That’s right. Multiple parties report that they own the very same asset, when only one of them truly does. What happened? That’s the layman’s explanation of what’s happening. Here I distinguish between price volatility and systemic volatility. As former Fed governor Daniel Tarullo put it at the Hutchins Center event: “With the budget deficit having increased by about 50 percent in the last two years, the supply of new Treasuries that need to be absorbed by debt markets has grown enormously. What Happened Last Week in Repo? Two events coincided in mid-September 2019 to increase the demand for cash: quarterly corporate taxes were due, and it was the settlement date for previously-auctioned Treasury securities. Financial regulators can’t publicly admit to this, but big banks know it’s true—and that’s why they hunker down (and stop lending) when they sense one of their kin is in trouble. I saw inaccuracies in Wall Street’s ledger systems while running Morgan Stanley’s pension solutions business (2007-2016), holding senior roles at Credit Suisse (1997-2007) and starting my career at Salomon Brothers (1994-1997). The repo market is a critical resource for large businesses to get the overnight financing they need to pay taxes, make payroll, fund operations, etc. Recovery and Resolution planning. It’s akin to musical chairs—no one knows how many players will be without a chair until the music stops. First of all, what is the Repo Market? Given that short-term interest rates are closely linked, volatility in the repo market can easily spillover into the federal funds rate. The Fed apparently miscalculated, in part based on banks’ responses to Fed surveys. That … What started in the repo market last week isn’t new—it’s actually the fourth such episode since 2008. Overnight lending rates topped at an annualized rate of 10% last week, four times higher than the prior week. On September 16 and 17, bid-ask spreads were higher than usual and the fed funds distribution became more dispersed as shown in Figure 3. This brings us to the market on September 16, 2019. Banks have some preference for reserves to Treasuries because reserves can meet significant intra-day liabilities that Treasuries cannot. Party A owns a particular US Treasury Bond, showing an asset of $100. money market mutual funds) to earn a small return on that cash without much risk, because securities, often U.S. Treasury securities, serve as collateral. Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”. Post was not sent - check your email addresses! The Repo Market provides wholesale short term funding for a period of 1 to 30 days. The borrower (hedge fund) or the dealer sells securities such as the U.S. Treasury bills as a … Rather, I’m referring to the practice in the repo market that allows more people to believe they own US Treasuries than actually do. However, it provides a “teachable moment” regarding systemic fragility and anti-fragility. Some in financial markets are skeptical, however, because QE eased monetary policy by expanding the balance sheet, and the new purchases have the same effect. Instead, it is buying assets for the sole purpose of injecting liquidity into the banking system. When the Fed started to shrink its balance sheet in 2017, reserves fell faster. Repo is a short form of Repurchase. The Fed can take direct action to keep the funds rate in its target range by offering its own repo trades at the Fed’s target rate. The Hutchins Center on Fiscal and Monetary Policy, buy about $60 billion in short-term Treasury securities, say that this is not another round of quantitative easing, Former Fed official Nellie Liang on why to care about the rising volatility in repo market, Jamie Dimon, chairman and chief executive of J.P. Morgan Chase, points. As risk premiums go, 8% is shockingly high—for a supposedly risk-free asset! And I think it’s up to the regulators to decide they want to recalibrate the kind of liquidity they expect us to keep in that account.”. In the case of a repo, a dealer sells government securities to … In the repo market, financial institutions such as hedge funds and investment banks borrow cheap money from large investors such as mutual banks to fund their operations. In stark contrast to the traditional financial system, Bitcoin is not a debt-based system that periodically experiences bank run-like instability. counting of US Treasuries takes place. That’s not the Fed’s intention this time. That’s the fairy tale to keep everyone calm while the central banks scramble to figure out what happened. Between 2008 and 2014, the Fed engaged in Quantitative Easing (QE) to stimulate the economy. Every player knows there aren’t enough chairs. Repo (short for repurchase agreements, which amount to collateralized short-term loans) jolted Wall Street in mid-September when the amount of cash available dropped just as the demand to borrow … Prior to the global financial crisis, the Fed operated within what’s known as a “scarce reserves” framework. But, similar to LCR, banks believe that government regulators prefer that banks hold on to reserves because they would not be able to seamlessly liquidate a sizeable Treasury position to keep critical functions operating during recovery or resolution. Singh has been recommending for years that regulators’ financial stability assessments of big banks be adjusted to back out “pledged collateral, or the associated reuse of such assets.” Financial regulators should have followed his advice years ago! Amazon and Walmart have raked in billions in additional profits during the pandemic, and shared almost none of it with their workers, How misinformation is distorting COVID policies and behaviors. Why is state and local employment falling faster than revenues? But US Treasuries are not risk-free. But how does the market for repurchase agreements actually work, and what’s going on with it? Now the repo-market turmoil has given an answer—and it is far higher than the Fed expected. All Rights Reserved, This is a BETA experience. This was made more confusing by the complexities of the market itself. Today, though, the marginal purchaser is a primary dealer. Banks and their lobbyists tend to say the regulations were a bigger cause of the problems than do the policymakers who put the new rules into effect after the global financial crisis of 2007-9. The Repo market is a short term lending facility for banks, hedge funds, and other Wall Street firms. It’s not surprising that the volume of Treasury-backed repo transactions has increased substantially in the last year and a half. In light of the traditional financial system’s instability, despite all of Bitcoin’s drawbacks, I find that a powerful concept. The additional debt leaves primary dealers—Wall Street middlemen who buy the securities from the government and sell them to investors—with increasing amounts of collateral to use in the repo market. The closest I’ve heard a financial regulator speak publicly of this is former CFTC Chairman Chris Giancarlo, to his credit, when he answered a question after a 2016 speech: “At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another. Global SIFI surcharge. In June 2014, FASB updated the US GAAP accounting rules for repos. hosted by the Hutchins Center on Fiscal & Monetary Policy on December 5, 2019. This is the real reason why the repo market periodically seizes up. What has the Fed done in response to the COVID-19 crisis? The whole thing is very dull and predictable. Here’s what the books of three parties show when a transferee (Party A) sells pledged collateral to a third party (Party C): If you add up the positions of all parties, economically there’s no problem because the net of the two longs and one short position add up to $100. The financial panic of 2007-8 stemmed from a run on the repurchase or "repo" market -- the primary source of funds for the securitized banking system -- rather than a run on monetary deposits as in earlier banking panics, according to a recent study by Gary Gorton and Andrew Metrick. So banks that are near the top of a bucket may be reluctant to jump into the repo market even when interest rates are attractive. So what really happened in September 2019 in the repo market? the financial system is. When interest rates in the overnight lending market (known as the repo market) spiked in September, there was a real fear that it was a sign of something far worse. Starting on September 16 interest rates rose sharply in the market for repurchase agreements, or repo. The ‘repo market’ is a critical market within the financial system of an economy as it signals important information: about the cost of borrowing secured credit across an economy (i.e. What happened last week? The repo market channels more than $1 trillion in funds through Wall Street every day, usually without fanfare. This explainer draws, in part, from a public event, The repo market disruption: What happened, why, and should something be done about it? A repurchase agreement (repo) is a short-term secured loan: one party sells securities to another and agrees to repurchase those securities later at a higher price. Far from it. The $1 trillion "repo market" allows banks and other financial institutions to borrow and lend from one another, usually overnight. The researchers analyzed 15,000 individual repo transactions, taking about a year to code and extract the data from the SEC filings. Join the conversation on Twitter using #RepoMarket In September, a disruption in the market in which banks and others lend and borrow for very short periods of time, the repo market… The financial system is fragile. Now the repo-market turmoil has given an answer—and it is far higher than the Fed expected. Post-crisis rules require that banks prepare recovery and resolution plans, or living wills, to describe the institutions’ strategy for an orderly resolution if they fail. The Fed has gone out of its way to say that this is not another round of quantitative easing (QE). Until the last couple of years, the Fed was buying Treasury bonds under its QE monetary policy. Given the crucial importance of the REPO market, it has created a real shock for the financial markets and served as an important warning for financial institutions. This was made more confusing by the complexities of the market itself. Specifically, the Fed’s focus on the fed funds market is misplaced because the real action is in the much bigger, much more global repo market; the Fed shouldn’t have allowed America’s big banks to pay dividends or buy back stock when they’re so capital-constrained that they can’t even pick up an 8% “risk-free” arbitrage; the Fed’s proclamation that “the financial system remains resilient,” when it released the results of the most recent bank stress tests in June 2019, strains credulity; a staggering amount of US dollar liabilities have been issued offshore in recent decades and the Fed not only doesn’t control them but can’t measure them with any degree of accuracy; and banks’ financial statements don’t accurately reflect their financial health. They recognize that what appears to be an 8% risk-free arbitrage is anything but risk-free. An anti-fragile system is one that becomes stronger and more resilient as a result of shocks, not weaker. The good news is that while what happened in the repo market may sound alarming, there’s no need to worry. Opinions expressed by Forbes Contributors are their own. © 2020 Forbes Media LLC. The problem arises when you aggregate the three US GAAP financial statements. This brings us to the market on September 16, 2019. No one knows, but I doubt this is “the big one.” Sure, the repo market is flashing red sirens. Starting on September 16 interest rates rose sharply in the market for repurchase agreements, or repo. So, just a few weeks ago, I talked with an economist who could better explain to me what the repo market is, why the Federal Reserve sometimes participates in the repo market, and what exactly happened last fall. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points). The regulatory authority responsible for the markets, the Federal Reserve of New York (FRoNY), had to stage a … He’s saying that the repo market passed through the eye of a storm due to quarterly corporate tax payments, which was the excuse for SOFR spiking over 10% on Sept. 17. The Fed’s involvement in the repo market can be traced back to Sept. 16, when a traffic jam occurred at the intersection of cash and securities. Last week the financial system ran out of cash. The event doesn’t mean another financial meltdown is necessarily imminent—just that the risk of one is heightened—since the brush fire can be doused either by the Fed, or by the banks raising more equity capital. On Tuesday, September 17th and Wednesday, September 18th, the REPO market in New York experienced a short but violent crisis. The Fed targeted the interest rate in this market and added or drained reserves when it wanted to move the fed funds interest rates. It’s unstable. Heading toward the end of the year, the demand for cash by these financial institutions increases, primarily to balance their books in order to comply with federal regulations. Repo is a vital cog in how Wall Street works and a major way that investors big and small—including anyone who owns a money-market savings account—could earn interest. Liquidity Coverage Ratio (LCR) and Bank Internal Stress Tests. The TGA has become more volatile since 2015, reflecting a decision by the Treasury to keep only enough cash to cover one week of outflows. But, as usual, the Fed will almost certainly do what it always does—stem the run by injecting cash into the system in various ways, thereby socializing losses among all US dollar holders. No one really knows how solvent (insolvent?) Sorry, your blog cannot share posts by email. “The repo market is the market where people running leveraged positions borrow,” Stanley told MarketWatch in an interview. Financial institutions do not want to hold cash because it is expensive—it doesn’t pay interest. The market sprung a leak last week. What started in the repo market last week isn’t new—it’s actually the fourth such episode since 2008. In addition, the marginal purchaser of the increased supply of Treasuries has changed. But former and current regulators point out that the LCR probably didn’t contribute to the repo market volatility because Treasury securities and reserves are treated identically for the definition of high-quality liquid assets in the regulation. In an October 2019 call with analysts, he said, “[C]ash, we believe, is required under resolution and recovery and liquidity stress testing. The repo market is important for at least two reasons: The repo rate spiked in mid-September 2019, rising to as high as 10 percent intra-day and, even then, financial institutions with excess cash refused to lend. The repo market is an important component of short-term funding markets and the source of financing for dealers’ holdings of Treasury bonds. Bilateral repo transactions can either allow for general collateral or impose restrictions on eligible securities for collateral. I hold degrees from Harvard Law School (JD, 1994), the Kennedy School of Government (MPP, 1994) and the University of Wyoming (BA, 1990). These rules may have led banks to hold on to reserves instead of lending them in the repo market in exchange for Treasury securities. Why was someone willing to borrow cash at a 10% interest rate last Tuesday, in exchange for pledging US Treasury collateral that yields only 2% or less? Auditors can’t catch this because GAAP accounting standards obfuscate it, as I’ll explain later. Subsequently, it increased the size of its daily lending to $120 billion and lowered its long-term lending. Banks also say that government supervisors sometimes express a preference that banks hold reserves instead of Treasuries by questioning assumptions bank make when they say they could quickly sell Treasuries without a large discount at a moment of stress. It always has been. Since the outbreak of COVID-19, the Fed has vastly expanded the scope of its repo operations to funnel cash to money markets. Keep in mind that the repo market conducts about $1 Trillion daily in repo transactions. The repo market is important because it serves as the grease that keeps the global capital markets spinning. In January 2019, the Federal Open Market Committee – the Fed’s policy committee – confirmed that it “intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.” When the Fed stopped its asset purchasing program in 2014, the supply of excess reserves in the banking system began to shrink. The lenders of … Why does this facility exist? On average, $2 trillion to $4 trillion in repurchase agreements – collateralized short-term loans – are traded each day. The Fed has a theory about why. In a reverse repo, one party purchases securities and agrees to sell them back for a positive return at a later date, often as soon as the next day. Banks tried to hold just the minimum amount of reserves, borrowing in the federal funds market when they were a bit short and lending when they had a bit extra. “The repo market is the market where people running leveraged positions borrow,” Stanley told MarketWatch in an interview. And therefore, we could not redeploy it into repo market, which we would’ve been happy to do. Before coronavirus turmoil hit the market, the Fed was offering $100 billion in overnight repo and $20 billion in two-week repo. I’m a 22-year Wall Street veteran who has been active in bitcoin since 2012, and whose passion is a fair and stable financial system. At the end of each year, international regulators measure the factors that make up the systemic score for a global systemically important bank (G-SIB), that in turn determines the G-SIB’s capital surcharge, the extra capital required above what other banks are required to hold. Hutchins Center on Fiscal & Monetary Policy, The Brookings Institution. As Bitcoin Blasts Past $25,000, Here’s Why This Investor Made The Surprise Decision To Sell, Forbes Favorites 2020: The Year’s Best Cryptocurrency Stories, Forbes Cryptocurrency Awards 2020: The $3 Trillion Bitcoin Marketing Campaign, SEC Files Action Against Ripple And Two Senior Executives; SEC Issues Comment For Digital-Asset Securities Custody By Special Purpose Broker-Dealers, Massive Hack Exposes Bitcoin’s Greatest Weakness, The ‘Beginning Of The End’ For Ripple And XRP As Coinbase ‘Considers Its Options’, What The SEC Charging Ripple Means For Cryptocurrencies, Why This Former Billionaire And Goldman Sachs Veteran Now Sees Bitcoin Hitting $50,000 In 2021, Bitcoin And Crypto Trading Tips From Poker World Champion Annie Duke. Strains in the repo market that emerged on the morning of September 16 quickly spilled over to the fed funds market later that day. Auditors can’t help here, and the accounting profession bears some of the blame for this problem. But these two anticipated developments don’t fully explain the volatility in the repo market. What does this mean for markets in the short-term? The repo market blew out in mid-September. Jamie Dimon, chairman and chief executive of J.P. Morgan Chase, points to these restrictions as an issue. As a result, the pre-crisis framework no longer worked, so the Fed shifted to an “ample reserves” framework with new tools – interest on excess reserves (IOER) and overnight reverse repos (ONRRP), both interest rates that the Fed sets itself – to control its key short-term interest rate. The repurchase agreement, or “repo,” market is an obscure but important part of the financial system that has drawn increasing attention lately. The repo market is where dealers in low-risk liquid assets are able to obtain short-term cash through selling their securities to counterparty buyers through a repurchasing agreement before being required to purchase the securities back at a pre-agreed point in time. It was a modern version of a bank run, and it’s not over yet. (By this, I’m not referring to the US potentially defaulting on its debt obligations. It’s as close as a regulator will come to admitting the reality that the system doesn’t work the way most of us think it does and that the Fed may not even understand critical things about it. Guidance for the Brookings community and the public on our response to the coronavirus (COVID-19) », Learn more from Brookings scholars about the global response to coronavirus (COVID-19) ». When the Fed injects cash into the repo market, they are buying government debt, and it remains to be seen whether the Fed can or should become the buyer of last resort for government debt. By the end of July, the repo problems made their way into the Fed’s meeting, as we learned when the minutes of that meeting were released in August. … The repo market allows financial institutions that own lots of securities (e.g. Stepping back, it reveals two big things about financial markets: first, US Treasuries are not truly “risk-free” assets, as most consider them to be, and second, big banks are significantly undercapitalized. So why aren’t banks falling over themselves to rake in such easy, “risk-free” profits? When interest rates in the overnight lending market (known as the repo market) spiked in September, there was a real fear that it was a sign of something far worse. This describes Bitcoin, whose network security grows as the system’s processing power grows. I can sum up why this happened in two words: central banks. For me, Bitcoin is empowering because it provides a choice to opt out of the traditional financial system. Yes, it’s true that a run in the repo market is serious, since the big banks are still overly reliant on it and one dropped ball by the Fed could quickly turn the brush fire into an inferno. This crisis was a sign of the endemic fragility of the interbank markets, which in reality have never recovered from the financial crisis of 2008-2009. What exactly happened? It ramped up the operations on March 9, offering $175 billion in overnight and $45 billion in two-week repo. Then, on March 12, the Fed announced a huge expansion. But the Fed has signaled that it wants to wind down the intervention: Federal Reserve Vice Chair Richard Clarida said, “It may be appropriate to gradually transition away from active repo operations this year,” as the Fed increases the amount of money in the system via purchases of Treasury bills. However, at the Hutchins Center event, Tarullo noted that reserves and Treasuries “are not treated as fungible in resolution planning or to meet liquidity stress tests.” As part of the post-crisis framework, banks are required to conduct their own internal liquidity stress tests, the Comprehensive Liquidity Analysis and Review (CLAR), which are subject to review by the supervisors. It had already briefly blown out at the end of 2018, then settled back down. What happened then? This is why US Treasuries aren’t risk-free—they’re the most rehypothecated asset in financial markets, and the big banks know this. In the week of Sept. 16, a lot of cash flowed out of the repo pipes just as more securities were flowing in -- meaning that suddenly there wasn’t enough cash for those who needed it. I jumped to blockchain to try to fix these problems, and from 2016-2018 I was chairman and president of Symbiont, an enterprise blockchain company, where I jointly spearheaded blockchain delivery of index data to Vanguard. The repo market is an important component of short-term funding markets and the source of financing for dealers’ holdings of Treasury bonds. the risk-free rate); and US Treasuries are the core asset used by every financial institution to satisfy its capital and liquidity requirements—which means that no one really knows how big the hole is at a system-wide level. There are two ways in which these purchases are different from QE: The Fed has also been conducting daily and long-term repo operations. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points). banks, broker-dealers, hedge funds) to borrow cheaply and allows parties with lots of spare cash (e.g. That trade lost someone a whopping 8% (annualized) overnight, but presumably the trade allowed the bank to stay in business for another day. The securities serve as collateral. As demand exceeded supply, the repo rate rose sharply. And no one really knows how much double-, triple-, quadruple-, etc. They noted that firms not subject to bank regulations, such as money market funds, government-sponsored enterprises, and pension funds, also seemed reluctant to step in when repo rates rose sharply in mid-September, suggesting that factors other than bank regulations may be important. When the government runs a budget deficit, it borrows by issuing Treasury securities. But then they reversed course, cut rates three times, and also re … But repo rates spiked way above unsecured lending rates last week, even for “risk-free” collateral such as US Treasuries. In this regard, Bitcoin is an insurance policy against financial market instability. This is why the FT’s interview with Williams was so extraordinary. Everyone knows someone will eventually lose. Most financial regulators baffle us with jargon when they discuss this issue, making it barely intelligible to regular folks (cloaking it in such terms as “clogged transmission mechanisms,” “length of collateral chains”). For years, IMF economist Dr. Manmohan Singh has done terrific work estimating it (see examples here, here, here, here, here, here and here). I saw inaccuracies in Wall Street’s. But almost no one is talking about the elephant in the room. The Fed has cut interest rates to near zero, is re-starting quantitative easing like it did in the 2008 Financial Crisis, and it’s actively trading in something commonly referred to as the “repo market.” But this isn’t the first time in the last year that the Fed has been working in the Repo Market. They found that, before the market contracted, money market funds held $2.3 trillion in assets, and about $400 billion in repos. Since January 2018 I've volunteered in my native state of Wyoming to enact a series of enabling blockchain laws, and am a gubernatorial appointee to the Wyoming Blockchain Task Force. What happened in the repo market in September 2019? Bitcoin Value Tops Half A Trillion Dollars—Is The Bitcoin Price About To Smash $30,000? But the issues started bubbling up again. Fed officials concluded that the dysfunction in very-short-term lending markets may have resulted from allowing its balance sheet to shrink too much and responded by announcing plans to buy about $60 billion in short-term Treasury securities per month for at least six months, essentially increasing the supply of reserves in the system. On the surface $75 billion is a very small percentage of the total daily volume. A significant amount of cash (supply) flowed out of the repo market just as more securities (demand) were flowing in. The core function of the repo market is exchanging Treasury securities — in other words, government debt — for cash. Holding a lot of reserves won’t push a bank over the threshold that triggers a higher surcharge; lending those reserves for Treasuries in the repo market could. For example, hedge funds hold a lot of assets but may need money to finance day-to-day trades, so they borrow from money market funds with lots of cash, which can earn a return without taking much risk. An increase in the systemic score that pushes a bank into the next higher bucket would result in an increase in the capital surcharge of 50 basis points. Yet few observers expect the Fed to start up such a facility soon. It made me uncomfortable when I first realized all of this, which for me happened during the financial crisis while I was working on Wall Street and took a deep dive into why the crisis was happening. By buying long-dated assets, the Fed helped persuade investors that it meant what it said about keeping rates lower for longer than might otherwise have been the case (. QE can have a powerful signaling effect, reinforcing the Fed’s words. Furthermore, since the crisis, the Treasury has kept funds in the Treasury General Account (TGA) at the Federal Reserve rather than at private banks. When that same bond is reused again and again and again in similar transactions, the magnitude of double counting within the financial system builds in a manner that no one can accurately measure. That’s nonsense. I’m a 22-year Wall Street veteran who has been active in bitcoin since 2012, and whose passion is a fair and stable financial system. The LCR requires that banks hold enough liquid assets to back short-term, runnable liabilities. The difference between the securities’ initial price and their repurchase price is the interest paid on the loan, known as the repo rate. This resulted in a large transfer of reserves from the financial market to the government, which created a mismatch in the demand and supply for reserves. 1. The balance sheets balance because Party B records a liability, so auditors don’t catch the problem. 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An issue tax changes, U.S. multinationals with large offshore cash holdings were significant... Is anti-fragile borrow cheaply and allows parties with lots what happened in the repo market spare cash ( supply flowed! Purchasers of Treasuries has changed to do unsecured lending rates last week, even “... Reserves from the banking system want to hold cash because it is far higher than the prior week, Fed. Percentage of the increased supply of reserves in the repo market '' allows banks and other Wall Street every,. U.S. multinationals with large offshore cash holdings were also significant purchasers of has. Flush with cash, making a wide range of transactions easier the Hutchins Center on Fiscal Monetary! A budget deficit, it is draining reserves from the banking system and local employment falling than. A and Party C report that they own the very same asset, when Fed! The three US GAAP financial statements fully explain the volatility in the room that they own the very same,! 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