Back in September this year, US General Collateral Repurchase Agreements (Repos) surged to 10%, from a normal range of 2%-2.5%, when a spike in short-term funding demand collided with quarterly tax payments – draining the liquidity in the market. Many may argue that this was a series of unfortunate events and that there is nothing to be worried about. But the real lesson to be learned is that such a “temporary” cash squeeze is a sign that either central banks or market participants do not understand the structural changes associated with the last decade of experimental monetary policy and improvised regulatory requirements.

Figure 1. General Collateral Repo (Source: Bloomberg)

In 2014, Fed reserves hit a record high of USD 2.9 trillion, mainly driven by the Quantitative Easing (QE) program in the money market. Since then, we have seen central bankers rolling back such programs, shrinking reserves to USD 1.3 trillion as of this summer. The Fed considered this to be enough cash to supply the market with resources in an efficient fashion, having USD 1 trillion in reserves and a “buffer” of USD 300 bn to absorb unexpected market shocks (like the ones seen in September this year). The truth is, this is not based on econometric validation, but merely a guess. This is the first time that such a program has been released or attempted to be rolled back. What we know is that as when rates spike, the reserve “buffer” can run out… and it did. Although we will probably see the Fed introduce new tools to create additional safety buffers, this may intensify the structural problem, as what is really happening is that banks have their hands tied.

Jamie Dimon, JP Morgan CEO blamed regulators. He argued that the banks had the cash and willingness to calm short term funding markets, but liquidity rules and requirements held them back. Further regulatory tools to increase the buffer will only cripple the system to be dependent on the Fed to be “flexible” when needed, instead of providing robust liquidity to market participants to be self-sufficient in meeting demand and ease any shocks that require Fed intervention.

The fact that Fed reserves are not enough, and banks have their hands tied, means that there is a structural problem in the American repo market. But how does this look in Europe? As there was no spike in the European repo, does it mean that things are calm? The answer is NO. Using seasonality to identify upcoming risks is a powerful tool for risk managers. Based on this we identify that there is a risk that the September event in the US may happen in Europe when year-end liquidity needs renew the pressure.

Unlike the American Market, the 8 Trillion Euro Market is becoming increasingly fragmented, meaning that European Money Market swaps have different underlying sovereign securities against the same currency. This wider range of securities is an increasing risk that may affect proper flows of capital and the ECB buffer shortage may be higher than the Feds.

Additionally, in recent years the repo market has been driven by investors seeking specific collateral instead of cash. This intensifies the segmentation mentioned above where price, liquidity and security dynamics vary among traders that specialize in bonds issued by their own governments. This can affect the efficient redistribution of cash, making it more complicated for the ECB to inject the required liquidity in such a liquidity squeeze scenario.

Figure 2. ECB Minimum Reserves

Figure 2 shows that the ECB has EUR 134 billion in minimum reserves to intervene in the case of a liquidity stressed scenario. Unlike the Fed, we see that the reserves are at historical highs which intuitively we could argue that Christine Lagarde may be in shape to stimulate the money market. The risks lie on whether a) these “buffers” will be enough to fund any investor cash requirements from the 8 trillion EUR money market and b) if the collateral of underlying securities, such as Italian and Spanish bonds, could induce further volatility coming from any spike in yields.  Back in September, the rapid Fed intervention was enough to avoid any spike in interest rate differentials that may affect the cost of hedging of our clients. However, we still see a possibility of the ECB being incapable of filling the market in an efficient manner. This gives rise to the potential for widening interest rate differentials in the short term and an increase in FX and interest rate volatility. 

Author: Daniel Porto