Repo Crisis Caused by Big Banks and Hedge Funds? Study Says Yes

Repo Crisis Caused by Big Banks and Hedge Funds? Study Says Yes

The Bank for International Settlements wrote a new report, blaming recent repo-rate spikes on big banks and hedge funds. Keep reading to learn more about the repo crisis, how big banks are causing it, how hedge funds are playing their part in it as well, and how to protect yourself and your savings from the repo crisis.

What is the Repo Crisis?

In order to understand the repo crisis, it is important to understand what a repurchase agreement is. It is a short-term secured loan in which one party sells securities to another party and agrees to repurchase them later at a higher price. The difference in the price is known as the repo rate.

According to the Brookings Institution, the repo rate spiked in mid-September 2019, rising to as high as 10 percent intra-day and, even then, financial institutions with excess cash refused to lend. This spike was unusual because the repo rate typically trades in line with the Federal Reserve’s benchmark federal funds rate at which banks lend reserves to each other overnight. The Fed’s target for the fed funds rate at the time was between 2 percent and 2.25 percent; volatility in the repo market pushed the effective federal funds rate above its target range to 2.30 percent.

Big Banks and the Repo Crisis

One of the reasons the study calls on big banks for raising this rate is because big banks are spending more capital on Treasury bills.

Also according to the Brookings Institution, The Federal Reserve uses repos and reverse repos to conduct monetary policy. When the Fed buys securities from a seller who agrees to repurchase them, it is injecting reserves into the financial system.

Conversely, when the Fed sells securities with an agreement to repurchase, it is draining reserves from the system. Since the crisis, reverse repos have taken on new importance as a monetary policy tool. Reserves are the amount of cash banks hold – either currency in their vaults or on deposit at the Fed. The Fed sets a minimum level of reserves; anything over the minimum is called “excess reserves.” Banks can and often do lend excess reserves in the repo market.

Hedge Funds and the Repo Crisis

Hedge funds are alternative investments using pooled funds that employ different strategies to earn active returns, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

They contributed to the repo crisis by using Treasury repos more and more to fund arbitrage trades. This type of borrowing leaves less cash available for others. Money-market funds that are offering the repos are looking for higher returns from hedge funds, which leaves lenders with not as much cash, causing the rate to spike.

What Happens?

According to Reuters, the repo market underpins much of the U.S. financial system, helping to ensure banks, companies, and investors have the liquidity to meet their daily operational needs. But when investors become fearful of lending, as seen during the global credit crisis, or when there is just not enough reserves or cash in the system to lend out, it sends the repo rate soaring above the federal funds rate.

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