11. Transmission of Monetary Policy – Fed’s Lift-off and Collateral Reuse

Manmohan Singh
Published Date:
October 2016
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Many recent studies focus on the tools available to the Federal Reserve (Fed) for lift-off, ie, the gradual increase in its policy rate after several years of keeping it at zero (eg, Frost et al 2015). Some studies and policymakers link the lift-off issues with financial stability elements where they allude to the academic literature on the need for safe assets (Stein 2014; Caballero and Fahri 2013). Recent FOMC minutes, academic studies and speeches by the Fed discuss these issues in detail.

However, aside from analysis by market participants that generally favour a large supply of safe assets, there is limited discussion about the financial plumbing connecting bank and non-bank balance sheets, or the changes to those balance sheets stemming in part from proposed regulations such as the leverage ratio and the liquidity coverage ratio (LCR). This chapter looks at the reshuffling of the bank–non-bank nexus that is likely to occur as a result of the Fed’s increasing role in dealing directly with non-banks.

As background, in the aftermath of the 2008–9 crisis, the Fed purchased US Treasuries and mortgage-backed securities (MBSs) – both high-quality collateral – through large-scale asset purchases, primarily from non-banks (Carpenter et al 2013). Those non-bank assets were converted into “deposit liabilities at banks”, with a corresponding asset entry of “reserves at the Fed”. In other words, the asset purchases converted good collateral in the market into banks’ holding of sizeable excess reserve balances at the Federal Reserve.

Since 2008 and until the Fed’s recent lift-off on December 16, 2015, interest rates in most of these markets were in the range of 0–25bp. The Federal Funds (FF) rate, or policy rate, has been around 10–15bp since the crisis, and is largely a negotiated rate stemming from the excess cash balances of non-banks such as GSEs (ie, Fannie Mae, Freddie Mac) and banks. Only banks had access to the 25bp interest on excess reserves (IOER) and thus arbitrage by depositing non-banks’ cash at the Fed. With interest rates bound at zero since 2008, the Fed introduced the overnight reverse repo programme (ON RRP) in September 2013, with the goal of preventing the price of collateral (ie, repo rate) from going below zero, thus minimising the wedge with the policy rate. The amount of the ON RRP, a temporary tool, was capped at US$300 billion until the lift-off, and provided an effective floor to the repo rate at 3–5bp. Simon Potter, who heads the markets group at New York Fed, remarks in his February 2016 speech that the lift-off was accompanied by increasing the RRP to about US$2 trillion:

So we couldn’t completely rule out that the federal funds rate and other money market rates might not go up one for one with rises in administered rates. One might also worry that money market rates might not move together as rates rise, meaning that, for example, a disconnect might emerge between secured and unsecured rates, or between overnight and term instruments. Either situation could result in impaired transmission of monetary policy into broad financial conditions.

Bilateral-pledged collateral market rates (via the bank/non-bank plumbing) – although unobservable – do pass through to other interest rates and, thus, to the real economy. When the market plumbing works, the general collateral financing (GCF) rate is a reliable proxy for bilateral repo rates (the distinction between GCF and GC rate has become increasingly important with the former picking up the “balance-sheet space” aspects stemming from regulations such as leverage ratio). Without the plumbing, the GCF rate would have little information content. It will be interesting to note if the FF rate will remain broadly in line with the GCF rate, as was the case pre-Lehman.1 The FF rate was within +/–3pb of the GCF rate, except for quarter-ending dates that straddle inventory, regulatory and reporting aspects. Since lift-off, the Fed offers 50bp IOER to banks only (see the dashed black line in Figure 11.1), and 25bp to eligible non-banks via the RRP (see the red line in Figure 11.1).

Figure 11.1Relevant Rates: Fed Funds, IOER, GCF and RRP

Source: DTCC, Fed, Bloomberg

Prior to the Lehman crisis, there was generally a shortage of reserves that was met by the Fed’s interventions from repo operations (via the relatively small SOMA account at the New York Fed) so that the Fed Funds rate was kept aligned with the collateral rate (the GCF rate to be specific) – see Figure 11.2. Fast-forward seven years, and there was an excess of reserves with the banking system, so changes in the Fed Funds rate are not possible. Has the market shifted from one where secured rates (GCF) were in sync with policy rates (Fed Funds), to where GCF is permanently higher?

Figure 11.2Fed Funds policy Rate and General Collateral Rate, Pre-Lehman Versus the Present But Prior to lift-off (First Chart 2005–08; Second Chart 2011–15)

Source: Depository Trust and Clearing Corporation (DTCC); Federal Reserve; and Bloomberg

This chapter focuses on the critical pieces of the plumbing in the wake of the lift-off: the repo markets and the bank deposits market. It argues that monetary policy during lift-off will have to address the new financial plumbing created by the sizeable asset purchases to accommodate (i) the “excess” depository market with the money funds, (ii) the demand for collateral stemming from proposed regulations, and (iii) the balance-sheet cost (or balance-sheet space) as excess reserves are included in the supplementary leverage ratio in the US.2 We conclude by discussing how monetary policy choices will be affected by the new plumbing environment.

The Fed’s Balance Sheet, RRP and Excess Reserves

The Fed’s balance sheet increased from roughly US$1 trillion (end-2007) to over US$4 trillion by end-2014, owing mainly to some US$3.4 trillion of asset purchases that sit on its asset side. The approximate corresponding entry shows excess reserves of US$2.9 trillion on the liabilities side – these are deposits of non-banks (which sold assets to the Fed) at banks, which then placed them as deposits at the Fed (Figure 11.3). Since October 2008 through December 2015, the Fed offered banks 25bp per annum (50 bps since lift-off) for their deposits (including excess deposits over the required reserves), but paid zero interest: (25 bps since lift-off) on deposits from non-banks, especially GSEs.3 It is important to note that a decline in excess reserves does not necessarily result in a reduction in the Fed’s balance sheet.4

Figure 11.3Main Changes in the Fed’s Balance Sheet (2007 Versus 2014)

In this context, it is useful to understand the triparty system. The operational structure of the RRP facility puts practical restrictions on the reuse of collateral outside the triparty system. Collateral can be used only in a triparty repo liability (so a firm that is a “dealer” in the triparty system, such as JPMorgan Chase or Bank of New York Mellon, could have as an asset a Fed RRP and as a liability a triparty repo with a customer).

Members of the Government Securities Division (GSD) of the Depository Trust and Clearing Corporation (DTCC) can reuse the collateral within the General Collateral Finance (GCF) triparty system. Here, we use the term “banks” very loosely: for example, Citibank could take collateral from the Fed and give to a fidelity mutual fund as a triparty investment, or could take collateral from the Fed and give GCF to Credit Suisse to give to that fidelity fund. To be clear, members of the GSD may be classified differently: Goldman Sachs is actually Goldman Sachs & Co., Deutsche Bank is Deutsche Bank Securities Inc., Barclays is Barclays Capital Inc. But members also include Pierpont Securities LLC, Jefferies LLC, Cantor Fitzgerald & Co., etc. The important point is that reuse of collateral can only end in a triparty repo; it can have no other use. Of the counterparties the Fed has taken on via the RRP, only the banks take on triparty repo liabilities. The “released” collateral from the RRP remains as an asset on the Fed’s balance sheet and within the triparty system.

But, even if bids for the RRP were uncapped (as has been the case since the lift-off, where the cap is about US$2 trillion), the collateral of the RRP would remain on the Fed’s balance sheet and not freely available to the financial system (Bernanke 2015; Gagnon and Sack 2014). Within the present triparty structure, none of the collateral can be used to post at central clearinghouses, in the bilateral derivatives markets or in the bilateral repo market, or delivered against short positions; note, however, that there exists a sizeable pledged-collateral market that is not constrained by the triparty structure (see Panel 11.1).

Panel 11.1:The Financial Plumbing: Pledged Collateral that Can Be Reused by Global Banks

Financial agents that settle daily margins may post cash or securities, whichever is cheapest to deliver from their perspective. These settlements form the core of the financial plumbing in markets that require debits/credits to be settled continuously. These securities are generally received by the collateral desks of the banks not only via reverse-repo but also from securities borrowing, prime brokerage agreements and over-the-counter (OTC) derivative positions. The largest suppliers of pledged collateral are the hedge funds; other sources include insurers, pension funds, central banks and sovereign wealth funds.

The “fair value of securities received as collateral that is permitted to be sold or re-pledged” by global banks was approximately US$10 trillion in 2007, but has declined in recent years to about US$5.6 trillion (see figures below and also those in Chapter 1). Before its decline, the pledged collateral metrics were of the same order of magnitude as money metrics such as M2 in the US or the eurozone. Securities that are pledged at mark-to-market values may be bonds or equities, are cash-equivalent from a legal perspective (ie, with title transfer) and do not have to be AAA/AA-rated. The underlying economics of pledged collateral reuse is similar to reuse of deposits in the banking system (Singh and Stella, 2012). Following the methodology of Singh (2011), the European Systemic Risk Board (2014) and Anderson and Joeveer (2014), and incorporating the amount of source collateral, the collateral reuse rate (or collateral velocity) can be approximated, and it declined from about 3 as of end-2007 to about 1.8 as of end-2015. Central banks should be cognisant of collateral reuse rate in the bilateral-pledged collateral market along with money metrics to gauge the short-term rate environment.

The constraint noted above implies that, regardless of the size of the bids on the RRP, the Fed’s balance sheet will not decrease as a result of the “use” of excess reserves. Papers on this subject are generally silent on this aspect – that the RRP is more akin to “accounting drainage”, since the US$3.4 trillion of assets purchased remain on the Fed’s asset side, with the RRP reshuffling line items only on the liability side.5 In fact, Simon Potter’s speech of April 15, 2015, includes current balances of RRPs within the measure of excess reserves.6

Figure 11.4Pledged Collateral Received by US Banks (2007–15)

Source: Hand-picked data by author from annual reports; see also Singh (2011).

Figure 11.5Pledged Collateral Received by European Banks and Nomura (2007–15)

Source: Hand-picked data by author from annual reports; see also Singh (2011).

The Fed is expanding the universe of deposit takers that have direct access to its balance sheet – a “short-circuit” via the RRP. For example, for each US$100 million of the RRP, typically a non-bank removes US$100 million deposits from a bank, and places it with the Fed. So the Fed becomes the new counterparty to the non-bank, while the bank (eg, Citibank or JPMorgan) gets “balance-sheet space” – a scarce commodity due to regulations and asset purchases related deposits – as the US$100 million deposits move from a bank to the Fed.

Lift-off – Some Analytics

Let us assume that “good collateral” such as US Treasuries in the hands of the market is x trillion – ie, the market can slice and dice a 10-year US Treasury into three-month or one-week repo, etc. Some of these bonds are reused but most of them (about 80–85%) are parked with central banks, sovereign wealth funds, insurers, pension funds etc.7 For simplicity, assume that the rest of the outstanding US Treasuries are with the Fed; because of constraints such as the RRP, those US Treasuries will not be accessible fully by the market. Furthermore, regulatory proposals – such as the liquidity ratio or no rehypothecation of initial margins in OTC derivative contracts – are leading to a higher demand for good collateral.8

There were two lift-off options. In the first route (which was chosen on December 16, 2015) the RRP expanded sizably. Enough money (or excess reserves in the financial system) could have been drained primarily from non-banks; this would have made collateral in the market domain less expensive (relative to money) and raise the GCF rate (see Figure 11.6). Intuitively, the FF is the price of money and GCF is the price of collateral (when plumbing works). In normal times, (eg, pre-Lehman), the two rates were broadly aligned. When the Fed lifts off the FF target rate move has to be passed on to other short-term rates; hence, the need for FF and GCF to move in tandem.

As shown in Figure 11.6, if the FF target rate is B, GCF rate will equate to FF rate by targeted draining via the RRP, while keeping the collateral in the market’s domain unchanged at x trillion; however, both FF and GCF will depend on actions by the Fed.9

Figure 11.6Large Reverse Repo Programme and Shifts in the Money Curve

Source: author’s estimates.

Note that repo curve shows the rate at which money is lent for given collateral (and tenor). Thus, the scarcer the collateral, the lower will be the repo rate – thus, the bold repo line is downward-sloping.10 The money curve is upward-sloping and depicts lower interest rates when money is not scarce (bold line), and higher interest rates when money is scarce (dotted line).

So, if money is absorbed directly to the Fed’s balance sheet, the market has less money relative to collateral, since the market’s holding of collateral (ie, ownership and possession) remains at x trillion; the collateral rate will be pushed up by market forces.

In other words, the inward move in the money curve (from the bold line to the dotted line) is a reflection of the fact that implies that the bilateral-pledged collateral market becomes illiquid as money moves to the Fed balance sheet and deprives the bank–non-bank nexus of the means to do the plumbing. This in turn reduces demand for collateral from (i) hedge funds that need financing or (ii) other collateral suppliers that wish to augment returns on their securities via securities lending activities by pledging collateral.

With a large RRP – say if the Fed takes money from Fannie/Freddie and the money market mutual funds (MMMFs) – those non-banks will withdraw money from the dealer banks. The dealer banks will in turn return the US Treasuries and agency mortgage-backed securities (MBSs) to the securities lenders in exchange for corporates/equities (which the securities lenders swapped to enhance returns). The dealer banks will also give back securities to the hedge funds, or real-estate investment trusts (REITs), as banks will not have funding from the money pools. This implies that the cost of funding long positions for non-dealers such as hedge funds in the bilateral-pledged collateral market will go up, and the demand for (and price of) securities will go down. As a result, the value of the Fed assets will fall – whether the Fed sells them or does a large RRP. However, at the time of writing in mid-2016, the use of the RRP remained muted, since GCF has been a better rate than the RRP at 25bp, and counterparties that have access to the RRP do not want to lose the balance-sheet “access” of dealers, as this access has been rationed (see Panel 11.2).

Panel 11.2:Demand for High-Quality Liquid Assets

This panel highlights that the demand for high-quality liquid assets (HQLAs) stemming from regulations is substitutable between banks and non-banks. Furthermore, in the aftermath of quantitative easing, monetary policy tools such as the RRP will impact on the plumbing and thus reshuffle HQLAs between the needs of the banks and non-banks.

At present, the banks’ demand for the RRP is negligible, as the reservation price is much higher than the 25bp offered by the RRP (ie, banks receive interest on excess reserves of 50bp for their own funds, or a little lower for their clients’ funds after splitting the 50bp with clients and netting for the FDIC (Federal Deposit Insurance Corporation) fee; in fact, foreign banks, which are exempt from the FDIC fee, are the most active in this market). The current RRP rate is a non-market price that sets a floor that prevents the repo rates from going below zero. The Fed has designed the RRP as a temporary tool that has been sufficient to meet the demand from non-banks (the cap of US$300 billion has been lifted since the December 16, 2015, lift-off to about US$2 trillion). More importantly, banks continue to provide liquid collateral (or HQLAs) via the financial plumbing (eg, repos, securities lending) by making a market between various non-banks (eg, hedge funds with collateral and MMMFs with money). Panel 11.1 shows that the bilateral plumbing is estimated at US$5.6 trillion (as of end-2015), down from a pre-crisis level of US$10 trillion.

For example, from a regulatory angle, the liquidity coverage ratio and leverage ratio are designed to ensure that financial institutions have enough high-quality liquid assets on hand – such cash and Treasuries – to ride out short-term liquidity disruptions. From the point of view of monetary policy and the RRP, the T accounts below provide a stylised summary of what a large RRP at US$1.3 trillion, beyond the present average use of US$150–250 billion, would look like. In this scenario, the demand for HQLAs from banks will decline as non-banks withdraw deposits from banks and increase their position in the Fed’s RRP. In other words, there is substitution between non-bank and bank demand for HQLAs.

Market sources that continue to ask for a large RRP should note that the RRP is a monetary tool for lift-off, and not a conduit to supply safe assets. The size of the RRP does not change the Fed balance sheet but the plumbing between banks and non-banks will be rusted in favour of a larger Fed footprint. Since a deep and liquid plumbing market provides pass-through price signals (such as the GCF rate), it remains unclear why the RRP’s size (ie, quantity) should be expanded to include more counterparties and/or increase the individual caps for the present 165 eligible counterparties.

Figure 11.7 illustrates the bilateral plumbing, exhibited as red and light blue boxes corresponding to the various financial agents. The figure depicts the exchange of money for collateral (shown by arrows) among banks, non-banks and the Fed. The impact of the Fed’s RRP is represented by the red colouring of some of the boxes. The red that replaces parts of the blue boxes denotes the decrease in market’s bilateral plumbing – due to the involvement of the central bank. Without the RRP, there would be no red color and all boxes would be blue (such as in Figure 4.5); the market would do all the plumbing and would price the rate at which money and collateral are exchanged (typically, bilateral repo, securities lending, prime brokerage and derivative margins).

Figure 11.7The new Plumbing: Large RRP and Rusting of the Plumbing

Source: author’s illustration.

Also, note that the horizontal axes of Figures 11.6 and 11.8 are labelled M (money) or CV (collateral x velocity). This is because the Fed’s RRP can exchange money (M) and collateral (C) only on a one-to-one basis. However, US Treasury sales to the market can do M: CV, where V≠ 1 (and the average velocity so far has been > 1).11

The second route to undertake the lift-off would have been for the Fed to sell US Treasuries to the market – this route was not taken.12 This would have increased the collateral in the market domain. In this scenario, will the GCF rate move in line with the Fed Funds rate? Collateral in possession of the market has a reuse rate (which is not in the Fed’s control), so the GCF rate may not coincide with FF rate (see Figure 11.8). However, controlled selling can be used to ensure that the GCF rate is close to the FF rate. Unlike a large RRP, sales of US$100 million US Treasury can release effectively more than US$100 million in collateral, depending of the reuse rate (below 2 at the time of writing, from about 3 in 2007).

Figure 11.8Asset Sales, and no Change in the size of the Reverse Repo Programme

Source: author’s illustration.

We can look at the second scenario from another perspective. If the Fed sells US Treasuries, non-banks would withdraw deposits from banks to purchase Treasuries from the Fed (ie, the reverse of the Fed’s asset purchase programme). In this scenario, banks, which are carrying constant dealer inventory due to the new regulation, will also get balance-sheet space. Thus, banks should be at least indifferent – in the context of balance-sheet space – to the Fed’s asset sales or a large RRP (see Panel 11.2 for the demand for high-quality collateral). Some of the large global banks, which are the primary conduits for plumbing in the global markets, would prefer asset sales, as this does not rust plumbing relative to a large RRP scenario, as the market can handle the duration of such sales (note: the 10-year UST rates have been below 2% since lift-off). However, markets can create wedges between the GCF rate and the FF rate – soon after lift-off, emerging-market sales of UST resulted in GCF rates touching 60bp, much higher than the FF rate in the 30bp range. This is similar to economic theory that argues that policy rates changes percolate to the long end; market plumbing (ie, the sale of long-dated securities) can ripple to the short-end rates (and may impact changes in the policy rate!).

In summary, the Fed can reach its monetary policy lift-off objectives with minimal footprint on plumbing – in fact the plumbing would provide useful information on key short-term rates such as the GCF rate.13 In this scenario, GCF will be a market rate; the plumbing does not get rusted by a large RRP. Under this modality, sales of US$100 million of US Treasuries will release effective collateral that will be a multiple of US$100 million; the multiple will be a function of collateral needs stemming from regulations, duration of bonds sold, etc.

Collateral reuse encompasses aspects of the use of collateral that are different from what the academic literature calls “moneyness”. These aspects include (a) acceptability to counterparties; (b) ease of use – how likely it is to suddenly become special, how much is floating around; and (c) how volatile the price is (ie, frequency of posting margins). Everyone will accept short term T-bills for everything, but not everyone will accept long bonds – so T-bills will be preferred to bonds on (a). A collateral possessor will have to replace the one-week T-bill every week, but renewing a maturing security entails a larger and more costly operation than a non-maturing security – long tenor bonds are preferred on metric (b). Long bonds will face a margin call at least once a week, but not bills, so bills win again on metric (c). Thus, a bill or short coupon with six months to two years to maturity, is a “sweet” spot, where everyone will accept it and it is easiest to deal with.

The next security in high demand will be 2–5-year notes, then longer notes (up to 10 years), then shorter bills, and then longer tenor bonds (over 10 years). Such collateral, generally speaking, contributes most to collateral velocity (and the overall plumbing of the financial system). Good collateral such as US Treasuries also incentivises reuse of other not-so-desirable collateral since most collateral in the bilateral plumbing market is exchanged (for money) as a portfolio of securities, and not as individual securities.

The RRP rate after lift-off is more expensive relative to the cost of issuing short-tenor T-bills (Stella, 2015; Duffee 1996), which are near zero for the shortest tenor. Thus, aside from the plumbing aspects of collateral, should the RRP – a temporary monetary policy tool – be considered as a conduit to issue safe assets? Also, a large RRP in the medium to long term would be orthogonal to proposed regulations from 2016 that will require prime MMMFs to maintain a floating NAV (net asset value).14

Panel 11.3Fed Risk Using Wrong Tools to Tighten

Financial Times column, Manmohan Singh, Nov 23, 2015

The Federal Reserve has been sending strong signals that it is preparing to raise interest rates for the first time since 2006. As the Fed prepares for liftoff, its operational framework and large balance sheet may pose challenges to market functioning.

The Fed’s balance sheet has increased from roughly $1tn at the end of 2007 to well over $4tn at present. This stems from about $3.4tn of purchases of US Treasuries and other bonds under the Fed’s quantitative easing programmes. This took such assets out of market ownership to reside on the Fed’s balance sheet.

This is important because market interest rates are effectively determined in the collateral market, such as the repo, or repurchase market, where banks and other financial institutions exchange collateral (such as US Treasuries, mortgage securities, corporate debt, equities) for money.

Financial agents that settle daily margins may post cash or collateral; this forms the core of the financial plumbing. Such “pledged” collateral is generally received by banks not only via repo markets but also from securities lending, prime brokerage agreements with hedge funds, and derivative positions. The largest suppliers of pledged collateral are hedge funds; other sources include insurers, pension funds, central banks and sovereign wealth funds.

The repo rate is an important market signal and should move in tandem with the Fed Funds rate; hence the need to have good plumbing.

In 2007, the collateral market was $10tn in size; now it is only $6tn. A further reduction lies ahead, threatening to rust the financial plumbing, as the Fed prepares to raise interest rates.

There are two ways the Fed can tighten monetary policy to control interest rates once it has raised them. The first is to use and expand its so-called reverse repo programme, which soaks up large sums of money from non-banks such as money market funds, but does not release collateral from the Fed’s balance sheet back into the market.

The second is to sell US Treasuries, which similarly mops up cash while also supplying collateral.

The reverse repo programme is currently capped at $300bn per day, but the Fed may raise this cap to ensure reverse repos mop up enough cash to maintain a floor on interest rates. Reverse repos work by persuading non-banks to remove dollars deposited with banks and place them with the Fed, in exchange for collateral such as Treasury bonds. So the Fed becomes the new counterparty to the non-bank, while the bank gets “balance sheet space” as the deposits move to the Fed.

Crucially, this process does not release collateral to the market as the operational structure of the reverse repo facility puts practical restrictions on the reuse of collateral. Thus, none of the collateral within the reverse repo programme can be used to post at central clearing houses, in the bilateral derivatives markets, in the bilateral repo market or delivered against short positions.

The consequence of a sizeable reverse repo programme would be that money becomes scarcer as it is drained from the market, thus raising the repo rate, while collateral becomes proportionately more abundant and therefore cheaper. Thus, by targeting the size of the programme, the repo rate can be made to track the Fed Funds rate; however, this will result in the repo rate not being a market rate.

A better option would be to keep the reverse repo programme size at its present level and sell US Treasuries . These bonds could be sliced and diced for repos and related collateral usage. While the Fed can control the amount sold, collateral gets reused, which is not under the Fed’s control, so the repo rate may not equate to the Fed Funds rate. However, selling of US Treasuries can be fine-tuned, to reduce a large wedge between two rates.

It is crucial to ensure that the market plumbing does not get rusty through the use of a large reverse repo programme. A deep and liquid collateral market provides price signals (like the repo rates) that would be weaker under a large programme.

For effective monetary policy transmission, all rates should move in sync with the Fed Funds rate and this requires good plumbing.


In recent years, many money and repo rates in the US have been between 0 and 25bp (and after lift-off between 25 and 50bps). This chapter has highlighted the financial plumbing connecting bank and non-bank balance sheets, and the changes to those balance sheets stemming in part from proposed regulations such as the leverage ratio and liquidity coverage ratio. Central banks were not cemented to pre-existing conditions where they were forced to act as a dealers of last resort to avoid market meltdown. Monetary policy is about facilitating output and price stability. The financial system in the US is in private hands and central banks need to create conditions and incentives under which markets can operate. The US Fed’s exit from the prolonged period of low interest rates and expanding balance sheet needs to be mindful of disruptions to the financial plumbing that has been impacted on by asset purchases and other unconventional practices. In this context, the chapter argues that market plumbing is useful to extract market signals and should not be compromised.

Market signals such as repo rates are crucial to understanding, since these have traditionally guided the policy rate (ie, the FF rate). If the Fed increases its footprint on the market plumbing, market signals will be weaker and may result in reduced correlation between the policy rate and other short-term rates (eg, the GCF rate). A normal lift-off assumes that all short-term rates will move in line with the policy rate; otherwise, monetary policy transmission may be compromised.

Specifically, the existence of a larger RRP will reduce market signals, rust the normal market plumbing as money moves to the Fed balance sheet, and keep the Fed’s footprint in plumbing for a long time. After lift-off, the FF and GCF rates need to move together (without large wedges for extended periods of time), for monetary policy transmission. In the aftermath of the Fed’s asset purchases – which have withdrawn good collateral from the market – the chapter argues for asset sales by the Fed to lubricate the plumbing and increase the collateral reuse rate. Unless excess reserves are removed (when shortage of reserves played an important role in aligning GCF rate to FF rate), it will be difficult for the FF rate to be meaningful. Perhaps excess reserves of around US$300-500 billion may be the new normal relative to the US$30-50 billion pre-Lehman since Triparty reforms have significantly reduced the intra-day overdrafts (see Chapter 8). Some economists argue that there is no need for the Fed’s balance sheet to unwind; in this scenario FF rate will continue its path basically supported by IOER and RRP (and as rates rise both IOER and RRP will come under increased scrutiny).

Furthermore, there is also apparently no obligation on the part of either the Fed or the US Treasury to supply safe assets under the monetary policy “rubric” at a higher cost than warranted. Coordination with the Treasury on debt issuance will be useful.


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The US bilateral repo market is a market for collateral: securities for possession and use (against cash). The triparty repo market in the US is a market for funding: money for broker-dealers/banks (collateralised by securities). The lift-off should be about rates that pass through to the real economy, and bilateral pledged collateral market provides this information. GCF rate is often used to proxy for bilateral rates when the financial plumbing works (Singh 2014). Since FOMC and Fed speeches focus on IOER (ie, interest on excess reserves), ON RRP, GCF, and FF, we restrict the discussion to these four rates.

To the extent that banks face the average ratio (or SLR in the US) constraint as a result of asset purchases by the Fed, they want balance-sheet “space” for higher-return financial intermediation/non-depository activities.

To be precise, the total US Treasuries and MBSs held by the Fed, as of April 22, 2014, were US$4.2 trillion, of which US$750 billion were held as of end-2007. Excess reserves, as per April 22, 2014, were at US US$2.9 trillion, basically all of which were added after end-2007. Also, FDIC website data suggests that the top 50 bank holding companies (including foreign) held US$7 trillion of deposits as of June 30, 2014, relative to US$4 trillion as of June 30, 2008. In fact the top four bank holding companies (Bank of America, Wells Fargo, Citibank and JPMorgan) hold about US$3.8 trillion in deposits as per FDIC’s June 30, 2014, data, relative to US$1.9 trillion as of June 30, 2008.

Only genuine sales of assets will reduce the size of the balance sheet, for instance when the Fed sells US Treasuries, in line with the QE actors, a non-bank will buy these US Treasuries. To do that it will remove some of its deposits from its bank (eg, Citibank) to pay for the purchase of US Treasuries. Citibank’s balance at the Fed will go down, or, “excess reserves” of the banks at the Fed will go down.

There is a key difference between selling assets from the Fed’s balance sheet to shrink the balance sheet and reshuffling Fed liabilities between line items called “excess reserves” and other items on the liability side such as RRP. Rearranging the Fed’s liabilities gives rise to changes in someone else’s balance sheet at every stage of the process; selling assets, in contrast, allows those assets to move directly to their final holder. An example: suppose the Fed sells US Treasuries to Goldman Sachs, which sells them to a hedge fund, which sells them to Bank of America (BoA), which sells them to an insurance company. The insurance company balance sheet asset is a substitution of the securities for cash deposits at its bank, eg, BoA. BoA’s liabilities (the insurance company deposit) and assets (the Fed’s reserve deposit) both go down.

Hedge funds and dealer banks actively reuse collateral. Some central banks, SWFs and pension funds (especially in the US) will lend their securities to augment return.

The term “good collateral” is synonymous with high-quality liquid assets (HQLAs) in the regulatory parlance. These are generally AAA/AA securities such as US Treasuries, German Bunds and French Oats.

In this case GCF will be a fiat rate and not a market rate. However, market sales (eg, emerging-market sales into the market) will increase GCF.

Thus, if repo rates are negative (like some German bonds in recent times), the money provider is willing to lend money at a negative rate for the Bunds.

Average collateral velocity calculated by Singh (2011, 2013) from annual reports of the key banks may not equal marginal collateral velocity, as proposed regulations will result in more siloing of good collateral.

Assuming MBS sell-off adversely impacts on the housing market (in line with recent Fed speeches and minutes).

Here it is useful to make the distinction between ownership and possession. The Fed will be careful to let the market have possession of these securities that are in market’s domain – as the collateral-since-reuse rate will be an exogenous variable. However, the Fed’s mandate is about monetary policy lift-off and the Fed Funds rate, and not about cushioning duration-related volatility at the long-end of the US Treasury curve. In this context, it would be useful for Fed to be cognisant of collateral reuse rate in the bilateral pledged-collateral market, along with other money metrics to gauge the short-term rate environment.

In line with regulatory intent, the push towards a floating NAV results in deposits moving to banks away from MMMFs, as RRP is capped at US$300 billion. On the other hand, a large RRP will result in a larger “put” from the Fed to MMMFs, and less deposit at banks (and thus more “balance-sheet space” for banks). Note that government and retail funds will still be allowed to carry the “par NAV” label.

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