Usage of the Federal Reserve’s overnight reverse repurchase agreement (ON RRP) facility increased markedly in May and June from little uptake to a peak of $991 billion on June 30. While news of over half a trillion dollars parked in a facility paying a 0.0% interest rate sparked media coverage as recently as June, the significant uptake of the facility, mostly by money market funds, appears to reflect shifts in the supply and demand for short-term funding and does not appear to be a sign of near-term financial instability. Chair Jerome Powell stated recently that the Federal Reserve is “not concerned” with the volume of the facility.
On the supply side, the Federal Reserve has used ON RRPs to bring in cash to cover its asset purchases and to replace funds the Treasury has withdrawn from the Fed to pay for stimulus checks and other fiscal programs. On the Fed’s balance sheet in recent months, the sum of Fed asset purchases and Treasury withdrawals has been offset closely by the increase in the usage of the ON RRP facility.
On the demand side, money market funds, typically the dominant user of ON RRPs, have seen an uptick in assets under management this year and have also shifted substantial sums from Treasuries to ON RRPs. The Fed stoked their demand for ON RRPs by opening eligibility to smaller MMFs on April 30 and by raising the ON RRP interest rate from 0% to 0.05% on June 16. In April, the Fed also lowered the minimum investment in the program for government-sponsored enterprises.
At the onset of the COVID-19 pandemic, the ON RRP facility saw a temporary uptake in usage to a peak of $284 billion, but the large issuance of Treasuries to fund stimulative measures limited money market funds’ need for the facility, as other safe short-term assets were readily available. Usage plummeted by the end of 2020, with operations rarely reaching $1 billion in size. This lack of participation carried into 2021. Usage spiked in March and then began to steadily increase in April. By mid-June, the ON RRP facility reached record highs, with over $500 billion committed overnight on a daily basis.
As money market yields declined and even went negative, market participants called for the Federal Reserve to respond by raising the ON RRP or IOR rates. There is a potential risk that short-term interest rates persistently around zero could lead to MMFs closing to new investors or even offering negative yields. Indeed, several MMFs did gate themselves in the early days of the pandemic-induced volatility as they faced profitability pressures.
On June 16, the Federal Reserve announced that it would raise the rate of the reverse repo facility by five basis points to 0.05%. The Federal Reserve also raised the IOR rate from 0.10% to 0.15%, keeping the 10-basis-point spread intact. As an early sign of increased uptake, the first ON RRP operation after the rate hike attracted $755 billion in bids, an increase of almost $250 billion from the prior day. Additionally, 68 counterparties participated, a significant increase from the average 42 participants throughout May and June. This rate hike likely came as a relief to MMFs struggling with the potential of offering negative yields. Zoltan Pozsar of Credit Suisse estimates that ON RRP usage will increase to $1.3 trillion by September.
Potential Causes of Recent Increased Usage
The Treasury Department holds its cash on deposit at the Federal Reserve in the Treasury General Account (TGA). In order to fund the stimulus packages passed by Congress, the Treasury issued net $2.4 trillion in Treasury bills in the second quarter of 2020. By early February 2021, the TGA held about $1.6 trillion, which the Treasury looked to draw down to both fund the stimulative measures and return to pre-crisis levels prior to the resumption of the debt ceiling. From then until the end of June, the Treasury has released approximately $879 billion from the TGA, which must be replaced by either increasing bank reserves or ON RRP usage. Over roughly that time period, total commercial bank assets have grown by almost $675 billion, while an additional $216 billion has gone into MMFs for a total of $891 billion. The inflows to MMFs likely ended up in the ON RRP facility. Additionally, the Federal Reserve continues to buy $120 billion per month in Treasury securities and agency MBS. The sum of TGA drawdown and Federal Reserve asset purchases is almost equivalent to the usage of the ON RRP facility by late May.
Lack of alternative investments for MMFs
It is likely that MMFs cannot find other reasonably safe short-term assets to invest in with their increased funds. According to Bloomberg, the going rate for a private overnight general collateral repo was -0.01% at the end of May 2021, making the 0.0% interest rate ON RRP facility relatively attractive. After the five-basis-point rate hike in June 2021, the Wall Street Journal reported that the going rate for borrowing and lending securities in the private market was 0.01%, which the ON RRP rate cleared again.
Since the outbreak of the COVID-19 pandemic, rates on Treasury securities have hovered around zero and flirted with going negative in March 2021. These low rates, coupled with a corresponding decreasing supply of short-term Treasury bills, could carry further explanatory power in the surging uptake of the ON RRP facility. Rather than the increasing uptake reflecting a simple one-to-one increase in MMF assets under management, MMFs appear to also be shifting their funds from Treasuries to the ON RRP facility.
Supplementary Leverage Ratio
Banks’ total assets continued to grow during the pandemic. Many corporations raised funds as a precautionary measure and thus have significantly higher cash balances. As a result, banks have record amounts of deposits and their associated assets. The biggest banks fought against the resumption of the Supplementary Leverage Ratio (SLR) in March. They argued that banks would refuse new deposits and encourage clients to put their funds in MMFs instead. In fact, from the start of March to the beginning of July, total assets under management in MMFs increased by about $150 billion. Meanwhile, usage of the ON RRP increased over $785 billion. While the SLR resumption could have played a part in increasing the assets under management in MMFs, it does not appear to have a large enough effect to cause the skyrocketing usage of the ON RRP facility.
The supplementary leverage ratio (SLR) is a capital requirement that measures a bank’s Tier 1 capital (such as common and preferred stock) as a percentage of its total on- and off-balance sheet exposures. The SLR doesn’t weigh banks’ assets by their relative risks. For that reason, it is intended to serve as a backstop to risk-weighted capital requirements. A bank whose SLR is above regulatory minimums may have an increased ability to grow total assets.
As businesses and consumers fled to the safety of bank deposits at the start of the COVID-19 pandemic, banks’ non-risk-weighted assets increased significantly. This asset growth lowered banks’ SLRs, potentially risking their willingness and ability to extend credit. To avoid that outcome, the Federal Reserve announced in April 2020 that it would exclude Treasury securities and reserves from the SLR calculation for bank holding companies. Additionally, the Federal Reserve, the Comptroller of the Currency, and the FDIC jointly announced a similar SLR exclusion for banks and other depository institutions in May 2020. Excluding Treasuries and reserves increased banks’ reported SLRs, lightening their balance sheet constraints. Both of these SLR measures expired on March 31, 2021. The Federal Reserve has said that it is considering revising the SLR.
Increased size and eligibility
For several years, the Federal Reserve maintained a participation limit of $30 billion per counterparty. However, the FOMC announced in March 2021 that it would raise this limit to $80 billion per counterparty, stating that the amount of credit in money markets has increased substantially since it established the original limit. FOMC members mostly supported the increase, with some requesting a completely uncapped facility.
Another change in the ON RRP facility that might have influenced the increase in usage relates to the eligibility standards. In April 2021 the Federal Reserve expanded eligibility for participation in the ON RRP facility. Previously, MMFs needed to have $5 billion in net assets to qualify, but this threshold is now $2 billion. This could also have driven increased uptake of the ON RRP facility, but real-time individual usage data is not publicly available.
The Fed also removed the rule requiring government-sponsored enterprises to have an average daily outstanding amount of reverse repo transactions of at least $1 billion.
On average, 42 counterparties participated in the facility in May and June before an increase in participation (up to 68) in connection with the rate increase implemented on June 16. The increase in individual cap, as well as rise in participation, could hypothetically increase the maximum size of the facility by $4.2 trillion to about $5.4 trillion (depending on the supply of Treasury securities).
Usage of the ON RRP spiked on June 30 to $991.9 billion, likely due to demand from Federal Home Loan Banks (FHLBs). FHLBs are the biggest lenders in the interbank fed funds market and foreign bank branches are the biggest borrowers, as explained here. At the end of every quarter, foreign banks typically seek to shrink their balance sheets to improve their reported regulatory capital ratios. In doing so, they reduce their borrowing in the fed funds market. FHLBs need somewhere else to park their cash, and the ON RRP is the best alternative.
Financial Stability Concerns vs. Shifting Supply and Demand for Short-term Assets
In Frost et al. (2015) detailing the ON RRP facility, the authors noted two channels through which the facility could affect financial stability. The facility could influence the likelihood of widespread runs from private short-term assets and the dynamics of such a run once it is already underway.
First, the unlimited supply of a short-term risk-free asset backed by the government has the potential to either encourage or ameliorate runs in times of stress. The ON RRP facility could improve financial stability by discouraging the creation of riskier, private short-term assets during non-stress times. Many scholars have argued that the proliferation of such assets helped precipitate the Global Financial Crisis. Some scholars suggest that increasing the supply of a safe government asset such as the ON RRP could be a more effective tool than regulation for addressing the externalities associated with private money-like assets, especially those created by the shadow banking sector.
On the other hand, the existence of an unlimited ON RRP facility as an outside option could encourage a widespread run from private assets in times of stress. If a run is already underway, the ON RRP facility could exacerbate the situation by providing an unlimited supply of safe assets, which could lessen the cost of running. Additionally, in a world without the facility, the supply of Treasury securities would not immediately expand as a result of financial instability, thus pushing down yields as an equilibrating measure. However, if the ON RRP facility exists in an unlimited capacity, the yields on government securities will not change significantly. This leaves a rise in the cost of private financing as the only equilibrating measure. Despite this negative possibility, the facility could dampen a pre-existing run through its prior displacement of risky private money-like assets. Additionally, the Federal Reserve could simply implement stricter caps on the facility to remove this risk.
Beyond the general possibility of runs, the recent spike in usage shows that the ON RRP facility can increase the role of MMFs in the financial system. The U.S. government has intervened twice since 2007 on the behalf of MMFs to ensure financial stability. Currently, federal regulators are debating tougher regulation on MMFs. The Securities and Exchange Commission (SEC) requested comments in February on potential reforms to MMFs that highlighted their role in financial instability, especially during March 2020. The SEC noted that, if reforms are not undertaken, investors in MMFs will continue to assume that official state intervention will occur in future times of stress. Arguably, the ON RRP facility provides a backstop to MMFs by limiting their exposure to negative yields.
It appears that the increased usage of the ON RRP facility is not a result of any design flaws. Fed officials say the facility is operating exactly as intended and is likely preventing money market rates from going negative. In an April 2021 speech, a senior New York Fed official stated that the potential financial instability consequences of the ON RRP facility have not materialized despite times of stress. Instead, there is a dearth of safe short-term assets for MMFs and other money market participants to invest in, as their assets under management (AUM) grow. This surge in AUM, combined with the Treasury’s stimulus spending, has forced market participants to the ON RRP facility.
On the other hand, there are critics of the Federal Reserve’s decision to raise the ON RRP rates five basis points. Zoltan Pozsar of Credit Suisse referred to the decision as “too generous,” believing that the repriced facility will shift the banking system from asset-constrained to liability-constrained. In his view, this rate hike transforms the ON RRP facility from a passive tool for establishing an interest rate floor into an active instrument that “sucks” deposits away from the banking system in a search for yield. To prove this point, Pozsar cites a money market manager claiming that the rate hike is a “dream come true.”
Overview of the ON RRP Facility
Prior to the Global Financial Crisis of 2007-08, the Federal Reserve primarily controlled the federal funds rate (FFR) in the interbank market by adjusting the supply of reserves in the banking system. This could be done through reserve requirements, purchases of Treasury securities in the secondary market, and repurchase agreements (repos) for US government securities. However, as a result of the unconventional measures undertaken to respond to the crisis, the aggregate reserve supply increased from an average of $11 billion in the five years prior to $2.6 trillion in 2014. At this scale, the Federal Reserve could no longer control the FFR simply through the supply of reserves. The interbank market is also no longer an important source of funds for banks.
The Federal Reserve instead turned to alternative tools and began paying interest on reserves (IOR) in October 2008. Theoretically, since excess reserves are a liquidity risk- and default-free asset, the IOR rate should serve as a firm floor for short-term interest rates, since banks could always choose to keep excess reserves instead of alternative investments.
Depository institutions are the only private entities that hold reserves with the central bank and are the only entities to receive IOR. This excludes the largest active money market investors, such as money market funds (MMFs) and the government-sponsored enterprises (GSEs). As a result, theoretically banks could thus earn arbitrage profits by borrowing from MMFs at one rate and then depositing these funds as excess reserves at the Federal Reserve for the higher IOR rate. In a world of perfect competition, this should result in short-term interest rates rising to the IOR rate as the arbitrage opportunity is eliminated. However, this arbitrage is not costless as banks must increase their balance sheets to borrow from MMFs, incurring Federal Deposit Insurance Corporation (FDIC) fees and higher capital and liquidity requirements. This arbitrage dynamic is concentrated among foreign banks, as they are subject to less strict regulatory requirements. However, due to this non-costless arbitrage, the IOR rate has not historically served as a firm floor on money market rates.
The main issue with the IOR rate is that only depository institutions can receive it, despite the wider set of participants in the short-term funding markets. In July 2013, Federal Reserve staff presented a proposal for the ON RRP program. In an ON RRP operation, the Federal Reserve borrows cash overnight from counterparties, secured by collateral from the Federal Reserve’s securities portfolio (almost always Treasury bills). Unlike IOR, ON RRPs are available to a broader range of banks that meet specified criteria, GSEs, and certain prime and government MMFs. This facility does not increase the Federal Reserve’s balance sheet, but instead shifts the composition of the Federal Reserve’s balance sheet from reserves held by banks to RRPs held by counterparties. This provides the Federal Reserve with another tool besides the IOR to control the FFR.
Stylized Description of the ON RRP Facility
The following types of institutions are eligible for the ON RRP facility:
Banks or savings associations with at least $30 billion in total assets or at least $10 billion in reserve balances for the last quarter (16 currently eligible)
A government-sponsored enterprise (15 currently eligible)
An SEC-registered 2a-7 money market fund that has for the past six months either net assets of at least $2 billion or average outstanding RRP transactions of at least $500 million (91 currently eligible)
As of the most recent update, there are 122 eligible counterparties for the ON RRP facility.
ON RRP Allotment
One important aspect in the design of the ON RRP facility was whether to allow full allotment or cap individual and aggregate bids. According to the Federal Reserve, a capped system would limit its involvement in financial intermediation and reduce the likelihood of a run caused by financial instability. However, capping participation could weaken the facility’s ability to establish an interest rate floor. At the start of operations, the Federal Reserve experimented with capped allotment.
Over the first year of testing, which began in September 2013, the Federal Reserve gradually increased the individual counterparty bid limit from $0.5 billion to $30 billion per day, where it remained until early 2021. Additionally, in 2014, the Federal Reserve established an aggregate ON RRP cap at $300 billion per day. The Federal Reserve then abolished any form of aggregate cap in 2015. Therefore, the only technical restrictions on the size of the facility is the Federal Reserve’s supply of securities, the individual allotment caps, and the criteria to become eligible to participate in the ON RRP facility.
ON RRP Rate
One area of debate surrounding the ON RRP facility is the optimal rate for the operations, specifically the spread between the ON RRP and IOR rates. Throughout its existence, the rate on the ON RRP facility has remained below the IOR rate, often with a spread of 10-25 basis points. The spread is currently 10 basis points. According to the Federal Reserve, a large spread lessens its involvement in financial intermediation, as it discourages very large ON RRP usage from banks.
However, some academic studies suggest that the spread should be lessened or removed altogether. Greenwood, Hanson and Stein (2018) argue for a narrowing of the spread as this would shift the Federal Reserve’s funding from reserves to the “more open and competitive RRP market.” They further suggest that it could save the Federal Reserve billions of dollars in interest payments, as well as encourage MMFs to invest in government-supplied safe assets instead of riskier, more run-prone assets like private repos and asset-backed commercial paper. Rather than simply reduce the spread, Gagnon and Sack (2014) and Martin et al. (2019) argue that the optimal spread between the ON RRP and IOR rates should be zero. Under this view, setting the two rates equal would increase liquidity, reduce the “overabundance” of reserves, and stabilize money market rates.
The Federal Reserve Bank of New York has conducted ON RRP operations on a daily basis since 2013. From 2013 through March 31, 2021, MMFs accounted for 88% of the takeup for ON RRP operations. Proving the importance of IOR, banks accounted for less than 1% of the operations, as they could simply earn the IOR rate (higher than the RRP rate). Average daily take-up was $80 billion from creation to the end of 2019, with spikes at the end of quarters.
In a 2015 Federal Reserve working paper, Frost et al. (2015) heavily discouraged a permanent ON RRP facility, noting that it could reshape financial markets by crowding out short-term private financing and atrophying financial infrastructure. They noted that participants at several Federal Open Market Committee (FOMC) meetings referred to the ON RRP facility as a temporary program. However, the ON RRP facility continues to operate nearly 8 years after inception., In March 2021, the FOMC minutes stated that “the facility would continue to be an important part of the monetary policy implementation framework going forward.”