As we wrote yesterday, the Federal Reserve Bank of Dallas published a paper titled, "Network structure of money markets and firms affects policy transmission," which also includes a nice primer on the repo, or repurchase agreement market. They write, "The repo market is the largest market for overnight liquidity. It is a critical source of financing for dealers, hedge funds and other non-depositories. Asset managers (including money market funds) and large depositories do most of the net lending in this market. Repo transactions take place across multiple segments, typically identified by whether they are centrally cleared and whether they occur on the books of custodial banks. In triparty repo, which occurs on the books of a custodial bank, most of the borrowing activity can be attributed to dealers and foreign banks." (Note: Thanks to those who visited with us during `AFP 25 in Boston!)
The Dallas Fed piece explains, "The Fixed Income Clearing Corp. DVP Service is a centrally cleared portion of the market that does not remain on the books of a custodial bank. Transactions in this portion of the market largely occur between dealers, though the composition of this segment has been changing as dealers optimize their portfolios in response to regulation and in anticipation of the adoption of a central clearing mandate for Treasuries."
It tells us, "The repo market famously reacted more strongly than others to the scarcity of reserves that emerged in September 2019. This may seem puzzling, as firms unable to hold reserve balances do much of the lending and borrowing in this market. The outsized repo market reaction is often attributed to the fact that large banks lent less liquidity into this market than usual."
The paper says, "This explanation is true but incomplete for two reasons. First, since delivery-versus-payment repos are settled in reserves, and because repo markets are core to the sourcing of funding for the settlement of Treasury auctions (which also occur in reserves), some repo market transactions generate large flows of reserves. Second, many net borrowers in repo cannot hold reserves themselves, so any reserves shortfall limiting intermediation binds first on them and is reflected in repo market pricing. Recent work has suggested that the supply of money held by non-banks may play an important role in determining what level of reserves is ample."
It continues, "Though repo is important, like other markets, it reflects idiosyncrasies associated with the purposes for which it is used. For example, it displays monthly seasonality associated with government-sponsored enterprises lending in repo, as their cash holdings increase prior to mortgage-backed securities payment dates. Similarly, around regulatory reporting dates, some banks, especially foreign banks, withdraw from intermediation in repo."
The piece states, "Individual money markets involve different types of participants, and the borrowing and lending sides in most of these markets tend to involve different types of institutions. Apart from brokered deposits and DVP repo, very little trading of liquidity occurs between financial institutions of the same type. Further, the shortest links between various markets can often run through a single type of entity and at times even a small number of firms. This can at times mean that, due to idiosyncrasies of specific entities and markets, rates in one market may not represent conditions in others."
It adds, "Pass-through efficiency is highest when money market rates broadly remain near the rate of interest on reserves, which appears broadly consistent with how the outside option provided by policy rates functions in the model in the original paper. Dispersion tends to be lowest when the level of reserves is consistent with the average level of money market rates being close to the rate of interest the Fed pays on reserves."
The Dallas Fed says, "The basic intuition about this result is straightforward and arises from two basic facts. First, when rates in money markets fall below the interest rate on reserves (IOR), banks have an incentive to borrow in those markets and earn the spread; similarly, when rates in money markets rise above IOR, banks have an incentive to economize on their reserve holdings and lend into those markets. Second, banks have regulatory and other limitations on the degree to which this intermediation activity is economical for them. It follows that intermediation capacity is less binding when money market rates are closer to IOR, maximizing the pass-through of policy rates and, thus, minimizing dispersion."
They comment, "The structure of the network of entities and markets varies over time and is a critical determinant of rates across markets. Some of the markets bank treasurers typically rely on to manage liquidity also generate significant client flows that impact bank reserves. The pass-through efficiency of policy rates as measured by dispersion is highest when reserves are at a level consistent with money market rates typically remaining close to IOR. This arises from both bank incentives and limits on intermediation capacity."
Finally, the piece says, "One example of the impact of intermediation capacity on rate dispersion follows from the effects of foreign banks withdrawing from repo intermediation around quarter-ends. It can dramatically affect pricing, as intermediation demands on domestic banks increase in response to the temporary shift in the network structure away from its natural optimum. The intuition that arises from understanding the relationship between the network structure of money markets, intermediation capacity and rate dispersion has useful applications when monitoring reserve scarcity and understanding how it evolves in response to changes in regulation, market structure and other factors."
