Friday, June 26, 2015

Reverse Repurchase Agreements - The Federal Reserve's Next Experiment

Back in 2014, Sheila Bair wrote a commentary for the Wall Street Journal, outlining one of the Federal Reserve's very little discussed programs, largely because the rather arcane concept is beyond us mere mortals.  It is through the use of reverse repo agreements that the Federal Reserve has given itself another tool in its already significant arsenal of experimental monetary policies.

Let's start by looking at the concept of a repo.  The repo or repurchase market, deals with the selling and buying of short-term securities.  A repo is a a contract where one party agrees to sell securities to another party (the counterparty) for cash for a short period of time (as little as a day) and agrees to purchase the same securities at a higher price in the future.  It can most easily be thought of as a short-term loan with one party borrowing cash from another and providing securities as collateral.  On the other hand, a reverse repo is the same contract but looks at the transaction from a lender's perspective rather than the borrower's.  Looking at the transaction from the lender's perspective, the lender provides cash, purchases the securities for collateral and then sells them back to receive cash in the future.  Most importantly, from the Federal Reserve's perspective, a repo is viewed as an asset whereas a reverse repo is viewed as a liability.  From a bank's perspective, a repo is a liability through which money is borrowed and a reverse repo is an asset through which money is lent.  

In the case of the Federal Reserve, it has a long history of using repos (i.e lending money), most particularly to provide liquidity during the 1987 stock market crisis, prior to the Y2K "crisis" and during the early days of the 2007 - 2009 financial crisis when repos were used to the tune of $134 billion, again, to provide liquidity.  In the past, the Fed has also used reverse repos (i.e. borrowing money), mainly with foreign central banks, however, during the financial crisis, the Fed began to use reverse repos by borrowing from primary dealers (aka the U.S. banking system) with the amount rising to $25 billion by the end of 2008.  From FRED, here is a graphic showing the current size of the reverse repo agreements held by the Federal Reserve:

As you can see, the reverse repo liability on the Fed's balance sheet is significant at $261.5 billion in mid-June 2015.

Now, let's look at what the Federal Reserve is doing now.  The Fed's program, called the Overnight Reverse Repurchase (reverse repo) Facility aka ON RRP which is operated by the central bank's open-market operations, sells part of its gigantic multi-trillion dollar Treasury assets (its balance sheet aka the System Open Market Account or SOMA) to a selection of financial institutions (the counterparty) with the understanding that it will repurchase the same assets the next day in return for paying the institutions a tiny return of 0.01 percent to 0.05 percent.  This means that the Fed's counterparties (aka Wall Street banks, government-sponsored enterprises and money market funds) get a risk-free place to park their money and earn a bit of interest on the deal.  This process helps set interest rates because no counterparty would be interested in lending money to a higher risk enterprise at a lower rate since the Federal Reserve is considered to be the lowest risk party.  As an added bonus, as you will see, the Fed gets to use this program as a new (and previously untried) tool for raising interest rates since the interest paid on the funds sets a new interest floor rate.

The Federal Reserve Bank of New York instituted the ON RRP program in September 2013 as a short-term test program to see whether it would make an effective tool when monetary policy "normalizes".  In January 2015, the FRBNY announced that it was continuing the program until January 29, 2016.  Counterparties will be allowed to submit one bid up to $30 billion in size for each operation with a minimum bid size of $1 million, noting that the maximum has risen from $500 million in September 2013.  The total amount awarded in any operation is set at $300 billion.  When bidding, the counterparties must also specific the rate of interest that must be at or below the specified offering rate.  As well, the specified interest rate can be negative.

Here is a list of financial institutions that are authorized reverse repo counterparties:

Here is a list of government-sponsored enterprises that are also authorized counterparties:

Here is a list of money market funds that are also authorized counterparties:

As you can see, by allowing money market funds to participate in ON RRP, the Fed has given large, nonbank financial institutions the ability to place money in overnight deposits with the Federal Reserve, a privilege that was formerly used only by the banking sector.

How can the Federal Reserve use ON RRP to impact interest rates?  Quite simply, if the Federal Reserve decides to raise the overnight rate paid to counterparties it means that counterparties will, in turn, raise the rate of interest that they will lend money to other, less safe borrowers.  With the Federal Reserve telegraphing higher interest rates later this year, it is becoming increasingly apparent that they may not have the tools necessary to push rates back up to historical norms, instead, having to rely on ON RRP to become its primary monetary tool.

How could the ON RRP become problematic?  This could happen in several ways:

1.) If the markets suddenly became volatile to the downside as was seen during the months prior to and during the early part of the Great Recession, borrowers in the short-term market will have to compete with the Federal Reserve to borrow money since they are viewed as being higher risk than the Fed.  This could result in a significant liquidity problem.

2.) Banks could see an outflow of deposits, particularly those deposits that are uninsured.

3.) Interest rates on Treasuries could rise significantly if investors feel that the Federal Reserve is a safer haven than the U.S. Treasury.

4.) Money market funds that normally buy commercial paper issued by non-financial firms as assets for their funds.  If there are increasing signs of market turmoil, money market funds may prefer to lend to the Fed through the use of reverse repos because this mechanism is viewed as a no-risk process, putting additional stress on the ability of Corporate America to borrow money.

If (when) there is another financial crisis, the Federal Reserve could find itself between a rock and a hard place.  At the same time as it is borrowing money through reverse repos, the Fed may have to provide funds to to stabilize the market.  Rather than reversing its quantitative easing policies  by reducing the size of its bloated balance sheet and shrinking the massive level of excess banking sector reserves held at the Federal Reserve, the Fed has decided to look at yet another experimental way of influencing short-term lending markets and through that mechanism, push interest rates higher.  This suggests that even the Fed is coming to the realization that its monetary policies since 2008 have been less than a spectacular success, necessitating even more intervention in what remains of the so-called "free market economy".

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