Fed aims to transform funding markets

A t the highest level, it looks as if the Federal Reserve hasn’t done much of anything for several months. Interest rates remained pinned near zero. Officials insist that any moves higher in inflation are transitory. Asset purchases continue unabated.
However, a significant shift appears to be brewing beneath the surface at the central bank that could drastically reshape a part of critical market plumbing, potentially preventing bouts of illiquidity in the $21.5 trillion Treasury market and altering balance-sheet calculations at the largest US banks.
Minutes of the Federal Open Market Committee’s April meeting, released last week, indicated that a “substantial majority” of officials see the benefits outweighing the costs of installing what’s known as a “standing repo facility,” which would effectively make permanent the emergency measures that the central bank rolled out during periods of turmoil in the funding markets in September 2019 and the onset of the Covid-19 pandemic in March 2020. It’s rare to see such a statement of widespread agreement.
The benefits of the Fed flooding the financial system with cash during moments of stress are fairly straightforward. The option for banks or foreign investors to place US Treasuries with the Fed as collateral and receive funds is far less disruptive than selling them into a market that has few buyers. The promise of such a backstop would make government bonds a true cash equivalent for large banks that are subject to liquidity constraints. Recall that in early March 2020, 30-year Treasury yields fell 85 basis points and then surged 63 basis points in the span of days — the world’s biggest bond market isn’t supposed to trade like that. Investors had to offload their holdings, and dealers weren’t in a strong position to step in and fill the void. The resulting chaos froze many other markets until the Fed stepped in to buy almost everything. A St Louis Fed report from March 2019, before the two high-profile blowups in funding markets, made the case for a standing repo facility. The hypothetical structure features an interest rate that would be higher than the fed funds rate, but only modestly so, such that institutions would flock to the central bank any time repo rates increased too much:
This administered rate could be set a bit above market rates — perhaps several basis points above the top of the federal funds target range — so that the facility is not used every day, but only periodically when a bank needs liquidity or when market repo rates are elevated. With this facility in place, banks should feel comfortable holding Treasuries to help accommodate stress scenarios instead of reserves. The demand for reserves would decline substantially as a result. Ample reserves — and therefore the size of the Fed’s balance sheet — could in fact be much closer to their historical levels.
In theory, a standing repo facility would increase demand for Treasuries from large banks subject to stress tests and other regulations because the Fed would pledge to take them in exchange for cash. In early 2019, the New York Fed found that the following eight banks alone would potentially want to hold $784 billion in precautionary reserves: Bank of America Corp, Bank of New York Mellon Corp, Citigroup Inc, Goldman Sachs Group Inc, JPMorgan Chase & Co, Morgan Stanley, State Street Corp and Wells Fargo & Co.

—Bloomberg