The April FOMC minutes suggest the Fed is planning a new standing repo facility (“SRF”), which would be the Fed’s third SRF. The contours of the new SRF are still up in the air, but we can infer them from a stated desire to backstop Treasury repo and the coverage gaps of the other SRFs. The Fed currently operates each day a de facto SRF for primary dealers and another for foreign central banks. This leaves non-primary dealers and investment funds as the obvious candidates for a new facility, as the two are the remaining active participants in Treasury repo. In this post we describe what a SRF is, how the current SRFs operate, and suggest that a new SRF would have a very limited market impact.
What is a Standing Repo Facility?
An SRF allows eligible counterparties to borrow from the Fed against eligible collateral at a fixed rate. The bolded parameters are design choices that are guided by the intention of the facility. For example, a Fed SRF was first floated by two senior Fed economists as a tool to facilitate balance sheet normalization. The proposed SRF would have smoothed the transition into a lower reserves regime by making Treasuries and reserves more fungible – banks finding themselves low on reserves could use the SRF to borrow more reserves against Treasury collateral. In light of that goal, the proposed SRF would have been open to banks, accept Treasury collateral, and lend at slightly above market rates (act as a backstop).
Another way to think about the SRF is as a type of Discount Window. Historically, the Fed acts as lender of last resort to banks by offering them loans through the Discount Window against a very wide range of collateral (with appropriate haircuts) at a fixed rate (top of Fed target range, higher for weaker banks). An SRF is also a facility that offers loans, but to a wider set of counterparties and against a more restrictive list of eligible collateral. SRFs expand the Fed’s safety net, improving liquidity and controlling rates. The current SRFs perform this function by offering loans to primary dealers and foreign central banks against certain credit risk free collateral.
The Current Standing Repo Facilities
In September 2019 repo rates went from trading around 2% to as almost 10% intraday as dealers were scrambling for cash. The Fed was worried it was losing control over overnight rates and quickly began making repo loans in size to primary dealers against Treasuries/Agency MBS collateral at IOR. Those trades became daily and evolved into a ‘de facto’ SRF for primary dealers designed to put a soft ceiling on repo rates. The facility helped control repo rates during the March Covid shock by lending as much as $450b in into the repo market at rates around IOR.
The second SRF, the FIMA Repo Facility, was set up in late March 2020 in response to volatility in the cash Treasury market. At that time, Treasury market liquidity was under stress as many investors were desperate to liquidate their Treasuries for cash. The Fed sought to support the cash market by offering foreign central banks the option of obtaining cash by borrowing from the Fed with their Treasuries as collateral, instead of selling them outright. Foreign central banks hold around $3 trillion Treasuries in Fed custody, so the facility had potential to moderate selling pressures. However, the FIMA Repo Facility was never meaningfully used (max participation $1.4b), in part due to its punitively high offering rate of IOR + 25 basis points (market rates were below IOR).
The two current SRFs help backstop the Treasury repo market, but do not cover all repo market participants. Historically, the Fed works through primary dealers, who intermediate by borrowing from the Fed and then lending to other repo market participants. These market participants are predominantly investment funds and non-primary dealers. Last March there was concern that the transmission mechanism was not working well as primary dealers had some trouble intermediating, potentially due to regulatory constraints (leverage ratio) or simply out of prudent internal risk management policies amidst volatile markets.
An SRF that would bypass primary dealers and lend directly to non-primary dealers and investment funds would further strengthen the FOMC’s control over Treasury repo rates. It would be logical to include all non primary dealers, but more thought would be needed on the types of investment funds to include. Investment funds are a broad group, and include the opaque hedge fund community as well as SEC regulated public funds like mutual funds. [Note: FOMC minutes also suggest banks as a SRF counterparty, but in practice banks are not active borrowers in repo. They are also sitting on an ever increasing pile of liquidity.]
The New SRF Is Unnecessary
Today’s financial landscape is one of superabundant liquidity ($300b+ earning 0% in the ON RRP) and broadening access to that liquidity. Sponsored Repo, an innovation by the DTCC, now allows cash to move from cash providers to investment funds/dealers in a manner that both reduces balance sheet costs and counterparty risk. The binding constraint in a world of super abundant liquidity has been dealer intermediation capacity, which are like the pipes through which money flows. Sponsored Repo offers a way around those limits by moving all legs of a matched book repo transaction into a central clearing house, the FICC. This allows dealers to net down their balance sheet exposure, significantly increasing the potential level of intermediation.
Sponsored Repo volumes have declined from high levels last March along with overall repo market volumes, but the list of participants in the service continues to grow and is now around 1800. This amounts to a substantial broadening of the pipes through which the $4 trillion in money fund assets and $4 trillion in bank reserves can flow to cash borrowers. As long as QE continues, Treasury repo will remain zombified.
In this context, market participants will have all the Treasury repo they want for the foreseeable future. That means a new SRF would end up unused like the other two SRFs. But the new SRF would be an evolutionary step in a gradual but very clear trend in the Fed’s toolkit. Pre-Crisis the Fed was the lender of last resort to banks, then over the past decade it also became the lender of last resort to primary dealers, money market funds, foreign banks, foreign central banks, state and local governments, and even domestic corporations. Fed has also lent indirectly to mom and pop shops via the Mainstreet Lending Program. The trend seems to be direct access to Fed lending by everyone – perhaps that perfects the transmission of monetary policy. At this pace, the Fed may only be one crisis away from reaching that goal.
Note: Brent Donnelly of HSBC included me in his list of top Fed experts on FinTwit. Thank you Brent and thanks everyone for your voting for me. It takes a lot of time to write these posts, but your support makes it all worthwhile. I am grateful for your readership – thanks very much!