On Monday the Federal Reserve held a major reverse repo test, as was announced by the NY Fed and by Zero Hedge. We have subsequently received several unconfirmed reports that the conducted test has been a disaster (we have calls into the Federal Reserve to confirm or deny this, we are eagerly awaiting their reply). Presumably, after conducting various repos last year, a typical transaction would be in the $1 to $5 billion range. At around the time the financial system was being pulled apart, were two separate $50 billion repo transactions on September 18, 2008, a day when as Paul Kanjorski had highlighted earlier in the year the money market system nearly collapsed as a result of Lehman and AIG's failure, and the Reserve Fund breaking the buck. Notable about Monday's reverse repo "test" was that it was quite sizable: in the $100 billion ballpark, on parallel with the biggest liquidity extraction from 2008. The outcome was the discovery that the dealer community does not have the capacity to do reverse transactions of this magnitude. As a result the Fed was forced to go directly to the money market industry, which has been speculated as a key source of excess liquidity withdrawals, another topic we discussed previously.
This sets a dangerous precedent on two levels. First, if the dealer community, recently expanded to consist of such middle-market banks as Jefferies which allegedly has over $20 billion on its balance sheet compliments of various Fed repo actions, is unable to satisfy reverse repos of this size, a big question mark appears as to what is the illiquid collateral backing the Dealer community, if it is unable to comply with a $100 billion liquidity withdrawal. Second, it indicates that reverse repos as a source of liquidity extraction by the Fed will be contained to the very precarious money market industry. All that is needed, in today's hair-trigger mindset on liquidity, is for another systemic glitch to be made apparent to all market participants, before yet another run on money markets occurs. As readers will recall, money markets were recently stripped of their implicit Federal guarantees: as such, this is the biggest potential threat to a nascent "recovery."
We will follow this topic closely, as the rumor now is that the Fed will no longer attempt dealer-based reverse repos after Monday's failure, but confine them exclusively to money markets. Whether or not the Fed is correct in gambling with the $3 trillion+ money market industry when it should be doing all it can to extract liquidity out of the very same dealer community it has so generously been rewarding for over 7 months, is very much open to debate.