Repo and FX markets buck year-end crunch fears

Price spike concerns ease as September’s surprise SOFR jump led to early preparations for bank window dressing

A rise in the cost of repo and foreign exchange derivatives has become a year-end tradition for several years now, as banks try to shed balance sheet exposures to keep a lid on future capital requirements.

Fears were heightened about what was to come on December 30 and 31 following a bigger-than-normal jump in secured funding costs and FX derivatives pricing at the end of September. 

However, despite some unique pressures, market participants say concerns those markets could freeze up on the final days of the year have abated, due to better preparation from market participants, helped by improvements in market structure and some potential policy changes from the Fed.

“I wouldn’t expect any sort of drastic behaviour from us,” says the head of repo at one US dealer.

Garth Appelt, head of derivatives, FX and emerging markets macro trading at Mizuho Americas, also says things had calmed since the September jump.

“There was a lot of anxiety around what people thought was going to happen. In the FX turns, we’ve seen a little pressure, but not as much as we thought we would,” says Appelt.

The wake-up call was at the end of September, and that’s what got everybody to prepare faster

Gennadiy Goldberg, TD Securities

The main driver at year end is so-called window dressing activity by dealers, as they try to reduce their balance sheet exposures on December 31, when a snapshot is taken for calculation of the capital requirement add-on for global systemically important banks (G-Sibs). Increasing exposures can push them into a higher bucket, where they will be subject to a higher add-on, so dealers typically scale back balance sheet-intensive activities as year-end approaches.

This results in worse rates for balance sheet-intensive products like repo, FX swaps and forwards, and cross-currency swaps, resulting in spikes on the final days of the year.

Concerns were rising that the pricing pressures could be exacerbated this year by an FX market deadzone from December 20 to January 7, $120 billion of year-end US Treasury settlements, and rising bank and US equity prices pressuring G-Sib scores further.

The fears were highlighted by a 21 basis-point jump in the US secured overnight financing rate (SOFR) and widening in cross-currency basis spreads in late September, plus big moves in forward-starting repo contracts for the final days of 2024.

But they proved to be short lived, as market participants – thanks in part to the September spike – looked to lock-in their repo and FX positions ahead of time, reducing the pool of demand that could force up prices in the final days of the year.

“The wake-up call was at the end of September, and that’s what got everybody to prepare faster,” says Gennadiy Goldberg, head of US rates strategy at TD Securities.

Other factors said to have eased balance sheet pressures include an uptick in nettable sponsored repo trades, and expectations of changes to the New York Fed’s reverse repo programme.

Key events

Funding rises are now commonplace at month-end, quarter-end and year-ends. Secured funding markets had a one-day nine basis point jump at the end of October and a 5bp single-day jump at the start of December.

But coming into this year-end, there are a number of specific events that many feared could put extra pressure on bank balance sheets and force up repo and FX prices.

Before, you were dropping a pebble into a lake, now you seem to be dropping a pebble into a coffee cup, and the ripples are a lot bigger

US bank treasurer

First, with both Christmas and New Year’s day falling on a Wednesday this year, Appelt anticipates FX trading will dry up after December 20. The liquidity gap between then and the new year potentially leaves the market susceptible to wide price swings if market-moving events occur, and also to price surges as dealer capacity shrinks at the end of December.

A second cause for concern this year-end is that there is a $120 billion of Treasury settlements due on December 31. JP Morgan strategists Teresa Ho and Pankaj Vohra, in the bank’s Global Fixed Income Markets 2025 Outlook, noted that the settlement “should add to the pressure for dealers to intermediate liquidity”.

Ultimately this is money that primary dealers and other US Treasury market participants must pay to the US Treasury in exchange for securities purchased, meaning it can’t go to supporting other intermediation activities on that day.

The worry was that small changes to dealer capacity could have outsized impacts in the repo and FX markets: “Before, you were dropping a pebble into a lake, now you seem to be dropping a pebble into a coffee cup, and the ripples are a lot bigger,” says the bank treasurer.

Another wild card cited was bank equity prices. Bank equity value is one of the inputs to the calculation of G-Sib scores, which determine which bucket a bank is in for calculation of additional capital buffers that range from 3.5% to 1%.

Bank share prices have been on a tear in 2024. The Dow Jones US Banks Index is up 33% year to date as of December 17.

Four funding market sources agreed the rising value of a bank’s share price can worsen its G-Sib score, and ultimately drive-up prices at the end of December, as banks look to pare back trading, making it a closely tracked year-end metric.

33%

Dow Jones US Banks Index YTD rise as of December 17

“For some banks, depending on where they fall along the G-Sib score bucket, the rise in banks’ stock over the past few weeks might further intensify balance sheet pressures, as the market value of common equities is included in the G-Sib calculation,” wrote JP Morgan’s Ho and Vohra in the 2025 outlook.

Bank share prices are “very much embedded in our calculations”, says the repo head, adding that “we have to manage around that share price fluctuation”.

More broadly, the stratospheric rise of the broader US equity market over 2024 could mean prime broking desks are more squeezed than usual for capacity. Looking into 2025, Ho and Vohra said insatiable demand from investors for equity repo financing could add further strain on dealer balance sheets if the bull market continues.

“The amount of equity collateral that dealers need to finance in the marketplace has grown meaningfully, driven by an equity market that continues to break record highs as well as strong investor demand for levered equity exposure,” they noted.

Balance sheet pressure

Foreign exchange and repo are always in the firing line at moments when banks look to window dress, and as the balance sheet pressures piled up, so did concerns that dealers would switch the taps off.

“If I’m running a bank and I need to reduce my balance sheet a lot and very, very quickly, the two easiest places to do that is to do less FX and repo,” notes the treasury head.

Balance sheets were suddenly reduced by larger banks and they are a large source of liquidity for the market

Joseph DiMartino, Clear Street

The first sign of trouble was at the end of September, when SOFR jumped 21bp from 4.84% on September 27 to 5.05% on October 1. This put SOFR 5bp higher than the top of the Federal Funds target range at the time of between 4.75% and 5%.

For comparison, the September spike was worse than the New Year jump a year ago, on December 28 2023, when SOFR printed at 5.40%, 9bp above its December 21 level, but it remained well within the Fed Funds target range at the time of 5.25% to 5.50%.

Joseph DiMartino, head of repo trading at prime broker Clear Street, says the September 2024 SOFR spike was once again caused by big banks tightening their belts.   

“Balance sheets were suddenly reduced by larger banks and they are a large source of liquidity for the market,” says DiMartino. He says the impact was felt most in the secured mortgage-backed securities markets, where rates gapped 10bp higher on September 30.

On the FX side, US dollar supply and demand is reflected in the cross-currency basis, and three-month EUR/USD and USD/JPY bases also widened in late September, as traders factored in dollar demand and anticipated year-end pressures. This year, the EUR/USD basis fell from -1bp on September 26 to -8.5 several days later. The USD/JPY basis widened over 20 bp in the same period.

A wobble

A move in the forward repo market in late November this year, however, really brought concerns over year-end funding pressures to the fore.

Described as a “wobble” by the bank repo head, the rise was concentrated in the price of forward repo agreements for December 30 and December 31.

The forward repo market jumped to around 5.60% in late November ahead of the Thanksgiving holiday on November 28, more than 100bp over SOFR. DiMartino says the rise was driven by an increased demand for both term financing covering the year-end period, and forward-starting overnight repo financing covering the last two days of the year.

While market participants pay more compared to rolling shorter-dated repos, it comes with more certainty. A sudden spike in overnight funding can cause havoc for leveraged hedge fund strategies, such as FX carry trades and the Treasury futures basis trades.

“There’s always a class of people who are like, ‘I don’t care about the rate, just make sure that I’m flat at year end, because I just don’t want to deal with the risk’,” says a US treasury head at one European bank.

“You don’t want to go past Thanksgiving needing to do something,” he adds.

It’s also good for banks, as they receive a premium for the balance sheet usage.

5.60%

Jump in forward repo market in late November

But fears of runaway secured financing costs proved misplaced, as repo forwards for the year end started declining soon after. They have now fallen from 5.60% in late November to nearer 5% in early December. Market participants say the decline occurred because many of the hedge funds that worried about a gap in funding at year-end have now arranged the funding they need in the term markets.

In other words, with a number of market participants locking in that funding already, the subsequently reduced demand for forward repo saw the price for that activity fall. It also shrinks the pool of demand for overnight repo in the final days of the year, which could have forced up prices.

SOFR itself has also calmed since the September spike, sitting at 4.62% as of December 17, well within the Fed’s 4.5%–4.75% target range set after its 25bp rate cut on November 7. The SOFR print for December 18, when it cut a further 25bp, was not available at time of publication.

Glenn Havlicek, co-founder of the repo e-trading platform GLMX says hedge funds are simply now more aware of repo market conditions than in the past.

“I definitely think hedge funds are hyper-focused on capacity,” he says.

TD’s Goldberg says the September SOFR surge was helpful as it provided a warning shot to the market to get its affairs in order.

The repo head at the US bank agrees: “Because of what happened on September 30, you’re seeing that preparation happen earlier, where people are going ahead and turning out their book earlier than they would have in the past.”

Liquidity gap

Foreign exchange cross-currency basis levels have also drifted back towards where they were before the September spike.

Similar to the repo market, Mizuho’s Appelt says FX derivatives users have sought to get ahead of potential year-end challenges, which has helped reduce concerns about a year-end dealer capacity crunch and resulting price squeeze that would move the basis market.

 

 

Part of it stems from the liquidity gap from December 20, which has reduced the amount of trading he anticipates will have to be executed between now and the end of the year. This means there should be less trading pressure on December 30 and 31 that could push up prices.

“A lot of books will have basically closed by the 20^th. We’re recommending to all our corporate clients that if they have stuff to do, they should do it by the 20^th,” he says.

Another aspect is the strong dollar, which has seen corporates taking profit on their in-the-money FX trades and rolling into new trades in recent weeks.

“Because we had a strong dollar for the last three or four months going into the election, a lot of corporates have been restriking, so they have a lot less to do now,” says Appelt.

Central clearing

Other pressure release valves have been less direct. On the repo side, one is said to have come from the incoming US repo clearing mandate. The US Securities and Exchange Commission has mandated all repo trades involving a broker-dealer, which includes most trades, to be centrally cleared from 2026.

GLMX’s Havlicek says the mandate has already driven a big uptick in use of sponsored repo – a programme where any market participants can use a clearing broker to push transactions into the Fixed Income Clearing Corporation, currently the only clearing house in the US that handles US Treasury repo transactions.

Sponsored repo volumes leapt more than 70% in the last 12 months to $1.8 trillion on December 17, FICC data shows.

There are structural changes going on in the marketplace, which actually relieves some of the funding pressure

Glenn Havlicek, GLMX

Havlicek says this isn’t due to any newfound enthusiasm from the buy-side for clearing – it is simply that the sell side is eager to generate netting benefits from clearing.

Netting also benefits dealers, as it reduces the balance sheet exposures that go into the G-Sib calculation. Dealers have therefore been incentivising clients to use sponsored repo by offering larger slugs of liquidity to clients who want to clear, he says.

“I think that if your dealer says, ‘I can provide you with more liquidity going through the sponsored programme’, then that’s where people are going to migrate,” he says.

Havlicek says the sheer volume of trades in the sponsored repo channel will help ease funding market stress at year-end.

“There are structural changes going on in the marketplace, which actually relieves some of the funding pressure,” he notes.

Cash borrower boost

Some also say Fed activities could help ease financing stresses into the year-end.

At the Federal Open Market Committee (FOMC) meeting in November, Fed staff suggested the policy committee lower the interest paid on cash parked in the New York Fed’s overnight repo programme by 5bp, to make it equal to the bottom of the Fed Funds target range.

In the meeting’s minutes, the Fed said the move “would probably put some downward pressure on other money market rates”.

In theory, giving money market funds and others parking cash into repo lending a lower rate of return at the Fed could encourage them to instead turn to private sector participants, boosting financing capacity for cash borrowers.

At the FOMC meeting on December 18, the Fed confirmed it is now implementing the change to the overnight reverse repo facility. The FOMC agreed to lower the offer rate to 4.25%, with participants allowed to park $160 billion per day in the Fed facility.

“Setting this rate at the bottom of the target range for the federal funds rate is intended to support effective monetary policy implementation and the smooth functioning of short-term funding markets,” the Fed said in a market notice. 

Editing by Lukas Becker