Traders are scrambling to discern what caused an unexpected rate spike in a vital but murky part of the financial system—the market for repurchase agreements, known as repo.
What is the repo market? A repo is when one party lends out cash in exchange for a roughly equivalent value of securities, often Treasury notes. This market exists to allow companies that own lots of securities but are short on cash to cheaply borrow money. And it allows parties with lots of cash to earn a small return while taking little risk, because they hold the securities as collateral.
A key feature is that the cash borrower agrees to repurchase those securities at a later date, often as soon as the next day, for a slightly higher price. That difference in price determines the repo rate. Repo rates can rise for a number of reasons, but they do so particularly when there is a shortage of cash in the system, making borrowers willing to pay more to get their hands on it.
Who is involved in it? Repo is a vital cog in how Wall Street works and a major way that investors big and small—including anyone who owns a money-market savings account—could earn interest. The lenders of securities in the repo market are often hedge funds and Wall Street broker-dealers that have large portfolios but need money to fund their day-to-day trading. The cash providers tend to be money-market funds or other asset managers that want a place to invest their cash on a short-term basis at little risk.
Why are we talking about repos now? Repo rates are normally aligned closely to the Federal Reserve’s federal-funds rate, which currently sits between 2% to 2.25%—and is similarly a short-term rate between financial institutions. But the rate on repos briefly and unexpectedly surged Monday past 5% and then soared again Tuesday, according to Refinitiv, raising the possibility of a funding crunch and catching traders off guard.
What is the link between the federal funds market and the repo market?
The federal funds market is a market for unsecured, overnight loans of reserves between banks and some other parties. Reserves are the money that banks hold with the Fed. In order to settle payments and other transactions, banks compensate one another with reserves. If they need reserves, they borrow them from other banks. The rate at which they borrow is the federal-funds rate, and the Fed aims to keep it in a narrow range. (When the Fed cuts “interest rates,” this is the rate it is lowering.) The Fed has a unique position in the repo markets: When it lends money in repo transactions, it is lending newly created reserves. By entering the repo market, the Fed can thus add more reserves, making them more plentiful and thus easier to borrow.
What caused the repo move? No one really knows precisely what happened. But traders pointed to a number of things happening at once that might have caused securities lenders to suddenly be willing to pay far more to get their hands on cash.
For one, Monday marked the deadline for companies to submit their quarterly federal tax payments. That sucked cash out of vehicles like money-market funds as companies transferred it from their accounts to the Treasury. Monday was also the day Treasury Department auctions of $78 billion in debt were scheduled to settle, meaning that $78 billion in cash was turned into securities.
Together, the factors could have “caused a shortage in cash in the system, causing a huge spike in overnight rates,” said Thomas di Galoma, managing director and head of Treasury trading at Seaport Global Holdings, in an email. Another theory: For whatever reason, traders were unprepared for what should’ve been an anticipated crunch in cash. “Term repo rates showed no bump earlier this month to bridge over the obvious one-day pressures that were due on Monday,” writes Jim Vogel, interest-rate strategist at FTN Financial.
Why does it matter? Whenever repo rates come under sharp and unexpected pressure, investors are going to question whether the cause was something short-term and mechanical, or whether there is a more serious source of stress in the market. That could be a surge in perceptions of risk or a major drain on cash, such as big trading losses.
“Whether this is a one-off day explained by a convergence of distinctive factors, or evidence that more troubling developments are afoot, will be a crucial question for short rates in coming days,” BMO Capital Markets analysts said in a note.
What does it have to do with the Federal Reserve? Given the linkages in short-term funding markets, a surge in repo rates can be an indicator that the Fed needs to intervene more directly in the market to keep the federal funds rate in its target range.
The Federal Reserve Bank of New York sought to stabilize the market Tuesday by offering its own repo trades at target rates, despite running into technical difficulties. Whether the Fed should be acting more aggressively to keep rates low is a hotly debated topic, with even President Trump often weighing in, arguing that the Fed isn’t doing enough.
The repo spike could increase calls on the Fed to do something more drastic, such as buying Treasury bonds again. Don’t be surprised if the Fed ends up fielding questions about the whole repo episode at the end of its two-day policy meeting Wednesday. “Longer term, our teams believe that more has to be done to address the growing liquidity mismatches as the frequency of monthly/quarterly spikes in overnight funding appears to be growing,” Wells Fargo analysts said in a note.
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