The Fed’s New Repo Misdiagnosis. The SRF Won’t Work 2
While the Fed has misdiagnosed the collateral issues plaguing the repo market, it is important to understand that its new Standing Repo Facility (SRF) can alleviate some pressure in the financial system during times of crisis.
It is possible that during periods of collateral stress, or, more colloquially, market meltdowns, repo counterparties will refuse to transact in anything except the highest quality collateral – T Bills.
Should this occur, normally widely accepted forms of collateral such as Agency MBS and Agency debt may no longer be accepted for repo. The end result being holders of such securities will no longer be able to use them as collateral to borrow cash in the repo market.
This is where the SRF can help by providing an invaluable source of last-resort repo liquidity for Agency related securities. Unfortunately, as illustrated in the chart below, the share of Agency debt and MBS securities used in repo transactions just isn’t very high.
Consequently, any positive effects arising from the Fed’s new facility providing last resort repo liquidity for Agency related securities will not be very significant.
This last-resort repo liquidity could also extend to Treasuries.
Not all forms of collateral are created equal, even within the UST asset class. In general, tenor and liquidity are the main factors in determining the desirability of collateral types ,and the same applies to Treasuries.
Which means that, in times of severe stress, some types of USTs can fall out of the bucket of “acceptable” collateral, as demonstrated in 2020 when Off The Run Treasuries were shut out of the repo market.
This collateral “divergence”, for lack of a better term, within the UST asset class is where the SRF can really shine. Traders and investors who find themselves holding Treasury securities that were once widely accepted as collateral in the repo market, but are suddenly not, can turn to the Fed’s new facility.
This will alleviate the pressure on this subset of market participants during a financial crisis, and could prove to be valuable in helping some of them avoid falling into insolvency.
In a semi-related way, another possible scenario where the SRF can be effective is when holders of USTs (the shorter tenor ones that are still accepted) need to borrow cash in the repo market but deem repo counterparty risk to be too high. Posting their collateral to borrow from the Fed then becomes the best option.
However, this could lead to the opposite of what the Fed intends by exacerbating illiquidity in the repo market, as collateral holders refuse to transact with anyone but the Fed, leaving those scrambling to get hold of collateral with even less chance of doing so.
Should this happen, it could lead to more severe sell offs across global markets as traders and investors are forced to liquidate positions in whatever assets they hold in order to raise cash to meet collateral/margin calls.
Ultimately, while the scenarios mentioned above are instances where the SRF can make a difference, it won’t be enough.
Because for all that the Fed and market folks want to believe in it, the SRF simply does not solve the underlying problem of collateral scarcity!
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