personal views of a former fed trader

RRP At The ZLB

RRP take-up reduces liquidity held by banks, but does not change the quantity of liquidity held by Non-Banks. This difference arises from our two tiered monetary system, where banks and non-banks hold different types of money. Banks lose reserves (money for banks) when they settle payments to the Fed on behalf of Non-Bank RRP participants. But from the perspective of Non-Banks, the RRP just replaces bank deposits (money for non-banks) with what are essentially secured deposits at the Fed. At the zero lower bound, the RRP is a cash equivalent and RRP take-up is largely a function of bank balance sheet constraints. In this post we walk through the balance sheet mechanics of RRP participation from the perspective of Non-Banks, Banks, and the Fed. The current context suggests the RRP is largely acting as a tool to manage the side effects of QE.

Non-Banks

Non-Bank participation in the RRP is almost entirely through 2a-7 money market funds (“MMFs”). Cash investors place cash in MMFs, who in turn place it in the RRP when there is nothing else to invest in (Note MMFs charge a management fee, so cash investor receive around 0% even if RRP is 5bps). For example, suppose an investment in Treasury bills is repaid and all money market rates are below the RRP offering rate. Then the MMF will just re-invest the proceeds into the RRP. The MMF receives $100 in its bank account from the maturing Treasury, and then sends it to the Fed’s RRP. The Fed returns the money the next day.

Another way to think about this is that Non-Banks are simply depositing money at the Fed instead of a commercial bank. Non-Banks have the same amount of money, it’s just held at the Fed in the form of a overnight repo loan (functionally a deposit secured by Treasury collateral). They are free to spend that money as they wish when its returned the next day. QE created so many deposits that banks basically ran out of space to hold them, so Non-Banks are depositing the money at the Fed.

Banks

Banks don’t participate in the RRP (they receive interest on reserves at a rate higher than the RRP rate), but Banks must settle payments on-behalf of their Non-Bank clients. Remember, Banks and Non-Banks use different types of money. Non-Banks hold their money as deposits in a commercial bank (bank deposits) and Banks hold their money as deposits at the Fed (reserves).

When a Bank’s Non-Bank client sends an RRP payment to the Fed, the Bank must settle the payment on behalf of the Non-Bank. This payment must be settled in reserves, so the Bank deducts $100 in deposits from the Non-Bank’s account and sends over $100 in reserves to the Fed. RRP participation thus reduces the level of reserves held by the banking system. The banking sector as a whole shrinks – banks have fewer reserves in their Fed account and fewer deposit liabilities to Non-Banks. This can be helpful for some banks, as bigger balance sheets entail higher regulatory costs.

Federal Reserve

The RRP does not change the size of the Fed’s balance sheet, but its composition. The Fed expanded its balance sheet by creating reserves out of thin air to pay for QE purchases, and is now borrowing those reserves back via repo. In this example, the Fed goes from owing $100 in reserves to a Bank to owing $100 in repo loans to a money fund.

The wrinkle in this is that the Fed’s counterparty is no longer a Bank, but a Non-Bank (money fund). Generally speaking, only Banks are allowed to make deposits at the Fed. The RRP facility allows Non-Banks to also directly place money at the Fed in the form a repo loan. This sidesteps the banking system and gives Non-Banks direct access the Fed’s balance sheet. Note an overnight repo loan is not the same as a reserve, but in this instance they are functionally comparable as safe liquid assets.

Motivation Matters

The impact of these balance sheet changes depend in part on the motivation for the shift. At the end of the day Banks have less liquidity and Non-Banks have the same level but different composition of liquidity. If Non-Banks are attracted by higher RRP rates, then some banks would involuntarily lose liquidity and may be forced to raise deposit rates or borrow from the market. These actions would flow through the markets in the form of higher rates, with corresponding impacts on asset prices.

At the ZLB, the RRP offers basically the same return as leaving money in a checking account (1bps MMF share after management fees vs 0bps in a bank deposit). Some Non-Banks cannot take bank credit risk and must move money out of banks and into the RRP regardless of rates. But for others the move is also not rate driven, but because they were pushed out by their bank.

Banks operate under regulations that make it costly for them to accept too many deposits. At the same time, QE is pouring $120b of deposits into the banking system each month. As Banks run out of space to hold deposits, they are asking their clients to move money into a MMF. The MMFs in turn have received so much money that they have no where to place it but the RRP. Demand for money is low across all money market borrowers.

In this context the RRP is acting as a tool to manage the side effects of QE, with limited wider market impacts. In fact, higher RRP take-up may even be positive news. An economic recovery implies greater demand for private credit, and banks must make room on their balance sheets for those loans. In the absence of QT, higher RRP take-up could also be caused by increased bank lending.

13 Comments

  1. James

    Excellent article, sincere thanks for taking the time to post this Joseph. Made certain points regarding this subject a lot more clearer.

    Purchased your book also. Great read so far.

    All the best.

  2. George

    Under the above framework, is there a scenario where too many reserves get moved out of the banking system which could cause another overnight rate spike like we saw in Sept. 2019?

    Thanks in advance.

    • Robert Pearson

      only if the Fed were happy to see an overnight rate spike (which is unlikely). Provided the guy at the Fed who deals with such things can remember the password to log on to the system that allows the Fed to inject as large a quantity of reserves, via OMOs, as are required to bring overnight rates back to target, there will be no spike in rates. It seems that back in Sep 2019 the Fed basically forgot how to do this for a day or so! To be fair, they hadn’t needed to do it for the best part of 10 years.

  3. John Henderson

    Frankly no wonder the man in the street does not understand money.It has all been captured.

  4. Kris

    Joe,

    Why do you write this? I mean – what motivates you here? You are giving away so much.
    Thank you.

  5. justbubble

    >>The Fed expanded its balance sheet by creating reserves out of thin air to pay for QE purchases,

    The “thin air” part is quite debatable. The Fed issues new reserves BACKED by the bonds that the Fed is “purchasing”. You could say that the reserves are the “payment” for the bonds. But the payment does not come out of thin air. The reserves are backed by the bonds, they are a claim on the bonds, which in turn are backed by Govt taxation powers, property/land and military might, up to and including nuclear weapons.

    Never forget, “money” is always a claim on SOMETHING, or else it would be worthless. Reserves are the highest powered money there is, and they are a claim against the collateral that backs the reserves. The problem is that US govt keeps issuing debt backed by assets that are not really increasing in useful value.

    FED creates too much reserves against newly issued govt bonds, reserves that first get spent once out of the Treasury General Account TGA) at the Fed, and then ends up as reserves of the Fed member banks ,as the spending winds its way into the accounts if the top 1%. Then the wealthy buys assets and, presto, asset inflation.

    Asset inflation is human labor devaluation. Asset inflation reduces the value of all your past and future labor: The price of the things you want to buy, like a house and stocks, go up before you can buy them.

    What is the alternative to QE? Well, it is to tax the billionaire class properly. That is what should be done. When there is a downturn or a calamity (like Covid19 or climate change), it should be our rulers in the billionaire class that take the losses and the responsibility. After all, they make all the decisions in practice. But instead they influence the Fed to do QE and inflate asset prices and screw everyone else with asset inflation and joblessness.

  6. AM

    Hi Joseph,

    Could you provide some colour on this article?
    https://www.ft.com/content/a0482f69-be5c-4d92-ae59-17a8e2b2cdde

    Thank you

    • Joseph Wang

      Thanks for the article. I don’t agree with it. Couple points – in the short end the RRP is basically a substitute for bills so if you really needed a safe place to put cash you can use RRP. Also, the Fed lends out the Treasuries it owns (see here) in case there is a shortage. I don’t see any pick up in demand to borrow Treasuries.

      • RB

        With RRP being largely uncapped and risk-free, how can we explain that 4 and 8 week bills are being auctioned off below the RRP?

        https://www.treasurydirect.gov/instit/instit.htm?auction_results

        If RRP offers 5BPS and the Fed has at least 300bn worth of bills sitting in SOMA that dealers could borrow- then what explains this insane bidding? There must be something else going on…

        • Joseph Wang

          Not everyone has access to the RRP. See here for an explanation why bill yields are below RRP.

          • RB

            Thank you for your reply. That definitely makes sense for yields in the secondary market. But why are these yields at auction so low? Dealers are bidding close to (or sometimes below) yields in the secondary. If the dealers’ strategy is to buy at auction and turn around and sell into the secondary, then why not allow for more of a carry?

            According to the NYFed Primary Dealer Data, dealers net position is about 50bn for bills, is that more than usual? Are they maybe bidding and holding bills for themselves, in order to do more of their overnight “securities out” lending/repo business? Securities lending overnight stands at 141bn, and repo lending overnight is at 1.1 tn – they don’t break those number down into collateral composition ( so no clue how much of that is bills and how much is coupons) – but is it fair to say that those numbers are still quite substantial, both in terms of dealers’ P/L and market participants’ liquidity/collateral needs?

  7. Yang, Youngbin

    Hi Joseph,

    “In the absence of QT, higher RRP take-up could also be caused by increased bank lending.”
    I was thinking about why increased bank lending would cause higher RRP take-up as follows.

    1. Banks cannot lend reserves.
    2. After Banks make a loan, Banks’ balance sheets expand.
    3. Under SLR regulation, to reduce balance sheet which was enlarged by lending activity, Banks will choose to ask their clients to move money into a MMF which, in turn, invest it in RRP.

    Is there any problem?
    Thanks in advance.

    • Joseph Wang

      Yes I agree, though you only need point 2 and 3. Banks cannot lend their reserves to a non-bank, but can lend to another bank (that is a fed fund).

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