A repo (repurchase agreements) market is an obscure but vital part of the financial system. The repo market is a major way that banks and financial firms raise capital to fund their businesses. It’s the market where cash and collateral are swapped every day (often overnight).
A repo is when one party lends another party cash in exchange for a security (usually Treasury notes).
It allows companies that own a lot of securities but are short cash to cheaply borrow money. And parties with cash can earn a small return with very little risk.
The problem is when there’s a shortage of dollars in the market for these short term loans the Fed has to come in and inject money supply.
And this week there was a shortage of dollars which spiked the short term lending rates.
The main drivers were declines in Fed reserves (bank deposits held at the Fed) and the distribution of those reserves – sometimes these reserves can be concentrated in a few institutions.
The bottom line is that a lot of cash flowed out of the repo market this week. And all of the sudden, there wasn’t enough cash for those who needed it.
As a result, Fed made a decision to offer two week cash loans.
This is important because the Fed gave an assurance to the financial market that they will add liquidity through the end of the quarter. And banks need to hold that cash to ensure they pass the regulatory requirements at quarter ends.
The Fed’s action this week was the first time the Fed stepped in since the financial crisis. The Fed injected over $200 billion in temporary cash over several days to calm the repo market.
The Fed is also trying to proactively deal with this issue. And one of the things they are considering is creating a standing overnight repo facility. They would essentially offer to lend a certain amount of cash to repo borrowers every day.
The second option would be more aggressive. The Fed could expand it’s balance sheet and increase the bank reserves.
Either way, it seems like the Fed has the tools to deal with this issue right away.
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