December 15, 2009 / 9:19 PM / 10 years ago

Primary dealers ask Fed for breakable repos

* Primary dealers respond to reverse repo tests with Fed

* Dealers say breakable agreements could let in more firms

* No breakability may deter money funds, dealers say

* Dealers seek flexibility from Fed

By Emily Flitter

NEW YORK, Dec 15 (Reuters) - The Federal Reserve’s main dealing partners say adding an escape hatch to a potential central bank tool to drain excess cash from the financial system will broaden its reach.

Since the Fed began testing reverse repos with primary dealers this fall, a handful of the 18 banks that help the central bank carry out its open market operations have recently suggested that so-called reverse repurchase agreements should be “breakable.”

Barclays, for one, told the Fed the tool would be more effective if money market funds had the option to quickly unwind these agreements — in which assets are temporarily transferred from the Fed to market participants in exchange for cash — in an emergency.

Money market funds, flush with cash, are a logical addition to the primary dealers as potential reverse repo counterparties for the Fed, capital markets professionals say. Money market funds could either conduct the repos through primary dealers or forge the agreements directly with the Fed.

“We had recommended breakable repos in the context of repos being expanded to include money market funds,” said Joe Abate, a money-market strategist at Barclays Capital.

“We felt this was an important safeguard in the event money funds face significant redemptions in the future and need to be able to exit a repo transaction and get their cash back.”

As part of its response to the financial crisis, the Fed bought longer-term assets, including mortgage-backed securities. In the process, its balance sheet more than doubled to over $2 trillion. Reverse repos are one tool the Fed could use to help it drain cash and tighten monetary policy when the time comes.

The Fed has said it could look beyond its normal trading partners, the primary dealers, and engage with other market participants, though no decision has been made yet.

WANTED: FLEXIBLE COLLATERAL

But a proposed rule change by the U.S. Securities and Exchange Commission could make it harder for money market funds to participate. The SEC’s new rules would make it illegal for the funds to hold illiquid assets such as the collateral the Fed would use in reverse repos.

Making the reverse repo agreements breakable would fix that, primary dealers say, and add flexibility to the Fed’s operations.

“People are going to need to source their cash at times and give back their collateral,” said George Goncalves, the head of fixed-income rates strategy at Cantor Fitzgerald. He stressed that his views did not represent those of his firm.

Breakable repos would not be the only solution to the money market funds’ constraints, dealers say, but other options would involve requiring dealers themselves to take on more risk — which they are reluctant to do.

If they were to act as intermediaries between the Fed and money market funds, the dealers would have to offer a separate breakable agreement — one that, if exercised, would be costly — to the money market funds.

Market sources said dealers currently offer puts to money market funds that would let them withdraw their cash, but they are usually not priced into a repo deal. So these puts can be used only in an emergency.

A money market fund that exercised one of these special puts in a non-emergency situation would have difficulty engaging in more repos in the future, these sources say.

“Breakable is better for dealers because we’re going to have to do the breakables with money market funds,” said Michael Cloherty, the head of U.S. rates research at BofA Merrill Lynch Global Research. “We would rather have the agreements with the Fed be breakable as well.” (Additional reporting by Kristina Cooke; Editing by Jan Paschal)

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