You or I might borrow money from a bank, put up our house as collateral, and pay interest on the cash. Financial institutions do this too amongst themselves; they borrow cash and put up bonds as collateral. Or they’ll lend cash in order to get collateral. This is called the repo market. Banks use this to cover pulls and pushes on the financial system. Traders use it to make short sales.
But some odd things have been happening in this market over the past few weeks and even years.
For starters, negative interest rates. “It’s like if the bank lends you money, they would paying you interest to be able to lend you cash,” says Peter Anderson repo trader with Potomac River Capital.
For example, just this morning, lenders were willing to loan cash for -0.1 to -0.15 percent interest — meaning they would pay -0.1 to -0.15 percent interest in order to lend that money if it meant they would get their hands on the newest five year treasury notes as collateral.
Why? Because they really, really need collateral. Collateral to make other deals, collateral to cover short sales.
There isn’t enough to go around, and this means that deals are failing. Fails happen all the time, but their volume has been increasing.
In 2012, the average volume of failed deals per week was around $30 billion. In 2014, it’s about $67 billion.
Some fails can be particularly bad. For example, when one entity fails to find the collateral it needs to complete a deal with another party, who needs that collateral to complete a deal with another party, and so on. “It creates a daisy chain of fails, a chain reaction of fails,” says Anderson.
This is what happened at the start of the financial crisis. Fails now are nowhere near that level, but they still present a source of unease.
“The fact that we are seeing repeated episodes where security doesn’t clear up for days at a time is a sign of a market that’s not functioning very well,” says Louis Crandal, chief economist at Wrightson ICAP.
Among the reasons for the tighter repo market is a new set of rules on bank capitalization that make banks less willing to tighten their grip on bonds being sought for use as collateral.
“Banks have been required to hold more capital against trades that prior to the crisis were seen as being relatively low risk, and which are low risk in good times.” However in a crisis, trades can create systemic problems like the daisy chain effect that took out Bear Sterns and Lehman Brothers. Regulators have insisted more capital be held against such trades, and so fewer trades are made.
“Thats not an unintended consequence,” says Crandal. “One of the points of Dodd-Frank and all the other changes in regulatory structures globally was to increase the cost of financial intermediation,” the fear being that razor thin margins amplified financial risk.
But regulators didn’t intend to increase the number of failed deals per se. In 2009, they developed a new rule to incentivize institutions looking for collateral to keep looking. Simply put: it’s a fee for failure. A financial institution looking for collateral to finalize a deal somewhere else now has to pay a 3 percent fee if it fails to find it.
This penalty should keep a lid on fails, says Joseph Abate, short rate strategist for Barclays. “I think this is transitory and will resolve itself within a week or so,” he says, speaking of the recent spike in fails. Periodically as economy improves and people begin to foresee interest rate rises, “the demand to borrow securities is picking up,” as people seek to short securities. In the process, they are applying demand side pressure on those securities in the repo market.
As treasury bonds are auctioned in tranches over a quarter, there are choke points at the beginning of an auction period where there are fewer bonds, and towards the end of the quarter, financial institutions will have used up
Crandal, at Wrightson ICAP, says the increasing fails rate is unlikely to blow up, but “it’s a case of existing market structures not really making sense in a new capital framework, and we haven’t developed new avenues for sourcing those bonds.”
If the issues persist, either the financial system on its own or regulators down the road will have to figure out a new way of doing business — such as a central clearing house for all repo trades, or a new type of financial entity tasked with handling that process.
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