The Repo Market
The repo market largely goes unnoticed by most market participants, but it plays a huge and essential role in the financial system, so this article will hopefully explain what it is, why it’s so important, and why investors should be watching it closely as the Fed begins to shift its monetary policy.
Let’s begin by just explaining what exactly the repo market is. So repo is shorthand for repurchase or repurchase agreement. These agreements are generally between financial institutions like banks or the Federal Reserve to repurchase collateral like treasuries or mortgage-backed securities. For simplicity’s sake, I will be using banks and the Fed as examples, but these repo agreements can be between non-bank entities as well. So in a nutshell, the repo market is where banks exchange collateral for cash. People often refer to the repo market as the financial plumbing because it kind of operates under the surface, but it is essential to a healthy functioning financial system. The repo market is how banks and financial institutions ensure they have enough liquidity to meet their daily operational needs. Without it, they can lack the cash they need for people who take out loans, withdraw deposits, their own payroll, or other operational expenses. If a bank is short on cash and needs an overnight loan to facilitate business or manage its deposits, they will put up collateral with another financial institution or the Fed who has cash to get that overnight or short-term loan. The loans are usually overnight, but sometimes they can be for a few weeks or months—they are just temporary loans to meet immediate or short-term cash needs.
As a side note, there is another side to this equation and that is banks who need collateral, not cash. A lot of financial institutions have certain collateral (treasury) requirements so sometimes they need to exchange cash for collateral. This is known as reverse repo—it functions the same way as the repo market, it’s just the other side of the trade. Sometimes banks really need cash and other times they really need collateral, so the market has demand coming from both sides. For the purpose of this article, I’ll be focusing on the repo market, but just know reverse repo is the other side of the same coin.
Alright, so in the repo market, banks are borrowing money and giving the lender (another bank, financial entity, or the Fed) some type of collateral, which are usually treasuries, to hold onto until they eventually repurchase that collateral back from them. They say ‘hey, I have collateral, can I have some cash’. But these lenders don’t just give out their cash for free. Even though they are receiving collateral, they will charge an interest rate that the borrower will have to pay when they eventually buy back the collateral they originally gave them. So say a bank puts up collateral and borrows a million dollars from another bank. The next day or week, the bank borrowing would repurchase its collateral for, say, $1.1 million. This fee they’re charging is what’s know as the overnight repo rate—the rate at which different market participants swap treasuries or other collateral for cash to cover their short-term cash needs.
The overnight repo rate banks are expected to pay will fluctuate depending on supply and demand as in how badly banks need cash or collateral or how much cash or collateral is available to lend out in the first place. If a bank really needs cash and other banks aren’t willing to lend, the bank trying to borrow will bid up the rate. If a bank doesn’t want to lend at 0.5% interest, borrowers might offer 1% or 2% until someone is willing to lend them the cash they need. And if a ton of banks are in need of cash and there just isn’t enough to go around, it will go to the highest bidder, which is another way the repo rate can shoot up.
Now, the basic force holding up the repo rate is the Fed funds rate, which is considered the risk-free rate of borrowing. If the Fed will lend money at 1% interest, nobody is going to lend for lower because the Fed has the lowest risk of default and all other borrowers would have an added risk premium. Technically the Fed funds rate is supposed be a little higher than the repo rate to encourage banks to lend among themselves, but for most intents and purposes the two rates can be thought of as one and are very closely related. All interest rates in the economy are derivatives of the Fed funds rate—you take their rate and add a risk premium to it depending on how risky one believes a counterparty to be and, given the repo market consists of big banks lending and the banks are generally seen as the next least risky counterparty after the Fed, the repo rate is usually pretty close or near identical to the Fed funds rate. It’s only slightly lower to keep banks lending to each other and only reliant on the Fed in rare instances. Supply and demand can certainly move the overnight rate, but, generally speaking, it’s expected to hover just above the Fed funds rate.
While the Fed funds rate is pretty predictable insofar as it’s closely managed by the Fed, the repo rate is more prone to supply and demand and market dynamics like short-term liquidity needs, so it’s important to watch it for dramatic changes as rare as that might be. It’s important because if the rate spikes and banks are paying a high interest rate for cash they borrow, people taking out loans or mortgages from those banks are gonna pay an even higher rate because they are a riskier counterparty and, thus, warrant a higher risk premium when banks issue those loans. For this reason, it is always in the Fed’s interest to prevent dramatic spikes in the overnight repo rate because such spikes can lead to massive spikes in all other interest rates in the economy.
Back in 2019, there was a huge spike in the overnight repo rate that got as high as 10%. Though it may not sound like a big deal, this was terrible news and sparked a very quick reaction from the Fed to pump billions into the repo market to lower that rate because an overnight repo rate of 10% (or really anything above the Fed’s target rate) means all other interest rates, including the Fed funds rate, will gravitate toward that higher rate. This is because if banks and other entities can get a 10% relatively risk-free return on their cash, there is no reason to lend to the government or anyone else for a lower interest rate. And, getting back to the risk premium element of interest rates, if these financial entities can earn 10% in the repo market, they will want more than 10% for any loan, credit card debt, or mortgages they issue to people (the riskier counterparties) in the economy. This is why a huge spike in the repo rate sounds an alarm to the Fed—they know how devastating interest rates that high would be to the real economy—it would lead to widespread defaults and a massive economic contraction where nobody could get or afford to get any credit. It could also lead to the government itself struggling to pay its debts if the interest rate on treasuries remained at those elevated levels for too long.
So the cascading effect the repo rate has on all other interest rates explains why the Fed is so concerned about the overnight repo rate spiking, but what was the cause of this spike in 2019? There are a couple different theories on this. One is there was a lack of liquidity from the quantitative tightening the Fed was doing at the time. The Fed was selling treasuries and mortgage-backed securities it bought during QE back to the banks and taking their bank reserves (taking their cash) in exchange, which some argue created a dollar shortage in the repo market that led to banks bidding up the repo rate in a fight for cash.
The second theory is the spike was because of a collateral shortage, not a lack of liquidity. This theory argues there was enough cash, but there wasn’t enough acceptable or quality collateral in the system. The contention is banks and other entities had cash to lend, but the borrowers didn’t have enough pristine collateral the lenders were willing to accept and because there wasn’t enough quality collateral to facilitate the lending, the lenders needed to be compensated more for accepting the inadequate collateral that was available. In other words, the low quality or lack of collateral kept lenders out of the market until the borrowers bid up the repo rate enough to compensate the lenders for the extra risk they were taking on.
Regardless of where you stand on the reason for the repo rate spike in 2019, it’s important to know that it happened, it was a big deal, and it’s very possible it happens again. As the fed continues to taper and eventually shifts to quantitative tightening, it will be removing cash from the system just like in 2019, which could lead to theory one for why the repo market spiked. But the Fed will also be raising interest rates and interest rate increases lead to treasury values falling (rates rise, bond values go down, rates fall, bond values go up—there’s an inverse relationship). So if rates rise and treasury bond values (also known as collateral) fall, there will be less collateral in the system. If rates go up by 10%, bond values will decline by roughly 10% and so there will be roughly 10% less collateral in the system, which was theory two for why the repo rate spiked. So regardless of which of those two factors you believe actually caused the spike or even if you think it was a combination of the two, the Fed is planning on creating an environment where both are true: a shortage of cash and collateral, which means the chance of another spike and Fed intervention in the repo market is considerably high in the near future.
You might be asking yourself at this point what the big deal is, the Fed managed the repo rate spike last time and can probably do it again, but the problem is their intervention, one, cost hundreds of billions of dollars and, two, it masks a real market problem that needs to be addressed. Price spikes are like pain signals for markets that tell participants there is something wrong and in need of fixing. If left to their own devices, the markets will resolve these problems on their own. They may not resolve them in the most desirable way and can be painful, but those resolutions are the result of economic imbalances. Throwing money at the problem the way the Fed does only delays the problem. They postpone current volatility for greater future volatility—it’s like adding anesthesia to a broken arm without repairing the actual arm. It may relieve the pain in the short-term, but it didn’t actually address the underlying issue. So if the next spike is even more dramatic than the previous, which historically has been the case with matters the Fed masks with their intervention, and it requires the Fed to spend even more money than last time to relive the pain and delay it once again to a day in the future, they are just compounding the problem rather than letting the market solve it on its own.
The Fed has unfortunately shown it prefers short-term stability over free markets and long-term stability and that is a very dangerous and unsustainable practice. If we see another spike in the repo rate and it is, in fact, the result of some systematic problem, the Fed dumping billions into the repo market is not going to fix it—it’s going to delay the crisis and delay it again until the Fed eventually can’t stop it or it can’t afford to print and hide the problem any longer.
Now, it’s possible a repo spike could just be a short-term liquidity problem that poses no significant risk to the system, but why then would the Fed have to intervene so much? Their very intervention in 2019 and hypothetical intervention in the future suggests it is a big deal that only they can resolve painlessly (at least in the short term). So if we see another repo spike and strong reaction by the Fed, I think it’s safe to say there is something systemically wrong they don’t want to unfold naturally—they are going to eliminate the free market pain signals by dumping as much liquidity into the repo market as needed. Doing so could successfully kick the can down the road one more time, but we should all pay close attention to how aggressive the next reaction is—how much money will it take this time? Because if it’s significantly more than it was last time, it’s safe to say the time after that will be even more and even more after that until the Fed can no longer suppress the repo market rates or interest rates in general and the financial system starts to implode. This might sound a little doomsday-y, but the Fed is playing with fire over a bed of gasoline soaked grenades with how much stimulus it is committing itself to in the future with every problem it delays and allows to compound. These problems, whether in the repo market or elsewhere, can’t be suppressed forever and eventually the chickens will come home to roost.