Pressure in Repo Market Spreads
Stresses amplify price swings in government bonds
By
Katy Burne
April 2, 2015 6:23 p.m. ET
6 COMMENTS
A shortage of high-quality bonds is disrupting the $2.6 trillion U.S. market for short-term loans known as repurchase agreements, or “repos,” creating bottlenecks for a key source of liquidity in the financial system and sending ripples through short-term debt markets.
Stresses in the repo market are amplifying price swings in government bonds and related debt markets at a time when many investors are reshuffling their portfolios around new interest-rate expectations, following a period of low volatility, traders and analysts said.
Although traders said the impact so far has been manageable, the broad concern is that scarcity in repos will pressure rates and could complicate efforts by the Federal Reserve to lift interest rates when the time comes.
Problems in the repo markets have been the subject of discussions at the U.S. Treasury, people familiar with the matter said. Since there is typically a strong relationship between repos and overall bond markets, the shifts can influence trading in everything from U.S. Treasurys to commercial paper, short-term IOUs taken on by companies.
“The less repo, the less liquidity in bond and other markets,” said Josh Galper, managing principal at consultancy and research firm Finadium LLC. RECALL THAT LIQUIDITY IS A DESIRABLE QUALITY IN ASSETS!
ENLARGE
Repos have been a topic of discussion at the Treasury. Photo: Andrew Harrer/Bloomberg News
In repos, investors such as hedge funds swap bonds in exchange for cash, often overnight, promising to repurchase the bonds later at an agreed-upon price. An obscure but pivotal corner of the financial world, repos allow investors such as hedge funds to borrow to finance their investments (THIS IS CALLED MATURITY TRANSFORMATION - BORROW SHORT, LEND (INVEST) LONG SEE SLIDE FROM STEIN!) while providing a place for money-market funds to earn a return on their piles of cash (YES, THIS IS MY RETURN ON MY RETIREMENT ACCOUNT!). Banks typically act as middlemen between repo lenders and borrowers for a fee. (REFERRED TO AS A TRI-PARTY REPO! )
SLIDE FROM STEIN (2015)
SO WE ARE CLEARLY IN A POSITION WHERE DEMAND EXCEEDS SUPPLY WHAT WE CAN DO IS SOMETHING ABOUT SUPPLY - THE RRP FACILITY - HOW BIG AND WHO WILL HAVE ACCESS - HUGE QUESTIONS!!! ECONOMICALLY AND POLITICALLY!
Repos also are an important source of day-to-day funding for banks themselves and independent broker-dealers, making the repo market the central nervous system for many of Wall Street’s securities markets.
Traders cite several factors for the dearth of sought-after securities, including a sharp increase in Treasury holdings by the Federal Reserve after its multiyear stimulus program; a scramble for U.S. government bonds as yields on European debt have tumbled; and new rules prompting big banks to reduce holdings of trading securities.
ENLARGE
For example, Goldman Sachs Group Inc.’s repo books contracted 46% last year to end December at $88 billion, its lowest balance since November 2008, regulatory filings show. Morgan Stanley’s repo books fell 47% to $95 billion over that period, and they were down 60% from 2006. SHORTAGE OF SUPPLY - REGULATORS ARE BREATHING DOWN THEIR NECKS GIVEN ALL THE TOXIC ASSETS THEY PRODUCED IN PAST -
The Fed in 2013 began testing a program to alleviate repo problems by offering an alternative for money-market funds and others that couldn’t get repos done with banks, but the program is capped. EXCERPT FROM SPEECH BY VICE CHAIR STANLEY FISCHER:
Because not all institutions have access to the IOER rate, we will also use an overnight reverse repurchase agreement (ON RRP) facility, as needed. In an ON RRP operation, eligible counterparties may invest funds with the Fed overnight at a given rate. The ON RRP counterparties include 106 money market funds, 22 broker-dealers, 24 depository institutions, and 12 government-sponsored enterprises, including several Federal Home Loan Banks, Fannie Mae, Freddie Mac, and Farmer Mac. This facility should encourage these institutions to be unwilling to lend to private counterparties in money markets at a rate below that offered on overnight reverse repos by the Fed. Indeed, testing to date suggests that ON RRP operations have generally been successful in establishing a soft floor for money market interest rates
The shrinkage in bank repo balances is so acute that interest rates on repos tied to certain securities have fallen into negative territory. That means financial institutions such as banks and money funds are willing to pay up to lend their cash just so they can have access to specific securities. (NEGATIVE INTEREST RATES!)
In late February, the rate on overnight repo loans secured by two-year U.S. Treasury notes fell below minus-3% on four days in a single week, according to data from repo brokers, the first reading that negative since last summer. On Tuesday at quarter-end, the rate on overnight repos backed by 10-year Treasurys fell to minus-3.5% intraday. Rates on Treasury-backed repos trading below 0% averaged minus-0.31% last month, versus minus-0.18% a year ago, said Joseph Abate, money-market-funds analyst at Barclays PLC.
DEMAND ....Firms clamoring for the bonds include banks that are required under new rules to hold high-quality assets for liquidity purposes, the $2.67 trillion money-market-fund industry that is limited to high-quality debt maturing in less than 13 months and hedge funds that require specific securities to settle certain bets and cannot accept substitutes. SO REGULATIONS ARE FORCING BANKS TO HOLD 'HIGH QUALITY ASSETS' AND HEDGE FUNDS NEED THEM TO CLOSE (COVER) THEIR SHORT POSITIONS (NO SUBSTITUTE FOR A TREASURY!)
Money-market funds take comfort in repos because the trades are secured by bonds. When they can’t find their first-choice trades in the repo markets, they look to the next best thing in the open market, dragging down yields on Treasury bills, commercial paper and other short-term debt. THE SHORTAGE IS RIPPLING INTO OTHER (SUBSTITUTE) SHORT TERM MARKETS.
“What we are discovering is that even the supposedly most liquid market in the world, U.S. Treasury debt, is now vulnerable to sudden bouts of volatility,” said Matt King, head of credit strategy at Citigroup Inc. “This follows very logically from the new constraints on repo.” AGAIN, BLAME THE REGULATORS
The volatility in Treasurys is reflected in interest rates and supply.
Interest on Treasury bills out to three months is about 0% already, according to data from Tradeweb Markets LLC. On Tuesday, the bills set to mature out to April 16 briefly touched intraday lows below zero. In the Oct. 15 Treasury-market “flash crash,” the yield on the 10-year Treasury note tumbled to its biggest one-day decline since 2009.
The Treasury Department has been cutting issuance of two- and three-year notes so it didn’t have to reduce bills in high demand, but recently the Treasury has begun to contemplate increasing its bill issuance, looking for cheaper funding, said a person familiar with the matter.
The supply of T-bills already has fallen more than $500 billion, or 20%, from their 2009 peak, according to Barclays.
The shortage of certain Treasury notes has caused some firms to miss their scheduled delivery of collateral in repos. The incidence of trades through primary dealers where participants failed to deliver Treasurys on time reached 3.6% in the first week of March, above its 2.5% average over the past year, according to the Federal Reserve Bank of New York.
The troubles have made it harder, and more expensive, for hedge funds to borrow specific securities to close out “shorts,” under which they borrow and then sell securities in a bet the prices will fall.
Chris Tackney, managing director and head of trading at Greylock Capital Management, which oversees $1 billion, said recently he was unable to borrow as many emerging-market bonds as he needed for a trade via the repo market. Finding a specific security can sometimes be so difficult, he said he gives up on such trade ideas, adding “It’s not even worth our time.” GREYLOCK CAPITAL IS THE FINANCIAL INTERMEDIARY IN THIS 'TRI-PARTY' REPO.
Some analysts believe that the turbulence in repos could lead to an even greater demand for government bonds, as investors prize stability in their portfolios. Fidelity Investments earlier this year said it planned to convert three funds, including its $111 billion Fidelity Cash Reserves fund, the world’s largest money-market fund, to holding government-only bonds, instead of broadly accepted collateral.
“If you’re a holder of Treasury assets you might be more reluctant to lend them out,” said Natan Magid, a U.S. rates strategist at BMO Capital Markets.
The amount of Treasurys available to be bought or sold near current prices this year has fallen 30-40% below its average since 2007, wrote Alex Roever and Jay Barry, strategists at J.P. Morgan Chase & Co., in a report Thursday.
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