What the Treasury Bond Collateral Crisis Tells Us About Trust

Confidence lies in the dwindling supply in the world. This is true between nations, trading counterparts and securities dealers. In the markets, we can measure this distrust of the different prices of similar financial assets ultimately supported by the US federal government.

Take, for example, the interest rate paid by the Federal Reserve to banks that place their money almost risk-free overnight in its “reverse repo facility.”

The Fed engaged in reverse repos for years, under which it would receive overnight cash, backed by the highest quality short-term securities, in exchange for “reserves,” a kind of non-transferable asset for financial institutions.

But institutions and investors have other low-risk options for their available cash, such as short-term treasury bills. In fact, a curiously persistent gap has emerged between interest rates on shorter-term Treasury bill rates and the periodically reset rates offered by the RRP.

For example, on March 23, the four-week Treasury note at one point yielded about 13 basis points (each one-hundredth of a percentage point), while the RRP offered 30 basis points. In the past, the markets did not value much difference between them.

If this propagation happened because of some strange event – a massive one-day computer crash perhaps – it could be seen as just noise, not a signal. Yet this difference has persisted quite consistently since June of last year. Both RRP and treasury bills offer daily liquidity, and the full confidence of the federal government is behind both. So why these differences in performance?

Part of the idea behind the RRP concept was to assure money market funds held by bank and corporate customers that they would always earn a low, but at least positive, rate of interest on cash from these safe RRP accounts. Ensuring that sense of security for account holders was paramount. Without this protection, public confidence in the system as a whole would be undermined.

The underlying problem was that banks and other deposit-taking institutions, such as money market funds, had not found enough solid lending or investment opportunities for the excess liquidity made available by the credit programs. quantitative easing. Since the onset of the pandemic in early 2020, demand for loans in the United States has weakened such that deposits from bank customers have not been able to be tapped as in the normal banking model.

Regular use of the “RRP” only started in 2014, and for a while the Fed (and its customers) only used it when needed. But the buy-back facility has grown in importance, especially in the past two years. On a daily basis, no RRP participant can bid for less than $1 million or more than $160 billion.

The facility has become more popular with institutions that find themselves daily with more cash than attractive short-term, low-risk opportunities. On April 4 of this year, for example, overnight RRPs were $1.73 billion.

So, given the Fed’s backing of this type of account, why are people willing to pay for short-term Treasuries (and get less of a return) when they could earn twice as much in using RRP?

The main reason, in my opinion, is that these Treasuries may be more useful. An investor or a merchant bank, after buying them, can lend and re-lend these securities several times each before their maturity. This is a process sometimes called “re-mortgage”.

Each time an institution that holds the items lends them out, it may charge a “securities lending fee”. The flexibility of these treasury bills to provide collateral makes them popular instruments for use in transactions typical of the fixed income securities market. Interest rate swaps, where two parties exchange different streams of income paid over different time periods, may have treasury bills used as collateral in the transaction.

On the other hand, while the RRP can offer a higher rate, unlike Treasury bills, they are not instruments that can be lent again.

This “collateral market” is a vital and underestimated aspect of the international financial system. Manmohan Singh, senior financial economist at the IMF, is the leading expert on the subject. His research has shown how the use of collateral can give an indication of the health of the market.

When financial market participants have high trust in each other, the “collateral reuse rate”, or the number of times Treasuries (or perhaps short-term German Bunds) are lent and re-loaned, increases. In the easier days of 2007, a short-term Treasury bill could be reused up to three times. By 2016, the reuse rate (a kind of inverse measure of trust) had fallen to 1.8 times. In recent years, the reuse of collateral has picked up.

Now, however, the persistent interest rate gap between RRP and short-term bills tells us that there is a new rush to access the best collateral. This suggests that financial counterparties trust each other less and less in the quality of their assets.