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The Reverse Repo Controversy

After managing to push so-called “meme-stocks” to unprecedented and unjustifiable record highs, the Reddit traders have stumbled upon what might turn out to be the “next big thing” in amateur trading: the Fed’s overnight reverse-repurchase agreement facility.

The phenomenon of coordinated amateur trading that we first flagged as a potential risk in BFI Bullion’s July 2020 edition of the Digger doesn’t seem to be going away anytime soon. After creating extreme volatility in various meme-stocks such as GameStop and AMC, rookie traders have now turned their attention to an obscure and highly technical corner of the market, one that they don’t even have access to.

The Fed’s reverse repo operations have been the focal point of countless discussions on online forums, especially Reddit, the preferred “meeting point” of thousands of amateur investors. Every afternoon, many of these traders monitor closely the central bank’s website, looking at the latest moves in the reverse repo market, coordinating and aligning their strategies accordingly.

What they’re actually looking for are signs of an imminent market crash, the onset of a deeper economic recession, and in some cases, the collapse of the financial system itself. They see the drastic increase in the use of this facility by banks and money market funds as clear evidence there’s something really wrong in the markets and in the real economy. And they are convinced that these developments constitute a “canary in the coal mine”.

The Fed’s reverse repo operations, or RRP, is a complicated and relatively unknown part of the “plumbing” of the financial system. The facility was established back in 2013 in an effort to prevent short-term interest rates from dipping below 0%, and most “mainstream” investors, even professional ones, aren’t aware of it. Even those who are, pay little attention to it.

As FX investor and Nasdaq contributor Martin Tillier concisely explained in a recent analysis on this topic, “A repo is a way for the Fed to add temporary liquidity to the market, whereby the central bank’s open market desk purchases assets from banks for a short time, usually overnight, before reversing the deal. It is basically a loan of cash to the bank, guaranteed by the assets purchased. A reverse repo is, logically enough, the reverse of that, where the bank makes a short-term, guaranteed loan to the central bank. Reverse repos are a sign of excess liquidity in the system, meaning that banks have money left over after covering their liabilities and investing and lending what they are comfortable with.”

Even more plainly put, the RRP is a safe place for banks to park extra cash that they don’t know what to do with. With yields on short-term paper pushed close to zero or below, the 0.05% that the reverse repos offer has become increasingly popular, and its use has exploded over the last year. As Bloomberg reported, “in anticipation of greater demand for the facility, the Fed boosted the size of the counterparty limit in March of this year — followed by a doubling of the cap in September — and made changes to counterparty eligibility criteria to make it more accessible.”

For the armies of amateur traders, this shift was a sure sign of trouble ahead. Especially after usage of the facility recently surged to an all-time high of $1.6 trillion, many of them became convinced that there’s a lot of market turmoil and even a full-blown recession on the horizon. The way they see it, if the banks themselves can’t find a sensible place to put their excess liquidity, if they don’t trust the markets and if they are reluctant to put their extra cash to work through lending, then perhaps they know something that the small, individual investors does not.

Whether the theories that make the rounds in these forums are accurate or not is really beside the point. As we saw in the past, ideas can go “viral” and the “hive-mind” can easily produce self-fulfilling prophecies. Coordinated trading has the capability to do more than just move the needle, as was illustrated by the GameStop saga, and it can have a very real impact on the market.

Given the swelling numbers of rookie traders, the rise of tip-sharing platforms and the exponential adoption of online trading, this is certainly a development that even traditional, conservative investors should pay close attention to.

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