The Fed’s New Repo Misdiagnosis. The SRF Won’t Work 1
The Fed has announced that it will establish two new repo facilities, one domestic Standing Repo Facility (SRF), and the other international.
The purpose of which is to ensure that funding markets have ready access to cash during times of acute market stress. While this is a positive step, in the sense that the Fed is actively trying to pre-empt future market meltdowns, it is unfortunately one that will not work.
Firstly, the Fed has gotten the problem the other way round. In times of market stress, people need collateral more than they need another outlet with which to raise cash with their collateral.
Think about it for a minute; market stress is a product of mass liquidations which stem from collateral/margin calls forcing people to sell assets to raise cash.
The stress becomes acute when this initial wave of selling precipitates further waves of collateral/margin calls that lead to even more selling, at which point it becomes a negative feedback loop.
During such times, demand for collateral skyrockets because traders and investors need to post more of it to avoid liquidating their positions. This is a result of collateral requirements increasing as market volatility increases – lenders want more assurance against market uncertainty.
Unfortunately, the increase in volatility also decreases the availability of collateral in the open market as everyone looks to hoard it for their own purposes.
Which is exactly what happened in 2008 and 2020.
As such, during times of crisis, everyone is scrambling to get their hands on collateral. People want collateral, and those who have it are kings.
The UST market seized up in March last year because people were hoarding collateral. That is, they were not willing to sell Treasuries because they needed them either for use as collateral, or as buffers against even more volatility.
Lack of collateral is the problem here, not the ability to use collateral to raise cash.
The Fed’s new SRF clearly demonstrate that they view the latter as the problem, not the former, hence them getting the problem the other way round.
Furthermore, the financial system itself is shouting about their lack of collateral, at progressively louder volumes. All one has to do is look at the explosion in usage of the Fed’s Overnight Reverse Repo Facility (RRP), which is almost at $1 trillion now.
Which brings us to our second consideration, that the new repo facility might not be large enough.
While a daily cap of $500 billion sounds high, it is important to remember that trillion dollar markets seize up during financial crises, and Overnight RRP use is also almost at a trillion. $500 billion would be enough if markets worked in a predictable, linear, and smooth fashion.
Unfortunately, they do not.
As such, it’s not about the smooth provision of medium-sized amounts of credit, but rather the ability to provide massive amounts of credit to meet massive amounts of demand for it, arising at the same time.
From this perspective, $500 billion is like a sea wall trying to stop a tsunami.
Lastly, the Fed already conducts daily repo operations, and over the course of the crisis period last year, conducted more frequent repo operations at larger amounts. This is an important psychological factor, because the market is, at this point, conditioned to the Fed taking some kind of action during market meltdowns.
It might not even be an understatement to say that, since 2008 and all the QEs that were implemented between then and now, market participants all around the world expect the Fed to intervene when markets convulse.
But, despite this expectation, 2020’s crisis still happened, and the UST market still froze.
Why then, would another $500 billion facility work now?
To be continued…
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