By Ryan Tracy
WASHINGTON--A critical part of the plumbing that keeps money
flowing through the financial system is experiencing turmoil as new
regulations prompt banks to step back from the multitrillion-dollar
"repo" market.
The large and opaque market for repurchase agreements helps keep
finance and trading moving, allowing hedge funds, investment banks
and other financial firms to borrow and lend short-term funds,
often overnight.
But there have been increasing signs of trouble. Big banks,
which act as middlemen between borrowers and lenders, have been
pulling back. In recent weeks, senior bankers have said they are
reluctant to participate in the market because of regulatory
requirements that make repo trading more expensive.
Goldman Sachs Group Inc. reduced its repo activity by about $42
billion in the first six months of this year, citing capital
requirements. Barclays PLC cut back lending through repos and
similar agreements by roughly $25 billion, to $289 billion in the
first half of the year.
Bank of America Corp. and Citigroup Inc. made first-half
reductions in repo lending of about $11.4 billion and about $8
billion, respectively. J.P. Morgan Chase & Co.'s repo lending
stayed roughly flat.
Repos function as short-term loans, which are backed by
collateral, such as a U.S. government bond. Borrowers agree to sell
the bonds to another party for cash, with the promise to repurchase
the bond at a slightly higher price some time in the future.
Borrowers are often hedge funds and lenders are typically
money-market funds. The banks' pullback could make it harder for
hedge funds to borrow, and money-market funds may have fewer places
to invest. Investors generally may find it harder to find a trading
partner for hedges or short sales.
Risks posed by the repo market are the focus of a conference on
Wednesday sponsored by the Federal Reserve Bank of New York.
The diminishing role of banks in repos "could exacerbate swings
in markets when interest rates rise" or other financial turbulence
emerges, said Barclays analyst Joseph Abate.
Regulators say the changes are positive. Before the crisis, many
Wall Street firms relied heavily on repos for cash. But they lost
access to those funds when investors panicked about the value of
mortgage bonds and the solvency of firms like Lehman Brothers
Holdings Inc. that relied on repos for cash.
New rules are "a constraint, but one that facilitates financial
stability in the long run," said Federal Deposit Insurance Corp.
Vice Chairman Thomas Hoenig.
Banks said privately they don't intend to abandon clients in
repo markets. But there are signs their reluctance to facilitate
huge amounts of repo activity is contributing to increased
volatility.
In June, a relatively high number of repo transactions tied to
U.S. Treasurys "failed," or didn't close because one of the parties
didn't provide the bond, according to research firm Wrightson
ICAP.
Though the so-called fail rate was far below crisis levels, the
development raised eyebrows. The Treasury Department asked about
the issue before its quarterly meeting with big Treasury-market
players on Aug. 5, said a person familiar with the matter.
At the meeting inside the Hay Adams Hotel near the White House,
one private-sector adviser told Treasury officials that market
middlemen "have declined in number and capacity, making the system
less able to deal with unexpected volatility," according to meeting
minutes.
Bank pullbacks have shrunk the pool of securities available for
repo trades with U.S. Treasurys as collateral, leading to smaller
transactions. "There is a shortage of collateral," said Joe Lynagh,
who oversees $18 billion in money-market funds at T. Rowe Price.
"Because that trend is continuing, you could see more funds rely
more on the Fed" for investing their cash.
Investors said there is such high demand for certain types of
bonds that some firms are accepting negative interest rates on the
cash they are lending in exchange for the in-demand collateral. As
of Tuesday, the rate to borrow five-year Treasury notes maturing in
2019 in the repo market was minus 0.25 percentage points--in other
words, financial firms were willing to pay bondholders for the
privilege of lending them cash.
Some worry that the Federal Reserve is about to exacerbate the
problems as it pulls back from its bond-buying program. The Fed is
testing a plan to put the brakes on money sloshing around the
financial system by seeking to attract that cash, which otherwise
may have gone into the repo market.
The upheaval may reshape how the financial system's plumbing
functions and is fueling worries about how markets will respond to
the next crisis.
The Fed has expanded its role in the repo market as it tests out
a new monetary-policy tool aimed at controlling short-term interest
rates.
The central bank is sitting on more than $4 trillion in bonds as
part of a program to stimulate the economy and has been testing
borrowing against some of those bonds in return for cash to drain
money from the economy.
The New York Fed's repo-trading desk accepted a daily average of
$121.3 billion of repurchase agreements in July, up from $73
billion in January. Money-market mutual funds have been especially
big players in this "reverse repo" pilot program, giving funds a
safe place to park cash.
Large market participants like money-market funds are
increasingly trading from the Fed, rather than with banks--a move
Fitch Ratings attributes to comfort with the central bank, better
terms and regulatory changes that are altering how financial firms
participate in the market.
There are signs the Fed is growing uncomfortable with its repo
market presence.
At a Senate hearing last month, Fed Chairwoman Janet Yellen
voiced concerns that the Fed could "become too large or play too
prominent a role" and could provide "a safe haven that could cause
flight from lending to other participants in the money
markets."
Katy Burne contributed to this article.