What the Treasury bill collateral crunch tells us about trust

Trust is in diminishing supply around the world. That is true among nations, business counterparts and securities traders. In the markets we can measure this distrust in the differing prices of similar financial assets ultimately backed by the US Federal Government.

Take, for example, the interest rate paid by the Federal Reserve to banks who park their money nearly risk-free overnight in its “Reverse Repurchase Facility”.

The Fed has engaged in reverse repos for years, under which it would receive cash overnight, secured by the highest quality short term securities, in exchange for “reserves”, a sort of non transferable asset for financial institutions.

But institutions and investors have other low-risk options for their spare cash, such as short term Treasury bills. In fact, a curiously persistent gap has appeared between the interest rates on the shortest term T-bill rates and the periodically reset rates offered by the RRP.

As an example, on March 23rd, the four week Treasury bill at one point yielded about 13 basis points (each one 100th of a percentage point), while the RRP offered 30 bps. In the past, markets have not priced in much difference between them.

If this spread happened because of an oddball event — a massive one day computer failure perhaps — it might be considered just noise, not a signal. Yet this difference has persisted fairly consistently since June of last year. Both the RRP and the T-bills offer daily liquidity, and the full faith of the Federal Government sits behind both. So why these yield divergences?

Part of the idea behind the RRP concept was to assure money market funds held by bank customers and corporations that they would always get a low-ish, but at least positive interest rate on the cash in these safe RRP accounts. Assuring this sense of safety for account holders was paramount. Without this protection public confidence in the system as a whole would be shaken.

The underlying problem was that banks and other deposit-takers, such as the money market funds, had not found enough sound lending or investing opportunities for excess cash made available by the quantitative easing programmes. From the beginning of the pandemic in early 2020, US loan demand weakened so that deposits from the banks’ customers could not be put to work as in the normal banking model.

The regular use of the “RRP” began only in 2014, and for a while the Fed (and its customers) only used it as required. But the repurchasing facility has grown in importance, especially in the last two years. On a daily basis, no participant in the RRP can bid for less than $1 million, or more than $160 billion.

The facility has become more popular with institutions which daily end up with more cash than attractive, short term low-risk opportunities. On April 4 of this year, for example, overnight RRPs amounted to $1.73tn.

So given the Fed’s backing of this type of account, why are people willing to pay up for short term T-bills (and get less yield) when they might earn twice as much using the RRP?

The big reason, in my view, is that those T-bills can be more useful. An investor or a dealer-bank, after purchasing them, can lend and re-lend these securities several times each before they mature. This is a process sometimes known as “re-hypothecating”.

Each time an institution that holds the bills lends them out it can receive a “securities lending fee”. The flexibility of these T-bills to provide collateral security makes them popular instruments for use in typical fixed income market transactions. Interest rate swaps, where two parties exchange different income streams paid over different time periods, might have T-bills used as a collateral in the transaction.

In contrast, while the RRP may offer a higher rate, unlike T-bills they are not instruments which can be re-lent.

This “collateral market” is a vital, under-reported, aspect of the international financial system. Manmohan Singh, senior financial economist at the IMF, is the leading expert on the topic. His research has shown how use of collateral can give an indication of market health.

When financial market participants have a great deal of confidence in each other, the “collateral re-use rate”, or the number of times T-bills (or perhaps short term German Bunds) are lent and re-lent, increases. In the easier days of 2007, a short term T-bill might be re-used as much as three times. By 2016, the re-use rate (a sort of inverse measure of trust) had dropped to 1.8 times. In recent years, collateral re-use has picked up again.

Now, though, the continuing interest rate gap between the RRP and short term bills tells us there is a new scramble for access to the best collateral. That suggests financial counterparties trust each other and their asset quality less and less.