Dissecting what’s going on in the repo markets
There are two sides to every deal. The repo markets are no different.
On one side of the deal, there are banks sitting on a large supply of cash. On the other side of the deal, there are the hedge funds that are sitting on a large supply of Treasuries.
Banks lend cash to hedge funds and hedge funds place Treasuries as collateral to banks. Hedge funds are able lever up trades they make on Treasuries.
How do they do it?
One increasingly popular hedge fund strategy involves buying US Treasuries while selling equivalent derivatives contracts such as interest rate futures, and then pocketing the difference. This is an arbitrage strategy that hedge funds use that would generally yield small profits.
The trade is not profitable on its own, given the close relationship and price between the two sides of the trade. Hedge funds use leverage via the repo markets to increase returns.
In some cases, hedge funds take those Treasury securities they own, and place it as collateral in the repo market for cash. Those hedge funds then use that cash to increase the size of their trade and buy more Treasuries, and place it as collateral in repo market for cash once again. This process can be repeated over and over to leverage off the potential returns of this trade.
The arbitrage strategy above was once popular amongst dealer banks themselves. However, higher capital charges have led to their displacement by hedge funds, due to hedge funds greater ability to take on the risk of this trade.
There has been a growing clout of hedge funds in repo market, including Millennium, Citadel, and Point 42, which are very active in repo market and are also the most highly leveraged multi-strategy funds in the world.
So what really happened in September 2019 in the repo market?
This brings us to the market on September 16, 2019. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points).
The repo rate reached as high as 10% that day.
Some have speculated that end of quarter pressures put on banks to meet those regulatory guidelines caused the repo spike.
However, you have to consider that these overnight funding Market issues arose in mid-September. Not at the end of September when you would expect banks to hoard more cash.
What happened in August and September that could have caused issues in the repo Market that rippled through hedge funds?
We turn our attention to Treasuries and their performance in August and September.
From July 31st 2019 to August 15th 2019 TLT (20+ year Treasury Bond ETF) increased almost 13%. This was following the Fed’s first-rate cut after the tightening cycle that we saw ultimately in December 2018.
The Fed cut the rate 25 basis points and the Treasury market responded with an outsized move on Long-Term Treasuries in anticipation more easy money Fed policies becoming a mainstay. The Fed reiterated that the rate-cut was a “mid-cycle adjustment”, but that didn’t stop Long-Term Treasury prices from surging.
From September 5th to September 13th the same Long-Term Treasury bond prices dropped 7%. This could be due to the fact that investors realized they over adjusted the price of long-term treasuries and were now adjusting prices down to reflect new expectations.
I believe much of the volatility in the overnight repo markets has to do with these large moves in Treasuries, which increased volatility in any trade related to Treasuries, which in turn would have an effect on leveraged trades made by hedge funds on Treasuries. Banks may have recognized this, and grew reluctant to provide cash funding to this market for this and other regulator reasons.
There is still a lot of research and learning I need to do on this, but these are my thoughts on the repo markets as of January 20, 2020. Please share your insights in the comments below.
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