Window dressing with the Fed's reverse repo program

If you are a bank or even a money market fund, you probably want your financials to show the maximum amount of your overnight liquidity placed with the Fed's RRP rather than with other banks. Your balance sheet looks less "risky" this way. And since most financial reporting is done at quarter end (with mid-year and year-end being the most important dates), you want to place your cash with the Fed on the last day of the quarter for one night and then take it out. And that’s exactly what’s taking place currently.

Why not leave your liquidity with the Fed for a longer period? Because the Fed's current RRP rate pays 5 basis points, while the private repo market is paying about double that. Of course as cash is pulled out of the repo markets for quarter-end and moved to the Fed or elsewhere, rates in the private markets rise. Once the liquidity comes back to the private markets at the start of the new quarter, the repo rates return to normal.

Source: DTCC

The larger the RRP program becomes, the stronger this quarter-end effect will be. Welcome to the wonderful world of window dressing.

________________________________________________________________________________

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Spike in bill rates rippling through repo, other money markets

Yields on treasury bills with near-term maturities have spiked to multi-year highs as the debt ceiling deadline approaches. While market participants are generally expecting to see a resolution (albeit a temporary one), some are not taking any chances.

USA Today (AP): — Fidelity Investments, the nation's largest money market mutual fund manager, has sold all of its short-term U.S. government debt — the latest sign that investors are increasingly nervous about the possibility of a government default.

Source: US Treasury

Institutional investors have rolled a chunk of their holdings into cash during September but in the last week or so started pulling out of government money market funds - moving funds into bank deposits instead.

Source: ICI (unit=$1MM)

Investors fear that their accounts will be frozen, as money fund managers who don't receive timely payments on bills are unable to meet redemptions. Many money market funds also use repo (collateralized loans) with treasuries or agency MBS as collateral. These short-term loans usually yield slightly more than treasury bills, giving money markets a few extra basis points. But with bills under pressure and investors getting out, repo rates have suddenly risen as well (after a period of declines - see post).

Bloomberg: - “We’ve seen some rise in repo rates in sympathy with the broad move higher in money-market yields, most dramatically in the near-term Treasury bills, given concerns over the debt-ceiling,” said Andrew Hollenhorst, fixed-income strategist at Citigroup Inc. in New York. “October futures contracts have had a sharp yield rise, signaling expectations for significant moves higher ahead, consistent with the sharp spike we saw in 2011 before the August debt-limit deadline.”

Source: DTCC

Some continue to believe that a technical default by the US government would impact treasury securities only. But as we see from the repo example, that assumption is quite naive. An adjustment to bill rates is already rippling through a number of other money market instruments. If we don't have a resolution on the debt ceiling soon, the shock will ripple across broader markets as well.

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Can the Fed's proposed overnight facility reduce pressure on the repo markets?

Repo rates in the US have seen sharp declines this year and are currently at levels not seen since 2011.

There are several reasons for this decline:

1. Excessive liquidity in the financial system (induced by the Fed) is chasing "secured deposits". Reverse repo provides a way to deposit funds with a bank, but receive collateral in return in order to mitigate counterparty risk. With demand on the rise, rates paid on these deposits have declined.

2. With the Fed buying up the exact same collateral sought by these reverse repo "depositors", the collateral pool is more limited. That competition for collateral suppresses the rates repo providers are willing to pay on secured deposits. The problem is too much cash and not enough collateral.

3. Recent bank regulation proposals (see post) are also beginning to discourage banks from building large repo books with clients.

4. More recently, a wave of short-sellers pushed repo rates even lower by looking to borrow and short increasing amounts of treasuries and agency MBS. Some are betting on rising rates while others simply hedge fixed income portfolios. Given the demand to borrow this paper, banks are paying less on cash proceeds that result from short-selling these securities (note that the repo process is the same as # 1 above except traders look to borrow a specific bond to short rather than accepting "general collateral").

5. It's also important to point out that treasury issuance is expected to drop off significantly in September (roughly $25bn in bills alone). Furthermore with the debt ceiling approaching and with the US Treasury having accumulated substantial cash positions, treasury issuance will fall further (see chart). That is one of the reasons the Fed should feel comfortable reducing its purchases in September - smaller purchases will not increase the overall supply of treasuries substantially.

In light of these developments, market participants are quite supportive of the Fed's proposed "full-allotment overnight reverse repurchase agreement facility" (discussed here) as a method to overcome some of the challenges. The Fed will commit to take as much in deposits as the market wants as long as participants accept the Fed's rate on this facility (some refer to this facility as "all you can eat" or "buffet" .) It will allow market participants that are long cash, such as money market funds, the GSEs, and some corporations to circumvent banks altogether in depositing their cash.

The Fed's new facility will likely be executed via a triparty repo that will not allow the Fed's securities to be used as collateral elsewhere (no "re-lending" of securities). Typically the Fed's bonds will be held by custodians such as JPM, BNY Mellon, and State Street. However by significantly reducing demand in the market for general collateral reverse repo, the program should free up a great deal of this collateral which banks currently use for this purpose. And that will end up easing some of the collateral shortages we've experienced in recent years. The rate on this facility should set a floor on general collateral repo rates because large participants will only execute reverse repo with banks (vs. the Fed) if banks pay a higher rate.

Unfortunately it may be a while before this facility is in place, since it will effectively sweep liquidity out of the system, reducing bank reserves. And it is unlikely that the Fed will want to reduce reserves via this program while increasing reserves via the securities purchases. That means the tightness in the repo market (low repo rates) may persist for some time, as cash rich market participants look for safe places to park their money.

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From our sponsor:

Fed contemplates creating "overnight reverse repo facility"

Today investors focused on the broad support for tapering in the July FOMC minutes, driving treasury yields sharply higher.

10yr treasury yield (source: Investing.com)

There was however another passage in the minutes that wasn't broadly covered in the mass media.

July FOMC minutes: - In support of the Committee’s longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee’s ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.

It's an interesting development because this project could potentially achieve three objectives:

1. The "full-allotment overnight reverse repurchase agreement facility" can provide competition for bank deposits. While deposits of under $250K rely of the FDIC insurance, corporate and institutional depositors remain concerned about bank credit risk because in a bankruptcy depositors become unsecured creditors. By allowing non-banks to participate, the Fed creates a deposit account that is free of counterparty risk (currently the only way to achieve this is by purchasing treasury bills).

2. Instead of just changing the interest paid on bank reserves to manage short-term rate policy (in addition to the fed funds rate), the Fed would now have another monetary tool - adjusting rates paid on these types of broadly held accounts.

3. By accepting broader deposits, the Fed can effectively "soak up" excess liquidity and "sterilize" some of its securities holdings. And by adjusting these rates, the central bank could fine-tune how much liquidity these accounts attract. This reduces the need to sell securities in order to drain liquidity from the system.

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From our sponsor:

The regulatory war on repo will have unintended consequences

In addition to the pending Basel-based regulation on minimum leverage ratio (see post), US regulators are pushing to set the minimum supplementary Tier 1 leverage ratio for the eight "systemically important" US banks to 5%. Once again, this is expected to hit the repo market as well as other assets with low risk weights.

Source: Barclays Research

This action will achieve the following:

1. Disrupt the functioning of money markets by pushing larger banks out of secured deposits. Deposits collateralized by treasuries (reverse repo) is the only way many institutional palyers can place cash with banks without taking unsecured bank risk. Now these institutions will be forced take bank risk or buy treasury bills - which will likely go negative as a result.

2. Reduce liquidity in the treasury markets. As discussed earlier, treasury trading volumes follow repo volumes - and this is not a great outcome for either.

3. Increase fails and the overall volatility of the treasury markets by making it harder to borrow treasuries.

Barclays Research: - A significant reduction in repo could reduce the ability of dealers to short securities without risk of being able to deliver, raising the prospect of the fails charge being triggered. This should factor into how aggressive they are at auction and actual auction pricing. Further, the possibility of increased fails could mean greater volatility in rates around Treasury auctions.

4. Create similar headwinds as in #2 and #3 above in the MBS markets and potentially other markets that involve some form of securities lending.

Barclays Research: - Full effects likely to be more widespread. We believe the knock-on effects of these rule changes are not likely to be limited to the Treasury and MBS markets. They would likely filter through to other markets, including credit and equities, potentially reducing liquidity and increasing volatility over time.

This regulation will certainly not reduce the risk of a systemic problem going forward - in fact it is likely to have the opposite effect. Banks will find other ways to make money, potentially by shifting to riskier assets. Ultimately it will be the end-users and market participants (mutual funds, ETFs, pensions, securities custodians, insurance firms, endowments, foundations, retail investors, etc.) who will feel the brunt of this regulation. Welcome to the world of "unintended consequences".


5 percent minimum for U.S. systemically important banks

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From our sponsor:

The Leverage Ratio regulation will hurt liquidity, introduce risks

New proposed bank regulation focused on the so-called Leverage Ratio is expected to do major damage to the US repo market. The measure is a blunt tool that does not permit any netting. That means if a client has a repo trade with a bank and an offsetting (reverse repo) transaction, the two can not be offset. Furthermore, the Leverage Ratio will show double the exposure by grossing up the transactions.

According to JPMorgan, this inability to offset positions will result in some $180bn of new capital requirements for major banks.

JPMorgan: - The inability of banks to offset repos against reverse repos could increase the denominator of the Leverage Ratio by up to $6tr. Applying the 3% minimum capital requirement to this $6tr potentially results in additional capital of $180bn across G4 banks.

That is expected to shrink the market considerably. And lower repo balances will reduce trading and liquidity in the underlying securities - the two markets are closely tied.

Source: JPMorgan

Some 80-90% of repo trades are collateralized with government securities, which will see declines in liquidity as the new rule goes into effect.

In 2008 financial institutions faced a major liquidity crisis that was in large part the result of short-term financing of highly illiquid securities. In order to address these problems, the regulators are now attacking the most liquid part of the market - the exact opposite of where they should be focusing. Ironically these new rules may actually introduce additional risks into the financial system by cutting trading volumes and reducing secured lending against government bonds, both of which are essential in a liquidity crisis.

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Draining excess reserves and the exit strategy

Questions continue to surround the Fed’s eventual exit from years of quantitative easing. The ultimate fate of what is to become of the 3.5 - 4 trillion dollar portfolio of securities (the expected peak holdings of Fed’s balance sheet) will determine, among other things, long-term interest rates, mortgage rates, corporate and US government borrowing costs, profitability of the banking system, returns on pension and insurance portfolios, and even the value of the dollar. In short, the exit strategy will drive the fixed income markets for years to come.

Some argue that the Fed has no need to sell securities and can simply sit on the portfolio as it winds down naturally through maturities and prepayments. The Fed can keep the economy from overheating by simply raising rates on excess reserves. And the fact that bank reserves (deposits at the Fed) will be in the trillions for years to come shouldn't matter they argue. That's because these reserves do not result in excessive lending and therefore are not inflationary. The lack of transmission from excess reserves to lending is visible in the so-called money multiplier (discussed here), which is at historical lows.

In normal times this argument may hold, but these are by no means normal times. By purchasing unprecedented amounts of securities, the Fed “created” trillions of excess reserves. And the central bank may not want to wait until 2020 (see post) for the reserves to decline to more normal levels on their own. Here are some reasons:

1. Some economists feel that even though reserves do not immediately transmit into lending, bank loans and leases have been rising steadily since early 2011 (QE2), and over the years could, if left unchecked, raise the money supply to inflationary levels.

Loans and leases on US banks' balance sheets (source: NY Fed)

2. Bloated excess reserves may ultimately impact the value of the dollar.

3. There are concerns that over a longer period, excess reserves could distort certain markets, creating financial bubbles - as banks seek to deploy cheap capital (in real estate for example).

4. With the reserves at their expected peak the Fed would be paying out about $6bn per year in interest to banks on riskless deposits. And those of us who have checking and savings accounts know that the rate we get on deposits is close to zero. Corporate accounts are not much better. That means that the banking system will get to keep most of that money. Now if the Fed raises the rate it pays on reserves (as suggested above), the banks will generate multiples of that amount in riskless profits. Once again, in a normal environment that would not be a big deal, but these days the Fed doling out free money to banks is not going to be very popular with the public.

These are some of the reasons the Fed may choose to drain at least some of the reserves. Selling assets may be one way to do it, but that may shake up the markets and significantly raise long-term interest rates. It will also generate realized losses for the Fed – another potentially unpopular outcome. But there is another solution. Back in 2009 the Fed set up tri-party repo arrangements with a number of dealers (see 2009 post). Eventually that will allow the central bank to lend out the securities instead of selling them. As dealers borrow the securities over a period of a week for example, they post cash as collateral to the Fed (dealers pay the coupon on the securities they borrow and receive the market repo rate on their cash “collateral”). That cash going into the repo account is taken out of “circulation”, thus draining the reserves.

If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed - until they pay down or mature. In effect the Fed would sterilize some or all of its securities purchases. Which means that draining the reserves does not have to entail the painful process of active portfolio unwind. And draining excess reserves is in fact a more likely exit strategy than some economists have been expecting.

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From our sponsor:

Triparty repo and the clearing bank risks

Avi Cohen had a good comment on the recent post about repo transactions (here), pointing out that triparty repo custodians face some intraday risks. It is indeed an important issue and should be discussed.

Repo markets have functioned well for decades. However this recent paper published by the NY Fed (below) outlined potential systemic risks in the tri-party markets that became apparent in 2008. The concerns are not with the repo market itself or the lenders/borrowers under the contract, but with the clearing banks that facilitate triparty repo transactions.

Both lenders and borrowers under the repo agreement often prefer for a third party to hold collateral and arrange settlement. This is similar to using an escrow account when two parties don't fully trust each other. Not surprisingly triparty repo usage has been increasing since the financial crisis and particularly when dealing with Eurozone banks (see discussion).

The risks the NY Fed discusses in their paper are posed by the clearing banks such as BoNY and JPM who handle some $100bn+ in repo each on a daily basis. Specifically the issue is with the exposure these custodians have on an intraday basis when repo transactions are unwound.

Consider the following scenario. On a quiet Friday morning a lender under the repo agreement informs her borrower that she wishes to unwind the repo loan and asks the borrower to return the money. The custodian (clearing bank) is told that the repo trade is closed. The clearing bank then transfers the funds to the lender, expecting to get that cash from the borrower upon the end of day settlement. But when the clearing bank, in the process of returning collateral bonds to the borrower, tries to settle, the borrower fails to make payment and the securities go back to the custodian (via DTC).

Now the clearing bank, stuck with these bonds, is forced to start selling. But it is Friday late afternoon and there are few buyers out there willing to even look at the bonds. The custodian bank goes into the weekend still holding the securities. On Sunday the media picks up the news that this particular borrower has failed. By Monday morning markets are in disarray and other repo lenders to the troubled borrower are stepping out of their repo, all forcing the clearing bank to liquidate more collateral. At the same time the other large clearing bank is doing the same. Now lenders to unrelated institutions are also spooked by this event and decide to step out of their loans as well. A panic ensues. Clearing banks are forced to liquidate billions in collateral that is declining in value. All of a sudden one of the clearing banks fails to make payment and the situation rapidly spirals out of control as all triparty lenders try to get their money out at the same time. It's a run on the repo clearing banks that forces credit markets globally to freeze.

This scenario, though quite remote, could be catastrophic. It was a serious enough concern for the clearing banks in 2008 that one very large custodian chose to liquidate collateral without waiting for the end of day settlement - which landed it in court later. But at the time it was the rational thing to do.

NY Fed: - Bear Stearns and Lehman Brothers, during the financial crisis of 2007-09 highlighted the fact that the two tri-party clearing banks are not only agents, but also the largest creditors in the tri-party repo market on each business day. This daytime exposure is associated with the unwind of repos, a process by which the clearing banks send cash back to investors and collateral back to dealers, regardless of whether a repo is expiring.

Between the time of the unwind and the time at which new trades are settled near the end of the business day, dealers must finance the securities that serve as repo collateral. During this transition period, the clearing banks provide financing to dealers, collateralized by the dealers’ securities. This provision of intraday credit creates multiple risks.

To deal with the risks posed by the clearing banks in 2008, the Fed set up its own "clearing bank" to make sure repo markets continue to function. It was called the Primary Dealer Credit Facility (PDCF). It's obviously no longer used, but this intraday settlement gap continues to pose some risks to the financial system (discussed in the paper).

These risks however have diminished since the financial crisis. Collateral haircuts are now higher, particularly for the less liquid bonds. Lenders restrict bond size/concentration that can be in the collateral pool to make sure they are able to liquidate them. And the bulk of the collateral handled by clearing banks these days is comprised of treasuries and agency bonds.

Enjoy!

NY Fed on Triparty Repo

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Repo transactions and shadow banking

We continue to get questions about the repo markets and the structure of repo transactions. The attached paper from the Financial Stability Board provides a good overview of repo and securities lending markets (including rehypothecation practices).

A repo transaction structure is quite simple.  Here is an example:

A hedge fund buys a high yield bond for $10mm. It then uses this bond as collateral to borrow $7.5mm from a dealer. That means the hedge fund puts up $2.5mm net to control a $10mm bond (similar to buying a house with a 25% down-payment) . The dealer will value the bond on a daily basis and if the bond declines in value, the hedge fund will be asked to post additional cash collateral (similar to a futures market). Most such transactions are overnight and are rolled (re-borrowed) daily. The risk to the hedge fund is that one day the dealer refuses to roll the loan and the fund would need to come up with $7.5mm to repay the bank, potentially forcing it to sell the bond quickly (and possibly at a loss). In fact this is how both Bear Stearns and Lehman failed, as their counterparties refused to roll their repo loans. A more likely scenario however is that the dealer raises the initial margin from 25% to say 30% forcing the fund to put up an additional half a million.

To reduce these risks, some funds (and some leveraged ETFs and closed-end funds) negotiate a longer dated repo - usually under 90 days. This gives the fund more time to find alternate sources of funding or liquidate the bond gradually - should market conditions require it.

Below is a generic diagram of a repo transaction, including the so-called tri-party repo (discussed here).

Source: FSB

One issue that keeps coming up repeatedly (including in this FSB paper) is whether this multi-trillion dollar market represents a form of "shadow banking" (discussed in this article by Dan Freed). In and of itself the repo market is no more a "shadow bank" than say the mortgage market. What makes something potentially a "shadow" banking transaction is the lending institution involved. For example a money market fund lending via repo or in some other fashion is a "shadow bank" because money funds are not bank holding companies. The repo example discussed above however does not represent shadow banking since a hedge fund would typically be borrowing from a registered bank. It's an important distinction.

Enjoy!
Securities Lending and Repos

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US repo rates spike

The US repo rates have risen to a 3-year high this week. The chart below shows the so-called General Collateral (GC) treasury repo rate. GC simply means that the borrower under the repo loan can post any treasury securities as collateral - as opposed to specific bonds.

Source: JPMorgan

JPMorgan attributes this increase to several factors.

1. Banks' total reserve balances at the Fed has declined recently.

Bank reserves (source: FRB)

Empirically it can be shown that declines in reserves corresponds to rising repo rates. Reserves will begin rising again as the Fed commences balance sheet expansion.

Source: JPMorgan

 2. Dealer holdings of treasuries (which are not prohibited under the Volcker Rule) have risen recently, increasing demand for treasury financing.

3. US money market funds, tired of extraordinarily low rates in secured lending (repo), have rolled some of their assets into unsecured US bank paper (commercial paper and CDs). This reduction in repo lending contributed to rising rates. Note that US money funds still prefer secured lending in Europe (discussed here).

4. Quarter-end generally corresponds to higher rates, as banks try to reduce balance sheets ("window dressing") for reporting purposes.

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Nothing "puzzling" about higher haircuts in bilateral repo markets

At times certain research from the Fed seems to be disconnected from reality. The NY Fed's recent analysis for example compares repo haircuts between bilateral and triparty repo (see discussion on triparty repo) transactions for different collateral types during the 2008 financial crisis. They found that bilateral haircuts were materially higher and varied by collateral type.

Source: NY Fed

And while the results make sense, the researchers' interpretation does not. They entitled the article "The Odd Behavior of Repo Haircuts during the Financial Crisis".

NY Fed: - The different behavior of haircuts in the bilateral and tri-party repo markets is puzzling. These two markets are similar, with both using the same contractual form and the same types of collateral. The purpose of some transactions in both markets is similar—market participants have stated that financial entities use the two markets for funding purposes. These two markets are also tightly linked; the larger securities dealers operate in both markets and often provide intermediation services by rehypothecating into the tri-party repo market collateral received via bilateral repos. These linkages suggest that haircut behavior across the two markets should be similar.

Clearly they don't seem to be aware of what actually transpired in 2008. When a firm (a hedge fund, a mutual fund, an insurance firm, a broker dealer, etc.) lent money to Lehman via repo on a bilateral basis, Lehman placed the collateral for this loan into the lender's securities account - at Lehman. Once Lehman filed for bankruptcy, it would not pay back the money borrowed. The securities account where the collateral was sitting however was frozen by the court. By the time the lender was able to access her collateral and sell it, it had sometimes declined in value so much that the proceeds did not cover the loan balance.

On the other hand if the collateral was held by a third party such as State Street or BoNY, as soon as Lehman couldn't pay, the lender was able to access and liquidate the collateral. Thus the differences in haircuts are not driven by the repo agreement itself - which is what these researchers seem to be focused on. It's driven by the fact that in a bilateral agreement it may take longer to access the collateral and liquidate it, potentially increasing losses. That risk of a longer liquidation period in the case of a default increased the bilateral haircut levels.

As one would expect, the riskier the collateral the higher the risk differential because while an extra few days may not make a difference for treasuries or agency MBS, it could be tremendous for a subprime tranche. And in 2008 no financial institution seemed immune from filing for bankruptcy, potentially resulting in frozen securities accounts. Therefore these risk premiums in the bilateral repo markets were perfectly in line with the expectations.

There should be nothing "puzzling" about this difference in haircuts. What is somewhat puzzling however is how central bank researchers who are disconnected from the realities of financial markets are given an opportunity to influence financial regulation and monetary policy.

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For money market funds risk aversion comes at a cost

Fitch's latest update on US prime money market funds shows increasing exposure to non-Eurozone banks (Nordic, Swiss, and the UK) as well as to Japanese banks. Eurozone exposure is now minimal.

Source: Fitch

Lending to European banks is increasingly executed via secured transactions (repo).

Fitch: - MMFs continue to exhibit risk aversion. While MMF allocations to European banks increased moderately since end-June, the proportion of secured exposure in the form of repurchase agreements (repos) also continued to climb (see chart, Repos Continue to Rise). As of end-July, repos represent about 36% of MMF allocations to European banks.

Source: Fitch

The retail money markets business is now completely subsidized in order to keep customers that are invested or considering investing in other products of the mutual fund firm. For investors with under $250K in cash, there is no reason to use a prime fund because an FDIC insured savings account at a bank will pay more - with no risk. Fidelity's retail money fund (SPRXX) is paying 1bp per year just to say it's not zero. The institutional prime money fund (FIPXX), with minimum investment of $10 million, pays 16bp per year. Risk aversion comes at a cost.

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PBoC managing China's rising interest rates

Interest rates in China have been on the rise. The 7-day repo swap rates have been increasing across all tenors. These swaps exchange the 7-day repo rate (reset weekly) for a fixed rate over a longer period (such as 2 years) - thus providing a window into the market's long-term expectations of repo rates. The increase is an indication of tightening liquidity conditions in the interbank market.

2-year fixed for floating  (7-day repo) swap rate (Bloomberg)

China's central bank has been trying to add more liquidity to the money markets in order to stabilize rates (without adjusting the bank reserve ratio).

WSJ: - The People's Bank of China injected 220 billion yuan ($34.7 billion) into the money market Tuesday via reverse repurchase agreements offered in its regular open-market operation, continuing efforts to ease monetary conditions and bolster a slowing economy.

So far these liquidity injections have not worked, as demand for short-term money remains high and rates continue to rise.

Reuters: - China's key money rates ticked higher on Tuesday, with the central bank's largest fund injection since early July failing to ease conditions amid elevated month-end cash demand and corporate tax payments. The People's Bank of China injected 220 billion yuan into the banking system via reverse repos on Tuesday, against a net 87 billion yuan scheduled to be drained this week due to maturing bills, repos, and reverse repos.

That guarantees a net injection of at least 133 billion yuan for the week not including additional reverse repos likely to be auctioned on Thursday. Such an injection would be the largest since the week of July 2-6.

"The market demand is quite large. Monday's demand was really heavy. The central bank's action today basically just satisfied current demand, but didn't in any way exceed it in a way that would bring rates down," said a trader at a city commercial bank in Shanghai.

The PBoC has been cautious about flooding the market with liquidity due to risks it could reignite inflationary pressures. Yet left unchecked, rising interest rates could threaten growth, given that the GDP is already growing at the lowest rate since 2009. This will require a delicate balance for the central bank going forward.

China GDP YoY (Bloomberg)

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US money market funds moving into "safer" assets; returns suffer

The latest Fitch report on US money market funds is showing three key trends:

1. On the non-US allocations, exposure to the Eurozone continues to decline, replaced by Australia, Canada, and Japan. This is one of the main reasons Eurozone banks are exiting US businesses.

Source: Fitch

2. Increasingly transactions with European banks are executed via repo (secured loans). We discussed this earlier.

Source: Fitch

3. This risk aversion is becoming increasingly costly for the fund managers as yields on the "safer" products fall below funds expenses.

Source: Fitch

The risk aversion is translating into near zero returns even for the "prime" money funds that carry more risk than government funds. As an example the Vanguard Prime Money Market Fund (VMMXX) returns less than 4 basis points per year. Treasury funds are of course even worse. Fidelity US Treasury Money Market Fund (FDLXX) yields 1 basis point a year.  (Some Europeans would consider this return to be excellent given their negative rates.) The fund is subsidized by Fidelity because with full fees the return would in fact be negative. Fidelity also closed this fund to small investors by requiring $25,000 minimum. These are difficult times to be in the money market funds business.

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Money funds' use of repo continues to grow

Here is a quick update on US money markets' exposure to EU banks. The percentage of funding provided to European banks via secured lending (repo) vs. unsecured funding (commercial paper) continues to grow. US money funds are desperately looking for any yield and EU banks may offer a couple of extra basis points. But the funds will increasingly demand collateral and execute this lending via tri-party repo for additional security.

Source: Fitch

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Finding alternatives to LIBOR

Bloomberg recently published a story that provides an overview of the problems with the LIBOR index. We discussed this issue some time back as the investigation against UBS and others was beginning to take shape. There were multiple reasons for banks to manipulate this artificial index depending on how these firms were positioned. And they did, since there were no rules against it - it is purely a survey.

Bloomberg: The BBA, the lobby group that has overseen Libor for 26 years, is under pressure to find an alternative way to calculate the benchmark, or cede control of it. Regulators from Canada to Japan are probing whether banks lied to hide their true cost of borrowing and traders colluded to rig the benchmark, the basis for interest rates on securities from mortgages to derivatives.

But the solution to this issue is not obvious. A common but a naive proposal is to use only the actual transactions in calculating LIBOR.

Bloomberg: “It can’t be beyond the wit of man to come up with a rate that is based on actual trades rather than guesswork,” said Tim Price, who helps oversee more than $1.5 billion at PFP Group LLP, an asset-management firm in London. “The idea that you can trust the banks and the BBA with this is laughable.”

But the reality is that for many banks, particularly in Europe, there are no "LIBOR transactions". LIBOR represents a rate on an unsecured loan from one bank to another. But except for overnight or very short-term maturities many banks are not able to borrow on an unsecured basis. Some can not borrow at all except from the ECB. Finding actual 3 or 6-month transactions would be extremely challenging and may even be impossible for certain currencies.

Another proposal is to use just the overnight rate that is targeted by the central banks (such as the Fed Funds effective rate for dollars or EONIA for euro). Certainly it is much easier to obtain quotes for all major currencies using the overnight rate, although in times of stress it would be biased to only the stronger banks. The key issue of this approach is that it limits one to only one tenor - the overnight. The industry clearly needs more of a term structure, ideally out to one year.

An extension of the overnight rate proposal is to use the Overnight Index Swaps (OIS). That gives one the term structure and the market is fairly active. Some in the industry and even central banks are beginning to use OIS rates quite actively for various purposes.

EUR (EONIA) OIS curve (Bloomberg)

Another good option is to shift to secured funding rates. That is now the primary way that banks lend to each other in Europe. The other positive aspect of secured lending is the fact that it is not limited to banks. From money market funds to hedge funds and corporations, secured funding is used quite actively globally. As long as the collateral type can be specified, the index is easy to obtain. Eurepo is a good example of secured lending index that is comparable to LIBOR/Euribor (although there may be issues with the way it is computed as well).

Eurepo curve (Bloomberg)

But even that index would need to be monitored carefully for longer tenors because the transaction liquidity for secured lending drops off greatly for longer maturities. Even in the US, where repo markets are massive, the tenor rarely goes beyond 3 months.

Dollar repo curve (Bloomberg)

It is therefore unlikely that the industry will find a LIBOR substitute that is both verifiable via actual transactions and has the tenor out to one year. But in spite of the tenor limitations, it is imperative that the industry begins to transition toward "observable" indices such as OIS or Repo. It will take years because so many existing long term contracts reference LIBOR (supposedly $360 trillion in total), but it is necessary given the lack of confidence this hypothetical and manipulated index has created.

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The increase in triparty repo usage and other developments in the repo markets

There is still a misperception in the media that only the CDS market can afford significant amounts of leverage to risk takers. Tremendous leverage is in fact available via repo, a market far larger than CDS. The media often misses the fact that MF Global failed because of repo based leverage. And by the way so did Lehman and Bear Stearns and Merrill Lynch - all failed because they could not roll their repo loans. That's why repo markets are of critical importance to the financial system and need to be well understood by policy makers. It's amazing that a typical US politician knows more about the Kandahar Province in Afghanistan than what a repo transaction is.

Data on repo markets is difficult to come by. Recent report from Fitch sheds some light on the latest developments in that market. Repo haircut (initial margin) - a key measure to track in these markets - obviously depends on the type of collateral. According to the report, treasuries tend to have a 2% haircut these days, while corporate bonds are 5%. That's 20 to 1 leverage. Haircuts for high yield bonds are higher (15-25%) and equities haircuts are around 50%, but vary with the volatility in the market. (There are other ways to leverage equities such as total return swaps.) Just for illustration, the diagram below shows how repo leverage can force asset sales if haircuts are increased from say 5% to 10%. Increasing haircuts is all it took to put MF Global out of business.

One recent development in the repo market has been the return of structured credit such as RMBS securities as collateral in repo transactions. Three years ago leveraging structured credit bonds in the repo market was impossible.

Source: Fitch Ratings

The biggest development has been the recent growth in triparty repo market. To begin with, here is a diagram of a triparty repo transaction (a number of readers have asked to see how this process works.)

Source: Fitch Ratings

Triparty repo eliminates counterparty risk that exists in a bilateral repo transaction. As concerns about counterparty risk increased in 2011 with fears of US banks' exposure to the Eurozone, the usage of triparty repo rose.

Source: Fitch Ratings

The repo market continues to dominate short term funding in the banking sector in Europe, with unsecured interbank funding basically dead across the Eurozone. Also with new derivatives regulation pushing CDS into central counterparties (clearinghouse), repo based leverage becomes an even more attractive way to put on risk. Following such developments in the repo markets will be increasingly important to understanding the health of the financial system.

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Contraction in Eurozone's repo markets is driving M3 decline

Yesterday the ECB released its monetary aggregates measures for the Eurozone through Dec-2011. The following chart shows the absolute level of Eurozone's M3 aggregate, a broad measure of money stock. (Note that at times it is helpful to look at monetary indicators on an absolute basis rather than as percent changes as economists tend to do.)  The upward trend in the money supply growth has reversed, mostly during the last quarter of 2011.

Eurozone M3 in EUR billion (seasonally adjusted)

An obvious question here is whether this broad money supply decline is similar to the US during 2008-2010. One key component of M3 driving this contraction in money stock is the amount of repo (secured) lending. The Eurozone repo loan balances have declined materially in Q4 - an issue that is quite different from what had occurred in the US.

Repurchase agreements (repo) component of  Eurozone's M3 in EUR billion (seasonally adjusted)   

Since repo has become the only form of interbank lending in the Eurozone, this is clearly an indication of deteriorating credit conditions. With the ECB providing longer term financing not available in the interbank repo markets, it is often quite attractive or even necessary for many financial institutions to shift their collateral into an ECB facility (ECB secured loans are not included in the monetary aggregates). LTRO term lending for example provides far more funding stability than rolling short-term interbank repo loans. The ECB has also been considerably more lenient with collateral than the current repo markets. The rapid rise in the ECB's balance sheet (EUR 2.7 trillion) "soaked up" a great deal of the collateral out of the repo markets, dampening growth in interbank credit.

ECB consolidated balance sheet (EUR million)

The pie chart below shows the contribution by country to the drop in the Eurozone repo levels over Q4-2011. Nearly half is coming from Italy as Italian institutions shifted financing to the ECB. It is not surprising therefore that Italy continues to deal with tightening credit conditions that are more extreme than the Eurozone as a whole.

Contribution by country to the Q4 drop in repo component of M3

The unprecedented accommodation provided by the ECB is not yet helping to expand the broad money supply. The banking system has shifted a substantial portion of its eligible collateral from the repo markets to the ECB who is providing longer term stable funding. Only once the dependence on the ECB is reduced and the interbank funding markets begin to heal, will we see a stabilization in M3 growth.

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EU corporates move cash from bank deposits to repo

A number of large European corporations have sizable cash positions, a similar trend to what's been happening in the US. In the past these corporations would simply deposit that cash in their local eurozone banks. But these days the companies are much more cautious with their cash. Some corporations have bank subsidiaries (for example Nestle owns Nestle Bank), a practice generally illegal in the US, but common in Europe. They use their "internal" banks to deposit funds with the central bank to avoid credit risk, contributing to this rapid rise in the ECB Deposit Facility balances.

EUR Billion (source: ECB)

Corporations that do not have a bank subsidiary do not want to leave unsecured deposits at the banks, so they revert to lending to banks on a secured basis via repo.

Reuters: ... a group of well-known, cash-rich companies with solid cash flows has stepped in the repo market, which provides a form of lending so far almost exclusively in use between banks, and between banks and central banks.

To obtain additional protections on these loans, the collateral is often held by third parties in a so-called triparty repo.

Reuters: Based on his daily practice, Euroclear's Reiss estimated that up to 25 percent of the triparty market was on behalf of companies, a massive and sudden rise from the 2 to 5 percent where it had traditionally been.

To accommodate their corporate clients, banks need collateral to post on these repo transactions. And that is putting additional strain on collateral availability and helping to drive down repo rates in the eurozone.

3- month Eurepo rate (Bloomberg)

Hat tip Blankfiend

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It was legal for MF Global to use "customer" money

Recently we posted a phone text conversation between two financial services professionals (Roy and Steve) discussing MF Global lost funds. The one thing that people found striking in that the discussion raised the possibility that MF Global may not have violated US law or CFTC/SEC rules by tapping "customer" collateral for the purposes of posting margin on its own proprietary repo positions. That sounded a bit odd - clearly there must have been improprieties associated with such actions.

 Let's start with the fundamental rule dealing with customer accounts:

Section 4d(2)3 of the Commodity Exchange Act ("Act") provides among other things that: (1) customers' funds shall not be commingled with the funds of the FCM; (2) an individual customer's funds may, for convenience, be commingled with the funds of other customers for deposit with a bank, trust company, or clearinghouse; (3) customers' funds may be invested in obligations of the United States, in general obligations of any State or any political subdivision thereof, and in obligations fully guaranteed as to principal and interest by the United States; and (4) the Commission may prescribe by rule, regulation, or order the terms and conditions under which these things may be done...

FCM of course stands for Futures Commission Merchant, and MF Global clearly was one. Looks like an open and shut case - MF Global violated (among other things) Section 4d(2)3 of the Commodity Exchange Act.   The media certainly seems to think so:

NY Times Dealbook: Wherever the money went, MF Global violated basic commodities laws that require firms to keep their customers’ money separate from the firm’s.

Not so fast.  Let's dig a bit deeper into the rules governing such accounts.

Rule 15c3-3 -- Customer Protection--Reserves and Custody of Securities
Securities Exchange Act of 1934

The term customer shall mean any person from whom or on whose behalf a broker or dealer has received or acquired or holds funds or securities for the account of that person. The term shall not include a broker or dealer, a municipal securities dealer, or a government securities broker or government securities dealer. The term shall, however, include another broker or dealer to the extent that broker or dealer maintains an omnibus account for the account of customers with the broker or dealer in compliance with Regulation T (12 CFR 220.1 through 220.19). The term shall not include a general partner or director or principal officer of the broker or dealer or any other person to the extent that person has a claim for property or funds which by contract, agreement or understanding, or by operation of law, is part of the capital of the broker or dealer or is subordinated to the claims of creditors of the broker or dealer. In addition, the term shall not include a person to the extent that the person has a claim for security futures products held in a futures account, or any security futures product and any futures product held in a "proprietary account" as defined by the Commodity Futures Trading Commission in § 1.3(y) of this chapter.

Therefore the definition of "customer" does not include a person holding any security futures product and any futures product held in a "proprietary account".   And what exactly is a "proprietary account"?

According to 17 CFR 1.3 (Title 17 - Commodity And Securities Exchanges; Chapter I - Commodity Futures Trading Commission; Part 1- General Regulations Under The Commodity Exchange Act; Definitions), the term proprietary account means “a commodity futures or commodity option trading account carried on the books and records of an individual, a partnership, corporation or other type association (1) for one of the following persons, or (2) of which ten percent or more is owned by one of the following persons, or an aggregate of ten percent or more of which is owned by more than one of the following persons:
(i) Such individual himself, or such partnership, corporation or association itself;
(ii) In the case of a partnership, a general partner in such partnership;
(iii) In the case of a limited partnership, a limited or special partner in such partnership whose duties include:

(A) The management of the partnership business or any part thereof,
(B) The handling of the trades or customer funds of customers or option customers of such partnership,
(C) The keeping of records pertaining to the trades or customer funds of customers or option customers of such partnership, or
(D) The signing or co-signing of checks or drafts on behalf of such partnership;

(iv) In the case of a corporation or association, an officer, director or owner of ten percent or more of the capital stock, of such organization;
(v) An employee of such individual, partnership, corporation or association whose duties include:

(A) The management of the business of such individual, partnership, corporation or association or any part thereof,
(B) The handling of the trades or customer funds of customers or option customers of such individual, partnership, corporation or association,
(C) The keeping of records pertaining to the trades or customer funds of customers or option customers of such individual, partnership, corporation or association, or
(D) The signing or co-signing of checks or drafts on behalf of such individual, partnership, corporation or association;

(vi) A spouse or minor dependent living in the same household of any of the foregoing persons;
(vii) A business affiliate that directly or indirectly controls such individual, partnership, corporation or association.
(viii) A business affiliate that, directly or indirectly is controlled by or is under common control with, such individual, partnership, corporation or association  ...

This convoluted list is saying is that a "proprietary account" would be a futures account held by certain partnerships.  That means interests in hedge funds, family offices, family trusts, Commodity Pool Operators, etc. would often be classified as "proprietary accounts" at MF Global.  These accounts are in fact excluded from the definition of "customer" under Section 4d(2)3.

Such account segregation rules are really meant to protect the retail investor.  When it comes to the more "institutional" types of clients, an FCM has far more room to maneuver.  It is a fairly good assumption that the bulk of MF Global's accounts by dollars constitute "proprietary accounts".

As a general matter when it comes to account protection, in a paper titled The (sizable) Role of Rehypothecation in the Shadow Banking System by James Aitken, Manmohan Singh, one can find the following quote:

Derivatives, repos and futures are not covered by SIPA, so any collateral associated with those products may not be covered (so there is uncapped rehypothecation in the United States, if collateral is associated with these products). To clarify, SIPA’s regime does not relate to collateral; rather it relates generally speaking to the return of a customer’s equity as calculated through something called the net equity claim. 

Margin posted constitutes separate moneys from the futures account cash or gains on futures trades.  In most cases collateral posted in MF Global's futures accounts could be used for general corporate purposes, including for posting margin on MF's own proprietary highly leveraged (via repo) euro-zeone sovereign bond holding.  So what happened to the "missing customer money"?  If you post margin against positions that lose money, and those positions are then liquidated, the margin will be used to cover losses.  Thus client's margin posted became MF Global's margin posted which went to cover MF Global's losses.

In a bankruptcy, such account holders become general creditors (possibly subordinated) of the bankrupt organization in the amount of collateral posted. MF Global is required to return the gains on the clients' futures positions and unencumbered cash (cash not used as margin), but when it comes to margin posted, these clients will need to line up along with the MF Global's bond holders and wait for the liquidation process.

Obviously the facts in the case are not public and it remains to be seen what laws/rules were violated. But as much as nobody wants to hear this, it may have been perfectly legal for MF Global to do what they did with at least some of the accounts.  FCMs long-held but not widely known benefit of having access to large amounts of customer cash will become well known and if the regulations change (and likely they will), it may severely impact their business models going forward.

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