The U.S. Treasury's Office of Financial Research (OFR) published its "2024 Annual Report" earlier this week, and the update contains a number of mentions of repo, money funds and stablecoins. (See the press release here.) The report says on "Treasuries," "Risk arises from the basis trade because the profit on individual transactions is usually small, and investors often use leverage to achieve large positions. Most often, this is done by funding Treasury purchases in repurchase agreement, or repo, markets. A repo is a contract in which a market participant sells an asset with an agreement to buy it back. Repos require posting extra collateral if the price of the Treasury drops. If collateral requirements rise and the trade, including the cost of leverage, becomes unprofitable, or if repo funding dries up, the investor may unwind the trade by selling the Treasury and buying an offsetting future. This happened en masse in March 2020, adding to market stress."
Discussing "Securities Lending," OFR writes, "Financial stability risks are influenced by securities lenders' ability to quickly return collateral. The lender owns the collateral provided by the borrower. Often, the collateral is cash, and the lender can place it into short-term money market investments. If security prices move significantly, then many borrowers may decide to return securities they have borrowed to their lenders. The lenders must quickly return the collateral and typically liquidate the associated investments. For example, if many stocks experience large price changes, flows out of short-term money markets might be large. Moreover, if the securities lender puts the collateral in illiquid investments and the investments fall in value, the lender will bear the loss. In the worst case, these dynamics can weaken the securities lender, often a large financial institution, and have potential knock- on effects for the financial system."
It comments, "Total deposits have changed little since the Federal Reserve began raising short-term interest rates in 2022.... Some depositors moved money into money market mutual funds (MMMFs) or other instruments that pay market rates of interest. However, the fraction of all deposits estimated to be uninsured has been fairly stable for many years."
OFR states, "Money markets support core functions of the financial system. They offer savers and investors access to very short-term debt instruments that have features similar to cash, or government-issued currency. Holders use these debt instruments to store value in cash substitutes that offer additional yield, to support their ability to make payments, and as collateral. Issuers use these debt instruments to manage the ebbs and flows of cash and to fund investments in other assets. Central banks use some of these instruments, mostly government-issued debt and repos, to achieve their interest rate targets. Money markets currently do not appear stressed, but that can change with little warning, in contrast to many other parts of the financial system in which stress develops more gradually."
They explain, "Money markets are liquid when lenders can readily access their funds and borrowers can obtain funds when they want and at a relatively low cost. Some money market instruments involve the risk of default or an inability to quickly convert assets to cash. A sudden loss of confidence can lead to runs and asset fire sales, causing funding to become less available to money market borrowers. Stress in money markets can also disrupt the ability to make payments. Because money markets are essential to the functioning of the financial system, such stress can rapidly spread."
The report continues, "Vulnerabilities associated with money markets remain moderate. Data gaps remain in repo markets, although a new OFR data collection will reduce them. Money market institutions and instruments are subject to maturity and liquidity risks and associated run risk. In addition, banks and many NBFIs, including those with high leverage, are exposed to default risk from each other through their activities in money markets, especially repo markets. Some stablecoins are inherently susceptible to runs, and stablecoins generally are opaque, making their risk hard to assess. Technology vulnerabilities at FMUs and TSPs on which money markets rely expose payment flows and the broader financial system to the risk of destabilizing service outages."
It also says, "U.S. repo markets are among the largest and most liquid short-term funding markets in the world. Total repo volume has been rising since 2021.... The OFR estimates that more than $4 trillion is outstanding. The rise is partly attributable to changes in the role of repo markets in the Federal Reserve's implementation of monetary policy.... If large repo lenders suddenly decide not to roll over repo, dealers must quickly find other sources of financing or sell assets, which may transmit repo market stress to other markets. For example, many dealers lend to hedge funds using funds borrowed through repos with MMMFs. Withdrawals from MMMFs can be quickly transmitted to hedge funds via repo markets."
Discussing "Money Market Mutual Funds" on pages 68-70, OFR tells us, "MMMFs accept funds from retail, commercial, and government entities. Withdrawals from MMMFs are settled the same day or overnight, and balances can quickly be moved to another investment. MMMFs place the funds in a variety of short-term investments such as repo, CP, and Treasury bills. At about $6.7 trillion as of August 2024, MMMF assets are large."
They claim, "MMMFs are subject to runs if their investors become concerned that they may not be able to withdraw funds on demand at par value. The only way to prevent run behavior is for MMMFs to invest solely in money market instruments with a one-day maturity and issued by entities certain to repay on time. As a practical matter, a sizable share of all MMMF instruments have maturity dates longer than one day. MMMFs' vulnerability does not change over time, in part because money market instruments almost by definition are perceived as safe until they suddenly are perceived differently."
OFR adds, "MMMFs are a significant source of short-term funding for longer-term assets and an important cash-management vehicle for investors. Their investments create a web of connections with the rest of the financial system.... These connections can rapidly transmit adverse shocks at MMMFs across global funding markets. Institutional and retail prime funds differ from U.S. government funds in their ability to invest in the unsecured obligations of private-sector entities. Though such investments are perceived as safe, they carry more credit risk than government obligations. Over the years, prime funds have experienced more sudden outflows akin to runs than government funds. The most recent episode was in March 2020. Regulations were revised in 2023 with the goal of reducing MMMFs' vulnerability to runs."
Finally, the report comments, "Several types of institutional MMMFs are required to report floating NAVs, but some investors may be concerned that NAVs will fall well below $1. In earlier periods of stress, MMMF sponsors played a critical role in preventing NAVs from falling below $1. They also have mitigated potential spillovers to affiliate funds and short-term funding markets more broadly. However, uncertainty about the availability and capacity of sponsor support has also fueled runs. As industry assets have grown relative to sponsors' capital resources, risks associated with reliance on sponsor support have increased."
