The brightest grads from the best business schools might not set their sights on working in the repo market, but the short-term lending market has been at the epicentre of recent financial crises. Signs of stress fractures in the market are causing alarm among some who see this somewhat niche area of the financial industry possibly triggering sell-offs across the board.
The day-to-day business of lending high-quality assets, typically government bonds in exchange for cash, and then reversing the trade, possibly as soon as the next day, provides little room for individual traders to shine. The benefit to the wider financial system is that repo acts as the lubricant that keeps the machine turning. Individual benefits, however, tend to fall with traders on more ‘exotic' desks. Repo traders don't go hungry, but returns are typically marginal.
GC repo rates 2000–2019:
During a time of crisis, it is the short-term lending market that reflects the troubled state of the market. The tail-spin that the repo market went into in September suggested that the internal plumbing of the financial system was about to break down. With the problem addressed rather than solved, investors are considering the upcoming quarter end and year-end reports — as these are times when the repo market faces most stress. With weeks to go until the next reporting deadlines, analysts are expressing concern that the problems in repo may trigger shockwaves through the rest of the market.
The plethora of innovative financial markets and tradable instruments may facilitate the supply of capital from those that have it to those who don't, but the banking system still operates on the basis of counterparts trusting each other. At the top of the pile sits the big banks. Looking back to the financial crisis shows that Lehman Brothers’ demise came about when the peer group stopped lending to it.
In calmer times, the lending between banks allows balance sheets to be optimised — the balance of liquid and illiquid assets are tailored to meet the required risk profile. If risk controls allow the short-term lending of cash in a deal collateralised by assets as high-grade as US Treasuries, then all the extra returns help at the end of the year when the bank's P&L is calculated.
September of this year saw the overnight repo borrowing rate spike as demand for cash exceeded supply. The rate of borrowing is typically nearer to the base interest rate. In the US, the fed funds rate on 17th September was 2.0–2.25%, but the overnight repo rate spiked at 7–10%. At that time, the US Federal Reserve stepped in to take emergency action and temporarily solved the problem when it swamped the market with extra liquidity.
The significance of September’s events is an indication of stress in the market. The Long Term Capital Crisis of 1998, as well as the financial crisis and Lehman crash of 2008, saw banks clamouring to hold on to cash rather than risk the marginal gain of lending to another party that might default. It is the first step toward a contagious outbreak of fear.
The report from the Bank of International Settlements (BIS), whilst not wanting to alarm, does point out that the problems in the repo market still remain. The chart of Reserves to Treasuries shows a trend for the big four US banks to hold cash, rather than government bonds. As these big four are essential liquidity providers to the repo market, this is a sign of the market drying up.
The causes of the shift are described by Claudio Borio, head of the monetary and economic department at BIS, as being structural and temporary in nature. Regulation brought in after the financial crisis was weighted heavily towards big banks moving away from being ‘too big to fail'. Ensuring each pillar of the banking community can operate on a stand-alone basis requires them to keep ‘healthy' balance sheets. With the regulatory reporting date of the banks being this quarter, a move towards cash occurs — the most liquid and fungible asset. The mid-September spike in repo rates occurred in the build-up to that quarter's reporting deadline.
A problem for the repo markets that is more temporary in nature is the profile of the existing borrowers. Hedge funds, in particular, have taken down considerable amounts of cash.
Big hedge fund — leverage levels
The strategy of harvesting small gains becomes a viable investment strategy in an environment where leverage allows for those trades to be scaled up in size. Whisper it, but this was exactly the technique adopted by Long Term Capital Management. It provided the firm with the opportunity to make generous returns — until the interest rate market turned. At that time, borrowing became more expensive, loans were recalled and the fund's positions liquidated at a loss because the strategy had not had time to materialise fully.
The principle that applied then applies now. If liquidity contracts, asset managers who are forced to liquidate positions can cause a vicious circle and major sell-off.
As things stand, the BIS and US Fed appear aware of the issue and are willing to introduce measures to support the market. The report from the Fed's meetings on Wednesday will be eagerly awaited with those in the boiler room, and the wider markets, the hope being that the fix is good enough for the job in hand.