Liquidity lowdown: What’s behind the recent funding spike?

Reverse repos spiked to their highest ever levels in April 2024 following record usage of the Bank of England (BoE) Short Term Repo (STR) facility.

The STR facility, introduced in October 2022, is designed to ensure short-term money market rates do not deviate significantly from the base rate, currently 5.25% in the UK, as the BoE sell government bonds back to the market. Eligible banks and financial institutions can borrow cash from the BoE with a one-week maturity and on 25 April 2024, we saw the largest single usage of the facility since its launch in 2022, with the BoE lending in excess of £7.5bn. This clearly signals a need for short-term funding, and with banks unable to secure enough funding from Money Market Funds (MMFs), they have been turning to the BoE to borrow instead.  

The facility injects reserves into the front end of the market and its recent record usage tested its capability, but it does question the ongoing impact of quantitative tightening (QT) as cash is drained out of the economic system. Typically, MMFs will lend cash to large banks in return for government bonds. We have observed that overnight collateralised reverse repo returns have increased from SONIA (Sterling Overnight Index Average) + zero to SONIA+5 basis points over the month of April. Banks will then lend this cash to other market participants at SONIA +5-10 basis points, creating an opportunity for riskless arbitrage.

Spikes in reverse repos can happen periodically, and we believe this latest spike may not only be in response to front end dynamics, but also in response to the large £35 billion UK 1% April 2024 gilt bond which matured last month. Much of the cash which was used to pay for the redemption was parked in repos. When the bond matured, this cash was most likely displaced, as banks found themselves slightly jumbled. They were forced to pay a premium to borrow cash to rebalance their positions. 

Along with the abundance of collateral in the system ever since the BoE started their QT journey and shrinking reserves, it is simple supply and demand, and monetary policy dynamics which is the likely cause of these spikes in market pricing. The BoE’s programme has effectively reduced the amount of cash in the economy to its lowest since 2021 and SONIA, the overnight interest rate for unsecured lending has therefore been drifting higher. There has certainly been some pressure in the front end of the repo market recently but MMFs will not be complaining. Given their daily regulatory liquidity requirements, reverse repos are frequently used by MMFs and any increase in return is always welcome news. Similar spikes have been seen in the past and in 2021 return on reverse repos spiked and continued on an upwards trajectory. Three years later, we are witnessing  similar market outcomes, albeit for different reasons.

In April 2024, we saw a notable increase in demand for cash from overnight deposits, with banks again willing to pay a premium to secure short-term funding. Deposits do not in themselves generate profits for a bank, loans do, and so holding excess deposits can be problematic for banks.  However, there has been a noticeable demand for overnight deposits in recent weeks, again likely due to supply and demand dynamics. Banks will often use excess euro cash to fund their sterling books, which means when forward rates move, demand for sterling cash moves. Rates on overnight deposits have been drifting higher and the average has moved from 5.18% to 5.20%, with some banks paying as much as 5.23% to secure overnight funding. Front end market dynamics have certainly been rather interesting in April 2024 as the search for liquidity continues, but as beneficial as this has been for MMFs, we believe these spikes may be, and are proving rather temporary.

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