Last month's spike in failed trades in Wall Street's key funding market sparked fears that it could be a sign of trouble brewing in the U.S. financial system, but the disruptions appear more likely to mark the "new normal" of the post-crisis era.
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.
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% of their total liabilities by early 2015 from a peak of 32% 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%, 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.