What's the matter with the repo market?

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      By Tim Robey, CAIACash Management and Short Duration Portfolio Manager, Eaton Vance Management and Justin Ziegler, CFASenior Credit Analyst, Investment Grade Fixed Income Credit Analyst, Eaton Vance Management

      Boston - On September 16, the cost to borrow - the overnight U.S. dollar (USD) repo1 funding rate - spiked up to 10% intraday,2 after hovering in the low 2% range since August 1.

      While there's no consensus why this happened, we do know that at the time, the need for cash was higher than usual as U.S. corporate taxes were due and large purchases of Treasuries also required funding.

      Repo transactions are important, helping to keep the capital markets running smoothly with cash flowing to where it's needed. Should we worry that this glitch in a relatively arcane area of the securities markets could cause wider problems affecting liquidity and the soundness of the banking system? We don't think so, especially with the U.S. Federal Reserve (Fed) to act as a backstop. But first, a little background on the repo market.

      How does the repo market work?

      Let's say a financial institution has a large inventory of Treasuries on hand for trading, liquidity and other needs. This firm agrees to sell the securities now for cash, at the same time committing to repurchase them after an agreed-upon period for the same amount of cash plus an agreed-upon rate of interest. Since the buyer of the securities only owns them temporarily, this transaction is treated as a short-term loan for economic and accounting purposes.

      Typically, large broker-dealers - including large banks - use this type of loan to finance their security holdings. Real estate investment trusts (REITS), hedge funds, mutual funds and exchange-traded funds (ETFs) also participate in the repo market.

      But don't banks have plenty of liquidity on hand to fund securities purchases or lend at attractive repo rates?

      Banks are required to hold cash against their deposit liabilities at the Fed, known as required reserves. In recent years, large banks have maintained cash well above their required amount, or excess reserves. So, yes, the large banks are flush with liquidity. However, that excess cash may not be readily available to allocate toward increased demand for repo funding.

      Regulations imposed in the aftermath of the 2008 global financial crisis (GFC) to protect banks from failing have constrained their ability to use their balance sheets. Such regulations include:

      Increased capital requirements: Banks are now required to hold more equity capital against their asset base. Put another way, every additional asset taken onto the balance sheet requires additional capital. More equity capital may help to protect banks from the kind of large unexpected losses experienced during the GFC.

      Increased liquidity requirements: Large banks must hold enough liquid, easily sellable assets to ensure that under a significant stress scenario, they could withstand 30 days of cash outflows - like a run on the bank.

      Living wills: Large banks are required to maintain resolution plans and the liquidity necessary to keep operations going through a bank failure scenario.

      These requirements create a safety cushion, at the expense of providing liquidity to the system as a whole. In addition, the holding company structure of U.S. banks presents the challenge of moving cash quickly from a bank, which posts the reserves, to separate broker-dealer operations, where the repo takes place.

      Taken together, these factors have limited the banks' ability to use their resources to fund client liquidity needs. Fortunately, the Fed has recourse to some powerful tools to restore balance in the capital markets - namely, the ability to lend directly to those who need cash.

      How did the Fed alleviate the volatility in the repo market?

      The Federal Open Market Committee (FOMC) conducted open market operations (OMOs), making excess cash available in an effort to lower the overnight repo rate closer to the federal funds rate. The repo operation has injected cash into the market with both overnight and 14-day term actions, which increased over the September 16 week to USD 100 billion and USD 60 billion, respectively, to be conducted through October 10.3

      Without FOMC intervention, we anticipate that these funding pressures will continue. Net Treasury issuance is expected throughout the fourth quarter. And companies historically need cash at the end of the year, while banks have a tendency to decrease their balance sheets.

      Why does repo market volatility matter?

      The overnight repo rate goes into the calculation of the Securitized Overnight Funding Rate (SOFR), which was selected as the replacement benchmark for London Interbank Offered Rate (Libor) in 2017. With over USD 150 trillion of securities tied to Libor,4 investors are concerned that SOFR would not be a good substitute if repo market volatility persists.

      Bottom line: New regulations around liquidity and capital, which are intended to prevent large banks from failing in the mode of Lehman Brothers, ensure that they have ample resources to meet their liabilities. But that has come at the cost of losing their ability to function as the large-scale liquidity providers they were in the past. The Fed has fixed the glitch, however, supplementing the liquidity gap with its repo facility to maintain the cash flowing through the banking system.