March 16, 2020
Nadav Orian Peer, Colorado Law
“It was inevitable: the scent of bitter [money markets] always reminded him of the fate of unrequited [convergence trades].”
Yes, this is a paraphrase. The Márquez original reads “almonds” in lieu of “money markets”, and “love” instead of “convergence trades”. An odd paraphrase, I am aware, but like the Márquez classic, Repo in the Time of Corona grapples with existential features of the human condition. Those are: (1) The desire to tap money markets for high-leverage trades; (2) The incessant drive towards regulatory arbitrage; (3) The Fed’s dilemma of dealing with the former two in its role as the ultimate purveyor of liquidity. Main characters and events include the rise of FICC sponsored repo, the sponsored hedge funds and the dealers sponsoring them, corona disruptions in the treasury market, and the Fed’s policy response. It’s nowhere as charming as Márquez, but quite as dramatic.
Flashback: Repo Post-Crisis
I started studying financial regulation in 2010 and, like many of my cohort, felt an urgency to understand the causes of the Financial Crisis, and the reforms just then taking shape. An early key insight, reading people like Ricks, and Gorton, was that repo was “money like”: a short-term claim held for transactional purposes, much like a bank deposit. Repo borrowers share another trait with banks: they are vulnerable to runs. This run risk materialized in 2008, and became an inflection point in the recession that followed. Work like this trained its readers to see the issuance of money claims outside of chartered banking (and the public safety net) as a threat to stability.
A second key insight, reading people like Mehrling and Pozsar, was a mental map of the repo market. The right-hand side of this map had cash investors (money funds, corporate treasuries) lending repo as a kind of cash equivalent. The left-hand side had hedge funds borrowing repo to leverage-up their trades. A dealer was drawn in the center of the diagram, reflecting the fact that cash investors and hedge funds do not interact directly. Dealers borrow from cash investors in the triparty repo market, and lend to hedge funds (often, prime brokerage clients) bilaterally. The dealer’s ability to profitably offer its balance sheet as this meeting ground, I learned, shapes the daily workings of money and capital markets.
A third insight was about the regulatory philosophy guiding the Dodd Frank Act and Basel III, the reforms everybody was trying to wrap their heads around. This third insight knitted together the first two. Morgan Ricks and others argued that as a non-sovereign money claim, repo was crisis prone, and should be prohibited outright. The regulatory reforms did not adopt this approach. They opted instead for a middle-ground, somewhere between eliminating repo and business as usual. Enter the smallish repo market of the 2010s, shrunk from its $5 trillion glory, to $1.5-2 trillion. That the repo market would remain smallish was premised on several assumptions. First, all major dealers were now regulated as affiliates of bank holding companies. Second, Basel III’s tightening of capital, leverage, and liquidity requirements meant these dealers’ balance sheets were becoming increasingly expensive. To address rising balance sheet costs, dealers had to mark-up their bilateral repo lending rates to hedge funds. Rising rates would make levered trades less profitable to hedge funds, ultimately curbing demand. That is, of course, as long as hedge funds and cash investors could not find each other outside the dealer’s balance sheet. Spoiler alert: they did.
The End of the Basel III Honeymoon
On September 17, 2019 the otherwise sleepy repo market made headlines when the repo rate spiked from 2% to 5%, with some distressed trades reportedly paying double that rate. Much of the commentary on the repo spike focused on what it implied about the tightness of bank reserves. This was essentially a story about the supply side: looser reserves would have created opportunities for profitable repo lending by banks. But readers following this episode also learned something new about the demand side, the identity of repo borrowers. The assumptions that underwrote the smallish repo market of the 2010s were loosening. Time to update the repo mental map.
“Sponsored repo” is the name of a new segment of the repo market. In just two short years, it went from basically non-existent, to $400 billion. The service is offered by the Fixed Income Clearing Corporation (FICC), a user-owned central clearing counterparty (CCP) whose primary regulator is the SEC. A hedge fund and a cash investor enter a repo, and the trade is novated to the CCP. As the central counterparty, FICC becomes a repo borrower to the cash investor and a repo lender to the hedge fund. The dealers themselves, it is worth noting, are still involved as the “sponsors” of those hedge funds. But the dealers’ balance sheets are basically out of the picture, thanks to the CCP.
It requires more careful study, but this arrangement raises concerns of regulatory arbitrage. In traditional CCP practice, each member (like the dealers) guarantees performance by its clients (like the hedge funds). FICC seems to use a similar model, in their words:
“While the Sponsored Members [=hedge funds] are principally liable to FICC for their securities and funds-only settlement obligations, the Sponsoring Member [=dealer] is required to provide a guaranty to FICC with respect to all obligations of its Sponsored Members, so that if a Sponsored Member does not satisfy any of its obligations to FICC, FICC can invoke the Sponsoring Member’s guaranty.”
If a hedge defaults, a dealer is still on the hook to FICC and its risk exposure as sponsor is essentially identical to on-balance sheet intermediation. It is not clear why regulators would provide sponsoring with favorable treatment. Be that as it may, dealers discovered favorable treatment was in fact forthcoming. A JPM primer explains:
“[Sponsored repo] …takes a significant step in alleviating the regulatory costs of fixed-income financing in a post-crisis world. ‘We believe sponsored repo cannibalizes less efficient forms of repo, ultimately freeing up capital and creating more capacity for banks to provide liquidity to the fixed-income markets…”
Since 2018, triparty repo volume (which includes FICC) rose by around $600 billion (~30%), with sponsored repo accounting for the majority of the increase. Some of this capacity was taken up by hedge funds engaging in relative value trades. A December research note by the BIS related the demand-side squeeze in the September repo spike to these sponsored hedge funds. Interestingly, the FT reports that last week’s disruptions in the treasury market were also related –to some degree, large or small, we do not yet know—to these relative value trades coming under liquidity pressure. These are the same market disruptions that the Fed cited in its string of announcements of large-scale repo auctions and asset purchases. Sponsored repo is still relatively small, but it raises new and perplexing questions about how the Fed’s crisis response is going to play out.
Trading Liquidity Risk
Relative value trades exploit small pricing discrepancies, which become profitable if leveraged many times over. For example, a hedge fund might purchase treasuries that are underpriced in the cash market, and hedge its position by selling futures against them. This trade elegantly eliminates market risk. The futures contract allows the seller to settle by delivering the actual treasuries towards the end of the contract period. At that time, prices would have to converge, and the seller hedge fund would pocket the pricing difference, amplified by its leverage. This leverage is obtained in the repo market, where the hedge fund can borrow cheaply by pledging its treasuries as collateral.
But while the trade eliminates market risk, the hedge fund is assuming a considerable amount of liquidity risk. The FT’s reporting about relative value traders coming under pressure amidst corona volatility is a case in point. As it turns out, the futures leg of the trade appreciated at a faster rate than the cash leg (the actual treasury securities). Here’s a speculation as to what’s going on. Futures contracts are subject to daily –and sometimes intradaily—variation margin by the clearinghouses. With treasuries appreciating, this represents a liquidity drain to hedge funds. As repo borrowers, however, the hedge funds are also gaining liquidity, because their treasury collateral is gaining in value (yields are dropping), making them entitled to positive mark-to-market. The problem, it appears, is that the cash market is moving more slowly than the futures market, meaning the liquidity drains dominate the gains. If so, the same frictions between cash and derivatives markets that relative value traders were trying to exploit are now turning against them (For more on the theme of liquidity exposure between cash and derivatives positions, see Merhrling, and Mehrling et al.).
Like many a convergence trader before them (say, LTCM), these hedge funds are struggling to maintain positions that will become profitable, if only they can survive to see the day. The FT reports that pressure on these hedge funds can translate —and perhaps, has already been translating— into disorderly liquidations, disrupting the broader treasury market. This is where the Fed’s recent policy announcements come in. To reiterate, how large a factor relative value trading has been in the current disruptions remains to be discovered. It is certain, however, that if the sponsored repo market continues its growth trajectory, such dynamics will become more likely in episodes yet to come.
Fed Support for Sponsored Repo?
At over 15% of the market, the rise of sponsored repo subverts the unspoken compromise of the post-crisis order: the repo market will survive, but only as long as dealers, the gateway to the ultimate borrowers, remain tightly regulated. With hedge funds meeting cash investors through FICC, the Fed could be increasingly facing the dilemma of whether to support sponsored repo. Failure to offer support risks market disruptions, while willingness to support is bound to increase leverage and risk. The post-crisis compromise was based on the premise that risk and leverage regulation ex-ante would save the Fed from facing this dilemma ex-post. This compromise is now unraveling.
Fed support of sponsored repo could take various forms, providing funding liquidity as a lender of last resort, or market liquidity, as Mehrling’s dealer of last resort.
Funding liquidity would become relevant if cash investors withdrew from FICC, perhaps after the failure of a sponsored hedge fund. The Fed could put itself in cash investors’ position, lending directly on the FICC platform. Indeed, only two months ago, the WSJ reported the Fed considered adding a sponsored repo facility to its evolving monetary policy implementation framework. So far, this has not happened. In part, legal concerns might be at play given the FICC’s DFMU status (designated financial market utility). Fed lending to DFMUs requires a Fed Board finding of “unusual and exigent circumstances” and consultation with the Treasury Secretary (12 U.S. Code § 5465(b)). This roughly parallels the famous Sec. 13(3) emergency lending authority to non-banks. So far, neither provision has been triggered. Stay tuned.
Short of a 13(3) announcement, funding liquidity to sponsored repo borrowers could only be provided indirectly, through the dealers. Hypothetically, a dealer could borrow repo through the Fed’s current auctions, and lend into the sponsored market. Such indirect support might face serious limitations. After all, the whole raison d’être of sponsored repo was “freeing up capital” for the dealers and BHCs. Reintermediation would require recommitment of this capital. Judging by low take-up in the first large repo auctions last week, dealers seem reluctant to offer their balance sheets for any purpose at this point.
Given that a run on sponsored repo has not yet happened, Fed actions have a more direct bearing to relative value traders through the impact those actions may have on market liquidity (as opposed to funding liquidity ). As hinted on Sunday evening’s FOMC conference call, the Fed was initially hoping the large repo auctions to dealers would encourage them to make steadier markets. Low dealer take-up of repo got the Fed moving to outright purchases of at least $700 billion in treasury and agency securities (with few exceptions, the Fed is legally not allowed to purchase private credit assets). Note that the Fed’s goal here is to stabilize market pricing conditions (dealer of last resort), not merely increasing bank reserves, which given the scale of purchases, are once again on a path to super-abundance.
To the distressed hedge funds, these market purchases might come as a lifeline. If the relative value trades are coming under pressure due to slower appreciation of treasuries (slower than the futures leg, that is), Fed purchases in the cash market could bring more rapid appreciation. The hedge funds were profiting by assuming liquidity risk, and Fed actions are intended to make this liquidity risk disappear. It might work, it might not. It remains to be seen.
All of this goes to the technical question of how the Fed might support (or is already supporting, wittingly, or unwittingly) sponsored repo. The broader question, of course, is whether the Fed should offer such support in the first place. To ask this question is already to acknowledge the decline of the post-crisis order. If sponsored repo is the regulatory work-around it appears to be, its growth would compromise the immunity system that the post-crisis order was so desperately trying to boost. Repo in the time of corona is a wakeup call for regulators: the public’s financial health should come first.
 FRBNY’s triparty repo statistics only begin in 2010. The $5 trillion figure is my back-of-the-envelope calculation based on the primary dealer survey. It aggregates “securities out” figures for Jan. 2007, and discounts it somewhat to account for haircuts. Working with repo statistics presents challenges that are beyond our current scope.