The Federal Reserve continues to prepare for the next liquidity disruption. We think their latest facility would likely help, both psychologically and practically.
The Fed on 28 July announced the creation of a permanent standing repo facility (SRF) that will help provide financing for holders of U.S. Treasuries, agency debentures, and agency mortgage-backed securities (MBS) (read their statement). Given current easy financial conditions, PIMCO’s short-term desk does not expect any demand for this facility in the near term.
However, we believe the permanent SRF represents a consequential and preventative step toward developing more resilient funding markets. It has the potential to change the psychology of fear felt by market participants and banks during periods of stress.
The defining characteristic of U.S. Treasuries is their abundant liquidity as measured by market depth and narrow bid-ask prices. Underlying these tight markets is the confidence that buyers and sellers will be able to obtain non-punitive financing on their Treasury holdings. In normal times this is taken for granted, but when funding liquidity dries up – as it did in September 2019 and March 2020 – it immediately diminishes the ability of dealers to make efficient markets and consequently raises the cost of funding for U.S. taxpayers.
Still, while we acknowledge the significance of establishing the SRF, we must recognize that it does not ensure total stability in all scenarios. The main weakness of the facility as currently designed is that it still relies on primary dealers – rather than a broader set of market participants – to act as the keystone to facilitate and transmit liquidity to the market. Yet, given the Fed’s renewed vigilance about market functioning, we would hope that this shortcoming will be addressed before we experience another period of market stress.
The facility has been in development for over two years (read more from the St. Louis Fed). When it was first considered, there was a concern among the Fed and some investors that as the Fed allowed its balance sheet to shrink, then banks might need more reserves in order to finance their own and their customers’ Treasury holdings. This scenario occurred in September 2019, when a dramatic one-day decline in reserves caused funding rates to spike from 2% to over 9% (read our blog post on the event). In response, the Fed restarted their asset purchases (buying $60 billion per month of bills) and implemented temporary open market operations (TOMOs). These operations helped to provide temporarily relief, and funding markets resumed functioning.
However, in March 2020 the shock and deteriorating conditions associated with COVID-19 derailed Treasury markets and money markets, reinforcing the need for additional safeguards. As demand for cash grew, investors rushed to sell any asset that they could, including U.S. Treasuries. These sellers ended up overwhelming the ability of banks and primary dealers to intermediate the Treasury markets. Investors who tried to avoid these disorderly markets by turning to dealers to finance their Treasuries found that – despite the Fed having provided dealers with hundreds of billions of dollars via TOMOs –dealers were unable (or unwilling) to extend financing for their clients.
Key components of the current proposal
The standing repo facility replaces the TOMOs that the New York Fed has been conducting since repo spiked in 2019. It is currently limited to primary dealers, will rely on the existing tri-party repo infrastructure, and is priced at the top of the Fed’s range (25 basis points). Additionally, starting in October it will be expanded to include banks that are not primary dealers. These counterparties will be able to pledge both Treasuries and agency MBS.
Also of note: The Fed is setting up a separate foreign and international monetary authorities (FIMA) repo facility for foreign official institutions against their holdings of Treasury securities held at the New York Fed.
Consideration for future developments
Overall, we believe the SRF is a good first step. In its current form it’s very similar to the temporary open market operations that it replaced, but it clearly signals that the Fed learned the importance of resilient liquidity markets from the funding turbulence observed in September 2019. Also, allowing the banks to participate and creating the FIMA facility should reduce the risk of a repeat of March 2020, when foreign sellers contributed to overwhelming dealer balance sheets with Treasuries.
Unfortunately, as constructed the SRF relies on the dealers to transmit liquidity to the buy side. One of the constraints that dealers face is that their balance sheets are limited by regulations designed to ensure that they hold adequate capital. Earlier this year the Fed allowed the expiration of temporary changes to the supplemental leverage ratio (we wrote about it here). This has increased the amount of capital that dealers are required to hold when they intermediate Treasury markets and could limit their ability to do so in times of stress.
We believe that access to the Fed for a broader set of participants during the volatility in March 2020 would have mitigated the severity of the market issues (read our take). Therefore, it would be helpful if the SRF could be expanded to allow the Fed to participate in sponsored repo (more from us on this here). Sponsored repo allows for dealers to provide more repo funding to counterparties, and dealers would be able to more effectively channel cash from the Fed to help finance Treasury markets. In this way, the transmission mechanism for market liquidity would embody a wider spectrum of investors and end users during times of tighter financial conditions.
The bottom line, however, is that while such a facility may not be perfect, it is a good first step in addressing the structural deficiencies in market financing that were exposed (once again) in the March 2020 COVID-related crisis. It should make the market more resilient in the event of a future shock.
For more insights on the Fed’s actions, see our blog, “Substantial Further Progress? Not Yet, Says the Fed.”
Jerome Schneider is a managing director and leads short-term portfolio management at PIMCO. Jerry Woytash is a portfolio manager on the short-term desk.