US Bond Market
Something very strange is happening in the repo market. | Image: Spencer Platt/Getty Images/AFP

In the last couple of weeks, we’ve been closely following the repocalypse. The hidden but vital bourse in the U.S. financial system known as the repo market suddenly experienced a jump in interest rates on Sept. 17. Consequently, the Federal Reserve had to step in to keep overnight loan rates at acceptable levels.

The Fed intervention was supposed to be a short-term fix. However, the market is in such dire need of cash loans that the Fed has extended its operations until Oct. 10, supplying a minimum of $75 billion in short-term repos. After that date, the New York Federal Reserve’s trading desk will continue its operations “as necessary to help maintain the federal funds rate in the target range” according to CNBC.

In other words, there’s no end in sight, which told us that there’s a serious problem in the $2.2 trillion marketplace. We did some digging and what we discovered left us flabbergasted.

U.S. Treasurys Carry Serious Risks

In the financial market, U.S. Treasurys are at the top of the hierarchy when it comes to safe-haven assets. The security is backed by the U.S. government that can raise taxes or print more U.S. dollars to meet its debt obligations. Thus, Treasurys are considered risk-free investments.

This is the primary reason why dealers (borrowers) can easily sell Treasurys to counterparties (lenders) in the repo market. The repo market works because the dealers promise to repurchase the collateral (Treasurys) the next day with a small interest payment.

The system was humming until a few weeks ago when liquidity was sapped out of the market. Initially, experts blamed the quarter-end tax payments and the sudden payment of Treasury notes worth $78 billion. However, the fact that the system still requires the help of the Fed tells us that something is fundamentally wrong. It is either that the banks are not willing to step in or they have no more cash to lend. Our research told us that the former is the case.

We know that there’s $1.4 trillion in reserves parked at the Fed. So, why are banks not taking out their excess cash that’s earning about 1.8% in interest at the Fed as opposed to loaning the money to gain 8% or above in the repo market? Are they afraid of something?

Apparently, they are.

Financial Times revealed that the same collateral (U.S. Treasury) was used 2.2 times in 2018. In other words, about three entities believe that they own the same U.S. Treasury. This means that it is possible that three banks can claim ownership over one U.S. Treasury.

Reuse Rate of collateral
Reuse rate of collateral inching closer to 2007 levels. | Source: Financial Times

It’s no wonder that some banks are stepping away from the repo market. When the music stops, they don’t want to be the ones holding securities owned by multiple parties.

Even Our Sources Were Surprised

We reached out to a number of experts to get their views on the high reuse rate of collaterals in the repo market. They refused to comment because the revelation of our research took them by surprise. However, we got a comment from Hans HODL who’s a quantitative researcher at Ikigai Fund. He said,

I think some of this has to do with banks hoarding [bonds] as well. The primary dealers can get bonds on the cheap direct from the Treasury, turn around, and sell them for a profit. But they’re keeping them instead.

Bonds are the safest assets if and only if you’re the sole owner. Perhaps these primary dealers are hoarding bonds because they are seeing the uncertainty in the financial system through the repo market.

This article was edited by Sam Bourgi.

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