MNI EXCLUSIVE: Ex-Fed Staffers Point To Missing Repo Arbitrage

By Jean Yung

     WASHINGTON (MNI) - The reluctance of large U.S. banks to engage in

old-fashioned rate arbitrage may have contributed to last month's surge in

overnight money market costs, former senior New York Fed officials told MNI.

     Higher regulatory standards and the introduction of the leverage ratio in

particular have made it more burdensome for the largest banks to buy and sell

repos in response to changes in funding conditions. When repo rates spiked

several percentage points above fed funds last month, arbitrage trades common

more than a decade ago that would have helped bring markets back in line were

noticeably absent, former Fed open market desk senior manager Trish Mosser said

in an interview.

     "There was money on the floor that no one picked up. The question is why,"

Mosser said. "It's not just that it's more expensive for the largest global

dealer banks to arbitrage and to shift their repo books. The fact is nobody has

been doing serious arbitrage in money markets for 12 years."

     --REGULATORY 'WEDGE'

     Prior to the financial crisis, money markets regularly experienced

technically-driven funding squeezes. The Fed frequently responded by injecting

liquidity and arbitrage would kick in so other short-term rates would converge

to the Fed's benchmark fed funds rate, Mosser said.

     But changes in banking regulation and market practices have resulted in

higher capital charges, costs of funds and vastly different risk management

parameters for trading desks.

     Systemically-important banks now hold an enormous portion of high-quality

liquid assets in the form of cash reserves in order to meet margin calls on

derivatives positions, make intraday payments and comply with liquidity coverage

ratio regulations. LCR requires each bank to hold enough liquid assets to cover

its cash needs for a month in a crisis.

     Todd Keister of Rutgers University, a former New York Fed economist,

pointed out in a 2017 research paper that not only does LCR raise the average

level of demand for liquid assets, including reserves, but the way the

requirement is structured can prompt huge swings in aggregate demand for

reserves when some banks get too close to the ratio's limits.

     "Liquidity regulations have made money market arbitrage more costly, and

that has the potential to drive a wedge in monetary policy transmission,"

Keister said. "So it's not that the regulations caused the problem. But they

prevented what normally would have solved the problem."

     --FED'S ROLE

     Fed Chair Jay Powell last month indicated the central bank may need to

resume asset purchases sooner than expected, if its market experts conclude that

reserves have become too scarce. Banks currently hold $1.4 trillion in cash

reserves at the Fed, down from a peak of $2.8 trillion in 2014.

     But Keister suspects that reserves aren't the only problem and policymakers

need to address a scarcity of regulatory liquidity.

     "My reading is banks are close to their internal liquidity buffers," he

said. "Even though there are plenty of reserves out there, they're held by

institutions that are not well situated to lend in repo."

     One proposed solution, the creation of a standing facility to accept

Treasuries for cash, could by its mere existence ameliorate some of the symptoms

of the repo crisis, Keister said. "Banks might be willing to operate with

smaller internal buffers, knowing the repo facility is there."

     Another option would be to set up term lending operations to banks that

would put them in a better liquidity position to take advantage of lending to

repo markets, he said.

     On the other hand, less action from the Fed could prompt banks to revive

the kinds of money market arbitrage trades that could benefit market liquidity

over the long term.

     "There are tradeoffs. The more the Fed intervenes to ease the short-term

pain, the more it undermines the incentive for people to be ready to do this

arbitrage in the future," Keister said.

     "It's been so long since money markets have had any volatility at all. A

little bit of turmoil that incentivizes people to do arbitrage again may not be

such a bad long-term outcome," Mosser said.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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