A big thank you to Shyam S. Rajan at Bank of America Merrill Lynch’s US rates team, for drawing our attention to this subtle yet significant change at the New York Fed on Wednesday:
The Federal Reserve Bank of New York’s Open Market Trading Desk is making the following change to the System Open Market Account (SOMA) securities lending program: Commencing with the operation on June 9th, 2011, the Desk will remove the $750 million issue-specific limit from the program. All other program terms and conditions will be maintained, including the 25 percent issue-specific and $5 billion aggregate limits.
To be clear, that means all nominal limits on how much of a particular Treasury issue any dealer owns have now been lifted. Dealers in Treasury securities will be able to hold as many Treasury securities as they want.
This is important, because — as Rajan previously observed — the limits ($750m per issue irrespective of sums outstanding) had been contributing to so-called specialness in the market, which is when the supply in the market is such that it makes bidding for the securities uncompetitive, skewing repo rates.
The new amendment should hopefully see specialness in the market reduce and bring about some form of a return to normalcy.
Indeed, as Rajan now notes:
Specialness in high SOMA holding bonds should reduce: As explained in our earlier piece, Fed purchases of the on-the-run securities in large sizes counter-intuitively richened up these issues in repo primarily due to the issue specific limits. A relaxation of these limits should help reduce specialness, all else being equal.
Bidding at SOMA borrowing auctions could become more aggressive: Primary dealers can bid for issues from the SOMA at a minimum bid rate of 5bp and pledge GC collateral in return. So far, dealers who were borrowing issues that were held in large amounts at the SOMA, did not have to bid aggressively, knowing that every other dealer could only borrow a maximum of $750mm. Hence, most bids submitted were likely to be accepted by the Fed irrespective of the bid level relative to the market. Now that every dealer can borrow up to 25% of the available borrowing, submitted bids on issues where the short base is high is likely to become more aggressive.
That said, not all the constraints on borrowing by dealers have been lifted.
First, there will now be a 25 per cent per limit on the available borrowing of any particular SOMA issue, and second, a dealer will still only be able to borrow $5bn in aggregate per day. Loans from previous days which have been unreturned will also reduce the par amount the dealer is eligible to borrow.
Nevertheless, it is a big change. And one that could make a significant impact on the repo markets — which have for a while been sending out a confused message by printing negative rates.
The next step, of course, will be for the Fed to address its own SOMA limits — an act which could immediately be interpreted as a “we’re getting ready for QE3″ signal.
Related links:
The perils of releasing the repo rate – FT Alphaville
The return of the SFP - FT Alphaville
The coming QEnding - FT Alphaville