Wholesale Money Markets: Repos and Eurodollars

Table of Contents

Repo Market

Repo (someone calls it RP) is an overnight collateralized loan, organized as a simultaneous sale and repurchase of a security. The person A, who borrowing money, is selling a security (say, treasure bill) to somebody B today and promising to buy it back tomorrow.

If the person A does not repay tomorrow, B will become the owner of the security and can sell it.
If B does not give back the security, A does not have to repay the money, and has a free loan which continues until B come up with the security.

Repo is collateralized in a sense on both sides: the money collateralizes the loan of securities, and the securities collateralizes the loan of money. It’s important to appreciate that almost all repo transactions have a dealer on one side or the other, that will help you stabilize the language.

For instance, a repo loan is a security dealer borrowing money from a pension fund, who is lending money to get some interest. This is like a deposit account practically. And they’re fully collateralized, there’s a treasury bill or something that the Pension fund has as the collateral for this loan. Because large deposits in banks are not insured, pension fund prefers to put their excess cash balances in the Repo than in the bank.

On the other side, security dealer lends money to banks and takes in securities as collateral sent over by bank, that’s often called a reverse. So in the diagram below, security is moving from Bank to Pension fund, and money is moving in the reverse direction.

Banks hold securities as part as their assets, and one way to fund that holding of securities is is to repo those securities out overnight. Particularly in the United States the, this sort of thing existed before the Fed, and it was the way that banks traded with each other before the Feds funds market.

Bank Debit	Credit	Security dealer Debit	Credit	Pension Fund Debit	Credit
	+reverse repo	+reverse repo	+Repo loan	+Repo loan

What’s happening in the Repo market is, in some sense, sort of like what was happening in the Fed funds market. In fact, in the Fed funds market, there’s not much dealing, it’s almost all just brokering. But in the in the Repo market, it’s all dealing.

What these repo dealers doing are that they are borrowing short and lending long. Just like a bank. They’re borrowing overnight and they’re lending term (even it is just a week). In doing so, they’re supplying liquidity to the world.

Legal Construction of Repo

The legal construction of repo is like a collateralized loan, but it’s much more symmetric. “Who gives margin to who?” is a question that sort of reveals deep features of Repo market.

If the value of the security falls below the value of the loan, then there’s an incentive for borrower not to repay.
If the the value of the security goes up than the value of the loan, then there is an incentive for lender to hold onto the security and not to return.

It is the person who lends money gets margin. Not the person who’s lending securities. Money is the better asset, and the person who lends money are the ones who can demand collateral, and extra security (called haircut). It indicates the hierarchy between money and credit.

Modern Finance and the Fed

Repo is where modern finance has just changed the world. A money market mutual fund could holds repo as its assets and issues deposits to foreign central banks.

In open market operations as the Fed buying or selling treasury securities in order to change the money supply. What really is going on here is the Fed is buying and selling to the dealers. It’s the dealers who make these markets securities. Nowadays the Fed intervenes mostly to test its ability to do reverse repo with the dealers, as a way of shrinking its balance sheet eventually.

Bank Assets	Liabilities	Dealer Assets	Liabilities	Fed Assets	Liabilities
-reserves	-deposits	+reverse repo -deposits			+reverses repo -reserves

Repos add reserves to the system, reverses pull reserves out. When the Fed is doing repo, it is the expansion of Feds balance sheet. When the dealer is borrowing money. The dealer doesn’t have an account at the Fed. So the dealer can’t hold reserves directly. What the dealer does, when he is paid, is to increase his deposit account at the bank.

Bank Assets	Liabilities	Dealer Assets	Liabilities	Fed Assets	Liabilities
+reserves	+deposits	+deposits	+repo loan	+repo loan	+reserves

The reserves in the banking system come from the Fed doing repo with the dealer. The Fed is doing repo with the dealer lending the dealer money and the dealer is providing security (say a treasury bill), and these reserves wind up in the bank because the dealer deposits them.

Ring Fencing

In the context of retail banking operations, the ring-fencing is to take all of the retail loans and all of the retail deposits, allocate to them some of the bank’s capital dedicated to that, and some of the bank’s reserves possibly too, to that. So that all the other stuff that the bank does (say, trading assets, wholesale borrowing, etc) have to have its own separate capitalization, and its own separate reserves.

Bank Assets	Liabilities
retail loans reserves dedicated	retail deposits capital dedicated
trading assets reserves dedicated	wholesale borrowing capital dedicated

So that if there’s a problem on part of bank (say, lose a lot of money in trading assets), that part of the bank is somehow legally separate or it can just fail. And the other part of the bank (say retail operations) can be carved off and kept safe and separate.

Volcker Rule and Limiting Proprietary Trading

The Volcker Rule, in simple terms, says that you can’t do any proprietary trading if you are a bank. Proprietary trading means essentially speculation, on the direction of movement on some price or other. Bank is allowed to do market-making called matched book.

Client A Assets	Liabilities	Bank Assets	Liabilities	Client B Assets	Liabilities
	CDS	*CDS*	*CDS*	risk assets CDS

The bank in the middle is doing matched book, since it is on the both sides of the trade, and making markets. This is allowed by Volcker Rule.

Eurodollar Market

Besides Fed funds and Repos, Eurodollars is the third main short-term wholesale money markets in the world. The Eurodollar rate, sometimes called LIBOR, normally (before the crisis in 2007) the Eurodollar rate is a tiny bit higher than Fed funds rate, just a few basis points.

In August of 2007, the spread between the fed funds rate, and the Eurodollar rate went from basically a couple of basis points to a hundred base points (one percentage). In the crisis there were banks who do not have access to the Fed’s fund market, and really need to roll their funding, but can’t get any banks who do have access to the Fed’s fund market to lend to them. So, there was a breakdown in the interbank funding markets, which was driving Eurodollar rate up, in order to create an incentive for somebody to borrow in the Fed funds market and lend it at LIBOR.

When we talk about Eurodollars, we’re talking about the balance sheet of banks that are outside the United States. Suppose FirmA has an account at BankB, and it withdraws some money from that account and transfers it to BankD in other country. What is behind the scene is that BankB transfer its reserves via NY Fed to BankC, which acts as correspondent banker with BankD. BankD is using its deposit at BankC as its reserve. It can go into the dollar borrowing and lending business, even though it’s in other country.

FirmA Assets	Liabilities	BankB (NY) Assets	Liabilities
-deposit_B +deposit_D		-reserve_NY_Fed	-deposit_A

BankC (NY) Assets	Liabilities	BankD (London) Assets	Liabilities
+reserve_NY_Fed	+deposit_D	+deposit_C	+deposit_A

Because the dollar is the world reserve currency, there’s a demand by people to have deposits in dollars who aren’t in the United States. However the Fed wants to focus on control of domestic credit, it prefer you do this offshore. So there is a separate world outside the U.S., in the international dollar reserve world, where people are using the dollar in order to make payments. When talking about payment system, we are talking about a credit system. People who are running deficits have some way of borrowing from people who are running surpluses.

The eurodollar market grows up initially because there were credit controls, capital controls, controls of international flows of capital. But eventually, those capital controls all broke down and the market continued to thrive, and Bretton Woods broke down, and eurodollar market grew to be larger than the fed funds market.

The crisis in 2007 revealed the big difference between the eurodollar market and the Fed fund market. The Fed funds market is like the real market. These are real dollars. The eurodollar market is a credit extension of that.

Global Funding Market

The Eurodollar market is not just a payment system, it’s the world’s funding market. Anywhere in the world people who want to borrow and people who want to lend, want to do business in dollars. The Eurodollar system is intermediating that flow. The Eurodollar system is taking the deposits of the lender and using them to fund a loan to a borrower, anywhere in the world. The eurodollar system is a dealer system.

Borrower Assets	Liabilities	Eurodollar Assets	Liabilities	Lender Assets	Liabilities
	term loan	term loan	o/n deposit	o/n deposit

Unlike repos, and like the Fed funds, eurodollars are unsecured.
Like repos, and unlike the Fed funds, eurodollars are a dealer market.

The reason for the Eurodollar market to exist is that foreign banks have customers who wish to hold dollar balances or take out dollar loans from them. This customer-led demand causes some of the banks to have a natural surplus position (more dollar deposits than loans) and other banks to have a natural deficit position (more dollar loans than deposits). They do business with each other, with surplus banks lending to deficit banks, and the rate charged in this interbank market is the London Interbank Offer Rate, or LIBOR.

Liquidity Challenges

The problem is these foreign banks’ reserves are not the reserves that are held at the Fed, their reserves are held at some banks in New York typically. The foreign banks have got to be a little more careful than the American banks who can borrow in the Fed funds market, or borrow with the Fed. So the off-shore foreign banks have more of a discipline problem than the on-shore American banks.

These foreign banks respond to limitation by being a lot more careful about lining up their cash flows in time – their deposits are typically deposits to a specific date. They’re attempts to line up the cash in-flow and the cash out-flow in time, managing liquidity using Forward Rate Agreements. There is implicit balance sheet entries that relying behind it.

Forward Rate Agreement

Think about 2 banks: BankX (forward borrower), and BankY (forward lender). Both of them are trying to arrange cash flows ahead of time in the future. BankX anticipates that two months from now, it will be making a loan for a three month term. It wants to arrange the funding for that. BankY is in the exactly opposite position – it is going to get cash in-flow two month from now. It wants to make sure they lock in something to use it for.

BankX can make a two-month deposit of a million in BankY, and BankY makes a 5-month deposit of a million in BankX. Neither one of them needs to actually pay anything, because it’s a swap of IOUs. There is a difference, however, in when these loans get paid back. Nothing happens at time zero.

BankX Assets	Liabilities	BankY Assets	Liabilities
2-month deposit in Y	5-month deposit from Y	5-month deposit in X	2-month deposit from X

At time two months, the 2-month deposit matures. BankY has to make a payment to BankX, which needs to make the 3-month loan as mentioned before. By swapping IOU’s now, you can lock in the source of funds in time.

BankX Assets	Liabilities	BankY Assets	Liabilities
3-month loan	5-month deposit from Y	5-month deposit in X	cash in-flow

Both banks can do this in an off-balance sheet way. Where the BankY could promises to make a deposit in BankX at rate F%, two months from now, that is called a forward forward.

The banks could also use a forward rate agreement, which is where the banks agree to exchange the difference between LIBOR and F%. In a forward rate agreement, BankY does not promise to make a deposit. BankY will say to BankX: “go ahead and you fund that three month loan at three month LIBOR. We will act as if there is a three-month deposit, which pays F% - LIBOR.”

BankX Assets	Liabilities	BankY Assets	Liabilities
3-month loan	5-month deposit from Y 3-month deposit (LIBOR) 3-month deposit (F% – LIBOR)	5-month deposit in X 3-month deposit (LIBOR) 3-month deposit (F% – LIBOR)	cash in-flow

The forward rate agreement allows BankX to lock in that rate of interest F%, because BankX promise to pay BankY the difference F% – LIBOR. If LIBOR goes very far up, then this is a negative number. BankY pays BankX. If LIBOR goes down, then BankX pays BankY.

So the forward rate agreement implements exactly what the swap of IOUs would do. It locks in funding for future but it does so in a way that doesn’t take up any balance sheet space. It is a off balance sheet that looks like a side bet on LIBOR:

If LIBOR is greater than F%, you pay me.
If LIBOR is less than F%, I pay you.

Forward Interest Rate

BankY would like F% to be a large number, because it’s an asset. BankX would like F% to be a small number, because they’re borrowing at that rate. However there is no negotiation between them, Instead there’s an arbitrage condition called Forward Interest Parity.

There are actual market rates for the 2-month deposit r(0,2), and the 5-month deposit r(0,5). Then there is exactly one forward interest rate F(2,5) that satisfies this condition called Forward Interest Parity, and F(2,5) is chosen for the agreement.

(1 + r(0,2)) * (1 + F(2,5)) = (1 + r(0,5))

Note that the forward interest rate F(2,5) is not equal to the expectation of the spot rate for the same period r(2,5), which is 3-month LIBOR, but 2 months from now. We don’t know what it is.

The Expectations Hypothesis of the term structure suggests that the forward rate should be equal to the expected future spot rate; in practice, however, there tends to be an inequality. The reason for this inequality is that the borrower is willing to lose money on the forward rate agreement as a form of insurance. Since it is the borrower of money who pays for the insurance (not the lender), this violation of Expectation Hypothesis illustrates the hierarchy of money and credit.

Forward Exchange Rate

When a bank is asked to make a loan in a foreign currency (say, Yen), but the bank does not have access to Yen funding, it only has access to dollar funding. There’s derivative markets out there, forward forward exchange contracts that help the bank line things up in time. The bank can get rid of this foreign exchange risk exposure using swap of IOUs with another bank.

BankX Assets	Liabilities	BankY Assets	Liabilities
6-month yen loan 6-month dollar deposit	6-month dollar deposit 6-month yen deposit	6-month yen deposit	6-month dollar deposit

Suppose the 6-month interest rate for yen is R^*(0,6), the interest rate for dollar is R(0,6), spot exchange rate from dollar to yen at time zero is s(0). If we have this arrangement, at the end of six months:

BankX is going to pay the amount of yen dollar * s(0)* (1 + R^*(0,6)) to BankY.
BankX is going to receive the amount of dollar dollar * (1 + R(0,6)) from BankY.

What’s the exchange rate that BankX would lock in today with this balance sheet structure? That’s the forward exchange rate F(6). The left hand side is the yen value of the dollar account at maturity. The right hand side is the yen value of the yen account at maturity.

dollar * (1 + R(0,6)) * F(6) = dollar * s(0) * (1 + R^*(0,6))

This is called Covered Interest Parity. It is an arbitrage condition, which means that the actual market forward exchange rate will be very close to the forward exchange rate implied by the formula.

Note F(6) won’t be equal to the spot rate six months from now s(6). The equation F(6) = s(6) is called Uncovered Interest Parity, which is not hold, empirically.

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