Over the past year, the Fixed-Rate Reverse-Repo (FRRP) program was clearly a success. In the beginning, it set a floor in overnight rates and eliminated the chance of a collateral shortage. During the height of the Fed’s QE program, it protected the general collateral (GC) market from flat-lining at 0% or dipping into negative rates. In addition, it’s helping with tri-party reform and will become an essential part of monetary policy going forward as the lower rate band of the federal funds target range.
Surprisingly however, the Fed has turned somewhat negative on the FRRP recently. First, they realized it became a window dressing tool for banks to reduce regulatory capital usage on month-end and quarter-end. The Fed also pointed out that during a period of financial stress – like a flight-to-quality – the FRRP might provide cash investors with an alternative to funding banks. If there is stress in the banking system, it’s better to have the Fed as counterparty. The Fed also noted that the FRRP might be expanding the Fed’s role in financial intermediation. With the creation of the FRRP, the Fed has basically become a market participant – instead of a referee on the sideline.
What Sparked The Program?
The official “reason d’être” of the FRRP program was to help manage interest rates and I suspect that will be its long-term role. However, given the Fed was not expected to begin tightening until two years after the program was announced, I believe the immediate reason was to keep GC from dropping to 0% or below. Clearly, the Fed was worried about the impact of QE purchases on the Repo market. Throughout June and July of 2013, GC was trending straight toward 0%. Had the program not started when it did, there was the possibility of market distortions and, no doubt, the Fed was conscious of preventing a collateral shortage.
Details of The Program
All total, there are 139 banks, foreign banks, broker-dealers and money funds who participate in the program. About 75% of the daily volume comes from the money funds. The participants provide the cash and the Fed lends them U.S. Treasurys from the SOMA portfolio in return; the securities which were accumulated through QE purchases. There’s an auction each day between 12:45 pm and 1:15 pm and the rate of the program has varied; right now it’s set at 5 basis points. Just last week, the Fed upped the individual counterparty limit to $30 billion and set an overall limit to the entire program of $300 billion.
Window Dressing
Since the FRRP rate was moved to 5 basis points on February 26, the average daily volume was $130.6 billion. More significant, the average volume on month-end is $199.7 billion and it’s $290.8 billion on quarter-end. In fact, the largest volume spike occurred on June 30 quarter-end when participants took over $339 billion in Treasurys from the Fed. The volume spikes in the graph [above] mark each quarter-end pretty clearly.
Back last year, right after September 30 quarter-end, I mentioned that the facility would be used for bank window dressing. That day, a total of $58.2 billion of cash went into the Fed, which seemed like a considerable amount at the time. It makes sense that banks and other financial institutions want the Federal Reserve as a Repo counterparty for accounting statement periods. Not only do banks prefer a 0% risk-weighting counterparty on their books to minimize their capital requirements, but the Fed is a desirable name to show on the financial statements. In fact, the FRRP program happens to be the best “window dressing” facility ever created. But that’s all about to change, realizing participants tendency to abuse of the program on quarter-end, the Fed has set a limit of $300 billion at the facility.
Where Does the Money Coming From?
Here’s a question: How can $339 billion flow out of the Repo market on quarter-end with little disruption to other money markets? The answer is that it does. According to Fitch Ratings, when the FRRP month-end and quarter-end volume spikes, that cash is generally being removed from European short-term assets. These assets including CDs, term deposits, and direct Repo trading with banks. Fitch concluded that the cash inflows into the FRRP program approximately matches cash outflows from Europe. Naturally, these financial institutions are trying to avoid Basel III regulatory capital charges on month-end and quarter-end. I assume it’s mainly European banks moving their cash into FRRP, given that European banks have more experience working under Basel.
How Do Market Repo Rates Affect FRRP Volume
I would expect that higher GC Repo rates would leave less volume at the FRRP facility. I took rate and volume data going back to February 26, when the FRRP rate moved up to 5 basis points. With higher market Repo rates, there is less volume at the FRRP, but it’s not so crystal clear. I had expected FRRP volume to trail-off considerably when market rates were 5 basis points higher than the FRRP rate, but it’s not the case. Cash investors are willing to lose 5+ basis points on a regular basis just to have the Federal Reserve as a counterparty – and it’s not just on month-end and quarter-end ! FRRP volume also stays at a minimum of $50 billion no matter what.
The Future of The FRRP
We started getting hints from the Fed as to the future of the FRRP program with the release of the June FOMC minutes. They said the FRRP “could play a supporting role” in draining reserves and tightening interest rates. Of course, Fed Chair Yellen noted that “we do have concerns about allowing that facility to become too large or play too prominent a role.” But still the Fed decided to make the FRRP rate the lower rate band for the federal funds target range going forward. In that respect, it appears the FRRP program is here to stay, but at the same time, Fed governors “agreed that the ON RRP facility should be only as large as needed for effective monetary policy implementation and should be phased out when it is no longer needed for that purpose.” So maybe it lasts only through the current tightening cycle. We’ll see.
