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What is currently happening on the repo market ?

Updated: 2 days ago

Fed reverse repo | reverse repo market | repo market explained


Current situation

The Fed's overnight reverse repo facility recently reported a new record $2.55 trillion in it's daily reverse repo usage. With this new record value at the end of the quarter, the trend of stronger demand for repo transactions continues.

The following article answers two fundamental questions about the repo market:

  1. How do reverse repurchase agreements (reverse repos) work and what is their purpose ?

  2. What are the reasons for the increasing demand ?


1. What is a reverse repurchase agreement (reverse repo)?

Repo transactions are collateralized money market transactions. In a repo transaction, securities are purchased from a counterparty with the agreement to resell the securities at a later date. Conversely, in a reverse repo transaction, securities are sold to a counterparty with an agreement to repurchase the securities at a later date.


Repurchase agreement or "Repo" transaction components. In step one, the investor provides $80 cash and receives $100 in collateral, typically bonds. In step two, the borrower buys back the collateral, paying the investor their initial cash plus an interest amount. The "repo rate" is the interest rate received by the investor, in this case (88–80)/80 = 10%, while the "Haircut" is a ratio of the cash loan to collateral (100–80)/100 = 20%". (Gary Gorton, 2009, "Securitized banking and the run on repo")

For central banks, repo transactions are a possible monetary policy instrument to manage liquidity in the market and to control short-term interest rate levels.

The Overnight Reverse Repo Facility (ON RRP) helps provide a floor under overnight interest rates by acting as an alternative investment for a broad base of money market investors when rates fall below the interest on reserve balances (IORB) rate. (Source: https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/repo-reverse-repo-agreements )

In a reverse repo, liquidity is pulled out of the market. This is done as follows: A central bank sells securities to its counterparty and debits the counterparty's current account with the corresponding amount. This is done with the agreement that the securities will be repurchased at the end of the term.



2. What are the reasons for the increasing demand in reverse repos?

Source: https://www.kansascityfed.org/research/economic-bulletin/is-bank-capital-regulation-driving-continued-use-of-the-overnight-reverse-repurchase-on-rrp-facility/


A research article from the Kansas City Fed draws the following conclusion:

A popular narrative suggests that regulatory capital requirements discouraged bank deposit-taking, driving up ON RRP use. However, this story neglects important contributors to the ON RRP’s surge. We find that limited money market investment opportunities, policy uncertainty, and administrative changes likely explain increased ON RRP activity.

In more detail:

  • Increases in the target range for the federal funds rate were accompanied by higher ON RRP offer rates, which improved the facility’s attractiveness relative to other investments.

  • ON RRP access shields counterparties from interest rate risk, which is critical when policy uncertainty is elevated.

  • Chart 3 shows that while Treasury bills (blue area) once made up the largest government MMF investment, their share has declined with lower bill supply and higher interest rate risk.

Image Credit: https://www.kansascityfed.org/research/economic-bulletin/is-bank-capital-regulation-driving-continued-use-of-the-overnight-reverse-repurchase-on-rrp-facility/



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Sources:

https://www.kansascityfed.org/research/economic-bulletin/is-bank-capital-regulation-driving-continued-use-of-the-overnight-reverse-repurchase-on-rrp-facility/

https://fred.stlouisfed.org/series/RRPONTSYD

https://www.newyorkfed.org/markets/domestic-market-operations/monetary-policy-implementation/repo-reverse-repo-agreements






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