The Recent Use of the SRF and its Implications for Monetary Markets

This analysis attempts to relate the ideas expressed by the brilliant Concoda in his article https://www.conks.plumbing/p/the-feds-repo-defensive-part-one. He is one of the world's leading figures in monetary plumbing and a great source of knowledge.?

The Standing Repo Facility (SRF) was established by the Federal Reserve as an emergency mechanism during the COVID-19 crisis, aimed at reducing volatility in the repo market, the primary dollar financing market, and the heart of both the dollar and eurodollar systems. Its purpose was to intervene in the repo market, providing reserves instantly to calm interest rate fluctuations, particularly those linked to the SOFR (Secured Overnight Financing Rate), which had become a key point of instability in the system.?

Although the SRF was designed as an emergency financing mechanism, it has not been used continuously until recent episodes of tension during quarter-end periods, where window dressing practices, amplified by regulations like Basel III and Dodd-Frank, have exacerbated pressures on monetary markets. This dynamic has created a stigma similar to that of the primary credit or discount window, limiting the SRF’s adoption by key market players. Additionally, dealers, facing heightened risks in their collateral inventories, may choose not to intermediate during critical moments, creating a paradox where, despite the shortage of high-quality collateral, there is a proportionally greater shortage of cash.?

1. Liquidity Mismatches and Limited Adoption of the SRF?

Even though liquidity in the financial system remains stable according to general indicators, with an adequate number of clearing and settlement tokens, and banking reserves still at excess reserve levels, structural liquidity tensions have solidified at key moments, particularly during quarter-end periods. At these times, large Global Systemically Important Banks (G-SIBs), especially European ones, play a crucial role as their behavior can amplify tensions.?

One factor exacerbating these tensions is the tightening of conditions at the Federal Home Loan Banks (FHLB), which have traditionally been a key source of liquidity for the U.S. financial system. The FHLBs have provided short-term financing to many financial institutions through the issuance of short-term notes, which in turn facilitates liquidity in the repo market. However, in times of tension, the FHLBs have begun to tighten their lending conditions, thus limiting access to this financing source.?

Additionally, the growing demand for liquidity in Interest-Bearing Deposit Accounts (IBDA), which pay interest on deposits, has worsened the situation. These accounts attract deposits that could otherwise be available to finance the repo market. As European G-SIBs and other large financial institutions seek to maintain their balance sheets tight and comply with regulatory requirements, this increased demand in IBDAs diverts capital toward these accounts, further reducing the amount of cash available for the repo market. This phenomenon triggers a reduction in financing supply in repo markets, putting upward pressure on interest rates.?

The Role of the SRF?

The Standing Repo Facility (SRF) was designed to provide a stable source of liquidity during these critical moments, especially when repo rates, such as the SOFR (Secured Overnight Financing Rate), begin to spike. The facility's goal is to prevent cash shortages in the repo market from causing interest rate dislocations, as happened in September 2019 during the "repo apocalypse," when repo rates surged uncontrollably.?

However, the recent adoption of the SRF has been limited. Part of this limitation is due to the stigma surrounding the use of central bank facilities. Market participants tend to avoid using these facilities for fear of being perceived as financially weak or unstable. This stigma is comparable to the one associated with the Federal Reserve’s primary credit or discount window, historically viewed as a last resort.?

Regulatory Effects: Basel III and Dodd-Frank?

Beyond stigma, regulatory pressures imposed by Basel III and Dodd-Frank have created contradictory incentives for dealers and other financial intermediaries. These regulations require banks to maintain high liquidity levels and comply with strict capital requirements, which limits their ability to intermediate in the repo market when liquidity demand increases.?

For instance, Liquidity Coverage Ratios (LCR) and risk-based capital requirements have forced banks to adopt more conservative capital management strategies, discouraging them from leveraging the SRF. Although the SRF offers a liquidity source in times of need, intermediaries may prefer not to use this facility to avoid the perception of financial vulnerability.?

Paradox of Cash and Collateral Shortage?

Furthermore, the perception of high risks in collateral inventories may discourage intermediaries from acting as liquidity facilitators, exacerbating tensions in the repo market. In this sense, a paradox emerges: despite the shortage of high-quality collateral, such as U.S. Treasury bonds, there is also a proportional cash shortage. In this context, financial intermediaries may be reluctant to take on more risk on their balance sheets, choosing not to engage in transactions that could compromise their liquidity position or regulatory risk profile.?

This mismatch between the supply and demand for liquidity not only impacts repo market interest rates but also limits banks' ability to provide financing to other sectors, creating a vicious cycle that increases volatility in the financial system.?

2. The Precedent of the "Repo Apocalypse" of September 2019?

The event in September 2019, known as the "repo apocalypse," was a reminder of how dislocations in the repo market can quickly destabilize the financial system. During that episode, repo and federal funds rates soared due to a combination of factors that aligned into a "perfect storm" of liquidity obstruction.?

Among the primary triggers were corporate tax payments, which drained liquidity from the banking system. Many companies use money market funds (MMFs) as a kind of interest-bearing account to hold deposits, which led to large cash withdrawals from MMFs when they made massive tax payments. This outflow of funds, combined with MMFs' reluctance to lend due to information asymmetry and market uncertainty, created a temporary run on the banks. Banks holding these funds were forced to cover the outflows, further reducing available reserves.?

Additionally, the Federal Home Loan Banks (FHLB), which typically provide short-term reserves, faced their own constraints due to the coupon payments on mortgage-backed securities (MBS). This further reduced the available liquidity in the system, as the FHLBs could not supply enough banking reserves at a critical moment.?

On top of this, the massive issuance of U.S. Treasury bonds overwhelmed dealers' collateral inventories. The intermediaries that typically participate in the repo markets were overwhelmed by the amount of collateral they needed to manage, exceeding their risk tolerance thresholds. As a result, many dealers began to limit their participation in the repo market, further exacerbating the cash shortage relative to the collateral supply.?

The reduction in banking reserves as a result of the Federal Reserve’s quantitative tightening (QT) policy also played a crucial role. As the Fed allowed U.S. Treasury bonds on its balance sheet to mature without replacing them, the amount of collateral available for rehypothecation was reduced. This limited intermediaries’ ability to use that collateral in the repo market, obstructing a key source of mass financing.?

Disparity Between Cash and Collateral?

The combined effect of all these factors caused a severe mismatch between the supply of cash and collateral in the repo market. While there was a significant amount of collateral available, financial intermediaries were reluctant to take on more risk due to the overload on their balance sheets, triggering a cash shortage relative to collateral. This drove repo rates above their usual spread, even surpassing typical limits such as the Interest on Reserve Balances (IORB) rate, and approaching the discount window.?

The Effective Federal Funds Rate (EFFR) was also affected, as the FHLBs could not provide enough banking reserves due to their own payment obligations. This created a seasonal liquidity bottleneck, aggravated by structural constraints in the repo market.?

Amplified Effects of Window Dressing?

This episode is currently exacerbated by the window dressing practice of European G-SIBs. During quarter-end periods, these banks temporarily adjust their balance sheets to meet regulatory requirements, further limiting their willingness to provide liquidity during critical moments. This amplifies liquidity tensions, especially when other structural factors, such as Treasury bond issuance or FHLB obligations, coincide.?

Lessons from the Repo Apocalypse: Creation of the SRF?

The "repo apocalypse" of September 2019 clearly showed that the financial system, particularly the repo market, is vulnerable to severe dislocations when multiple factors combine to drain liquidity. This led to the creation of the Standing Repo Facility (SRF) as a tool to mitigate future crises by providing a stable source of liquidity and preventing repo rates from spiking.?

However, the recent limited adoption of the SRF suggests that structural tensions persist and that intermediaries continue to face difficulties managing their collateral inventories and accessing liquidity when they need it most. Moreover, dealers’ aversion to using the SRF indicates that their willingness to act during moments of tension is crucial for the effective transmission of the Fed's monetary policy tools. This reluctance may even hinder the optimal functioning of the Fed’s liquidity facilities, leaving the financial system exposed to future episodes of volatility.?

3. The Role of European G-SIBs and "Window Dressing"?

European G-SIBs have played a central role in exacerbating liquidity tensions in the repo market, particularly due to the practice of window dressing. This strategy, which involves temporarily adjusting their balance sheets to meet regulatory requirements and improve their appearance to regulators, has amplified liquidity pressures at quarter-end periods. During these times, European G-SIBs reduce their exposure to the U.S. repo market, significantly limiting their intermediation.?

This temporary reduction in exposure has a direct effect on the supply of liquidity. When European G-SIBs decrease their participation in the repo market, the dealers’ capacity to absorb excess collateral is reduced, creating a mismatch between the supply of collateral and available cash. This imbalance causes interest rate dislocations, exacerbating volatility at a time when liquidity demand is at its highest.?

Combined Impact of Basel III and Dodd-Frank?

The combination of window dressing and the regulations imposed by Basel III and Dodd-Frank has further restricted banks’ willingness to act as intermediaries in the repo market. These regulations impose strict liquidity and capital requirements that banks must maintain, reducing their capacity to provide liquidity during times of high demand. This creates a paradox, where despite the availability of high-quality collateral (such as U.S. Treasury bonds), there is an even greater shortage of cash, further aggravating tensions in the repo system and driving up interest rates.?

Global Effects: Liquidity Shortage in Cross-Currency Swap Markets?

The window dressing practices of European G-SIBs not only impact the U.S. repo market but also have global implications, affecting the eurodollar system. During quarter-end periods, these European banks not only reduce their participation in U.S. repos but also maintain their activity in European markets. With the euros they obtain, these dealers conduct cross-currency swaps, a key tool that allows them to exchange euros for dollars in the global market.?

This process of swaps creates a kind of “synthetic repo,” the next step in the liquidity hierarchy after traditional repos. However, the use of these swaps also creates instant inelasticity in the cross-currency derivatives market, draining liquidity that might otherwise be needed in other parts of the short-term dollar market. Liquidity shortages in the cross-currency swap market can have far-reaching consequences since it is a key mechanism for international dollar financing, affecting both the U.S. and the global financial system.?

Temporal Dimension and Risk of Inaction?

The withdrawal of European G-SIBs and the subsequent liquidity shortage not only affect the short term but also add a critical time-sensitive dimension. Liquidity deteriorates rapidly, and the lack of timely action can cause significant damage to the financial system. In this context, if key intermediaries in the wholesale money markets, such as European G-SIBs, are unwilling to turn to the Federal Reserve’s emergency mechanisms (such as the SRF), the problem worsens. The longer it takes to act and stabilize the markets, the greater the damage to the global financial system could become.?

This phenomenon highlights the importance of rapid intervention in liquidity markets. The longer the system goes without an adequate response, the greater the negative impact on both the repo system and the eurodollar system. Managing liquidity is crucial in times of financial stress since a lack of liquidity can quickly destabilize the entire system.?

4. Future Challenges in a Repo-Dominated Monetary Market Environment?

The repo market remains a critical source of liquidity for financial intermediaries and hedge funds. However, the structural tensions affecting the system, such as regulations on bank reserves and the shortage of high-quality collateral, continue to put increasing pressure on the financial system. These tensions are further exacerbated by the window dressing practices of European G-SIBs, who limit their participation during key moments of tension, amplifying interest rate volatility.?

In particular, the cross-currency swap market—a synthetic financing mechanism widely used to obtain dollars in global markets—also feels the impact of these tensions. As European G-SIBs withdraw from the U.S. repo market and turn to cross-currency swaps to finance their euro liquidity needs, the liquidity drain in this market spills over into the global system, amplifying liquidity tensions. This not only affects the U.S. repo system but also the global monetary system, given that cross-currency swaps are a key channel for international dollar financing.?

Additional Challenges: FHLB and IBDA Accounts?

In addition to these factors, other structural challenges create hidden liquidity risks. On one hand, the tightening of conditions at the Federal Home Loan Banks (FHLB) has reduced the availability of a key source of short-term financing, affecting intermediaries’ ability to obtain cash. Historically, the FHLBs have been a significant source of reserves for the banking system, but as they have tightened their conditions, financial institutions have faced greater difficulty in accessing this liquidity.?

On the other hand, Interest-Bearing Deposit Accounts (IBDAs), which pay interest on deposits, have faced difficulties absorbing the growing demand for liquidity. As more financial players turn to these accounts as a safe haven, the amount of cash available to finance the repo market and other key sectors of the monetary system decreases. This creates a mismatch between the supply and demand for liquidity in the financial system, adding further tension.?

QT from the FED and Reduction of Treasury Bill Issuance?

Another factor exacerbating these tensions is the quantitative tightening (QT) policy of the Federal Reserve, which has been reducing the amount of reserves available in the system through the maturity of U.S. Treasury bonds. This process not only reduces the liquidity available but also affects intermediaries’ ability to use these bonds as collateral in the repo market. As the FED allows bonds on its balance sheet to mature without replacing them, the ability to rehypothecate collateral decreases, further limiting liquidity in the system.?

At the same time, the U.S. Treasury has reduced the issuance of short-term Treasury bills, another important resource used as collateral in repo operations. This decline in bill issuance adds pressure to a system already facing a shortage of high-quality collateral. Without an adequate supply of this type of collateral, financial intermediaries have fewer tools to finance their liquidity needs.?

Aversion to Mechanisms Like the SRF and Hidden Liquidity Risks?

Despite the creation of tools like the Standing Repo Facility (SRF), its adoption has been limited. One reason behind this limited adoption is the insufficient reputation of these types of mechanisms, which have generated a degree of aversion among financial intermediaries. This stigma, similar to that associated with the primary credit or discount window, has led many market participants to avoid turning to the SRF, even amid repo market tensions.?

This phenomenon suggests that the Federal Reserve may have underestimated the effectiveness of the SRF as a risk mitigation tool. Intermediaries’ reluctance to use these facilities during times of tension poses the risk that, instead of smoothing market dislocations, they could worsen due to the lack of a reliable emergency liquidity source. This aversion to the SRF creates hidden liquidity risks that could materialize during periods of high demand, such as quarter-end periods or episodes of volatility in money markets.?

5. Failures in the Repo Market and the Increase in the MOVE Index?

Tensions in the repo market not only reflect a dislocation of liquidity but have also led to increased volatility in bond markets, as evidenced by the rise in the MOVE index. The MOVE, which measures implied volatility in U.S. Treasury bond yields, has been a key barometer of stress in financial markets. Its recent increase is a clear indication of tensions in the repo market and a lack of liquidity. The growing volatility observed is largely a reflection of poor risk allocation in portfolios via leverage.?

A key aspect of this dynamic is the role of hedge funds, which participate in leveraged strategies such as treasury basis trades and relative value trades, using the repo market as a source of financing. These funds play a crucial role in stabilizing prices in the U.S. Treasury market. However, when a leverage problem arises in the repo market, the impact is immediate: volatility spikes in U.S. Treasury bond prices, as directly reflected in the MOVE index. This volatility, in turn, spills over into other markets, including equities, where hedge funds purchase leveraged assets.?

So far, excess bank reserves have helped mitigate the impact of these tensions. However, this cushion could gradually disappear as liquidity drains from the Reverse Repo Program (RRP) and cash is withdrawn from money market funds (MMFs). This depletion of liquidity could leave the system more exposed to dislocations in the repo market and an increase in overall volatility.?

Failures in Collateral Intermediation?

Failures in the repo market amplify liquidity dislocations, particularly during quarter-end periods when European G-SIBs reduce their participation due to window dressing. This withdrawal affects collateral intermediation, creating bottlenecks in financing. Not only do repo rates rise, but bond market fluctuations increase as well, impacting the prices of fixed-income assets. These repo failures often consist of the failure to deliver or receive collateral, reflecting rising risk in the market and growing distrust among participants.?

The rise in the MOVE index signals that market participants anticipate larger swings in U.S. Treasury bond prices, indicating growing uncertainty over future liquidity and financing conditions. This volatility is further aggravated by the Federal Reserve’s quantitative tightening (QT) policies, which have reduced the amount of available collateral in the system. The tightening of financial conditions, along with persistent tensions in the repo market, has led operators to expect more frequent episodes of volatility.?

Liquidity and Volatility Risks?

The combination of repo market failures and the rise in the MOVE index underscores the close relationship between liquidity risks and volatility in bond prices. If these issues are not adequately addressed, the financial system could face sustained increases in bond market volatility, which in turn could feed back into greater instability in monetary and repo markets. In this context, the Federal Reserve’s response and the effectiveness of tools like the SRF will be key to containing these episodes and preventing their spread.?

6. Conclusion: The Need for Adjustments in "Monetary Plumbing"?

The recent limited use of the Standing Repo Facility (SRF) has exposed underlying structural vulnerabilities in global monetary markets. Despite the Federal Reserve’s efforts to stabilize the repo market, tensions persist, partly due to the practices of European G-SIBs such as window dressing, and the constraints imposed by regulations like Basel III and Dodd-Frank. These tensions have exacerbated the paradox of high-quality collateral and cash shortages, highlighting the need for more effective interventions to mitigate these risks.?

The challenges are significant. The tightening of FHLB conditions, the inability of IBDA accounts to absorb all liquidity demand, and the reduction in U.S. Treasury bill issuance, along with the Fed’s quantitative tightening (QT) policies, have created an environment where liquidity risks are more difficult to manage. Additionally, the insufficient reputation of mechanisms like the SRF has created an aversion to using these facilities, increasing the risk of temporary but severe dislocations in the monetary system. If key intermediaries continue to avoid using these tools due to risks associated with managing their collateral inventories, the repo system risks facing growing instability.?

To avoid future dislocations in monetary markets, the Federal Reserve must review and adjust its liquidity provision tools. The SRF was designed to be a key tool during times of tension, but its limited adoption and the restrictions on its use suggest that it is necessary to expand its accessibility or modify the incentives to encourage intermediaries to use it more actively. If these structural tensions are not addressed and emergency responses are not improved, the repo market could experience increased volatility and risk, threatening the stability of the global financial system.?

Ultimately, the current financial environment requires a more sophisticated monetary plumbing strategy. The Fed’s emergency tools, such as the SRF, must be reviewed not only to address immediate risks but also to create a more resilient long-term liquidity system. Global coordination among central banks and rapid intervention will be crucial to preventing liquidity tensions from escalating and affecting both the repo system and the eurodollar system, which are intrinsically interconnected. If the Fed underestimates these risks and does not adjust its strategy, liquidity dislocations could quickly spread globally, with devastating consequences for financial stability.?

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