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Hedge funds exacerbated the recent repo crisis

By Lawrence Gash

Report emphasises parallels with state of repurchase agreement market in 2008

The Bank for International Settlements (BIS) has pointed the finger of blame for the recent trouble in the repo markets at hedge funds, accusing them of exacerbating the turmoil by excessively borrowing cash to enhance the returns on their trades.

The overnight repurchase agreement (repo) market, where banks lend cash to other institutions in exchange for collateral and repurchase the following morning, has endured a torrid second half of 2019.

With liquidity tightening and US repo markets depending heavily on four banks as marginal lenders, the repo rate spiked in September. In a rush to avert any further disruption the Federal Reserve intervened. By early December the Fed injected $322bn (£244bn, €290bn) in liquidity to sure up the market.

While commentators and figures within the financial world seemingly agree that the September spike and ongoing disruption can be traced back to JP Morgan’s drain of liquidity via reserves at the Fed and the money markets, the BIS outlined that hedge funds almost pushed this crisis off the cliff.

In ‘September stress in dollar repo markets: passing or structural?’, a paper accompanying the quarterly review by the central banks’ central bank, the BIS observed that: “Increased demand for funding from leveraged financial institutions (eg hedge funds) via Treasury repos appears to have compounded the strains of the temporary factors.”

Claudio Borio, head of the BIS’ monetary and economic department, cited: “High demand for secured (repo) funding from non-financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades,” as a major factor in the turmoil.

The report emphasised the dire consequences this increased demand could have had, observing: “Any sustained disruption in this market, with daily turnover in the US market of about $1 trillion, could quickly ripple through the financial system. The freezing-up of repo markets in late 2008 was one of the most damaging aspects of the Great Financial Crisis (GFC)."

The American financial system came close to collapsing on the eleventh anniversary of Lehman Brothers’ bankruptcy, with the crisis reaching its most serious point on September 16.

It is by no means clear whether this crisis has been averted or simply put off for another date, even with the billions of dollars injected by the Fed. Mr Borio observed that repo markets: "may again find themselves in the eye of the storm should financial stress arise at some point."

Recently published minutes from October’s FOMC meeting revealed that the Fed thinks the crisis could return by Christmas. Major banks typically try to avoid lending funds and to shrink their balance sheets at the end of the year when regulators analyse performance and decide on the ‘global systemically important bank’ (GSIB) scores for financial institutions.

FURTHER READING: Central bank group appoints leader for new digital currency unit

FURTHER READING: Mervyn King: Global economy ‘sleepwalking towards new financial crisis’

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