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.

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.

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 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.

How the limit order book became abstracted into options and why gamma exposure matters

Information obtained from a thread courtesy of squeezemetrics via Twitter

You know how old-school traders talk about using the limit order book to know where supply and demand are? Basically what happened is that the limit order book got abstracted into options, and the actual buying and selling is now done by option dealers, on behalf of customers.

So what happens is, I sell a call because I want to collect some premium and give up some upside. This is largely equivalent to submitting a bunch of progressively larger limit sell orders above the market, except that those orders cannot be seen.

So what happens is that the option dealer takes the other side of those would-be limit orders by shorting the underlying and committing to, in this case, a schedule of buying the underlying when it goes down, and selling more when it goes up.

This means that there are, through the agency of the option dealer, a bunch of what are effectively limit orders sitting above and below the market, all of which will push against any move in the underlying itself. The more of these there are, the more stifling it gets.

So when GEX is really high, that’s when it’s super-stifling. BUT WAIT THERE’S MORE. As these call options lose value, the dealer slowly buys back some of the underlying that they shorted before, slowly supporting the market, ceteris paribus. Low volatility, upside drift.

(Hopefully it’s obvious why knowing where supply and demand will be is useful.)

Who and What are primary dealers?

Primary dealers are trading counterparties of the New York Fed in the implementation of monetary policy. The make markets for the NY Fed as needed, and bid on a pro-rate basis in all Treasury auctions at reasonably competitive prices.

There are 24 banks designated as primary dealers. Well known banks that are primary dealers include JP Morgan, Wells Fargo, Bank of America, Citi Group, Deutsche Bank, just to name a few.

Why do we have primary dealers?

Primary dealers are counterparties who buy government securities and resell them to the overall market. These are banks that have an inside track to buy US Treasuries.

Primary dealers purchase the vast majority of the U.S. Treasury securities (T-bills, T-notes, and T-bonds) sold at auction. They will then resell those securities to the public. Their activities extend well beyond the Treasury market.

Arguably, this group’s members are the most influential and powerful non-governmental institutions in global financial markets.

Where are primary dealers located?

Many dealers are in the US. There are also dealers across the globe, including Japan and Europe that distribute US Treasuries to those geographical areas of the world.

What are the requirements for primary dealers?

Firms must meet specific capital requirements before it can become a primary dealer.

The capital requirements for broker-dealers that are not affiliated with a bank is $50 million. Banks acting as primary dealers need to have $1 billion of Tier 1 capital (equity capital and disclosed reserves).

Prospective primary dealers need to show they made markets consistently in Treasuries for at least a year before their application.

What are the options Greeks?

This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.

Greeks refer to dimension of risk that an options position entails. The Greeks are used by options traders and portfolio managers to hedge different risks to their positions.

Is simple terms, the Greeks are derived based off a pricing model, like Black-Scholes, using inputs: option price, underlying stock price, days to expiration, and risk free interest rate.

The most commonly used Greeks used are Delta, Gamma, Theta, Vega.

Delta

Delta is the amount an option price is expected to move based on a $1 change in the underlying stock.

Calls always have positive delta, between 0 and 1. If the underlying stock price goes up and no other variables change, the price for the call will go up.

If a call has a delta of 0.50 and the stock goes up $1, the price of the call will go up about $.50. If the stock goes down $1, the price of the call will go down about $.50.

Puts always have a negative delta, between 0 and -1.

Gamma

Gamma is the rate of change in delta for every $1 change in the stock price. If delta is the “speed” at which option prices change, you can think of gamma as the “acceleration.”

Options with the highest gamma are the most responsive to changes in the price of the underlying stock.

Gamma is highest for options with strike prices near the current underlying stock price. It is also highest for those options at the money that are closer to expiring vs. those options which are due to expire further out in the future.

Theta

Theta, aka time decay an option buyer’s biggest enemy, and option seller’s best friend. Theta is the amount the price of calls and puts will decrease theoretically for a one-day change in the time to expiration.

In the options market, the passage of time will erode an options value. Time value melts away and does so at an accelerated rate as expiration approaches.

Vega

Vega is the amount call and put prices will change, in theory, for a corresponding one-point change in implied volatility.

Vega does not have any effect on the intrinsic value of options, it only affects the “time value” of an option’s price.

Typically, as implied volatility increases, the value of options will increase. That’s because an increase in implied volatility suggests an increased range of potential movement for the stock.

Conclusion

If you’re trading options, you absolutely must understand those Greeks above and how they impact your trading strategies.

What is delta hedging? How does this influence option market makers’ gamma exposure?

This article is part of a more broad series of research questions I address regarding Gamma Exposure. Check out this post for more.

Market makers are exposed to risks in the market and continuously protect themselves against these risks. One way they they manage risk is by remaining delta neutral on their portfolio. This is called delta hedging.

Example

Say you wish to buy one call option on SPY which has a delta value of 0.45. The market makers, who took your order, will have the opposite position of a -0.45 delta.

When the market maker sells you that call option, they can immediately hedge against their -0.45 delta by buying one call option on SPY with a 0.45 delta OR by buying 45 stocks, (which always have a delta of 1).

For the purposes of gamma exposure, we make the assumption that the market makers are hedging their trades by buying stocks in the underlying instrument.

What is gamma in risk management? How do you hedge gamma?

Gamma is a risk to the market maker when the markets are moving drastically in one direction. Gamma hedging is done to protect the dealer from larger than expected moves in the underlying options contract.

Gamma is the convexity of an options position, and is never get hedged away immediately. By continuously hedging delta risks, dealers hope to limit their exposure to large moves in the stock.

Example

To go along with the example above, let’s assume the dealer gamma has a value of -0.05.

Say your call position moves up $1, and now on the market makers book, they have a delta of -0.50, down from -0.45. The dealer would look to sell 5 more shares of the stock. The gamma was at -0.05 and the underlying price moved up by $1, and this caused the delta on their books became more negative by this -0.05 amount.

If the call position moves down $1, from a delta of -0.45 down to -0.40 on the dealers books, then the dealer would look to buy 5 shares of the stock.

It is this simple (theoretical) illustration that shows the activity of market makers (dealers) that can help you understand the activities of those and how those active rehedging programs can have such a sizable impact on the options and stock market.