What is ACTUALLY going on in the repo market?

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.

sept repo

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.

tlt prices

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.

The Federal Reserve is telling us there’s something wrong with hedge funds

Wall St Journal (Paywall)

One potential solution is to lend cash directly to smaller banks, securities dealers and hedge funds through the repo market’s clearinghouse, the Fixed Income Clearing Corp., or FICC.

Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligations—repaying the cash or returning the securities. Firms trading through the FICC contribute to a fund that would cover a borrower’s default. Critics of the new plan say if the Fed lends cash directly through the clearinghouse, it could end up contributing to a hedge-fund bailout.

The Fed’s aim, according to analysts, is to step back from temporary efforts to quell repo-market volatility and increase financial reserves. After September’s volatility, officials succeeded in suppressing year-end swings with temporary measures, such as offering short-term repo loans and buying Treasury bills.

With the Fed acting as a backstop to hedge funds, is this admitting failure in the repo market with repo operations? Maybe failure is a strong word. Let’s say that repo operations have been less effective at diffusing money market issues than they Fed anticipated?

Did the Fed believe these funding issues would go away after year-end, only to discover these issues aren’t going anywhere anytime soon?

This is an interesting development that I post about more in the days to come.

Update: Follow-up post here – What is ACTUALLY going on in the repo market?

Why are some banks blaming regulations on the spike in the repo market?

Back on December 31, 2018 (before our September 2019 repo blowup) the rate on “general collateral” overnight repurchase agreements (repo rate) went from from 2.56 per cent to 6.125 per cent. This was the highest repo rate observed since 2001 and was the single largest percentage jump since at least 1998.

Some (including JP Morgan Chief Jaime Dimon) believe that various regulatory measures introduced in the wake of the Lehman crisis designed to make the financial system safer ends up putting stress on banks at quarter-end and moreso at year-end.

What regulations are said to cause stress in the repo markets?

The Basel III regulatory framework, calculates a tiered capital surcharge on global systemically important banks (GSIB) and is based on factors like their geographical sprawl, complexity and absolute size.

These charges are calculated from a snapshot at the end of the year which means that the world’s biggest banks (JPMorgan Chase, Citigroup and Bank of America) are motivated to deflate the size of their overall balance sheet and trading book ahead of the end of every year, and then reflate them again afterwards.

This allows banks to essentially operate with less capital, boosting returns to shareholders in the form of stock buybacks and dividends.

Some believed that the spike in repo rates in December 2018 suggests that big banks were wary of playing their usual role in facilitating markets this year feeding the turbulence in the repo markets,

In mid-December 2018, the Basel Committee on Banking Supervision opened up a consultation on whether it should revise its quarterly assessment of balance sheets, noting that “heightened volatility in various segments of money markets and derivatives markets around key reference dates (eg quarter-end dates) has alerted the Basel Committee to potential regulatory arbitrage by banks”.

Some argued that regulators could also easily tweak the impact by calculating daily averages rather than using a snapshot, and move to a smoother sliding scale of capital ratios as opposed to the current tiered approach that encourages gaming.

Changes have not been made to these regulations however, and the repo market continues to wreak havoc on Fed policy as of January 2020.

What is a repurchase transaction (repo)?

Repo is a generic name for repurchase transactions.

In a repo transaction, one party sells an asset (such as Treasury Bonds) to another party at a set price. The seller commits to repurchase the same assets from the same party at some future date. If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss.

Repos are a way for borrowers to raise short-term funding by agreeing to buy and sell securities over very short timeframes. In practice they function much like a collateralized or secured deposit, and are a vital part of the financial system.

Banks had become increasingly active in the repo market in recent years, lending out some of the surplus money they hold at the Federal Reserve to earn a little extra return in a safe and liquid way.

How is repo rate determined?

The difference between the price paid by the buyer at the start of the repo and the price received at the end is effectively the lending rate on the repo. This is known as the repo rate or repo interest.

Why are repos used?

Repo agreements can serve four primary functions to different institutions:

They are a safe investment for those with extra cash laying around.
Borrowing costs are cheap.
Yields can be enhanced for institutions holding safe assets and by increase their leverage.
They provide a means for short-selling and short-covering.

It’s safe because the cash is secured by collateral, which is generally safe assets. It also makes it easy for seller of repo to make money back by selling those secured assets if the buyer does default on their payments.

Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.

What is repo with an example?

When an institution or bank needs immediate cash but doesn’t want to sell their securities, they can enter into a repurchase agreement to supply their immediate cash needs.

A repurchase agreement is similar to a loan, and you are using securities as a collateral.

For example, say XYZ Bank Corp. needs to raise cash in order to meet some reserve requirement level. They have plenty of securities on hand, but not enough cash.

In this situation, XYZ Bank Corp. decided to enter into a repurchase agreement with ABC Bank Group.

ABC Bank Group will take on XYZ Bank Corp’s securities and will lend them cash overnight to ensure they are meeting those reserve requirements.

Once the term is up, XYZ Bank Corp will “repurchase” their securities from ABC Bank Group and their debts will consider to be settled.

If it IS possible, how would you do it?

Don’t consider whether it’s possible.

Consider if it IS possible.

And if it IS possible, how would you do it?

If it IS possible, what would it look like?

We are all at the mercy of news trading algos

It’s become commonplace for news stories to drastically and instantly influence the movement of stock prices. This has become more observable in the past two years, with China trade deal news dominating headlines seemingly every day.

According to Larry Harris (Trading & Exchanges) there are four kinds of informed traders, with news traders exhibiting the second most influence on the market. According to Harris:

News traders collect and act upon new information about instrument values. They try to predict out instrument values will change, given new information. News traders try very hard to discover material information before other traders to.

Unlike value traders, news traders do not estimate the value of an instrument from first principles and all available data. Instead, they implicitly assume that current prices accurately reflect all information except their news.

It’s difficult trying to day trade or swing trade around the drastic changes in stock prices that are triggered from a single headline.

Many algorithms are programmed as news traders, which read news headlines or tweets and have some pre-programmed objective-based method of interpreting the sentiment of those headlines.

Algorithmic trading has been of much chagrin of people in Wall Street such as Jim Cramer. Earlier this fall, Cramer said the following about machine trading

Cramer blamed the errant jumps in the transport stocks on machine trading, calling the buying “robotic.”

“Real human buyers wouldn’t pay up eight points for FedEx on no news, unless they think there’s going to be some sort of takeover, which there probably isn’t. Real buyers work an order. They wait for sellers to come to them,” he said. “Instead, these machine buyers they blitzed all the sellers all the way up, and you have to believe they didn’t even attempt to try to get a good price for their customers.”

The dreary truth

We have to accept the fact that algorithmic trading is a part of the market as we know it.

As a day trader you will always at the mercy of algorithms suddenly going against your positions which makes day trading harder than it already is.

If you’re a swing trader, you can ride out the waves because news headline trading tends to smooth out over time (unless it’s something dramatic like a President Trump tweet tantrum).

So we must deal with it, must learn from it, and must learn how to trade with or around it. It’s up to you what you do.

Who are the four kinds of informative traders?

This post is a work in progress and will be updated frequently. Please bookmark page to see updates.

The follow note is based off Larry Harris’s book, Trading and Exchanges.

There are four types of informed traders who operate in markets. Those traders are value traders, news traders, information-oriented technical traders, and arbitrageurs.

Informed traders help prices more informative. Uninformed traders make prices less informative.

Value traders estimate the fundamental values of a particular investment. These are the traders who attempt to estimate the fundamental value of a company, and buy or short a stock based off this.

News traders estimate changes in fundamental values. They rely on value traders properly pricing an investment, and trade based off news events they believe can materially affect the price of an investment.

Information-oriented traders estimate patterns that are inconsistent with fundamental values.

Arbitrageurs estimate the differences in fundamental values. They identify investments which generally correlate. When they notice a divergence in those investments, they short one investment and long the other until the prices converge once again.

Why do options market makers take on short volatility positions?

Adapted from Options Volatility and Pricing Textbook by Sheldon Natenberg.

Option market makers typically profit when there is more options volume being traded. The reason for this is market makers profit from the difference in the bid-ask spread, and higher volume provides and opportunity for them to take in more profits on this spread.

When options trading volume is elevated, you also tend to see higher volatility in the market. This is because demand for options increases as volatility increases due to market participants purchasing protection for their portfolios and/or speculators looking to profit from large price swings.

Market makers have an indirect long volatility position

As a result of this, option market makers have what is known as an indirect long volatility position, because they profit when volatility is high as a result of increased volume. Market makers want an increase in the volume of options but not because they have long volatility positions per se.

To hedge against this indirect long volatility position, you will see market makers take short volatility positions in volatility contracts, most commonly the VIX.

The market maker takes a short volatility position because they want to hedge themselves against the possibility of there being low trading volume which would ultimately hurt their profits.

What I’m currently reading in January 2020

As of January 2020, here are the books at the top of my reading list. I’m currently flipping back and forth from these books on various topics.

Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris

I first heard of this book from squeezemetrics on Twitter. This individual said that this was one of the best books they found to gain a deeper understanding of the markets, and helped inspire the gamma exposure research that they have completed.

I got this a month ago and have to agree that this book is fantastic at helping you understand the inner workings of the stock market. If you are up for advanced knowledge on the markets, this book is for you.

From Amazon:

This book is about trading, the people who trade securities and contracts, the marketplaces where they trade, and the rules that govern it.

Readers will learn about investors, brokers, dealers, arbitrageurs, retail traders, day traders, rogue traders, and gamblers; exchanges, boards of trade, dealer networks, ECNs (electronic communications networks), crossing markets, and pink sheets.

Also covered in this text are single price auctions, open outcry auctions, and brokered markets limit orders, market orders, and stop orders.

Finally, the author covers the areas of program trades, block trades, and short trades, price priority, time precedence, public order precedence, and display precedence, insider trading, scalping, and bluffing, and investing, speculating, and gambling.

The Big Book of Dashboards: Visualizing Your Data Using Real-World Business Scenarios by Steve Wexler, Jeffrey Shaffer, and Andy Cotgreave

I got this book because I want to improve my data visualization abilities for this blog and for those charts I post on Twitter as well. I also want to improve my own record keeping process for my trades and create a more professional dashboard that will allow me to review past trades.

From Amazon:

Comprising dozens of examples that address different industries and departments (healthcare, transportation, finance, human resources, marketing, customer service, sports, etc.) and different platforms (print, desktop, tablet, smartphone, and conference room display) The Big Book of Dashboards is the only book that matches great dashboards with real-world business scenarios.

Option Volatility & Pricing: Advanced Trading Strategies and Techniques by Sheldon Natenberg

I’ve had this book for a few months, and I’m constantly coming back to it for a deeper understanding on options and the options market.

This book is great for anyone looking to dive deeper into understanding options and options theory. If you trade options or just want to understand the options market better, this one is a must read.

From Amazon:

One of the most widely read books among active option traders around the world, Option Volatility & Pricing has been completely updated to reflect the most current developments and trends in option products and trading strategies.

Featuring:

Pricing models
Volatility considerations
Basic and advanced trading strategies
Risk management techniques
And more!

Written in a clear, easy-to-understand fashion, Option Volatility & Pricing points out the key concepts essential to successful trading. Drawing on his experience as a professional trader, author Sheldon Natenberg examines both the theory and reality of option trading. He presents the foundations of option theory explaining how this theory can be used to identify and exploit trading opportunities. Option Volatility & Pricing teaches you to use a wide variety of trading strategies and shows you how to select the strategy that best fits your view of market conditions and individual risk tolerance.

Links above are affiliate links. If you purchase any of those books through the link I posted, I’ll get a tiny cut of the sales proceeds. Your support is appreciated.

What are Federal Reserve repo operations?

Repo operations (within the context of the Federal Reserve) are Repurchase agreements and are conducted only with primary dealers.

The Fed purchases Treasury, agency debt, or agency mortgage-backed securities from a counterparty, subject to an agreement to resell the securities at a later time.

It’s similar to having a loan that is collateralized with assets. These assets from the banks have a higher value than the loan to protect the Fed against market and credit risk.

Repo transaction temporarily increase the quantity of reserves in the banking system.

The New York Fed began conducting repo operations in September 2019 to ensure supply of reserves is ample and to mitigate risks of money market pressures near year-end that could affect policy implementation of interest rates.

What is a repo?

Repo is a generic name for repurchase transactions (which can include buying or selling). It is a transaction in which one party sells an asset (such as Treasury Bonds) to another party at a set price and commits to repurchase the same assets from the same party at some future date.

If the seller defaults, the buyer is free to sell that asset to a third party to offset their loss. This is what makes a repo very similar to a collateralized or secured deposit.

How is repo rate determined?

Why are repurchase agreements (repos) used?

Repurchase agreements can serve four different functions for various market participants:

They are a safe investment
Borrowing costs on repos are very cheap
Yields can be enhanced for those holding a large amount of safer assets
They provides a means for short-selling and short-covering

It’s safe because the cash is secured by collateral, which is generally safe assets. Makes it easy for seller of repo to make money back by selling those secured assets.

Yields are enhanced because a party could lend out a high demand asset to the market, and in return they receive cash for cheap which can be used for funding or reinvesting profits.

Why do banks use repos?

Banks will use repurchase agreements (repos) for short-term borrowing. They do this to raise short-term capital and generally use agreements which are very short-term, generally overnight or 48 hours.

The implicit interest rates on these agreements is known as the repo rate, and is a proxy for the overnight risk-free rate.

Repo can be used for many purposes. One such purpose would be as an efficient source of short-term funding

It also allows institutional investors to meet liquidity requirements without having to liquidate long-term investments. The repo market has become an important source of cash for non-banks to meet Basel regulatory requirements.