As such, from the banks’ perspective, reverse repo moves reserves off their balance sheets for a short while.

In return, they receive USTs, which they can lend out in the repo market for an extra return. Depending on the rates they receive, it may even turn out to be a profitable trade.  

But, would this be enough to cause a spike in usage of the o/n reverse repo facility on par with what happened in 2020?

Recall that in March 2020, we saw the repo market fail to clear, mass liquidations in markets across the globe, and even the UST market (a.k.a the world’s most liquid market) freeze up.

That is the context behind the spike in o/n reverse repo in March 2020. The magnitude of demand for USTs, and how quickly that demand spiked, illustrates the sheer desperation financial market participants were experiencing.

Bearing this in mind and looking at the chart above, does it seem like “banks have too much reserves” tells the whole story?

Considering how quickly o/n reverse repo transactions with the Fed have spiked higher than what it was in March 2020, something else is also going on.

Which takes us to the other way of interpreting this – What if this isn’t a problem with overflowing reserves, but one of UST scarcity?

Going back to March 2020, traders and investors were scrambling to get their hands on USTs, only to find that everyone who had Treasuries was hoarding them (hence the breakdown of the UST market).

The reason for this is that USTs, especially T Bills, are the best kinds of repo collateral. And, in times of crisis, lenders in the repo market demand more collateral to protect themselves from losses.

If investors do not have enough cash or liquid assets to obtain more collateral, they would have to liquidate their positions in order to repay their repo borrowings. These initial liquidations cause market prices to fall, and if there is too much leverage in the system, sparks off a mass liquidation and a cascade of even more collateral calls.

Needless to say, when this happens, demand for USTs goes through the roof.

This mad scramble for Treasuries is what led eligible market participants to rush to tap the Fed’s o/n reverse repo facility a year ago – as a means to obtain Treasuries.

In other words, traders and investors enter into reverse repo with the Fed when USTs are not easily obtainable, which in itself is a sign of liquidity problems in the repo market.  

Consequently, skyrocketing levels of o/n reverse repo transactions with the Fed hint at potential problems far more systemically significant and destructive than just banks having too many reserves. March 2020, as well as the Great Financial Crisis of ‘08, are excellent examples of just how terrible things can get for markets all around the world, and the global economy.

With markets trading at extraordinary levels and leverage running at extremes, sky high reverse repo takeup is yet another sign that the financial system stands very vulnerable to any kind of shock.

Caveat emptor!