We have been talking to friends about the implications of new Repo facility from the Fed – as described, albeit somewhat vaguely – in the last Fed minutes. A couple themes have come up.
If the Fed opens the facility up to a broad range of participants – a wider net than they deal with for open market operations already – then there will be big dent in the tri-party dealer repo market. For a couple bps, investors will choose to park money at the Fed vs. a dealer. This creates a tiered market, albeit one based on reasonable credit differentials. But, like a game of musical chairs, it could also crowd out some cash borrowers, especially for less liquid paper (read: corporates, ABS, equities).
If enough of the tri-party market cash lenders migrate to the Fed program, it could make the tri-party fire sale problem smaller. The Fed won’t be defaulting anytime soon, so no fire sales.
If the GSEs can execute repos with the Fed facility, it will be death knell for the Fed Funds market. GSEs can’t leave cash in IOER accounts, so they end up being the guys selling funds at ridiculously low levels to the banks. Fed Funds liquidity is bad enough with IOER a multiple of the Fed Funds effective, but without the GSEs, it will be a ghost town. With less Fed Funds trading, the FDIC will see their insurance premium revenue fall.
So what happens when the Fed Funds market has no liquidity? It ceases to be a good benchmark of anything. (We might argue that Fed Funds ceased being a good benchmark a while ago, but this is the Fed’s solution.) The non-functional Fed Funds market will then take their toll on the OIS markets. OIS curves are used to discount IRS curves when CCPs figure out margining. They switched from LIBOR when those rates became impossible to realize. If Fed Funds suffers the same fate, will the CCPs have to find something else to use?
Repo will emerge as the benchmark the Fed pays attention to and can actually impact. Repo futures and GCF swaps might be the big winners if the Fed repo facility displaces Fed Funds.
The markets have been heading away from unsecured exposures for a while now. The Fed Repo facility has the ability to give that final shove.
Lets keep the discussion going. Your comments are welcome.
July 14, 2016
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