At the end of 2022, the daily volume of overnight reverse repos (reverse repurchase transactions) between the US Federal Reserve (Fed) and private sector eligible money market participants—mainly money market funds (MMFs)—reached a new record high of $2.55 trillion. The persistently huge footprint of the Fed in private short-term financial transactions, both during the previous quantitative easing (QE) period and the current monetary and quantitative tightening (QT) phase, reflects the preference of financial institutions and other companies to deal with the Fed rather than conducting businesses among themselves. This is an unhealthy development with largely negative implications for the US financial system and economy going forward.
The Fed’s overnight repo and reverse repo facility (ON RP/RRP) allows MMFs to borrow from or lend to the Fed, using government securities as collateral and agreeing to buy or sell back those securities at agreed rates, on an overnight basis. The ON RRP facility has attracted a record amount of cash after enjoying growing daily transaction volume since mid-2021. It consistently reached above $2 trillion since June 2022—swelling notably at the end of quarterly reporting periods. This happened despite Fed officials’ earlier expectations that such a volume would dwindle when the Fed started to tighten monetary policy to fight inflation. This phenomenon is driven by the way the Fed has used its reverse repo facility, which currently pays 4.3 percent to eligible participants such as MMFs, as a soft floor; and payment of interest—currently at 4.4 percent—on bank reserves at the Fed as a ceiling, to guide the effective Fed funds rate. The effective Fed funds rate currently trades around 4.33 percent—within the targeted range of 4.25 percent to 4.5 percent. There are two related reasons for the recent surge in Fed reverse repo activity.
Firstly, recent regulatory policy changes have prompted the increased use of the Fed reverse repo facility. The supplementary liquidity ratio (SLR), regulating the amount of liquidity commercial banks need to hold relative to its balance sheets, was relaxed in 2020 during the acute phases of the Covid-19 pandemic. The decision gave banks more flexibility in taking deposits and holding reserves and US Treasury securities. The SLR was then restored in March 2021, causing banks to lose willingness to accept deposits and holdings of US Treasury securities and reserves at the Fed. Their reluctance pushed customer money to the MMFs, which must find a place to invest the funds that are required to be kept in instruments of high quality and short maturity. In fact, the SLR decision designed to reduce risk in the banking system seems to have pushed money to non-bank institutions, mainly the MMFs. Additionally, the Fed may have facilitated the move into ON RRP by relaxing the facility’s eligibility standards, raising the daily counterparty limits, and raising the offer rates.
Secondly, as the ON RRP has been made more attractive on a risk-adjusted basis during a period of policy uncertainty, MMFs have found few alternatives to invest the inflow of money. This led to the increase of their assets under management from around $3 trillion in 2012-2019 to around $5 trillion since early 2020 after the onset of the Covid-19 pandemic. As mentioned above, banks have reined in their appetite for taking deposits and other short-term borrowings. Additionally, over the same period, the outstanding amount of US Treasury bills has declined by $1.5 trillion as the United States extended the maturity of its borrowing to take advantage of low interest rates. As a result, the volume of ON RRPs has grown significantly at the expense of dealing with private counterparties such as during private repo/reverse repo transactions. ON RRPs now account for more than 63 percent of the portfolios of MMFs.
The importance of the Fed in intermediating the supply and demand of short-term funds has several implications for the US financial system and economy.
On the positive side, the Fed’s daily dealing with MMFs and other eligible participants through its ON RP/RRPs has enabled it to be aware of, and continually adjust to meet, the changes in MMF demand for cash or government securities. The Fed thus avoids the need for extraordinary and emergency interventions to calm market turmoil as in the September 2019 and March 2020 episodes.
However, this has come at a high cost: the intrusive role of the Fed in money market activities. MMFs and other players have been incentivized to rely on the Fed’s ON RP/RRP facility. They enjoy practically zero counterparty risk and use top quality government securities as collateral at remunerative rates. But they tend to reduce dealings with other private sector entities using private investment instruments as a result. This has already been reflected in the daily transaction volume in various money markets at the end of 2022: $2.55 trillion in the ON RRP market; around $1 trillion in all private repo markets used to calculate the secured overnight offer rate (SOFR) as the new money market benchmark rate replacing the Libor (London Interbank Offer Rate—being discontinued due to accusations of rate manipulation by banks); and around $100 billion in the interbank Fed funds market. If these trends continue they will marginalize the role of private markets for short-term funds, weakening the usefulness of market price signals arising through the autonomous supply and demand for funds among private entities.
Specifically, the rates calculated from the private money markets—such as SOFR from private repo transactions and the Fed funds rate from the Fed funds market—will risk losing their relevance as benchmarks for pricing short-term funds in the United States. Generally speaking, this could hamper the optimal allocation of short-term funds in the US economy, impairing its efficiency over time.
Moreover, the Fed has generated net earnings, mainly from interest income on its holdings of government and other securities as well as on its lending to banks. This has allowed it to transfer about $1 trillion to the Treasury department cumulatively since 2010, reaching a record annual payment of $109 billion in 2021. However, as the Fed has begun to reduce its holdings of government securities through QT and pays interest in ON RRP transactions and on bank reserves at the Fed, it is estimated to post a loss of $80 billion by the end of 2022. In other words, the US government stands to lose a stable and painless source of revenue from the Fed when such an income can be useful given many urgent needs for government spending.
The way the Fed implements its monetary policy decisions has incentivized MMFs to deal with the Fed at the expense of other private entities. By guiding the effective Fed funds rate within targeted ranges and implanting other prudential regulations, especially the Supplementary Liquidity Ratio for banks, it has led the US economy to rely on the Fed for its normal operations as a money market maker of first resort, rather than a traditional lender of last resort during financial crises. This development could, over time, undermine the efficiency and robustness of the market economy the United States claims to have.
Hung Tran is a nonresident senior fellow at the Atlantic Council GeoEconomics Center; former executive managing director at the Institute of International Finance and former deputy director at the International Monetary Fund.
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