MNI EXCLUSIVE: Debate On Fed Standing Repo Facility To Return

The Federal Reserve will need to revive its debate over the creation of a standing repo facility as a permanent source of alternative funding for dealers under stress to avert any repetition of the market strain seen in March, former Fed officials, researchers and market sources told MNI.

The tool, which would allow qualified dealers to exchange Treasuries for bank reserves on demand, is one of several proposals for money market reform following the most severe test of the financial system since the collapse of Lehman Brothers. An assessment of the impact of recent regulatory changes on banks, central clearing and margin requirements also require attention if there is to be no repeat of the unprecedented seize-up in the Treasury market, sources said.

As government borrowing soars, vulnerabilities exposed this spring are likely to be tested again and more frequently, with even small shocks requiring heavy Fed intervention, Darrell Duffie, a Stanford University professor and outside adviser to the Fed, told MNI. The Congressional Budget Office estimates the quantity of Treasuries outstanding to jump to USD24 trillion by 2023, from USD20 trillion currently, before soaring to an estimated USD120 trillion by 2050, Duffie said.

"If there was a big, bad macro shock tomorrow," Duffie said, "we would be back where we were in March with an enormous flood in sales of Treasuries and the need for emergency purchases by the Fed."

SAFETY NET

A standing repo facility would formalize temporary repo operations the Fed has been conducting since March and expand dealers' capacity to offer liquidity in times of extreme volatility. Officials debated the idea after the Fed was forced to intervene in September 2019 amid a sudden surge in short-term borrowing costs, but could not agree on the merits of the tool.

"You could make the argument that if it ain't broke, don't fix it, and there are risks to transitioning to a new system. But I think it's broke," former top Fed regulator Pat Parkinson told MNI. "Right now you don't have enough supply of liquidity and you have tremendous demand. Some steps will be taken to limit that demand but I'm not confident that they will be sufficient to avoid a repetition of the events of September and March and the need for the Fed to intervene more extensively and frequently than they have in the past, which I don't think is a good thing for the financial system and not a good thing for the Fed."

"You want to increase capacity of the marketplace, and a standing facility would be a good way of doing that," he said.

The key factors for the Fed are "where they set the rate and who is allowed to participate," former New York Fed research director Jamie McAndrews told MNI. "Who should have access to these public facilities is a big question that should involve Congress," he said.

A new regulatory framework would be needed to address the moral hazard of opening the facility to numerous independent broker-dealers providing liquidity to U.S. fixed income markets but not regulated as banks.

"If the dealers with access to the standing facility were not regulated, access might incent those dealers to hold smaller liquidity buffers than appropriate," Parkinson, now a special adviser at the Bank Policy Institute, said. "But, as in the case of banks and the discount window, if you condition access to the (standing repo) facility on dealers meeting appropriate liquidity regulations, then those concerns can be addressed effectively, and that shouldn't stand in the way of moving forward."

PRICING

Lending through the standing repo facility should be at a penalty rate, not so low that it looks attractive under normal circumstances but also not so high as to be punitive and stigmatizing usage, sources said.

Market participants find the current corridor of repo rates of 0 to 15 bps to be "a very narrow and constrictive range," said Josh Galper, managing principal of securities financing consultancy Finadium. A higher range of 0 to 30 bps or 0 to 50 bps "would allow market participants to price where they think is more accurate, rather than being bound by a tight ceiling provided by the Fed."

"If it's a high enough spread off current repo rates, then if market stress does return the same way, it would simply be known that the Fed will be there to take it up. So rates are not going to get higher," he said.

"The creation of a standing repo facility will solve a host of problems including public perception about what Fed intervention really means."