Demystify the Feds ON-RRP Operations, Why do we care so much about them? | Finally figured out what Michael Burrry IS trying to tell the world

DD 👨‍🔬

Two things that have led me here 1. Trying to figure out WTF Michael Burrry was trying to reference and getting it wrong several times 2. Why the fuck do we care so much about the Feds ON-RRP operation?

There’s been so much hype about the ON-RRP volume the past three months or so, and it made me reflect. I don’t actually know why I’m hyped about it or why people keep posting about it. I had a good idea of why, at least I thought I did, but I decided to go about researching it further and ended up collaborating with a repo expert who’s had over 20+ years in the industry working at 3 different primary dealers.

All I knew was incorrect. From how the Feds ON-RRPs are used, who is putting the money into ON-RRPs, and why I was hyped about it increasing every day.

So let’s go on a journey to understand some history of the Feds ON-RRP operations and how that led me to realising I was looking at the wrong hints from Michael Burrry.

1. A Series of Unfortunate Events

2. Honey, I Sucked All the Liquidity Out

3. Honey, I Blew up the Rates

4. Star Wars: The Fed Strikes Back

5. What Michael Burrrry was trying to allude to (ran outa puns)

A Series of Unfortunate Events

From the above, you can see how this was a disaster waiting from back in 2008 when they started buying up assets due to the GFC. It all came to nip them back in the butt, let’s see what happened next shall we?

Honey, I Sucked All the Liquidity Out

Despite people often referring to 6. (myself included in a past DD) as Quantitative Easing (QE), it’s not. It looks like it though on face value. The Fed had to say it was not specifically in previous notes and meetings, as these types of operations do not stimulate the economy, it’s just the get the markets “oiled up again”. We’re talking about their repo operations here specifically, not adding back assets to their balance sheet.

Rates, Rates and Rates

Before we get into the next section, let’s understand the floor system that the Fed uses. The general gist of a floor with subfloor system, the fed sets several targets. Policy is announced as a target range for fed funds rate, top range of that is given by the IOER that they set and the bottom is the ON-RRP.

Interest Rate on Excess Reserves = IOER = Floor

Overnight Reverse Repo= ON-RRP = Subfloor

Why not call it a roof and floor? To make it confusing for anyone that’s not in their world to understand 😂

Below is a visualisation to help put it in perspective, the federal funds rate aims to sit in the middle generally.

Honey, I Blew up the Rates

What happens if the fed funds rate were higher than the IOER?

That would mean a bank wanting to lend their cash would earn more interest on the fed funds market compared to lending to the fed at the IOER - aka the money the fed pays them on their reserves. This demand for fed funds would then cause the fed funds rate to go down (theoretically).

Let’s Chat ON-RRP

We only talk about the recent spike in activity, and totally ignore what’s happened previously. This ends up leaving us uninformed of the contextual reasons for it spiking.

So starting in that rough 2018 period, it becomes obvious that the ON-RRP facility is not actually helping all that much when it comes to their ability to control the federal funds rate, keeping it within the 25-basis point target range they had back then.

There’s also another reason for their disappearance which is to do with the Fed hiking rates from 2016 onwards, the banks can now get paid more in interest from the Fed on their reserves in comparison. There’s liquidity regulations nowadays in comparison to pre GFC times. The Liquidity Coverage Ratio (LCR) is a big boi, but in summary, banks just need to hold some combination of reserves and U.S. treasury securities to guard against deposit outflows in times of market stress.

Due to a range of reasons, banks actually prefer reserves compared to securities - main reason being if treasuries are sold off quickly, it’ll drive prices down, so in the end, reserves are preferred.

Rate Wars: The Fed Strikes Back

That was a lengthy one, but now you know the contextual history of how the Fed manages its rates and why RRP is exploding (on purpose to manage rates, if that was not clear already). It’s honestly not that big of a deal that people make it. Please remember online new sources do tend to write for viewership, as such, disaster writing will bring in more viewership than boring macro economics talk….

Let’s dig into some myths that often get talked about incorrectly in relation to ON-RRPs operations of the Fed. Before we get to debunking, let’s understand Tri Party and what itm eans.

Tri Party Repos

Both Repo and Reverse Repo operations are done in a triparty format (also remember, they are one in the same transaction). Only around 0.1% are done DVP (directly). This is largely for efficiency purposes - let’s visualise what this tri party process looks like.

The most obvious thing with a triparty repo is that the customer receiving the collateral does not have access it. It’s sitting in the trade shell the custodial bank set-up. So if the they want to re-use the collateral sitting in that shell, it’s actually the custodial bank that’ll set that up. DVP (Direct) can’t be reused unlike Tri-party.

Collateral Re-use is simply as follows, custodial bank takes the existing shell and puts it into another shell.

I think we know enough now, so let’s get to debunking!

Debunk Time!

Hedge Funds are involved with RRP

This is not exactly a popular one, but i’ve seen it mentioned before. HFs have zero involvement in the Feds’ ON-RRP market. The following link plainly debunks this one. https://www.newyorkfed.org/markets/rrp_counterparties#reverse-repo-counterparties

While HFs are not involved with the Feds’ ON-RRP market, they certainly are in the repo market as it’s how they leverage their long positions and cover their short positions.

The effect of the high RRP amounts will blow up everything

The above is dramatic, but you get the general vibe that’s shared within the sub. All the analysis we’ve done above should give you the answer. Once rates increase, money market funds will move elsewhere. We’ve seen recent increases, so why no change in ON-RRP volume? Because MMFs are not gonna show a rate better than 5bps, as the repo market also moved up the same amount… So why move your money if there’s no benefit? We can observe the recent days tapering off in volume since the 5bps increase, so this will likely be the future trend, if not decreasing.

The Fed will continue its balancing act. It is very much a build-up from 2008 and u/criand ’s recent post is some good storytelling on it (as well as this DD from a more technical standpoint). As such the Fed are learning as they go, it’s becoming clear that loading up the ON-RRP facility is not sufficient to influence rates, which is displayed through the most recent rate increase by 0.05%. They just does not care about the volume of ON-RRP being high, because that’s how it’s designed to work, policy-wise. They have far more assets than the participants have cash, so as long as demand is there it’ll keep rising until something otherwise changes (such as rates increasing as mentioned above).

We’re only noticing this because big numbers attract attention and we made a connection between rehypothecation and reverse repos. But wrongly so in my opinion. (pls no pitch forks).

RRP is used to support trading/margin functions

This is not a popular theory either, but better to touch on it while we’re here.

It’s illogical to use RRP as a way to post margin. It “could” be done, but why would you spend cash to borrow treasury securities? You end up in the same spot regardless if you’re using cash or a security to post for margin.

Trading 212

May as well touch on this topic while it’s making its rounds. What’s described in their terms they are trying to get people to agree to is described as a collateral swap with a haircut. The haircut is anything over that 100% mark. To be clear, it’s very common and it should not come as a surprise to anyone who has bought shares through a broker that lends out customers’ shares.

You should get in contact and ask what type of collateral is posted and MORE IMPORTANTLY ask for your shares not to be lent out. If they say “nah dawg”, then ask if you get the profits reaped from the haircut in the case above, or any interest charged.

As to what happens when the MOASS happens and HFs start going bankrupt, no clue. A good topic for someone to delve into. What about bond value taking a dive? Dunno, best guess would be they’d have brokers knocking on their door.

Treasury Securities are being shorted utilising rehypothecation

I think this is probably the biggest theory that’s misunderstood.

It’s technically possible to do this, the problem is that it just makes no sense to do it. The main reason is due to how the shell functions that the Custodial bank sets up. They create a shell for the collateral that the Fed dumps their securities into, the only problem is, the dealer/counterparty does not know which issue they’ll get in that shell. The Fed decides what to put in that shell.

So let’s imagine you are wanting to short a bill and you have a crystal ball.

You’re not gonna be shorting a 3 month bill simply due to the maturity of the trade, and more likely a longer dated issue such as the 30yr where you’ll make far more money.

Using the crystal ball:

IF you knew the bill or bond being given in the RRP shell

AND IF you could sell that issue in time before the market closed for the day AND sell it for cash (same day) settlement.

AND IF the Fed whispered in your ear that you’d have it for a week straight (meaning you won’t have any fail to delivers)

AND IF the Fed did this all in DVP for you (0.1% of all ON-RRP trades, Fed only does Tri-party), else you can’t touch the security as it’s in a shell created by the custodial bank

So if all these unlikely things were to occur, you’re still in the pickle of being in the need to buy back the bond you shorted the next day (because these are overnight transactions remember), if you don’t find it then you’ll be on the hook for 300bps (3%) a day on FTD charges, which in the bond world, is a big deal.

You’d also likely need to be a primary dealer (big boys like goldman) to pull this off in the first place, but the Fed would get pissed and you’re jeopardizing your primary dealership status - which is something you don’t want to risk as you’ll make more money being a primary dealer rather than being kicked out of the club.

The source i’ve been working with has said over his 24 years time at a variety of primary dealers, Not one would have voluntarily shorted ON-RRP bonds. It’s just way too risky and there’s virtually no upside - IF you could even pull off the above in the first place.

Figuring out what MB meant this whole damn time….

There’s been three things that Michael Burrry mainly tweets about

1. Cryptocurrency

2. Inflation

3. Leverage

(and random non financial stuff - borrrrinnngggg)

I’ve personally been on a mission to understand wtf he meant ever since he deleted his profile the first time, leaving us a link to a note from the federal reserves on the in and outs of collateral re-use (pictured below).

The Fed note was so so heavily focused on Reverse Repos, Repos, Rehypothecation that it clouded my judgement in terms of what he was trying to reference within that paper. Largely because it was the talk of the town at the time (and still is), but as we went through above, the purpose of that was to show that the ON-RRP numbers we screenshot all day are not a huge concern.

It’s the tweet above that ironically connected the dots for me, but also answered the question in itself as it gave us what we already knew in a way. But i’ll walk you through what i perceived him trying to point out in regards to the speculative bubble. I believe this was the chart he was alluding reference to, specifically, the margin loans trend.

Unencumbered Products

This refers to positions that are purchased outright that are free of legal, regulatory, contractual or other restriction on the ability of the reporting entity to monetize the assets. The entity in this case are primary dealers, the big bois of the world, of which 24 exist. You can find the list here, names from Goldman, Morgan Stanley to you get the gist. Now note, the chart above is only based on a subset of primary dealers, so the numbers could very well be bigger.

Back to the Chart

What we can see is the following:

I was attempting to find what “order of magnitude by 2” he was referring to, and the closest thing i can refer to is the total is how margin+cash accounts have gone from millions -> billions -> trillions. The greatest crash in US history was “The Wall Street Crash” in 1929 (or at least most famous, please correct me if i’m wrong), sadly i don’t have data that goes back that far - but i don’t think it’d be a long shot to imagine that aggregate margin+cash accounts may have been in the tippy top of the millions in the 1920’s.

Therefore we’ve gone from millions in the 1920’s to billions in the late 1900’s and we’ve just hit the trillion mark in Dec-2020. So there are your two orders of magnitude ladies and gentlemen.

And that is what i believe MB has been referring to, we obviously did not figure it out, because the dude had to come back from his SEC enforced slumber to literally serve it up on a plate via a tweet.

It essentially comes down to this logic in the past year since COVID happened, with primary dealers, aka big banks like Goldman saying “Yeah nah, we’re not gonna get fucked, let’s pump cash into the market via our HF buddies to make sure they don’t tank and continue their bull run” - All while being leveraged to the tits… pretty easy judgement to make from my POV. As we say, kick that can down the road.

TL;DR

• The Feds ON-RRP are really nothing to be worrying about, let alone posting everyday. As soon as rates go up high enough, Money Market Funds (make up majority of ON-RRP volume) will take their cash elsewhere (we’re starting to see this already)

• Hedge funds are not involved in ON-RRP as they are not “on the VIP list” if ya get what i mean

• ON-RRP is not used to support margin/trading functions

• Treasury securities that are rehypothecated are not being shorted (it’s purely illogical)

• Margin balances are fucked at $800b+ an ~83% increase from last year. It really feels like they are trying to prop the market up via speculative and spectacularly dumping cash into the market (don’t forget the increased presence of retail in these markets now as well)

Counter DD

The first part of the DD tends to go against the grain of https://www.reddit.com/r/Superstonk/comments/o9aanm/black_monday_events_are_mondays_which_experience/ which is u/Criand’s post about RRP in some areas. To note, i agree on most points about the spikes re EOM dates.

The thing i have the largest disagreeance with is that the Feds ON-RRP operations are something to worry about. As soon as rates go up to a certain level, MMFs will start moving their cash elsewhere and ON-RRP volume will shrink again (and treasury balance for the Fed increases as a result). My prediction is that we’ll enter a similar cycle before 2020 where rate increases become more abundant (we’re seeing hints of this already with recent 5bps increase).

Edit: Fuck. Ignore the orders of magnitude part. I overshot big-time 😅 10^6, 10^12, 10^18, far more than two orders of magnitude. It however may be referring to different events 🤔Let me know your thoughts in the comments!

Edit:

Thanks for taking the time to read, judging by the top comments while I was asleep, it looks like i succeeded in creating some awesome discussion and further thoughts on this topic! I encourage you to take this further and write even better DDs that help promote our knowledge within the sub on the matter!

Thanks for the great comments u/Longjumping_College, u/Criand, u/lightwhite u/Modswithnobods!