Many of our readers are probably aware of the quarterly spike in reverse repos, which has previously been amply documented and discussed elsewhere. The Fed has introduced these overnight reverse repos two years ago, and has made them accessible to a wide range of counterparties (altogether 163 at last count), including banks, primary dealers, mutual funds, brokers and GSEs. In these transactions the counterparties are essentially depositing cash with the Fed overnight in exchange for treasury securities.
Photo via izismile.com
The Fed’s counterparties receive interest rather than having to pay interest (currently 25 basis points) when borrowing treasuries in these transactions. By setting the rate it pays at a higher level than the rate on short term t-bills, the Fed encourages participation. The reason for introducing the facility was that the Fed wanted to test various “exit” procedures from its extraordinary monetary accommodation.
The flow of money and securities in repo markets, from a 2013 IMF working paper by Manmohan Singh
Reverse repos will temporarily withdraw liquidity from the financial system, which will ceteris paribus tend to put upward pressure on short term market interest rates. Here is what has happened since the facility was introduced:
On December 31, overnight reverse repo transactions with the Fed spiked to a record $475 billion. The green line is the general collateral repo rate (more on this further below) – click to enlarge.
At the same time, the repos are supposed to relieve shortages of high quality collateral, which have reportedly become a problem as the Fed’s QE programs have lowered the amount of treasury bonds available for trading and swapping. Originally capped at a maximum of $300 billion, the RR facility has been expanded to a maximum of $2 trillion after the rate hike of December 16, which seemingly underscores its primary function as a tool to remove excess liquidity.
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