Illiquidity in the U.S. repo market spooked investors in the second half of 2019, and the U.S. Federal Reserve is considering a major policy change that could help remedy the situation. However, the potential changes could come with some major political fallout.

What Is The Repo Market?

The term “repo” is short for repurchase agreement. Repo loans are overnight loans taken out by small banks and hedge funds that are repaid the following day. These banks and hedge funds use low-risk securities, such as U.S. Treasury bonds, as collateral for the loans.

Liquidity in the U.S. repo market dropped back in September, and the Fed was forced to step in for the first time since the financial crisis in 2008.

The Potential Fix

The Fed is reportedly considering completely overhauling the current repo market and instead begin allowing the repo market clearinghouse, the Fixed Income Clearing Corp. (FICC), to lend directly to small banks and hedge funds. This change would essentially eliminate the larger bank middlemen from the process and provide a direct source of overnight loans for small banks.

In theory, this change would reduce uncertainty and risk and reduce the chances a freeze in the repo market could disrupt the financial system. However, providing wealthy hedge fund managers with a direct path to Fed lending via the FICC might not sit will with the average American. The prospect of a taxpayer-funded hedge fund bailout would likely trigger political backlash.

Problems Ahead?

While proponents of the potential changes argue it would add liquidity and transparency to the repo market, opponents are concerned the changes would be seen as the Fed giving the green light to hedge funds to increase their leverage and make risky bets.

Earlier this month, the New York Fed injected another $56.7 billion into the repo market in an effort to keep fed funds interest rates in-line with the Fed’s target range of between 1.5% and 1.75%. The Fed also said its balance sheet grew from $3.8 trillion in September to $4.17 trillion by the end of 2019.

“The big picture answer is that the repo market is broken,” James Bianco, founder of Bianco Research in Chicago, told MarketWatch back in December. “They are essentially medicating the market into submission...But this is not a long-term solution.”

Benzinga’s Take

Perhaps uneasiness about the Fed’s role in the repo market is one of the driving forces behind a recent rally in gold and bitcoin prices, investments many traders see as stores of value and inflation hedges. In the past month alone, the SPDR Gold Trust (NYSE: GLD) is up 4.5%, while the Grayscale Bitcoin Trust (OTC: GBTC) is up 13.8% overall.

Do you agree or disagree with these predictions? Email feedback@benzinga.com with your thoughts.

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