“Effective Immediately,” Fed Shuts Down Arbitrage Opportunity with the Bank Term Funding Program (BTFP)

This is funny, in a central-bank kind of way.

By Wolf Richter for WOLF STREET.

The Fed confirmed today in a press release at 7 PM EST that its infamous tool to deal with the March 2023 bank-panic and bank-liquidity crisis, the Bank Term Funding Program (BTFP), will cease making new loans to banks, as scheduled, on March 11. Existing loans can continue for their term of up to one year. This decision was disclosed on January 9 by Michael Barr, Fed Vice Chair for Supervision, at a panel appearance.

What’s new – the funny part – is that the Fed also said that, “effective immediately,” it would shut down the arbitrage with which banks have been gaming the BTFP to make some extra bucks. We’ve been discussing this BTFP arbitrage for a while, including here with a chart. The whole thing was a hoot.

The BTFP was conceived in all haste over a weekend in March 2023 and was announced on Sunday after two regional banks, Silicon Valley Bank and Signature Bank, had collapsed and were shut down by regulators on Friday, with visions of contagion turning this into a full-fledged financial crisis.

But the BTFP had a fatal flaw: under certain conditions, the interest rate that the Fed charges on loans at the BTFP (the rate is market-based) could fall substantially below the interest rate the Fed pays on its reserve balances (the Fed sets this rate).

And that’s exactly what happened starting early November during rate-cut mania. It opened up a riotous risk-free arbitrage opportunity that banks took advantage of.

Today the Fed had had it with this deal and shut down the arbitrage for new loans “extended from now through program expiration.” In the press release, it says that the interest rate to borrow at the BTFP will be “no lower” than the interest rate on reserves. And with this change, the arbitrage becomes unprofitable for new loans. The press release:

“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.

“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.”

On the new BTFP term sheet released today, applicable to new loans, the rate calculation paragraph now reads (I marked the new language in bold; IORB = interest on reserve balances):

“The rate for term advances will be the one-year overnight index swap rate plus 10 basis points, provided that the rate may not be lower than the IORB rate in effect on the day the advance is made; the rate will be fixed for the term of the advance on the day the advance is made.

When the worker bees at the Fed hashed out the terms for the BTFP over the weekend (eating pizza and sleeping on the floor?), they overlooked the possibility that the market-based interest rate to borrow at the BTFP – the one-year overnight index swap rate, plus 10 basis points – could fall substantially below the Fed-set interest rate that banks earn on their reserve balances.

In March 2023, the rate at the BTFP was close to the rate the Fed paid on reserves. But during rate-cut mania starting in early November, Treasury yields from one-year on up plunged, and related yields plunged in parallel. By mid-December, banks could borrow at the BTFP below 4.8%, and then leave the cash in their reserve accounts at the Fed and earn 5.40%. Risk free, hassle-free income for nothing.

From July through October, the BTFP balance was around $110 billion. But at the beginning of November, it began to surge. Last week, it jumped by $14 billion. Since November 1, it has jumped by nearly 50%, or by $52 billion, to $161 billion.

On Thursday, the Fed will release the new figures through Wednesday, and the balance likely jumped again. But that should be the last increase in the BTFP balance because the door to make money on this circus has effectively closed now:

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