Salve for a Constrained Repo Market, or Potential Funding Destabilizer?
A series of imbalances have arisen in money markets in the decade since the financial crisis, including September’s dramatic spike in overnight repo rates. We believe market participants’ increased reliance on overnight funding and banks’ reduced ability to intermediate money markets under post-crisis regulations were key drivers of this spike – and continue to leave repo markets vulnerable.
The recent repo squall also shined a spotlight on “sponsored repo” transactions, a growing segment of the U.S. overnight funding market that has helped boost participation and liquidity since its origination two years ago. But is sponsored repo a salve for constrained repo markets, which have grown increasingly sensitive to dealers’ balance sheet allocations? Or is it a potential Trojan horse of financial instability, contributing to an overreliance on overnight funding that could lead to future liquidity imbalances and volatility in term repo rates?
Behind the growing dependence on overnight funding
As a refresher, a repurchase agreement (repo) is a financing trade in which the lender of cash receives securities as collateral. Before the financial crisis, banks and broker-dealers were very willing to intermediate these trades given their negligible costs, which helped ensure money markets remained fairly priced (e.g., with no arbitrage). However, post-crisis leverage and liquidity rules have significantly increased these costs, limiting dealers’ appetite for repos.
For many dealers, one solution has been to engage in more trades that “net” assets versus liabilities and therefore have reduced capital costs. In this example, netting involves offsetting a collateralized financing trade with a collateralized lending trade. But the challenge for dealers is that the same counterparty must be on both the cash investing and borrowing side of a netting trade. This presents an obvious problem: There are only a few limited circumstances in which an account would look to raise cash by financing a U.S. Treasury bond and simultaneously lend the cash that was raised in the repo market.
Enter ‘sponsored repo’
To solve this problem, the Fixed Income Clearing Corporation (FICC) introduced its sponsored repo program, which provides the ability to “net” trades through a centrally cleared counterparty. Through the FICC, dealers have long been able to net trades with other dealers in the interdealer market; sponsored repo extends the potential benefit of interdealer netting to non-broker-dealers by allowing eligible FICC members to sponsor their clients.1 A sponsored client’s trade contract is then novated (replaced with a new contract) to face the FICC, reducing the balance sheet impact of the trade. This allows dealers to provide more attractive pricing and to intermediate more trades.
Over the past year, repo financing demand has increased as the U.S. deficit expanded and the Federal Reserve reduced its balance sheet. These developments have increased the amount of collateral that the repo market is required to fund. Money market funds are an important funding source, providing funding for over $1.25 trillion in overnight repos as of the end of September 2019, up $150 billion from September 2017.2 The evolution of sponsored repo has contributed to this upward trend, and its growing significance and utilization bear watching for the subtle structural changes that may result.