The September mayhem in the U.S. repo market suggests there's a structural problem in this vital corner of finance and the incident wasn't just a temporary hiccup, according to analysis from the Bank for International Settlements.
This market, which relies heavily on just four big U.S. banks for funding, was upended in part because those firms now hold more of their liquid assets in Treasuries relative to what they park at the Federal Reserve, officials at the Basel-based institution concluded in a report released Sunday. That meant "their ability to supply funding at short notice in repo markets was diminished."
And hedge funds are financing more investments through repo, which "appears to have compounded the strains," the researchers added.
This brings the BIS, the central bank for central banks, into a controversy that has vexed observers for almost three months: Why did the repo market get so bad, so quickly? On Sept. 17, rates on general collateral repo briefly surged to 10% from about 2%. And while rates have fallen since, participants are wary that trouble may resurface at year-end — a time when repo liquidity has historically been scarce.
Given this, the Fed's repo cash injections continue to be carefully monitored, with the 28-day term operation on Monday once again showing healthy demand for funding at the year-end turning point.
Many, including the Fed, concluded in the immediate aftermath that two transitory events collided: investors used repo to finance the purchase of a large batch of newly auctioned Treasuries at the same time that quarterly corporate tax payments drained liquidity from that market.
But the BIS doubts an ephemeral supply-and-demand imbalance is totally to blame.
"None of these temporary factors can fully explain the exceptional jump in repo rates," Fernando Avalos, Torsten Ehlers and Egemen Eren wrote in the latest BIS Quarterly Review.
Reserves — or cash that banks stash at the Fed — are the easiest asset for banks to tap when they want to quickly move money into repo. And it would've been logical for banks to pour cash into repo to get those 10% returns from an overnight loan.
The four banks that dominate the market hold about 25% of the reserves in the U.S. banking system, but 50% of the Treasuries. That mismatch likely slowed the movement of cash into repo, the BIS researchers postulated.
"Not only did the spike in the repo rate come as a surprise to the New York Fed, but they also haven't been able to normalize it as quickly as they thought they could," Bloomberg Opinion columnist and chief economic adviser at Allianz SE Mohamed A. El-Erian said Monday on Bloomberg TV. "It hasn't proven to be temporary. It hasn't proved to be reversible without massive injections of liquidity. Which means that structural issues are playing a role."