Collateral Damage
Whispers of a “collateral shortage”, a lack of safe assets that form the major daisy chains of the global monetary system, have been circling all over financial and social media. But in reality, we’re far from it. The U.S. empire has embarked on a debt-issuance bonanza these past few years, and the financial behemoths have eaten all they can chew. What’s more, a reworked innovation of the Fed, a reverse repo facility by the name of “RRP”, has provided practically infinite amounts of safe assets for systemically important entities to consume, enough to ward off any major plumbing upheaval.
The recent insatiable bid for ultra-short-term Treasury paper, which drove the speculation, is instead the frontrunning of a debt ceiling fiasco, a drama that’s about to unfold.
This is yet another classic case of enormous demand for t-bills (Treasuries with a one-year expiry or less) that mature before an impending debt ceiling drama hits Bloomberg terminals. The U.S. empire — as a whole at least — is not going to let itself default on its debts, yet investors always prefer the assurance of repayment, plus the comfort of not having to deal with another debt ceiling debacle. The enormous amount of liquidity stored in global money pools has found its way mostly into short-term Treasuries, over a sea of other alternatives in the global dollar funding complex.
Subsequently, we’ve seen rates on 1-month bills plunge over the last few weeks and below every other short-term investment, from GCF repo (green, below) to the Fed’s O/N RRP facility (red, below).
Another one of those short-term investments is bilateral repo (pink, above), resting alongside GCF (general collateral financing). Bilateral repos act as quasi-bills, providing similar intraday liquidity. Unlike the Fed’s RRP facility which returns overnight funds at 3:30 pm, cash from a bilateral repo is returned at 8:30 am, with the added option to exercise later on at any time during business hours — thereby mimicking intraday liquidity of bills.
When the supply of bills dries up, the bilateral repo market acts as a sponge, absorbing excess cash that would otherwise make it into the t-bill market. This is what we’ve witnessed just recently in Concoda’s U.S. Money Market complex.
Because of a rush to lock in pre-debt-ceiling doomsday investments, repo rates are being pressured to the lower end of the Fed’s target range. Though this is far from an ominous indication that a collateral shortage, with the potential to impede the monetary plumbing, is imminent. Investors want to allocate cash wherever possible before the debt ceiling drama, and one avenue is to lend in rates markets sporting inferior yields.
Many will also ask why some rates can drop below what the Fed pays via its O/N RRP facility, the lowest, truly risk-free overnight offering. But not all entities have access to the Fed’s money. Only a select number of banks, government-sponsored enterprises — Federal Home Loan Banks, and money market funds (MMFs) have gained admission. Moreover, overnight reverse repos through the Fed’s triparty repo platform are, by far, the worse choice for those looking to invest overnight cash. Since liquidity is locked in until late afternoon, some entities with RRP access will prioritize access to their funds over higher returns. All this results in a “leaky” Fed floor in money markets.
A leaky lower bound, however, is nothing close to a true collateral shortage or squeeze, where rates spike or drop uncontrollably, forcing the Fed to intervene. Since the repo spike of September 2019, the Fed has been able to prevent both incidents from reoccurring, after implementing its Standing Repo Facility (SRF). The idea of the SRF is that by offering unlimited repo loans at the most favorable rate to primary dealers, those dealers will transmit the necessary liquidity to other parts of the repo market, suppressing fear and volatility. This not only worked to quash the 2019 repo turmoil but the SRF has not been used ever since on a wider scale.
Today, with the RRP/SRF combo present, the only catalyst for a collateral shortage is what Concoda calls an “illiquidity spiral”. The most likely way a collateral shortage can develop is through rising volatility causing illiquidity, which induces further volatility, and so on:
“volatility creates more illiquidity, and illiquidity leads to more volatility, resulting in a doom loop that eventually gets too much for most market participants to endure” — The Federal Reserve’s Gambit, Concoda
This has grown more likely because of the actions monetary leaders took to try to paper over the cracks during various crises, resulting in a system that’s lost all order beneath its surface, while being able to act relatively normal on top. The only thing that can reveal those flaws currently is extreme volatility. The monetary plumbers, the dealers who make markets, price in higher bid and ask spreads, and the extreme cost to intermediate markets ends up forcing them to not only hoard but unwind financial daisy chains, which are not fully backed by collateral. This scenario may indeed create the much-hawked “collateral shortage,” but only if the Fed doesn’t intervene before an illiquidity spiral develops. Judging by the last decade or so, they will be quicker to step in than ever before.
Today, no present catalyst could seemingly drive such volatility. But if a collateral shortage, or worse a full-on collateral squeeze, does (for some black swan-related reason) emerge, money market rates will let the Fed know by dislocating its “jaws”:
The repo rate complex (above, bottom left) will fall below the lower bound of the Fed’s target range, now sitting at 4.75%, likely prompting another round of intervention — or even a debt ceiling resolution. With the former, it will require another chaotic fix, yet the Fed will find a way to regain control over rates markets. After all, when you’re the monetary authority of the ruling global hegemon, you always do eventually.