Scott Skyrm on the Dynamics of the Repo Market in 2021

Changes in overnight repo rates can be anticipated by tracking how much Treasury debt is being issued on net, and how much the Fed is going to buy.

Scott Skyrm is the Executive Vice President in Fixed Income and Repo at Curvature Securities. Scott joins David on the podcast to discuss REPO markets, where they have been and where they are going. Specifically, Scott and David discuss the role of broker-dealers like Curvature Securities in the repo market, how repo markets are tied to treasury markets and government deficit financing, why repo rates have recently entered negative territory, potential reforms to the repo market, and much more.

Support Macro Musings and get a free NDGP Targeting mug.

Read the full episode transcript:

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: Scott, welcome to the show.

Scott Skyrm: Thank you, David. I really appreciate being invited to come here. It's a treat.

Beckworth: Well, it's an honor for me too. I was thinking about where we first met and I believe it was on Twitter, maybe it was in the blogosphere, I can't recall for sure. But you joined Twitter about the same time I did, and I know I've been following you there. You have great analysis on overnight rates, repos, so for all those incredible things going on in those markets. You've been a delight to follow, to learn from, and so it's just a great honor to get you on the show today.

Beckworth: And I'm excited to have you on, because there's been some exciting developments in those markets, and you're knee-deep in them, right? You're operating in the repo market space, and I'm excited to get your take on what's happening. Before we do that, though, Scott, could you tell us about your career journey, your path. How did you get into the repo market industry?

Skyrm: Right, so I had worked some summer jobs in Wall Street firms, and then when I graduated from college, I had wanted to be on a trading desk. And I wasn't too sure what type of trading desk I wanted, although I was always kind of interested in the macroeconomy, and that was kind of what I concentrated in at school with economics. So as it turns out, I ended up applying to a job at the Bank of Tokyo back in 1989, and they hired me as kind of an assistant on the trading desk, and it just, I was really lucky. You're very lucky to get put on a trading desk, especially not having to start off in another area.

Skyrm: So it was kind of a stroke of luck, and I really liked it, I really liked what I was doing there. There was a lot to learn. So I was really an assistant, and an assistant on a Wall Street desk in the late '80s was a lot different than now. I got people's lunch, I got people's coffee, I made copies. I was doing nothing that I was trained for in college. There was just no use of my macroeconomic classes with basically being somebody's go-to person to run their errands for them.

Beckworth: Sounds like a movie or something.

Skyrm: But I think that's maybe the price you pay to get a seat and get accepted, and then, and actually this'll tie in really well, and then when there is an opening, all of a sudden, you have an opportunity, and that's really what happened with me.

Beckworth: So how did you go from there into the repo industry specifically?

Skyrm: So it's interesting, so there was a repo trader on our desk who also did the settlements of the securities, which of course you cannot do right now. You cannot be a trader and do the settlements. But back then it was considered okay. So then that trader went to India to get married, and the head trader basically said to me, he said, "Scott, can you do the settlements? And we're going to have a guy in the operations department, we want to give him a chance, and we're going to let him do the repo in the morning."

Skyrm: So literally the first day that the guy was gone, and I was set up to do the settlements for the company and kind of watch them, the guy from the operations group didn't show up. It was like two hours into it, the repo day I think then started around 8:00, maybe it was 9:00, 9:30, and the guy hadn't shown up yet, and the head trader said to me, he said, "Scott," and he was a Japanese guy, "Scott, can you do it?" And I said, "Do what?" He was like, "Can you do repo?" And I said, "I can do the repo, don't worry." And I had no idea if I could do the repo. But I figured it out, I did the repo, it worked out. And then after that I think the window opened for me and it closed for somebody else, because I was actually sitting there at the desk and willing to take on more.

Beckworth: So when did you start that position at repo, what year was that?

Skyrm: 1990.

Beckworth: Okay, so you've seen repo through a lot, then. You've seen a lot of changes in the market, I imagine, observed how it's grown in importance.

Skyrm: I've seen so many changes that most of the changes I've seen are irrelevant now.

Beckworth: Huh. Great perspective, fascinating. But it's great, because that means you've seen several decades of repo market developments, you know this like the back of your hand, and maybe to start off our conversation today, I know most listeners will know what the repo market is, but maybe for those who don't, who are maybe just joining the show for the first time, explain what the repo market is.

Repo Market Basics

Skyrm: So the repo market is one of the largest markets in the world. I forget the current statistics, but the US Treasury repo market is probably $5 trillion, ballpark. And the overall US Treasury market is $20+ trillion worth of securities and growing, and what repo is is, it's kind of two things. So one of the things that repo is, it's a collateralized loan. So if you have cash, and you want to invest that cash, a repo investment is a fully-secured collateralized loan, you give your cash to somebody, you give $100 million in cash to somebody, you get $100 million worth of Treasury collateral, it's very safe and it's very secure.

Skyrm: On the other hand, there's also hedge funds, banks, broker-dealers, that there are entities out there that are trading the US Treasury market, and they leverage themselves. So a hedge fund might have, let's say $1 billion in capital or assets under management, and they may want up to $10 billion worth of US Treasuries, which is really not in far out left field, that they're leveraged 10:1, they're mostly leveraged a lot more than that. So in order for them to leverage themselves, they need to loan those Treasury securities to someone like a bank or a broker-dealer and get cash to fund their investment.

Skyrm: So if you look at the repo market on one hand, you have cash investors who want to invest their cash and hold a Treasury security. On the other hand, you have leveraged investors like hedge funds who have bought more securities and they need to borrow against those securities, and kind of the repo market is the intersection between the cash investors and the collateral providers.

If you look at the repo market on one hand, you have cash investors who want to invest their cash and hold a Treasury security. On the other hand, you have leveraged investors like hedge funds who have bought more securities and they need to borrow against those securities...the repo market is the intersection between the cash investors and the collateral providers.

Beckworth: So Scott, going back to that first perspective on repos, a place to park cash for these institutional investors, kind of a wholesale investor perspective. Is it fair to compare the repo account for them, similar to what a bank account is for me? I can go get that money out at any time, it's demand deposit. With an overnight repo, if you're parking cash, you can get it out the next day if you need to, if you're sensitive and you want to run with it.

Skyrm: Let me just mention one thing. In the repo market, we never say the word park.

Beckworth: Oh, okay.

Skyrm: Because parking securities is an illegal form of repo, in a way. So investing cash ... Now, of course, you don't have to worry about that, you're not at a broker-dealer. But I send emails and messages that ...

Beckworth: Right, right. This is David Beckworth speaking entirely, not Scott.

Skyrm: So in terms of, let's say you're a money market fund, and you're a $100 billion money market fund. You might own CDs, you might own discount notes, agency discount notes, you may own some short term mortgage-backed securities, maybe you own some treasuries, and then you kind of go down to your shorter term, because you don't want everything invested for two years, or whatever the 2a-7 rules are now, you don't want everything invested necessarily for two years, because what if your investors in the money market fund decide to turn in their shares? So in general, you're going to have some invested longer-term, some investment shorter-term, and some investment overnight. And in general, that investment overnight, and I think in the 2a-7 rules there is some type of mandate for how much percentage of the money market fund needs to be invested in cash overnight.

Skyrm: But there's a certain percentage that they like to keep in cash that will be there for redemptions, or if there are additional investment opportunities, that that cash'll be ready. So in general, when you get down to the overnight cash investment, or the one week, maybe the one month, most of that cash will go into the repo market.

Beckworth: So is it fair, though, to compare it to like a bank account for a person? I mean, it's easily accessible, you can pull it out the next day, it's that spirit of it?

Skyrm: Yes, exactly. And that's important, too, is that if you're doing an overnight repo, you're holding a government security and you're giving it back to your counterparty the next day. So it's liquid, it's very liquid, the rates are very, very competitive. And one thing that's really made the repo market, and this might be too wonky for most of your listeners, but I'll just lightly touch into it, is that one thing that's really important in the repo market is that it's exempt from some bankruptcy rules so that, if you have a repo transaction with a company, and they go bankrupt, you're able to liquidate that investment with the counterparty. If they had given you securities, you can liquidate those securities, if you had given them securities, you can buy back those securities in the market if your counterparty is in default or in bankruptcy. And that was all pretty much established under a company called Drysdale in the early 1980s that went bankrupt, and a lot of this law was kind of worked out, and it was really a pivotal moment for the repo market, which allowed the repo market to grow significantly. Because knowing that if your counterparty was in default or bankruptcy, your securities wouldn't be tied up in their account for maybe years while they're working out the bankruptcy.

One thing that's really important in the repo market is that it's exempt from some bankruptcy rules so that, if you have a repo transaction with a company, and they go bankrupt, you're able to liquidate that investment with the counterparty... [this] allowed the repo market to grow significantly.

Beckworth: Okay. So Scott, when I think of the repo market, am I really thinking about the overnight money market? Is this kind of like the heart of the money market in the US financial system?

Skyrm: So the repo market is certainly a large part of money market rates. Now, you could definitely argue that perhaps LIBOR was the reference rate for short-term investments and short-term interest rates for a lot of years, and that's been changing over the last few years, because with some of the problems that have occurred with LIBOR in terms of the LIBOR rigging, the Federal Reserve going back a few years ago had developed an overnight repo reference rate, it's called SOFR now. SOFR has three components to it. They're basically three kinds of different repo rates. And the Federal Reserve has made it clear to the market that they want the market transitioning out of LIBOR and into SOFR.

Skyrm: And so whereas, I would also say that repo has been the overnight or short-term interest rate that has had the most economic impact on the market. So in other words, with $5 trillion ballpark of repo transactions and treasuries that are occurring, when repo rates move it has a large impact economically on interest and who's paying interest and who's receiving interest. LIBOR's being phased out, and the LIBOR reference rate is supposed to become a kind of a derivative repo rate called SOFR.

Skyrm: And at the same time, the interest rate that used to be the fundamental policy rate, which was Fed funds, Fed funds was the key interest rate for overnight since maybe the 1920s, 1950s, something like that, Fed funds was the rate. Fed funds market has kind of died out, and Fed funds is an uncollateralized rate where banks would basically give each other cash, some people call it trading deposits, back and forth. But the Fed funds market, which used to be much larger, is really very small now. And ironically, the Fed funds rate is still the key policy rate for the Federal Reserve. So, when the Federal Reserve sets the Fed funds target range, it's based off of the Fed funds rate, even though the Fed funds market is very thin right now, and not very well-traded. If you were to think about that a little bit, and LIBOR is switching over to a SOFR rate, it wouldn't be surprising to me if some day, that the target range might be in SOFR. It's certainly possible. I don't think that's next year or the year after, but some years down the road it would make sense for SOFR to become the new policy target range.

Ironically, the Fed funds rate is still the key policy rate for the Federal Reserve. So, when the Federal Reserve sets the Fed funds target range, it's based off of the Fed funds rate, even though the Fed funds market is very thin right now, and not very well-traded.

Beckworth: Yeah, that makes a lot of sense to me and I've heard others say that as well. But in general there's been this transition from unsecured overnight money markets to secured overnight money markets, from Federal funds and the like to a repo market, and I guess if you had to pick some points, when did this transition take place, what were the pivotal times, or was it just a gradual process in your view?

Skyrm: I would say it's somewhat of a gradual process. So off the top of my head, certainly the size of the repo market is growing and has been growing. Actually, let's go one step before that. So as the US government has a larger and larger deficit, there's more and more Treasury securities out there in the market, and as there's more and more Treasury securities, there becomes a much larger repo market. So certainly the repo market has become more economically significant because there's more Treasury securities. And kind of the demise of the Fed funds rate, I would say I'm not an expert on that, but I just know from ... You can read articles that have popped up over the last five or so years, that there's only a few participants in the Fed funds market now, and maybe it's ballpark 70 billion a day, ballpark, that number might be a few years old, so what's driving the repo market?

Skyrm: I would say also, as the Treasury market grows and there's more participants in the market, there's more international participants, there's hedge funds. As cash investors become more sophisticated… So a cash investor 20, 30 years ago might've just left their money in their bank account at their clearing bank, and then they realized, "Wait a second, that clearing bank marks me up like 10 basis points. Why don't I go to the repo market and get a better rate, and then have a rate that's securitized with a US Treasury security?" So I think there's also, more sophistication in the market has driven more players into the repo market.

Beckworth:. All right, so Scott, that's kind of an overview of the repo market, a lot more we could go into, different parts of it, bilateral repo, tri-party repo. But I want to come back to you and your work. So there's this important repo market, it's incredibly important to funding the government's deficit, and keeping the money markets running smoothly. What role does your firm and you play in this market?

Role of Curvature Securities in the Repo Market

Skyrm: So what's very interesting about Curvature Securities is we are a broker-dealer that only does securities finance. Basically, repo. Which means that, in contrast to other broker-dealers, which a full-service broker-dealer holds customer accounts, they've got retail investors who open up accounts, they buy stocks and bonds, and even a broker-dealer that's more institutional will hold maybe hedge fund accounts in their broker-dealer. And so Curvature was set up back about five or so years ago, we started doing business about four years ago. But the idea was, our principles rightly foresaw that there were going to be some changes in the markets overall, especially with Basel III and Dodd-Frank, new bank regulation, which had capital costs for assets, or increase capital costs, capital regulatory costs for assets, leverage ratios limiting the size of balance sheets.

Skyrm: So back right around 2015 was when a lot of that regulation started filtering in the market, and it caused banks to shrink their balance sheets. And when banks shrunk their balance sheets, the easiest thing to shed from your balance sheet are repo transactions, because that's a very low-spread business. It's a business, so I mean, if you look at a major bank and they published their return on assets, and let's say it's ballpark 100 basis points, or a full 1%, loans versus where they borrow money for deposits, a repo desk is trying to make five basis points on their transaction. So when there is increased bank regulatory charges and limits, a lot of banks started getting out of the repo business or really cutting down the size of their repo businesses.

Skyrm: And at that point, Curvature Securities, my company, and there's some other, we call them independent broker-dealers that moved into the space to basically provide repo financing for participants in the market, and the participants in the market are generally hedge funds, cash investors, money funds, broker-dealers, and entities like that.

Beckworth: So, you are literally in the heartbeat of the repo market. You are the broker-dealer who helps facilitate this market.

Skyrm: Right. We have a pretty good chunk of the market for our size, and of course, when spreads are low, you have to make that up with volume. So we try to do a lot of volume, we have a competitive advantage over the banks, so that we can provide narrower spreads to our clients than the banks charge, because the banks have to pay capital charges and have leverage ratios. We don't have that, so we're able to kind of work tighter spreads for our clients, and it's been a very good business.

Beckworth: All right, Scott. So we've been discussing the repo market, you provided a great overview of it, what you do, how your firm participates in it. So one comment I often hear is that the repo market is essential to the functioning of US Treasury market, for the government to fund itself. So can you expand upon that, tell us why this is such an important link?

Importance of Repo Market for Government Financing

Skyrm: Well, think of it this way. If you've ever heard the phrase, ‘financial markets are the engine that runs the car of the economy,’ if you wanted to take that analogy one step further: the repo market is the oil that lubricates the engine of the financial markets that help power the economy of the vehicle. Having a financial market or having a repo market, a funding market that's large and liquid and efficient just makes everything else run so much smoother, so that when a company, as in a corporate bond, or the US Treasury issues debt, there's an easy way, if an investor buys that debt, and they need to leverage themselves, they're buying two for one for the capital that they have, they're going to leverage themselves, you want to have a very efficient lending market so that they can get cash to finance that transaction. It makes them more willing to participate in buying and selling in the market.

If you've ever heard the phrase, ‘financial markets are the engine that runs the car of the economy,’ if you wanted to take that analogy one step further: the repo market is the oil that lubricates the engine of the financial markets that help power the economy.

Skyrm: And when a cash investor needs to sell a security, it might not be at that moment that the bank wants to buy the security, so the bank might buy the security and hedge it with another US Treasury, and you need the repo market for that. So you need the repo market to cover the short to finance the long position. It just makes the entire bond market more efficient and the tighter the spreads are the in repo market, the more efficiency that can kind of be passed to the overall cash market.

Beckworth: Okay. So we need to keep the repo market running well, and that's part of what you do with your firm, in order to keep those budget deficits financed. Now, one of the things that's been talked about a lot recently, and we saw it last week or so, is the movement in overnight market rates, repo rates in particular, to negative territory. There's been a lot of talk about that that we may be headed in that direction. Can you tell us if that's true, and if so, why?

Are Overnight Repo Rates Going Negative?

Skyrm: Okay, so let me break it down into a couple different points. So first off, in terms of negative repo rates, there have been negative repo rates many times before in the history of the repo market going back years and years, and negative repo rates will occur. They occur more often when the Federal Reserve has set the Fed funds target rate close to zero. So what happens is when there's a security that's in demand, let's say there's a lot of shorts on the security, and there's short covering that needs to borrow those securities, the price of that security will go up and the price goes up in terms of lower interest rates.

Skyrm: So negative interest rates for specific securities are nothing new, and they occur quite often. For general collateral rates like the overall repo rate, like the daily repo rate, which is like the cash investment rate, actually traded somewhat negative, slightly negative a few times last week, I think once this week. So that's a very strange occurrence, and it doesn't make a lot of sense that someone who has cash will say, "Okay, I'd like to invest my cash with you at the bank, what rate will you pay me?" And the bank says, "No, no, no, you're paying me for me to take your cash," because that's what negative rates mean. Negative rates mean you have cash, and you're going to pay somebody to hold that cash for you. Of course there's a variety of reasons why people will invest their cash at a negative rate. One reason is that it's mandated, they have to invest, like it's in their charter that they have to invest in US Treasuries or US Treasury repo, and so there's a few reasons, but kind of that's the main one.

Skyrm: So that's kind of why it occurs and why it did occur, and basically what's going on right now in the markets is that rates are very close to zero. And if you look at the repo market and overnight rates, most markets are supply and demand driven. So if you look at the government bond market and the repo market, the more issuance there is by the Treasury, the more supply of securities come into the market.

What's going on right now in the markets is that rates are very close to zero. And if you look at the repo market and overnight rates, most markets are supply and demand driven. So if you look at the government bond market and the repo market, the more issuance there is by the Treasury, the more supply of securities come into the market.

Skyrm: Now, of course, there's a lot of other factors involved, a lot of moving parts, but let's just say that that's the main driver of the supply of securities in the market. Then, you have Fed QE program, which I think they're not calling it QE right now, I still call it QE. They call it adding to the portfolio, something like that. So the more that the Fed comes into the market and purchases, takes securities out of the market. So whereas the Treasury has been putting, ballpark over the last few months, like 200 billion net new securities into the market, the Fed has been taking about 120 billion new securities out of the market, net about 80 billion treasuries.

Skyrm: So if you wanted to predict when are rates going to start moving higher, when are repo rates, when could rates turn negative, it's really a call on if the Treasury stops issuing more debt, that'll create a shortage of the securities, and rates will go negative... If the Fed stopped buying so many securities in QE, that'll be less demand, and rates will start to go higher. So really, you have to watch how much net debt is the Treasury issuing, how much is the Fed buying? And that's going to determine where overnight rates are going to go.

If you wanted to predict when are rates going to start moving higher... [or] turn have to watch how much net debt is the Treasury issuing, how much is the Fed buying.

Beckworth: So I understand the supply side story on treasuries, the relative supply amount given what the Fed and the Treasury's doing. I wonder, though, about on the Fed side, though, in terms of reserve creation. So here's a story I've heard, and I want to run it by you and you can provide feedback whether it makes sense or not. But the story is, it's not just that the Fed's taking out all these assets, these treasuries, but it's adding all these reserves. So you mentioned 120 billion a month. And then the Treasury General Account, that Janet Yellen, our secretary of the Treasury, said she's going to wind that down, another trillion dollars there. And all these reserves are going to be gushing into the market, and they got to go somewhere, and a lot of the bank balance sheet space is used up. So banks have to hold reserves, they don't really have a choice. They can discourage it, but they're the ones that have reserves.

Beckworth: And all the bank balance sheets are pretty saturated, so the next thing is they might go to money market funds, and they in turn could park some of those reserves at the Fed at the overnight reverse repo facility. But definitely paying 0%, and as more and more goes in, those money market funds, they have to charge their clients some kind of fee just for processing this, and at some point they're earning zero at the Fed, they've got to pass on these fees to their clients, which means negative yields. I mean, is there also pressure coming from all the reserve creation through this story I just said?

What About the Fed’s Reserve Creation?

Skyrm: Yes, so let me hit a couple points. Number one, with the Treasury TGA account, the Treasury back in August had run up the size of that account to about a trillion and a half, and normally it's about, I don't know, 400, 500 billion. So the TGA account is the Treasury General Account, it's kind of, "Let's have some extra cash around sitting in the Treasury in case we have to spend some money." Back in August, the Treasury was expecting another stimulus package, or larger stimulus packages, so they ran up the size by issuing a lot of Treasury bills into the market. And as you noted, Janet Yellen had mentioned that the Treasury's going to run down that TGA account, I think it's supposed to run down to, I don't know, 400 billion or so by the end of June, and of course that basically means that more, there's going to be more securities maturing from the market, because they're not going to be issuing bills to replace that cash. So that's a decrease in the amount of supply of securities in the market.

Skyrm: However, we did just get another $1.9 trillion package in March, and I forget how much money has already been put out the door, 250, 275 billion went in stimulus checks to people. So I don't think the Treasury TGA account is going to have as large an impact on the market as we expected a few months ago, because we ended up getting the stimulus package. But if you want to look, and those are specific events that are important right now. But if you want to look at how to analyze the market, and you know how I was talking about treasury issuance versus QE purchases and things like that, if you want to look and see where the market is in terms of financing the debt, you really look at the spread between Fed funds, the Fed funds rate and the general collateral rate.

Skyrm: So right now the spread between the Fed funds rate and the general collateral rate is trading about four basis points below Fed funds, which basically means that Fed funds are uncollateralized cash investments between banks. Treasury investments, general collateral, people are willing to fund treasuries lower than Fed funds, which makes a lot of sense. You can get a US Treasury-collateralized investment on your cash, and it should be a lower rate than you pay in Fed funds.

Skyrm: However, that spread between general collateral and Fed funds tends to vary over time. So if you took that rate, if you looked at the spread between Fed funds and general collateral, and you looked at it back in, let's say, September of 2019, Fed funds, general collateral was ... And I forget the exact numbers, but it was an easy 10, 15 basis points over Fed funds. Which basically, so that's switched, where now it's trading below Fed funds, general collateral, back then it was trading much higher than Fed funds, and that's a gauge of, okay, how many Treasury bonds are in the system that are being financed by the repo market versus the demand? So right now you could say there's a lot of demand for Treasury securities as an overnight investment, whereas back a year and a half ago, the repo rate had to keep raising relative to Fed funds in order to finance all the Treasury securities that were around in the market.

Skyrm: When you want to look at bank reserves, you could say that, "Okay, when there's kind of stress in the market, and bank reserves that go into the repo market are being used to finance treasuries as much as they can, but the general collateral rate trades much higher over Fed funds," and it's a sign that there's a saturation of Treasury securities in the market.

Beckworth: Okay. So is it important, then, what kind of treasury is being issued? So if the government began to issue more T-bills over notes and bonds, would that be helpful to the repo market? What do people want? They want the T-bills, the notes, the bonds?

Skyrm: Bill issuance tends to correlate better with repo rates than longer-term treasuries.

Beckworth: Okay.

Skyrm: Because what'll happen is, as I mentioned before when we talked about negative rates, a company, let's say a money market fund, a bank, a central bank, which is mandated, our cash through six months' investments must be US Treasuries. So when you have a mandate like that, and if overnight repo rates are negative, probably short-term bills are negative also, because they are connected.

Beckworth: All right. Well, let's go to September 2019. You touched on it already, you mentioned that the repo market had to have a higher interest rate to finance the treasuries during that period. What is your story? From where you sat as a repo broker-dealer, what was going on that led to that outcome? And that was this great repo market crisis we were all over-excited about for a while.

Explaining Repo Rates from September 2019 and March 2020

Skyrm: Yeah, that was very interesting, because we've never seen anything like that before in the repo market, where rates spiked up to 9% one day.

Beckworth: Yeah, amazing.

Skyrm: I mean, it was really crazy. And pretty much, if you look at my example, which I was kind of opening up the door for that September 2019 discussion, I opened up that door a few minutes ago, is that ... So what pretty much occurred, and of course if you're interested in further reading, I did publish a white paper on it.

Beckworth: Oh, okay.

Skyrm: And it went out to a bunch of my customers, I might've put it on Twitter. But pretty much, Zero Hedge picked it up and republished the entire think on their website, I think late September, early October. And I pretty much, graphs and charts, here's what happened. But I'll tell you it's kind of, in a nutshell, what happened. We were just talking about when the market's super-saturated with treasuries, so let me set the stage.

Skyrm: The Fed is raising rates, overnight interest rates, raising Fed funds rates, so then they're theoretically draining liquidity from the market so rates go higher. The Fed was unwinding QE, so they're taking Treasury securities and mortgage-backed securities that were in their SOMA portfolio, and putting them back into the market. So you have the Fed draining cash, putting securities back into the market, and at the same time the Treasury was issuing a lot of debt, there was some big budget deficits back then, so the Treasury itself was putting a lot of treasuries into the market.

Skyrm: And what happened was that general collateral rates relative to Fed funds, general collateral was trading well, well above Fed funds. There are a lot of treasuries, a lot of hedge funds, a lot of leveraged money had come in, and a lot of leveraged money owned treasuries. So you have a lot of hedge funds and leverage money that need to finance their treasury purchases every day, and at the same time you had a little hiccup that occurred where it was a day where there was a tax date, and there's a little less cash in the market, and a lot of the hedge funds had really big positions. And there was probably something else going on at a big bank, which never really came out, but there were all sorts of hushed rumors, and something to do with an oil platform and money going back to Saudi Arabia.

Skyrm: None of that was ever confirmed, but there was something else going in the market also that drained some cash, and then that little drain of cash, when you have all these hedge funds, first thing in the morning 7:00 to 8:00, financing hundreds of billions of dollars’ worth of treasuries, and all of a sudden there's kind of not enough cash to fund them at that time in the morning. Of course, by the time the day ended, rates were back to normal. But first thing in the morning, there just wasn't all the cash out there that was required to finance all the hedge funds and the leveraged money. So there's a panic, and rates spiked, and they eventually came down by the end of the day.

Skyrm: But one of the things that was happening also was that the Fed, even though we had a foreshadow of that on year-end the year before, December 31st, 2018, there was a rate spike then also. And it was kind of foreshadowed, the Fed had never come in and restarted some of its programs. So right now, you have the RP program, where the Fed will take collateral, give cash to primary dealers, as kind of a market mechanism to keep rates from spiking. But the Fed had turned that off years before, and they never turned it back on. And then of course during the repo crisis of September 2019, they turned that program back on.

Skyrm: But basically, typically there are some programs to kind of help stabilize the market, and that particular one was closed at that time.

Beckworth: Okay, what about the March 2020 incident? So there the story often told is that first people were running out of risk assets like stocks and other equity, and then they went into treasuries, and then from treasuries they went into cash. So from where you sit as a repo broker-dealer, what did you see happen?

Skyrm: Well, I'll tell you what we saw in March. So if you kind of connect September through December, back then, as I was saying, the treasuries were very cheap on the curve, because of all those reasons I cited before. There's a lot of leveraged money that owned treasuries and were very leveraged with their treasury portfolios. Those spreads came in a little bit in January, and some of those companies kind of got out of those positions, but there still were a lot of "basis trades" on, where hedge funds are long treasuries, they're hedged with futures, and they've got a really good spread in there, they'd done great in the fall in that trade, and going into February, they were still very leveraged. And of course, that particular trade doesn't do well if somebody is out there buying futures to hedge themselves in the market.

Skyrm: And so kind of what happened was as the virus, as the COVID crisis kind of started, futures rates started moving lower, and the spread between treasuries and futures widened considerably, the spread between treasuries and mortgage-backed securities widened considerably, so what ended up happening is that as the market started pricing in lower rates and Federal Reserve rate cuts, spreads widened, and a lot of hedge funds and leveraged money took losses, because they had been in this great, juicy trade for a long time, and then as they started taking losses they started liquidating their positions. And there were a couple companies that went bankrupt, went out of business. It was kind of more in the REIT space, the companies that went bankrupt or the hedge funds or REITs that went bankrupt, they're more in the mortgage-backed security space, because those spreads really widened.

Skyrm: In the treasury space, spreads had widened, and it was kind of, everybody's looking for the door at the same time. So when everybody is looking for the door at the same time, it creates a lot of volatility, there's a lot of volatility in the market. Banks took on larger and larger assets on their balance sheets, which of course, beginning April 1st after that, the Federal Reserve ended up exempting the SLR, special leverage ratio rule for the banks, because they'd taken on so many assets to basically keep the treasury market flowing. So there was a crisis in the market, we've had crises before, but from where I saw, it was really an unwinding of a lot of leverage that had occurred kind of in previous months.

Beckworth: Now you mentioned everyone was trying to get out at the same time, which created a lot of this pressure. And when you say get out, get out of their treasury holdings, their non-cash holdings, into cash?

Skyrm: Yeah, getting out of their treasury holdings or their "basis trades." They're long treasuries that were cheap on the curve, they were short futures that were expensive on the curve. So to get out of that trade, they got to sell their treasuries, which are cheap; they've got to try to buy back their futures, which are rich. So they're chasing a spread that's widening, and then you have a lot of people doing that at the same time, it really pushes spreads out.

[In March 2020, everyone was] long treasuries that were cheap on the curve, they were short futures that were expensive on the curve. So to get out of that trade, they got to sell their treasuries, which are cheap; they've got to try to buy back their futures, which are rich. So they're chasing a spread that's widening, and then you have a lot of people doing that at the same time, it really pushes spreads out.

Beckworth: Well, do you see, moving forward, a need to reform any part of this market? So treasury market repo, money markets, is there any structural problem that you could see causing these type of crises to occur again?

Skyrm: So let me just say upfront that I am a middleman in the market, so I want to see the Wild West happen.

Beckworth: Right, good times.

Skyrm: I want to see volatility, I want rates going up and down. The more volatility in the market, the more distortions occur on the yield curve, the more trading opportunities there are. So for us, if we're going to finance our customers, I want those customers doing a lot of business, and they do more business when there's distortions in the market and the market's volatile. So I do like that, by the way.

Potential Repo Market Reforms

Skyrm: But I would say, if you're going to look at some type of reforms, there was talk about a funding facility that was maybe going to be opened up to non-primary dealers, where dealers or counterparties could give collateral to the Fed at a certain rate, somewhat of a penalty rate. And what happened was in the last year, the Federal Reserve, they took the RP program, which basically puts a ceiling on repo rates, and that's only open to the primary dealers. But they raise the rate on the RP program to kind of create a ceiling in the repo market, and I think that the Fed, and I've written about this in my market commentary, I think that the Fed achieved what they wanted to achieve by keeping that rate above the market so that it's a penalty rate, but it's there in case rates spike.

Skyrm: And in terms of reforms, strangely, I see people talking about central clearing in treasuries and repo, and we kind of already have central clearing. It's not like a blockchain thing, which maybe will occur someday, but there's a central clearing counterparty called Fixed Income Clearing Corp, FICC owned by DTC, and they're a central clearing counterparty, so we kind of already have that. I would say off the top of my head, I can't really think of anything more in terms of having infrastructure in the market that we need. There's a ceiling on rates, the RP program, there's a floor on rates, the RRP program ... Oh, I'll give you a great reform that we need. They need to get rid of the Fed funds rate by now. The volume of the Fed funds every day... It's not a real rate. It's been stuck at seven basis points when general collateral's been trading at zero and negative, it's just not a real rate anymore. There's not a lot of participants in that market. And yes, 50 years ago it was a really important rate, lots of local banks trading Fed funds, going to the money center banks to get funded or give them cash. And now it's just, it's got a few participants, very little trading volume.

A great reform that we need [is] they need to get rid of the Fed funds rate by now...It's not a real rate. It's been stuck at seven basis points when general collateral's been trading at zero and negative, it's just not a real rate anymore. There's not a lot of participants in that market.

Skyrm: But still, our entire economy is referenced in Fed funds and the Fed funds target rate, it's referenced to this Fed funds rate which is barely a rate anymore. And I will say that certainly the Federal Reserve and regulators have been pushing to get rid of LIBOR, and LIBOR is going to disappear eventually, and the replacement for LIBOR is SOFR, and that's been made pretty clear. SOFR has a futures contract now, there's a lot of volume in the SOFR futures contracts these days. So SOFR's become a good interest rate futures for the Fed to kind of base policy on, and I would say that if I were to predict something that in the next 10 years, SOFR will be the policy rate, and Fed funds will no longer ... Actually, Fed funds is relevant now even though it probably shouldn't be a relevant rate.

Beckworth: Yeah, no, very interesting, and I've heard other people as well call for the SOFR to be the new target policy rate going forward. All right, so in the time we have left, just one last question. If someone wants to look up the repo rate, so preparing for the show and some other work I've done, there's several places that one can go. DTCC has a repo rate, there's a bank that has it, and then you mentioned the SOFR rate itself is a repo, an average of them, so where would you recommend we go to look for repo rates?

Skyrm: Okay. So if you want to look for a general collateral repo rate, DTC publishes something called the GCF repo rate, that's probably on their website. You can find that. That's pretty close to the repo rate, it is on Bloomberg. I think SOFR is, I think in the Wall Street Journal each day, and SOFR can be looked up on the Fed website, every morning around 8:00 they update it for yesterday's rate. So these rates are pretty available.

Beckworth: All right, well with that our time is up. Our guest today has been Scott Skyrm. Scott, thank you so much for coming on the show.

Skyrm: My pleasure, have me back some day.

Photo by Olivier Douliery

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.