On June 30th, cash invested in the Fed’s reverse repo facility spiked to $339.5 billion. Market reaction to this figure was somewhat muted. Quarter ends have always been problematic for the banks and broker dealers and with the pressure on market participants to reduce their balance sheets and risk profiles, the figure did not really receive the kind of reaction we might have expected in the past. But is this figure worth a second look?
The Fed’s reverse repo program is now approaching its one year anniversary. When it was launched as a ‘temporary’ facility on September 23 last year, participants were limited to a maximum of $500 million per day. Over time this daily limit was gradually increase to $10 billion per participant. The Fed’s website currently lists 118 eligible institutions (not to mention primary dealers); a figure that is virtually unchanged since the program’s inception. Combining these figures we will see that the capacity of the program has increased over time from less than $60 billion to a figure over $1.3 trillion. The most recent figures reported by SIFMA (May 2014) show primary dealers raising approximately $2.4 trillion on a daily basis via the repo market. Surprisingly there has been little written about the fact that the Fed’s capacity (but not outstanding) is now approximately half the size of the current market.
Over its brief life we have seen a pattern to the Fed’s repo outstandings. Volumes tend to go up around month end and fall significantly towards the middle of each month. This would clearly imply that there is a significant window dressing effect to dealers’ reported balance sheets. No great surprise but there it is. One other pattern we have observed was an increase in outstandings between mid April and mid May. This is easily explained by the pattern of tax payments the Treasury receives around the April 15 filing deadline. Finally, at each quarter end we have noted progressively higher spikes: $58 billion in September of 2013, $198 at year end 2013, $242 billion on March 31 and finally $339 at half year end. These conclusions are further confirmed by the daily number of participants. Near the middle of the month, participants average less than 50. At month end and quarter end this increases to close to 100. It would appear that there are a number of (risk adverse) participants who have decided to deal with the Fed consistently while others will shift their cash there when dealers’ inventories shrink.
The Fed has consistently portrayed the effects of its reverse repo facility as benign or even beneficial to the market. The repo program allows the Fed to immediately impact short term rates if it deems this action necessary. Dealers will always have to pay a spread above the ‘risk free’ rate to fund themselves. The Fed’s program will also absorb liquidity in the event that dealers’ inventory and short term cash are not roughly equal. The increase of Fed repo around April 15 clearly illustrates this dynamic. In addition, the facility allows the Fed to manage short term rates without the need to liquidate its SOMA holdings. This will give it significantly greater flexibility as it tries to transition from its current program of quantitative easing to a gradual return to normal interest rates.
But are there downsides to this program and its periodic volume spikes? As a general rule, central banks and other market regulators have concentrated their efforts on removing risk and its close associate leverage from the financial markets. Beginning in late 2008 the Fed lead the way using its safety, size and clout to insert itself in a space that had formally been the domain of dealers. The CPFF, MMIFF. PDCF and TALF all relied upon the Fed in its capacity of lender of last resort to bring stability to the market. While all of these facilities have been retired, the Fed and other central banks continue to perform certain functions that the private sector has traditionally taken responsibility for. The repo facility and the benign terms of the Fed’ SOMA lending program are two examples of this approach of keeping the training wheels on long after junior has learned to ride the bike. Yes, the repo program absorbs excess liquidity. Yes, it allows conservative investors to continue to use the repo market. And yes, it is a useful tool for managing short term rates. But what about the reduction in capacity in the dealer market and the possibility of a massive flight away from dealers in the event of an (inevitable) shock to the system? The seeds of each new crisis are often found in the solution to the previous one.
Our first observation is that the Fed may be making it entirely too easy for short term investors to desert the dealer market in the event of a crisis. Historically, in times of stress cash investors would seek out the most credit worthy institutions while shunning the weaker ones. But these weaker institutions were not without some options. They were able to negotiate funding with other dealers with larger haircuts or place their inventory through a CCP. With the now easy option of investors simply jumping ship en masse, the market liquidity needed to support this historical solution may not be there and it goes without saying that a trip to the discount window would at this point be an extremely bad solution.
As for using the Fed’s repo facility to affect a change in monetary policy, the Fed has not yet explained whether this new program will replace its traditional short term open market transactions with primary dealers. Pre 2009, the Fed added and drained liquidity by conducting repos or matched sales with dealers. It seems unlikely to us that a dealer would be willing to put capital at risk if it was trading against the Fed. Further, keep in mind that cash investors’ trades with the Fed are optional. Bidding on matched sales is an obligation of a primary dealer. It will be very difficult to affect monetary policy by relying on a purely voluntary tool. There will also come a time when it becomes necessary to liquidate some of the Fed’s SOMA holdings. Simply selling them overnight will not be effective.
Finally, the Fed is further reducing capacity in the repo market via its reverse repo program along with the various capital and liquidity rules it has enacted. There will be a time in the future that markets will demand an expansion of dealers’ balance sheets in order to accommodate the ebbs and flows of institutional investors. Without the ability to expand and contract their repo capacity, dealers will be hamstrung in the execution of their traditional role.
On the whole we do see a significant benefit to the Fed’s repo program as a tool for implementing the Fed’s rate policy and to make up for the dramatic reduction in the volume and importance of the Fed funds market. But, we question the long term impact of a tool that will reduce the role of dealers without providing a viable alternative for the functions they perform. Market making is highly dependent on capacity both in the short covering space as well as the funding space. If we are to maintain orderly financial markets, dealers must have the ability and responsibility to fulfill these roles. In the long run, the Fed’s repo program may have a detrimental impact on this function.