Collateral shortage and reverse repo

The US is different from other financial markets because so much of financing is outside the banking system. Bank lending is more important in other countries. Capital markets are the driver of finance in the US which means there are special needs for collateral with lending and leverage.

The capital markets cannot work efficiently if there is a shortage of collateral regardless of how much excess reserves are in the banking system. The spike in reverse repo, while an overnight offset to the impact of QE as measured through changes in the Fed balance sheet, is a reaction to changes in the micro plumbing of financial markets. Recent increases in reverse repo have been a response to the elimination of SLR (Supplementary Leverage Ratio) relieve for banks, the drawdown of the TGA (Treasury General Account) at the Fed, actions to the debt ceiling statutory ceiling at the end of July. 

In general, structural changes cause changes in the demand and supply of deposits at banks. At times banks want to hold less deposits for regulatory reasons. This constraint by banks causes money to flow to other short-term investment like money funds. The overall flow to other parts of the financial system creates collateral shortages which generates rate stress. 

In the case of collateral shortages, rates can spike because there is inelastic demand for necessary collateral especially early in the day. If risk increases, flow to safe assets increases, or there is a price dislocation which creates the demand for collateral, the available safe assets are constrained even with the Fed balance sheet (QE) increasing. 

Investor should care about plumbing because disruptions in the most liquid market for safe assets, Treasuries, will create the perception market dislocations. Increased risk perception concerning collateral will generate a build-up for portfolio safety and risk-taking should diminish. Hence, we should see a portfolio rebalancing out of risk assets. A collateral repo disturbance will increase the desire for a safety reserve.