Why the repo market went awry…

ON SEPTEMBER 17TH, for the first time in a decade, the Federal Reserve intervened in the overnight repurchase, or “repo” market, where banks and hedge funds get short-term funding by swapping $1trn-2trn of Treasuries for cash each day. After the repo rate rose to 10%, the federal-funds rate, at which banks can borrow from each other, climbed above the Fed’s target (see chart). The Fed swooped in, offering $75bn-worth of overnight funding, and both rates came back down. But it has had to keep lending to stop them rising again. During October it said it would lend for longer periods, increased its limit on overnight repo operations to at least $120bn and started buying short-dated Treasuries directly, at a pace of $60bn per month.

The turmoil indicated an unexpected shortage of liquidity in the financial system. Before the financial crisis the Fed had controlled the federal-funds rate using a “corridor”, with a ceiling and floor. Banks could borrow at the ceiling rate, but the floor rate was zero, meaning cash held at the Fed earned nothing. To keep interest rates on-target the Fed used “open-market” operations, swapping Treasuries and cash.

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via The Economist: Finance and economics Business Feeds

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