The U.S. Federal Reserve's multibillion-dollar intervention in the U.S. repo market in September was an event of long-term significance, showing the effect of central banks' post-crisis actions and the growing influence of non-banks like hedge funds, according to the Bank for International Settlements.
In its quarterly review published Dec. 8, the bank said "something quite unexpected took place" in a critical segment of the market: on Sept. 17, U.S. overnight general collateral repo rates spiked to 6% with some trades reportedly occurring at up to 10% in a disorderly market. This pulled up the Libor-replacement secured overnight financing rate, or Sofr, too.
The repo, or repurchase agreement, market is where banks and investors borrow money at an overnight interest rate in exchange for Treasuries and other high-quality collateral to cover short-term funding needs.
The Fed's injection of cash into money markets in September and its subsequent $60 billion monthly purchases of Treasury bills to pull down interest rates was the first time it had intervened like this in a decade.
The Financial Stability Oversight Council, which is made up of the heads of U.S. financial regulators, has called for a review into the Fed's intervention to assess the implications for financial stability.
Big 4 banks' behavior
BIS said the reasons for the problem in the repo market are still not completely clear, but there seems to have been a high demand for secured repo funding from non-financial institutions like hedge funds while at the same time the big four U.S. banks — Bank of America Corp., JPMorgan Chase & Co., Wells Fargo & Co. and Citigroup Inc. — appeared unwilling to supply the funding because their liquidity buffers were running low.
Claudio Borio, head of BIS' monetary and economic department, said the significance of this event goes well beyond the short-term dislocations that prompted it and the behavior of the big four banks in the U.S. was critical.
BIS said cash balances held by the U.S. Treasury grew in size and became more volatile after 2015 but the drain and swings in reserves are likely to have reduced the cash buffers of the big four banks and their willingness to lend into the repo market.
"They have recently become the marginal lenders to the repo market, replacing money market funds," he said. "Their unwillingness, in turn, seems to reflect post-crisis changes in internal risk management practices and, possibly, the lack of flexibility to take advantage of short-lived arbitrage opportunities."
BIS draws the conclusion that central banks' post-crisis actions have profoundly affected how financial markets function.
It said banks have gotten used to a period of abundant excess reserves so withdrawing them might turn out to be a shock for the market. Borio compares it to a muscle that has atrophied and cites the effect of large-scale purchases by the ECB that he said has turned the euro area repo market from one driven by funding needs to one driven by the demand for underlying securities which affected interest rates.
Repo markets may find themselves in the eye of the storm should financial stress arrive again, BIS warned.
Forex, OTC derivatives markets
The report also covered the foreign exchange and the over-the-counter derivatives markets in a triennial survey.
In FX markets London, New York, Singapore and Hong Kong increased their collective share of global trading to 75% in April 2019, up from 71% in 2016. Trading in OTC interest rate derivatives markets is mainly concentrated in London.
The bank said foreign exchange and OTC derivatives markets picked up in trading between 2016 and 2019 with the foreign exchange market rising to $6.6 trillion per day in April 2019, while interest rate derivatives trading soared to a record $6.5 trillion.
Trading short-term instruments grew faster than long-term instruments and this mechanically increased reported turnover because short-term contracts have to be replaced more often. The trading of foreign exchange swaps with maturities mainly of less than a week rose to $3.2 trillion in April 2019 from $2.4 trillion in April 2016.
Though the U.S. dollar and euro dominated global foreign exchange markets, the share of emerging market currencies in global foreign exchange turnover rose to 23% in 2019 from 15% in 2013. This contrasted with interest rate derivatives in emerging market currencies which saw their share of global activity decline.
Easing trade tensions
The easing of trade tensions between the U.S. and China was the defining characteristic of financial markets in the past quarter, BIS said.
The ebb and flow of trade tensions dominated the quarter, though further monetary easing continued to support risky assets along with signs later in the quarter that recession fears might have been overdone.
The lessening prospects of a no-deal Brexit following a meeting between the U.K. and Irish prime ministers in October along with better U.S./China trade tensions boosted risk appetite in markets during the period.
Equity prices rose, the VIX — or Volatility Index, a measure of risk aversion — fell to new lows, corporate spreads narrowed, yields on safe sovereign bonds were up and the U.S. dollar depreciated. This meant the overall financial conditions in the U.S. and the euro area loosened and became relatively easy by historical standards, BIS said.