Overnight reverse repurchase, or OverNight Reverse RePurchase in English, or ON RRP for short, is a monetary policy auxiliary tool launched by the Federal Reserve in 2013. Its purpose is to allow the Federal Reserve to quickly absorb excess U.S. dollars outside the banking system in the short term. It is mainly used to shrink the liquidity of U.S. dollars in the market. It is the lower limit interest rate of the Federal Reserve's interest rate corridor (Interest Rate Corridor), which is commonly known as the "floor interest rate." Overnight reverse repurchase actually functions as a short-term "shrinking" process. Since the U.S. dollars on the market have entered the Fed's account, they are not circulating in the market in the short term. Therefore, paying attention to the overnight reverse repurchase volume is of great significance for understanding the US dollar liquidity in the market. The process of overnight reverse repurchase is: the Federal Reserve "lends" a variety of bonds it holds to institutions on the previous day, and the institutions put the U.S. dollars they hold into the Fed's account. The next day, the Federal Reserve returns these U.S. dollars and a certain amount of interest to the institution, and the institution "returns" the bonds obtained the previous day to the Federal Reserve. In this process: “Bonds” include U.S. Treasury bonds, agency bonds, or mortgage-backed securities (MBS); “Institutions” include money market funds, financial depository institutions and other institutions outside the banking system; "Interest" is the interest calculated based on the overnight reverse repurchase rate. The original intention of the overnight reverse repurchase facility is to allow the Federal Reserve to better adjust the liquidity of US dollars in the market. When there is an excess of US dollars in the market, the overnight reverse repurchase facility is used to absorb excess US dollars and help the market return to a stable state. The overnight reverse repurchase rate is determined by the Federal Reserve, and this rate is the lower limit of the "interest rate corridor" established by the Federal Reserve. It should be noted that overnight reverse repurchase is different from the Federal Reserve's Overnight Repo Facility (Standard Repo Facility, or SRF). The two processes are exactly the opposite. The overnight reverse repurchase is the Fed's withdrawal of market liquidity, while the overnight repo facility is the Federal Reserve's injection of liquidity into the market. What is the significance of overnight reverse repurchase? The purpose of overnight reverse repurchase is to assist the Federal Reserve in shrinking the liquidity of US dollars in the market. When there is a surplus of U.S. dollars in the market, an effective tool can be used to reasonably absorb the excess U.S. dollars, maintain reasonable liquidity of the market, and maintain the healthy development of the market. Here’s PensionCraft’s explanation of overnight reverse repos: The working principle of overnight reverse repurchase is as follows: If there is a surplus of U.S. dollars in the market, if it is not absorbed in time, the excess of U.S. dollars may cause inflation and disrupt the normal development of the economy. At the same time, overnight reverse repurchase can also be used as a current account for U.S. dollars held by financial institutions. When financial institutions are in urgent need of U.S. dollars, they can withdraw the U.S. dollars from overnight reverse repurchase at any time without selling U.S. Treasury bonds. This also ensures the stability of U.S. Treasury bonds in the market. For financial institutions, if excess US dollars cannot obtain reasonable returns through conventional financial investments, they can seek an asset allocation method that can obtain safe and reasonable returns. As a result, the institution can submit an overnight reverse repurchase demand to the Federal Reserve. The institution will hand over the excess money to the Federal Reserve in exchange for bonds, and return the bonds to the Federal Reserve the next day to recover the principal and receive interest at the same time. If necessary, this operation can be continued the next day, allowing the excess cash to generate value. When overnight reverse repurchases continue to occur, it is equivalent to the Federal Reserve withdrawing excess U.S. dollars from the market, because as long as overnight reverse repurchases occur, the money is in the Fed's account and not in the market. The effect achieved is similar to the "shrinkage" adopted by the Federal Reserve. As a result, overnight reverse repurchase uses the Federal Reserve to "sell" bonds and provide interest when "buying them back" to absorb excess cash in the market and help the Federal Reserve maintain the balance of market liquidity. Why did the Fed launch an overnight reverse repurchase facility?
The Federal Reserve regulates U.S. dollar liquidity in the market by setting a target federal funds rate (Federal Funds Target Rate), which is the so-called "anchor rate." With the help of the federal funds rate, when inflation occurs in the market, the Fed raises the interest rate to curb inflation and control price increases. When deflation occurs, the Fed lowers interest rates to increase currency liquidity in the market and stimulate consumption. However, the interest rate in actual use is not a fixed value, but an interest rate range based on the target fund rate, which is commonly known as the "Interest Rate Corridor" in English. This interest rate range is the interest rate range provided by the Federal Reserve when it provides loan facilities and deposit facilities to financial institutions. The lower limit of this interest rate corridor is limited by the overnight reverse repurchase rate set by the Federal Reserve. In order to deal with the possible serious excess of US dollars, the Federal Reserve launched an overnight reverse repurchase tool. The purpose of this tool is that when the federal funds rate cannot effectively control currency liquidity, the Fed can use this tool to quickly absorb excess cash outside the banking system in the short term. During the adjustment process, if FFR is higher than ON RRP, it means that the institution can obtain more interest returns by lending funds to other financial institutions than lending to the Federal Reserve, so ON RRP does not work. If the FFR is temporarily lower than the ON RRP, then institutions will be more willing to actively lend the remaining funds to the Federal Reserve to obtain better interest returns. Then the ON RRP will begin to play its role, and the Federal Reserve will be able to effectively recover excess cash in the market, and at the same time will also increase the FFR interest rate above the ON RRP. Therefore, the ON RRP becomes the lower limit of the interest rate corridor. In the past, overnight reverse repurchase was used as an auxiliary tool for the Federal Reserve to adjust monetary policy, and its use and trading volume were not large. But starting in 2021, the trading volume of overnight reverse repos has surged rapidly, and even recently exceeded $2 trillion. Data source: St Louis Fed This is mainly due to the fact that the Federal Reserve stimulated the economy by increasing currency issuance during the COVID-19 epidemic. As the epidemic slowed down and various industries resumed work and production, these additional U.S. dollars became excess cash in the market. At the same time, the prices of almost all investment assets were seriously overvalued. Therefore, institutions used the excess cash they held to replace bonds from the Federal Reserve and obtain the interest on overnight reverse repurchases and obtain a certain amount of income. As a result, the total amount of overnight reverse repurchases exceeded US$2 trillion. At the same time, the Federal Reserve briefly recovered some of the excess cash in the market, playing a short-term role in "shrinking its balance sheet." How is the overnight reverse repo rate determined? The overnight reverse repurchase rate is set by the Federal Reserve’s FOMC meeting, and overnight reverse repurchase operations are conducted through the New York Fed’s Open Market Trading Desk [source]. For example, on October 25, 2022, the overnight reverse repurchase rate was 3.05%, so the actual inter-bank lending rate was higher than 3.05%. That is, if the Bank of Japan deposits excess dollars with the Federal Reserve, the Bank of Japan Historical data for the overnight reverse repo rate is as follows: Overnight reverse repo rate: St. Louis Fed Let me emphasize again: the overnight reverse repurchase rate is the lower limit of the interest rate corridor set by the Federal Reserve. What does the increase in overnight reverse repurchase volume mean? An increase in the volume of overnight reverse repurchases often means that institutions have a large amount of excess funds on hand. For example, the volume of overnight reverse repurchases has increased sharply starting in 2021. This phenomenon may mean the following issues to pay attention to [source]: 1. A glut of dollars outside the banking system Institutions outside the banking system mainly refer to money market funds. In English, they are Money Market Funds, or MMF for short, which is a personal account similar to an interest-bearing checking account.
During the COVID-19 period, the quantitative easing policy greatly increased the supply of US dollars in the market through large-scale purchases of Treasury bonds and MBS. Such accounts also received a large amount of funds, but during the same period, there was a shortage of high-quality investment objects. So, as COVID-19 eases and ends, these surges lead to excess dollar liquidity, which increases overnight reverse repo volumes. 2. The supply of U.S. Treasury bonds decreases During the COVID-19 period, the Treasury Department responded to the impact of the epidemic by issuing additional U.S. Treasury bonds, which increased the amount of reserves in the U.S. Treasury’s TGA account. As the epidemic eased, the Ministry of Finance began to reduce the issuance of U.S. Treasury bonds. As the issuance of U.S. Treasury bonds decreased, the risk-free assets available for investment in the market decreased, thereby increasing the stock of U.S. dollars in the market, resulting in an increase in ON RRP. More U.S. investment tips What are Bollinger Bands and how do I use them? What is Moving Average (MA)? What is the Money Flow Index (MFI)? And How to use it? What is the Federal Reserve Balance Sheet? What are minority interests? How to handle the profits of subsidiaries? What is Shareholders’ Equity? Shareholders’ Equity What is the Price to Cash Ratio (P/CF)? How to calculate? What is Operating Expense OpEx? Operating Expenses What is Cost of Goods Sold (COGS)? How to calculate? What is a Company’s Preferred Stock?