Federal Reserve has ramped up its interest rate on emergency loans

Federal Reserve:

• Announces its bank term funding program will cease making new loans as scheduled on March 11
• Adjusts interest rate on new BTFP loans to be no lower than interest rate on reserve balances on day loan was made
• New rate on BTFP loans effectively increases rate by nearly 50 bps; change is effective immediately
• Says change to BTFP rate ensures the program continues to support its goals in current rate environment

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The TL/DR on this is that the BTFP program had been open to arbitrage abuse, involving borrowing at a lower rate using high-quality collateral and potentially investing or lending that capital at a higher rate. Borrowing under the program has surged in recent weeks.

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The Federal Reserve's Bank Term Funding Program (BTFP) was designed to address potential liquidity issues in the banking system, particularly during times of financial stress or instability. The mechanism of arbitrage in the context of the BTFP can be understood through a few key points:

1. Purpose of BTFP: The BTFP is typically aimed at providing longer-term loans to banks, using Treasury securities and other government-backed securities as collateral. This is especially critical during periods when the market value of these securities may have fallen significantly, but their long-term value remains stable.

2. Access to Cheaper Capital: Banks holding these securities may face liquidity issues if they cannot sell them without incurring substantial losses. The BTFP allows these banks to use these securities as collateral to obtain loans, usually at a favourable interest rate. This can be cheaper than the cost of capital available in the open market, particularly during periods of financial stress.

3. Arbitrage Opportunity: The arbitrage opportunity arises from the difference in the interest rates. Banks can borrow from the Federal Reserve at a lower rate using the BTFP and can potentially invest this capital in other financial instruments or loans that yield a higher rate. This differential can lead to a profit, essentially an arbitrage gain.

4. Risk Management: While this presents an opportunity for profit, it also requires careful risk management. The banks must manage the risk of their new investments and ensure they can repay the BTFP loans.

5. Market Stability: By providing a source of cheaper funding, the BTFP helps stabilize the financial markets. It assures that banks can continue to operate without needing to sell off assets at distressed prices, which can further depress the market.

6. Regulatory Oversight: Such programs are usually accompanied by strict regulatory oversight to ensure that the facility is used for its intended purpose of maintaining liquidity and stability, and not for excessive risk-taking or generating undue profits through arbitrage.

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