68 Finance & economics The EconomistNovember 2nd 2019
O
n september 17th, for the first time in
a decade, the Federal Reserve inter-
vened in the overnight repurchase, or
“repo” market, where banks and hedge
funds get short-term funding by swapping
$1trn-2trn of Treasuries for cash each day.
After the repo rate rose to 10%, the federal-
funds rate, at which banks can borrow from
each other, climbed above the Fed’s target
(see chart). The Fed swooped in, offering
$75bn-worth of overnight funding, and
both rates came back down. But it has had
to keep lending to stop them rising again.
During October it said it would lend for lon-
ger periods, increased its limit on over-
night repo operations to at least $120bn and
started buying short-dated Treasuries di-
rectly, at a pace of $60bn per month.
The turmoil indicated an unexpected
shortage of liquidity in the financial sys-
tem. Before the financial crisis the Fed had
controlled the federal-funds rate using a
“corridor”, with a ceiling and floor. Banks
could borrow at the ceiling rate, but the
floor rate was zero, meaning cash held at
the Fed earned nothing. To keep interest
rates on-target the Fed used “open-market”
operations, swapping Treasuries and cash.
The crisis changed everything. The Fed
added investment funds and securities
dealers to the list of approved borrowers in
the repo market and, using quantitative
easing (qe), bought vast quantities of long-
dated Treasury bonds. Its balance-sheet
ballooned to $4.5trn. Holders of Treasur-
ies, mostly banks, ended up with cash
mountains. To keep market interest rates
on target, the Fed raised the floor rate. The
ceiling became redundant, as did repo-
market operations. Regulations intended
to avoid another bail-out forced banks to
hold more cash and safe liquid assets, such
as Treasuries.
Under the old system, if commercial
banks were short of cash the quantity they
sought on the repo market would rise.
When cash became superabundant the Fed
lost any insight into banks’ thinking about
how much cash they needed to hold. Now
the repo-market turmoil has given an an-
swer—and it is far higher than the Fed ex-
pected. Collectively, America’s commercial
banks now hold $1.3trn of cash.
Even that does not seem to be enough.
Demand for cash grows with the economy.
And demand from the government is grow-
ing particularly fast because of the fiscal
deficit, which will reach $1trn next year,4.7% of gdp. The Treasury is therefore issu-
ing lots more bills and bonds, which finan-
cial firms and investors purchase with
cash. But buyers are becoming scarcer, es-
pecially foreign ones. High policy rates in
America have pushed up hedging costs, de-
terring European and Japanese pension
funds from buying Treasuries. Since 2017
the share of Treasuries held by foreigners
has fallen from 40% to 35%.
That has left more for American buyers
to mop up. “Primary dealers”—banks au-
thorised to deal Treasuries directly with
the government—bear the brunt of these
market forces. Their holdings of Treasuries
have ballooned. In 2017 they held $200bn-
worth of Treasuries outright, and financed
positions worth an additional $1.5trn in the
repo market. By September this year these
figures had risen to $250bn and $2trn re-
spectively. When repo rates spiked in Sep-
tember it was because primary dealers
could not borrow enough cash to cover
their positions. Commercial banks will
usually lend as much cash as primary deal-
ers need, but as their cash piles dwindled
they grew more reluctant to do so.
Three ways to avert another repo-mar-
ket meltdown are being discussed. Post-
crisis regulations concerning banks’ cashholdings could be tweaked. The Fed could
commit to continuing repo operations. Or
it could buy short-dated Treasuries out-
right. All are politically contentious.
Some bankers say they hold more cash
than legally required because they fear that
miscalculating and having to borrow from
the Fed would damage their reputations.
Steven Mnuchin, the treasury secretary,
has said it might be possible to change the
rules in such a way as to increase liquidity
without increasing risk. But any change
would draw heavy political crossfire. On
October 18th Elizabeth Warren, a leading
contender for the 2020 Democratic presi-
dential nomination, wrote to Mr Mnuchin
urging him not to relax the rules.
Before the crisis, large-scale lending by
the Fed in the repo market caused little
concern. But now that more lightly regulat-
ed institutions, such as investment funds,
can borrow too, repo-market operations
are bound to attract more scrutiny. For this
reason, among others, the Fed wants them
to be the exception, not the rule. It has al-
ready accepted that it will have to start in-
creasing its balance-sheet again, by buying
$60bn-worth of short-dated Treasuries per
month. Critics (wrongly) claim this is qeby
stealth. But the Fed had hoped to see the
balance-sheet shrink further, to give it
room for manoeuvre in any future crisis.
The repo market’s wobbles have re-
vealed not only banks’ huge appetite for
cash, but the unforeseen consequences of
post-crisis prudential regulation. Those
wobbles, and the Fed’s reaction, do not nec-
essarily indicate that America’s financial
system is imperilled. That the Fed was
blindsided is far more worrying.^7NEW YORK
What caused September’s turmoil in the vast and essential repo market?Money marketsMaking the world go round
Repo, man
United StatesSources:Bloomberg;FederalReserveBankofNewYork;Federal Reserve*Closelytracksthereporate
†Includinginflation-protectedsecuritiesFederal-fundsSecuredovernightfinancing*Interest rates, spread over the Fed policy
rate lower bound, percentage points2018 20193
2
1
0
-1Treasuries financed using repo†, $trn2015 191817162.0
1.5
1.0
0.5
0Long-termOvernightFederal Reserve, total liabilities, $trn19171513110920075 4 3 2 1 0Excess reserves of
depositary institutionsPrimary-dealer net treasury positions, $bn2015 16 17 18 19-1000100200T-bills^300
Treasuries†under2 years
Treasuries† over 2 years