Finadium has released a new research report on the Federal Reserve’s reverse repo facility with a focus on collateral, winners and losers, and the potential impacts to US interest rate benchmarks.
The Federal Reserve’s reverse repo facility (RRF) is currently being tested as a mechanism for absorbing cash in financial markets while potentially helping set US interest rate benchmarks in the future. Like any government intervention in the markets, the RRF offers opportunities and challenges, depending on which side of the equation market participants sit today. In this report, Finadium evaluates the current behavior of the RRF and what an expansion, and an ultimate move to market rates, would mean for banks, money market funds, Government-sponsored Entities (GSEs) and the markets.
With US$3.4 trillion in holdings, the Federal Reserve can be called the world’s largest hedge fund; conversations about the Fed reducing its bond buying strategy (“tapering”) have sent jitters through financial markets. But an increase in the Fed’s RRF to align with market rates would be equally dramatic. By offering better counterparty credit risk for treasury-backed overnight repo than private dealers, the Fed could, if it so chose, effectively take over the market and crowd out dealers looking for funding. Along the way, the Fed would flood the market with new investments for cash providers at attractive risk–adjusted rates, although still lower than what the private sector would offer to large counterparties. A move by GSEs from uncollateralized Fed Funds investments to repo would all but end the utility of Fed Funds as an interest rate benchmark, and with it Overnight Index Swaps (OIS) that rely on Fed Funds liquidity for pricing and validation. Lastly, the new facility encourages the question, what kind of exit strategy could the Fed utilize to secure a safe return to private sector repo activity in the future? All of these issues warrant careful analysis for both market participants and policy makers.
This report should be read by repo dealers, traders in interest rate linked securities, cash investors including money market funds, securities lending agents and beneficial owners, and by policy makers looking for greater insight into the consequences of a significant new monetary policy.
For the table of contents and, for Finadium subscribers, to download the full report, visit the Finadium website.