The repo man

   By Guest Blogger Ryan Lewenza

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No I’m not talking about the person who comes by and repossess your sketchy friend’s car and TV from time to time. Today I’m talking about the arcane but important ‘repo’ or repurchase market. I hope you have your coffee ready as I’m going to cover a dry but critical part of the financial markets.

What is the repo market?

The repo market involves financial institutions swapping cash for government securities on a short-term basis. Below is an illustration of a repurchase agreement. One financial institution (Bank A) needs cash for one day (maybe some of their big clients withdrew money from their bank account accounts) and they enter into a one day agreement to sell US treasury securities for cash with another institution (Bank B), and promises the next day to buy back the securities at a slightly higher price. The slightly higher price is the repo rate, or the rate at which two financial institutions borrow/lend with each other, often on an overnight basis. This happens every single business day as banks with excess cash lend it out for a day or a week to a bank that requires cash.

Some years ago I used to work on the trading floor at one of the big Canadian banks and I remember how at the end of the day these specific traders would be on the phones with other banks’ lending out hundreds of millions of dollars of bank capital for just one day. I got to see firsthand how this all worked and while it’s not the most exciting thing, I learned how important this function was for the banks and financial markets.

A Repurchase Agreement Example

Source: Wikibanks

Why is the repo market important?

First, as briefly noted above, it allows financial institutions with lots of securities to borrow cheaply, and allows institutions with spare cash to earn a rate of return of their funds at low risk. It’s low risk to the lender since they own the securities, which are pledged against the loan. So if the other institution fails to pay back the short-term loan, then the lender just keeps the securities.

Second, the repo market allows the Federal Reserve and other central banks to conduct their monetary policy and help maintain a functioning financial system. So the repo market allows financial institutions to lend between themselves and for financial institutions to borrow/lend capital with the central bank (e.g. the Fed). This is particularly important during times of financial stress like the 2008 financial crisis or more recently during the Covid-induced recession and market meltdown last March.

This little known market sees $2 to $4 trillion in daily trading of these repurchase agreements so it’s a big deal. Essentially, the repo market is the grease that keeps the economy chugging.

Without it trade doesn’t happen, corporations don’t pay their employees and you don’t have some ‘benjamins’ to spend on your main squeeze.

And when it does go south, as we saw in September 2019, it can have huge consequences for the markets and economy.

In mid-September 2019 the repo rate spiked to an intra-day high of nearly 10%, as financial institutions with excess cash refused to lend it out. The repo rate typically tracks the Federal Reserve’s overnight benchmark rate, which at the time was 2% to 2.25%. What caused the repo rate to spike that day and completely detach itself from the Fed’s benchmark rate?

It’s believed that two events in mid-September 2019 led to this scary spike in the repo rate. First, was that quarterly taxes were due for corporations so there were large cash withdrawals from the banking sector. Second, it was settlement date for previously purchased US Treasury securities, so again cash was needed to pay for these securities. These two events led to a shortfall of cash in the financial system, which caused the repo rate to spike violently on the day.

The Fed was then forced to respond and clean up the mess. The Fed announced that they would better support the repo market by offering $75 billion in daily repos, which was subsequently increased to $120 billion of daily lending. Basically the dam and had sprung a leak and the Fed had to come in and fix it up. If they hadn’t and the dislocations continued then we could have been looking at something far worse, possibly the start of another financial crisis.

US Repo Rate Spiked in September 2019

Source: Bloomberg, Turner Investments

For now the repo market is functioning well and not much of a concern. However, there are some out there that believe the repo market is at risk from all the central bank money printing and QE. Sure there will be the occasional blip but the Fed stands ready to step in during any times of stress so I’m not too concerned at present.

Now you know a bit about the repo market. You’re welcome!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.