It's not the liquidity, It's the plumbing

It looks like the markets survived the year-end financing turn in repo. This stable year-end was only possible through massive Fed intervention to supply billions to the money markets and avert a financing disaster. It was a calmer year-end than prior years. Between Treasury bill buying and repo financing, all of the QT will be reversed. It may not be called QE4 but it certainly resulted in QT-minus. 

The repo problems that arose in September and have required a change in Fed operations is just a tip of the iceberg in a growing problem of financial market complexity.  What investors have learned is that the money markets and short-term funding markets are very complex systems. Complex systems will break. Complex systems, when stressed, may respond in unexpected ways. When regulations try and change complex systems, there will be unintended consequences. 

The "financing system" is the plumbing that sends central bank liquidity around the financial and real economy. When there is a lot of excess liquidity, leaky or stopped plumbing is not apparent and may not matter. When there is a shortage or no excess liquidity, the plumbing matters a lot. Many will not know there is a plumbing problem until there is stress in the pipes. At that time, it may be too late. Unfortunately, just adding more liquidity does not changing the plumbing. Liquidity only masks the problem. 

Financial plumbing is defined as the market structure that matches borrowers and lending in the short-term financing markets. The institutional structure, regulations, and the players or agents all matter in determining the smooth flow of funds. Dislocations in rates are just a reflection of the hot spots or points of blockage in the system. The blockage can be in one market or for a limited time, but a blockage can then back-up and crossover to other parts of the system. Liquidity seeks the path of least resistance and avoids blockages.

There is no magic solution to the problem other than to recognize the complexity and the fact that any change will lead to a market response. The Fed can provide greater funds, but this is just a means of de-stressing blockage; not solving the problem. If there is a leaky pipe reducing the water available at the tap, the solution is not to just force more water through the pipe.

What have we learned over the last few months?

Bank excess reserves do not mean excess funds. The Fed, through QT, started the process of reducing perceived excess reserves in the banking system. Given there was so much excess, it was assumed that a reduction of the Fed balance sheet would not impact rates. Unfortunately, there wa no good idea of the appropriate amount of excess reserves. It was assumed to be greater than pre-Financial Crisis levels, but there was not good firm number.

What we have found is that there are other binding constraints in banks that require more liquid funds be held by banks. Between liquidity requirements, reserve requirements, stress test requirements, and limits on intraday overdrafts, banks need to hold more reserves. There are less excess funds available, and regulatory requirements increase the amount of window-dressing and precautionary funds necessary at quarter ends.  There will be greater quarterly stresses with less excess funds available at critical times. The second lender of last resort, large money center banks, will not have funds available

Fiscal deficits do matter. Given the structure of auctions, dealers, and multiple institutional buyers, the market may not clear immediately. Bonds will have to be held in inventory by dealers and financed while end buyers are found. Bigger auctions require more financing of inventory. This is seen in current dealer positions. There will be funding stress when bonds mature and at auction dates. The market has also found that with greater variation in Treasury balances held at banks, there is greater reserve stress.

Players also matter. There has been a high concentration in excess reserves at only a few banks which means that their activities will have an undo weight on the repo financing market. Additionally, the “shadow” market of financial players outside the banking system like money funds have become more important. Hedge funds have also become more important in repo financing. The demand for funds as well as the supply have become more varied. There have also been no styles of funding through repo with the FICC and sponsored repo. The linkages also matter. The market has found that stress in the repo market leads to stress in the currency swap markets where there is significant funding that competes with repo. These institutions are more sensitive to regulations and current market structure than previously thought.

While the Fed has supplied the funds, this is not a solution and it highlights financing problems in the most liquid bond market in the world. A full review is warranted but that should not immediately lead to new regulations. Nevertheless, if a better understanding of the repo market structure is not acquired, the potential for a crisis will be fall upon all those trading fixed income.