Repo blowup was fueled by big banks and hedge funds, BIS says

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 a new 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 around 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, JPMorgan Chase, Bank of America, Citigroup and Wells Fargo, 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.”

Volatility in the amount of cash the U.S. Treasury keeps parked at the Fed also affected banks’ reserves. “The resulting drain and swings in reserves are likely to have reduced the cash buffers of the big four banks and their willingness to lend into the repo market,” the BIS team wrote.

JPMorgan Chase Chairman and CEO Jamie Dimon has put the blame on regulators themselves. He said in October that his firm had the cash and willingness to calm short-term funding markets but liquidity rules for banks held it back.

Some analysts have also pointed to a new corner of the market which has seen immense growth: sponsored repo. This allows banks to transact with counterparties like money-market funds without impacting their balance sheet constraints. The downside is that it’s only available on an overnight basis, and as a result has further concentrated funding risk.

Along with changing market structure, the researchers also connected the repo ruckus to banks being somewhat out of practice in daily reserve management. That’s because trillions of dollars worth of Fed asset purchases — the so-called quantitative easing program meant to help the economy recover from the 2008 financial crisis — had left the banking system flush with cash for years.

“The internal processes and knowledge that banks need to ensure prompt and smooth market operations may” have started to decay, BIS wrote. “This could take the form of staff inexperience and fewer market-makers, slowing internal processes.”

The Fed in 2017 started shrinking its balance sheet and shortages began to re-emerge last quarter. The central bank stopped paring back holdings in August and started buying Treasury bills in October, an attempt to add reserves to the banking system. That was part of its campaign to keep the repo market calm, an effort that began in September with overnight and then longer-term repo operations.

“These ongoing operations have calmed markets,” the BIS researchers wrote.

Already, there’s been high demand from money-market participants for cash via repo that the Fed’s been offering with tenors that will extend into the new year. The central bank will conduct a 28-day term repo operation as well as an overnight one.

The BIS report also took a look at the European repo market, which escaped the kind of turmoil that engulfed the U.S. in September.

Yet the current tranquility in European repo doesn’t mean all is calm. Beneath the surface, the 8-trillion-euro ($9 trillion) market is becoming increasingly fragmented, raising the risk that cash may not flow through properly, the BIS said.