Repurchase agreement (repo) and reverse repo

Introduction

A client recently asked why the reverse repo market has grown from zero in mid-March to $1 trillion at the end of July. In short, there is either too much cash or not enough collateral.  

Primary policy tool: FFR

The Federal Open Market Committee (FOMC) sets monetary policy by adjusting the Federal Funds Rate (FFR). In 2008, the FOMC went from a single rate to a target range for FFR. The FFR is the interest rate at which depository institutions and the Federal Home Loan Banks borrow and lend reserve balances to each other overnight. The official target is currently 0.00-0.25%. The Effective Fed Funds Rate (EFFR), the rate that clears the market, has recently averaged 0.08%.    

The FOMC has two other policy tools to ensure the FFR stays within the target range. The primary tool is Interest on Reserve Balances (IORB). Their secondary tool is Overnight Reverse Repurchase Agreements (ON RRP).     

Primary supplementary policy tool: IORB

On July 29, 2021, the Interest Rate on Excess Reserves (IOER) and the Interest Rate on Required Reserves (IORR) were replaced by IORB. Currently, reserve balances are slightly over $4 trillion. 

Secondary supplementary policy tool: ON RRP

A repurchase agreement (repo) is an overnight borrowing for dealers in government securities. A dealer sells government securities to investors in exchange for cash and buys them back the next day at a slightly higher price. The investor has entered a reverse repurchase agreement (reverse repo) with the dealer. They have agreed to buy securities and sell them back for a small gain. The reverse repo closes the repurchase contract. 

The ON RRP program began in 2013. There is typically activity at month and quarter-end. Since the end of March, use of the facility has exploded and recently topped $1 trillion. 

Total assets at the Federal Reserve (Fed) are $8.2 trillion, mostly U.S. Treasury securities. The Fed lends securities in exchange for cash and agrees to buy them back the next day. On Monday, Aug. 16, for example, 70 counterparties submitted $1.036 trillion in exchange for collateral at 0.05%. 

Not enough GSE collateral

Government-sponsored-entities (GSEs) include the Federal National Mortgage Association, known as Fannie Mae, (FNMA), Federal Home Loan Mortgage Corporation, known as Freddie Mac, (FHLMC), Federal Farm Credit Banks (FFCB) and Federal Home Loan Banks (FHLB). They were created by acts of Congress but not explicitly guaranteed by the government.