Savvy market participants in the US are pointing to a recent injection of about $53 billion by the Federal Reserve into the “repo” market.
What is this repo market? Repo is short for repurchase. These are extremely short-term (overnight, a few days, a week) borrowings by financial institutions who face a temporary short-fall of cash. They agree to sell securities and then buy them back the next day or soon thereafter (hence repurchase). Details of these arrangements appears in: (https://www.businesstoday.in/sectors/banks/what-is-crr-slr-repo-rate-reverse-repo-rate/story/234473.html )
Why do the institutions face a temporary short-fall?
Banks may face excessive one-day withdrawals on a particular day. This time it appears to have come from accounts that had to make payments to meet a tax deadline. So, if many clients write large last-minute checks to the income tax authorities (you have done that too haven’t you?), then the banks are short of funds. They however have securities like treasury bonds, which they agree to sell and then repurchase later. It could also be brokerage accounts whose clients have purchased large amounts of securities on a given day for which payments have to be made. Whoever the borrower, these types of transactions take place ALL the time, worldwide, it is in the order of trillions of daily dollars. Very few people even notice these things, you are probably not aware that these are even going on, but now you can see that they must. They are after all, part of the glue that holds financial markets together.
What interest rates are paid on these overnight loans?
Known as the “repo” rate, these are typically quoted in annual terms, the Current repo rate in India as of August 2019 is 5.4% per annum. If you borrow 10 lakhs for 1 day at this rate, the interest you would be paying is about rupees 144 overnight. Small enough that nobody cares about it. In the US this rate is about 2.3%, which means that the overnight cost for 10 lakhs is about Rs. 62. Smaller still.
So, when should you care?
The default assumption in this repo market is that the financial institutions doing the borrowing and the repurchase are good credit for one day. This is why you don’t typically care about them. But suppose there was a situation when the central bank needed to step in to provide liquidity to the repo market. Those that remember the financial crisis of 2008-09 are quick to jump to the conclusion that some institution coming in to borrow is in trouble. But hold that thought for a bit.
At a minimum, too many borrowers on any day would increase the repo rate. It is a simple demand-supply argument and probably what happened in the US the other day. Some financial reporters picked up on the news, some of course remember the 2008-9 financial crisis years ago, which saw these repos rates spike for multiple days, indicating serious trouble. Indeed, Lehman brothers in the days before going under actually invoked a rarely used accounting gimmick called REPO 105 treating the promised repurchases as SALES, because they were sitting on a bunch of crappy securities that were bleeding value, and the last thing they wanted to do was to actually BUY THEM BACK. But that is a story for another day.