We all remember the Fed’s sort-of promise to abide by self-imposed System Open Market Account (SOMA) restrictions — supposedly, so as not to completely corner the US Treasury market.
Well, according to Bank of America Merrill Lynch’s Shyam S. Rajan, those restrictions could be up for review quicker than you can say “the Fed owns more Treasuries than China“.
The point being that:
Fed purchases of on-the-run issues and dealer limits on SOMA borrowing have resulted in a large dislocation in the repo markets in certain issues. �
If fails in the on-the-runs continue to increase, the most likely solution in our view is for the NY Fed to raise dealer borrowing limits in its securities lending program.
The situation was exacerbated in early April thanks to the FDIC’s new charge on banks that lend overnight funds to the Federal Reserve, as well as the scrapping of the Supplementary Finance Programme.
As Rajan states, the FDIC charge saw prominent lenders of collateral in the repo market step out of the market because they no longer had an incentive to lend — not until rates adjusted sufficiently lower. The SFP wind-up, meanwhile, has led to a further shortage of collateral, richening general collateral (GC) rates dramatically.
This in turn has taken a toll on the banks’ favourite post-crisis arbitrage — borrowing from GSEs and investing with the Fed at the interest-on-excess-reserves rate.
Now, it should be the case that the Fed can lend back the Treasuries it holds on its SOMA account to dealers as and when needed by the market, eliminating tightness as it does.
But, as Rajan notes, there are number of reasons why this hasn’t been enough to ease the market this time around:
The SOMA lends out 90% of its holdings to primary dealers in its daily lending operations. By this rationale any issue held in large amounts by the SOMA should be available to dealers and should not trade any more special than the spread at which SOMA lends at which is GC-5bp or lower. However, the constraining factors to SOMA borrowing are:
Dealer limits: Each dealer is allowed to borrow a maximum of $750mm per issue and $5bn in total par amount at any one time. Given that most of the repo market is dominated by 8-10 primary dealers, there is invariably a sizeable portion of certain issues that is left at the SOMA unborrowed.
Unreturned outstanding loans: Collateral borrowed from the SOMA window and not returned by 12 pm on the following day (when the SOMA lending auction takes place) takes away from the dollar amount available in the lending window.
The dealer borrowing caps referred to currently stand as follows:
It’s one of the reasons he says why on-the-run three-year notes — of which the SOMA holds $12.8bn — have recently turned special, with the issue trading close to fail levels for almost the entire week.
But even here, there lies an anomaly.
As he explains (our emphasis):
However, the SOMA lending data shows that through the week the maximum par amount submitted to borrow was $7.2bn. There remains at least $1bn of unused collateral at the Fed on most days, taking into account the outstanding loans not being returned. This indicates to us that not all 20 primary dealers are active participants in the repo market, and borrowing needs are highly concentrated from a small number of dealers. This dynamic becomes more pronounced when market positioning is short as shorts tend to be concentrated in the on-the-run issues. With the Fed likely to continue buying a significant portion of on-the-run issues2, we expect specialness in the on-the-runs to continue and the number of fails to stay high.
Which means that if the Fed fails to be avoided and for that “small number” of dealers to continue to have access to funding, some sort of change to dealer limits may have to be implemented shortly.
In Rajan’s opioin, it’s enough to allow primary dealers to borrow 10 per cent of Soma holdings — to open up the entire amount of available Soma stock to 10 dealers at any particular time
That move alone could be enough to increase liquidity in the repo market and end the current market dislocation.
Here’s hoping.
Related links:
The perils of releasing the repo rate – FT Alphaville
The return of the SFP - FT Alphaville
Crescenzi: The House of Pain — The Money Market – CNBC
New Fee Shakes Up a Lending Market - WSJ
The US Treasury market is not enough – FT Alphaville