Repo Market

US Default Shouldn’t Matter – But It Will

The US may ‘technically’ default on its debt soon, but why should you care? After all, everyone knows that it’s just a temporary thing, the US isn’t insolvent yet. Tax revenue will come in, the Treasury will eventually get back its licence to borrow and everyone who was owed money by the US government will get repaid. So why panic? Because our financial system is so schizophrenically put together that even a technical default will send it into a nausea inducing tailspin. Believe me, we do not want this. This one’s for those who don’t work with me in financial markets – those who do, go sit in a corner and tremble in terror, you already know how bad this could get. I’ve got a paragraph for you at the end!

Pretty much the main channel for transmitting US default into financial catastrophe is the interbank repo market. Repo is the business end of the credit creating,1 balance sheet churning monster that is the financial system. As banks constantly chop and change their cash positions by promising to borrow and lend, they fund their promises in the gigantic, super-liquid repo markets. Repo is where you take assets that you own (valuable things like securities, government bonds, stocks, and the like) and sell them to another bank for cash. You agree to repurchase them in a given length of time at a slightly higher price, thus paying a bit of interest. It’s essentially like a mortgage, but generally only for a few days, and using financial instruments rather than houses. And it’s super cheap! Because all banks hold large portfolios of things like bonds and stocks, they can always get their hands on cheap, short term funding. So when DodgyCorp Inc. fails to repay its $200 million loan on time to a given bank, that bank can just take some of the bonds it owns, sell them to another bank, and get the money they need to plug the gap. This sort of rapid churning of short term funding is what lets the system run the kind of crazed, highly leveraged balance sheets it does.

Unfortunately, we’ve baked systemic fragilities into the repo market. Defaulted Treasury bonds can’t be used as collateral, and because bundles of treasuries are packaged up and repo’d together, it’s likely that the IT simply wouldn’t be able to handle particular bonds defaulting. Given the legal difficulties involved, this could get really messy, and some commentators believe the Treasury repo markets would simply stop working all together. Even if this can be ironed out, a default will make investors less likely to buy US debt, meaning the interest rate on that debt will rise. A rise in these US government bond rates means interest rates across the system rise, including in repo markets. Because banks have to borrow in repo (which costs them the repo rate) but mostly end up lending their spare cash to the Federal Reserve (at the policy rate, which is pretty much zero), a rise in repo rates means they simply won’t bother. They’ll sit on their hands, the balance sheets will stop churning, and the machine will grind to a juddering halt. Credit won’t flow to businesses, payment systems may have to be suspended, and a lot of real economic activity will come to a halt because of what can only be appropriately called ‘some finance bullsh*t’.

The reason I’ve bored you with this stuff is to point out a universal truism about the financial sector: it is far too big, complicated, and irrational. It’s the result of haphazardly accumulated special privilege, not any kind of rational design, and this makes it likely to do real damage when some little known part of it goes wrong. For finance people, you know that the repo market in treasuries is pretty much crucial to the entire design of the financial system, with its reliance on a few IT systems and a bunch of conventions that leave it highly vulnerable. How arbitrary do you think that looks to everyone else? And how absurd is it that an event that’s essentially academic can be propagated by this highly fragile system into a real shock that will decrease ‘economic activity’, i.e. get people to do fewer things, create less wealth, and end up worse off?



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