A critical part of the plumbing that keeps money flowing through the financial system is experiencing turmoil as new regulations prompt banks to step back from the multitrillion-dollar "repo" market.

The large and opaque market for repurchase agreements helps keep finance and trading moving, allowing hedge funds, investment banks and other financial firms to borrow and lend short-term funds, often overnight.

But there have been increasing signs of trouble. Big banks, which act as middlemen between borrowers and lenders, have been pulling back. In recent weeks, senior bankers have said they are reluctant to participate in the market because of regulatory requirements that make repo trading more expensive


Regulators say the changes are positive. Before the crisis, many Wall Street firms relied heavily on repos for cash. But they lost access to those funds when investors panicked about the value of mortgage bonds and the solvency of firms like Lehman Brothers Holdings Inc. that relied on repos for cash.

New rules are "a constraint, but one that facilitates financial stability in the long run," said Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig.

Banks said privately they don't intend to abandon clients in repo markets. But there are signs their reluctance to facilitate huge amounts of repo activity is contributing to increased volatility.

In June, a relatively high number of repo transactions tied to U.S. Treasurys "failed," or didn't close because one of the parties didn't provide the bond, according to research firm Wrightson ICAP.

Though the so-called fail rate was far below crisis levels, the development raised eyebrows


Bank pullbacks have shrunk the pool of securities available for repo trades with U.S. Treasurys as collateral, leading to smaller transactions. "There is a shortage of collateral," said Joe Lynagh, who oversees $18 billion in money-market funds at T. Rowe Price. "Because that trend is continuing, you could see more funds rely more on the Fed" for investing their cash.

Investors said there is such high demand for certain types of bonds that some firms are accepting negative interest rates on the cash they are lending in exchange for the in-demand collateral. As of Tuesday, the rate to borrow five-year Treasury notes maturing in 2019 in the repo market was minus 0.25 percentage points--in other words, financial firms were willing to pay bondholders for the privilege of lending them cash.

Some worry that the Federal Reserve is about to exacerbate the problems as it pulls back from its bond-buying program. The Fed is testing a plan to put the brakes on money sloshing around the financial system by seeking to attract that cash, which otherwise may have gone into the repo market...

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