by Death Taxes and QE

The Q3 quarter-end repo spike could point to reserve scarcity, but more likely indicates that dealers are reaching capacity limits. Dealers are forced to comply with balance sheet constraints and Basel III leverage ratios (like the SLR) purposed to prevent their bank holding company from taking on too much risk (too much leverage). But the monsoon of Treasury issuance which dealers are forced to absorb, finance and hold on their balance sheet means that even when things seem placid, their fragility only grows.

There’s one straightforward solution to increasing a dealer’s ability to provide liquidity and make markets: exempting Treasuries from said regulations. This would make banks a limitless marginal buyer of Treasuries and explain the SEC’s confidence in throttling the current marginal buyer – hedge funds. An exemption would be a “crossing the Rubicon” moment for the US Treasury and the first step towards an endgame.

Only a couple of days ago, zerohedge cited repo guru Mark Cabana’s warning on the large reserve drain into Q3 quarter-end, which sent Treasury repo rates spiking above even what was offered at the Fed’s repo facility. The facility, designed by Zoltan Pozsar, was created to prevent another September 2019 episode, when repo rates spiked far above the Fed’s target range:

Recall that a classic repo trade is borrowing cash secured by Treasury collateral: a dealer, for example, can borrow $100 from a money market fund to finance a security purchase (or whatever it may be) by pledging $101 worth of Treasuries. The extra $1 is called the haircut. The “pawn” analogy is perfectly accurate: you sell an item to a pawn shop for some amount of cash and agree to repurchase (“repo”) it back at some time in the future. If you can’t repurchase it, the shop will keep the item you sold. Thus, the transaction is secured by collateral, and here, that collateral is almost always Treasuries.