The Real Story Of The Repo Market Meltdown, And What It Means For Bitcoin
Last week the financial system ran out of cash. It was a modern version of a bank run, and it’s not over yet. The Real Story Of The Repo Market Meltdown, And What It Means For Bitcoin
Stepping back, it reveals two big things about financial markets: first, US Treasuries are not truly “risk-free” assets, as most consider them to be, and second, big banks are significantly undercapitalized. The event doesn’t mean another financial meltdown is necessarily imminent—just that the risk of one is heightened—since the brush fire can be doused either by the Fed, or by the banks raising more equity capital. However, it provides a “teachable moment” regarding systemic fragility and anti-fragility.
What’s Happening, In Plain English?
Somebody—probably a big bank—needs cash so badly that it has been willing to pay a shockingly high cost to obtain it. That’s the layman’s explanation of what’s happening. Interest rates have betrayed common sense—interest rates in the repo market should be lower than rates in unsecured markets, for example, because repos are secured by assets and thus supposedly lower-risk. But repo rates spiked way above unsecured lending rates last week, even for “risk-free” collateral such as US Treasuries.
But US Treasuries are not risk-free. Far from it. (By this, I’m not referring to the US potentially defaulting on its debt obligations. Rather, I’m referring to the practice in the repo market that allows more people to believe they own US Treasuries than actually do. It’s called “rehypothecation.”)
Why was someone willing to borrow cash at a 10% interest rate last Tuesday, in exchange for pledging US Treasury collateral that yields only 2% or less? That trade lost someone a whopping 8% (annualized) overnight, but presumably the trade allowed the bank to stay in business for another day. As risk premiums go, 8% is shockingly high—for a supposedly risk-free asset!
On the flip side, the better question is why banks weren’t willing to lend against “risk-free” collateral for an 8% “risk-free” gain? Banks are supposedly healthy and flush with cash, right? So why aren’t banks falling over themselves to rake in such easy, “risk-free” profits?
hockingly, the Fed admitted to asking itself this same question, as revealed in an extraordinary interview on Friday with New York Fed President John Williams in the Financial Times. The Fed has a theory about why. Many analysts do too. But almost no one is talking about the elephant in the room.
The Elephant In The Room
For every US Treasury security outstanding, roughly three parties believe they own it. That’s right. Multiple parties report that they own the very same asset, when only one of them truly does. To wit, the IMF has estimated that the same collateral was reused 2.2 times in 2018, which means both the original owner plus 2.2 subsequent re-users believe they own the same collateral (often a US Treasury security).
This is why US Treasuries aren’t risk-free—they’re the most rehypothecated asset in financial markets, and the big banks know this. Auditors can’t catch this because GAAP accounting standards obfuscate it, as I’ll explain later.
What it all means is that, while each bank’s financial statements show the bank is solvent, the financial system as a whole isn’t. And no one really knows how much double-, triple-, quadruple-, etc. counting of US Treasuries takes place. US Treasuries are the core asset used by every financial institution to satisfy its capital and liquidity requirements—which means that no one really knows how big the hole is at a system-wide level.
This is the real reason why the repo market periodically seizes up. It’s akin to musical chairs—no one knows how many players will be without a chair until the music stops. Every player knows there aren’t enough chairs. Everyone knows someone will eventually lose.
Financial regulators can’t publicly admit to this, but big banks know it’s true—and that’s why they hunker down (and stop lending) when they sense one of their kin is in trouble. They recognize that what appears to be an 8% risk-free arbitrage is anything but risk-free.
Most financial regulators baffle us with jargon when they discuss this issue, making it barely intelligible to regular folks (cloaking it in such terms as “clogged transmission mechanisms,” “length of collateral chains”). The closest I’ve heard a financial regulator speak publicly of this is former CFTC Chairman Chris Giancarlo, to his credit, when he answered a question after a 2016 speech:
“At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another. Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.”
This is why the FT’s interview with Williams was so extraordinary. It’s as close as a regulator will come to admitting the reality that the system doesn’t work the way most of us think it does and that the Fed may not even understand critical things about it. Specifically, the Fed’s focus on the fed funds market is misplaced because the real action is in the much bigger, much more global repo market; the Fed shouldn’t have allowed America’s big banks to pay dividends or buy back stock when they’re so capital-constrained that they can’t even pick up an 8% “risk-free” arbitrage; the Fed’s proclamation that “the financial system remains resilient,” when it released the results of the most recent bank stress tests in June 2019, strains credulity; a staggering amount of US dollar liabilities have been issued offshore in recent decades and the Fed not only doesn’t control them but can’t measure them with any degree of accuracy; and banks’ financial statements don’t accurately reflect their financial health.
No one really knows how solvent (insolvent?) the financial system is.
Auditors can’t help here, and the accounting profession bears some of the blame for this problem. In June 2014, FASB updated the US GAAP accounting rules for repos. Here’s what the books of three parties show when a transferee (Party A) sells pledged collateral to a third party (Party C):
* Party A Owns A Particular Us Treasury Bond, Showing An Asset Of $100.
* Party B Borrows It, Showing A Liability Of $100 ($100 Of Securities Sold, Not Yet Purchased).
* Party C Shows An Asset Of $100.
If you add up the positions of all parties, economically there’s no problem because the net of the two longs and one short position add up to $100. The problem arises when you aggregate the three US GAAP financial statements. Both Party A and Party C report that they own the same asset (!) The balance sheets balance because Party B records a liability, so auditors don’t catch the problem. When that same bond is reused again and again and again in similar transactions, the magnitude of double counting within the financial system builds in a manner that no one can accurately measure.
For years, IMF economist Dr. Manmohan Singh has done terrific work estimating it (see examples here, here, here, here, here, here and here).
Singh has been recommending for years that regulators’ financial stability assessments of big banks be adjusted to back out “pledged collateral, or the associated reuse of such assets.” Financial regulators should have followed his advice years ago!
What does this mean for markets in the short-term? No one knows, but I doubt this is “the big one.” Sure, the repo market is flashing red sirens. But the run on repo can be stalled in one of two ways: (1) banks raise new equity capital, or (2) the Fed injects more dollars into the system.
Yes, it’s true that a run in the repo market is serious, since the big banks are still overly reliant on it and one dropped ball by the Fed could quickly turn the brush fire into an inferno. But, as usual, the Fed will almost certainly do what it always does—stem the run by injecting cash into the system in various ways, thereby socializing losses among all US dollar holders.
A Teachable Moment
If this topic makes you uncomfortable, it should. It made me uncomfortable when I first realized all of this, which for me happened during the financial crisis while I was working on Wall Street and took a deep dive into why the crisis was happening. The financial system is fragile. It’s unstable. It always has been. What started in the repo market last week isn’t new—it’s actually the fourth such episode since 2008.
Here I distinguish between price volatility and systemic volatility.
Bitcoin’s price is highly volatile, but as a system it is more stable. In stark contrast to the traditional financial system, Bitcoin is not a debt-based system that periodically experiences bank run-like instability.
In this regard, Bitcoin is an insurance policy against financial market instability. Bitcoin is no one’s IOU. It has no lender of last resort because it doesn’t need one.
For me, Bitcoin is empowering because it provides a choice to opt out of the traditional financial system. In light of the traditional financial system’s instability, despite all of Bitcoin’s drawbacks, I find that a powerful concept.
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