The run-up of repo rates to a high of almost 10 percent has grabbed national attention.
In fact, spikes in the repo rate are nothing new and not surprising since repo is in greater demand around statement dates.
But the attention is understandable. Repo is being asked to do too much.
Institutions such as CME Group with something to lose if our global short-term financing problems aren’t solved should consider providing solutions.
If a financial instrument is used for multiple inconsistent purposes, as the repurchase agreement (repo) market is right now, the price of the misused financial instrument will reflect forces important to one set of users but not all. The short-term sector of our financial markets is plainly malfunctioning. A fix is needed.
The attention paid to the run-up in repo rates, followed by a substantial continuing Fed injection of credit into the repo market, is evidence of a misused repo market. In its traditional role as a market for the supply of collateral, it is no surprise that around tax and reporting dates the short-term demand in the repo market for quality assets for window-dressing and tax purposes is often high, consistent with a market which, like the market for Thanksgiving turkeys, has a seasonal dimension.
But recently the repo market has been picking up new assignments, jobs that have no seasonal dimension. Repo has two newer responsibilities. First, it has largely replaced the Fed Funds market as the market that transmits changes in the Fed’s monetary policy. Second, a version of the repo rate designed by the Fed and called the secured overnight financing rate (SOFR) has been proposed to replace LIBOR as a pricing basis for short-term credit. However. the repo rate alone is not sufficient for all three important distinct tasks. The use of repo as a policy instrument is in direct conflict with the use of repo as an index for credit pricing.
The article explains how we got into the present dire straits, suggests an escape, and that one direct beneficiary of such an escape would be CME Group (CME).
The earlier uses of short-term instruments.
There was once a collection of short-term rates tailor-made for each of the three functions of the short-term market. There was LIBOR for funding and pricing of commercial and personal debt, the Fed Funds rate for monetary policy, and repo for securities lending.
However, LIBOR was killed by inter-bank credit fears and scandal during the Financial Crisis. The Financial Crisis also changed the Fed’s means of using short-term markets for policy purposes. Once the Fed began paying interest on commercial bank balances of excess reserves, the need for large banks to serve as a source of Fed Funds borrowing for the rest of the commercial banking system disappeared. The Fed Funds market became obsolete. Read the Financial Times' discussion here.
Paying banks to hold reserves became desirable when the Fed decided to use its balance sheet to finance the recovery. To induce banks to absorb the major increase in excess reserves the commercial banks would need to hold to provide the Fed with liabilities to finance its growing asset acquisitions, commercial banks were paid an interest rate high enough to motivate the expansion of their excess reserve positions. The Fed’s rate on excess reserves rapidly dwarfed the significance of the fed funds rate, and large banks abandoned the fed funds market altogether.
As a result of the closure of the big banks’ Fed Funds desks, the repo market replaced Fed Funds as the go-to market for smaller banks seeking reserve assets to finance short-term corporate borrowing around tax dates and for balance sheet optics. But to use the repo market as a substitute for the Fed Funds market puts more pressure on repo.
How did we get caught off guard?
As the amount of excess reserves recedes with the Fed's attempt to return to pre-Crisis operating procedures, there are conflicting demands placed on short-term instruments. One telltale sign that run-ups in the repo rate are no longer acceptable is the market reaction to the run-up, exposing the fact that the repo rate has, through lack of foresight from market participants, become an overworked, underpaid, market wheelhorse that is expected to simultaneously serve all three functions: source of credit, policy rate, and securities lending rate. The national attention to the run-up of the repo rate suggests the repo market is not a satisfactory source of money for every market user.
Escalating repo rates around statement dates are nothing new. In fact, calendar-based sudden run-ups of repo rates have been common for decades. However, the growing importance of the other uses of repo has attracted negative attention to this return of run-ups of repo rates.
The Fed’s two inconsistent decisions.
The market focus on the repo market explosion reveals the pressure the Fed placed on the repo market with the first of its two conflicting decisions. First, as the Fed withdrew from its excess reserves-based policy, it failed to return to the repo market-based daily market interventions that were the New York Fed’s bread and butter before the Financial Crisis.
The repo market is perfectly capable of handling a dual role - the primary vehicle for securities lending and an instrument of monetary policy implementation. Indeed, prior to the crisis, the New York Fed’s Open Market Desk, then the primary arm of the Fed for FOMC policy implementation, handled the two functions for over 50 years.
The repo market can once again serve the purpose of funding liquidity shortages as excess reserves are withdrawn from the system. But this decision would require the New York Fed to reestablish its daily open market desk operations. And that would lead to a return to targeting repo rates to implement the FOMC’s policy decisions since the Fed Funds rate cannot be used effectively until excess reserves no longer bear interest. The repo rate would once again be the de facto policy rate.
Second, and more problematic, the Fed has introduced the Short-term Overnight Financing Rate (SOFR), a version of the repo rate intended to replace LIBOR. That decision is not compatible with the other two uses of the repo market. An index rate for broad categories of debt that spikes at statement dates will create undue concern among commercial and consumer users of SOFR as it leaves the impression that securities lending hiccups around tax dates are influencing important consumer-related costs such as mortgage and credit card rates.
The direct tie of consumer and commercial interest rates to FOMC policy decisions creates even greater problems. The Fed must use a collateralized overnight instrument in its transactions, which will make SOFR money cheaper than unsecured money and the repo rate itself an index of past policy decisions. LIBOR was effective as a loan index precisely because it depended on market expectations of future determinants of conditions in the markets for the short-term unsecured debt, the primary cost of commercial lending.
Why accept this problem so passively?
Perhaps the changing uses of short-term instruments should be matched by changes in the instruments used. Why should short-term instrument users place burdens on short-term instruments designed by issuers to meet their specific needs, without also modifying issued instruments to meet new user needs?
Since Goldman Sachs assisted the mortgage agencies in modifying mortgage market instruments to permit mortgage writers to meet their diversification needs by introducing the mortgage-backed security, market participants have understood that markets can benefit from redesigning financial instruments.
Yet instead of replacing LIBOR with a non-deposit, unsecured three-month instrument purpose-built to meet the needs of commercial and consumer indexed borrowers, we have attempted to place that burden on the repo market. The repo market cannot be all things to all men.
There are alternatives. One possibility is to design a three-month instrument that will spring to life spontaneously by introducing a self-settling replacement for Eurodollar futures. Eurodollar futures is the largest futures market in the world, measured in dollar volume, yet it settles at an index rate, LIBOR, that is coming to an end in 2021. No more LIBOR. No more Eurodollar futures.
By settling a futures market through exchange-originated origination of the deliverable instrument, explained here, CME Group could simultaneously replace the Eurodollar contract, while providing a new cash market that resolves the problems of a missing source of funding for our most important consumer credit markets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.