Chain reactions in funding markets

We are witnessing a turbulent end of the year in terms of global liquidity, with tensions not only in the United States but also internationally. Currencies like the Indian rupee have drawn attention due to their recent volatility. However, traditional explanations blaming the U.S. Federal Reserve (FED) or speculators fall short of fully capturing the magnitude of the problem.

This phenomenon, also reflected in currencies like the Brazilian real, Japanese yen, and Chinese yuan, highlights structural tensions in the global financial system, particularly within the Eurodollar system and funding markets. The interplay between monetary policies, regulatory constraints, and trade imbalances underscores the vulnerability of emerging economies within a dollar-dominated system.

We are observing how pressure in dollar funding cascades from one market to another, creating a chain reaction. In unsecured markets like Fed Funds, this pressure signals significant reserve shortages, which are more closely tied to collateral availability and dealers’ balance sheet capacity.

Liquidity tensions and interest rate spreads

The FED anticipated greater monetary tensions by recently expanding the Standing Repo Facility (SRF). This does not imply an imminent crisis, but subtle signs indicate how intermediaries are attempting to manage funding problems.

It is noteworthy that spreads between SOFR (Secured Overnight Financing Rate) and IOER (Interest on Excess Reserves) tend to widen toward the year’s end. This phenomenon, driven by stricter capital requirements for international banks and balance sheet constraints on U.S. banks, has destabilizing effects on global liquidity. The well-known year-end “window dressing” exacerbates regulatory pressures on dealers, making them less willing to intermediate, which drives rates higher.

Interestingly, SOFR has recently surpassed the FED’s discount window rate. This suggests heightened pressure on dealers’ collateral inventories, as regulatory restrictions and balance sheet constraints leave them less inclined to act as intermediaries. These tensions affect not only developed financial markets but also amplify challenges for emerging economies reliant on dollar flows.

In India, the Reserve Bank of India (RBI) implemented a series of measures to counteract the rupee’s depreciation, including interventions in the non-deliverable forward (NDF) market to pressure speculators, particularly in the rupee-dollar relationship. An NDF is a forward contract that fixes a future exchange rate based on the expectation that the dollar-to-rupee price will decline. However, these strategies proved counterproductive.

Intervention in the NDF market amplified downward pressures, while the use of international reserves drained domestic liquidity, forcing the RBI to resort to repo operations. These maneuvers reflect a broader problem: the increasing inelasticity of the global financial system in meeting dollar demand. This challenge intensifies during periods of stress, such as year-end, when regulatory and liquidity pressures peak.

Pressure on dealers’ collateral inventories

While the FED’s quantitative tightening (QT) policy has impacted bank reserves to some extent, no significant pressure on this front is apparent for now. Bank reserves remain at comfortable levels, and although unsecured markets like commercial paper or Fed Funds have seen slight increases in trading volumes, no acute shortages in reserves are evident. Mechanisms like the SRF effectively cushion balance sheet-related reserve issues. The real problem with the FED’s QT lies not in reserves but in reducing the level of collateral available for rehypothecation, limiting the liquidity creation capacity of the system.

The focus of tension appears to have shifted toward collateral. Post-crisis regulations have tightened leverage requirements, forcing dealers and banks to maintain stricter ratios between capital and balance sheet assets. At year-end, dealers face additional constraints as they cannot easily adjust exposure through repos or cross-currency swaps. The latter, being costlier than repos, further limit dealers’ capacity to intermediate, driving up rates like SOFR, which has recently surpassed even the primary credit rate of the discount window.

The use of equities as collateral has also reached historic highs, creating significant pressure on dealers’ balance sheets. Many have turned to total return swaps as a lucrative intermediation strategy, but this approach has its consequences. Although inventory assets can be rehypothecated, the added pressure on collateral has intensified this year-end. This is partly due to the leverage required to maintain upward pressure on stock prices, a particularly relevant factor in an environment where many ETFs rely on total return swaps to maximize leverage and sustain high asset valuations.

Global tensions further compound these issues. Currency interventions by the Reserve Bank of India (RBI) and active yuan management by the People’s Bank of China (PBoC) have heightened dollar funding pressures. These tensions are evident in the cross-currency swap market, where obtaining dollars is increasingly costly, especially as dealers shy away from intermediation.

Additionally, shadow banking, particularly hedge funds, has intensified its hedging against carry exposures in cross-currency swaps, further aggravating dollar pressure. This environment has created a vicious cycle in which collateral limitations, regulatory tensions, and global market dynamics contribute to rising funding costs.

Repo and treasury markets

The massive issuance of Treasury securities, especially coupons, has added significant strain to repo markets and dealers’ balance sheets. Dealers must absorb excess issuance to maintain their status as primary dealers, creating additional pressures on their balance sheets. As the U.S. government issues more debt to finance growing fiscal deficits, the liquidity demand to purchase these securities exerts considerable pressure on dealers, who face regulatory and operational limits. This phenomenon affects not only U.S. banks but also international financial institutions’ ability to operate efficiently in repo markets.

The increased leverage in these markets has posed significant challenges to their functioning. During periods of economic stress, such as the global liquidity crises of 2008 and 2020, repo markets have been critical points of systemic fragility. Although the transition from LIBOR to SOFR represents a positive step in terms of transparency and stability, it also introduces additional risks. Corporate credit lines tied to SOFR can become unsustainable during periods of high financial stress, exposing the system to unexpected vulnerabilities.

These dynamics are reflected in increasingly negative swap spreads. Initially, this reflects risk aversion, with arbitrage opportunities between repo and fixed swap rates. However, negative swap spreads deepen when dealers face limitations in intermediation, as higher repo costs prevent them from capitalizing on these arbitrage opportunities.

During periods of regulatory stress, these restrictions amplify. Post-crisis balance sheet and capital requirements further limit dealers’ ability to intermediate, exacerbating tensions in repo and Treasury markets. This cycle of restrictions and rising costs underscores a structural fragility in the global financial system, which could become a significant risk during periods of systemic stress.

Fragility in the Eurodollar system

The growing U.S. public debt adds another layer of complexity to global funding markets. While Treasury securities remain perceived as safe havens, their rapid accumulation poses long-term risks. Uncontrolled debt growth could place additional pressure on dealers, making it harder for them to intermediate and provide liquidity to the market.

The peak usage of reverse repos, where money market funds park excess cash, has added further pressure and increased the system’s fragility. This phenomenon not only absorbs liquidity that could be used for private investments but also heightens competition for high-quality collateral. As this dynamic intensifies, the financial system’s ability to facilitate leverage diminishes, limiting economic growth and imposing significant fiscal pressure on taxpayers.

Additionally, these tensions drive up the dollar’s value, making it harder to obtain in wholesale and synthetic markets like cross-currency swaps. This dollar appreciation particularly affects emerging economies and market participants relying on these instruments for dollar funding.

The challenge is compounded by the global economy’s increasing dependence on the U.S. dollar and Treasuries as reserve assets. While this dependence reinforces the dollar’s position as the world’s reserve currency, it also amplifies tensions during financial stress. In periods of uncertainty, this dependence creates a vicious cycle where liquidity constraints, rising funding costs, and the lack of effective alternatives to dollar-denominated assets intensify global financial system fragility.

Consequences

While we are not facing a seismic monetary event, the global financial system is under elevated pressure in funding markets. These tensions have been amplified by dealers’ difficulty intermediating with their collateral inventories, driven by both regulatory factors and direct pressures on those inventories.

Negative swap spreads and elevated SOFR peaks reflect a reduction in intermediaries’ balance sheet capacity. This phenomenon is exacerbated by tensions in the Eurodollar system, where many currencies are depreciating against the dollar, increasing the need for dollar funding to contain exchange rate pressures. If this pressure intensifies and persists, the risks of destabilizing the global financial system are significant.

In response, the FED has expanded the Standing Repo Facility (SRF) as a measure to ease tensions in bank reserves. However, this action may be insufficient if tensions persist and affect collateral, the only asset that can be rehypothecated to generate more credit and liquidity globally.

The G30’s work on the 2023 regional banking crisis has already highlighted collateral’s critical role during financial stress. Focusing solely on bank reserves overlooks a crucial part of the problem. As QT matures bonds, it also reduces the availability of collateral for rehypothecation, indirectly affecting reserve movements. This is especially relevant in a context of asymmetric reserve accumulation, where liquidity concentrates in certain institutions, leaving others facing shortages in a globally tense financial environment.

In this framework, the interaction between QT, collateral management, and Eurodollar system dynamics underscores the need for a more comprehensive approach to addressing current tensions. Ignoring these interdependencies could lead to more severe mismatches in financial markets, with potentially disruptive consequences for global stability.