Wednesday, October 21, 2009

The Fed's tri-party reverse what ...?

Much has been said recently about the Fed's activities in what the media refers to as "testing" of reverse repo transactions. This has caused a great deal of confusion because many have interpreted the "test" as a signal for the Fed to begin some sort of tightening.

The Fed definitely wants to be prepared to act, particularly to minimise the impact of new securities purchases. But repo transactions are nothing new for them - it's a typical tool used to add or take away liquidity in daily operations. What is new is the Fed's goal to expand repo counterparties beyond the primary dealers.

FT: The Fed also said the use of reverse repos could be extended further, with "the possibility of expanding the set of counterparties the [New York Fed's market] desk might employ for conducting reverse repos beyond the primary dealers".

But to face institutions who are not the primary dealers will create additional counterparty exposure for the Fed. It is also operationally difficult to execute direct repo trades with hundreds of counterparties (wiring cash back and forth and moving securities). To address these issues, the Fed has apparently been setting up and testing the "tri-party repo" arrangements.

FT: ... the Fed said it had been conducting reverse repo tests in the so-called triparty repurchase market, in which custodian banks such as Bank of New York and JPMorgan act as intermediaries.

In such an arrangement, instead of delivering securities directly to the counterpary, the Fed would place them at the custodian for the benefit of the counterparty. This way if the counterparty fails, the Fed could get a hold of the securities from the custodian.

The reason a number of counterparties may want to do this is that it will allow them to run a repo book directly with the Fed, including access to place cash overnight or term on a risk-free basis (which may produce a higher return than holding T-bills).

It's not clear how soon the Fed plans on using these programs actively. Some speculate this action will come quite soon but will be limited only to new securities purchases. That simply means that no new liquidity will be added going forward.

The voting members of the FOMC will be replaced by the new group (they rotate) in 2010. The new bunch looks modestly more hawkish as the chart from Credit Suisse shows.

It is highly unlikely the Fed will take any liquidity out before the end of the year, but they may begin to get a bit more aggressive in Q1. Much depends on the differential in the rate of change between the narrow and the broad measures of the money supply. The Fed wants to see more bank lending before it acts.
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