Josh Galper on the Current State of Repo Markets, Key Bottlenecks, and a Balanced Proposal to Restore Stability

Josh Galper is the Managing Principal of Finadium, an independent consultancy in capital markets based out of New York City. He joins the show today as part of a two week special on the Fed and repo markets, as he helps us take a look at recent repo market stress from the private sector. Specifically, David and Josh discuss the current state of US repo markets, key bottlenecks that have arisen in 2019, and a balanced proposal to restoring stability in capital markets.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Welcome back, Macro Musings listeners to ‘Week Two’ of our special coverage of the Fed and repo markets. I'm your host, David Beckworth, and I'm joined by Josh Galper, who is deep in the trenches of the repo market, and is the managing principal of Finadium, an independent consultancy in capital markets based out of New York City. As you may recall from last week's episode, we were taking a deep dive into the world of money markets and Fed policy, because repo market interest rates spiked in mid-September to almost 10 percent while the Fed’s interest rate target was around two percent. This development caught many by surprise, including the Federal Reserve, and revealed there were severe funding pressures in the repo market. That is, there weren't enough bank reserves to fund repo activity. This is a big deal because, the repo market is the heart of the US money market, and funds many other long term investments.

Beckworth: There is some concern that these money market pressures could reemerge this month, as additional corporate tax payments come due, more Treasury debt is issued, and year-end tightening of balance sheets by the big banks for regulatory reasons will drain additional reserves in the money market. Money markets may come under severe stress again. No one knows for sure, and as a result, the Fed has responded with an added injection of about $500 billion of reserves to overnight repos, term repos, and outright Treasury purchases. Last week, we talked to George Selgin, who helped us see the problem from the perspective of the Fed's balance sheet. Be sure to check out his episode if you haven't already. This week, Josh Galper joins us to help us understand the problem from the perspective of the repo market. Josh, welcome back to the show.

Galper: Hi, David, thanks for having me back.

Beckworth: It's good to have you back on. You are in the trenches, as I mentioned. You know the capital markets well, you know repo, and you also recently wrote an article titled, “US Repo at Year-End 2019: The Hard Choices Ahead.” And I like it, because it doesn't mince words, and it really takes the issue head-on, and there are no easy answers as your article explains. I want to get into that. Before I do, I want the listeners to know that we're recording this on December 16th, in the afternoon, and this was supposed to be one day where repo markets could have become explosive, rates could have, again, taken off, but they haven't. Is that right, Josh?

Galper: Well, as of data at the end of Friday, yes, that's the case. Going into today, we won't really get full data until tomorrow morning.

Beckworth: Okay.

Galper: But so far, there's some minor expected volatility at year-end, but by and large, the repo markets seem pretty much as expected.

Beckworth: Josh, tell us about the repo market. What is it, and why is it so important?

Repo Market Basics: Primary Dealers, Bilateral Transactions, Sponsored Repo, and GCF Repo

Galper: Sure. So, the repo market can be viewed as the grease of capital markets. It, by itself, a repo transaction is not something to get overly excited about. It's a temporary exchange of cash for collateral, often overnight, sometimes for a week or a month, or on 90 days, sometimes even a year. But what repo really does, is facilitates, as you mentioned in your intro, a wide variety of other transactions, that without repo, those other transactions couldn't happen. Repo has become also vitally important to how primary dealers finance the large amount of US debt issuance that's been occurring in 2019. Primary dealers have always used repo to finance Treasuries, there's no change there, but the difference is that, as primary dealer balance sheets have grown, which is largely as a result of US Treasury issuance, the repo market is ever more critical for financing that inventory.

Repo has become also vitally important to how primary dealers finance the large amount of US debt issuance that's been occurring in 2019.

Beckworth: And so primary dealers are a big part of the repo market. You've also mentioned in your paper, the tri-party part, the fixed income clearing corporation sponsored repo part. Can you explain those components as well?

Galper: Sure. So, US repo markets have a number of different sections, if you will, where some parties can trade with others, and there are quite a number of overlapping counterparties between sections. So, if you're a large bank, for example, you have access to all the different parts of the market, whereas if you're a smaller broker dealer, you might have access to only one part. So, the part that most people understand well is the bilateral market, and that's simply a private exchange of cash and collateral between two counterparties. Some of that is done entirely in-house by the two parties, and other parts are sent to FICC for what's called DVP, or delivery versus payment settlement. Another transaction is known as tri-party. A tri-party is a bilateral transaction. So, the two counterparties are still exposed to the credit of the other, but in tri-party, a third party, hence tri-party, is responsible for the operations and valuation portion of the transaction. So, we may exchange cash for collateral, and we will each hold an account with a tri-party agent, and the tri-party agent will then determine how much cash and collateral should be exchanged based on the value of the transaction on each day.

Beckworth: Okay.

Galper: The next part of the market to consider is sponsored repo, and in sponsored repo, a buy side firm will do a transaction with a sponsoring dealer, who will then send the transaction to FICC for an ovation on the CCP that FICC runs. So, in this model, there's a central counterparty, that's the CCP, which is becoming the buyer to every seller and the seller to every buyer in the repo trade. So, it's no longer bilateral, but it's centrally cleared with FICC as the credit backstop for the market. That's become an increasingly popular mechanism for transacting in repo, reaching about 400 billion as a high watermark in October of 2019. The last part of the market that we should note is GCF repo, and this is a market between FICC clearing members. In this market, broker dealers and banks will exchange repo with each other. It's a CCP market as well, where transactions are then sent to tri-party for the operations and valuation component.

Galper: So, if you're transacting in sponsored repo, for example, you may have one set of counterparties that are going to transact with you in the sponsored repo platform. If you're in GCF, that could be another set of counterparties, and then if you're in the bilateral market, that's simply between you and your client.

Beckworth: Okay. Lot of moving parts there. Let me ask this question: during the September repo market crisis, what part of the market do you think was the most important? What part was getting hammered the most? Were all of them equally, or was there certain players that you just listed there that were more actively a part of the challenge?

Explaining the Recent Volatility in Repo Markets

Galper: Sure. So, my own bias is to separate the words repo and crisis.

Beckworth: Okay.

Galper: Certainly, there was substantial volatility. It was not terribly unexpected volatility. This was foreseen. The core issue being that bank balance sheets face serious restrictions in the current regulatory model, and so, you could expect that as banks’ repo dealers have been operating in pretty much 100 percent capacity for quite some time, that if anything exceptional were to occur, which happened in the middle of September, that volatility would be an end result. So, who actually got hurt in the middle of September were smaller dealers. And these are firms that are committed to financing their clients, but they don't have access to the same pools of liquidity that large banks do. And meanwhile, large banks themselves have substantial reserves to call on. They're also bound by liquidity regulations that ensure that they have 30 days of capital in the event of a stress scenario, and reserves at the Fed in a very, very worst case scenario.

Galper: But if you were a smaller dealer in the middle of September, you could have found yourself unable to get cash on the GCF repo market the way you normally did, in order to finance your underlying client.

If you were a smaller dealer in the middle of September, you could have found yourself unable to get cash on the GCF repo market the way you normally did, in order to finance your underlying client.

Beckworth: Okay. So, you wouldn't call September a crisis, but 10 percent, that was a big number, right? I mean, I guess the question is-

Galper: Huge number.

Beckworth: Okay. Why didn't these banks set on reserves lend into that 10 percent, and arbitrage away some of that, what looked like, yield that was available to them?

Galper: Well, in fact, firms did. There were definitely other broker dealers, foreign banks, hedge funds, that did engage in repo transactions to take advantage of those high numbers. But, when you look at the SOFR data, which is a great source of information about spread volatility, you can see that those nine, 10 percent numbers, they were truly at the high end.

Beckworth: Okay.

Galper: And that, while the market SOFR did shoot up that week, it wasn't SOFR at nine or 10 percent, it was SOFR at five percent and change, but was a smaller portion of the market having experienced much higher rates.

Beckworth: Okay. And this goes to a comment you made earlier that maybe, the fact that I can remember the 10 percent, speaks to the media focus on the sensational, on the outlier, that 90th percentile trade as opposed to maybe what was more typical.

Galper: Yeah.

Beckworth: Okay.

Galper: And, this is a minor grumble I have with the media that, again, looking to separate the words repo and crisis, I mean, in truth, if the events of middle of September had gone on for several days, a crisis could have developed. What in fact happened was an expected sharp rise in volatility for reasons that we saw coming, but where calmer heads did prevail the next day, or by the end of that day, in fact, to get rates back in order. I do find that some of the media has been a bit excited about what's been going on in the repo market, where such concerns, I think, it's great to have an educated public at the same time, that the true concerns, deep worries, about the functioning of the market really might be a little premature to say that the sky is falling.

What in fact happened was an expected sharp rise in volatility for reasons that we saw coming.

Beckworth: Okay. Well, that's good to know, Josh. You're deep in the repo market, you can tell us that. That's great to hear. What about the health of the repo market overall? So, we're focusing in on our conversation, September, today, end of the year, but over the entire year 2019, 2018, has the repo market done well, is it flourishing, is it growing?

Repo Market Performance Since 2018

Galper: Well, the repo market's been growing, and really is a function of US debt issuance.

Beckworth: Okay.

Galper: Going into the end of 2018, the repo market was looking pretty good. Dealers were much more concerned about spreads than liquidity. So, the thinking being that there was perfectly adequate amounts, or even too much cash coming into the market, to take advantage of spreads that were decent for repo dealers, and that in 2019, those spreads could narrow making repo less profitable. As 2019 has worn on, the concern has gravitated more towards the liquidity. When you look at the amount of US debt issuance that's come into the market, these are tremendous numbers, and also very fast for the markets to accommodate. And what we're seeing is that the natural buyers for this inventory aren't always there. As a result, primary dealer repo holdings have gone up, as have their balances for US Treasuries. So, that's when you start to have a liquidity conversation and liquidity concerns.

Galper: At this point, I'd say the repo market is doing fair enough, but there are genuine bottlenecks. And that's really what our research report was about, and I believe we'll get to in a little bit.

At this point, I'd say the repo market is doing fair enough, but there are genuine bottlenecks. And that's really what our research report was about.

Beckworth: That's fascinating. So last year's increase in interest rates in the repo market was driven by different reasons than this year. So, this year's liquidity, and that's fascinating, due to this increased debt issuance. And you had a section in your paper about the debt issuance, and you just touched on it, that there are limits to debt issuance. And so, that's one of the arguments that the system can only handle so much debt issuance given the way the system is set up. And I want to peel that back a little bit more. So, the issue is, there's all this debt going out, the primary dealers have to take it, by law, they have to. To be a primary dealer, the agreement is, you got to buy this debt when it's auctioned from Treasury. And then the question is, how are they going to get funding for that. And I guess the concern was, or still is, is that, there's not enough bank reserves out there to fund the debt. Is that the right way of looking at that?

Galper: Well, there are not enough natural buyers to fund the debt, and there are not enough carry traders to fund the debt. And when fixed income desks can't sell that debt, then repo desks are asked to finance it. And so, that's really where the bottleneck starts to hit, because if you think about a system where policymakers really expect the markets to function in a certain way, and if the market fails to function that way when policymakers are saying, "Of course, we're going to issue debt, and it's going to get bought by some mysterious party." But, if that doesn't happen, and then you've got a set of highly restrictive regulations in the form of a supplementary leverage ratio, and CCAR, and liquidity coverage ratio, et cetera, that's when any new constraint that comes into the market can really hurt the market. That's, of course, where the Fed was really forced to step in, and has already stepped in again, leading up to the end of the year.

Beckworth: Okay. So, you mentioned the carry trade, which then directs my mind to the yield curve. So the yield curve flattening and inverting for a little bit, I'm sure that influenced the decision some carry traders and foreigners wanting to buy the US debt that probably had some debt in the market. Is that right?

Galper: It did. We understand that the Bank of Japan has been buying US Treasuries unhedged, simply in order to earn the rate of return. You know, of course, where interest rate stands in Japan.

Beckworth: Yeah. So, I understand that point, but I guess where I'm going to go with this other point is, the Fed drained reserves, and we know that had some bearing on what happened in September. Also, the standard story is at least that there was a big corporate tax payment coming in which strained reserves as well as issuance of debt. And one of the stories you touched on in your paper, and we talked about with our guest last week, is the Treasury General Account. So, the Treasury General Account has grown dramatically since 2008, and more recently, this year, it's grown a lot as you know, in your paper. So, my question is this: if the Treasury was not depositing all these funds at the Fed in the TGA, or the Treasury General Account, and instead, was depositing these funds in institutions outside the Fed, so private financial firms, then those funds would be reserves that could be used to help fund the debt. Is that right?

Galper: Yes. Yes, they could. So, if we can look at this as a seesaw, there's a certain amount of cash out there, and that cash is looking for short term investments. On the other side, there's a certain amount of balance sheet capacity. That balance sheet capacity dictates how much repo dealers can engage in. If one side of the other is out of balance too much, then you're going to have volatility in the repo market. If both sides are exactly in balance, then you're going to have an excellently functioning repo market, with perhaps the Federal Reserve’s reverse repo facility mopping up a little bit at the margins, or banks having a little bit extra balance sheet left at the end of the day. What we saw in the middle of September, and I'm including the TGA in this, is that the amount of cash available to invest in the repo markets went down – by a lot. So, at the same time that banks were expecting that their Monday would be perfectly normal, there was less cash in order for them to be able to execute and get the collateral funded that they needed to.

Galper: So, while cash was going down, at the same time, the amount of collateral, US Treasuries, that dealers needed to fund was going up. And that's been going on for a while now. So, no surprise there. The only surprise, which, again, shouldn't have been a surprise, was the amount of cash that was not available in the middle of September to invest in repo. So, the Treasury General Account is one part of this. Another part was the net increase of 54 billion in US Treasury settling, an estimated 100 billion in cash that corporations took out to pay their tax bills. And also, on September 14th, just a couple of days before the repo volatility occurred, Saudi Arabia's oil installation saw a major terrorist attack. And that had some knock on effects in the commodities markets where traders needed to meet margin calls. And also, we don't know this for sure, but we understand that the Saudis actually took money out of the markets themselves to cover their own costs.

Galper: There's some other theories kicking around here; hedge funds were to blame, JP Morgan did some stuff back in the spring, but none of this was a huge surprise. It's simply that the seesaw became too imbalanced too fast.

Beckworth: Okay. And part of that seesaw are the regs, right?

Galper: Right.

Beckworth: Okay. So, that's an important piece of the puzzle. I guess my question, let me put it this way, if the TGA ... And I'll throw in the foreign repo account as well, both of these categories on the Fed’s liabilities side, they have grown dramatically since 2008. And, in fact, if you do a counterfactual: where would they be if they'd stayed pre-2008 levels? Back then, the Treasury only put in about $5 billion today, it's like 350 billion, it swings up and down. You take the TGA, and you take the foreign repo, you're getting north of 600 billion, which is about the same amount that quantitative tightening drew down in terms of reserves. The Fed pulled out about 600 billion, and then these two other accounts did the same thing. And so, my question is, if these two other accounts hadn't grown as large as they are, would we be having this conversation today, or would these other factors that you've mentioned, the bank regulations, the yield curve, carry trade, would these still be an important factor in the repo markets?

Galper: Given the amount and speed of US Treasury debt issuance, I don't know if we'd be having the same conversation today, but we'd probably be having it in the next year.

Beckworth: Okay.

Galper: That's my guess.

Beckworth: Because we see debt as far as the eye can see. There's going to be lots of deficits going forward. Okay, fair enough. Let me go back to the sponsored repo, because that's relatively new, and it receives a lot of attention during September. In fact, some people were pointing a finger at it. So, walk us through that argument and why you think it's not very convincing.

Is Sponsored Repo to Blame for Volatility?

Galper: So, sponsored repo is new. That doesn't yet make it bad or good. You can argue that it's a monetary transmission mechanism. You could argue that it's simply a tool. What I think the criticisms ... Well, so, the benefits of sponsored repo is that it really reduces balance sheet cost for dealers in the transaction. That's what it comes down to.

Beckworth: Okay.

Galper: This is good for the markets, because dealers can do more business. It's good for market participants, because they can engage in more utilization. We don't see any changes in rates on sponsored repo versus off the platform, but, simply the fact that it exists, ought to suggest greater balance, a greater capacity, and greater stability in repo. That's what it ought to do. Following the events of mid-September, you're right, sponsored repo did come under criticism, which I personally feel is unfounded. The critics basically claim that sponsored repo concentrated liquidity in sponsored banks and approved borrowers, and that, potentially, sponsored repo has been decreasing term, making more business overnight than it had been. We looked into both of these arguments, and certainly, the US repo market is highly concentrated. In fact, the Federal Reserve's Liberty Street Economics blog did a study back in April 2019, and found that about 94 percent of the repo market is concentrated in the hands of just a few firms.

Galper: Meanwhile ... It's a great quote, actually, from the Liberty Street Economics, they said, “new repo participants are three percent of total gross activity, and the average amount of GCF repo and FICC delivery versus payment, DVP activity, for a top 10 dealer is larger than the sum of the repo activity for all new participants.” So, one big dealer does more business than all new participants combined.

Beckworth: Wow.

Galper: So, this is true. Now, whether it's that sponsored repo simply encourages the status quo, or perpetuates the model, that we could argue that it may, indeed, assist in maintaining the status quo, but I would not say that sponsored repo caused the problem. The problem is really caused, as much as anything, by a regulatory moat that is quite vast, that protects the largest banks, stops other banks from really encroaching too much on their territory, while also mandating, really, what the large banks can and cannot do.

Galper: Looking to the question of whether sponsored repo is concentrating more activity in overnight versus not, so far, our analysis of the data suggests not. The Office of Financial Research did a pilot study of bilateral repo some years ago, where they found that overnight transactions are about the same amount as they are today according to primary dealer balance sheet filings. I'm not someone who would point the finger at sponsored repo specifically. I will say that it bears further study, but I think that the issues in the repo market are much broader than sponsored repo as one channel.

Beckworth: Moving forward, you mentioned that there's still going to be challenges next year, maybe the year after, because of these ongoing budget deficits. And, my question is, even if the Fed does QE4, and completely reverses all the loss of reserves on its balance sheet, are we still going to have challenges, even though the bigger the Fed's balance sheet, are we going to have these challenges because of the amount of debt issuance going forward, and in turn, does that mean we need to get some more long term solutions in play?

Outstanding Questions and Long-term Solutions

Galper: So, unfortunately, I am not in possession of the crystal ball that I wish that I had.

Beckworth: Okay.

Galper: My gut feeling, and my feeling from reading Fed open market committee notes, and looking at the data, are that the current amount of not QE activity that's going on, will be insufficient to solve the repo market liquidity issue. If the Fed engages in a large scale QE4 activity, then that could potentially change market conditions. But, the last Fed notes, FOMC notes, that I read, suggested that FOMC members were more interested in letting things work its course through the 60 billion a month in purchases, as opposed to engaging in a major new initiative, like QE4 or the standing repo facility. So, to get back to the first part of your question, or first part of where you were going, looking into next year and the year after, we've got some big ticket issues here in US markets to address. And they really come down to how much is the Federal Reserve going to own this market, provide liquidity for the market, backstop the market, versus how much do regulators want that banks have more capacity and flexibility in providing financing.

Galper: Given that we're dealing with a small number of banks here, we could be saying, it's really five to 10 banks that are going to be the backstop for the entire marketplace. On the other hand, the Federal Reserve could step in, provide standing repo facility that's open to all market participants, and the Fed is the backstop. I don't see a scenario right now where the Federal Reserve is going to be buying enough debt to completely cover all the US Treasury issuance, given the amount of projected debt issuance that's still going to occur. I could be totally wrong here. The Fed could totally step up and take care of this. But, at the same time, you start to ask yourself questions like, "Well, if the Fed is going to be buying all this from the dealers, why doesn't the Fed become something of a primary dealer?" It won't happen, but that's a question. Or, if the Fed is going to be offering a standing repo facility only to primary dealers, why shouldn't it engage further, and similar to the Swiss Central Bank trading on SIX's repo platform, why wouldn't the Fed become some sort of liquidity provider on the FICC, GCF repo market?

Galper: These are really big questions, and they're complex questions, and we can date them back to the 1930s and Glass-Steagall, to say, "How do we want capital markets to look to ensure that, in effect, the amount of business or debt issuance that politicians and policymakers want to enact, gets funded through this market channel, where it's expected?" Incidentally, sort of puts the light on modern monetary theory in that regard, thinking blithely that, yes, the markets will absorb all that new debt issuance that we're going to enact because of the huge spending program. So, they're the big questions.

Beckworth: And you make that point very clear in your paper. There's two paths here, is ultimately what you're saying. And a path has to be chosen ... I think, if I understand you correctly in your paper, there's not really a middle path. It's one path or the other; whether you get the Federal Reserve really becoming the market maker, first resort, or as the last resort, or you rely more on banks.

Galper: Well, technically, you could choose both paths. You could offer banks more balance sheet capacity, and we can discuss in a couple of minutes what that means...

Beckworth: Okay.

Galper: ...and, the Federal Reserve could engage in further liquidity operations of one form or another, that eases pressure on primary dealers and hence on the repo markets. My guess is that the outcome will lean more towards one side than the other, and if the outcome leans towards providing banks with greater liquidity, then it remains to be seen truly how much more US debt issuance is going to come, which may then force the Fed to get involved anyhow.

Beckworth: I mean, if you look at the projections for the amount of debt that's going to be issued going forward, it would imply a huge, huge balance sheet for the Federal Reserve, which I think the Fed itself is nervous about exploring.

Galper: Yeah, there's a lot of negative complications there for the Fed. And there's moral hazard. There's the question of what is a free market? What are functional capital markets? And even today, it could be argued that US capital markets are not the envy of the world, that you could look at the number of listings, you could look at liquidity in various sectors. You could look at flash crashes and say, "Things aren't working great here." They're not terrible, they still function quite well, but they could be better. And then, does the Fed want to be injecting itself into that scenario?

Beckworth: Well, I've had George Selgin on several times on this show, he was the guest last week. We were looking at the problem from the Fed’s perspective, but some previous shows, he came on and talked about how the movement from a corridor system to a floor system where you separate the size of the Fed's balance sheet from the stance of monetary policy, really opens up the Fed to this very problem. In other words, in the past, the Fed could say, "Hey, we can't buy up more debt. We can't do all these wonderful things, because the size of our balance sheet is closely linked to the stance of policy. And we have a congressional mandate to hit these targets." But now they can't say that. Now they can expand their balance sheet and not affect the stance of policy, because of interest rate on excess reserves. And as a consequence, they have opened themselves up to the very possibilities you've outlined.

Galper: Yes, yes. I find it to be very problematic no matter how you slice it. Now, there will be solutions. Many have been proposed already, some will be enacted, and then it will remain to be seen exactly how those play out. The core issue of concern that I see is almost more philosophical than the practical, what program are you going to enact?

Galper: It's really a core question about, are you going to offer banks more deregulation, or is the Federal Reserve going to become this massive market player that it has been for much of the last decade, but, in effect, truly taking over the markets?

It's really a core question about, are you going to offer banks more deregulation, or is the Federal Reserve going to become this massive market player

Beckworth: Let's take a look at some of the deregulations that you have suggested. And you begin with a supplemental leverage ratio. Explain what that is, and how the Fed and Treasury could tweak it to make banks have more balance sheet space to engage in repo markets.

Deregulatory Solutions

Galper: Sure. So, in the supplementary leverage ratio, which is a version of the Basel III leverage ratio, it's built on the idea that, in the denominator of the ratio, are all assets and liabilities. Of course, US Treasury holdings fall in there. If you were to exempt US Treasuries from the denominator of the supplementary leverage ratio, that would quickly result in the ratio being much more attractive for banks. That is to say, banks couldn't hold more US Treasuries and engage in US Treasury repo without having a hit to the denominator of their leverage ratios. Now, you don't have to exempt them entirely. You could simply weight them differently, you could exempt them for certain types of transactions, but the whole idea of the Basel III leverage ratio, is it's supposed to be unweighted. If you go ahead and exempt something, or you give it a weighting to reduce its impact, you're really playing with the whole idea.

Galper: And, I think it would be naïve to think that the US could do that, and then Europe not responding in kind, and other major economies respond in kind quite quickly, leading to a cycle where banks have much more liquidity so long as, in the denominator of their leverage ratios and their assets, they're holding government bonds. The big hazard there, going forward, is that banks would take that excess liquidity, invest it in areas that today look quite placid, quite safe, but that, because of excess liquidity, could wind up generating a future crisis.

Beckworth: Okay. So, it would free up balance sheet space for repos, but it could end up funding the next great bubble.

Galper: That's right. That's right. I'll mention also the G-SIB calculations, the G-SIB buckets. This is something that some folks have pointed fingers to for being a source of concern for end of year. I'm more sanguine about this. I don't believe that G-SIB calculations are going to be that impactful, especially after the Federal Reserve noting that it's going to inject an additional 600 billion plus into repo markets at the end of the year. But what the G-SIB numbers are, determine how much additional capital that banks need to hold. So, if you're in a certain G-SIB bucket, there are two methodologies for it, probably a little geeky to go into it in that level of depth, but there are a couple different calculation methodologies in the US. If banks are over the bucket number, then they have to hold an additional half percent or whatever it might be of capital.

Galper: Banks are known to play with that number during the year, and a recent analysis from Morgan Stanley, that was also discussed in the Wall Street Journal, pointed out how some banks at the end of Q3 were over their G-SIB numbers from the same point of Q3 2018. So, as another idea, I think the supplementary leverage ratio tweak would be the easiest way to go, but I do know that others have pointed out that easing constraints on the G-SIB buckets, or changing those buckets in some way, could also result in more repo liquidity, especially at end of year.

Beckworth: Okay, let me spell out that acronym. That's a global systematically important banks, that's what G-SIB stands for. Is that right?

Galper: Correct. Yes.

Beckworth: So these are the big banks. They're systematically important in theory. They're supposed to be ones that will affect the entire banking system, so they have extra capital surcharges applied to them, extra buffers they have to carry, and the argument is, at the end of the year, they clean up their balance sheets if they can minimize that extra charge.

Galper: Right, right. And technically, it's global systemically important banks. I myself have said both systematically and systemically probably a dozen times each. But it is systemically.

Beckworth: Okay. Thank you for that correction.

Galper: But easy to confuse.

Beckworth: Okay. So, you don't think that's as big a deal as the supplemental leverage ratio. You think that's the bigger constraint right now in the banking system, why they're not lending into the repo market like they could.

Galper: Well, we know that to be the constraint on your average given day of the week. Yes.

Beckworth: Okay.

Galper: The G-SIB numbers come more into play at the end of year. That's when the calculations are made, and that's also why you've seen the end of year pullbacks.

Beckworth: Okay. Well, let me go back to the to the supplemental leverage ratio, and I don't want to get too in the weeds here, but the repo falls into the leverage part, the denominator, and my question is why? And I think this is an important issue. Again, it gets a little bit in the weeds, but if you do a repo transaction, you don't actually take a Treasury off your balance sheet. It's still kept there for accounting purposes. And is this why the leverage doesn't shrink when you do repo?

Galper: Well, you're taking in cash, and you owe somebody back cash.

Beckworth: Okay.

Galper: And that's a liability.

Beckworth: But in the past, that was not the case, like with Lehman, or at least Lehman was playing with the rules, and they did do this. They did somehow ...

Galper: Well, Lehman was pre-Basel III, that was before the supplementary leverage ratio. And in fact, a lot of why those rules developed was because of Lehman Brothers.

Beckworth: Because they did put the repo off balance sheet?

Galper: So they ... Again, getting into the weeds here, sorry, I'll try and stay out as much as possible, they engaged in an accounting maneuver called repo 105, which turned out to be legal, quasi legal, uncertain. But in the end, what really failed Lehman Brothers was a lack of market confidence in Lehman Brothers. You could see the drop off in overnight repo funding, quite dramatic in the Lehman post crisis reports.

Beckworth: Okay. Now, you mentioned in your article, and we've seen this in the news, that there is some sympathy towards this tweak from the Treasury Department, from Randy Quarles at the Board of Governors. But you also highlight, they may be in favor of it right now, but someone else could win the election other than Trump, and that would push those plans back. So, that tweak, if it happens, will have to wait until 2020.

Galper: Well, I guess theoretically, it could be pushed through awfully, awfully fast, but I think that there are more votes and more regulators that would need to make that call, than just Treasury Secretary Mnuchin, and Fed Vice Chairman for Supervision, Quarles. These are complicated regulations to propose, review, get approved. The Federal Reserve, for example, proposed the Net Stable Funding Ratio regulation, a good couple years ago, and we've not seen it finalized, and we may never see it finalized. What I do say is Senator Elizabeth Warren, for example, has already written to Treasury Secretary Mnuchin, asking for a full accounting of what happened in the middle of September. And, I think it's pretty safe to say ... Well, in fact, she says in her letter that she's concerned about this being an opportunity for banks to push for deregulation. And I think it's pretty much safe to say that if she or someone who thinks along her line, becomes president in 2020, that there would be no way that banks would see deregulation.

Galper: Further, I mentioned earlier, modern monetary theory, if someone reaches the presidency who thinks about modern monetary theory, they may say, “that Federal Reserve with its basically unlimited balance sheet looks awfully good as a home for sucking up all this debt issuance so we can engage in spending.”

Beckworth: Okay. One other point on the deregulation, and then we'll move on, because I know this gets a little in the weeds, I don't want to lose our listeners, but the other reg that I hear a lot about is liquidity coverage ratio. And, one of the points that comes up is that, when this regulation is implemented, in theory, or at least on paper, the high quality liquid assets,  the top tier,  the best ones you can pick, are both Treasuries, and bank reserves, but in practice, bank reserves are getting more weight, or there's a preference for them, and you could tweak that, you could tweak this rule and make it possible for them to be content with Treasuries, and therefore, you wouldn't necessarily weaken the rule, you would just apply different emphasis on which assets the banks would hold. Any hope there?

Galper: Well, so that's a really interesting question. There's 1.3 trillion today in excess reserves that banks hold at the Fed. What we understand is that banks have been told by supervisors that they really don't want banks using that money for everyday purposes, that those are really supposed to be truly emergency reserves. If the Fed is explicit with large banks that that 1.3 trillion could be used, or could be used under certain circumstances, for example, if repo markets moved by more than 30 basis points on any one day, then that would unlock somehow these excess reserves, that would really be a way of allowing the large banks to stabilize repo markets without providing them extra liquidity for other purposes. So, it's an interesting idea, but it would have to be specifically tailored so that banks would have access to that cash for repo market purposes and not for other purposes.

Galper: Now, incidentally, the standing repo facility would also likely drive down the amount of excess reserves held, because it would incentivize banks in different ways. So, banks could be holding US Treasuries and know that they could trade those in for cash at any moment. So, the standing repo facility then would be another way of getting a similar kind of job done.

Beckworth: So I wonder if we get president Elizabeth Warren, she might be more friendly towards the LCR tweak that I just suggested, weighting Treasuries is equal to, in practice, to reserves, and I would also see maybe under her, the standing repo facility, those two things maybe working together, and that would be something she would be more eager to support.

Galper: Entirely possible. Yes.

The Standing Repo Facility

Beckworth: Let's talk about that standing repo facility a little bit more. What is your sense on whether it's going to happen? I know you don't have a crystal ball, but, I mean, you are in Wall Street, you talk to people, you're part of the ecosystem there. Are they looking forward to it? Is there a sense that it's going to happen soon? Are they making plans for it?

Galper: No, no one's making plans for it yet. The latest FOMC notes that I read about the standing repo facility, were that the FOMC members were really taking a wait and see approach. I view this myself as maybe not the best way to go. I think that we are going to hit more repo volatility. It's really not a question of if, it's more a question of when. The standing repo facility could, quite far, in fact, entirely smooth this out if it were broad enough in terms of the amount and the breadth of market participants that could participate. But right now, no one at major repo dealers is planning for this to happen, and I don't believe that the Fed is yet planning for it to happen either. If I could go back one second to talk about the amount of liquidity and the breadth of coverage, right now, the Fed is engaging in daily operations, both overnight and term, to provide liquidity to repo markets, and they're setting the amount.

Galper: The standing repo facility could be limited or unlimited, and it could reach, as I mentioned earlier in this conversation, only primary dealers, or every market participant who may need liquidity. Pointing out again, that there are bottlenecks in the system, and even though the Fed might provide unlimited liquidity to primary dealers, that might not always be able to reach the smaller broker dealers who need it to fund their underlying clients. So, the design of the standing repo facility, it's not just whether or not it'll happen, but the design really matters here. And hence, that will dictate how impactful it is to calming market volatility.

Pointing out again, that there are bottlenecks in the system, and even though the Fed might provide unlimited liquidity to primary dealers, that might not always be able to reach the smaller broker dealers who need it to fund their underlying clients.

Beckworth: Bill Nelson, who was on the show previously, he makes the case that they're going to do it. They're going to have to open it up to more than just the primary dealers to make it work.

Galper: Right, which introduces a whole other level of moral hazard to the Fed, because how much they want to be facing off against smaller dealers, smaller broker dealers, who have limited amounts of capital, in order for them to fund hedge funds, RITs, and others, who are engaging and leverage transactions. I listened to the Bill Nelson interview, by the way, I thought it was tremendous. It was great. He really knows his stuff inside and out. From a markets' perspective on my side, I would say that there's a lot of market functioning here that often is not discussed at the policy level, and I think that for the standing repo facility and other potential solutions, getting into how those are going to affect the mechanics will have a lot to say or have a lot to do with the final outcome.

Beckworth: So Josh, is your concern with the standing repo facility that effectively is going to just increase the footprint of the Federal Reserve, is going to be the market at some point when it comes to money markets, it's going to be the other side of every transaction, and therefore, we won't have a true, private, money market anymore?

Galper: That is a concern. And, in fact, I have contradictory concerns about the standing repo facility. So, one is indeed, as you mentioned, that the Fed would be the market, that it would no longer be a free market where pricing is determined by market participants, but rather by the Fed with its policy objective. That would distort the secured overnight financing rate, which you might argue already, is distorted, because of the Fed setting interest rates, but even so, the SOFR could only trade in a band. There would be no additional risk taking. When that happens, then you have market expectations about what risk is available in the market, what is actually going to happen, and you could have a lot of distorted behavior by market participants about what trades they're willing to enter into. Because, if they know that they're protected from sharp volatility increases by the Fed, then they might do more than they otherwise might.

Galper: The other set [of concerns] is, if the Fed is going to engage in the standing repo facility, then my hope is that it would allow it to be accessed by all market participants, rather than going through dealers who may still have their own bottlenecks, and hoping or expecting liquidity will reach those smaller dealers when it's needed the most. And that's uncertain.

Galper: I sort of think we’re in a new era where I think other ideas should be introduced, for example, should the Fed have the ability to trade on Tradeweb or BrokerTec? Should it be able to transact against the CCP, in some way, on FICC? These mechanisms would make it even easier for market participants to reach the Fed and access its liquidity, again, introducing a whole new degree of moral hazard both for the Fed and the market. But if this is how it has to go, then I would hope, for market participants, that the Fed not look only at a small number of primary dealers to be counterparties to the facility.

Beckworth: And I think what you're touching on is the creepy nationalization of finance, start of the great financial crisis. And, the question is, can you pull it back? Can you get back to something like what Canada has? And Canada now has a corridor system. They had a corridor system before the crisis, they moved to a floor system like the Federal Reserve, and they're able to claw back and get to a smaller footprint for the central bank. And, it's not clear how you do that in the United States. Now, one possibility is, you do the standing repo facility, and you use it as a way to shrink the Fed's balance sheet, and that would be a plus in terms of less of a footprint, but then on the negative side, it would be potentially a big backstop, it could become the market. And so, you'd be trading one intervention for another. So it's not clear there's a straight path to something pre-2008.

Galper: So I'd like to offer my major heresy...

Beckworth: Okay, let's hear it.

Galper: Alright. Which, I don't believe that this is going to happen in the immediate future, but I think it could really solve the problem, which is a return to a Glass-Steagall kind of setup. I think that if you separate who can access the Fed’s facilities versus who takes risk in the markets, have those be different entities, then I think we could be looking at a different set of scenarios whereby the Fed could engage more, but with a different set of counterparties, knowing who's really taking the risk, and who's exposed if something wrong happens in the market. I think that, combined with the Order of the Liquidation Authority that's been set up as part of Dodd-Frank, that could lead to a setup where the Fed could get itself out of making the market, could provide liquidity where it's needed, and not have retail investors, the general public, be on the hook if something were to go wrong.

Beckworth: So, who would actually have access to the Fed's balance sheet then, or to the standing repo facility, in this scenario?

Galper: So, let's pretend that primary dealers have access.

Beckworth: Okay.

Galper: Let's pretend that the Fed does have some kind of way to trade on the CCP, on the FICC's GCF repo platform. Or rather, to be more specific, clear on the FICC's GCF repo CCP. In that case, the Fed could offer its liquidity to firms that transact on the CCP, knowing that, that is one group of firms that in turn has to go out and then finance their underlying clients. This separates the too big to fail, "Oh my gosh, is JP Morgan in trouble because of repo markets." It's not, but separates concerns from your average investor, as well as regulators, that major banks that provide mortgages and such could be impacted by this turmoil in institutional repo. So, it's a separation of where the risk really lies. For right now, the risk lies everywhere, because we have these very large banks similar to European universal banks, which have aggregated all of their liquidity operations at a high level of the firm.

Beckworth: Well, Josh, you'll need to run for Congress and make that proposal one day.

Galper: Yeah, I think I'd be laughed out of the court, but ... And in fact, not all banks have centralized their liquidity at the top of the firm, but there's a lot of aggregation going on at the higher levels. The idea of returning to Glass-Steagall, I think, is politically, pretty much, impossible in this day and age, but I do think that in order to return to a real functional capital markets environment, I think the greater changes need to be made, and I don't think they're going to be solved solely by deregulation. I think what we're talking about here is much more smart regulation combined with strategic Federal Reserve liquidity provision that calms out imbalances in the seesaw of who is able to provide balance sheet in repo, and what cash is available to take the other side.

I do think that in order to return to a real functional capital markets environment, I think the greater changes need to be made, and I don't think they're going to be solved solely by deregulation. I think what we're talking about here is much more smart regulation combined with strategic Federal Reserve liquidity provision

Beckworth: Okay. Well, in the time we have left, Josh, once again, looking at that crystal ball that you don't have, and tell us what to expect next year for repo markets.

Repo Markets in the Year Ahead

Galper: Next year for repo markets, I think, we're going to hit additional acute points of volatility. I think we're going to hit more Federal Reserve proactivity for smoothing out that volatility. I think the experiences of mid-September have taught the current crew at the markets desk at the Fed, at the New York Fed, what they need to do and how fast they need to do it. And meanwhile, I think we're going to continue this complex conversation about who should really be providing liquidity. Should it be the Fed? Should it be private banks, and how much, and how much free range should they have? And that conversation, I don't believe, is going to get resolved in 2020. I think that that's one that extends for some time to come.

Beckworth: Do you think it gets resolved after the election?

Galper: I think the election could strongly push it in one direction or another. I don't think it gets finally resolved after the election. I still think that there's work to do. But, depending on who wins the election, that could meaningfully nudge the needle and set up short term solutions that solve market liquidity constraints for the time being.

Beckworth: I remember thinking about this, when will the announcement come out for, say, the standing the repo facility? And then you think, well, when is the announcement going to come out from the FOMC on their review? They're having a big review of their policies in terms of what do they target? What tools do they use? And, increasingly, it seems like everything hinges on 2020 elections, or they don't want to, maybe, say something before the election that might be deemed controversial. So, it might be that the review gets pushed back. The latest I've heard is that the review will be released, or they'll be some kind of announcement mid-2020, and I'm just wondering what that means for the standing repo facility, if there's a decision to be made on that.

Beckworth: Because there has been a lot of discussion, as you mentioned in the minutes, about this standing facility. So, it'll be interesting to see if it happens next year, which you think may not be the case for the year after.

Galper: I think it's entirely reasonable that the standing repo facility could be announced next year. I think then, the next questions are, how much and for whom? And that of course will have its own winners and losers and impacts in the market, and review, et cetera, et cetera. But I don't think that that solves really the problem that we've discussed, the core problem, which is, how do we get back to robust capital markets that are run by the markets without substantial government intervention?

Beckworth: Okay. Well, with that, our time is up. Our guest today has been Josh Galper. Josh, thanks again for coming on the show.

Galper: Thanks very much for having me.

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