This is the third post in a sequential four-part series on the Federal Reserve’s foreign repo pool. The previous Parts, I & II (see summaries at the very end of each post), noticed the increasing size of the pool, analyzed the user base and how the pool fits into the users’ reserve allocation process, but left questions concerning the cause of the reallocation unexamined.
This post starts the inquiry into the multifaceted ‘Why’ question by exploring the most important factor: the foreign repo pool rate (FRPR) and subsequently how the rate is set (with a simple model to calculate a high(er) frequency proxy) and why Basel III regulations and US extensions thereof seem to lead to a structurally higher FRPR, attracting inflows into the pool.
III. The Foreign Repo Pool Rate
Transactions in a free-market environment should, according to textbook definitions, lead to wealth and/or utility gains for all parties involved. Applying this principle to FOIs lending to the Fed via its foreign repo pool requires an evaluation of the risks and returns this activity entails. Bluntly stated, rationally behaving FOIs should only lend cash to the Fed if relative risks & returns offered by the pool exceed alternatives elsewhere.
From a risk perspective, the evaluation is simple: there is no safer counterparty than the central bank endowed with the authority to create money by crediting its own account. In addition, since the pool is at the end of the day structured as repos, cash lenders receive high quality collateral from the Fed’s SOMA portfolio, i.e. either Treasuries or Agency MBS. If MBS is involved at all, its role is likely small since pre-GFC, the Fed didn’t own any and usually CBs prefer to limit their liquidity operations to the ‘purest’ safe assets, i.e. Treasuries.
An allocation to the foreign repo pool, in consequence, is at least as safe as owing Treasuries. The only distinction, besides some minor operational features, is the interest rate paid to FOIs.