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 Wall Street institutions, hedge funds and real estate investment
trusts rely on the $5 trillion repurchase agreement market to
finance their daily trades and any disruption is worrying because it
could force them to cut holdings of bonds, stocks and other
securities.
What unsettled some traders was that the jump in failed trades
evoked memories of the global financial crisis when such a spike was
one of the symptoms of credit markets seizing up and the financial
system choking on toxic subprime debt.
The amount of deals where one party failed to deliver the government
debt pledged as collateral jumped to $456 billion in the week ended
March 9, the most since a record $2.6 trillion during the financial
crisis, according to industry and New York Federal Reserve data.
(Graphic: http://tmsnrt.rs/1quIYM9)
About one in 10 Treasury-backed repo trades failed in early March,
compared with one in three during the crisis.
This time, some traders wondered whether failed trades could be, for
example, a sign of cash problems of some institutions that perhaps
were too exposed to the struggling energy sector.
So far, however, there has been little evidence that the failures
reflect systemic woes. Rather, they are a result of a combination of
one-off factors as well as tougher financial regulation and less
liquidity that make trading more choppy and less predictable.
"It's a concern, but it speaks to a special part of the market,"
said Lance Pan, director of research at Capital Advisors Group in
Newton, Massachusetts.
A number of unusual factors contributed to the cash crunch in March.
Heavy selling by foreign central banks of older Treasuries boosted
Wall Street's demand for cash as dealers needed more money than
usual to buy the bonds.
In the repo market, older Treasuries are less desirable because they
are less liquid, so lenders charge higher interest to those using
them as a collateral.
That coincided with the government cutting back on longer-dated
Treasury issues. The sales, excluding T-bills, fell to $192 billion
in March from $264 billion a year ago.
BACK TO NORMAL
The market has calmed since, with failed trades totaling about $100
billion at the end of March, in line with the recent average.
On Monday, the overnight repo rate backed by Treasuries was quoted
at 0.45 percent, also in line with its recent average, and 0.08
percentage point above the daily average on the Fed's policy rate.
“Things have moved back to a more normal situation,” said Alex
Roever, head of U.S. interest rate strategy at J.P. Morgan
Securities in New York.
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However, occasional bouts of volatility and trade failures could be
a regular feature of a market that continues to adjust to stricter
regulations and tighter Treasuries supply.
New rules have made repo trades more expensive for dealers. Dealers
have to set aside more capital for repos to comply with the
Dodd-Frank Act and Basel III rules aimed to curb excessive
risk-taking.
As a result, Wall Street dealers have pared their repo and trading
activities. Dealers' reliance on repos fell to 13 percent of their
total liabilities by early 2015 from a peak of 32 percent in 2007.
"You just don't have the liquidity like you did before," said Bret
Baker, portfolio manager at TCW Group in Los Angeles.
Lower trading volumes mean costs of trades could surge with fears
that more deals might fail.
In late March, dealers paid money market funds and other cash
investors in the repo market an interest rate of 0.85 percent, the
highest since late 2008.
While dealers have reduced their repo borrowing, some money funds
have converted in recent months from riskier debt, such as
commercial paper, to funds that park cash only in government
securities and repos to comply with stricter rules.
This shift, in addition to demand for longer-dated Treasuries, has
heightened repo demand and likely turned some repo rates "special,"
or negative, where an investor holding a repo pays the dealer
instead of earning an interest.
That happens when the investor needs the Treasuries to cover another
position that could be costlier. The latest "special" episode, which
coincided with the spike in failed trades in early March, was brief.
For some investors, however, the rough spell could foreshadow more
disruptions in the future.
"It's functioning but it's functioning at a higher cost,” J.P.
Morgan's Roever said.
(Reporting by Richard Leong; Editing by Tomasz Janowski)
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