Something strange is happening in the market right now

In the past few days, the S&P 500 (SPX) has risen to all-time highs. I mean, that’s strange given our current economic back drop. But that’s not what I’m talking about.

What’s strange about the current state of the market?

While the SPX is at all-time highs, the volatility indices have been rising as well. These indices include VIX, VVIX, and VXX.

If you don’t know what these are, that’s okay. VIX is an index that tracks the implied volatility of the SPX based off how the options for that index are priced. It is what the one month expected move in the market is, in a sense. VVIX is an index that tracks the implied volatility of VIX based off how the options on VIX are priced. VXX is an index that tracks the volatility based off the weighted balance of the first two VX futures contracts which trade.

For now, let’s focus on VIX. On August 25^th, VIX closed at 22. As of today’s close on August 31^st, it is 26.4. In percentage terms, VIX was up today 15%. (Many people don’t like quoting VIX changes in percentage terms — I don’t care).

In 3 of the past 4 days, we have seen VIX close higher than where it opened. This has happened all while the SPX has hit all-time highs in each of the past four days.

VVIX — also known as the volatility of volatility — has shown a similar trend to VIX, rising in 3 of the past 4 days. VXX — which is based off the front two months of futures contracts on VIX futures — has also steadily risen and shown similar trends.

Realized volatility is far below implied volatility options are pricing in

The volatility that is implied by SPX options is much higher than the realized volatility we’ve seen in the past 30 days. According to my calculations, realized volatility for the past month has been under 10%. Meanwhile, VIX has held strong above 22, and has continued to climb in recent days as noted above.

Why is this strange to me?

In general, you tend to see VIX fall as SPX rises. In general, there is an inverse relationship between these two items.

Today, VIX rose by 15% while SPX fell by roughly 0.3%. According to my data, this has only happened 5 times going back to 1993.

Note: The above chart is in percentage terms.

I’m not the only one that has noticed

Mark Sebastian, from OptionPit.com and frequent guest on The Options Insider Radio noted the following:

What he is saying here is that there is a huge difference between the volatility being priced the NASDAQ 100 Volatility Index — VXN — and the S&P 500 Volatility Index — VIX. This is interesting to me because the NASDAQ 100 is composed of non-financial companies and is weighted heavily towards those tech stocks. The very tech stocks which have been going parabolic in recent weeks (some may even say months).

In addition, Matt Thompson noted the following:

The 5-day average contango, which is merely the difference in the implied volatility priced in by the front month futures contract and the second month futures contract is at 16.9%, which was at the 99^th percentile since 2004. Also he noted what I noted earlier, that the VIX is much higher than the realized volatility on SPX.

What does this all mean?

This could mean a number of things. Ultimately it means there is a lot of uncertainty in the market, and options are pricing in more volatility than the volatility that we’ve witnessed in the last month.

This could mean that big money is hedging their positions with put options on SPX or call options on VIX or buying VX futures, all of which could cause the premiums paid to rise.

In addition, the VX futures for October are pricing in extra volatility due to the upcoming election. The pricing of these October futures remains elevated when compared to the September and November VX futures prices.

Investors are nervous about what could come in the next month or two. And they have good reason to be.

There is still no agreement on extended economic stimulus that the American people desperately need. Republicans and Democrats have still not agreed to a deal. As of the last update I saw, Republicans proposed a $1.3 trillion stimulus, which was rejected by Democrats. The House, led by Democrats, passed a $3 trillion stimulus back in May. They said they would be willing to lower their demands to $2.2 trillion. No deal is in sight, and that could have investors spooked.

Fact is, we are in a bubble

The last time market closed at all-time highs with VIX this elevated was during the late 90s tech boom. That was a time period which also coincided with easy Federal Reserve monetary policy and high speculation in stocks.

We are seeing similar behavior in the tech stocks and work-from-home stocks today. Apple, Amazon, Google, Facebook, Tesla, Nvidia, Zoom, and AMD are all examples of stocks which are booming right now.

But the pain for the American people is far from over. Continuing claims continue to remain above 14 million. The unemployment rate is over 10%. The economy is attempting to recover slowly. But stocks? They’ve ripped to all-time highs at a much more rapid rate. And the disconnect between those two has investors nervous right now.

Dark pools are not buying this rally anymore either

In order to understand what’s happening, check out the Dark Pools. According to the Dark Pool Index over at Squeezemetrics.com, Dark Pools have printed under 45% for 17 days in a row. In general, a print over 45% is considered to be bullish, and there tends to be a slight lag between dark pool prints and stock market returns.

This is meaningful to me because Dark Pools bought the rally all through April well into July. But they aren’t buying anymore.

Perhaps we will begin to see a return of selling to the market in the coming days or weeks. I know I’m on high alert for that right now and will be ready to short this market when the opportunity presents itself.

The rise of the carry trade

One great book I’ve been reading lately is The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, and Kevin Coldiron (Amazon affiliate link)

This book has been eye-opening to me. The authors have elegantly connected the dots between Central bank interventions, interest rates, the carry trade, bringing all of these elements together.

The concepts explained in this book made me understand why fundamental analysis seems to matter less these days and why Federal Reserve press conferences garner so much attention.

What is the carry trade?

A carry trade is a type of trade that makes money when “nothing happens” or when volatility is low (variance of price is low). This trade is similar to selling insurance, where you collect a premium in exchange for taking on downside risk of some event taking place.

A carry trade can be done in a number of ways. The term “carry trade” is a broad term that groups these different types of trades together.

What are the features of a carry trade?

The features of the carry trade include leverage, liquidity provision, short exposure to volatility, and a “sawtooth” return pattern of small steady profits punctuated by occasional large losses.

What is an example of carry trade?

One type of carry trade is a currency carry trade. In this trade, you borrow a currency that has a low interest rate, then use that money to buy another currency that pays a higher interest rate.

The goal of this trade is to profit on the difference between the interest rates.

However, one problem with this trade is that on its own, it doesn’t have high yields. The payoff for this trade is small, so to increase returns and make these investments more attractive for investors, those who do these trades employ significant leverage. Leverage on such trades could be 10 to 1, 20 to 1, sometimes even 60 to 1 leverage.

Why are carry trades popular with investors?

Carry trades generally will return steady profits for extended periods of time. This is what makes them attractive to investors. During boring times in the market with low volatility, these strategies are profitable.

What are the drawbacks to the carry trade?

When the carry trade loses money, it has the potential to lose a lot in a hurry. This massive loss potential is due to the amount of leverage used in a carry trade. Because the carry trade relies on stability in prices (low volatility), any behavior outside of “normal” behavior leads to high volatility and high losses.

In addition, carry trades have an effect of increasing liquidity as the carry trade expansion phase goes on. This leads to a carry bubble. As the carry bubble pops, the carry trade has the opposite affect on liquidity. The decrease in liquidity in the market happens because carry trades are forced to be reduced or closed altogether.

In this sense, the cycle of the carry bubble and carry crash and the economic cycle have become one in the same.

To be continued…

Good articles for more information

The World Is One Big Carry Trade – institutionalinvestor.com (intro below)

As I watched a 2,000-point sell-off in the Dow Jones Industrial Average on Thursday, March 12, I realized that Tim Lee — the founder and chief economist at piEconomics — had got it all figured out before he recently retired.

Along with co-authors Jamie Lee (no relation) and Kevin Coldiron in The Rise of Carry, he laid out his theory of how unprecedented levels — and types of — central bank intervention in financial markets over the past few decades have turned the global economy into a series of overlapping carry trades…

This article and series of articles continues to be a work-in-progress.

Back to work here…

Hello friend!

I’m back to working on this blog starting this month.

This is what I’ve been up to

The months of February and March were crazy with the coronavirus and its impact on the market. I was busy most of the time in these months trading, documenting, programming, and continuing the improve and refine my trading processes.

2018 (with emphasis on the last three months of the year) was extremely rough for me. I fought the Fed multiple times on trades and I lost. I was actually looking for jobs in January and February because I wasn’t sure I’d be able to continue trading.

That changed, fast

Volatility in the market took off. I held short positions that profited insanely. Negative gamma had proven to be my ally. Convexity won out.

This extended my runway another 4-6 months at a minimum. It’s been a scary ride but I’m loving every minute of it.

What’s to come

Anything that I’m interested in. I’m currently interested in the following things, in no particular order.

Understanding gamma exposure deeper
Other options greeks and their effects on markets
Higher order options greeks (vanna and volma)
Game theory
Kelly criterion and position sizing
The rise of the carry trade
Federal Reserve operations
The current state of the economy
The current state of politics in the world
Python programming
Calculating gamma exposure from easy to obtain information
Building trading dashboards

That’s just a few I can think of off the top of my head.

Follow this blog to stay updated.

Trading in the Zone – Book Notes

I recently finished reading Mark Douglas’s book, Trading in the Zone. This book found me at an opportune time, as I’ve been going through a rough patch with my trading and especially my mindset while trade.

If there is one book I highly recommend you read as a trader to get your state of mind right, it’s Trading in the Zone. Here are my book summary notes below. Note that my summary notes are not short. It’s over 2,500 words of the best wisdom I pulled out of the book.

Book Summary Notes

Have confidence in trades.

Focus on opportunities.

Fundamental analysis is the study of finding supply and demand of an investment based off fundamental information.

Technical analysis is based off patterns in an investments’ historical data.

Technical analysis is more “in the moment” than fundamental analysis. You react in the moment to changes in prices.

Good traders have rules for entry and exits.

Accept risk before putting on a position and never assume you are correct. Be quick to admit you’re wrong.

Accept the possibility that you will lose money so that you can objectively manage a position.

Good traders aren’t afraid because they have effective management strategies to enter and exit trades.

The four primary trading fears are:

Being wrong
Losing money
Missing out
Leaving money on the table

We blame the market for our losing money.

How you view the market affects the consistency of your results.

You can never know the myriad of ways the market can make you lose money.

Accept that the outcome of a trade is unknown, and that one trade is not a reflection on you as a trader. Failure to accept this leads to costly decisions.

Doing more market analysis will not make you a better trader. Acceptance of what the market is will.

Accept the risk you take on with every trade, and you will no longer be afraid.

Trade without fear, and have rules to prevent reckless behavior.

The market presents you with unlimited possibilities, and this can challenge those not equipped to deal with this fact.

Desires are generated internally, but must be fulfilled externally.

Once we identify a desire we are drawn to fill that desire externally. Denial of this opportunity to fulfill a desire leads to pain.

Accept that trades are a probabilistic outcome, and define how much risk you are willing to take on this probability.

Prices always move. Your entries and exits last as long as you want.

The market will not make you exit a trade. You must do that. Don’t be a passive loser. Actively lose by defining your risk.

Trading gives you ultimate freedom. This can be a curse because you have no structure to follow.

Most of those who get into trading initially struggle to create a set of rules to follow.

That which draws us to trading is the same thing that makes us resist creating trading rules.

Your impulses hinder your ability to trade well for psychological reasons.

You must keep yourself responsible for the way you take profits and take losses.

If you play probabilistic edges, you must be consistent in how you trade them and not get thrown off by a few losing trades.

Don’t get hung up on any single trade.

Adapt to your environment and create rules so that you can adapt appropriately.

Winning early as a trader can hurt your long-term performance.

Trying to “understand why” the markets do something can hurt you in the long run.

Your mental attitude will produce better results than analysis alone.

Trading can be a simple pursuit in which you don’t need a ton of skills, but rather a winning attitude.

Operate from the belief that trading losses are a natural part of trading and should be considered as your business expenses.

We feel pain when reality fails to meet our expectations, especially when they are unrealistic.

Losing traders blame markets for their losses.

You blame markets for your results if you don’t accept the randomness of markets, have rules to protect you against this randomness, and take responsibility of your results.

Your goal is to extract money from the market, and the markets’ goal is to extract money from you.

Markets owe you nothing. Don’t blame them for your losses.

Take complete responsibility of your trading. Otherwise you will view the market as your adversary and you believe that your problems can be fixed by better analysis.

Every entry and exit on a trade is an opportunity for you to act in your own best interest.

You are never fighting the market, because it owes you nothing.

Learning about markets isn’t bad, but it can give you a false confidence that you know what will happen next and ignore the randomness inherent to markets.

Learning more about markets isn’t going to eliminate losing trades. Don’t take losing trades personally.

Accept your losses and you will no longer view market information as painful. You will view it as it is, information.

Our bias to avoid pain makes us ignore or alter information that the market provide us.

In sports there is a more discernible connection between one’s focus and results. It’s harder to see this connection in trading.

Leaving money on the table can be more painful than taking a loss because you know you missed out on a large profit.

Make winning and consistency are states of mind.

Make yourself available to what the market is offering you.

Our biases make us interpret information that is favorable to our own egos, even though it can hurt more in the long run.

Fear causes 95% of the errors you are likely to make.

Think about trading in a way that keeps fear at bay so that you can continue to focus on opportunities.

Let the market unfold and make yourself available to opportunities with a clear mind.

Accept risk and you won’t have anything to fear.

You see what you’ve learned to see, and miss that which you haven’t learned to see.

Every trade is an edge with a probable outcome. Know this to define your risk, and eliminate your fears.

Perceive the market objectively. Don’t project your own feelings on the market.

Your emotional mind links your current state to your most recent trading experiences, which can be painful and create a fearful state of mind.

The “secret” to trading well is four items:

Trade without fear OR overconfidence
Perceive what the market is offering clearly
Stay focused on the “now moment opportunity flow”
Enter the “zone” and believe in an uncertain outcome with an edge in your favor

Great traders don’t let emotions of recent trades influence their process.

To be a consistently successful trader one must learn adapt.

It can take years for most traders to figure out that consistency trumps picking the occasional winner.

The best traders cut their losses without hesitation if the market tells them it’s not working.

The three most costly trading errors you can make

Not predefining your risk
Not cutting your losses
Not systematically taking profits

Thinking that you “know” what will happen next is the cause of most trading errors you will make.

The most effective trading belief you can acquire is “anything can happen.”

Every trader acts on their own belief about what is high and what is low, and collective behavior pattern is displayed in the price at that moment.

Every trade you make is unique from every other trade you’ve made.

Train your mind to think in probabilities, and have actions that you take to deal with these unknown outcomes.

Don’t ever convince yourself you’re right when you enter into a trade. Instead, define the risk.

When you think you know what will happen, you are effectively thinking you know the future actions of every single individual and how they will move prices.

Markets are unique, anything is possible. To ignore this fact is foolish.

Your beliefs are shaped by your expectations. These beliefs cause you perceive market information that confirms your bias, and ignore market information that conflicts with your bias.

Market information that goes against our position is ignored when we find it too painful to acknowledge.

We focus on information that helps minimize our pain, which is destructive to our trading.

We lose out on opportunities when we choose to ignore what the market is telling us.

Our pain-avoidance mechanism shields us from seeing information that is not aligned with our beliefs.

Traders must learn to be rigid in our rules, and flexible in our expectations.

There are five fundamental truths you must accept to think probabilistically:

Anything can happen
You don’t need to know what will happen next to make money
Wins and losses are randomly distributed for any given edge
An edge is an indication of higher probability of one thing over another
Every moment in the market is unique

When you put on a trade, your only expectation is that something will happen. That’s it.

Define a stop loss for every trade. This should be some point where the odds of success are greatly diminished in relation to the potential profit.

Losses are the cost of doing business in the course of finding winning trades.

Each moment in the market is an opportunity to do something on your behalf. You always have an opportunity to:

Scratch a trade
Trade profits
Cut losses
Add or detract from a position

Expectations are beliefs projected into some future moment.

We can’t know what to expect from the market because other traders are always there to enter and exit trades based off their own beliefs about the future.

The only thing you should “know” in trading is what an edge looks like, how much you need to risk, and a plan for taking profits or losses on a trade. You can never know if any one trade will work out.

Don’t have an agenda when you trade. Make yourself available to the opportunities the market makes available to you with a clear mind.

Emotional pain is a response we have when the world expresses itself in a manner opposite of our beliefs.

Don’t expect the market to make you “right” or “wrong”.

Don’t expect to market to go in your favor forever. Establish rules for taking profits.

Gathering more information to predict if a coin will flip heads or tails is silly. Why would you expect it to work in the markets? Remember that every trade is probabilistic.

Every moment is unique, and therefore you will never “know” what will happen next.

Don’t try to change your beliefs. Remove the energy behind that belief, and channel it towards better beliefs.

It’s hard to make new discoveries when your internal beliefs conflict with those discoveries.

The underlying cause of fear in trading is interpreting market information as threatening.

You must believe that every edge has a unique outcome in order to trade without fear.

You must believe you don’t know what is going to happen next.

Train your mind to expect a unique outcome in order to see market information objectively.

Believe that each moment is unique in order to achieve mental freedom while trading.

Trading is a pattern recognition numbers game. Identify patterns for some edge, define your risk, and take profits consistently. Some trades work and some don’t. Don’t take it personally.

Trading is one of the hardest things to do because the more you think you know, the less successful you’ll be.

Manage your expectations as a trader and align your mental environment with the five fundamental truths.

Trust yourself to operate in an unlimited environment
Focus on flawlessly executing a trading system
Think in probabilities – the five fundamental truths
Create a strong belief in your consistency as a trader

Your primary objective as a trade should be to produce consistent results. The way you do that is by following your trading rules with unshakeable confidence.

Consistency should be your primary reason for trading.

Making mistakes will happen until your beliefs are in harmony with your desires and your beliefs are consistent with what works from an environment’s perspective.

Don’t think less of yourself when you make mistakes.

Mistakes should not hold negatively charged energy for you.

Beliefs must be in alignment with goals and desires to eliminate any conflicting energy.

You must create the belief that you are a consistently successful trader.

Don’t make it a goal to guess correctly. Make it a goal to be consistent with your techniques.

Tell yourself, I am a consistent winner because:

I objectively identify my edges
I predefine the risk of every trade
I accept risk and am willing to let go of trades
I act on my edge without hesitation
I pay myself as the markets make profits available to me
I monitor myself for my susceptibility to make errors
I never violate these principles above

To be an objective observer, think from the market’s perspective. There are always unknown forces waiting to act on price movement so that every moment is truly unique.

The typical trading errors are:

Hesitating
Jumping the gun
Not predefining risk
Defining risk but not taking a loss
Exiting a winning trade too soon
Not taking profits on a winning trade
Letting a winning trade turn into a loser
Moving stop too close to your entry point
Trading too large a position in relation to your equity

You can change your identity by changing your desires.

Losses call for larger % returns in order to be profitable. A 50% loss requires a 100% return to become profitable again.

Divide your position into thirds or quarters, and scale out of the position when taking profits.

Take off a portion of a winning position whenever the market presents you with the opportunity to do so.

In a three contract trade, establish a stop loss, and take profits by scaling out of the position one contract at a time.

Scale out of positions to create “risk-free opportunities”. These are positions where you have taken profits to the extent of max loss allowable on the remainder of the position, therefore guaranteeing a break-even trade at a minimum.

Try to achieve a risk to reward ratio of 3:1, which means you risk one dollar for every three dollars of profit potential.

Success or failure of a strategy should be based off a sample size of 20 trades or more.

An edge is merely a snapshot which captures a limited portion of all probabilities.

Be willing to make 20 trades on a strategy before making a judgement of its effectiveness.

Follow your trading rules and focus on the five fundamental truths in trading.

If you can go through 20 trades without allowing your emotions to influence you adherence to rules and probabilities, then you discover that thinking in probabilities is a functioning part of your identity.

Conclusion

Again, if there is one book I highly recommend you read as a trader to get your state of mind right, it’s Trading in the Zone.

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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.

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.

The World has Gone Mad – Ray Dalio Article Summary

Two months ago Ray Dalio wrote an article on how the world has gone mad with regards to monetary policy. Here is my short summary of Mr. Dalio’s article:

We are currently “pushing on a string”, a phase which Ray says we have never seen during our lifetimes. This is the situation where investors are flush with cash, and would rather invest it, not spend it.

The prices of financial assets have gone up as interest rates have plummeted. Low expected returns aren’t just driving up the prices bonds, but also equities, private equity, venture capital, etc.

Startups don’t have clear paths to profits, so they rely on selling dreams (Adam Neumann WeWork is a prime example) to get people to invest in their ideas. Investment managers are sitting on large hordes of cash and are looking for any place to park their funds, hence the overblown valuations of companies.

Government deficits are large and continue to grow. As a result, governments must sell more debt that nobody is interested in buying because the interest rates on these debts are so low. Central banks end up buying this debt by printing new money. (But don’t say they are monetizing the debt).

Down the road, as pension and healthcare liability payments come due, those obligated to make these payments will be unable to do so. How does this happen? Those institutions have expected returns of 7%, much greater than expected returns in the market in the coming years.

As these institutions are unable to make payments, unfunded liabilities will balloon as a result of suppressed growth. Teachers and governmental employees are those most exposed to this risk.

In sum, money is basically free (because of low to negative interest rates) for those who have money and creditworthiness. Money is unavailable for those without money or creditworthiness.

This contributes further to the wealth gaps we see today. Technological innovations are creating a way for companies to cut jobs further as well. The effects of low interest rate monetary policies are no longer “trickling down” to workers as a result. Thus explains how to we got where we are today.