This is an interesting article from the FT which discusses the explosion of repo trading between money funds and the Federal Reserve bank of New York. When the Federal Reserve actually raises rates some day (in the distant future) this is the mechanism which they will employ to drain reserves from the banking system.
Via the FT:
New York Federal Reserve takes on key role in repo market
The Federal Reserve Bank of New York has emerged as the single largest player in an important segment of the short-term lending market that was at the epicentre of the financial crisis.
The Fed’s decision to quadruple its trading with government money market funds in the repurchase or “repo market” is a sign that the central bank is now engaging more directly with the shadow banking system at the expense of large Wall Street banks.
Historically, the repo market was where big banks pawned out their securities such as Treasury bonds to lenders including money market funds, insurers and mutual funds, in exchange for short-term financing. Now the Fed is stepping in to trade as well as it prepares to end its current near-zero interest rate policy.
Armed with a balance sheet of $4.3tn of bonds purchased during quantitative easing, the Fed is using what it calls its reverse repo programme, or RRP, to trade with money funds at a time when tough new regulatory standards have made such borrowing less attractive for the banks.
Rather than lending to the banks, money market funds have sharply boosted their dealings with the US central bank.
Between September 2013 and the end of May, government money market funds increased their use of repo trades with the New York Fed by $65bn to a total of $87bn, while decreasing their repo holdings with dealer-banks by $38bn, according to a study by Fitch Ratings.
The growing presence of the Fed in repo is a signal that it is testing new ways to control short-term interest rates once it starts tightening monetary policy.
When official short-term rates are eventually pushed higher, the Fed plans to use the RRP to drain cash from the financial system via short-term loans of Treasuries from its huge balance sheet.
Robert Grossman, managing director at Fitch, said the change in the Fed’s presence in the repo market had been dramatic and that the central bank could use RRP to significantly escalate its role.
The Fed’s presence could further expand if it decides to change the rules around eligibility requirements for money market funds. The RRP facility is currently limited at $10bn per counterparty, but analysts expect that could rise.
While the growing presence of the Fed in the market has been welcomed by money market funds keen to transact with the central bank, it comes with risks for the central bank and the broader financial system.
Bill Dudley, New York Fed president, warned last month that if use of the repo facility were to grow too quickly it might “result in a large amount of disintermediation out of banks through money market funds and other financial intermediaries into the facility. This could encourage further enlargement of the shadow banking system.”
Without a cap on use of repo with the Fed, investors who ordinarily lend to banks could instead flock to the central bank in times of market stress, exacerbating a flight from funding of banks, he warned
Other market participants have been supportive of the Fed’s new role.
“The facility could also enable the Fed to become a ‘dealer of last resort’, just as it is a lender of last resort to regular banks. This would ensure a troubled shadow bank could always find a counterparty in the market,” Paul McCulley, chief economist at Pimco, wrote in an opinion piece for the Financial Times this week.
Fitch said the relationship between banks and government money market funds had changed since the Fed launched the RRP. The likes of Citigroup, Bank of America, Crédit Agricole, Goldman Sachs and RBC now rely less on money market funds for funding, while BNP Paribas, Deutsche Bank and Barclays conducted the largest volumes of repo funding with these players as of May 31.
Government money market funds engage in repo trades using only US Treasuries and other types of government debt and include $881bn of assets, according to Fitch