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Since the 2008 financial crisis, the repurchase agreement (or ‘repo’) market experienced around a decade of stability.
However, the repurchase agreement market has experienced significant turbulence in recent years. A technical glitch in the fall of 2019 reportedly caused short-term interest rates to shoot up well above the Fed’s target range (2%-2.25%). The Fed injected $128 billion into the market in order to stabilize it.
Making matters worse, due to the economic threat of the Coronavirus pandemic beginning in early 2020, the Fed scheduled a series of short-term loans totaling $1.5 trillion for the repo market.
For more on how the repo market played a major part in the 2008 financial crisis:
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What are Repurchase Agreements?
A repurchase agreement (or ‘repo’) is a short-term collateralized loan.
Essentially, a ‘repurchase agreement’ refers to a kind of short-term borrowing for dealers in government securities. Repurchase agreements involve a dealer selling government securities to investors typically but not necessarily overnight. Dealers promise to purchase the security back on a designated date, at a slightly higher price.
This transaction benefits both parties. Buyers often have large cash pools sitting around that aren’t making them any money through interest. They get to receive some profit for holding the asset. Dealers get to cheaply receive financing for immediate needs.
Repo vs. Reverse Repo
Essentially, a repurchase agreement and reverse repurchase agreement comprise a single transaction. ‘Repo’ refers to the buyer’s side, where they agree to temporarily purchase assets for a specified period. ‘‘Reverse rep
From the buyer’s side, the deal is called a repurchase agreement (repo); from the seller’s side, the deal is called a reverse repurchase agreement (reverse repo).
The 2019 Repo Market Crisis
As noted in the introduction of this article, the repurchase agreement rate spiked in mid-September 2019. It peaked as high as 10 percent intra-day, but financial institutions with excess cash reserves still did not lend. This sudden spike of the repo rate took many by surprise as repurchase agreements typically trade at or near the Federal Reserve’s benchmark federal funds rate (2%-2.25%).
In retrospect, two factors majorly contributed to the repurchase agreement rate soaring: (1) quarterly corporate taxes were due, and (2) it was the settlement date for previously-auctioned Treasury securities. These two factors led to a huge transfer of capital from the financial market to the government.
Simply put, there was high demand but little supply. But these two developments alone cannot fully explain what happened with the repo rate.
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Before the 2008 financial crisis hit, the Federal Reserve operated within a ‘scarce reserves’ framework. That means financial institutions tried to hold on to as little cash as possible.
Why? Money sitting in the bank doesn’t accrue interest.
Whenever a bank needed a bit more money, it just loaned some from the federal funds market. If the bank had a bit too much capital reserved, it loaned it out. The Fed targeted the interest rate in this market and added or drained reserves when it wanted to move the fed funds interest rates.
After the crisis, the Fed worked to rehabilitate the economy through Quantitative Easing (QE). Quantitative Easing is a type of unorthodox monetary policy in which a central bank buys longer-term securities from the open market (thus, boosting the money supply) for the purpose of encouraging lending and investment.
The Fed created reserves to purchase securities. It expanded both its balance sheet and the supply of reserves in the banking system. The surplus of capital meant it could not operate within the scare reserve framework it had before, so it made the shift to an ‘ample reserves’ framework.
With the new framework came new tools as well–namely, interest on excess reserves (IOER) and overnight reverse repos (ONRRP). IOER and ONRRP are interest rates set by the Fed. This allows the central bank to control its key short-term interest rate.
The 2019 Crisis
In January 2019, the Federal Open Market Committee– the Fed’s policy committee–announced that it would continue to operate within the ample reserves framework. But the Fed had been reducing the cash reserves in the banking system.
The Fed terminated their asset purchasing program in 2014. Three years later, it shrunk its balance sheet. These decisions caused the cash reserves in the banking system to shrink further. Fed researchers surveyed major banks to pinpoint the minimum amount of reserves it needs to be considered “ample.” Nobody really knew, but the amount was guesstimated to be $1.2 trillion. The Fed ended up taking about a trillion dollars out of the system.
Banks, in reality, contributed to the Fed’s miscalculations. Financial institutions decided to hold onto their reserves, refusing to lend in the repurchase agreement market. Many people wanted to use Treasuries as collateral for cash, but the cash wasn’t there.
Demand exceeded supply, and the repurchase agreement rate spiked.
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The Fed intervenes
As noted in the introduction, the Fed responded by injecting $128 billion into the repurchase agreement market. The central bank has been actively lending in the repurchase agreement market since the rate spike in 2019 and has worked to enhance market liquidity through credit programs such as the PDCF.
When the Treasury market stalls, the U.S. economy suffers. Businesses cannot get bonds off their books. This means they do not have access to short-term financing to address immediate needs. They also cannot make more loans. For citizens, the Treasury market must continue to operate smoothly, otherwise, consumer loans (e.g. mortgage) cost more.
The Fed has been looking for ways to rework the repurchase agreement market in order to prevent further crises. One well-received solution suggests creating a ‘standing repo facility.’ This would entail the Fed actively capping the repo rate by lending at a target rate (likely equivalent to or similar to the Fed’s target range).
The central bank is also looking to improve the liquidity of repurchase agreements. It has, for example, considered incentivizing banks to incorporate more discount window access into their internal stress tests.
Things changed, of course, when COVID-19 unceremoniously arrived.
Repurchase Agreements in the COVID-19 Era
The coronavirus pandemic caused the Treasury markets to seize up once more. Investors, fearful of how the virus could harm the economy, started offloading their Treasury securities for cash. The difference between the number of buyers and sellers on the market grew mismatched, sending up interest rates on government debt. The Fed intervened by purchasing these government bonds.
The Fed started with $60 billion in aid. The amount offered then grew when the Fed announced it would offer $500 billion over a three-month operation. The next day, however, the Fed offered even more aid, proposing to inject $1 trillion per week.
Fortunately, the central bank found that it would not have to provide such sizable relief packages. In April, the Fed announced that it would start scaling back the frequency of its operations, claiming the repurchase agreement marked had achieved “more stable…conditions.”
But as recent history has shown, the Fed must be ready and prepared to address repo rate spikes. The situation remains ongoing, as the coronavirus will remain a major point of concern for the foreseeable future.
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