It became abruptly apparent in September, when overnight repo rates surged to near 10%, that liquidity in the banking system had suddenly become insufficient. While a confluence of factors (corporate tax payments, settlement of Treasury auctions, etc.) ultimately tipped the secured funding market into imbalance, it was policy choices—monetary and regulatory—that unwittingly pushed this market to the brink of illiquidity.

Monetary policy framework

Since 2008, the Federal Reserve (Fed) has been conducting monetary policy via a “floor” operating system that sets the lower bound for market interest rates (the “floor”) by paying interest on bank deposits held at the Fed (bank reserves). This system doesn’t have an effective facility to cap market rates. Rather, an abundant supply of bank reserves is necessary to provide downward pressure on market interest rates.

The inconvenient truth

In the fall of 2017, the Fed judged that aggregate reserves were more than abundant. Eager to “normalize” monetary policy, the Fed began reducing its balance sheet to a size no larger than necessary to effectively and efficiently implement monetary policy. But, complex regulations layered onto the banking system post-GFC made it difficult to judge when reserves might begin to become scarce. And because the demand curve for reserves is non-linear, there is no warning as you approach this inflection point. There is no check engine light, the engine just starts to malfunction, which is what happened in September.

Repo market dynamics

Reserves, when abundant, can be a source of funds for the repo market. The Fed’s balance sheet contraction was reducing this potential supply as demand for repo funding was not only trending up, but also becoming increasingly concentrated at the overnight point. This amplified the effects of this sudden imbalance as those reliant on funding in overnight markets don’t have the luxury of waiting for the price (funding rate) to align with their perception of fair value. Because overnight funding markets must find an absolute clearing level every day, imbalances are resolved via an abrupt adjustment in the market price (repo rate).