While the rest of the country fretted over taper terror, government shutdown and debt ceiling limits, the Federal Reserve tested its Fixed Rate Full-Allotment Reverse-Repo Facility (a mouthful—let’s call it FARRP) for the first time September 24. FARRP allows banks and non-banks, like money market funds and asset managers, to access Fed-held assets—i.e., the long-term securities bought under the Fed’s quantitative easing—via securities dealers’ tri-party repo (and reverse-repo) market for short-term funding. (More on repos to follow.) FARRP aims to address what many feel is a collateral shortage in the non-bank financial system caused by too much QE bond buying concentrating eligible collateral on the Fed’s balance sheet, where it doesn’t circulate freely. As a result, many private sector repo rates turned negative. But, should FARRP be fully implemented, the facility could actually hinder some assets (in this case, high-quality, long-term collateral like bonds) from circulating through the financial system—much like quantitative easing (QE) locked up excess bank reserves. A more effective means of freeing collateral in the repo market is tapering the Fed’s QE.
Repurchase agreements, or repos, are used to generate short-term liquidity to fund other banking or investment activity—a means to move liquidity (cash) from one institution to another. In a repo, one party sells an asset—usually long-term debt—agreeing to repurchase it at a different price later on. A reverse repo is, well, the opposite: One party buys an asset from another, agreeing to sell it back at a different price later. In both cases, the asset acts as collateral for what is effectively the buyer’s loan to the seller, and the repo rate is the difference between the initial and future sales prices, usually expressed as a per annum interest rate. The exchange only lasts a short while—FARRP’s reverse repos are overnight affairs to ensure markets are sufficiently funded. In the test last Tuesday, the private sector tapped the facility for $11.81 billion of collateral—a small, but not insignificant, amount.
FARRP’s first round is scheduled to end January 29, and during that time, non-bank institutions can invest between $500 million and $1 billion each at FARRP’s fixed overnight reverse-repo rates ranging from one to five basis points. A first for repo markets: Normally, repo and reverse-repo rates are free-floating, determined by market forces. Another of FARRP’s differentiating factors is private-sector need will facilitate reverse-repo bids instead of the Fed. Ideally, FARRP’s structure will encourage unproductive collateral to be released back into the system when it’s most needed—and new sources of collateral demand may help ensure this. Swaps, for example, are shifting to collateral-backed exchanges due to Dodd-Frank regulation—meaning more collateral will be needed to back the same amount of trading activity. Collateral requirements for loans will likely also rise.
The plan’s intentions are indeed good, but it isn’t foolproof. Even with increased collateral demand, FARRP probably won’t have too great an impact on reverse-repos—or repos. Because the collateral shortfall likely occurred from too much QE—the Fed’s bought so many government bonds—a large chunk of high-quality collateral is simply sitting as excess reserves, instead of supporting lending in the non-bank financial market. FARRP may release some of this idle, unproductive collateral to private sector institutions—but it may not move much from there.
Like the majority of QE money—which went where demand for it was highest (bank balance sheets)—collateral probably flows were it’s demanded. In this case, it likely ends up in money market accounts where it can’t be multiplied via securities lending, dampening its velocity and, therefore, FARRP’s impact. Moving collateral from the Fed isn’t enough—it needs to be able to work through the greater economy via banks and securities dealers to boost market activity.
Of course, collateral is arguably slightly more helpful in money market accounts. But longer term, FARRP may miss the mark on improving collateral multipliers. Markets would more likely have better access to high-quality collateral if the Fed tapered bond buying. Less long-term bond buying probably means a more collateral-saturated market—not to mention more willing-to-lend banks and overall increased economic activity. Until then, FARRP will help incrementally boost collateral’s liquidity for now, without much market impact otherwise.