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The meltdown in the global financial system’s ‘plumbing’ was more disturbing than it appeared

The difference between the price at which the securities are sold and bought back is effectively an interest rate.

In the US that is usually close to the rate the Federal Reserve Board sets for overnight interbank transactions, which was just above two per cent when repo rates shot up to as much as 10 per cent in mid-September.

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The official explanation for what happened was that a US quarterly corporate payment coincided with the settlement of a large auction of Treasury bonds. A misjudgement by the Fed of the amount of liquidity available in the system saw the market caught short of the liquidity it needed and therefore the rates soared.

That may be a part of the explanation but, in the Bank for International Settlements’ latest quarterly review issued over the weekend, there is a more complex analysis that suggests structural reasons for the seizure of a market that turns over about $US1 trillion ($1.5 trillion) daily.

In commenting on that analysis Claudio Borio, head of the BIS economic department, said the turmoil in the repo market had also affected the Secured Overnight Financing Rate (set to replace the London Interbank Offered Rate as the key global benchmark for about $US400 trillion of financial transactions and foreign exchange swaps.

The analysis by BIS staffers made the point that one of the most damaging aspects of the financial crisis was a freezing of repo markets in 2008. It may be an arcane element of the financial system but it is a critical one, helping to distribute liquidity through the system between those who have excess liquidity and those who need it.

Banks get used to a protracted period of abundant excess reserves, withdrawing them may result in unpredictable and sudden market adjustments. It is as if a muscle had atrophied.

Claudio Borio, the head of the BIS economics department

For much of the post-crisis era, as central banks bought bonds and securities as they embraced quantitative easing, commercial banks accumulated large excess reserves with their central bank.

In the US, from October 2017 the Fed started to shrink its balance sheet, allowing its hoard of Treasury securities to run down, and the interest rate it paid on banks’ excess reserves fell below the rates available in the repo market.

Banks’ excess reserves started reducing and their holdings of US Treasuries rose. The sector, which had been a supplier of collateral to the repo market previously – buying liquidity – had become the dominant lender.

By September, probably because of the post-crisis prudential reforms that demanded they hold more high-quality liquidity, the four biggest and most tightly-regulated banks owned more than half of all the US Treasury securities held by banks in the US.

So, the excess reserves of the biggest banks, from which they could provide liquidity in a crisis, have been running down and been replaced with Treasury securities even as the banks’ role in repo markets has become pivotal.

Claudio Borio, head of the BIS monetary and economic department, said the problems in the US repo market had affected key reference rates used for trillions of dollars of financial transactions.

Claudio Borio, head of the BIS monetary and economic department, said the problems in the US repo market had affected key reference rates used for trillions of dollars of financial transactions.Credit:Jenny Evans

The other relevant post-crisis development has been the increased activity of shadow banks – hedge funds, private equity firms and other non-regulated players – as some bank activity has been prohibited or made less attractive by the legislative and regulatory response to the crisis.

The BIS analysis said that in the lead-up to the repo market dislocation leveraged players, like hedge funds, had increased their demand for repos to fund arbitrage trades between cash bonds and derivatives.

It appears the funds were buying Treasuries and then selling interest rate futures to generate arbitrage profits. To juice up the returns they were using the Treasury securities they had bought as collateral for cash in the repo market that they could then use to repeat the strategy in a continuous loop of transactions.

With the big banks sitting on a lot of liquidity they couldn’t deploy because of the prudential regime; the corporate tax payments and Treasury bond issue sucking liquidity out of the market and the hedge funds needing liquidity to fund their trades, the market and the Fed weren’t prepared for a cash shortage. The Fed has since made large lines of liquidity available to the market.

“The dislocations suggest that central banks’ post-crisis unconventional operations have left a profound imprint on market functioning,” Borio said.

“Banks get used to a protracted period of abundant excess reserves, withdrawing them may result in unpredictable and sudden market adjustments. It is as if a muscle had atrophied.”

What the repo experience says is that there have been, and could be in future, more sudden shocks to the global financial system.

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The interaction between the post-crisis reforms to banking systems, changes to central bank and bank balance sheets and the surge in non-bank participation in markets creates, as the repo market showed, the potential for novel and destabilising events.

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