Article 10.2 New York Federal Reserve takes on key role in repo market

By Tracy Alloway and Michael Mackenzie

Financial Times June 19, 2014

The Federal Reserve Bank of New York has emerged as the single largest player in an important segment of the short-term lending market that was at the epicentre of the financial crisis.

The Fed's decision to quadruple its trading with government money market funds in the repurchase or ‘repo market' is a sign that the central bank is now engaging more directly with the shadow banking system at the expense of large Wall Street banks.

Historically, the repo market was where big banks pawned out their securities such as Treasury bonds to lenders including money market funds, insurers and mutual funds, in exchange for short-term financing. Now the Fed is stepping in to trade as well as it prepares to end its current near-zero interest rate policy.

Armed with a balance sheet of $4.3tn of bonds purchased during quantitative easing, the Fed is using what it calls its reverse repo programme, or RRP, to trade with money funds at a time when tough new regulatory standards have made such borrowing less attractive for the banks.

Rather than lending to the banks, money market funds have sharply boosted their dealings with the US central bank.

Between September 2013 and the end of May, government money market funds increased their use of repo trades with the New York Fed by $65bn to a total of $87bn, while decreasing their repo holdings with dealer-banks by $38bn, according to a study by Fitch Ratings.

The growing presence of the Fed in repo is a signal that it is testing new ways to control short-term interest rates once it starts tightening monetary policy.

When official short-term rates are eventually pushed higher, the Fed plans to use the RRP to drain cash from the financial system via short-term loans of Treasuries from its huge balance sheet.

Robert Grossman, managing director at Fitch, said the change in the Fed's pre­sence in the repo market had been dramatic and that the central bank could use RRP to significantly escalate its role.

FT

Source: Alloway, T. and Mackenzie, M. (2014) New York Federal Reserve takes on key role in repo market, Financial Times, 19 June.

Haircuts

Although the securities bought and sold are considered relatively safe collat­eral for the lender of the cash, there is always the danger that the price of the bills, etc. might fluctuate during the period of the agreement to the detriment of the buyer who is committed to a pre-agreed selling price. The buyer might also be exposed to illiquidity risk and counterparty risk related to the securities bought. Therefore it is common practice to impose a haircut on the collateral, where the seller receives the amount of cash secured on the collateral less a margin (over-collateralisation). If the haircut were 2%, the seller of a £200 mil­lion repo would receive £196,000,000 cash in return for £200 million worth of securities. The repo interest is only applied to the lesser amount.

Another way of looking at this is that if a bank wanted to own £200 million of gilts it would only be necessary to find £4 million of cash. The other £196 mil­lion could be borrowed in the repo market by using the £200 million of gilts as security.

Haircuts on Treasuries are relatively low; if the collateral used is mortgage- backed bonds or corporate bonds, the haircut will be a larger percentage. Haircuts rose even for Treasuries in many countries during the financial crisis as doubt crept in about government default risk. Haircuts are lower for high-quality counterparties, e.g. a central bank supplying collateral in a repo. They are also lower for overnight repos than longer-term ones due to the lower securities price fluctuation risk, and for securities trading in highly liquid mar­kets. Longer-term bonds are more volatile than short-term bonds or bills and so if they are used as collateral a large haircut will be required, as it will if a non-standard legal agreement is used for the repo.

Article 10.3 discusses some new rules on minimum haircuts. If the market value of the collateral drops by a larger amount or percentage than an agreed threshold during the term, the lender might be entitled to variation margin. This is a call for extra cash or collateral to be handed over.