Boxing Day: Why money markets get jumpy at year-end

The Secured Overnight Financing Rate (SOFR) has started jumping about again as the year ends. Money market desks know the pattern. Primary dealers and the biggest global banks are short of balance-sheet room, and wholesale funding markets feel it every December.

SOFR is the benchmark that replaced LIBOR, and it measures the cost of borrowing cash overnight against Treasury securities in the repo market. On a normal day it sits close to the range the Fed sets for its own policy rate. At month-ends and especially quarter-ends it has lately jumped above the rate the Fed pays banks on their reserves, as it did at the end of September. The turn of the year is the biggest of these dates, because it combines a quarter-end, a year-end and the snapshot that determines banks' regulatory charges for the following year.

Banks tidy up for the snapshot

Under the Basel G-SIB rules, global banks’ systemic risk scores are based on their balance sheets at the end of the year. That gives them a strong reason to shrink for a few days and pull back from repo lending on the last trading day. Non-bank borrowers then have to pay a hefty premium for cash over the turn of the year. The plumbing still works, but only after some awkward contortions.

The incentive is concrete. The score places each large bank in a bucket, and each bucket carries an extra capital charge. A bank close to the threshold of a higher bucket can save a meaningful amount of capital by trimming its size, its short-term funding and its trading assets on the measurement date. Repo lending is easy to cut for a few days, so it is the first thing to go. Many foreign banks also report leverage ratios based on quarter-end balances, which gives them a similar reason to step back on the same dates.

Who pays the premium

The borrowers left short are mostly outside the banking system. Hedge funds that finance holdings of Treasuries through repo, including those running the popular trade that exploits small price gaps between bonds and futures, need to roll their borrowing every day. So do smaller dealers. When the big banks step back, these borrowers must bid up the rate to find cash from other lenders, chiefly money-market funds, which are the main winners from the spike. The costs are small for a single day but add up for leveraged funds, and any disruption can spill into the Treasury market itself.

Why it is worse than last year

The system has less spare cash than it did. Since 2022 the Federal Reserve has been shrinking its balance sheet by letting bonds mature without replacing them, which drains reserves from the banking system. For most of that time the drain fell on the Fed's overnight reverse repo facility, where money-market funds park surplus cash. Balances there have fallen from more than $2 trillion at their peak to a small fraction of that. With that buffer largely used up, further tightening now falls on bank reserves, and repo rates have become more sensitive to swings in demand.

The Fed has noticed. It slowed the pace of its balance-sheet reduction in June, and it runs a standing repo facility, created in 2021, through which eligible dealers can borrow cash against Treasuries at a set rate. That facility acts as a ceiling, though some firms are reluctant to use it for fear of signalling distress, and not all borrowers have direct access.

The warning from 2019

Year-end spikes are an annoyance. The episode that matters is September 2019, when a combination of corporate tax payments and a large Treasury settlement drained cash from the system and overnight repo rates briefly shot up to several times their normal level. The Fed was forced to inject cash through emergency repo operations and later resumed buying Treasury bills. The lesson was that reserves had fallen below the level banks needed, and that the point at which scarcity bites is hard to spot in advance. The recent pattern of quarter-end spikes suggests the system is edging closer to that point again.

The case for calm

There are reasons not to overreact. The spikes have been short and predictable, the standing repo facility is there as a backstop, and the Fed has said it will stop shrinking its balance sheet well before reserves become scarce. The reinstatement of the debt ceiling on 1 January should also help in the short run, since the Treasury will run down its cash account at the Fed, which adds reserves back into the banking system while bill issuance shrinks.

Those factors will probably ease pressure early in the new year. They do not remove the structural incentive that produces the year-end squeeze.

A fix on the table

The Fed proposed in July 2023 to measure several of the indicators that feed the G-SIB score as averages over the year rather than as year-end snapshots. That would remove much of the incentive to shrink for a few days in December. The proposal has not been finalised, and its future under the incoming administration is uncertain.

The year-end spike in funding costs is a by-product of the rules. It will probably fade in the first days of January, and return next December unless regulators change how the scores are measured. Until they do, expect leveraged funds to keep paying a premium to money-market funds every December, and expect quarter-end spikes to grow if the Fed keeps draining reserves through the first half of next year.