Why The Repo Markets Went Crazy, And Why December Could Be Even Worse

guests that we had. Then. Uh, there was one thing that I would have changed, which is that we were due to have Sultan Posar on one of the panels and unfortunately get to drop out a couple of days before for a sort of last minute commitment. But the reason it would have been great to have him there was because something big happened in the market that same week, right, So I was just trolling a little bit. I agree

with you. That would have been the one change that would have been the one thing that would have made it absolutely perfect. And of course what you're referring to was the tantrum or I'm not sure what we were, what word we're using to describe it, but the sort of craziness, the rebo madness of early September was right around that time, and of course Sulton is by many people considered to be the pre eminent expert on in this area. Right also a former Odd Thoughts guest, and

I should just back into this a little bit. So Zoltan pos Our, former advisor to the U. S. Treasury Department, now a strategist at Credit Swiss, and he's been writing a lot about the repo market. In fact, you know, just four or so weeks before we had that rebo madness incident, and this was where short term borrowing rates

in the money market suddenly surge. Four weeks before that actually happened, Zulton had been writing again some eerily prophetic things, like he actually wrote in a piece of August research that the funding pressures that Credit Swiss is forecasting include overnight general collateral repo rates drifting outside the FEDS target band. And that is exactly what happened. I remember, and I'm not just saying this because he's here in studio and we're about to talk to him, but I remember even

before I noticed. I remember the day that the rates shot up. I didn't even notice it until some trader at a bank I beat me on my Bloomberg and said, are you watching what's going on in the repo market. It's exactly what Alton predicted. And that was the first Then I went and looked. That was my first, uh, my first indication that something was amiss. Someone alerting me in that way. That's how that's how closely his research

is tied to we've seen in people's minds in the market. Yeah, Sultan is at one with the repo market and uh, money market crunches. Again, just to provide a bit of background, So what we actually saw on that day was rebo rates, uh,

the cost basically of making secured overnight collateralized loans. Those repo rates jumped from I think it was about two percent to something like ten and lots of people had talked about the possibility of a funding squeeze, especially around quarter ends, which is where we get these sort of traditional crunch points in the financial systems because big banks have to pull back on their rebo financing ahead of

quarterly liquidity requirements and other regulations. But far far fewer people had expected it to happen at this sort of random juncture in time, this slightly random week in September, so again it was really unusual. It spooked quite a few people and everyone immediately he said, we must speak.

Resulting coodes are absolutely and it's important to remember too that when people see this stuff, everyone has sort of still after all these years post crisis PTSD, and you look at bank overnight funding costs and they're soaring from two to ten percent in a day, And of course a big debate immediately broke out. Is this something strictly about financial market plumbing or is there something deeper and more systemic at play that sort of speaks to some

inherent frailty of the financial system. And obviously things have quieted down quite a bit since then, but nonetheless I think you know, they're still people are still unsettled, and no one really knows what the ultimate fix is going to be. The Fed is applied temporary fixes, greater expanding its a supply of reserves uh or overnight operations to satisfy the bank demand for this short term liquidity, but

no one really knows where this is ultimately headed. It seems right, So I'd say it's actually debatable whether or not things have calmed down in the repo market. But why don't we just jump straight into the discussion with Zoltan and we'll be able to get into all of these really really interesting and fascinating questions. So, Sultan Postar, thank you so much for coming on yet again. Very nice to be here. So let's start off with that

week in September. Presumably you're sat in Credit Swiss, maybe watching overnight market rates as you do. What are you thinking when you start to see the repo rate jump like it did. Well, Actually, I wasn't in Credit Swiss the day of this happening. I was actually traveling down to the See to see some clients with one of our sales guys. And you know, we saw the markets open up and you're chatting in the cafe cars and okay, well Monday wasn't good. Tuesday's shaping up to be worse.

And I'm not kidding. Five minutes into that train ride, the train broke down and we were basically told to have to get off the train and there's going to be another train coming. You have to call the client. That's sort of but the train is running late. And then the FEDER announced the REPO operations. But then the FED was late with the first operation due to technical glitches. And I looked at Phil, the sales guy, and I

told him, look, I'm in the country. Is funding itself overnight in the repo market the trains don't run and the fense do an operation on times it has to be has to be a joke or about some sorts. But the September blowout was, you know, it took many people by surprise. UM. I think a lot of people focus on what happened and they kind of look for the trigger that triggered it on that day, and I think that's actually the wrong question, on the wrong thing

to focus on. The September blowout in the report market was a long time in the making. What it had to do with is basically taper, and taper was just very slow burning process where you know, the fat took more and more reserves out of the system, and when when the system ran out of liquidity, which in this specific case means you know, reserves that the system can settle with. You know, the moment you ran out of ran out of those reserves, the repal market seized up.

So this was basically a six billion dollar process, which

is how much the fat tapered. The one thing that was very important to watch is basically look at who are the most reserves rich banks, how much reserves they have lost as the FED was tapering the balance sheet and what is the body language of banks CEOs and banks CFOs and when you listen to them during earning scolls as to what is the minimum number of reserves that they need to hold from a business perspective, you know, the largest bank that held them most amount of reserves,

JP Morgan during the stapor process has gone from having three dollars of reserves at the FED two hundred and spenty billion as of the end of the second quarter of this year. And so when you saw that number, you knew that the bank that was always the lender of next less resorts in the repo market basically ran out of money. So let's back up, just for people that maybe aren't as familiar with some of the terminology or even the structure of the banking system and the

hopes that they can understand this topic. When you or I have our money held at a bank, we have a deposit. The reserves are essentially where banks deposit their money at the FED and the there's a fixed amount of reserves available, and that greatly expanded during the financial crisis thanks to quantitative easing. Essentially the FED going out and buying safe assets like treasuries or mortgage backed securities with reserves, and then it's starting to shrink them as

part of the taper process. And essentially what happened or what's going on is the shrinking of the balance sheet collided with regulatory requirements on banks to hold a certain yes amount of reserves at the FED. To explain this sort of collision of arguably different arms of the government make imposing different demands on the Okay, so let's let's

start with um two observations. Number one. You know, the payment system used to be used to be no longer is used to be a credit system, which basically means that pre crisis, you know, when banks make payments between each other and they transfer money from one bank's reserve account to another bank's reserve account, you know, it used to be the case that banks would go into a

negative balance in their reserve accounts at the FED. So that's the whole intraday credit provision that the FED used to provide to the system, which basically ensured that payments

between banks never bounce. Okay, if there's not enough money in your reserve account, the FED is going to put in the right amount of money so that payments can settle, and then that intraday credit provision by the FED gets pushed into the overnight markets used to be the overnight FED funds market, and that's the way the banks settled

UH those claims at night. Post crisis and post Basil three, there is no bank that is ever going to use intraday credit from the FED, because if you were to use intraday credit, it means that you are in severe breach of your liquidity coverage ratio or your introdict liquidity requirements and all that stuff. So, quite literally, post Basil three, the system settles with the amount of reserves that are in the system, so there's nobody who's taking cash from

the FED on the margin. Then you look at the amount of reserves that are in the system. The distribution of those reserves UH is not equal. Some banks hold more, some banks hold less, But basically the banks that have the abundance of reserves, the reserves rich banks, they are the ones that are lending into the system's settlement process on the margin. So in English, you bent from the Fed adding liquidity into the system on the margin so

that payments can settle. Two and this is no secret um writing about this all the time, to JP Morgan basically using its hbo A portfolio to take their excess liquidity, high quality, high quality liquid assets. Again, most of US two years ago was reserves, taking that money and lending it into the report market or whichever corner of the funding markets such that payments can happen. Okay, So basically you went from the FED providing introduting liquidity in the

system to JP Morgan and other reserved RISH banks. But again JP Morgan is the largest example providing introduce credit UH in the system on the margin. What has happened is that as you taper the balance sheet, you basically took reserves away from the system. Quite literally, you basically forced UH these large reserves rich banks to trade out of reserves, and there's collateral coming in cash being taken out.

On top of it, the FED is basically cutting the interest on reserves rate trying to encourage all these reserves rich banks to let go of their reserves and reverse in more collateral by treasuries, and by by that process they are forcing a redistribution of reserves across the system. But as they were forcing that change, they basically uh flattened the distribution of reserves. They basically um forced the large bank to spend their reserves such that repo trades

normal on any given day. But then basically the flip side of that was that they exposed the system two very bad days in the report market, on tough days when a lot of money has to move. We'll come back to that in a second, and quarter ends and on your ends. So a lot of people just on the reserve point. Then it's at a lot of people have been debating the language around this. Is it a scarcity of bank reserves or a shortage? And why does

the difference between the two actually matter. I don't think there's a difference. I mean it's a shortage. Basically, what I'm saying is that the system ran out of tokens to settle this right, because again back to the earlier point, the FED was always ready in the past to add reserves into the system on the margin intraday as needed. Okay, So it was never possible to run out of reserves.

But in this regime where the FED had x amount of reserves in the system and nobody is going to take credit from the FED, you literally the system literally settles with the amount of reserves that are in the system. So if the bank that has the access and is lending into into the system and the margin runs out of that money runs out of reserves, the system literally

seizes up because you run out of tokens. What was the regulatory logic, as you mentioned the Botel three requirements, what is the regulatory logic of no longer wanting the banks to be able to essentially have overdraft capabilities or use overdraft capabilities at the FED. I don't think that there is a piece of regulation that says, you know, don't take it, or the FED never said that I

will never give it. I think it's just, you know, if if every bank has to like the LCR for example, licuity coverage ratio tells that every bank has to pre fund thirty days worth of outflows, Okay, so every bank

is going to be thirty days pre funded. Okay, So no one is going to be in the funding markets to kind of get the liquority to be able to settle, okay, And this is actually a very important question you're asking, right, So the banks don't have a liquality problem here, right, All that has happened is that, you know, the banks

have been the marginal lenders into the report market. So the entities that ended up with a liquidity problem or the dealers, but basically for the past year it were the banks that were the marginal lenders in the report market. But the banks are only going to lend into the report market on the margin until they reach a limit in terms of how much reserves they have to hold at the FED and below which they are unwilling to go okay. So this was basically a liquidity problem for

the dealer community. And the problem at a higher level was that the banks, despite having the liquidity, were unable to lend more into the report market because if they were to be lending more, they would breach their intra

day liquidity requirements. It's just it's just one of those unintended consequences where it's just one of the unintended consequences of the rules where where everybody basically wants to show, you know, how much liquidity they have to the Fed, and they are unwilling to go below that because then there is regulatory scrutiny to pay. So just just up back for a second, because this question comes up quite

a lot. But if you're not in the money markets, sort of in the weeds of a lot of this, why should you care about what happened to the repo market in September? And I mentioned, you know, for instance, the effective federal funds rate getting pulled up along with repo rates. Is that the big sort of takeaway from this that the Fed sort of briefly lost control of money market rates or monetary policy, or however you want to put it. I don't know. I think it's I

think it's something far bigger. So why does this matter? You know, it's an overnight rate? I tweeted, By the way, I said, what should we ask? Assulton? That that was this was by far the most common question. It's like, it's interesting, but why should we care? So? Repo is how you get to live to fight another day. Okay, so that's not my meme, that's, you know, coming from Perry Merlin. Yeah, but again. Repo is how you get

to live to fight another day. It's very What that means is you go to the overnight rebol market because you run out of money. You can't make payments today, payments that are due today. So on the margin, you go and try to get some money so that you can make a payment today and you pay that money back tomorrow to someone. If you can't borrow in the repo markets and you can't get the cash to make your payments today, you're not going to open up tomorrow, okay.

So if you are an RV fund that needs to roll funding on its position, if you are a primary dealer and you can't fund to roll your positions and top up your clearing account that at your clearing bank. If you're a small dealer that can't fund, you're right of business tomorrow. So that is why you basically care about this stuff. You know, It's like when you look at on electric cardiogram and the heart ticks. You know, it takes ticks ticks, and it doesn't take and it

starts to beep. So it's something like that either ticks or it doesn't tick. So it's existential. You know, when you see these rates at ten percent, it means that people are having a hard time getting the money to make payments. U S Treasury is having a hard time pumping treasuries into the system on settlement days, you know, the money is not moving to the Treasury general account because people are not bidding to part with their money. In this case, the large banks run out of reserves,

so the money ain't going to the US Treasury. So quite frankly, you know, if you need to pay unemployment insurance benefits and food stems and all that stuff, the funding of that stuff process gets comed up. So this is this is this is serious stuff. And you know the reason why the FED response to these things quickly.

I mean, they could have responded quicker, but the reason why they respond to it quickly is because, you know, they just recognize the nature of these overnight markets where the money doesn't flow, people can't pay, people can't pay, they go out of business. Headlines can happen, right, you know. The the good thing was that, you know, this dislocation

didn't last for more than a day. If these these locations go on for two days, three days a week, it can turn into an existential problem for a lot of people. So another thing that I've been wondering just on the idea of the FED having to come in and sort of swoop in and fix this problem as soon as possible, although as you point out, it could have been faster and they did have technical difficulties when

they first tried to do it. How much of the confusion or the fact that reboat rates actually got to ten percent, how much of that do you think had to do with Simon Potter having recently left the New York Fed? And also, actually I've always wondered this, but do you ever talked to the FED about these issues? Do do they, you know, talk to you about your thoughts on this? But for the record, in five years, I've seen them once two years ago it was any

other question. I don't think so, I think. I think again it's you know, I guess the the the message would be that, you know, Taper, I guess was a mistake. So the difference between the report market printing normally like it has been for the past five years versus the report market falling apart on December thirty one of last year early September this year, it's basically those six billion dollars of reserves that were taken out of the system

by Taper. So if you look at the usage of the reverse report facility the other report facility, right, you know, that's the facility where money go os when that money is not needed because there is not enough collateral. People don't have the balance sheet, there's not eno farbitrash opportunities, so nobody takes the money from the money funds and on the money funds put it at the FED, and then money goes there to die. It's very important to to kind of realize that Taper started when the usage

of that facility was zero. That means that you know, lazy cash in the system was already gone when Taper started. So all these you know, Taper and increase in treasuries, cash penancies, the increase in the foreign report pool was basically taking money out of bank hql A portfolios is your liquidity portfolios of the banks, and it was taking reserves out of the portfolios of JPMorgan and all the

other large American banks. So basically, you know in English, that means that Taper was taking the liquidity buffer away from the system. That basically ensured that these large banks have the extra cash to lend in to periodic these locations in the report market and in the FX market

and all all sorts of other markets. So the fact that we engineered taper and we tapered as much as fast as we did without the safety valve built into the process where if God forbid to we take out too much reserves, we should have a facility to kind of put as much liqurity back into the system as as as needed, right and let that the usage of that facility speak loud that taper should stop. We didn't

do that. So back to your other question, I think the problem is that we tapered this much, this fast, So it was kind of a architectural mistake. So personnel changes, I would say, have nothing to do with, you know, the blowout and the response to that blowout the day of I think it has to do more with why did we end up in this position in the first place.

And by the way, when you when you listen to you to the FED throughout the whole taper episode, you know, when you read those speeches, the indicators that the FED was looking at to see if things are getting tight or if you should stop taper, we're the wrong things to look at the feed was looking for banks use of introday credit force for signs of stress to show up.

You know, earlier in the conversation we said that there's no bank that is ever going to use introduce credit from the FED post Bossal tree because it's not worth the reputational risk. Nobody wants to be the first one to use it. Nobody wants to be the person to

max out the the lines. And if people were to use it, you know, no one's going to be willing to kind of let those things faster and be rolled into the UH the risk can been though, So basically I think I think you had the wrong things they were looking at, and and they they tapered way too much, pay too fast, and they put the system into a precarious position. And again the conditions for what happened in the ripple market in September. We're building over time as

they were shrinking the balance sheet. It's almost like a wildfire where you have all these dry leaves accumulate and then something that happens, and then a wildfire gets really bad because because the dry leaves accumulated over over the time. You mentioned something there that speaks to the last time you appeared on our show, and that relates to the

role of a foreign participants in the market. We just did an episode actually with Brad Setser and which we talked about Taiwanese life insurers and their thirst for dollar denominated assets. I think it was what we talked about.

I think it was back in April or May, was the last time we talked to you, and it was kind of about this topic and that as rates on dollar denominated assets, particularly treasuries, were coming down, there was less appeal to hold US government debt and that it made more sense for foreign buyers to essentially just have money at the federal reserve, leaving all these treasuries on the dealer balance sheets. Talk to us about this aspect

of the repo crunch. How much of it is essentially a result of what you were talking about when we talked to you in the spring, about the fact that normally these foreign buyers would be in the government bond market, but when raids got too low, it just didn't make any sense. So on I just hold the money right at the Fed, exacerbating the reserve shortage. Yeah, so you know, rave gets too low, and the other important thing is that the curve inverted. Right, So that's what we talked

about last time. It has a lot to do with it, right because if you think about what the world used to look like too three years ago, when Japan and Taiwan and all those Asian accounts are buying more, I mean they're still buying, but not as much and definitely not enough preductive to supply. The theme in the money markets back then was that, you know, Asia, Asia is buying, they have to hedge it back to yen, you know, to euros and other currencies, and they typically do the

three month points. So you buy, attend your treasury, you hedge it back and roll those hedges every three months. So that's a pressure on three month funding costs. Now, libor widened sixty basis points around money funder form, which also coincided with that with the time in markets, cross currency bases between yen and dollars widened as much as

a hundred basis points. Very interestingly, the Fed didn't care one bit about the so called oys oys basis blowing out to a hundred basis points between yen and dollars I mean English, but that means basically that parity between term funding on shore and term dollar funding in Tokyo completely broke down, you know. So people in Tokyo were paying a hundred basis points over for dollars at the three month point, then people on shore here in New York.

That was kind of a big deal, but you had no speeches about it, no blogs, no papers, no nothing. You know, when three month funding costers are stressed in the fex S pop market, right as a dealer, you can lend into that demand by borrowing in UH at the three month point. Also in the fex S pop market in its unsecured markets, secured markets, or you can borrow not at the three month point, but at the one month point, the one week point, the overnight point.

So the point here is that you know, the dominant bid for funding is at the three month point. The funding of that of that borrowing need can be distributed along a three month stretch in money markets going from overnight to three months. So overnight markets are going to kind of feel this stuff, but only a part of it, a little part of it. When a curve gets inverted, okay, And as we discussed last time, all the carry traders

get knocked away on the margin. So the foreign hedge buyer is not buying as much as the foreign banks are not buying as much. The r V hedge funds can buy as there's one group of entities that has to buy by law. Those are the primary dealers. So the dealers started to back up with inventory. But the dealers are in the moving business, they are not in the carey business. So dealer is never going to term fund its inventory. Uh, they tend to fund it overnight

and roll it overnight. And here's the important point. When the dealer is the marginal buyer of treasuries and they fund things overnight, the only way you can fund it overnight funding demand is overnight. You can't you can't go anywhere. I mean, you're not gonna, you know, fund an overnight funding demand with like the three month point because you know, if the fat cuts and you're in a bad position. So everything over the past year in fixed income markets,

in money markets was funded at the overnight point. And that's a dangerous situation because if the money doesn't come in, but it goes out maybe because there's a large settlement day, maybe because there's a tax payment day. Now, once the money goes away, you literally hit an air pocket, okay, and if there's no want to lend into that air pocket, you have a problem. And the Fed cares deeply about

our overnight rate sprint. So the overnight rates breaking down and those spreads widening out massively is a far bigger deal than three months cross currentcy basis blowing out to a hundred basis points. You know, the inversion dealers becoming the last bid for treasuries. Everything happening overnight, which is the FEDS sensitive points UM has a lot to do

with with everything that happened. There's quite a lot of irony in this when you think about a lot of those UM post crisis liquidity rules were basically aimed at taking at improving fragilities in the repo market, right and like strengthening the overnight plunding market, and instead you seem

to have ended up with a slightly opposite situation. Well you you know, you ended up in a slightly opposite situation because I think the other the other important thing that people tend to overlook is that the report market has grown tremendously this year. Is that because of treasury issuance or something else. Well, partly treasury issuance, but also

the growth of sponsored dripo. Sponsored dripo for those who don't live in the front end, is basically a new I don't know, okay, so let's educate Joe a little bit here. So sponsored dripo is is a new way of of doing ripo in net Okay. So there's basically three banks for now UH that have the ability to do sponsored dripo. These are State Street, Bony and JP

Morgan sponsored dripo. The the idea is basically to let well capitalized member banks there's not dealers from now banks of f I c C to sponsor in money funds and sponsoring hetge funds into the repo markets such that when you sponsor these entities in and you let them face off against each other through a matched book that you provide UM, you can net these positions so they

don't use balance sheet okay. So this is basically a way for UH, for the system to provide more balance sheet and more liquid it into the report market that are using balance because balance sheet constraints is one of those things that that basil trees is constraining. So all these treasury collateral coming into the system um has for the most part being funded in the sponsored repo market. Sponsored reaper at the moment is only available on an

overnight basis. So if you were an RV fund or if you were whoever and you needed balance sheet in the report market, it's a relative value fund right well, and if you needed balance sheet in the report market, it was only available to you overnight because term term trades are not available, not available in the sponsored report space just yet. You know, in addition to the things we discussed before that dealers got backed up with the paper,

they had to fund it overnight. It was also the case that the ReLit, the value hedge funds and whoever you know, uses report to fund treasuries could only do that overnight. So this this kind of new new piece of the market sponsored report, which has grown to something like three billion dollars in size, also was a part of priming the system for a accident, because again, if the money doesn't come in because it has to go someplace sells, then basically a lot of long positions that

are funded overnight I can't get rolled. And that's precisely how you can end up with report. It's going from normal to ten percent the next day. But I want to get soon to the sort of how ultimately the FED fixes this structural plumbing. What have you issued? But before we do, I just want to go back to one key question that I recalled coming up in the immediate wake of the repub madness. The bank, the big banks like JP Morgan, did they still have tech quicly speaking,

excess reserves beyond their liquidity requirements? The banks had reserves, but those reserves were by no means excess. And this is and this is what people tend to get lost on. Right, So it is perfectly possible for the largest US banks to sit on a hundred plus billion dollars of reserves in their reserve accounts. And it's perfectly understandable why they don't lend those reserves, right because they need those reserves

to satisfy their intra day aliquidity requirements. They need those reserves to be able to pass their resolution stress tests things like that. Okay, so again, when you when you go to a bank that had three hundred billion two years ago down to a hundred and it wouldn't lend more in the report market. The two hundred billion was the access and all of that was spent and whatever

is left is not there to be played with. You know, if you think about these reserves as high powered money, that hundred billion that's there, that ain't high powered money. That's dry powder that has to sit there and you can't use it. You know. The two weeks before the REPO blowout, I've seen um they are all clients of credits with the bank portfolios. I've seen four of the largest bank portfolios. And you talk to the c i os that run these portfolios, they will tell you that

I would like to earn more with my cash. I would like to harvest yields in treasury markets. I would like to harvest you know, yields in the g C market, but I can't. And currently I'm making uneconomic decisions with my reserves because I need to hold those for regulatory purposes. So that is basically the environment in which we are

getting closer to this, to this REPO blow out. A lot of people, you know, point their fingers at the bank saying, you know, they were the ones who caused it, because they have so much at the FED, why didn't they land more. There's nothing that a bank would like to do more than to earn a ten percent yield by moving all their cash into an overnight market and get that money back tomorrow and make ten percent. So the fact that you have these yields has to do

with just banks inability to land, not their building investiment. Right. So this is sort of what I was getting at with these scarcity versus shortage of reserves earlier. There's this big arbitrage available in the market, free money basically, but the banks can't come in and do it. So just

getting to solutions to this problem. We've seen the Fed uh increased overnight liquidity operations and also announced that um I think it's going to buy up to six was it sixty billion of TEA bills or did they increase it recently? Sixty billion a month? Sixty billion a month

of te bills? And yet there have been a couple of times this month where we have seen repo rates start to creep up again, and we've seen some analysts at the cell side, JP Morgan, Goldman, SAX and Bank of America Mary Lynch also saying that they think the FED hasn't done enough to solve the market problem. So what exactly is it that the FED needs to do and how big of a sort of problem in the repo market remains. So I agree with the strategists at JP Morgan and Bank of America. I I think as

well that the FED has not done enough. What we have is good for now, but it's not a structural fix. You know, there's a big difference between you know, a liquidity problem and a liquidity problem and a balance sheet problem. Okay, So you know, in September we had a liquidity problem because the system ran out of reserves, you know, the tokens you settled it. So the only thing the FED had to do is just pump in reserves on a margin.

You know. The big event that's coming up is the year end turn and during year and no one is going to have the balance sheet two move money around. So you know what what I'm trying to say with that is, you know, it's okay that the FED has a report facility. Uh And for as long as there are primary dealers that are willing to take liquidity from that facility and broadcast that liquidity to the rest of the system, to the hedge funds and little dealers and

and whoever needs that money, the facility works. But once the primary dealers have a balance sheet constraints, and they won't be the intermediary between the FED and the rest of the system. It doesn't matter how much the FED wants to put liquidity into the system with that report facility, there's not going to be a mechanism through which they can inject that that liquidity into the system. So like a very weird analogy here would be that, you know, if I'd like to play tennis, but I don't have

membership at the country club. You do, Joe, Um, you know, I can go in with you. It would be the exact opposite in real life. But well, right, but if you're out taking a hike, there's no tenants for me because my friend who's got membership to the country club, you know, cannot get me in. So you basically need

someone to hold your hand to get that liquidity. And during year end, no one has the balance sheet and no one has the ability to be, you know, to be the good Samaritan is going to take to the compurity from the FED and give it to you. So again, and we we've hit on this, but just to make it clear, you know, quarter end r end are important because regulator there's a snapshot taken of the bank's financials, and it's literally on that day that the regulators take

a look at the books and everyone. It's like kind of cleaning your room before your parents get home and something like something like that. So what is the solution then, such that we can avoid having these problems pop up every time that the parents come home to check out the check out whether the room is cleaned. And do you expect that in the absence of something new, we are going to see something dramatic again reappear on the market over the next you know, as we get close

to your end. Yeah, so there's there's a couple of things. Let's talk about reple first, and I'm make to the bill purchases. You know, fundamentally, the issue is that the repo operations that the FED is doing, in technical lingo, it's done on a tri party basis, so it cannot be netted. So that's how you get to the sort

of balance problems. People say that the fetch to turn this threeple facility into a I mean, it's a standing reple facility effectively anyway, But I think what they really mean is that they need to make the FED needs to make this reple facility nettable. I think that that will never happen. It will never happen because the FED, just by its d n A, they like, they like

to be super senior in their dealings. And there is no way that the FED is ever going to lend into f I c C, the Fix Them Clearing Corporation, you know, A. They are not going to lend into the clearing corporate, into the clearinghouse and be a peri passu lender alongside everyone else. It's just not the way they do things. Two, if they were to do things, uh in a super senior way, they would basically upset everyone in the clearing house because everybody just got subordinated

to the largest lander in in the clearing house. So I think it's either the FET who's not going to do it because they're not comfortable with it, or they will do it in a way which is just going to set the stage for them for a massive coordination problem and you know, just upsetting the governance of the Fixing Com Clearing Corporation, which again is the is the central clearing house for for report transactions, uh, not to mention other things like you know, with the With this

growth of sponsored repot, there is now as we speak about hedge funds that now have access to f I c C. So are we really going to go into a regime where hedge funds can put collateral into the clearing house and and and the FETE effectively on the margin is going to fundle That's probably not. I don't think that we should go down that path. So that's the thing that one thing they do, but they will never do really. Um. The second thing they could do is to open up this facility for banks as well

as dealers. So this is a very important distinction at the moment non primary dealers. Well no, so at the moment, it's the primary dealers that have access to this facility, but the banks do not. Okay, So just to just to give you a concrete example, let's say JP Morgan Securities as a primary dealer has access to the report

facility JP Morgan Chase Bank and A the depository does not. So, if you go back to the earlier conversation, we had dealers got backed up with treasuries they needed to get that funding in the report market, and the banks, the bank portfolios were the marginal landers in the report market. Okay. So, and the reason why the money dried up in the report market on the margin is because the banks hit their logos level of reserves and need ald so they

stopped landing. Despite the fact that they have all those reserves, just can't go below it because you would be reaching your regulations. So what you could do is you could open up this facility for banks and uh, the chief regulator who's random quarrels in the FED would have to give a speech saying, we are fine with large banks to have all bonds h A portfolios. This you know, hundred odd billion dollars that is sitting at each of the large banks hl A portfolio can be spent to

the last penny. It's okay for these largest banks to have bonds only in their h A portfolio because the FED stands ready with a report facility to turn those bonds into cash when introdated liquidity needs a rise. And if there is a resolution scenario where the bank has to be one down and um, you know, we will take those treasuries, give money in turn and let that money pay out its creditors and wind down in an

orderly fashion. If that speech were to happen. And if that change to the philosophy with which the regulator would like to see the banks run their liquidity portfolio happens, and the banks get access to the report facility, then you basically free up easily five to six billion dollars of reserves. And that's five to six billion dollars of extra money that can go into the treasury market, and it can go into the report market. Is that going

to happen? Probably not, because you are not going to change the philosophy with which you run these security portfolio is just to get through this year end turn that's coming up. A third thing you could do is you can put a footnote on the on the Repo facility page of the New York Fed's website saying here and is shaping up to be a very bad event. Let's just be clear that whatever money you will take from this facility going into that turn is going to be nettable.

So from a regulatory perspective, you're just not going to have to count that in your leverage ratio and all these things. So you know, if I'm a dealer and I go to this facility, I take fifty billion and I pass it on. I mean, the FED knows exactly how much I took, and it knows exactly how much balance sheet to ignore from my calculation. Is that going to happen? I don't know. I mean, a couple of the dealers that are primary dealers run their report books

out of branches. Those branches roll up to the holding company in their respective countries for reporting purposes. So can the FED guarantee that the French regulator and the Japanese regulator is going to have the same view on what's notable and what's notable? I don't know, So I think it's kind of a coordination problem. So I don't think that any of those things will happen. And if none of these things happen, you basically set the stage for

something quite ugly happening around the year and turn. Because it's not going to be just a liquity problem, right. The people are not going to have the balance sheet to take the liquility that the FED is trying to put into the system, and the market can really get seized up. So if you thought September was bad, December

can get universe. But then again, you know, you see headlines Treasury secretaries looking into ways of dealings, you know, with some of the REGs and maybe some changes coming from the regulatory side, you just don't know, you know. So if something big is going to come then here and there's less of an issue. If if none of

those things will come here and is an issue. Right, so you can imagine that any tweaking of the existing regulation, like there's an optics problem there, which is like a bunch of people will say that you're basically rolling back bank regulation. Um. And in fact, we've seen, you know, people like Elizabeth Woren actually start talking about repo markets and what Jamie Diamond over at JP Morgan was saying, I have one more question, and you sort of alluded

to it just then. But um, we've been talking about the repo market sort of in isolation, although as you say, it is a very very big deal for markets overall. But is there a specific scenario in which a coming up in repo another bout of repo madness, maybe one that's worse at the year end. Is there a scenario in which that impacts risk asset exposure at the primary dealers or the banks or big market participants as well. Oh, definitely, definitely, In fact, in fact, you've seen a micro tremor and

in September. You know, it's hard to see it, but you know, if you if you talk to h to the equity desk at a dealer, they will tell you that this happened. So what happened in um in September and REPO blew out the equities that the street was the most long in sold off and the equities that

the street was most short in rallied. So what that tells you is that the balance sheet that the equity derivatives desks and you know cash equity desks are providing to the streets, the lungs were trimmed because there was no balance sheet for them, and the shorts were trimmed and because there was no balance sheet for them, right,

So that's what caused those moves. And what happened was that, you know, it's some dealers and it's not all dealers worked like this, but there are some dealers where equity derivatives and FFEX forwards and REPO basically rolls up to a single person. So you shift equity across these businesses based on where the spreads are the richest. So in September,

when ripo blew out. There were some dealers that to balance it away from equity derivatives and the flex desk and moved it to the repo desk because you wanted to harvest those widespreads to the extent possible. And as you move that equity, as you moved to equity and you took balance sheet from equities away, there was an

impact on equity market. The reason why this didn't get out of hand and it didn't start to impact more names and didn't last for longer is because the fat step then started to and in the report market, and the report market calm down, So whatever equity you shifted there went back to to the equity desk. So again, if this thing persists, and you know this is just a spill over into risk assets. But if this thing persists, remember that repo is how you get to live to

fight another day. If you have to fund at ten percent for a day, another day, and a third day, it can become existential to the point where you end up with headlines and newspapers front page, you know, so that can also spill over into risk assets. So I think I think there is a very real chance uh that if we don't have a better set of pipes from the FED and a more aggressive QUEI um than

you have a very very problematic here. In turn, you just opened up the if we we don't have time to go there because you just opened up the most controversial Pandora's box of whether they should even count is whether this is QUEI or not. And I feel like we could do a whole separate discussion on that. Unfortunately,

I don't think we have the time. But I think that was a great leaving us with that potentially gloomy note of maybe a bigger repo madness coming in December, and one that potentially spills over into a risk assets something to uh, I wouldn't exactly say look forward to, but something for everyone to pay attention. And I think after this discussion, hopefully people have a much deeper understanding of what's really going on. So Sulton is so great to talk to you. Thanks for coming out, Thank you

very mu sure, thanks Alton, that's so good, Joe. You know what I love about that conversation is that Bolton sort of brings these big picture theoretical approaches to everything that we've just seen in the repo market. But he also gives you the sort of technical, behind the scenes look with what is actually happening at some of these

desks and the primary dealers. So I really like that. No, I think this is incredibly important and it's kind of touched on what we talked about last time, but in a more specific way that it's easy to say, look at some charts and say, oh, this bank should have access reserves and this is just a plumbing issue and

so forth. But then you get into these very specific scenarios in which people who are running portfolios or people who have to figure out how they're going to provision their own liquidity, may move money or may decide to move money from one activity to another, and it's, uh, it's very real world. It's not just a series of cells on a spreadsheet that should, uh should behave in

some predictable pattern. Right. Well, I also think you know people here money markets and rebot badness, and they think this was a really technical issue in the plumbing of the financial system, as people always put it, but actually a lot of it is behavioral, sort of on both sides. So you have people who, for instance, don't want to access the discount window because it seemed to be a

bad thing post crisis. And then on the regulatory and political side, you have people who probably are unwilling to

really tackle this issue because of the optics involved. Right, you don't want to be seen to be bailing out banks or rolling back financial regulation, even though you know logically there seems to be something slightly off with the system, or even as he described the fed's own posture of not wanting to be subordinate, or other entities that want to lend into this market not wanting to compete with

the Federal Reserve. All kinds of questions that again on paper or on Twitter, someone might be able to The FED just needs to do X, set up a standing repo facility. Why haven't they done that already? I thought. I learned a lot from that conversation about why it's not not quite so simple as just setting up a

new death square. Anyone can swap treasuries for reserves and have the liquidity they need for regulators, Yes, indeed, and now of course, uh, we'll all be watching out for what happens at the year end if we weren't doing so already, So we'll have to have a sultan back on in the new year to Yeah, I actually thought that wasn't I thought. I was like, Okay, they're never gonna let this happen again, because we saw this, and

we know that the urine is already stressful. So I'm I'm a little disconcerted about how concerned a sultan is for the year. And one other point that I really liked, and I think it's to get the language of a cross here and this idea, and he used the term several times tokens to describe reserves, and it's a good reminder that money, while they may you know, there are many different forms of the dollar, and they basically trade it one to one all the time, they're not completely fungible.

And so you think about a casino, uh, and you have a dollar, and you have a one dollar token or token worth one dollar, and in theory you know that they're pegged perfectly and they always trade. But it doesn't mean you can't have an issue, or that the poker players who want to leave wouldn't be really upset if there was some issue with just the mechanics of

the conversion. Even if say the casino owner had plenty of money and they could make good for everyone, you could get these sort of very technical, angry situations, stressful moments if they were a token shortage or something else. And that really sort of speaks to the issue that there are all these different forms of the dollar, but if there's a shortage of one, you could still have or if there's a temporary shortage in the provision of one, you could still have these issues. So I think the

language he used there is extremely helpful in that understanding. Yeah, it's sort of like, um, I guess liquidity, liquidity everywhere, but not a drop to drink kind of thing, right, the systems awashing liquidity, But that doesn't necessarily mean that you can move it from one end to the other.

So if you have if your regulator wants you to have one, very specific types of type of liquidity, because again, treasury bills three months are among the most liquid, safest, most valuable assets in the world, and if even they're not good enough under certain sort of regulatory demands, you get these bizarre situations in which highly liquid, well capitalized banks could still find themselves uh with some sort of shortfall. Yes, indeed, all right, again, something for us to watch out for

going into the year end. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe wi Isn't Though. You can follow me on Twitter at the Stalwart and be sure to follow our producer on Twitter at Laura M. Carlson. And all the Bloomberg podcast check them out at the handle at podcasts. Thanks for listening one