The Fed’s policy announcement to raise rates had one technical detail that didn’t get much media attention but is actually quite important. The reverse repo (RRP) rate was not only raised from 5bp to 25bp but the Fed also removed the cap on the RRP facility (which was at $300bn). It means that the program participants such as banks and money market funds can place nearly unlimited amounts of liquidity with the Fed overnight and earn 25bp. The program size is only limited by the size of the Fed’s securities holdings which exceed $4.2 trillion.

This sets the overnight riskless rate at 25bp which becomes the floor for the Fed Funds rate (and other money market rates such as commercial paper and private repo).

The immediate demand to place overnight funds with the RRP facility has been relatively modest at $143bn (note that we should see the reserves at the Fed drained by the uptake amount in the next H.3 report).

Source: NY Fed

Instead of using RRP, many market participants are enjoying the tightness in the private repo markets as general collateral (GC) repo now clears about 20bp above the RRP rate. The key reason for this relatively elevated spread is the increased regulatory pressure on banks to cut back on their balance sheet usage.

Source: DTCC

However the RRP demand is expected to spike at year-end as banks focus on window dressing. Given the somewhat elevated level of market stress and no cap on the RRP facility size, the uptake will be particularly large this time as we saw at the end of Q3 (note that the chart below shows the total reverse repo held by the Fed, which includes RRP).

Source: St. Louis Fed

Some are concerned that given the pressure on banks’ balance sheets, this shift to RRP could disrupt the private markets on December 31st and send the GC repo rates to new highs.