Reverse Repo and the Collateral Crisis

By Lewis Huxley, Finance Graduate at Durham University 

The state of the US repo market has rarely been a prominent topic in financial journalism. In fact, should you wish to converse in depth on the subject, you would find a significant absence of company. However, with overnight reverse repo trade volume peaking at all-time high levels in recent weeks – reaching a record $992 billion on June 30th – repo markets could offer disturbing insight into an economy that is far from healthy.

So what is the repo market? Repo is shorthand for repurchase agreement, in which one party sells securities to another while agreeing to purchase those same securities back for a higher price. This kind of agreement has a specified length, usually overnight, and is classified as a ‘repo’. Repos are, in essence, a short-term collateralised loan between two counter-parties. Instead of a traditional interest rate though, the difference in the price of the security between the two transactions is, in effect, the interest on the loan or the ‘repo rate’. Due to the short-term nature of the market and the type of firms that operate within it (often large financial institutions), there is rarely a lot of risk or reward involved for either party. This often leads to one question: what is the benefit to participants? If you break it down to basics it is simple – financial institutions would rather not sit on large sums of cash earning zero interest, while the reverse side of the trade allows firms to borrow large sums to fund their short-term capital needs cheaply. The importance of the repo market can be difficult to fully understand. If repo rates rise, it can cause credit lines to dry up significantly and have a knock-on effect on things like business loans – something that can quickly escalate into a crisis of its own. For simplicity’s sake it can be viewed as a necessary operation in order to keep financial markets running smoothly.

Since around September, 2019, the US Federal Reserve has been heavily and directly involved in the repo market – for the first time to this extent since the financial crisis. This was due to a severe ‘cash crunch’ at the time that caused repo rates to soar upwards of 10% (i.e. banks would not part with cash for lower than this rate). The Fed intervened with a view to reduce friction in markets, not unlike oiling a machine, before exiting out again through the first half of 2020. Of course, we all know now what was to come during this period. The shock to the economy caused by Covid-19 forced the Fed’s hand and meant there was no way they could withdraw from the repo market without causing markets to grind to a halt. What started as a $50-60 billion operation in 2019 was ramped up dramatically with the announcement of a 3-month injection of $500 billion in March 2020. The following day, the Fed reinforced their position and announced they would inject a further $1 trillion over 3-month and 1-month operations, stating they would be prepared to offer up to $1 trillion per week going forward. This policy has been heavily scrutinised, with US senators Bernie Sanders and Elizabeth Warren using it as a major talking point ahead of last year’s election.

At this point it is important to note that the Fed also offers what is known as a ‘reverse repo’ via their Reverse Repo (RRP) facility. This uses the same mechanism as a repo, but rather than the Fed buying Treasury securities (T-bills), they instead exchange those same securities and receive cash on their balance sheet – purchasing them back the next day. The key difference between the two types of operations are that, while repo operations add liquidity to the financial system by providing institutions with cash, reverse repo operations instead remove liquidity from the system. According to the Fed’s own rules on repo market operations, “overnight operations cannot go over $500 billion in lending”. However, as mentioned at the start of the article, this figure has almost doubled with the recent surge in overnight reverse repo operations. So what has caused this increase and what are the potential ramifications?

It is difficult to pin down one catalyst; indeed, there may not be just the one. On June 16th the Fed raised the interest they would pay on overnight reverse repo agreements to 0.05% – attractive considering most short-term investments yield very little. Back when the rate was 0%, offering little reason outside of collateral requirements to partake in reverse repos, more than $500 billion was parked in the overnight RRP facility. With rates rising there is little to no incentive to move money out of RRP, so we are left with a network of large financial institutions seemingly drowning in liquidity and parking funds with the Fed. This doesn’t fully explain the volume in RRP, however, as the $500 billion recorded before this Fed intervention was agreed upon at 0% interest. This implies some bleak possibilities; either investors are unwilling to invest in a bloated stock market or inflation could present a far bigger problem than anyone is willing to admit. There are also a number of alternative theories relating to the increasing repo volume. One such theory is that a handful of large financial institutions have made a series of risky trades that have left them in an uncomfortable position, necessitating the use of T-bills as collateral to avoid looming margin calls. The use of these short-term securities for “collateral reuse” can transform ordinary government borrowing into fuel for the financial system – enabling risky behaviour from those able to partake (to the displeasure of critics). While it can be difficult to assess the accuracy of many theories, vocal criticism of RRP combined with its sheer scale does lead one down the proverbial rabbit hole.

Whatever the true cause of the increases, the Fed and Treasury may soon reach crisis point if they continue. Increased banking regulation over the years from Basel and Basel II has led to an increase in the use of government securities as collateral. With such large RRP volume leading to huge demand for T-bills, a shortage of T-bills has developed that will seemingly only worsen as the Treasury looks to scale back their auctions. Fed Chairman Jay Powell acknowledged as much in his recent testimony to the House Financial Services Committee, stating “You could say there is a shortage of safe short assets… there’s a shortage of T-bills”. This is not a sustainable position. The US simply cannot keep up with demand for its debt and is nearing the limit on borrowing, the “debt ceiling”. Back at the end of June, Treasury Secretary Janet Yellen exclaimed they may “exhaust emergency measures” to avoid breaching the debt ceiling “as soon as August”, going on to implore Congress to step in to avoid a potentially “catastrophic” default. In more recent news, on July 28^th, the Fed announced it was creating separate standing repo facilities to try and support money markets, but we have yet to see how effective this action will prove. With legislation unlikely until October or November the collateral shortage will most likely worsen – the result being a weakened financial system one global margin call away from crisis.

Since completing this article, on July 30^th, a new record high reverse repo volume was recorded – a staggering $1.04 trillion overnight.

Lewis Huxley

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