Repo market little known but crucial to the system

Repo market little known but crucial to the system
By Michael Mackenzie in New York
Copyright The Financial Times Limited 2007
Published: August 11 2007 03:00 | Last updated: August 11 2007 03:00


The repurchase, or repo, market is a little-known part of the financial system but it acts as a crucial safety valve in times of stress. It enables the flow of cash between central banks and financial institutions, providing the plumbing that keeps markets functioning smoothly.

This week, as financiers faced higher overnight borrowing costs in the money markets, central banks came to the rescue and flooded the financial system with cash. This was done to keep in line with one another the actual and target overnight borrowing rates, such as the US Federal Reserve's Fed funds rate.

The Fed injects cash into the money market on a daily basis so that the effective rate stays near its present target level of 5.25 per cent. Early yesterday the effective funds rate traded at 6 per cent as banks demanded higher rates to lend to each other, and then fell towards 5.375 per cent after the Fed injected $35bn (€26bn, £17bn) in two separate operations.

This week, money market rates for eurodollar deposits and commercial paper rose well above normal levels. That meant banks, companies, insurers and hedge funds that rely on using short-term funding faced higher costs.

That pressure pushed the Fed funds rate higher, which, if sustained, could imperil the economy.

In the Fed's repo operation, dealers posted mortgage securities as collateral and received cash in return from the Fed. Next week, the dealers and the Fed will reverse the trade. Usually, the Fed does not accept mortgages as collateral for repo transactions but the move signals an attempt by the central bank to alleviate financing fears.

Wall Street dealers are seeking the sanctuary of government bonds and are selling their holdings of riskier assets such as mortgages.

Traders said that if the financing problems continued and the effective funds rate remained above its target level, the Fed was likely to repeat repo operations until the market settled down.

"Central banks can ultimately fix a liquidity crunch by shipping in boatloads of cash and they are effectively doing that," said Alan Ruskin ofRBS Greenwich Capital.

"There is very little doubt that they will come through in the end."