How expensive can it be to borrow USD cash for one night collateralizing fully with the US Treasuries? Given current rates, perhaps somewhat above 2% would be reasonable. What about 10%? This is how much some of the participants in the USD Repo market had to pay to provide themselves with liquidity on the 16th of September. Where did this number come from?

What is a repo agreement?

Starting with a high-level description of a repo contract, repurchase agreement (repo) is a form of short-term borrowing. At the inception of the contract, one counterparty sells a security to the other counterparty promising to repurchase is back for a slightly higher price. What security can be used as collateral? Naturally, in both parties’ interest is to exchange possibly stable and liquid security in order to eliminate any market and credit risk. From the intuitive point of view, the buyer (lender) is more interested in lending money on a fixed-rate, rather than to gain exposure to the underlying security. To illustrate it with an example:

Inception of the trade: 01/01/2019

The first cashflow of 980 is the result of applying a “haircut”. The lending bank has to make sure it is sufficiently protected against any possible market moves and the credit risk of the counterparty. Even though the value of the treasury is USD 1000, Bank B will only lend 98% of this amount, indicating the haircut of 2%. In that sense, this transaction is an example of an “overcollateralized” trade.

On the next day, Bank A will buy the security back paying the initial price plus interest, in this case, 2% per cent annual rate. Important remark here would be that for accounting purposes repo transaction would be treated as a loan and not as an outright sale and purchase of assets. Also, usual practice between the 2 parties would be to sign a master agreement specifying the details of their ongoing repo activities. In this case, we are talking about the Global Master Repo Agreement (another type of a popular master agreement would be the International Swap and Derivatives Association agreement, commonly referred as ISDA which is primarily used to standardize, unsurprisingly, swaps’ and derivatives’ trade flow).

Characteristics of the US Repo market

USD Repo market is by far the biggest repo market in the world providing short term funding for most big financial institutions. It is also used as a tool used by FED to perform monetary policy and every day approximately 2.2 Trillion USD are being provided in exchange for eligible securities only to be repaid the next day. Let us look at the details.

The U.S. repo market comprises of two segments. First one, the bilateral repo, describes the volume of transactions conducted between 2 trading parties. The second, triparty repo, involves the clearing bank facilitating the settlement of the transactions. The difference lays in the nature of the acceptable security: a triparty repo contract would be less restrictive allowing for a range of relatively stable securities to be posted as collateral. This will be later referred to as “general collateral” (GC). On the contrary, bilateral repo agreements are stripped of the additional safety of the clearing house and usually require the collateral to be a specific, very stable and liquid security, most commonly the US Treasuries. Those transactions fall into the “specific collateral” (SC) basket. One more characteristic of the SC market is that many positions here are “open”, meaning that although the trade has an overnight tenor it will continue until one of the counterparts decides to close it (Adrian, Begalle, Copeland and Martin (2011)).

However, the story for SC repo market doesn’t end here. The ability to specify the underlying security gives an advantage to many investors. Some of them will use repos to hedge their positions requiring specific collateral and will obtain the cheapest to deliver (CTD) in a futures contract. However, the most common motivation would be to establish a short position in the underlying security or simply borrow a security when its price is high and return when its price drops (Duffie (1996).

From the perspective of the recent market events, in this article, we want to focus specifically on the interesting property generated by this market arrangement. It can be simply described as an advantage of the standard owners of the government securities (broker-dealers, mutual and pension funds, money-market funds, custodial agents etc.) that can lend those those specific securities in high demand and eventually re-lend the money with higher interest, earning a spread (D’Amico, Fan, Kitsul (2013))

From here we can see that well-functioning SC Treasury repo market is essential for efficiency and liquidity on the treasury cash market because of the role it is playing in facilitating market-making, hedging, speculative activities and arbitrage trading. It should be obvious by now that ensuring those qualities is subject to the availability of the underlying Treasury collateral. But what happens when there are not enough Treasuries on the market?

Tuesday, the 16th of September

To understand what has actually occurred we can take a look at the table below:

Source: Federal Reserve Bank of New York

This table is representing the distribution of rates for a given trading day. (“Date” column is referring to the date of publication which is always one business day after the trading day. I.e. 09/17/2019 is describing rates observed on the previous day.) Here it is necessary to explain the way those rates are calculated.

FED is reporting 3 main repo rates for every trading day: SOFR, BGCR and TGCR. Here we focus on the broadest of them all, that is the SOFR rate. The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralised by Treasury securities. The SOFR includes all trades in the Broad General Collateral Rate plus bilateral Treasury repurchase agreement (repo) transactions cleared through the Delivery-versus-Payment (DVP) service offered by the Fixed Income Clearing Corporation (FICC), which is filtered to remove a portion of transactions considered “specials”. The rate is a volume-weighted median of the tri-party repo transactions. This rate is usually hovering within the FED benchmark rate target. (This is why all the rates decreased sharply on the 19th incorporating the cut announced the day before from 2-2.25% to 1.75-2%).

Yet, on the morning 16th of September, some of the market participants were borrowing cash for as much as 10%, adding up to the list of problems Mr Powell was facing over the past week. How can this anomaly be explained?

Possible reasons

It is most probable that a confluence of events resulted in the unexpected scenario:

  1. Starting from those more obvious, we have to remember that we are getting to the end of the quarter and many companies had to liquidate their money market savings in order to pay their taxes.
  2. Secondly, the week before this event a bond selloff happened increasing the need for cash.
  3. Adding on that, last week brought also a Treasury auction with USD 78 billion sold and the settlement date around the day of the repo spike.
  4. The last argument is the most sophisticated one and it was raised in the aforementioned paper by D’Amico, Fan and Kitsul in 2013. According to their research, the today money market is structurally out of balance. Although their research was mostly focused on the absence of qualified securities and not the USD cash, as it happened last week, it will probably be insightful to bring some of their conclusions.

“Specialness” spread

Citing the authors: “The repo-specialness spread is defined as the difference between the overnight repo rate for general collateral (GC) and the corresponding SC rates”. Intuitively, because only specific securities are eligible as collateral for a large majority of repo transactions, their relative value on this market increases irrespectively of the demand-supply imbalances of the market. For example, assuming that FED would purchase certain collateral-eligible treasures, we would expect them to now be more “rare” on the market. Hence, their specialness spread should increase reducing the interest the borrower would have to pay given his ownership of this specific security at the inception of the repo agreement.

Logically speaking, we are now openly acknowledging that repo transactions are not simply a collateralised borrowing. If they were such, we would expect to see variances in the interest charged depending on the value of the collateral. Providing more risky security would be compensated by applying a higher haircut but not by charging a higher rate. Instead, what we see on the market is that the type of security is what drives borrowing cost. One might aptly suggest that FED is trying to mitigate the problems resulting from the scarcity of eligible securities by making them available to borrow every day at noon through its Securities Lending Program. Under this program, the FED offers to lend up to 90% of its holding of the Treasury securities. The issue here is that this program is limited to primary dealers and each dealer can borrow up to 25% of the lendable holding creating a room for inefficiencies. More details and methods to calculate the premium can be found in the paper itself.

FEDs Answer

For the first time in more than a decade, Fed had to step in on the short-term lending market to alleviate the pressure on the Repo rates. During the two consecutive business days, a total of USD 128 billion was pumped into the financial system. It seems that, for now, the repo market came back to normal. The question is: for how long?


Repo market is perceived by many as shady. This opinion was earned during the Financial Crisis when everyone realised what can happen when this market freezes. What can be said about the sanity of the system that requires so much short term borrowing to keep things from collapsing? Apparently, on the 11th of September 2008, Timothy Geithner, former US Secretary of the Treasury, informed Paulson that Lehman Brothers had to source USD 230 billion in overnight repos to keep all the trades open. This might remind us about the importance of the “financial plumbing” that most of us don’t necessarily pay much attention to. Banks are asked to keep a certain level of reserves, deposits are insured, regulations applied and the capital is risk-weighted appropriately. However, we are far (and perhaps we will always be to some extent) from a “bulletproof” financial system. There are still areas of high concentration and dependency and last week reminded us of only one of them.


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