OVERNIGHT REPURCHASING AGREEMENTS – HOW SAFE ARE THEY FOR INSTITUTIONAL INVESTORS?

Stores of value comes in many forms in traditional finance. US Treasury bills, cash, bank deposits, corporate bonds, repurchase agreements, gold, silver, housing and land, to name the most popular. There are significant differences between these stores of value which are considered by all economic actors when safety concerns become predominant: Liquidity or how easy it is to trade these assets and how different risk factors may affect them. Let us look at the process of repurchasing agreements (repos) involving very liquid instruments of Treasury securities and money.

This article addresses the part of the financial market, which is more sophisticated and mostly used by the institutional investors or financial experts. However, today solutions are becoming available in the blockchain and digital currency space that can overcome certain hurdles that in the past have been factors in the moments of crisis in the financial markets. Blockchain will soon start introducing such simple products that will be also able to cater to the needs of such sophisticated institutional investors.

 

SECURING BANK EXCESS RESERVES OVERNIGHT

Using a central bank like Federal reserve for overnight repurchase agreement is considered one of the safest options that is not only secure, but also brings interest. The current interest rate on required reserves (IORR) is 2,40%. Considering that liquidity cannot be an issue, this is a good solution for banks in times of depressed economy or systemic trouble. There is no way the FED can lose your money barring a catastrophic event that would wipe out the global power grid. But there are some caveats.

You must be a bank with a registered account at FED to be able to park excess reserves in this manner. This option is not available to institutional investors. The next best thing for these market actors is the overnight repurchase agreement, where they place their money in a bank, get a Treasury security as collateral, and redeem it the next day. In this way, interest is also collected which has recently been hovering around that of the IORR.

A less safe option would be to simply deposit the funds overnight at a bank without getting a Treasury security. If the bank collapsed an investor has no security to sell, which is a concern for larger players as smaller deposits are covered by insurance.

Generally repurchasing agreements containing two very liquid stores of value, money and a Treasury security are deemed a safe short-term operation only slightly riskier than placing funds directly at FED. The risk lies within the possibility that money may disappear overnight and the value of the Treasury security drops at the same time, so it can’t be sold for more than the sum deposited in a bank.

 

THE NARROW BANK SAFE HAVEN REJECTED BY FED

To eliminate this risk for institutional investor, a new financial institution called The Narrow Bank (TNB) was proposed. The idea behind it is very simple. An institutional investor would open an account at TNB and deposit funds, which would then be placed at the FED by TNB. The FED would pay the IORR and TNB would return the funds to the investor while retaining a small commission.

This idea was rejected by the FED, worrying that such an institution might interfere with its macroeconomic goals, attracting a lot of depositors and inflating its balance sheets. Another issue was the possibility that lenders might find such deposits more attractive than repurchasing agreements, thus negatively influencing the trading of stock and bonds funded by this process. The flow of funds rushing into TNB could also exacerbate a crisis situation, depriving the banking system of short-term funding. The FED argues that too much safety might have a destabilizing effect on the economy as the predetermined interest rate available to TNB that would not get lower with increasing demand, would make it a more attractive option than US Treasury bills.

 

REPURCHASING AGREEMENTS COULD HAVE PLAYED A MAJOR ROLE IN THE FINANCIAL CRASH OF 2008

There is another good reason for seeking alternatives to repurchase markets for security reasons. According to a study done in 2009 by Gorton and Metrick at National Bureau of Economic Research, it was a run on repurchase market, rather than on bank deposits, as had been the case in the past, that eventually caused the insolvency of the US banking system.

Investment and commercial banks were heavily involved in securitized banking before the crisis. Buying securitized bonds mainly composed of mortgages also involved protection from the seller in the form of repurchasing agreements. The authors tracked the difference between the 3-month LIBOR (London Interbank Overnight Rate) and OIS (Overnight Index Swap), using this spread as a proxy for fears about bank solvency.

As panic spread in August of 2007 lenders became unwilling to provide short term financing at historical spreads, which led to a rapid increase of the LIBOR – OIS difference. For some assets, the repurchasing agreements disappeared completely. With increasing haircuts on even high-rated collateral, the markets became increasingly aware of the pressures on the banking sector which led to doubts about liquidity and solvency until the government had to step in with bail-outs.

In short, dependence on overnight repurchasing agreements loans for financing mortgage-backed securities is a very risky business. When this dynamics collapses, it may affect also the less risky repurchasing agreements that have Treasury securities as collateral and the system freezes.

 

X8CURRENCY – INSTITUTION-FRIENDLY SAFE HAVEN

Let us conclude this brief overview with the benefits of the X8Currency for institutional investors. Unlike an institution like the Narrow Bank, there is no limited time frame, but there are limits to the funds placed in X8C due to the finite number of X8X licence tokens. This does not only preclude exacerbation of crisis, but gives large players  an opportunity for active involvement in X8 dynamics as distributors, while providing ample space to accommodate risk-aware larger investors holding the said licence.

The structure of the X8 project seeks balance between acceptable safe haven assets from the standpoint of legal compliance as well as systemic risk and revolutionary fintech solutions. X8currency is a systematic solution for many of the sophisticated challenges of the financial system and is more than merely a tokenized form of a traditional currency. At the same time the X8currency product is among very few new forms of money out there, which is also at the same time respecting the monetary policy mandates of the central banks.

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David Prezelj
David Prezelj

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