Evening Brief – 01.25.24
Goodbye Arb
The Federal Reserve confirmed late Wednesday that the Bank Term Funding Program (BTFP), which was implemented in the wake of the bank panic and liquidity crisis in March 2023, will cease making new bank loans on March 11, as scheduled. Existing loans can be extended for a maximum of one year.
The Fed also announced that it would end the arbitrage that banks have been using to game the BTFP, adjusting the interest rate on new BTFP loans to be no lower than the interest rate on reserve balances on the day the loan was made, effectively raising the rate by nearly 50 basis points.
The BTFP program had been vulnerable to arbitrage, which involved borrowing at a lower rate with high-quality collateral and then potentially investing or lending that cash at a higher rate. Borrowing under the program began to rise in November and December 2023, as the Fed hinted at the end of its monetary tightening campaign.
“As the program ends, the interest rate applicable to new BTFP loans has been adjusted such that the rate on new loans extended from now through program expiration will be no lower than the interest rate on reserve balances in effect on the day the loan is made,” the Fed explained.
A riskless “free money” arbitrage was available to banks who could deposit collateral with the Fed at its BTFP facility, receive cash at par for a cost of one-year overnight index swap (OIS) +10bps and then post that cash earning the Fed Funds rate, pocketing the difference. The gap peaked at more than 60 basis points.
“This rate adjustment ensures that the BTFP continues to support the goals of the program in the current interest rate environment. This change is effective immediately. All other terms of the program are unchanged,” noted the Fed.
By the middle of December, banks could borrow at the BTFP for less than 4.80% and then leave the cash in their reserve accounts at the Fed, earning 5.40%. Since the arbitrage became profitable, bankers have used $47.6 billion in the arbitrage.
From July through October of 2023, the BTFP balance was approximately $110 billion. However, by the beginning of November, it began to surge. Last week, it increased by $14 billion. Since November 1, it has risen by about 50%, or $52 billion, to $161 billion.
After March 11, banks and other depository institutions will continue to have ready access to the discount window to meet liquidity needs, the Fed noted.