal Advisor. This hits the Repo market in two ways, first municipalities are good cash providers to the Repo market, and second, the Street borrows securities from municipalities through the securities lending groups. The new rule is set to begin July 1, 2014 and several broker-dealers are analyzing the additional amount of regulatory work that’s required to continue to do business. Some broker-dealers might cease doing business with municipalities.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

The Fed’s Toolbox

juni 11, 2014 in Columns-Artikelen by onze redactie

Making it more snug, like a screw turned into a hole a little tighter. That’s why tighter monetary policy has been referred to as a “snugging.” Tightenings have been described in different ways by different Fed chairmen. William McChesney Martin started the analogy that it’s the Fed’s job to take away the punch bowl just as the party gets going. Fed Chairman Paul Volcker liked the term snugging a lot. Back in April 1987, he called for a tightening as “some slight snugging” of interest rates, but he had also used the term often before then.* Fed Chairman Alan Greenspan continued to use snugging, but expanded it. He used it to describe any tightening, be it 25 basis points or 50 basis points. I’ve also read that snugging was used to describe unannounced changes in monetary policy, back before central banks specifically announced interest rate targets.

Toolbox

These days snugging isn’t used as much to describe tightenings, which happens to be an important Federal Reserve discussion right now, perhaps even a dilemma. The Fed injected massive liquidity in the market over the past few years, so when it comes time to tighten policy, the Fed must tighten rates and take cash out. It’s not as easy to take trillions of dollars out of the market and not leave some collateral damage along the way. The Fed uses different tools to manage interest rates and snugging is one of the actions they perform, just like a screwdriver is the tool used to tighten a screw.

The main “driver” of the recent loose monetary policy was the Quantitative Easing (QE) purchases, that is, putting massive amounts of cash into the market by purchasing government securities. Now, picture that it’s time drain that liquidity. The Fed needs a tool, like a phillips head screwdriver to tighten the screw and thereby tighten monetary policy. If the policy was a phillips head screw (QE purchases), then they should use the same tool to reverse policy and remove the liquidity.

But that’s not what the Fed wants to do. Yes, all of that liquidity can be removed by selling the SOMA portfolio, but it’s not their plan. I get it though, with the announcement of both the Fed and Treasury selling securities at the same time, there would be a massive sell-off in the market pushing all U.S. interest rates higher, and a huge financing spread for Treasurys in the Repo market. It would make it look like QE was a tradeoff between low rates yesterday to be paid back with higher rates tomorrow. Basically, the Fed doesn’t want to use the phillips head screwdriver to remove the phillips head screw.

So how does the Fed drain without selling securities? They have to use the other tools in the toolbox. Luckily, they have several to choose from: there’s the Interest On Excess Reserves (IOER), the Term Deposit Facility (TDF), and the brand-new Fixed-Rate Reverse-Repo facility (FRRP).

The IOER and TDF are basically the same tool. They both pay banks to deposit their excess reserves at the Fed. One is overnight and the other is term. They both drain cash from the market. Let’s call these tools flat head screwdrivers. One of them has a short shaft the other one has a long shaft. Not exactly best tools for removing a phillips head screw, but they can do the job if used carefully.

The FRRP is the new tool and it’s very specialized, like one of those special screwdrivers with the star head or square head; you have to buy them specifically at the hardware store. It’s a screwdriver like the phillips head and flat head, but if it is used, it doesn’t quite fit very well. Still, not the best tool for the job.

Using The Right Tool

The Fed realizes they will need to drain liquidity in order to raise interest rates – whenever that time comes. Under the QE programs, they amassed a portfolio of $4.05 trillion government securities and pushed overnight rates down close to zero. The trick for the Fed, and all of the discussion right now about testing new tools, is because there’s a massive snugging job to drain so much liquidity. Remember, if you use the wrong tools, you just might strip the screw. The Fed just arrived at the job with a whole box of tools, when all they really need is one, the phillips head screwdriver (sell the SOMA portfolio), but it’s not a part of the discussion because everyone knows it would make the original QE purchases look like a mistake. Given there’s no reason to point out mistakes, they’ll use those other tools to do the job.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Fed Funds And Repo

mei 27, 2014 in Columns-Artikelen by onze redactie

The overnight federal funds rate is currently the base interest rate which anchors the entire U.S. financial system. For years, it was the only benchmark short-term interest rate, at least until the overnight Repo rate came around.

Banks are required to keep a certain portion of their deposits as reserves at the Fed. Any cash in excess of those “required reserves” and not written as loans are a bank’s “excess reserves.” Those reserves can be deposited at the Fed or loaned to other banks in the inter-bank federal funds market.

History

I always wondered what “fed funds” actually meant. It’s not “Fed Funds” with a capital “F,” the term is short for “federal funds.” Where did the “federal” part come from?

The first federal funds were traded in New York in the summer of 1921. Back in the day, banks could transfer funds between each other in two ways: from their clearinghouse account or from their account at their Federal Reserve Bank. A clearinghouse transfer took at least one day to clear whilst the Fed account cleared on the same day. If a bank needed funds to clear a transfer in their clearinghouse account, they could borrow those funds from another bank which settled at the Federal Reserve Bank account. The next day, when the clearinghouse funds arrived, the overnight loan in their Federal Reserve Bank account was paired-off and netted. Thus the origin of borrowing “federal funds” – funds that could be borrowed from another bank at a Federal Reserve Bank account.

Participation in the federal funds market was limited to banks who held funds at the Federal Reserve Banks. The Fed liked the federal funds market because it provided members with a way to borrow bank reserves without tapping the discount window. By 1930, trading in federal funds included wire transfers and other payment methods. Non-banks were prohibited from the fed funds market, but it was not yet an official rule.

As the U.S. financial system matured in the 1960s, non-banks wanted an overnight cash investment that paid a market interest rate, but they were not allowed to access to the federal funds market. Instead, the overnight Repo rate became the means of allowing non-banks to earn an overnight rate, though it was slightly below the federal funds rate. The combination of the federal funds rate for banks and the Repo rate for non-banks became the dual overnight rates of the U.S. financial system.

The prohibition of non-bank access to the federal funds market was formalized by the Monetary Control Act of 1980. In it, only banks which held reserves at the Federal Reserve were allowed to participate in the federal funds market, all other financial institutions were relegated to the Repo market.

The Market Today

The fed funds market today is structured along the same lines as the Repo market. There is no exchange or central marketplace, instead, buyers and sellers meet at the different inter-dealer brokers (IDB), which include: ICAP, Tullet, Tradition, Cantor, etc. Participants in the funds market include large banks, small banks, GSEs, and foreign banks. At the end of every trading day, the Federal Reserve publishes the weighted average of all of the IDB trades which becomes the “federal funds effective rate,” along with the high and low trade of the day. The CME’s Fed Funds Futures contact is based on the effective rate, whereas the opening trade in fed funds each morning is used to price many other financial contracts.

Fed Funds And Repo

The Repo market, by comparison, is made up of banks, securities dealers, money funds, hedge funds, and many other financial institutions. The Repo market includes both the banking system and the shadow banking system, all in one place. It’s the overnight borrowing and lending market of the entire financial system.

Though the federal funds rate is the target short-term rate for monetary policy, the Fed uses the Repo market to manage the rate. In the past, the Fed used Matched-Sales (now Reverse-Repo operations) to drain funds; System RP, Customer RP to add liquidity, and just recently added the Fixed-Rate Reverse-Repo Facility. Basically, the Fed uses the Repo market to drain and add cash to keep the fed funds rate near its target rate. Under the 0% rate environment, there’s less fine tuning required. Given the fed funds target is a range of .25% to 0%, there’s much less day-to-day adjustments involved. If, and when, the fed funds rate becomes a specific target rate again, there will be more fine tuning.

The Spread Between GC And Fed Funds

The Repo rate for Treasury collateral (General Collateral or GC) should always trade a couple of basis points below fed funds, but it doesn’t. GC Repo is collateralized by a U.S. Treasury security whereas fed funds is an uncollateralized loan. In other words, there’s nothing backing that fed funds loan except the credit of the counterparty. Granted the overnight risk is minimal; GC is still more secure. Even so, GC has traded anywhere from 25 basis points above fed funds to 500 basis points below fed funds over recent years.

There’s always a general trend in the relationship between the two markets, but over time, the spread can vary wildly. The spread between GC and fed funds tells a lot about the financial markets at any given time. It’s a good indication of what’s going on behind the scenes, especially over quarter-end when cash and balance sheets are tight. At times, the spread shows when there’s stress in the market and when market participants are over-leveraged.

In general, things like a flight-to-quality, supply and demand for Treasurys, and new Treasury issuance are all factors which affect rates in the Repo market, but not necessarily the fed funds market. A crisis will move GC well below fed funds. We’ve seen terrorist events, a banking crisis, a liquidity crisis which create strong demand for Treasury collateral. In reality, they’re two separate markets that are interconnected.

Back in the 1980s, the GC Repo rate commonly traded between 25 and 30 basis points below fed funds; the relationship was simpler back then and Repo was viewed as a collateralized loan verses fed funds as uncollateralized.

When GC is above fed funds, it usually means there’s oversupply of Treasury securities in the market or bank balance sheets are limited. During the Savings And Loan Crisis in the early 1990s, the GC/fed funds relationship reversed and GC traded between 20 and 25 basis points above fed funds. Banks could not arbitrage the two markets to bring them back inline.

Beginning of 2001 there was another shift in the spread between the two markets. The CFTC changed their 1.25 rule allowing for FCMs (Futures Commission Merchants) to invest their Seg fund cash in Repo in corporates and agencys, instead of just Treasurys. The spread premium that U.S. Treasury collateral enjoyed narrowed. In late 2000, GC was averaging 7 basis points below fed funds, after the beginning of 2001, GC averaged only 3.5 basis points below funds.

One Way Arbitrage

There’s an arbitrage between the two markets, but it only works in one direction. When the GC Repo rate is greater than fed funds, funds traders can borrow collateral instead of lending funds to another bank. Thus, when there’s upward pressure in GC, cash moves from fed funds into Repo and the two rates remain connected. Higher GC rates will pull the funds rate higher. There’s a limit as to how high GC can trade relative to funds, as long as banks are willing to arbitrage the market. When the relationship between GC and fed funds is out of balance, it’s usually on a quarter-end or year-end when banks have balance sheet limitations.

The arbitrage does not work the other way around. If GC rates are below fed funds, there’s really nothing that can be done. When an investor is demanding U.S. Treasury collateral, you can’t substitute an uncollateralized loan for it. That’s why GC can drop hundreds of basis points below fed funds.

Conclusion

According to Liberty Street Economics, the size of the fed funds market was $200 billion in 2007 and was down to only $60 billion in 2012. The Repo market, by contrast, was as large as $7 trillion in 2007 and is estimated to be around $4.5 trillion today.

Remember, I’m a biased Repo market veteran so I don’t see much use in fed funds as the policy rate anymore. Yes, it’s good to have a market for banks to borrow and lend excess cash, but it shouldn’t be used as the benchmark rate for U.S. monetary policy and the world’s benchmark currency. The Repo market is the overnight market for the entire financial system, as opposed to just the declining inter-bank market. I’m surprised the Fed didn’t switched to targeting the Repo rate years ago.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.

Repo Roundup May (Overnight Rates, FTT, Fitch Ratings, NSFR)

mei 20, 2014 in Columns-Artikelen by onze redactie

Last Thursday, May 8th, a net $29 billion worth of collateral left the market; on this coming Thursday, May 15th, another net $16 billion* is about to leave too. Since the beginning of the collateral shortage on April 17, GC averaged 5.7 basis points which was 1.8 basis points below fed funds. There’s no reason to expect the soft funding will end until new supply hits the market, and that won’t be until the end of May when $55 billion in net new securities will settle between May 28 to June 2.

Fixed-Rate Reverse-Repo (FRRP) And The Collateral Shortage

Clearly, when the overnight GC Repo rate drops below 7 basis points, volume at the FRRP increases significantly. Between March 3 and April 16, GC averaged 7.5  basis points and the volume at the FRRP program averaged 87.5 billion a day. When GC dropped to average 5.7 basis points since April 17, FRRP volume picked up to average 173.9 billion. What explains the sharp increase in FRRP volume at rates 1.8 basis points apart? Remember, even when the inter-dealer market for GC is above the FRRP rate of 5 basis points, the offered side that dealers show their customers is lower. If the inter-dealer GC rate is trading at 7 basis points, the rates that customers are shown are between 6 and 4 basis points. For some customers, even lower. When the inter-dealer GC rate drops below 7 basis points, two basis points above the FRRP rate, it makes sense for customers to move into the Fed. Of course, having the Fed as a counterparty is an added benefit. It will someday be interesting to see what happens if GC rates drop even further when there’s a significant collateral shortage or major flight-to-quality.

Financial Transaction Tax (FTT)

It’s back! The UK challenge to the Financial Transaction Tax (FTT) was decided on April 29th. Remember, beginning last year France, Germany, Italy, and Spain, among others, began pursuing a transaction tax which is potentially devastating for the Repo market. A total of 11 countries have signed up for it, and if agreed, it will begin in 2016. We’re supposed to get the final details by the end of this year. The UK challenged the tax and the EU judges decided that it was impossible to challenge a proposed future tax, therefore, the challenge was premature and thrown out. However, the UK is allowed re-challenge the tax after it goes into effect.

Fitch Ratings

Fitch Ratings announced that the Fed’s Fixed-Rate Reverse-Repo facility is good news for money market funds’ ratings. At the same time, the facility is neutral for broker-dealers’ ratings. Since a larger portion of money market funds’ cash investments are now facing the Fed instead of broker-dealers and banks, money funds have less counterparty risk and therefore less fire-sale risk if their counterparty defaults. With the FRRP limit at $10 billion,** most money funds can completely fulfill their overnight cash investment through the Fed. It makes sense that money funds with access to the Fed facility should receive a better credit treatment.

Net Stable Funding Ratio (NSFR) Rumor

Last week I wrote about the Net Stable Funding Ratio and its potential effect on the Repo market. One reader was nice enough to forward some additional information to me. Evidently, there’s a bit of a conspiracy rumor about a change in the NSFR related to Repo. I’m told that Repo transactions were changed to be defined as “loans,” rather than “securities finance transactions,” at the last minute in January. Evidently, the change was slipped in right around the same time the Basel Committee decided to allow Repo netting for the Leverage Ratio. Some people believe the Basel Committee is attempting one last ditch effort to restrict leverage in the Repo market, knowing they had already conceded on the Leverage Ratio.

SEC Broker-Dealer Leverage Ratio

The SEC issued a regulatory report last year saying that they’re considering a Leverage Ratio for broker-dealers. The exact details of the rule are not clear as to whether the SEC will define the broker-dealer Leverage Ratio similar to the Dodd-Frank rule. I doubt it. In the past, U.S.-based broker-dealers had leverage as high as 40-to-1 in 2007, but, in general, leverage is down to around 22-to-1. In my experience, the NASD/FINRA has always watched broker-dealer leverage and had soft limits, though they never issued a complicated formula like the Dodd-Frank Leverage Ratio.

* ICAP Wrightson; Money Market Observer; May 11, 2014
** There’s a rumor of an increase in the FRRP counterparty limit to $15 billion coming soon. I’m not sure if an increase from $10 billion to $15 billion will have a significant effect on overall volume, there are only a few counterparties who can print more than $10 billion on any regular day. However, a $15 billion counterparty limit will be very useful on quarter-end.

Kind regards,

Scott E.D. Skyrm

About the Author: Scott E.D. Skyrm

I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I have a book in the process of being published, currently title “The Money Noose” about MF Global. Find more information on Scott E.D. Skyrm’s website – Click here -.