By Steven K. Beckner
(MaceNews) – A less noticed, but still potentially important, outcome of the March 16-17 Federal Open Market Committee meeting was an operational change in the Fed’s Overnight Reverse Repurchase Agreement Facility (ON RRP).
Though largely dormant for the moment, the change could have a significant impact down the road as Fed asset purchases continue to bloat reserves.
In the face of money market rate pressures, the Fed did not change the interest rate it pays on excess reserves (IOER), which remains at 10 basis points, or the Fed’s offering rate on overnight reverse repurchase agreements (ON RRP), which it left at zero. It seems to be satisfied, for now, that the effective federal funds rate is averaging 0.7 basis points – within the target range of zero to 25 basis points, albeit on the low end.
What the Fed did do, though, was to greatly expand counterparty limits for use of its ON RRP facility from $30 billion to $80 billion. The Fed said the increase in the per-counterparty limit “reflects the growth and evolution of U.S. dollar funding markets since the limit was last changed in 2014 and helps ensure that the ON RRP facility supports effective policy implementation.”
The ON RRP facility was formally launched in 2014 after a period of experimentation to help put a floor under the funds rate by giving entities not eligible to earn IOER, such as money market funds and government sponsored enterprises (GSEs like Fannie Mae), a place to park their cash. The Fed sells Treasury securities to such financial institutions and buys them back at a specified price on a designated maturity date. at a higher price. The difference represents interest earned by the Fed’s counterparties.
Essentially, the firms lend the money to the Fed, which pays them back with interest (when there is positive interest). GSEs and others can invest cash with the Fed at a guaranteed overnight rate.
The theory was that any counterparty eligible to participate in the ON RRP facility should be unwilling to invest funds overnight with another counterparty at a rate below what it could get from the Fed, thus setting a floor.
When the ON RRP facility was in active use, take-up was found to be sensitive to the spread between market rates and the rate offered by the Fed, with higher take-up occurring on days when the market rate on repurchase agreements was close to or below the ON RRP rate. Money market funds typically increased their usage at the end of quarters.
Currently, with the rate at zero, the facility is going unused, but the Fed is presumably making way for expanded cash inflows in the future as the Fed continues to expand its reserves, putting more downward pressure on money market rates. Reserves are headed toward $5 trillion by year’s end.
Not everyone was enthused about the ON RRP program when it was created. Former FDIC Chair Sheila Bair, for instance, blasted the program in 2014, warning “the mere existence of this facility could exacerbate liquidity runs during times of market stress.”
“Borrowers in the short-term debt markets will have to compete with it for investment dollars and all, to varying degrees, will be viewed as higher risk than lending to the Fed,” Bair wrote. “Even a relatively minor market event could encourage a massive flow of funds to the Fed while contributing to a flow away from other short-term borrowers.”
“Nonfinancial companies could find themselves unable to find buyers for their commercial paper,” she declared. “Banks could confront a sudden outflow of deposits, particularly those which are uninsured ….”
“Ironically, faced with a more acute liquidity crisis, the Fed would likely have to use the funds it is borrowing through reverse repos to provide a lifeline to the very markets that suffered,” Bair further warned. “For investors seeking safety, the Fed would become the borrower of first resort ….”
The program also had its critics within the Fed. Some feared the New York Fed will have too big a “footprint” in the money markets, altering existing institutional relationships and encouraging surges of money into the ON RRP at times of crisis.
Only time will tell how big a role the ON RRP will play and how much good – or how much disruption – it might do.