The Impact of Quantitative Easing
Now we’re going to find out whether the Fed’s QE3 and QE4 programs are distorting the short-term funding markets. Since the middle of April, overnight rates have bounced around due to a variety of competing events: the April seasonal collateral shortage, $85 billion a month in QE programs, and changes in the net issuance of US Treasurys. Before the recent QE programs began in September 2012, General Collateral (GC) was trading at .26% and averaging 10.8 basis points above fed funds each day. This month, GC has averaged .09% and is only +1.6 basis points above fed funds. No doubt the Repo market is feeling the effects of the QE programs and quite possibly they’re permanently creating a shortage of high grade collateral in the Repo market.
But here’s the really interesting part: Going back to QE2, which ran from November 2010 to June 30, 2011 and pushed overnight rates down to 0%. The month after the QE2 program ended, overnight GC rates were stuck at 0% each day and other problems were starting to spill over. For example, some investors were not investing their cash anymore, they just left it in the account at their clearing back. The graph [below] shows overnight GC rates from June and July of 2011 (at the end of QE2) versus current GC rates from May and June 2013 (this year). There’s a pretty strong correlation between the two, except for the recent bump in rates this month, which is entirely attributed to the large Treasury settlements on May 31 and June 3 of about $84 billion.
The QE3 and QE4 programs might have more permanent effects than QE2. In late July and early August 2011, the government was close to the Debt Ceiling. As investors panicked about the US hitting the Debt Ceiling, the short-end of the Treasury market sold off, dumping US Treasurys back into the Repo market. The Fed’s current QE programs and in danger of creating another collateral shortage, except this time, there’s no Debt Ceiling crisis to save to overnight funding market. At least it’s not projected until November.
Specials – 10 Year Note
The 10 year note really heated up in the Repo market again and it goes back to what I mentioned last month – the 10 year note auction cycle. On May 14, 2013 the 10 Year Note outstanding was the 2.0% 2/23, a triple issue since it had been reopened twice. When the new 10 Year Note (1.75% 5/23) settled the next day and became the “current” issue, it was only single issue. From the beginning, there are just too many shorts in the 10 Year Note sector, so it’s no surprise that a single issue 10 Year Note is trading so special. The squeeze will end on June 15 when new supply from first reopening of the 1.75% 5/23 settles, but until then, as long the shorts are so deep, the 10 Year Note will continue to trade close to the cost of the Fail Charge at -3.00%.
Is there anything wrong with fails? Up until 2003, fails were not considered such a big deal in the Treasury market. Before the Fail Charge, if you failed in the Treasury market, it was the equivalent of receiving a 0% rate on your cash. In most fail situations, a temporary rate of 0% for a few days wasn’t a major issue. In recent years, the problems with chronic fails came to light and the market discovered how fails: added assets, increased regulatory capital charges, created unhappy counterparties, created distortions in the market, and most of all, generated unwanted credit risk.
Before 2009, from an individual bank’s point of view, the largest problem associated with fails was the credit exposure it created. The counterparty credit risk arises because the market price of the security continues to move, but price set on the failing trade remains the same. The existence of fails was somewhat of a loophole in counterparty credit exposure since a fail didn’t allow a firm to properly manage their credit exposure, they could not call margin on fails. In addition, if there was any perceived default risk, then firms just stopped doing business with another. Say a dealer bank is teetering on the verge of bankruptcy on a Thursday. If all the trades are closed out and there are fails, there’s still counterparty risk. If that was the case for Bear Stearns, or Lehman, or MF Global, a firm could get caught up in the same bankruptcy they were trying to avoid because the closed securities failed.
There are generally three stages of fails:
- Mild – The issue trades at negative rates, sometimes very negative. Most of the time all the settlements clear, but sometimes there’s a fail which is a “one day event.”
- Strong – The security trades near -3.00% each day and large fails remain at the end of each day. Just like the 10 Year Note now.
- Extreme – No offers, no trading. This represents securities with the deepest fails. Limited volume trades on the brokers’ screens and dealers race to lift the first offer each morning.
Fails Come In A Couple Varieties:
- “Frictional Fails” – This is the name for a fail due to errors and mistakes, they can generally happen at anytime and are a regular occurrence.
- “Cascading Fails” – Deep demand for one specific security or the overall financial system is locking up. Sellers are unable to deliver securities to buyers, which makes the buyer unable to deliver the security to someone else if they sell it. Market participants keep buying and selling and the total amount of fails continue to increase. Just like what happened after September 11, with the 3.625% 5/13, and during the Banking Crisis of 2008.
Distinct Periods of Chronic Fails:
- After Sept 11, 2001 – Fails were massive because clearing banks and many market participants were unable to process trades. The money wire had problems for days, securities clearance (Fed Wire and DTC) had fails for about two months.
- 3.625% 5/13 – This issue failed for over 5 months and it forever changed the landscape of fails. It even created formalized negative interest rate trading in the Repo market.
- Banking Crisis 2008 – This was a very extreme fail event and prompted the Fed and Treasury to take action to once and for all solve the fail issue. Beginning in September 2008, customers stopped lending securities into the market because they were worried about counterparty exposure and that they would not get their securities back, due to the fails. It was a self-fulfilling problem, since market participants didn’t lend their securities there was not enough supply in the market. Fails in the Treasury market hit an all-time record high of $5.06 trillion on October 15, 2008. There was clearly systemic risk in the bond market preventing the market from functioning properly. One thing to note, a banking crisis doesn’t necessarily mean significant fails, for example, there were few fail problems during Liquidity Crisis of August 2007.
Solving The Fail Problem
Over the years, many mechanisms were put in place to help resolve the fail issue, they relied on two principles: increasing the costs of fails and adding more supply into the market.
- Buy-Ins – There were always discussions about Buy-Ins in the Treasury market during periods of chronic fails. In the case of a Buy-In, the counterparty being failed to goes out into the open market and purchases the failing security. Once the security is purchased, a bill is sent to the other party for the cost of closing out the fail. This practice is common in the High Yield corporate bond Repo market and the Stock Loan market, where issue sizes can be small and securities can potentially fail for months.
- A Little Help From The Fed – The Fed loans securities into the market each day through its SOMA Securities Lending Program. During times of severe shortages, the Fed will make more of its holdings available and allow individual dealers to borrow more than their normally allocated percentage.
- Regulatory Capital Charge – Broker-dealers must reserve capital against fails in the case of a fail-to-delivery over 5 days old and a fail-to-receive of over 30 days old. The capital charges were never high enough to give the market an incentive to clean up the fails.
- “Snap Reopenings” – Though common in other sovereign bond markets, the Treasury first used a “Snap Reopening” after September 11, 2001. In a surprise move in October, the Treasury announced they were auctioning more supply of a failing issue in an unscheduled auction. Though the Treasury maintained the “Snap Reopening” would not be a regular tool for addressing fails, the practice was again used in October 2008 to reopen the current 10 Year Note at the time.
- The Fail Charge
During the height of the Banking Crisis in 2008, the Treasury put pressure on bond dealers to institute a mechanism to finally deal with the fail problem. The need for the Treasury Market Practices Group (TMPG) to solve the issue took on new importance when the Fed dropped the fed funds target rate to the range of .25% to 0%. Now, with overnight rates close to 0%, there was virtually no penalty for failing at all. Some might call it an unintended consequence of the 0% interest rate policy by the Fed. Compare 0% rates to the fed funds target rate of 6.50%, just a few years earlier. There was a strong incentive not to fail when the cost was 650 basis points. In December 2008, the bond market was in a bind, with overnight rates close to zero, there was little incentive to cover shorts and no real mechanism to promote negative Repo rates.
In January 2009, the TMPG announced plans to institute a steep penalty for fails – a charge of 300 basis points – making a fail the equivalent of covering a short at -3.00%. The SEC took comments on the Fail Charge in April 2009 and once Fixed Income Clearing Corp (FICC) was on board, the whole market was assured to adopted it. The charge began May 1, 2009 for Treasurys and on February 1, 2012 for Agencys. The new practice included allowing margin calls on fails.
The Fail Charge was like extending the “playing field’ in the Repo market from 0% to -3.00% and it meant Repo rates were no longer stuck at 0%. What’s more, Repo rates for specials will even dip below -3.00%, as we’ve seen in the current 10 Year Note the past week. Though there’s no economic reason to pay a rate below -3.00%, the market will from time to time. Some Repo desks are required to cover all their shorts each day and some Repo traders believe it’s better to pay -3.25% than explain to their boss why they didn’t cover a short.
Clearly, the Fail Charge has created a more fluid Repo market and became a mechanism to price failing securities – negative Repo rates. Since the Fail Charge began, there has been no period of market-wide protracted fails. Yes, there are fails in individual issues, like the 10 Year Note today, but those fails remain a temporarily phenomena. The Fail Charge can’t solve everything, since there will always be a time when the demand for a security outweighs the available supply, but overall, chronic fail problems in the Treasury market were solved by the Fail Charge.