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Where is all the cash going? The Federal Reserve and the Overnight Reverse Repurchase Programme.

In the last months some attention has been drawn to the huge amounts of money that some market participants are parking at the Fed using the Overnight Reverse Repurchase Programme (ONRRP). The recent spike in the use of this facility, reaching nearly the $1000bn at the beginning of July, have risen alarm among some analyst but the use of the Fed’s programme per se, does not imply the existence of any financial stress. Its use is related mainly with the way in which the financial markets operate nowadays in an environment characterized by low yields, increasing amounts of liquidity and banking regulatory requirements. According to Jerome Powel, chair of the Fed, “the reverse repo facility is doing what it is supposed to do, which is to provide a floor under money market rates and keep the federal funds rate well within its range”.
 

The Overnight Reverse Repurchase Programme.
Concerning Fed’s programme, it was approved in 2013 with the goal of keeping the effective federal funds rate[1] (FFR) from failing below the target set by the Federal Open Market Committee. The ONRRP establishes a floor for the wholesale short-term rates that, if used, allows some non-bank financial institutions to avoid negative rates. The ONRRP makes it possible for the Fed to drain liquidity from the system overnight and complements the interest on excess reserves (IOER), used for depository institutions to keep their excess reserves on the central bank. In an ONRRP, the financial intermediaries buy Treasuries from the Fed, under the agreement that the Fed will repurchase those Treasuries the following day at a higher price.

Prior to 2013, the Fed was able to control the FFR through the IORB, the interest remunerating the reserve balances[2]. This was because banks, having access to a positive remuneration coming from the IORB, were not willing to lend money in the interbank money markets at a lower rate than the one offered with the Fed.

At that time, the control of the FFR trough the IORB was possible because the great majority of transactions in the interbank money market were done by commercial banks. Although, this situation changed in the year 2013 as a consequence of the emergence of the Government-Sponsored Enterprises as key players providing lending. Since the GSEs did not have the option to park their excess cash at the Fed through the IORB, they were lending it and with this, creating a gap between the IORB and the FFR. The solution to this problem was the creation of the ONRRP, allowing non-banking financial institutions to keep their excess cash at the central bank. The facility, initially created as a temporary programme, turned out to be effective in 2015 once the Federal Reserve started to raise interest rates. 

It seems that right now, the main participants using the facility are Money Market Funds. These financial institutions are mutual funds that invest in highly liquid short-term assets and participate in the repo markets. The assets in which they invest and the ones that they use as a collateral in the repo operations are generally safe assets mainly consisting of Treasury bills, Government agency obligations (mainly Mortgages Backed Securities) and high-quality commercial paper. The MMFs are one of the most important sources of short-term financing nowadays and they play a key role in the financial system. This importance, in addition to the lack of the central bank’s safety net and the possibility to initiate and contribute to the process of fire sales of assets as a consequence of the fast withdrawals of money they can experience, make them to be important institutions when it comes to financial stability. They way in which MMFs provide liquidity to the system is through the repo market, buying risk-free securities. In this process, the MMFs are involved in traditional repo operations in which firms sell securities to the MMFs with the compromise of repurchasing them after some time (normally overnight or for periods ranging from 7 days to 28) at a higher price. In order to avoid the materialization of credit risk, the parts involved treat the securities purchased by the MMFs as a collateral with a higher value than the one of the principal. In the process, the firms are able to get short term liquidity from the MMFs in exchange of an interest payment determined by the difference between the security prices. 

In relation to the use of the facility right now, the MMFs want to park their cash into the Fed to avoid bearing negative interest rates. This is understandable if we consider that the level of safe assets in which MMFs can invest is being constrained by the huge demand of these assets, coming from market participants and the Fed (right now purchasing on a monthly basis $120bn of Treasuries and MBS). In addition, the MMFs have been receiving higher amounts of cash as a consequence of the increase in the level of household’s savings and the reluctance of banks to increase deposits. This reluctancy to take new deposits has to do mainly with the regulatory requirements in a context of high bank reserves and, more precisely, with the suspension of the regulatory changes affecting the Supplementary Leverage Ratio (SLR) in place since the beginning of April 2020. 

Concerning this ratio, the 1st of April 2020, the Fed decided to tweak the way in which the SLR was calculated in order to minimise the effects of the coronavirus on the functioning of financial markets. The change affected the denominator of the ratio, the total leverage exposure, through the exclusion of the reserve balances and the Treasuries from it. With this decrease in the total leverage exposure of banks the SLR ratio was increased thus, allowing banks to continue holding Treasuries and providing liquidity to the market through repo operations. Additionally, the exclusion enabled banks, especially those classified as a Global Systemic Important Banks (GSIB), to hold more reserve balances and Treasuries without having to fund themselves with more capital. The 19th of March 2021, the changes in the way SLR was calculated expired making depository institutions to increase their capital requirements because of their holdings of reserve balances and Treasuries. The expiration of this regulatory changes has been behind the decision of GSIB to push deposits to MMFs and hence, encouraging these to use the ONRRP facility. According to the March 2021 Senior Financial Officer Survey conducted by the Fed, the expiration of the SLR relief and the increase in capital surcharges were behind the reduction of the bank’s balance sheets, pushing savers and their deposits into MMFs. 
 
Conclusion.

As previously seen, the effects of the ONRRP per se are not disruptive for the current well-functioning of the financial system since the Fed is just withdrawing excess liquidity from the market. Apart from this, as the central bank acknowledged in 2015, the necessity to keep this facility exacerbates the risk of flight-to-quality during periods of financial stress. During periods of high market uncertainty, MMFs, as well as other non-banking financial institutions, can decide to park their cash in the Fed at the expense of a reduction in the general level of liquidity. This liquidity decrease, if acute, can disrupt the wholesale short term money markets forcing participants to initiate a process of fire-sales, leading to a contagion in financial markets that can increase the systemic risk.
Concerning the evolution of the facility, once the effects of the change in the SLR has vanished, its use will be mainly[3] conditioned to the evolution of interests rates, specially those of the Treasury bill, as well as the supply of these. 

 
[1] The federal funds rate is the rate at which financial institutions lend to each other overnight on an unsecured basis.
[2] The reserve balances are the excess reserves that commercial banks deposit at the Fed.
[3] Apart from the Treasury bills rates, the use of the facility is also affected by a seasonal component that has to do with the calculation of the home leverage ratio requirements affecting the branches of international banks operating in United States. 
 
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