US Trying to Combat Treasury Repo Fails, May Lead to Negative Rates

Ah, the US keeps inching its way into the behaviors of post-bubble Japan. The latest pending regulatory move it to reduce failures to deliver securities in the Treasury repo market, a vital source of short-term financing for banks and broker dealers. But the remedy under consideration would lead to negative rates on some repos. a rare occurrence in the US but relatively common in deflationary Japan.

From Bloomberg:

Treasuries are in such high demand that investors are lending cash for next to nothing to obtain the securities as collateral through so-called repos, which dealers use to finance their holdings. The problem is many parties involved in repos aren’t delivering the bonds because there is no penalty for not doing so, causing “fails” to exceed $5 trillion…

Now, an industry group is trying to fix the mess, which New York Fed Executive Vice President William Dudley said could cause the U.S. borrowing rates to rise if not rectified. The Treasury Market Practices Group wants to impose a “penalty” on failed trades, a move that may result in borrowers who put their Treasuries up as collateral for loans effectively receiving 2 percent interest.

“This is an extraordinary thing to perceive for a market of the size and significance of the U.S. repo market,” said Lena Komileva, an economist in London at Tullett Prebon Plc, the world’s second-largest interdealer broker…

“The more chronic fails disrupt the Treasury market, the more it reduces its liquidity and efficiency,” Dudley said in a Nov. 12 interview. “Over time, this could have some negative consequences for the ability of the U.S. Treasury to raise money at the lowest cost possible. Reduced liquidity also affects other markets as the Treasury market is used to hedge positions in other security classes.”…

Yves here. Something tells me this is not the real reason, but I do not know this market well enough to divine what the real reason might be. Reader input invited.

Back to Bloomberg:

In a repurchase agreement, one party provides cash to another in exchange for a security, and vice versa. …

Since the bankruptcy of Lehman Brothers Holdings Inc. in mid-September traders, investors and dealers have been willing to lend cash to obtain Treasuries at almost zero interest…

Repo trades go uncompleted when it’s difficult to obtain the securities or the cost to get them becomes too expensive. Fails aren’t usually considered a breach of contract and the parties involved typically keep re-scheduling delivery…

“A negative rate repo is somewhat counterintuitive as basically, a lender is not only lending money, but paying a borrower to take that money,” said Robert Toomey, managing director of the Securities Industry and Financial Markets Association, a New York-based trade group. “The borrower has something, in this case a particular security, that the lender really wants. It’s essentially paying a premium to get a particular security.”

Negative repo rates have happened before. The Bank of Japan’s decision to adopt a zero interest-rate during the “Lost Decade” of the 1990s because of deflation and a protracted banking crisis triggered the phenomenon for Japanese government debt. Rates less than zero surfaced in the U.S. in 2003, when the Fed’s target fell to 1 percent and traders sought to cover bets against 10-year Treasuries after their yields jumped more than a percentage point in about a month….

“For certain sectors of the Treasury curve, such as the short-end, the implementation of negative repo rates would provide a significant kick to the market,” said Ira Jersey, an interest-rate strategist at Credit Suisse in New York. “Yields have room to fall further, with the front end outperforming the long end.”.

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12 comments

  1. ndk

    John Jansen from Across the Curve, who traded Treasuries for a long time, has a possible explanation:

    Several market participants with whom I speak suggest that the problem resides with several large central banks and who have chosen not to lend securities in the repo market. If those entities could be cajoled into lending again it would take quite a bit of pressure off the market.

    This is plausible, and it passes the smell test: “is this action beneficial for U.S. financial institutions?” Our foreign creditors gotta just love us.

  2. Anonymous

    Yves Smith is the continuing recipient of an interesting person award from the far distance of my observation — and here she is posting this at 1:44 a.m. on a Sunday/Monday. But I wonder whether the answer to the “what’s up with this” question isn’t deceptively simple… A repo is essentially a secured loan — secured by the treasury instrument which is “sold” at the same time a right to re-buy “repo” it is created. Without the instrument, it becomes essentially an unsecured loan, no? Delivery fails mean there is no “on hand” security to be the basis of the next “secured” loan .. so it would have to be unsecured…. The failure to deliver / to hand / to transact in the security subject of the lending has the effect of changes it into… something more like unsecured lending.

  3. Peripheral Visionary

    Yves, the Treasury-only money market funds were having such huge inflows (which I believe have not yet reversed) that they were having difficulty locating Treasuries. They frequently have large positions in repos as opposed to direct ownership of Treasuries, and it would not surprise me if they were the ones on the other end of the fail to delivers.

    It is likely the larger banks and dealers who were promising more Treasuries than they could deliver and juggling their inventory between their open positions; as Anonymous above said, effectively unsecured lending. I see this shift as helping the Treasury funds but putting more pressure on the big banks and dealers; so I’m not sure if this was really intended to benefit anybody as much as to stop the monkey business.

  4. Anonymous

    Treasury MMF that use repos have risk. Failure of Broker to deliver Tsy Security. Broker goes under, MMF takes hit…”safest” mmmf takes hit.

    Tsy Direct or cash account, cash settlement for Tsy security at broker.

  5. doc holiday

    Yves, do you know what this is Exactly like, do yah, huh, huh?

    Re: "A day after Ramanathan’s warning, the Treasury said it was reviewing the trading of two- and five-year notes after a scarcity in the securities led to rising fails. The Treasury has conducted at least nine such reviews, known as “large position reports,” to monitor against market manipulation since 1997.

    A week later the Treasury Market Practices Group recommended imposing a penalty rate that equals either 3 percent minus the Fed’s target rate for overnight loans between banks, or zero, whichever is greater. The central bank’s target is 1 percent. The TMPG said it plans to discuss by Jan. 5 a potential plan to implement the measures."

    WHAT this is like is this (this is a special treat, so no need to thank me, as usual {punk}):

    From the Yves treasure vault:

    http://www.nakedcapitalism.com/2008/06/one-method-to-flush-out-oil-speculators.html

    Daniel Dicker, a former oil trader writing at TheStreet.com, contends that there is a way to test the hypothesis that speculation is influencing oil prices (a view that Dicker supports). Exchanges could impost a "liquidiation only" requirement, which was last used to break the Hunt brothers' attempted corner of the silver market in the early 1980s (hat tip reader Michael).

    In one instance, however, the speculation premium was "successfully" tested – in the silver markets in 1980 when the Hunt brothers attempted to corner the market. As silver approached $50 an ounce in January 1980, the commercial participants asked for relief from the enormous margin calls from ever-rising prices. The CFTC and the Comex (the predecessor to the Nymex) responded effectively by imposing "liquidation-only" trading — traders were allowed only to close existing positions and not permitted to initiate new positions.

    This forced purely speculative positions to be closed rapidly, as they could no longer be "rolled" into future months at expiration. This caused the price of silver to drop by $12 the day after it was imposed, a decrease of over 20%! Over the course of the next three months, as contract months expired, the price dropped over 50%.

    >> Huh, huh,,, huh?

  6. doc holiday

    So, Treasury yields are going to rocket, as prices drop like the oil market this summer … I’m still trying to figure this out, like how can adding inventory to the yield curve bring about scarcity?

    Treasury is like OPEC looking for price stability, so one would think that Treasury would be like OPEC and decrease the inventory to increase the yield. Thus, maybe the at of imposing a premium penalty, Treasury takes the wind out of speculation and then they don’t have to touch inventory because policy acts as intervention … huh, huh, what think for free opinion bullcrap??

  7. doc on a mission

    As you will recall:

    To achieve the $5 billion redemption, SOMA will purchase $7,126,019,000 of the 2/21/08 26-week Treasury bill (912795C82), $5,239,824,000 of the 11/23/07 13-week Treasury bill (912795B34), and will not participate in the 9/20/07 4-week Treasury bill (912795A27) auction. As with all SOMA purchases in the Treasury auctions, the amounts purchased are “add-ons” to the amounts publicly announced and issued by Treasury.

    The good news is that M1 and M2 have finally expanded. This may not last; the
    Fed has been taking $29 billion out of the financial system every day for about two weeks. I assume that these “reverse repos” are an effort to balance the $700 billion rescue plan.

    http://timingthemarket.blogspot.com/

    What are these guys doing??

  8. doc holiday

    Prior to the fall of 1970, Treasury sold notes and bonds for cash in subscription offerings and it sometimes refinanced maturing notes and bonds by offering to exchange new notes and bonds for the maturing securities.

    Beginning in 1960, Treasury sometimes refinanced maturing debt by issuing new debt inone or more subscription offerings and using the proceeds to redeem the maturing debt. These operationswere called “cash refundings.” See Gaines (1962, pp. 174-176) and Banyas (1973, pp. 8-10 and 27-30). The subscription offerings in a cash refunding were not different from the subscription offerings used tofund a budget deficit.

    Drawbacks to Exchange Offerings. In setting the terms of an exchange offering,Treasury bore the risk that it might set the yields on its new issues too low and that investors might choose to redeem an unexpectedly large fraction of the maturing debt. This could expose Treasury to a cash flow crisis as it scrambled to meet investor demands for cash redemption.

    On at least two occasions the Federal Reserve directly supported floundering exchange offerings. In November 1955, Treasury offered either a 1-year certificate of indebtedness or a 2-year 6-month note inexchange for $12.2 billion of securities maturing on December 15 (FRBNY Circular No. 4286, November 25, 1955). When market conditions deteriorated sharply on the last day of the subscription period, theFederal Reserve purchased $167 million of the certificates on a when-issued basis for the System Open Market Account.

    Ok, I’m really sick of myself, have a nice day!

    http://www.g7.utoronto.ca/g20/20031026_cs_usa.pdf

  9. doc holiday

    When is the last time we had a nice: Joint Report on the Government Securities Market
    DEPARTMENT OF THE TREASURY
    January 22, 1992

    The Honorable J. Danforth Quayle
    http://www.treas.gov/offices/domestic-finance/debt-management/gsr92rpt.pdf

    The Federal Reserve now engages in spot-checking of customer bids in Treasury
    auctions for authenticity

    The Treasury and the Federal Reserve are instituting a new system of
    confirmation by customers receiving large awards (over $500 million), to verify
    the authenticity of customer bids.

    While continuing to seek creditworthy counterparties, and while enhancing its market
    surveillance capabilities, the FRBNY plans to discontinue the "dealer surveillance" now
    exercised over primary dealers through the monitoring of specific Federal Reserve standards and
    through regular on-site inspection visits.

    Reopenings could occur
    either through standard auctions, through "tap" issues whereby the Treasury offers
    securities to the market on a continuous basis, or through other means.

    > Sorry, had to toss that in.

  10. doc holiday final

    When is the last time we had a nice: Joint Report on the Government Securities Market
    DEPARTMENT OF THE TREASURY
    January 22, 1992

    The Honorable J. Danforth Quayle
    http://www.treas.gov/offices/domestic-finance/debt-management/gsr92rpt.pdf

    The Federal Reserve now engages in spot-checking of customer bids in Treasury
    auctions for authenticity

    The Treasury and the Federal Reserve are instituting a new system of
    confirmation by customers receiving large awards (over $500 million), to verify
    the authenticity of customer bids.

    While continuing to seek creditworthy counterparties, and while enhancing its market
    surveillance capabilities, the FRBNY plans to discontinue the "dealer surveillance" now
    exercised over primary dealers through the monitoring of specific Federal Reserve standards and
    through regular on-site inspection visits.

    Reopenings could occur
    either through standard auctions, through "tap" issues whereby the Treasury offers
    securities to the market on a continuous basis, or through other means.

    > Sorry, had to toss that in.

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