FED Operating System and Repo market – challenges and threats in 2020 and subsequent years
The current FED operating system, which has existed since 2008, requires that banks have so many reserves that they actually have more than they need. When this is met, the FED can control interest rates by simply changing the interest rate on deposits resulting from reserves. The reserve requirement (liquidity ratio) is the minimum value of the ratio of mandatory reserves to the category of deposit liabilities towards depositaries – bank clients (called the net value of transaction accounts – Net Transaction Accounts NTAs) set by the Board of Governors of the Federal Reserve System, due from depository institutions to their customers (e.g. due from commercial banks, including US branches of a foreign bank, savings and loan companies, savings bank, credit union). The categories of deposit liabilities currently subject to the reserve requirements are mainly current accounts. There is no reserve requirement on personal savings accounts and term deposit accounts. The total amount of all NTAs held by customers in US depository institutions as well as the US paper currency and currency held by public non-banking institutions is M1.
The depository institution may meet the reserve requirements by holding cash in the treasury or reserve deposits. An institution that is a member of the Federal Reserve System must store reserve deposits at the Federal Reserve Bank. Non-member institutions may choose to hold their reserve deposits at a member institution on a “pass-through” basis.
The reserve requirement of the depository institution varies depending on the amount of NTA contained in dollars held by its customers. As at January 16, 2020, institutions with net transaction accounts of:
- below USD 16.9 million: no minimum reserve requirement
- between USD 16.9 million and USD 127.5 million: the liquidity ratio is 3% NTA
- more than USD 127.5 million: liquidity ratio is 10% NTA.
Thresholds of monetary amounts are converted annually in accordance with the statutory formula (The Garn-St Germain Act of 1982) and specified by FED in details by regulation D. Since December 27, 1990, non-personal term deposits and bank obligations arising from deposits in euro are exempted from the obligation to hold reserves.
If an institution does not meet its reserve requirements, it may supplement the shortfall with reserves borrowed from the Federal Reserve Bank or an institution with reserves exceeding the required level of reserves. These loans are usually due within 24 hours.
The institution’s overnight reserves, averaged over a certain period, must be equal to or exceed the average required reserves calculated for the same reserve maintenance period. If these calculations are met, there is no requirement to maintain reserves at any time. As a result, mandatory reserves play only a limited role in the creation of money in the United States.
The International Banking Act of 1978 requires the branches of foreign banks operating in the United States to comply with the required reserve rate standards.
The reserve has two forms. These are appropriately un-borrowed reserves that the FED issues when it buys securities on the open market (objective QE) and borrowed reserves that the FED lends on the overnight market to secure repurchase or repo contracts. Data on reserves are published every two weeks, the reporting period ends on Wednesdays. Borrowed reserves are a system security valve. They are used in a so-called marginal fine-tuning operations.
The FED implements its monetary policy using a corridor within which the Effective Fed Funds Rate moves, which is limited at the bottom by the interest rate of reverse repo overnight (ON-RRP), in which the FED sells its treasury securities to American dealers (a loan collateralized with treasury securities). The upper part of the corridor is IOER (Interest On Excess Rate), i.e. the interest rate on the excess reserves maintained by banks on the account in the FED. The Effective Interest Rate On Funds should, from a theoretical point of view, move within the corridor.
In the second half of 2017 and at the beginning of 2018, the FED reduced its balance sheet value of System Open Market Account from the level of approx. 4,4 USD trillion (QE unwind), assuming that after three rounds of QE, the level of reserves was much higher than that needed for the smooth functioning of the system (4 March 2020: SOMA is USD 3.85 trillion). Apparently this did not happen because it turned out, that repo rates began to rise above the FED target. Another factor affecting the reduction in the level of reserves was the increase in the treasury general account – TGA (about USD 300 billion) and the foreign repo pool. TGA is a checking account maintained by the FED branch in New York that is used by the Treasury Department to make all official government payments. From the dealers’ point of view, the liquidity requirements increased due to the fact of the government bonds issues, which involves the need to buy them for further resale and the requirements imposed by Basel guidelines.
In mid-September 2019 there were sharp increases in rates, which clearly caused problems. This seems to suggest that the FED has gone too far and reserves have started to shrink, even though over USD 1 trillion of excess reserves remained in the system. The FED began to stimulate the market by actually lowering its target rates. The second option was to run quantitative easing. But quantitative easing works only when the FED buys long-term bonds. Reduces rates, but at the longer end of the maturity spectrum. Purchases made by the FED in the last few months were not long-term bonds. They boiled down to converting reserves into short-term T-bills. This should not stimulate markets. This is to prevent or compensate for the shortage of reserves so that rates do not rise above the FED target, which would of course be problematic. Powell referred to this as an organic FED balance sheet adjustment. Of the USD 169 billion invested in short-term T-bills via repo at the end of 2019, after adjusting the balance sheet, at present (March 4, 2020) approximately USD 303 billion is invested in T-bills. By providing liquidity to the market in this way, the FED firstly reduced the target rate and secondly, partially financed the growing deficit (USD 1.1 thousand billion in the fiscal year 2021). In turn, if you look at the repo market as a liquidity factor for financing huge positions using financial leverage (option and futures markets are operationally supported by the repo market), then the interest rate increase in August 2019 from about 2% to 9.25% in peak, in the long term could cause the hedge funds to close large market positions, which in turn could lead to negative feedback and market stock sale. This provision of liquidity by the FED through the purchase of short-term T-bills can explain the recent upward wave on the stock market (November 2019 – February 2020). The increase in liquidity on the repo market enables funds to create huge positions on the stock, bond and loan markets, with the use of leverage. But this liquidity can and is also used by large banks to build a position in Eurodollar, which affects the supply of Eurodollar and the off-shore US dollars creation. Before the introduction of Basel III requirements, transactions on Eurodollar between banks were not reflected in the FED books. After the Basel III introduction, new regulations and the need to meet the requirements of LCR ratios, the rules of the game and the dynamics of this market have changed.
The FED can permanently expand its balance sheet – which it does, it can carry out ad hoc repo operations (on a daily basis), which it also undertakes or can establish a standing rate facility.
What does the standing rate facility window means?
In this window, the FED lends cash to banks that are in good condition and have high quality liquid assets, including treasury instruments (HQLA).
When the bank reserves are drained from the system, the moment when the shortage occurs can be diagnosed by a market signal: the federal funds rate and other money market rates rise in relation to the target level.
In such a situation, banks may use the standing rate facility option, which will introduce reserves into the system and prevent further increase in interest rates. This means that the instrument provides sufficient reserves in the banking system and enables the control of interest rates, while enabling the FED to safely discover the lower limit of sufficient ample reserves.
The Fed seems to give up ad hoc repo operations, hoping that increasing the balance sheet level by outright purchase of financial instruments will be sufficient.
The question remains whether in the future the FED will decide to launch a permanent standing rate facility. It seems that this instrument should be of a reserve nature and should be used in situations of a sudden increase in the demand for reserves. Banks should treat this instrument as a kind of security buffer they can use occasionally in an emergency.
There is a lot of pressure to use the FED balance sheet to support various fiscal programs, and this pressure may increase in the future. The level of the general treasury account is also a matter of concern. For the time being, this is not a problem until another debt ceiling crisis occurs. Sooner or later there will be a need to steepen the yield curve, which will make it easier for foreign investors to buy US Treasury bonds. At the moment, the emphasis is on the short-term end of the curve, which causes investors are not interested in allocating funds to the long end of the curve. This in turn means, that prime dealers are forced to invest valuable balance sheet space in long-term bonds. We expect further interest rate cuts and the launch of the QE program in the near future. Throughout the puzzle, we observe the role of the TGA account as a marginal liquidity provider on the market and investment funds operations – marginal liquidity takers. The situation is complicated, and the FED’s adaptability to changing situation is a function of its tail (the FED needs more time to make changes in its balance sheet and observe its impact on the market than that indicated by the need for dynamics of market changes). There is also the question of whether the created system actually effectively allocates and uses reserves, and just as importantly, how exposed it is to liquidity shortages, whether the European and American banking sectors are exposed to the US dollar liquidity crisis.
We monitor the situation with careful attention, and will inform about the results of our observations in one of the next reports.
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The views expressed in this document do not constitute research, are not investment or commercial advice and do not necessarily reflect the views of all management teams. They change over time.