Repo markets: New York Fed’s Farp targets collateral squeeze

Joti Mangat
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Reverse repo to influence non-bank interest rates; money-market funds and GSEs swap cash for collateral.

The Federal Reserve Bank of New York’s snappily titled fixed-rate full-allotment reverse repo facility (Farp) got off to a tentative start on September 23 when an undisclosed number of money-market funds and other non-bank financial institutions availed themselves of $12 billion of high-quality collateral in return for cash deposits.

Although market-based GC repo rates have dropped to zero or below since the crisis amid collateral shortage, the Fed is offering non-bank depositors a positive return on their money for the three-day duration of the reverse repo.

Recent press reports have mistakenly described the open market operation as a clandestine form of tapering. In fact Farp has nothing to do with a quantitative easing unwind. Rather, it is a pilot monetary policy programme designed to manage non-bank interest rates, or the return on collateral circulating in the shadow-banking system.

“Monetary policy very much depends on the Fed’s being able to influence the amount of credit in the financial system as a whole,” says Alex Roever, managing director and head of interest rate strategy at JPMorgan in New York. “Historically this has been achieved using reverse repos to impact the Fed funds rate. Since December 2008, when Fed funds was cut to a range of zero to 0.25%, this market has been harder to influence. The new facility is a tool that the Fed has wanted to introduce for some time now to give it better control over non-bank interest rates.”

Under the programme, qualifying reverse repo counterparties including money-market funds operated by 25 US investment firms as well as the government sponsored entities (GSEs) receive 10-year treasuries from the New York Fed in return for depositing cash previously held on account with deposit-taking institutions. In the latest of the experiments, held on September 27, non-banks took $16.6 billion of treasuries, indicating that participation in the programme is growing. Although the first week’s trades all offered a return of one basis point on non-banks’ deposits, the programme is able to offer up to 5bp. Although this return seems negligible, taken in the context of market-based rates as low as 0.098 during August, the Farp rate provides an attractive new incentive for non-banks to trade.

With the markets fixated on the prospect of Fed tapering, it is not immediately obvious what the significance of a relatively small monetary policy experiment from the system’s open market operations branch is. However, the apparent rationale for Farp sits at the intersection of several financial market themes of global significance, namely shadow banking, Basle III’s liquidity coverage ratio (LCR) and the widely reported shortage of high-quality collateral among buy-side institutions.

Money-market funds and other short-term instruments such as repo and securities lending in the financial system at large have come under increased scrutiny in recent weeks as prudential regulators on both sides of the Atlantic make official announcements about the need to increase supervision of shadow banking. Both Michel Barnier, EU commissioner for the internal market and services, and Federal Reserve governor Daniel Tarullo have initiated new rules to regulate money markets, specifically curtailing constant or fixed net asset value funds which guarantee investors principal protection. Indeed, Federal Reserve Bank of Boston president Eric Rosengren wrote to the SEC 10 days before the first Farp operation on behalf of the 12 Fed presidents asking the SEC to effectively ban fixed NAV funds for both retail and institutional investors.

While Farp elegantly solves the dual problem of collateral shortage among non-banks, and costly LCR requirements for deposit-taking institutions while managing non-bank interest volatility, the additional benefit of guaranteed positive returns it gives to money-market funds for parking their cash with the Fed has some economists scratching their heads. “With a publicly united front the Fed has told the SEC that money-market funds should not be construed as insured or principal protected. But the New York Fed now guarantees par plus to money market funds and other non-banks. The two initiatives are orthogonal to each other,” says Manmohan Singh, senior economist with the IMF in Washington DC.