Repos (short for repurchase agreements) are short-term borrowing transactions, often made overnight. In a repo transaction, the borrower will sell certain securities in their possession with the agreement to buy them back the next day. If the transaction is not rolled over, then the trade has to be settled the following day, with the borrower repurchasing the collateral from the lender for slightly more than it had previously sold it for, compensating the lender with interest for taking on the risk.
Large corporations and banks typically hold vast quantities of highly liquid financial assets, and so they like using these markets as a means of quick and easy financing. There are more than $1 trillion worth of overnight repo transactions collateralized with US government debt occurring every day. Banks frequently go to these markets to fund the loans they issue, and to finance the trades they execute.
The repo market seized up last week. Demand for cash from U.S. companies that needed to pay their corporate tax bills, sucked a lot of the available cash out of the financial markets. September quarterlies were due. Last week was any counter-party in need of cash, and only holding collateral like Treasuries, agreed to pay the much higher going repo rates. That’s supply and demand.
5 years ago, the Fed ended quantitative easing (QE), its maneuver to buy highly liquid bank securities to boost overall bank reserves. Total bank reserves have steadily been decreasing, having peaked in August, 2014, and are now close to where reserves were in 2011. One principle reason for that: an elevated level of government debt issuances (think about the need to fund the deficit) in the past four years have sucked reserves out of the financial system. The squeeze like the one last week occurs indicating that there aren’t enough reserves in the financial system for repo markets to clear at the Fed’s preferred “target rate,” or the Fed Funds rate. That explains why the central bank has been engaged in open market operations to inject reserves back into the banking system through overnight purchases of Treasuries. “The Fed plans to use open market operations to address funding pressures through the quarter-end.
A little in depth, but in short, this is due to the need for corporates to pay taxes and not enough liquidity in the system because of the need to fund the deficit.
Thanks very much for your discussion of repos. I knew there was an overnight spike that embarrassed the Fed, but did not really understand the nature and function of these instrument as well as you have described them.