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Explanator: The Fed has a problem with repo. What is this?



(Reuters) – As if the US Federal Reserve no longer had enough room in its signboard heading for its interest rate meeting this week, chaos deep into the US financial system's water pipeline has thrown policymakers unexpectedly wrong.

FILE PHOTOS: The Federal Reserve Building on Avenue Avenue is pictured in Washington, USA, March 19, 2019. REITERS / Leah Millis / File file

Cash available to banks for their short-term financing needs but did not dry up on Monday and Tuesday, and US money market interest rates rose to 10% on some overnight loans, more than four times the Fed's interest rates.

This forced the Fed to make an emergency injection of more than $ 50 billion, the first since the financial crisis more than a decade ago, to prevent rising borrowing costs even further. He will hold another one on Wednesday.

The exact cause of the squeeze is a matter of debate, but most market players agree that two random events on Monday were at least partly to blame. First, corporations had to withdraw money from money market accounts to pay quarterly tax bills, and then on the same day, banks and investors who bought $ 78 billion in US bonds and bonds sold by Uncle Sam last week had to arrange.

On top of that, the reserves that banks park with the Fed and often lend to other banks overnight are the lowest since 2011, thanks to the central bank's abandonment of its huge bond portfolio over the past few years.

Taken together, these factors test the limits of the repurchase agreement – or repo market – $ 2.2 trillion, a gray but essential component of the US financial system.

For whatever reason, the episode added fuel to the argument that the Fed should take steps to avoid further disruption to the down market repo market.

(GRAPHIC – US Repo Course, here)

WHY IS THE IMPORTANT REPO MARKET?

The repo market supports much of the US financial system by helping banks have the liquidity to meet their daily operating needs and maintain sufficient reserves.

In repo trading, Wall Street companies and banks offer US Treasuries and other high quality securities as collateral to raise money, often overnight, to finance their trading and lending activities. The next day, the borrowers pay off their loans plus what is usually nominal interest and repay their bonds. In other words, they buy or repurchase the bonds.

The system typically buzzes along with the interest rate charged on repo deals that wrap close to the Fed's reference overnight rate, which is currently in the range of 2.00% to 2.25%. That percentage is expected to drop by a quarter on Wednesday.

But sometimes investors are afraid of lending, as observed during the global credit crisis, or at other times there is simply not enough reserve or money in the system to lend, as it seemed this week. And this can lead to market shrinkage and increase borrowing costs.

But when investors fear lending, as observed during the global credit crisis, or when there are simply not enough reserves or cash in the system, it sends a repo rate that rises above the Fed's interest rate.

Trading stocks and bonds can be difficult. It can also squeeze lending to businesses and consumers, and if the outage continues, it could turn into a US economy that relies heavily on credit flow.

WHAT CAUSES RESCUE IN BANK RESERVES?

Coming out of the financial crisis after the Fed cut interest rates to near zero and bought more than $ 3.5 trillion in bonds, banks have amassed huge reserves held in the Fed.

But that level of bank reserves, which peaked at $ 2.8 trillion, began to decline when the Fed began raising interest rates at the end of 2015. They fell even faster when the Fed began to reduce the size of its bond portfolio about two years later,

the Fed stopped raising interest rates last year and cut them in July and is expected to do so again on Wednesday. Now it also ceases to allow bonds to open their balance sheets.

The question that bothers politicians now is whether these actions are sufficient to stop the reduction in reserves, which is a major source of liquidity in the financial markets as a repo.

The Fed's bank reserves last stood at $ 1.47 trillion, the lowest since 2011 and nearly 50% below its peak of five years ago.

(GRAPHICS – Bank Reserves held in the Fed,

here)

1. RUN SPOT REPO OPERATIONS

Through the Federal Reserve Bank of New York, the Fed may conduct random repurchase transactions at a time of funding stress, which allows banks and dealers to swap cash and other high-quality securities with minimum cash interest rate. He did it on Tuesday and will do it again on Wednesday.

2. MORE INTEREST IS THE EXEX RESERVES PAYMENT

By making it less profitable for banks, especially foreign ones, to leave their reserves to the Fed, this can encourage banks to lend to each other in the money markets.

3. CREATING A SUSTAINABLE REPO DEVICE

Such a permanent funding program will allow eligible participants to exchange their bonds for a fixed interest rate.

The Fed and its employees have examined such a facility, but have not determined who qualifies, what would be the level of interest paid and the time to start.

4. RAMP UP BUYING WAREHOUSES

The Fed can fill up the level of bank reserves by slightly increasing its sovereign debt in the US. This runs the risk of being perceived as a resurrection of quantitative easing rather than a technical adjustment.

Report by Richard Leong; Editing by Dan Burns and Richard Borsuk

Our Standards: The Thomson Reuters Principles of Trust.

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