Could Quantitative Tightening Cause Another Liquidity Crisis in Repo Markets?

Executive summary:

  • Quantitative tightening (QT) has been underway since June 2022, with the Fed shrinking its balance sheet in order to bring reserves and liquidity in the financial system back down to more normal levels.
  • The overnight reverse repo facility is now getting down to low levels, raising questions about whether another breakdown in financial market liquidity and stress in short-term funding markets could occur.
  • At this time, we believe a repeat of the unexpected rate spike of September 2019 is unlikely. Current liquidity conditions are normal.

What is the repo market and how did it change after the Global Financial Crisis (GFC)?

The U.S. repurchase agreement, or “repo” market, provides more than $3 trillion in short-term funding each day. Most repo transactions are overnight and are collateralized by Treasuries. Repos (to get cash) and reverse repos (to lend cash) are used for short-term borrowing and lending.

With the advent of quantitative easing (QE) in 2008, the U.S. Federal Reserve (Fed) moved from a scarce to an ample reserves regime. The Fed used to control rates by managing the supply of bank reserves so that interest rates would clear at target. But now banks frequently hold substantial reserves. These reserves are now managed and incentivized by the Fed, which pays interest rate on reserve balances (IORB). Non-banks, such as money market funds, can also park money at the Fed’s Overnight Reverse Repo Facility (ON RRP).

These two mechanisms act as a floor system, allowing the Fed to control short-term interest rates. For example, if interbank rates fell below IORB, a bank could make more money using the Fed facility and would do so.