Odd Lots - Why The Repo Markets Went Crazy, And Why December Could Be Even Worse

Episode Date: November 11, 2019

Back in September, chaos erupted in short-term funding markets, as the cost for financial institutions to borrow reserves soared. Immediately a major debate broke out over whether this represented a systemic problem for the financial system or merely a technical problem with the "plumbing." Things have quieted down since September, but the debate hasn't stopped. And there's still no permanent fix. On this week's Odd Lots podcast, we spoke with Zoltan Pozsar of Credit Suisse, who has a reputation for understanding the mechanics of these funding markets better than anyone else in the world. He broke down what really happened, and why we could see more craziness as soon as next month.See omnystudio.com/listener for privacy information.

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National of Formation in Santee in Sauton, and welcome to another episode of the Odd Lots podcast.

I'm Tracy Allaway. And I'm Joe Wisenthal. So, Joe, I was in New York with you in early September, wasn't I?

We did the Odd Lots live show. That was early September. Yes, I think it was. That already seems like a really long time ago to me,

but yeah, that was really fun. And we had a great a great line of of guests and it was it was just it was absolutely perfect i wouldn't have changed one thing about the lineup of guests that we had that now uh there was one thing that i would have changed which is that uh we were due to have zoltan posar on one of the panels and unfortunately he had to drop out

a couple days before for a sort of last minute commitment but the reason it would have been great to have him there was because something big happened in the market that same week. Right. So I was just trolling a little bit. I agree with you. That would have been the one change. That would have been the one thing that would have made it absolutely perfect. And of course, what you're referring to was the tantrum, or I'm not sure what word we're using to describe it, but the sort of craziness. The repo madness of early September was right around that time. And of course, Zoltan is by many people considered to be the preeminent expert in this area. Right. Also a former Oddlots guest. And I should just back into this a little bit. So Zoltan Pozar, a former advisor to the U.S. Treasury Department, now a strategist at Credit Suisse, and he's been writing a lot about the repo market. In fact, you know, just four or so weeks before we had that repo banness incident, and this was where short-term borrowing rates in the money market suddenly surged. Four weeks before that actually happened, Zollinger.

Bolton had been writing, again, some eerily prophetic things. Like, he actually wrote in a piece of August research that the funding pressures that Credit Suisse is forecasting include overnight general collateral repo rates drifting outside the Fed's target band. And that is exactly what happened in September. I remember, I'm not just saying this because he's here in studio and we're about to talk to him. But I remember even before I noticed, I remember the day that the rates shot.

shot up. I didn't even notice it until some, a trader at a bank, Ibeed me on my Bloomberg and said, are you watching what's going on in the repo market? It's exactly what Zoltan predicted. And that was the first, then I like went and looked. That was my first, my first indication that something was amiss. Someone alerting me in that way. That's how, that's how closely his research is tied to what we've seen in people's minds in the market. Yeah. Zoltan, is at one with the repo market and money market crunches. Again, just to provide a bit of background. So what we actually saw on that day was repo rates, the cost basically of making secured overnight collateralized loans. Those repo rates jumped from, I think it was about 2% to

something like 10%. And lots of people had talked about the possibility of a funding squeeze, especially around quarter ends, which is where we get these sort of traditional crunch points in the financial systems because big banks have to pull back on their repo financing ahead of quarterly liquidity requirements and other regulations. But far, far fewer people had expected it to happen at this sort of random juncture in time, this slightly random week in September. So again, it was really unusual. It spooked quite a few people.

and everyone immediately said, we must speak to Zolt and Posar. Absolutely. And it's important to remember, too, that when people see this stuff, everyone has sort of still, after all these years post-crisis PTSD, and you look at bank overnight funding costs and they're soaring from 2% to 10% in a day. And of course, a big debate immediately broke out. is this something strictly about financial market plumbing, or is there something deeper and more systemic at play that sort of speaks to some inherent frailty of the financial system? And obviously, things have quieted down quite a bit since then, but nonetheless, I think, you know, people are still unsettled and no one really knows what the ultimate fix is going to be. The Fed is applied temporary fixes greater expanding its supply.

of reserves or overnight operations to satisfy the bank demand for this short-term liquidity. But no one really knows where this is ultimately headed, it seems. Right. So I'd say it's actually debatable whether or not things have calmed down in the repo market. But why don't we just jump straight into the discussion with Zoltan? And we'll be able to get into all of these really, really interesting and fascinating questions. So Zoltan Pozar, thank you so much. for coming on yet again. Very nice to be here.

So let's start off with that week in September. Presumably you're sat in Credit Suisse, maybe, watching overnight market rates as you do. What are you thinking when you start to see the repo rate jump like it did? Well, actually, I wasn't in Credit Suisse the day of this happening. I was actually traveling down to D.C. to see some clients with one of our sales guys. and, you know, we saw the markets open up and we're chatting in a cafe cars and, okay, well, Monday wasn't good. Tuesdays shaping up to be worse. And I'm not kidding, five minutes into that train ride, the train broke down. And we were basically told to have to get off the train and there's going to be another train coming. You had to call the client that's sort, but the train is running late. And then the Fed announced the repo operations. But then the Fed was late with the first operation due to detect. technical glitches. And I looked at Phil, the sales guy, and I told him, look, I mean, the country is funding itself overnight in the repo market. The trains don't run. And the Fentcad can do an operation on times. It has to be a joke of some sorts. But the September blowout was, you know, took many people by surprise. I think a lot of people focus on what happened and they kind of look for the trigger that triggered it on that day. And I think that

that's actually the wrong question and the wrong thing to focus on. The September blowout in the repo market was a long time in the making. What it had to do with is basically taper. And taper was just very slow burning process where, you know, the Fed took more and more reserves out of the system. Right. And when the system ran out of liquidity, which in this specific case means, you know, reserves that the system can settle with.

Right. You know, the moment you ran out of those reserves, the repo market seized up. So this was basically a $600 billion process, which is how much the Fed tapered. The one thing that was very important to watch is basically look at who are the most reserves rich banks. Right. How much reserves they have lost as the Fed was tapering the balance sheet. And what is the body language of bank CEOs and bank CFOs? when you listen to them during earnings calls

as to what is the minimum number of reserves that they need to hold from a business perspective. You know, the largest bank that held the most amount of reserves, JPMorgan, during the staper process, has gone from having $350 billion of reserves at the Fed to $120 billion as of the end of the second quarter of this year. And so when you saw that number, you knew that the bank that was always the lender

of next to less resorts in the repo, market basically ran out of money. So let's back up just for people that maybe aren't as familiar with some of the terminology or even the structure of the banking system and the hopes that they can understand this topic. When you or I have our money held at a bank, we have a deposit. The reserves are essentially where banks deposit their money at the Fed. And there's a fixed amount of reserves available. And that greatly expanded during the financial crisis. thanks to quantitative easing, essentially the Fed going out and buying safe assets like treasuries or mortgage-backed securities with reserves. And then it is starting to shrink them

as part of the taper process. And essentially what happened or what's going on is the shrinking of the balance sheet collided with regulatory requirements on banks to hold a certain amount of reserves at the Fed. So explain this sort of collision. of arguably different arms of the government imposing different demands on the bank. So let's start with two observations. Number one, you know, the payment system used to be, used to be, it no longer is. It used to be a credit system, which basically means that pre-crisis, you know, when banks make payments between each other, and they transfer money from one bank's reserve account to another bank's reserve account, you know,

it used to be the case that banks could go into a negative balance in their reserve accounts at the Fed. So that's the whole intraday credit provision that the Fed used to provide to the system, which basically ensured that payments between banks never bounce. Okay, if there's not enough money in your reserve account, the Fed is going to put in the right amount of money so that payments can settle. And then that intraday credit provision by the Fed gets pushed into the overnight markets and used to be the overnight Fed funds market, and that's the way the banks settled those claims at night.

post crisis and post-Bazel 3, there is no bank that is ever going to use intraday credit from the Fed because if you were to use intraday credit, it means that you are in severe breach of your liquidity coverage ratio, all your interdict liquidity requirements and all that stuff. So quite literally, post-Bazel 3, this system settles with the amount of reserves that are in the system. So there's nobody who's taking cash from the Fed on the market. margin. Then you look at the amount of reserves that are in the system, the distribution of those reserves is not equal. Some banks hold more. Some banks hold less. But basically, the banks that

have the abundance of reserves, the reserves rich banks, they are the ones that are lending into the system's settlement process on the margin. So in English, you went from the Fed adding liquidity into the system on the margin so that payments can settle to and this is no secret, because I've been writing about this all the time, to JPMorgan basically using its HBLA portfolio to take their access liquidity. That's high quality liquid assets.

High quality liquid assets. Again, most of which two years ago was reserves, taking that money and lending it into the repo market or whichever corner of the funding market such that payments can happen. Okay. So basically you went from the Fed providing equity in the system

to JPMorgan, and other reserve rich banks, but again, J.B. Morgan is the largest example, providing intradate credit in the system on the margin. So what has happened is that as you tapered the balance sheet, you basically took reserves away from the system. Quite literally, you basically forced these large reserves rich banks to trade out of reserves. There's collateral coming in, cash being taken out. On top of it, the Fed is basically cutting the interest on reserves rate trying to encourage all these reserves rich banks to let go of their reserves and reversing more collateral by treasuries.

And by that process, they are forcing a redistribution of reserves across the system. But as they were forcing that change, they basically flatten the distribution of reserves. They basically forced the large bank to spend their reserves such that repo trades normal on any given day. But then basically the flip side of that was that they exposed the system to very bad days in the repo market on tough days when a lot of money has to move. We'll come back to that in a second, then on quarter ends and on year ends. So a lot of people, just on the reserve point then, Sultan, a lot of people have been debating the language around this. Is it a scarcity of bank reserves or a shortage? And why does the difference between the two actually?

matter. I don't think there's a difference. I mean, it's a shortage. Basically, what I'm saying is that that the system ran out of tokens to settle with, right? Because again, back to the earlier point, the Fed was always ready in the past to add reserves into the system on the margin intradate as needed. Okay? So it was never possible to run out of reserves. But in this regime where the Fed had X amount of reserves in the system and nobody is going to take credit from the Fed, you literally, the system literally settles with the amount of reserves that are in the system. So if the bank that has the access and is lending into the system on the margin runs out of that money, runs out of reserves, the system literally seizes up because you run out of tokens. What was the regulatory logic,

as you mentioned, the Basel three requirements? What is the regulatory logic of no longer wanting the banks to be able to essentially have overdraft capabilities or use overdraft capabilities? Or use overdraft capabilities at the Fed. I don't think that there is a piece of regulation that says, you know, don't take it, or the Fed never said that I will never give it. I think it's just, you know, if every bank has to, like the LCR, for example, a liquidity coverage ratio tells that every bank has to pre-fund 30 days worth of outflows. Okay, so every bank is going to be 30 days pre-funded.

Okay, so no one is going to be in the funding markets. to kind of get the liquidity to be able to settle. Okay? And this is actually a very important question you're asking, right? So the banks don't have a liquidity problem here, right? All that has happened is that,

you know, the banks have been the marginal lenders into the repo market. So the entities that ended up with a liquidity problem were the dealers, but basically for the past year, it were the banks that were the marginal lenders in the repo market. But the banks are only going to lend

into the repo market on the margin until they reach a limit in terms of how much reserves they have to hold at the Fed and below which they are unwilling to go. So this was basically a liquidity problem for the dealer community. And the problem at a higher level was that the banks, despite having the liquidity, were unable to lend more into the repo market because if they were to be lending more, they would breach their intraday liquidity requirements. it's just one of those unintended consequences where it's just one of the unintended consequences of the rules where everybody basically wants to show you know how much liquidity they have to the Fed and they are unwilling to go below that because then there is regulatory scrutiny to pay.

So just to step back for a second because this question comes up quite a lot. But if you're not in the money markets sort of in the weeds of a lot of this, why should you care about why? what happened to the repo market in September. And I mentioned, you know, for instance, the effective federal funds rate getting pulled up along with repo rates. Is that the big sort of takeaway from this, that the Fed sort of briefly lost control of money market rates or monetary policy or however you want to put it? I don't know. I think it's, I think it's something far bigger. So why does this matter? It's an overnight trade. I tweeted, by the way, I said, What should we ask as Zoltan?

This was by far the most common question. It's like, it's interesting, but why should we care? So repo is how you get to live to fight another day. Okay. So that's not my meme that's, you know, coming from Perry Merling. Yeah. But again, repo is how you get to live to fight another day. It's very important.

What that means is you go to the overnight repo market because you run out of money. You can't make payments today. payments that are due today. So on the margin, you go and try to get some money so that you can make a payment today and you pay that money back tomorrow to someone. If you can't borrow in the repo markets and you can't get the cash to make your payments today,

you're not going to open up tomorrow. Okay, so if you are an RV fund that needs to roll funding on its position, if you are a primary dealer and you can't fund to roll your position, and top up your clearing account at your clearing bank, if you're a small dealer that can't fund, you're out of business tomorrow.

So that is why you basically care about this stuff. You know, it's like when you look at an electrocardiogram and the heart ticks, you know, it ticks, ticks, ticks, and it doesn't tick, and it starts to beep. So it's something like that. It either ticks or it doesn't tick. So it's existential. You know, when you see these rates at 10%,

it means that people are having a hard time getting the money to make payments. U.S. Treasury is having a hard time pumping treasuries into the system on settlement days. You know, the money is not moving to the Treasury General account because people are not willing to part with their money. In this case, the large banks run out of reserves. So the money ain't going to the U.S. Treasury. So quite frankly, you know, if you need to pay unemployment insurance benefits and food stamps

and all that stuff, the funding of that process gets gummed up. So this is, this is serious stuff. And the reason why the Fed responds to these things quickly, I mean, they could have responded quicker, but the reason why they respond to it quickly is because, you know, they just recognize the nature of these overnight markets where the money doesn't flow. People can't pay and people can't pay. They go out of business. Headlines can happen, right?

You know, the good thing was that, you know, this dislocation didn't last for more than a day. If these dislocations go on for two days, three days a week, it can turn into an existential problem for a lot of people. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. So another thing that I've been wondering, just on the idea of the Fed having to come in and sort of swoop in and fix this problem as soon as possible, although as you point out, it could have been faster and they did have technical difficulties when they first tried to do it. How much of the confusion or the fact that repo rates actually got to 10%, how much of that do you think had to do with Simon Potter having recently left the New York Fed? Oh, and also, actually, I've always wondered this, but do you ever talk to the Fed about these issues? Do they, you know, talk to you about your thoughts on this? Before the record, in five years, I've seen them once. Two years ago it was.

And the other question, I don't think so. I think, again, it's, you know, I guess the message would be that, you know, taper, I guess, was a mistake. So the difference between the repo market printing normally, like it has been for the past five years, versus the repo market falling apart on December 31st of last year, early September this year, is basically those $600 billion of reserves that were taken out of the system by Taper. So if you look at the usage of the reverse repo facility, the other repo facility, right? you know, that's the facility where money goes when that money is not needed because there's not enough collateral, people don't have the balance sheet, there's not enough arbitrage

opportunities, so nobody takes the money from the money funds and then the money funds put it at the Fed and then money goes there to die. It's very important to kind of realize that taper started when the usage of that facility was zero. That means that, you know, lazy cash in the system was already gone when Taper started. So all these, you know, taper and increase in Treasury's cash balances, the increase in the foreign repo pool was basically taking money out of bank HQLA portfolios, as your liquidity portfolies of the banks. And it was taking reserves out of the portfolios of JPMorgan and all the other large American banks. So basically, you know, in English, that means that taper was taking the liquidity buffer.

away from the system that basically ensured that these large banks have the extra cash to lend into periodic dislocations in the repo market and in the FX swap market and all sorts of other markets. So the fact that we engineered tapered and we tapered as much as fast as we did without the safety valve built into the process where if, God forbid, we take out too much reserves, we should have a facility to kind of put as much liquidity back into the system as needed, right, and let the usage of that facility speak loud that taper should stop. We didn't do that. So back to your other question,

I think the problem is that we tapered this much, this fast. So it was kind of a architectural mistake. So personnel changes, I would say, have nothing to do with, you know, the blowout and the response to that blowout the day of, I think it has to do more with why did we end up in this position in the first place? And by the way, when you listen to the Fed throughout the whole taper episode, you know, when you read those speeches, the indicators that the Fed was looking at to see if things are getting tight or if we should stop taper were the wrong things to look

at. The Fed was looking for banks use of intraday credit for signs of stress to show us. You know, earlier in the conversation, we said that there's no bank that is ever going to use intraday credit from the Fed post-Bazal tree because it's not worth the reputational risk. Nobody wants to be the first one to use it. Nobody wants to be the first one to max out the lines. And if people were to use it, you know, no one's going to be willing to kind of let those things faster and be rolled into the discount window. So basically, I think you had the wrong things they were looking at.

And they tapered way too much, way too fast, and they put the system into a precarious position. And again, the conditions for what happened in the repo market in September were building over time as they were shrinking the balance sheet. So it's almost like a wildfire where you have all these dry leaves accumulate and then something bad happens. And then a wildfire gets really bad because the dry leaves accumulated over the time. You mentioned something there that speaks to the last time you appeared on our show, and that relates to the role of a foreign participants in the market. We just did an episode actually with Brad Setser in which we talked about Taiwanese life insurers and their thirst for dollar denominated assets. I think it was what we talked about. I think it was back in April or May was the last time we talked to you.

And it was kind of about this topic and that as rates on. dollar denominated assets, particularly treasuries were coming down. There was less appeal to hold U.S. government debt and that it made more sense for foreign buyers to essentially just have money at the Federal Reserve, leaving all these treasuries on the dealer balance sheets. Talk to us about this aspect of the repo crunch. How much of it is essentially a result of what you were talking about when we talked to you in the spring about the fact that normally these foreign buyers would be in the government bond market, but when rates got too low, it just didn't make any sense. So I want to just hold the money right at the Fed, exacerbating the reserve shortage. Yeah, so, you know, rate gets too low and the other important thing is that the curve inverted, right? So that's what we talked about last time.

It has a lot to do with it, right? Because if you think about what the world used to look like two, three years ago when Japan and Taiwan and all those Asian accounts were buying more, I mean, they are still buying, but not as much and definitely not enough relative to supply. The theme in the money markets back then was that Asia is buying, they have to hedge it back to yen and, you know, to euros and other currencies. And they typically do the three-month points. So, you know, buy a 10-year treasury, you hedge it back and roll those hedges every three months. So that's a pressure on three-month funding costs. Now, LIBOR widened 60 basis points around money fund reform, which also coincided with that time in markets. Cross-currency basis between yen and dollars widened as much as 100 basis points.

and very interestingly, the Fed didn't care one bit about the so-called oise-oice basis blowing out to 100 basis points between yen and dollars. I mean, English, but that means basically that parity between term funding onshore and term dollar funding in Tokyo completely broke down. you know, so people in Tokyo were paying 100 basis points over for dollars at the three-month point, then people onshore here in New York. That was kind of a big deal, but you had no speeches about it, no blogs, no papers, no nothing. You know, when three-month funding costs are stressed in the FX swap market, right,

as a dealer, you can lend into that demand by borrowing in, at the three-month point also in the FX swap market, in its unsecured market. security markets, or you can borrow not at the three-month point, but at the one-month point, the one-week point, the overnight point. So the point here is that, you know, the dominant bit for funding is at the three-month point. The funding of that borrowing need can be distributed along a three-month stretch in money markets, going from overnights to three-months. So overnight markets are going to kind of feel this stuff, but only a part of it, a little part of it. When the curve gets inverted, okay?

And as we discussed last time, all the carry traders get knocked away on the margin. So the foreign hedge buyer is not buying as much. The foreign banks are not buying as much. The RV hedge funds can't buy as much. There's one group of entities that has to buy by law. Those are the primary dealers. So the dealers started to back up with inventory. But the dealers are in a moving business.

They are not in a carry business. So a dealer is never going to term fund its inventory. They tend to fund it overnight and roll it. overnight. And here's the important point. When a dealer is the marginal buyer of treasuries and they fund things overnight, the only way you can fund that overnight funding demand is overnight. You can't go anywhere. I mean, you're not going to, you know, fund an overnight funding demand with like the three-month point because, you know, if the fat cuts, then you're in a bad position. So everything over the past year in fixed income markets, in money markets, was funded

at the overnight point. And that's a dangerous situation. because if the money doesn't come in, but it goes out, maybe because there's a large settlement day, maybe because there's a tax payment day. Once the money goes away, you literally hit an air pocket. And if there is no one to lend into that air pocket, you have a problem.

And the Fed cares deeply about our overnight rate sprint. So the overnight rates breaking down and those spreads widening out massively is a far bigger deal than three-month cross-current basis blowing out to 100 basis points. You know, the inversion dealer is becoming the last bid for treasuries, everything happening overnight, which is the Fed's sensitive point, has a lot to do with everything that happened. There's quite a lot of irony in this when you think about a lot of those post-crisis liquidity rules were basically aimed at taking, at improving fragilities in the repo market, right? and strengthening the overnight funding market,

and instead you seem to have ended up with a slightly opposite situation? Well, you ended up with a slightly opposite situation because I think the other important thing that people tend to overlook is that the repo market has grown tremendously this year. Is that because of treasury issuance or something else? Well, partly treasury issuance, but also the growth of sponsored repo. Right.

Sponsored repo, for those who don't live in the front end, is basically a new... Including me. I don't know it. Okay, so let's educate Joe a little bit here. Thank you. So sponsored repo is a new way of doing repo in that... Okay, so there's basically three banks for now that have the ability to do sponsored repo. These are State Street, Boney, and JPMorgan.

Sponsored repo, the idea is basically to let well-capitalized member banks. There's not dealers for now, banks of FICC. to sponsor in money funds and sponsoring hedge funds into the repo market such that when you sponsor these entities in and you let them face off against each other through a matched book

that you provide, you can net these positions so they don't use balance sheet. Okay, so this is basically a way for the system to provide more balance sheet and more liquidity into the repo market that are using balance sheet.

because balance sheet constraints is one of those things that Basel 3 is constraining. So all this Treasury collateral coming into the system has, for the most part, been funded in the sponsored repo market. Sponsored repo at the moment is only available on an overnight basis. So if you were an RV fund or if you were whoever and you needed balance sheet in the repo market, the relative value fund, right? And if you needed balance it in the repo market, it was only available to you overnight because term trades are not available in the sponsored repo space just yet. You know, in addition to the things we discussed before that dealers got backed up with the paper, they had to fund it overnight. It was also the case that the relative value hedge funds and whoever, you know, uses repo to fund treasuries could only do that overnight.

So this kind of new piece of the market sponsored repo, which has grown to something like $300 billion in size, also was a part of priming the system for a accident. Because, again, if the money doesn't come in, because it has to go someplace sales, then basically a lot of long positions that are funded overnight can't get rolled. and that's precisely how you can end up with repo rates going from normal to 10% the next day. I want to get soon to the sort of how ultimately the Fed fixes this structural plumbing, what have you, issue. But before we do, I just want to go back to one key question that I recall coming up in the immediate wake of the repo madness. The big banks like J.P. Morgan, did they still have, technically speaking, excess risk? reserves beyond their liquidity requirements? The banks had reserves, but those reserves were by no means access.

And this is what people tend to get lost on, right? So it is perfectly possible for the largest U.S. banks to sit on 100 plus billion dollars of reserves in their reserve accounts. And it's perfectly understandable why they don't lend those reserves, right? Because they need those reserves to satisfy those reserves. their intraday liquidity requirements. They need those reserves to be able to pass their resolution stress tests, things like that. Okay. So again, when you go to a bank that had 300 billion two years ago down to 100 and it wouldn't

lend more in the repo market, the 200 billion was the excess and all of that was spent and whatever is left is not there to be played with. You know, if you think about these reserves as high-powered money, that 100 billion that's there, that ain't high-powered money. That's dry powder that has to sit there and you can't use it. You know, the two weeks before the repo blowout, I've seen, I mean, they are all clients of credits with the bank portfolios. I've seen four of the largest bank portfolios. And you talk to the CIOs that run these portfolios, they will tell you that I would like to earn more with my cash. I would like to harvest the yields in treasury markets. I would like to harvest the yields in treasury markets. I would

like to harvest, you know, yields in the G.C. market, but I can't. And currently I'm making uneconomic decisions with my reserves because I need to hold those for regulatory purposes. So that is basically the environment in which we are getting closer to this repo blowout. A lot of people, you know, point their fingers at the bank saying, you know, they were the ones who caused it because they have so much at the Fed. Why didn't they lend more? There's nothing that a bank would like to do more than to earn a 10% yield by moving all their cash into an overnight market and get that money back tomorrow and make 10%. So the fact that you have these yields has to do with just bank's inability to lend, not their billing less to land.

Right. So this is sort of what I was getting at with these scarcity versus shortage of reserves earlier. There's this big arbitrage available in the market, free money basically, but the banks can't come in and do it. So just getting to solutions to this problem, we've seen the Fed increase overnight liquidity operations and also announce that I think it's going to buy up to six. Was it 60 billion of T bills? Or did they increase it recently?

60 billion a month, yeah. 60 billion a month of T bills. And yet there have been a couple of times this month where we have seen repo rates start to creepier. up again. And we've seen some analysts at the sell side, J.P. Morgan, Goldman Sachs, and Bank of America, Merrill Lynch, also saying that they think the Fed hasn't done enough to solve the market problem. So what exactly is it that the Fed needs to do and how big of a sort of problem in the repo market remains? So I agree with the strategists at JP Morgan and Bank of America. I think as well

that the Fed has not done enough. What we have is good for now, but it's not a structural fix. You know, there's a big difference between, you know, a liquidity problem and a liquidity problem and a balance sheet problem. Okay, so, you know, in September,

we had a liquidity problem because the system ran out of reserves, you know, the tokens you settle with it. So the only thing the Fed had to do is just pump in reserves on the margin. You know, the big, event that's coming up is the year-end turn. And during year-end, no one is going to have the balance sheet to move money around. So, you know, what I'm trying to say with that is, you know,

it's okay that the Fed has a repo facility. And for as long as there are primary dealers that are willing to take liquidity from that facility and broadcast that liquidity to the rest of the system, to the hedge funds and little dealers and whoever needs that money, the facility works. but once the primary dealers have a balance sheet constraint and they won't be the intermediary between the Fed and the rest of the system, it doesn't matter how much the Fed wants to put liquidity into the system with that repo facility.

There is not going to be a mechanism through which they can inject that liquidity into the system. So like a very weird analogy here would be that if I'd like to play tennis, but I don't have membership at the country club, you do Joe yeah um you know I can go in with you it'd be the exact opposite in real life but well right but if you're out taking a hike there's no tennis for me because my friend who's right membership to the country club you know cannot get me in so you basically need someone to hold

your hand to get that liquidity and during year end no one has the balance sheet and no one has the the ability to be you know to be the good samaritan who's going to take the liquidity from the fed and give it to you. So again, we've hit on this, but just to make it clear, you know, quarter end, year end are important because a regulator, there's a snapshot taken of the bank's financials, and it's literally on that day that the regulators take a look at the books and everyone, it's like kind of cleaning your room before your parents get home and something like that. So what is the solution then such that we can avoid having these problems pop up, every time that the parents come home to check out whether the room is cleaned.

And do you expect that in the absence of something new, we are going to see something dramatic again reappear on the market over the next, you know, as we get close to your end? Yeah. So there's a couple of things. Let's talk about repo first and then make sure to the bill purchases. You know, fundamentally the issue is that the repo operations that the Fed is doing, in technical lingo, it's done on a tri-party basis. So it cannot be netted. So that's how you get to the balance of problems. People say that the Fed should turn this repo facility into a,

I mean, it's a standing repo facility effectively anyway, but I think what they really mean is that they need to make, the Fed needs to make this repo facility netable. I think that that will never happen. It will never happen because the Fed, just by its DNA, they like to be super senior in their dealings. And there is no way that the Fed is ever going to lend into FICC, the fixed income clearing corporation.

You know, A, they are not going to lend into the clearing house and be a peri-pasoo lender alongside everyone else. It's just not the way they do things. Two, if they were to do things in a super senior way, they would basically upset everyone in the clearinghouse because everybody just got subordinated to the largest lender in the clearing house. So I think it's either the Fed who's not going to do it because they're not comfortable with it or they will do it in a way, which is just going to set the stage for a massive coordination problem

and, you know, just upsetting the governance of the fixed income clearing corporation, which again is the central clearinghouse for repo transactions. Not to mention other things like, you know, with this growth of sponsored repo, there is now, as we speak, about 25 hedge funds that now have access to FICC. So are we really going to go into a regime where hedge funds can put collateral into the clearinghouse, and the Fed effectively on the margin is going to fund all that, so probably not. I don't think that we should go down that path. So that's what thing that, one thing they could do, but they will never do, really.

The second thing they could do is to open up this facility for banks as well as dealers. So this is a very important distinction. At the moment. So non-primary dealers? Well, no. So at the moment, it's the primary dealers. that have access to this facility, but the banks do not.

Okay, so just to give you a concrete example, let's say JPMorgan Securities as a primary dealer, has access to the repo facility, JP Morgan Chase Bank, N.A., the depository does not. So now if you go back to the earlier conversation we had, dealers got backed up with treasuries, they needed to get that funding in the repo market,

and the banks, the bank portfolios were the marginal lenders in the repo. market. Okay. So and the reason why the money dried up in the repo market on the margin is because the banks hit their lowest level of reserves they need to hold. So they stopped lending despite the fact that they have all those reserves. You just can't go below it because it would be breaching your regulations. So what you could do is you could open up this facility for banks and the chief regulator, who's rental quarrels in the Fed, would have to give a speech saying, we are fine with large banks to have all bonds HQLA portfolios.

This, you know, $100 odd billion that is sitting at each of the large bank's HQLA portfolio can be spent to the last penny. It's okay for these largest banks to have bonds only in their HQLA portfolio because the Fed stands ready with a repo facility to turn those bonds into cash when interday liquidity needs arise and if there is a resolution scenario where the bank has to be wound down and we will take those treasuries,

give money in return, and let that money pay out its creditors and wind down in an orderly fashion. If that speech were to happen and if that changed to the philosophy with which the regulator would like to see the banks run their liquidity portfolio happens and the banks get access to the repo facility,

then you basically free up easily five to six hundred billion dollars of reserves, and that's five to six hundred billion dollars of extra money that can go into the treasury market and it can go into the repo market. Is that going to happen? Probably not, because you are not going to change the philosophy with which you run these liquidity portfolios just to get through this year and turn. That's coming up. A third thing you could do is you could put a footnote on the repo facility page of the New York Fed's website. saying year end is shaping up to be a very bad event,

let's just be clear that whatever money you will take from this facility going into that turn is going to be netable. So from a regulatory perspective, you're just not going to have to count that in your leverage ratio and all these things. So, you know, if I'm a dealer and I go to this facility, I take $50 billion and I pass it on. I mean, the Fed knows exactly how much I took

and it knows exactly how much balance you to ignore from my calculation. is that going to happen? I don't know. I mean, a couple of the dealers that are primary dealers run their repo books out of branches. Those branches roll up to the holding company in their respective countries for reporting purposes. So can the Fed guarantee that the French regulator and the Japanese regulator is going to have the same view on what's netable and what's netable? I don't know. So I think it's kind of a coordination problem.

So I don't think that any of those things will happen. And if none of these things happen, you basically set. at the stage for something quite ugly happening around the year and turn because it's not going to be just a liquidity problem, right? The people are not going to have the balance sheet to take the liquidity that the Fed is trying to put into the system. And the market can really get seized up. So if you thought September was bad.

Oh, man. December can get even worse. But then again, you know, you see headlines. Treasury Secretary is looking into ways of dealing with some of the regs and maybe some changes coming from the regulatory side, you just don't know. So if something big is going to come, then the year end is less of an issue. If none of those things will come year end is an issue. Right. So you can imagine that any tweaking of the existing regulation, like there's an optics problem there, which is that a bunch of people will say that you're basically rolling back bank

regulation. And in fact, we've seen, you know, people like Elizabeth Warren actually start talking about repo markets and what Jamie Diamond over at JPMorgan was saying. I have one more question and you sort of alluded to it just then, but we've been talking about the repo market sort of in isolation, although as you say, it is a very, very big deal for markets overall. But is there a specific scenario in which a gumming up in repo, another bout of repo madness, maybe one that's worse at the year end, is there a scenario in which that is, a scenario in which that impacts risk asset exposure at the primary dealers or the banks or big market participants as well. Oh, definitely. Definitely. In fact, in fact, you've seen a micro tremor in September.

And, you know, it's hard to see it. But, you know, if you talk to the equity desk at a dealer, they will tell you that this happened. So what happened in September when repo blew out, the equities that the street was, the most long in sold off and the equities that the street was most short in rallied. So what that tells you is that the balance sheet that the equity derivatives desks and, you know, cash equity desks are providing to the streets, the longs were trimmed because there was no balance sheet for them and the shorts were trimmed because there was no balance sheet for them, right? So that's what caused those moves. And what happened was that, you know, at some dealers, and it's not all dealers broke like this,

but there are some dealers where equity derivatives and FX forwards and repo basically rolls up to a single person. So you shift equity across these businesses based on where the spreads are the richest. So in September, when repo blew out, there were some dealers that took balance sheet away from equity derivatives and the FX desk and moved it to the repo desk because you wanted to harvest those widespread to the extent possible.

And as you moves that equity, as you moved that equity and you took balance sheet from equities away, there was an impact on equity markets. The reason why this didn't get out of hand and it didn't start to impact more names and didn't last for longer is because the Fed stepped in, started to lend in the repo market and the repo market calmed down. So whatever equity you shifted there, went back to the equity desk. So again, if this thing persists, and this is just a spillover into risk assets, but if this thing persists, remember that repo is how you get to live to fight another day. If you have to fund at 10% for a day, another day, and a third day, it can become existential to the point where you end up

with headlines and newspapers, you know, front page. So that can also spill over into risk assets. So I think there is a very real chance that if we don't have a better set of pipes from the Fed and a more aggressive QE than you have a very, very problematic here in turn. You just opened up the, and we don't have time to go there because you just opened up the most controversial Pandora's box of whether this should even count is whether this is QE or not QE,

and I feel like we could do a whole separate discussion on that. Unfortunately, I don't think we have the time, but I think that was a great, leaving us with that potentially gloomy note of maybe a bigger repo madness coming in December and one that potentially spills over into risk assets, something to, I wouldn't exactly say look forward to, but something for everyone to pay attention to. And I think after this discussion, hopefully people have a much deeper understanding of what's

really going on. So Zoltan is so great to talk to you. Thanks for coming out. Thank you very much. Thank you. That was so good. Joe, you know what I love about that conversation is that Zoltan sort of brings these big picture theoretical approaches to everything that we've just seen in the repo market. But he also gives you the sort of technical behind the scenes look with what is actually happening at some of these desks and the primary dealers. So I really like that.

No, I think this is incredibly important. And it's kind of touched on what we talked about last time, but in a more specific way that it's easy to say look at some charts and say, oh, this bank should have excess reserves and this is just a plumbing issue and so forth. But then you get into these very specific scenarios in which people who are running portfolios or people who have to figure out how they're going to provision their own liquidity may move money or may decide to move money from one activity to another. And it's very real world. It's not just a series of sales on a spreadsheet that should behave in some predictable pattern. Right. Well, I also think, you know, people hear money markets and repo madness and they think this was a really technical issue in the plumbing of the financial system, as people always put it. But actually, a lot of it is behavioral sort of on both sides.

So you have people who, for instance, don't want to access the discount window because it seemed to be a bad thing post-crisis. And then on the regulatory and political side, you have people who probably are unwilling to really tackle this issue. because of the optics involved, right? You don't want to be seen to be bailing out banks or rolling back financial regulation, even though, you know, logically, there seems to be something slightly off with the system. Or even as he described the Fed's own posture of not wanting to be subordinate or other entities that want to lend into this market, not wanting to compete with the Federal Reserve, all kinds of questions that, again, on paper or on Twitter, someone might be able to, oh, the Fed just needs to do X, set up a standing repo facility. Why haven't they done that already? I thought I learned a lot from that conversation about why it's not quite so simple as just setting up a new desk where anyone can swap treasuries for reserves and have the liquidity they need for regulators.

Yes, indeed. And now, of course, we'll all be watching out for what happens at the year end if we weren't doing so already. so we'll have to have Zoltan back on in the new year or two. Yeah. I actually thought that wasn't. I thought I was like, oh, okay, they're never going to let this happen again because we saw this. We know that the urine is already stressful.

So I'm a little disconcerted about how concerned Zoltan is for the year. And one other point that I really liked, and I think it's to get the language across here. And this idea, and he used the term several times tokens to describe reserves. And it's a good reminder that money, while they may, you know, there are many different forms of the dollar and they basically trade it one to one all the time. They're not completely fungible. And so you think about a casino, and you have a dollar and you have a one dollar token or a token worth one dollar. And in theory, you know, they're pegged perfectly and they always trade, but it doesn't mean you can't have an

issue or that the poker players who want to leave wouldn't be really upset if there were some issue with just the mechanics of the conversion. Even if, say, the casino owner had plenty of money and they could make good for everyone, you could get these sort of very technical, angry situation, stressful moments if there were a token shortage or something else. And that really sort of speaks to the issue that there are all these different forms of the dollar. But if there's a shortage of one, you could still have, or if there's a temporary shortage in the provision of one, you could still have these issues. So I think the language he used there is. extremely helpful in that understanding. Yeah, it's sort of like, I guess, liquidity, liquidity everywhere,

but not a drop-to-drink kind of thing, right? The system's awash in liquidity, but that doesn't necessarily mean that you can move it from one entity to the other. So if you have, if your regulator wants you to have one very specific type of liquidity, because again, Treasury bills, three months are among the most liquid, safest, most valuable assets in the world. And if even they're not good enough under certain sort of regulatory demands, you get these bizarre situations in which highly liquid, well-capitalized banks could still find themselves with some sort of shortfall. Yes, indeed. All right. Again, something for us to watch out for going into the year-end. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter

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