When plumbing works well, you don’t need to think about it. That’s usually the case with a vital but obscure part of the financial system known as the repo market, where vast amounts of cash and collateral are swapped every day. But when it springs a leak, as it did in mid-September, it rivets the attention of the U.S. Federal Reserve, the nation’s largest banks, money-market funds, corporations and other big investors. It even gets airtime on National Public Radio. The Fed calmed things down by pumping in billions of dollars, but it may have a lot more work to do on the pipes -- and a lot more money to lay out.

1. What’s the repo market?

It’s where piles of cash and pools of securities meet, resulting in more than $3 trillion in debt being financed each day. Repo is short for repurchase agreements, transactions that amount to collateralized short-term loans, often made overnight. Repo deals let big investors -- such as mutual funds -- make money by briefly lending cash that might otherwise sit idle, and enable banks and broker-dealers to get needed financing by loaning out securities they hold in return. A healthy repo market is more than the world’s biggest pawn shop: It helps a wide range of other transactions go more smoothly -- including trading in the over $16 trillion U.S. Treasury market.

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2. How is the Fed involved in it?

In a number of ways. For years, central banks around the globe have used their own repo markets to temporarily extend credit in tight markets, stabilize financing costs and guide interest rates. Many things have changed in the repo market since it melted down in September 2008, a crucial part of that year’s financial panic. Since then, the Fed has worked with other regulators to curb risk-taking and bolster liquidity requirements as a way of preventing a recurrence. And since 2013, the Fed has entered the repo market on a large scale, using transactions there to put a floor under rates.

3. What happened?

In the week of Sept. 16, a lot of cash flowed out of the repo pipes just as more securities were flowing in -- meaning that suddenly there wasn’t enough cash for those who needed it. That mismatch drove overnight repo rates to 10% on Sept. 17, from about 2% the week before. More alarming for the Fed was the way volatility in the repo market pushed the effective federal funds rate to 2.30%, above the 2.25% upper limit of the Fed’s target range -- just as the Fed was preparing to drop that ceiling to 2%.

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4. Why did that all happen?

In one view, different events that acted as catalysts just happened to land at the same time and push in the same direction. A big swath of new Treasury debt settled into the marketplace, landing on dealers’ balance sheets just as cash was being sucked out by quarterly tax payments companies needed to send to the government. Many also say the weight of post-crisis regulations served to slow banks from adding more cash by jumping in to grab the windfall of higher repo rates.

5. What did the Fed do?

In its first direct injection of cash to the banking sector since the financial crisis, it laid out as much as $75 billion a day in temporary cash over four days to quell the funding crunch and push the effective fed funds rate down. In what are known as overnight system repos, the Fed lent cash to primary dealers against Treasury securities or other collateral.

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6. Was that enough?

It did calm the markets, eventually bringing the rates down around 2% by Sept. 19. The following week, the New York Federal Reserve Bank began began extending these temporary loans for beyond one day, in what is known as a term operations, and provided a schedule of their future repo plans through Oct. 10. It also beefed up its overnight operations to $100 billion in the days leading to the end of the quarter -- a milestone often accompanied by increased volatility. Those actions may be sufficient for a temporary patch, if the liquidity squeeze really just reflected a temporary crunch. But as the Fed intervention dragged on, strategists, economists and some former Fed officials voiced the belief that the repo turmoil is a sign of a longer-term problem.

7. What do they think is wrong?

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To some, one factor is that the rules regulators imposed to make the market safer led dealers to pull back on their involvement, reducing overall liquidity. And many think these distortions will continue as long as government spending and Treasury’s debt issuance continues to rise. But the broadest view is that the financial system has run low on bank reserves -- excess money that banks park at the Fed -- and that the current repo turmoil is a sign that the banking system lacks the buffers markets need in times of stress.

8. What does that mean?

It could mean that bank reserves, although they currently top $1 trillion, don’t amount to having enough money in the system. Proponents of this view think the Fed may have to start buying bonds again as a way of boosting reserves -- by some estimates, perhaps as much as $500 billion. This time the purchases would not be like the quantitative easing of the past, meant to support the broader economy, but just to clear up the mechanics of its balance sheet.

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9. And what does that mean?

As with any corporation, the Fed’s assets and liabilities must balance. The Fed’s liabilities mainly come in the form of currency in circulation and bank reserves. As the nation’s economy expands, as it has since 2009, the amount of currency in use has been growing, too. Without action by the Fed to add to its assets, the growth of currency would reduce the liability represented by reserves.

10. What can the Fed do about the repo squeeze?

It did one thing at its September meeting, and two other steps are being discussed. It lowered the interest rate it pays on so-called excess reserves -- the cash banks park at the Fed beyond what’s needed to meet regulatory requirements -- to 1.8% from 2.1%. Lowering the IOER rate -- interest on excess reserves -- gives banks an incentive to lend out more of their money, which would keep repo under control and the effective federal funds rate within the Fed’s target range.

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11. What else do investors want the Fed to do?

Many market participants want the Fed to activate a new tool, called a standing overnight repo facility, that it’s been considering. The facility would amount to a standing offer to lend a certain amount of cash to repo borrowers every day. The most drastic step being suggested would be for the Fed to create more bank reserves by expanding its balance sheet and thereby buoying bank reserves. Fed Chairman Jerome Powell said Sept. 18 that the central bank is monitoring when it’s appropriate to start expanding the balance sheet. Jon Hill of BMO Capital Markets said that while the daily intervention has been less than the market wanted, “it’s enough for now.” But Rick Reider, global chief investment officer of fixed income at BlackRock Inc., wrote in a note that “All of this funding market gyration points to the increasingly obvious fact that the end of Fed reserve draining is insufficient to stabilize these markets.”

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net;Alexandra Harris in New York at aharris48@bloomberg.net

To contact the editors responsible for this story: Mark Tannenbaum at mtannen@bloomberg.net, John O’Neil

©2019 Bloomberg L.P.

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