A Fed-sponsored committee has suggested replacing LIBOR with the Secured Overnight Funding Rate (SOFR). But unlike LIBOR, which is based largely on judgment, SOFR is based on a blended batch of more than $1 trillion in daily repo transactions backed by US Treasuries. When repos spiked, SOFR hit 5.25% on September 17, up from 2.42% the day before (see graph 3).
Some are worrying that this volatility will complicate the Fed’s ability to get financial institutions interested in using SOFR—even though many would be using a 90-day average and not the overnight rate. “This episode is a shot across the bow regarding funding assumptions,” says Robert Lynch, Head of Rates Trading for BNY Mellon Capital Markets, LLC, a registered broker dealer.
Either way, it is imperative for the Fed to understand the intricacies of these funding pressures because the US Treasury can ill afford hurdles as it borrows more, and the Fed has stated that its long-standing aim is to hold primarily Treasuries in its own portfolio.
In a September 23 speech, New York Fed President John Williams said his bank’s actions, “Had the desired effect of reducing strains in markets, narrowing the dispersion of rates and lowering secured and unsecured rates to more normal levels relative to other benchmarks.” At the same time, he said it was, “equally important that we examine these recent market dynamics and their implications.”
Even if the Fed gets its arms around the problem, it may not come without some hiccups. Well-meaning regulations have often had unintended consequences and repo market ripples have caused big problems in the past.
Even today, repo’s presence at the core of money markets makes it possible for issues to ripple out, especially if bank reserves and market capacity could be lower than in the recent past.
In an April speech, Lorie Logan, Senior Vice President at the New York Fed, said she favored a regime with ample reserves because it could act as a buffer, cutting down on the need to tightly manage reserves from day to day and helping liquidity shocks to “be absorbed without the need for sizeable daily interventions by the central bank.”
The Fed must be careful to understand the impact of its next actions, lest changes in critical pieces of plumbing under Wall Street’s securities markets contribute to pressures elsewhere.
“There is risk in the system and when the Fed pushes risk out of one compartment, they just push it into another,” says Skyrm.
Katy Burne is editor of Aerial View Magazine at BNY Mellon in New York.