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March 4, 2014

“Fixed rate full allotment reverse repo will become the Fed’s central policy tool” | Barclays research note

"We believe that the fixed rate full allotment (FRFA) reverse repo will become the Fed’s central policy tool" says Barclays Joe Abate in a research note last Friday.  I'm wondering if a Fed monetory policy shift from Fed Funds to FRFA rates will also prompt the shift of interest rate benchmarks from unsecured to secured funding rates.

"We believe that the fixed rate full allotment (FRFA) reverse repo will become the Fed’s central policy tool" says Barclays Joe Abate in a research note last Friday.  I'm wondering if a Fed monetory policy shift from Fed Funds to FRFA rates will also prompt the shift of interest rate benchmarks from unsecured to secured funding rates.

Thanks are due to Izabella Kamiska of FT Alphaville for highlighting the key points of Barclays' research note in her post on Feb 28th: Do we even need a fed balance sheet reduction?

Definitions

The Fed's current primary monetary policy tool is Fed Funds – the rate set by the Fed paid by settlement banks to square off their short and long cash positions at the end of the money market day.

FRFA is the latest acronym for the reverse repo facility the Fed started last year – see my post fast start for new Fed facility.  The Fed sets the rate at which it borrows cash and pledges US government bonds.

IOER is the Fed's interest on excess reserves – paid to banks putting up reserves at the Fed in excess of minimum required amounts.

Key points from the post / article

1.  Fed Funds' influence is waning

Given today's much higher bank reserves, the Fed Funds market lacks a short side, Fed Funds daily volumes have collapsed and Fed Funds rate correlation with the other interest rates has weakened

Fat chance then of OIS replacing LIBOR (Fed Funds is the USD OIS rate)…

2.  GC is leading Fed Funds not the other way

GC is general collateral repo rate which refers to highly liquid US government bond based repo

Conventionally GC is viewed as a spread off Fed Funds but that is changing according to Mr Abate

3.  A contraction of bank reserves of $2 trillion is needed to bring Fed Funds back to prior level of influence – this is not likely because:

Fed won't want to sell $2 trillion of assets given the acute sensitivity around taper etc. and its other facilities don't have anything like this kind of capacity to put cash into the market

Basel III Liquidity Coverage Ratio (LCR) requires banks to hold high-quality liquid assets at (eventually) 100% of est. 30-day crisis cash outflows which encourages higher cash reserves

4.  Which of FRFA and IOER is better as a Fed Funds alternative?

Abate suggests FRFA is better as this naturally includes money funds and large buy side firms as well as banks and thus has a broader influence on interest rates

Wait… isn't Fed Funds fundamental to swap pricing?

Yes.  Since the crisis, OIS has been implemented by major banks as the index used to discount USD, EUR and GBP swaps.  For USD, OIS rates are Fed Funds overnight rate together with future projected versions of that overnight rate out along the curve.  As an example here's Ben Larah's post on insurance companies struggling with the business issues and costs of the change.  Major banks have made the change but perhaps another discounting change is coming…

How might the USD IRS market absorb this change?

In my post a year ago on how LIBOR might get replaced, I outlined two candidates – OIS and secured funding rates.  The problems with Fed Funds would appear to both make OIS less of a candidate (for USD at least) and also bolster secured funding rates (albeit that FRFA rate might still be different from the GC repo rate I looked at in the post).  

The transition to FRFA as instrument of Fed monetary policy (if it happens) could cement the transition of US interest rates benchmark from unsecured to secured funding rates – something like this:  
  • GC repo rates move fully to trade as a spread to FRFA rather than a spread to unsecured rates and unsecured rates including Fed Funds begin to trade as a spread to GC/FRFA the new benchmarks
  • GC repo futures and swaps liquidity outstrips OIS futures and swaps
  • IR swaps start to be discounted off the more liquid GC repo rate curve instead of OIS (Sorry, I know you just finished the transition from LIBOR discounting to OIS…)
  • Eventually GC repo becomes the primary traded index in the swap market and LIBOR becomes a legacy index
  • Regulators are happy as GC repo is a transaction based and deeply liquid rate – limiting potential for manipulation
How will we know?
 
One barometer of the change might be the relative open interest between secured funding rate futures (e.g. LIFFE GC repo futures or FRFA futures – if someone lists them) and unsecured funding rate futures (e.g. OIS futures on CME).
 
This could take some time – years at least to shift the new trades market and decades before the existing portfolio of LIBOR and OIS swaps roll off or are unwound.
 

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