Boxing Day: The year-end squeeze in money markets

While equity investors enjoyed eggnog and a holiday rally, money market desks were dealing with the annual squeeze that comes with year-end balance-sheet reporting. At the turn of the year, global systemically important banks (G-SIBs) shrink their balance sheets hard to keep Basel surcharges down, and for a while they pull market-making capacity out of the repo market.

Why the calendar matters

The incentive is written into the rules. The extra capital a global bank must hold depends on a score built from measures of its size, interconnectedness and complexity, and several of those measures are taken as a snapshot at the end of the year. A bank that carries a smaller balance sheet on 31 December can land in a lower surcharge bucket for a whole year, saving capital worth far more than the profit from a few days of repo lending. Shrinking for the photograph is therefore rational, even if the picture is misleading.

Foreign banks face a sharper version of the same pull. European and Japanese lenders report their leverage ratios on quarter-end figures, while American banks report averages over the quarter, so the non-American banks cut back at every quarter-end and hardest at the year-end. Those banks are big intermediaries in the dollar repo market, lending cash against Treasuries to hedge funds and dealers. When they step back, borrowers must find the money elsewhere and pay more for it.

Banks step back for the snapshot

Non-bank counterparties then have to park spare cash at the Federal Reserve's Overnight Reverse Repo facility, and repo rates spike for reasons unrelated to demand for money. The Fed's standing repo facility caps the damage. The yearly contortion still shows how much friction post-crisis rules have built into the plumbing. It works only because the central bank will deal with everyone.

The two facilities form the floor and the ceiling of the market. Money-market funds can lend to the Fed overnight at the reverse repo rate of 5.30 per cent, so they rarely lend to anyone else for less. Banks and dealers that are eligible can borrow from the Fed's standing repo facility at 5.50 per cent, the top of the policy range, so private repo rates rarely rise much above that. At the year-end the private market thins out, and cash flows back and forth across both boundaries as the usual intermediaries retreat.

A cushion that is shrinking

This year-end differs from recent ones in one respect. At the end of 2022 money funds had more than $2.5 trillion parked at the reverse repo facility, a vast pool of idle cash that could flow into private repo whenever rates there rose. Since the debt-ceiling deal in June, the Treasury has sold a flood of bills, and money funds have moved much of that cash out of the Fed facility to buy them. The pool has fallen sharply, which leaves less spare cash to smooth out the year-end. It now holds roughly $700 billion, still a sizeable buffer but well under a third of its peak.

At the same time the Fed is shrinking its bond holdings by up to $95 billion a month, which drains reserves from the banking system once the reverse repo buffer is used up. Bank reserves are still above $3 trillion, comfortably more than the minimum the Fed thinks the system needs. Each year-end with a smaller buffer, however, is a test of how close to that minimum the system has drifted.

When the plumbing jammed

The market has a recent reminder of what happens when cash runs short. In September 2019, as corporate tax payments and a large Treasury settlement drained reserves on the same day, overnight repo rates briefly jumped to around 10 per cent, several times the Fed's target. The central bank had to lend hundreds of billions of dollars through emergency repo operations and later began buying Treasury bills to rebuild reserves. The standing repo facility, set up in 2021, is the permanent version of that emergency fix.

The 2019 episode was not a year-end event, which is the point. Reserves had fallen further than officials realised, and the pinch came on an ordinary day in the middle of a month. Year-end squeezes are predictable and usually fade within a day or two; the dangerous ones are those that reveal a shortage that had been building unseen. Quantitative tightening, under way since June 2022, shrinks the Fed's balance sheet every month, which makes such a hidden shortage more likely as time passes.

Who pays for the squeeze

The cost lands on those who borrow in the repo market over the turn of the year: hedge funds financing Treasury positions, including the leveraged basis trade, and dealers holding inventories of bonds. Foreign banks and companies that need dollars pay through the cross-currency swap market, where the cost of borrowing dollars over the year-end also rises. Money-market funds, by contrast, earn a little extra for lending at the right moment. Japanese banks, whose financial year ends in March, add a second and smaller squeeze each spring, so the pattern recurs well beyond December.

The case for the rules is that capital surcharges have made the biggest banks safer, and a few days of higher repo rates each December is a small price for that. The case against is that rules measured on a single date invite banks to window-dress, and that the Fed ends up standing behind the market precisely when private intermediaries withdraw. Regulators have discussed measuring surcharge indicators as averages instead of snapshots, which would remove most of the year-end effect.

The year-end repo squeeze is a creature of regulation. Rates should settle within days, and the squeeze will return each December for as long as banks are judged on a single year-end snapshot. With the reverse repo cushion thinner than at any recent year-end and the Fed still shrinking its balance sheet, the first quarter is when the plumbing gets its real test, and a spike on an ordinary day would push the Fed to discuss slowing its bond run-off sooner than it has signalled.