The repo market, explained — and why the Fed keeps pumping hundreds of billions into it

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The coronavirus crisis has caused the Federal Reserve to radically up its involvement in what’s basically one of the world’s most important pawn shops: “the repo market.”

Short for repurchase agreements, the repo market is a complicated, yet important, area of the U.S. financial system where firms trade trillions of dollars’ worth of debt for cash each day. The activities on this market keep the wheels turning on Wall Street and the broader economy.

To further illustrate just how important it is, the repo market has demanded Fed action for more than seven months now. It first caught the Fed’s attention last fall, after a technical glitch caused short-term interest rates to surge well above the Fed’s target range. Then, in response to the economic threat from the coronavirus, it led U.S. central bankers to drop a bazooka in March — a series of short-term loans totaling $1.5 trillion.

But the Fed’s involvement is complicated. Experts say it’s an important part of ensuring things don’t go from bad to worse, but it’s still managed to raise some prominent peoples’ eyebrows, including those of Sens. Elizabeth Warren and Bernie Sanders.

Here are the main things you need to know about the cash crunch, including what the repo market is, why it’s a big part of the Fed’s coronavirus response, and how it could impact you.

What is the repo market?

To understand how these operations impact you, it’s first important to learn some of the basics on how the repo market works.

The repo market is essentially a two-way intersection, with cash on one side and Treasury securities on the other. They’re both trying to get to the other side.

One firm sells securities to a second institution and agrees to purchase back those assets for a higher price by a certain date, typically overnight. The contract those two parties draw up is known as a repo.

Essentially, it’s a short-term collateralized loan. And just as most loans come with an interest payment, you can think of the difference between the original price and the second, higher price, as the “interest” paid on that loan. It’s also known as “the repo rate.”

Why would two parties want to participate in a process as antiquated as the repo market? Because it ultimately benefits them. Financial firms with large pools of cash would prefer to not just let that money sit around — it doesn’t collect interest, meaning it doesn’t make any money. On the other side, it allows financial institutions to borrow cheaply to fund short-term needs. There’s also (typically) not much risk involved for either parties.

Experts estimate that around $2 trillion to $4 trillion of debt are financed here each day, meaning it’s vital to the overall functioning of the financial system. The cash that institutions receive goes toward funding daily operations.

Experts have offered up a wide variety of analogies meant to explain how the process works. Some refer to it as the plumbing of the financial system, while others call it the market’s beating heart.

Why exactly did the Fed get involved in the repo market?

But that work exists largely in the background. You probably don’t think about the amount of work that your heart is doing every day, as it pumps an estimated 2,000 gallons of blood throughout your body. You do, however, start to notice it when things go wrong. And in such cases, you probably need a first responder. 

That’s where the Fed comes in. 

The Fed’s involvement in the repo market can be traced back to Sept. 16, when a traffic jam occurred at the intersection of cash and securities. Experts say that piles of cash flowed out of the system because corporate tax payments came due. That happened right as new Treasury debt settled onto the markets. Financial institutions wanted to borrow cash to purchase those securities, but supply didn’t match those demands.

This ultimately caused a cash crunch, and the repo rate soared — reaching as high as 10 percent intraday on Sept. 17. In other words, banks didn’t want to part with their cash for anything lower than that rate. It pushed up the federal funds rate along with it, which was supposed to be trading in a target range between 2-2.25 percent at the time. It was also days away from a second reduction.

Is that all that caused the credit crunch?

Largely in the background, the Fed had also been shrinking its balance sheet and selling off the large holdings of assets (which included mortgage-backed securities and Treasurys) that it’d purchased in response to the 2008 financial crisis.

Experts say this process should also take some of the blame for the credit crunch last fall. Just as quantitative easing (Q.E.) increases the amount of bank reserves in the system, this opposite process sniffs them out.

“The general theme that caused the repo market volatility has been almost a decade in the making,” says Jon Hill, vice president on the U.S. Rates Strategy team at BMO Capital Markets.

Fed researchers surveyed major financial institutions to determine what level of reserves would be enough to be considered “ample,” but nobody knew for sure just how many reserves needed to stay in the system.

All in all, the Fed took about a trillion dollars out of the system. The repo market’s dysfunction showed that officials might’ve taken the process too far.

“I don’t believe for a second that you can take nearly a trillion dollars out of the system and something’s not going to go bump in the night,” says Greg McBride, CFA, Bankrate chief financial analyst. “What we saw in the repo market was a direct result of that.”

How much did the Fed inject?

The main responsibility of stabilizing the market was left up to the New York Fed. This regional Fed bank is tasked by the Federal Open Market Committee (FOMC) with carrying out its open market operations, so naturally they were the ones who took up the task, in what’s called “overnight repo operations.”

In its first overnight repo market operation since the financial crisis, the New York Fed injected $53 billion worth of cash in exchange for short-term Treasury bills. Those purchases then go on the Fed’s balance sheet until they’re paid back.

In October, the Fed began organically growing its balance sheet again by purchasing shorter-term Treasury bills at a pace of about $60 billion per month, while also buying up to $20 billion each month to replace maturing securities.

Though the process looks like Q.E., officials have stressed that it isn’t. That’s because the operations were not designed to stimulate the economy and push down long-term rates, but to get the markets well-oiled again.

The Fed’s repo operations led to the balance sheet growing in size again, recovering about half of what it initially sold off.

The Fed planned to continue those operations until the second quarter of 2020, when it planned to taper off its repo operations.

Where does the coronavirus come in?

When the coronavirus came along, Treasury markets started seizing up even more. It showed officials that now was not the time to be backing away from its repo market operations — but to instead be ramping them up.

Amid fears about the coronavirus pandemic’s impact on the economy, jittery investors started dumping Treasury securities in a quest for cash. That led to a mismatch in the number of buyers and sellers on the market, pushing up interest rates on government debt. The Fed stepped in to buy these government bonds to get the wheels moving again.

When the Treasury market doesn’t function properly, it has broader implications for the U.S. economy. Firms can’t get bonds off their books, meaning they suddenly don’t have the capacity to fund short-term financing needs or to make more loans. Strains like this impact borrowing costs for mortgages and other types of consumer loans.

What the Fed decided to do next makes those $60 billion operations look like mere breadcrumbs.

On March 12, the Fed said it would offer $500 billion in a three-month operation. The following day, the Fed planned to inject $1 trillion more, split between a three-month operation and a one-month operation. It was prepared to offer up to $1 trillion every subsequent week.

“These changes are being made to address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak,” the New York Fed said in a statement.

How this impacts your finances

That’s the main reason why the Fed’s repo operations are so important. When credit dries up, it makes it harder for businesses and firms to get access to a much-needed loan. And during a recession, that can be the difference between a firm staying afloat — meaning workers still get their paychecks — or ultimately failing.

It all makes its way back into the economy one way or another.

“The idea was just to get the markets functioning again,” says Stephen Stanley, chief economist at Amherst Pierpont. “In a normal course of business, you expect that you’ll be able to borrow what you need to operate normally, and when that flow of liquidity starts to dry up, then what you see is firms are forced to liquidate. That can feed on itself.”

Still, a lot is up in the air, and experts in Bankrate’s April Fed Forecast survey said the U.S. central bank likely isn’t done introducing measures to keep the financial system afloat.

All of this underscores the need for Americans to build up an emergency savings fund. Experts typically recommend having three to six months’ worth of expenses completely liquid and accessible, with the most recommended vehicle being a savings account.

How long will the Fed keep intervening?

The New York Fed on April 13 announced it would start scaling back the frequency of its operations “in light of more stable repo market conditions.” That process will begin on May 4, according to the Fed’s statement, when it plans to conduct its regular overnight repo operation in the morning but eliminate its second operation in the afternoon.

The Fed’s three-month repo operations will take place once every two weeks instead of once a week, while one-month operations will continue to occur once a week.

All of these overnight operations can’t go over $500 billion in lending.

That could, of course, change at any time. The New York Fed said its open-market trading desk “will continue to adjust repo operations as appropriate to ensure that the supply of reserves remains ample” and to support smooth short-term money markets.

How well are the operations working?

Banks are not utilizing the entire package that the New York Fed is willing to offer, suggesting that the market is sufficiently liquid again and that the repo market operations are working.

As of April 22, the Fed had $157.5 billion in outstanding repos tagged to its balance sheet. That’s after peaking at $442 billion on March 18.

The Fed will likely be pressed to offer more color on how well the repo market operations are working when its two-day meeting concludes on April 29.

But experts have long said that volatility could occur if the Fed ends the interventions too soon or scales them back too far. Some experts say the Fed will be forced to create what’s called a standing repo facility, which would be a permanent repo operation.

Minutes of the Fed’s December meeting showed that officials discussed the idea of creating this program, though the details still need to be hammered out.

“It should not have broader implications unless the Fed were to pull back on its repo operations too quickly without a standing repo facility in place,” Griffiths says. “That could cause more volatility and reduce people’s confidence that the Fed has a grip on what’s going on.”

Before the Fed lets go, a standing repo facility will likely be necessary, due to the “huge issuance needs of the U.S. government,” BMO’s Hill says. “Some demand is likely to persist.”

How does that relate to the repo market? To put matters in simple terms, there’s too much debt coming onto the market and too little money. Thus, lenders increase their repo rates. And though experts say it’s not the time to worry about debts and deficits, the repo market is going to be even more important as new government debt to finance Congress’ coronavirus response enters the market.

Why has it drawn criticism?

Anytime the Fed arrives to Wall Street’s rescue with mounds of cash, it’s going to lead to some pushback. Part of that reasoning is because it seems like an experimental policy, with the risks not fully realized.

“Part of my thinking is that the Fed and other central banks have gone on this wild experimental policy for the past decade on zero percent interest rates and quantitative easing,” says Dan North, chief economist at Euler Hermes. “My idea all along was, those are very risky policies put in place to help a sputtering economy.”

But another reason is because the operations are so complicated, it’s led to a fundamental misunderstanding of how the repo operations work.

The $1.5 trillion injection became a major talking point for Sanders and Warren on the 2020 presidential campaign trail. The Democratic senators have compared the short-term loans as the equivalent of handing out free money to rich investors, wondering why the money couldn’t instead be used to provide free healthcare or cancel the trillions of dollars in student loan debt.

https://twitter.com/SenSanders/status/1238223131204030466?s=20

It’s important to understand that these operations aren’t taxpayer funded, nor do they prevent money in the federal government’s budget from being used elsewhere. The process isn’t really printing money at all: It’s a short-term loan that has to be paid back.

“It puts reserves into the banking system temporarily,” Griffiths says. “It’s not necessarily printing physical cash.”

Regardless, experts say it’s going to be important for the U.S. central bank to describe what it’s doing and why, the more involved the Fed gets in handling the crisis.

“This points to the importance of communication for the central banking community to explain actions in the modern operating framework,” Hill says.

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