Mini Course on the REPO Market and Liquidity [Part 2]

In Part 1 of this article / mini course, we examined in detail how the repo market works and the functioning of the "safety valve" introduced by the Fed. At this point, however, a fundamental question remains to be answered: where does the current liquidity crisis originate? Can we truly speak of a liquidity crisis, or is that an exaggeration? Why has the Fed announced the end of Quantitative Tightening?

In this second part, we will answer all of these questions.

Liquidity: The Plumbing of Finance

A few days ago, the Federal Reserve announced the conclusion of its Quantitative Tightening (QT) program — that is, the suspension of the planned reduction of its balance sheet. This is far from a coincidental decision, motivated by the growing signs of stress in the financial system that we have analyzed so far.

To fully understand what it means that "liquidity is running out," two fundamental concepts must be clarified: liquidity and the monetary base.

The Federal Reserve's Balance Sheet: The Source of Everything

The Federal Reserve's (Fed) balance sheet is a crucial instrument of monetary policy. It can be expanded through Quantitative Easing (QE) or reduced through Quantitative Tightening (QT), directly influencing the monetary base and the financial conditions of the economic system.

Imagine the Federal Reserve's balance sheet as a giant water tank that feeds the entire American financial system. On one side, we find the assets: primarily Treasury bonds and mortgage-backed securities (MBS) purchased during the various phases of Quantitative Easing.

On the other side (the liabilities), we find the "vessels" where this water — liquidity — is distributed. The Fed's liabilities are divided into four main components:

1. Currency in Circulation ($2.4 trillion): Physical banknotes in circulation

2. Reserve Balances ($2.85 trillion): Commercial bank deposits held at the Fed

3. Treasury General Account (TGA) ($850 billion): The U.S. government's "checking account"

4. Reverse Repurchase Agreements (ON RRP) (nearly zero): Where money market funds park liquidity

   
   

Note: the balance between the Fed's assets and liabilities is currently deeply negative, and the Fed is operating at a loss. You can read more about this in this article.

The fundamental principle: a zero-sum game

When the Fed's balance sheet remains constant (no QE or QT), the liabilities operate as perfect communicating vessels in a zero-sum game: if one component increases, the others must necessarily decrease, since the quantity of liquidity in the system remains constant and unchanged. Nothing is created, nothing is destroyed: liquidity can only shift from one line item to another.

Imagine that the U.S. government issues $100 billion in bonds. Investors purchase them through the banking circuit. On the Fed's side, this is recorded as a shift in balance sheet items: $100 billion moves from bank reserves to the government's TGA account. A simple transfer of liquidity.

BOND ISSUANCE AS A DRAIN ON SYSTEM LIQUIDITY

We arrive here at a fundamental point for understanding why the system experienced a liquidity crisis in October 2025.

We have seen that when the government issues government securities — Treasury bonds, bills, or notes — and collects liquidity from investors, those funds end up in the TGA. This means that a portion of the money available in the financial system is "frozen" in favor of the government. This constitutes a genuine drain on liquidity: that money transferred into the TGA is no longer available to banks, businesses, and financial markets.

This interaction between the TGA, Treasury issuance, and bank reserves is one of the most subtle — and often least understood — aspects of American monetary policy. No direct decision by the Fed is required: the natural flow of government revenues and expenditures alone is enough to influence the liquidity available in the market.

Normally, what makes the difference in the impact of this TGA drain is the timing of operations — that is, the time gap between the moment the government builds up its account at the Fed and the moment it opens the public spending tap, returning liquidity to the system.

↑ TGA = ↓ Bank Reserves = Liquidity Drained

When the government spends, the process reverses:

↓ TGA = ↑ Bank Reserves = Liquidity Injected

THE PERFECT STORM OF 2025

1)   On July 4, 2025, President Trump signed the "One Big Beautiful Bill Act," raising the debt ceiling by $5 trillion — the largest single increase in American history. By July, the TGA had fallen to just $296 billion.

2)   Between July and October 2025, the Treasury launched a record issuance of $603 billion in new Treasury bills, rebuilding the TGA from $296 billion to nearly $1 trillion. The speed of liquidity drainage was nearly $200 billion per month. To put this in context: this drained liquidity at a rate five times faster than the normal pace of Quantitative Tightening.

3)    On October 1, 2025, the U.S. government entered a shutdown because Congress failed to approve the federal budget. This means all "non-essential" services are suspended, payments are frozen, and many federal employees go unpaid. Less federal spending means less money entering the banking system through salaries, contracts, and payments. The shutdown is therefore reducing the effective liquidity circulating in the real economy, which remains frozen in the TGA account.

In a phase of Quantitative Tightening like the current one, the impact of TGA-driven drainage takes on even greater proportions for system liquidity.

TGA — Surge following the July issuances

The impact on bank reserves

Bank reserves over the past month have plummeted to just $2.8 trillion, the lowest level since September 2020. This figure represents approximately 9.8% of GDP. The so-called "comfort zone" sits above 10% of GDP, around $2.9 trillion. The "stress floor" — the level below which the system enters acute stress — is estimated at 8% of GDP, approximately $2.5 trillion.

The safety margin is therefore only $300 billion. And there is a troubling historical precedent: in January 2023, reserves were at these same levels. Two months later, Silicon Valley Bank collapsed, triggering the worst regional banking crisis since 2008.

Bank Reserves at 5-year lows

ON RRP Account (Reverse Repo Facility)

As explained in Part 1 of this article, an essential component of the liquidity system is the ON RRP market, where non-bank intermediaries "park" their excess liquidity or make it available to banks and other operators that need overnight liquidity. As of October 2025, this account has been virtually drained, falling from $2.5 trillion in 2022 to just $2 billion at the end of October 2025.

The (forced) end of Quantitative Tightening

The Fed announced last week that QT will end on December 1, 2025. After reducing its balance sheet from $9 trillion to $6.6 trillion, draining a total of $2.4 trillion in liquidity, the normalization cycle formally comes to a close. The decision is certainly no coincidence but rather the result of everything shown throughout this article. Liquidity is not just a number: it is the water that sustains the entire financial system. When reserves fall below a certain threshold, even small shocks can trigger dysfunctions in funding markets, with potentially dramatic, sudden, and unexpected chain reactions.

The decision to end QT is a forced move given the current situation: the system has reached the lowest tolerable level of liquidity, and maintaining "sufficient" reserves has become imperative.

Joseph Wang, who previously served as a senior trader at the Fed, offers a structural perspective: "The demand for repo financing will continue to grow structurally alongside public debt. The Fed will need to expand its balance sheet through the SRF or T-bill purchases." In other words, even if the TGA decreases in the coming months, automatically returning liquidity to the system, the long-term trajectory will still require some form of Fed balance sheet expansion.

Dunham & Associates, an analysis firm specializing in money markets, puts its finger on the real issue: "Liquidity problems don't approach gradually — they hit hard and fast." October 31, 2025 demonstrated that the safety valve worked, but it is operating dangerously close to its structural limits. The SRF remains an overnight rescue mechanism. But if the system were to enter a severe liquidity crisis, the SRF would no longer be enough. The $350 billion margin above the stress floor may look comfortable on paper, but it can evaporate in a matter of days if adverse factors converge.

Total Assets (Quantitative Easing e Tightening)

Looking at the chart above, which shows the expansions and reductions of Fed assets through QE and QT, something quite frightening emerges: we are not even at 50% of the last expansion recorded during pandemic-era QE. Despite this, the financial system, much like an addict demanding ever-larger doses, finds itself once again in a liquidity crisis. The question arises naturally: what will happen when QE is no longer enough?

After more than 15 years of monetary expansion, the global financial system can no longer survive without massive central bank interventions. Every attempt at normalization reveals just how fragile the equilibrium built on abundant liquidity truly is.

As the International Monetary Fund reminds us, dependence on QE is not without costs: it erodes central banks' ability to respond to new crises, amplifies distortions in asset prices, and above all, puts at risk the trust in their role as neutral arbiters of the markets.

The question, therefore, is no longer whether QE will continue, but how far this system can hold together without disruptions or without undermining trust in the system — and what will happen when trust, not liquidity, becomes the true missing currency.