The Collateral Supply Effect on Central Bank Policy

Abstract

This paper starts by describing the evolution of US money markets over the course of the 1990s and the 2000s. The crucial transition was from an unsecured core money market, the Federal Funds market, to a collateralized market, the repo market. Due to this shift, collateral supply has become an important factor in money market dynamics. Three important implications of this transformation are discussed: First, government debt issues now affect the money market not just due to the need to settle payment for the debt, but also due to the on-going need to fund the carry of the debt. Second, because long-term debt is an important component of collateral supply, any significant increase in long-term rates will have a dramatic effect on the value of the aggregate collateral supply thereby making monetary policy implementation more difficult. Third, the events of March 2020 provide evidence of structural instability in the repo market, and of the problematic nature of a ‘dealer of last resort’ solution. This paper argues that the collateral supply implications of the new money market environment merit careful study, and critically evaluates the dealer of last resort, the proposal for a centralized counterparty for Treasuries, and the proposal for a standing repo facility.