Liquidity Crisis in the United States – Mini Course on the REPO Market and Liquidity [Part 1]

October 31, 2025 was a particularly intense day for U.S. money markets. At month-end, the Fed recorded a sudden surge in the use of its "emergency valve" in the repo market, where banks and financial intermediaries experienced a liquidity crunch, requiring $50.35 billion in loans and forcing the Federal Reserve to inject $29 billion in liquidity. What led to this emergency situation, and what impact could it have on the stock and bond markets? In this analysis, I will try to explain step by step the entire complex mechanism behind the gears of liquidity in the American financial system. More than an article, this will be a mini course on the complex workings of the overnight market, interbank lending, the rate corridor, the Fed's balance sheet, and the critically important role of the Treasury in this matter.

What you will learn in this article:

• How the Overnight Repurchase Agreements (Repo) market works

• What the IORB, ON RRP, and SOFR rates are

• What the Standing Repo Facility (SRF) mechanism is

• How Treasury issuance is draining liquidity from the system

• Why the system is in a liquidity crisis

• Why the Fed is forced to halt QT and we will likely see Quantitative Easing again soon

THE REPO MARKET

First of all, what is the repo market? The repo market (Repurchase Agreement) is the backbone of overnight and very short-term liquidity in the United States. A $12 trillion market, the heart of American liquidity. It is the mechanism through which banks, dealers, and money market funds exchange cash for Treasury securities, usually for just one day. In essence, these are collateralized loans: those in need of liquidity temporarily hand over securities as collateral, committing to repurchase them at a slightly higher price the following day.

THE RATE CORRIDOR

The equilibrium of the U.S. monetary system is regulated through an interest rate management mechanism commonly known as the rate corridor. This corridor is bounded by two rates administered directly by the Federal Reserve:

• Interest on Reserve Balances (IORB), which serves as the upper bound,

• Overnight Reverse Repurchase Agreements (ON RRP), which represents the lower bound.

  
  

These two instruments form the cornerstone of monetary policy implementation under the ample reserves regime currently adopted by the Fed. By adjusting these rates, the monetary authority steers the effective federal funds rate toward the target range set by the Federal Open Market Committee (FOMC), thereby stabilizing liquidity conditions in the interbank market.

The effect of this mechanism is transmitted, with varying intensity and time lags, to the interest rates applied to loans, mortgages, and bond instruments. Let's look at them more closely:

IORB RATE

IORB (Interest on Reserve Balances) is the rate the Fed pays on bank reserves. By depositing money at the Fed, banks can earn this risk-free return. It is the key instrument that controls the flow of money to the real economy. Only banks and credit unions can deposit reserves at the Federal Reserve and receive the IORB rate. All other non-bank operators, such as money market funds or GSEs, cannot receive the IORB.

ON RRP RATE

For these non-bank operators, the Fed offers the ability to earn a return on their excess liquidity at the ON RRP (Overnight Reverse Repurchase Agreements) rate. This rate is always risk-free (since the counterparty is always the Federal Reserve) and is always lower than the IORB, serving as the floor of the administered rate corridor.

The ON RRP rate is always LOWER than the IORB rate

Important note: the IORB and ON RRP are rates that the Fed pays on the excess liquidity of financial intermediaries. An intermediary with excess liquidity can deposit it at the Fed and earn the risk-free rate guaranteed directly by the Fed. These are ways to absorb liquidity from the system, NOT to provide it.

But what if a bank finds itself in the opposite situation? That is, it doesn't have excess liquidity to "park" at the Fed, but actually needs liquidity? This is where the REPO market comes into play.

WHO LENDS AND WHO BORROWS

As already mentioned, the repo (repurchase agreement) market is a mechanism through which financial operators exchange short-term liquidity, using securities — often Treasuries — as collateral.

In the repo market, the main providers of liquidity are not banks, as one might intuitively assume, but money market funds and government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac. This reflects a deep functional division between the actors that typically supply and those that demand liquidity in the financial system.

Money market funds manage capital from investors seeking safety, immediate liquidity, and capital stability. To meet these needs, they invest in short-term, low-risk instruments — and the repo market, especially when collateralized by Treasury securities, represents an ideal solution: safe, flexible, and modestly remunerative.

GSEs also frequently hold large temporary cash flows, generated from the management of mortgages and bond portfolios. Bound by statutory mandates that limit their risk-taking, these entities seek liquid, risk-free instruments to temporarily deploy their cash — and repo perfectly meets this need.

Conversely, banks — particularly primary dealers such as JPMorgan, Goldman Sachs, Citigroup, Bank of America, etc. — more often operate as borrowers in this market. They use repo to finance securities positions, support market-making activities, or manage temporary cash imbalances. Furthermore, prudential rules such as liquidity coverage requirements (LCR) and Basel regulations make it inefficient for banks to accumulate idle liquidity: it is better to put it to work generating income, financing themselves short-term when necessary.

In essence, the repo market functions as a channel through which entities with "passive" liquidity (money market funds and GSEs) make it available to those with "operational" needs (banks and dealers). This symbiosis is fundamental to the smooth functioning of financial markets — but, as demonstrated by stress episodes such as the one in September 2019 in the United States, it can prove fragile when the flow of liquidity is suddenly disrupted.

This distinction between "providers" and "borrowers" of liquidity is the reason why the ON RRP rate reserved for "providers" is lower than the rate reserved for banks.

So what happens in the REPO market?

A fund has excess liquidity that it is willing to lend at an interest rate. At this point, it has two choices:

• Option A (ON RRP): Deposit liquidity at the Federal Reserve through the Overnight Reverse Repo (ON RRP) and receive a fixed rate guaranteed directly by the Fed (risk-free).

• Option B (repo market): Lend liquidity directly to banks/dealers in the repo market, earning a slightly higher market rate (based on supply/demand dynamics), namely the SOFR rate.

  
  

THE SOFR RATE

The SOFR rate (Secured Overnight Financing Rate) is typically always higher than the ON RRP rate, as it includes a small premium for counterparty risk (lending to the Fed would always be more advantageous), operational costs, etc.

ON RRP, SOFR, IORB, IOER

Until 2021, SOFR rates were consistently (or nearly so) above the IORB rate (which at the time was called IOER, Interest on Excess Reserves). During liquidity crises, the SOFR rate could spike well above the IOER rate, dangerously destabilizing the system. On September 17, 2019, SOFR surged in a single day from 2.43% to 5.25%, with intraday peaks reaching 9–10% — a level unseen since the pre-crisis era — while IOER remained at 2.35%. This situation reflected a dangerous liquidity crisis that forced the Fed to restart its Quantitative Easing program and flood the system with liquidity.

SOFR rate consistently above IOER until 2021 — September 2019 spike

A liquidity crisis indicates a shortage of immediately available funds in the banking system, preventing operators from financing their positions or meeting short-term cash needs. To prevent similar situations from recurring, the Fed established the SRF mechanism in 2021.

Standing Repo Facility (SRF): the "ceiling" that completes the rate architecture

The SRF (Standing Repo Facility) completes the rate corridor mechanism by introducing a true maximum ceiling. This mechanism allows banks and primary dealers to obtain liquidity directly from the Fed, using high-quality securities (primarily Treasuries) as collateral. Unlike the traditional repo market — where banks negotiate with money market funds and GSEs — here the counterparty is the Fed itself.

The mechanism is simple but powerful:

• Banks deliver securities to the Fed as collateral (e.g., U.S. Treasury bonds)

• In return, they receive overnight liquidity

• The following day, they return the liquidity plus interest, recovering their securities

• The SRF rate applied is preset (decided by the Fed on a case-by-case basis, and always aligned with the rate corridor) and is structured to remain below the IORB rate.

  
  

Why is the Standing Repo Facility (SRF) revolutionary?

Before 2021, sudden demand for liquidity could send repo rates soaring well beyond sustainable levels (as in 2019, with SOFR at 10%). The SRF solves this problem by introducing a ceiling on rates: no bank will pay a rate on the repo market higher than the SRF rate for overnight liquidity. If intermediaries demand excessively high rates to lend liquidity, the bank simply turns directly to the Fed. This ensures that SOFR is always higher than ON RRP but lower than the SRF rate (which in turn is close to IORB).

- IORB - SOFR

In this chart, you can see how until 2021 (when the SRF system was established), the IOER rate (dashed green, now called IORB) was very often below the SOFR rate (purple). From 2021 onward, we can see how the situation normalized, with a less volatile SOFR consistently below IORB. We can say that the SRF mechanism is doing its job admirably.

At the same time, however, it may be masking situations that are more problematic than they appear. From the chart, it is possible to observe how the SOFR rate in 2025 is far more jagged compared to previous years, a sign that some tension in the liquidity market is present and, most likely, without the SRF mechanism masking everything, we would have witnessed situations far worse than 2019. Let's be clear: this mechanism effectively distorts and alters the equilibrium between supply and demand. Whether this is a good or bad thing, only time will tell.

SOMETIMES THE SRF ISN'T ENOUGH — OCTOBER 31, 2025

In exceptional situations of stress in the liquidity market, it can still happen that the SOFR rate temporarily exceeds the Standing Repo Facility (SRF) rate. This is precisely what occurred, for example, on October 31, 2025.

The establishment of the SRF does not entirely eliminate the possibility of upward deviations in SOFR; however, the fact that the Federal Reserve itself acts as a direct counterparty for banks creates a risk-free arbitrage opportunity: when SOFR rises above the SRF rate, banks can obtain liquidity more cheaply directly from the Fed and reinvest it in the repo market, thereby quickly bringing the rate back to consistent levels.

A crucial question remains, however: how deep must the liquidity shortage be for the market to still show pressures strong enough to push SOFR above the IORB level, despite the presence of the SRF? In these cases, the SRF does not eliminate the crisis but mitigates its symptoms, revealing possible structural tensions in the distribution of bank liquidity.

The arbitrage mechanism — October 31, 2025

• SRF rate: 3.90% (we do not have the official figure, but it typically hovers around the IORB value)

• SOFR rate: peaks at 4.27%

  
  

Under these conditions, banks were able to exploit the SRF system to execute a risk-free, guaranteed-profit arbitrage operation:

1. Step 1: The bank draws liquidity from the Fed through the SRF at a rate of 3.90%.

2. Step 2: At the same time, the bank lends that same liquidity in the open repo market (where SOFR is at 4.22%).

3. Result: The bank earns a risk-free spread of 0.37% (4.27% – 3.90%) on every dollar financed.

   
   

This arbitrage is a risk-free operation that, as a result, immediately pushes the SOFR rate back below the SRF level — a true pressure valve to deflate system stress that makes it impossible for SOFR to remain above the SRF for too long. As we have already noted, on October 31, someone needed over $50 billion through the REPO circuit, with the Fed having to inject $29 billion in liquidity into the system.

Overnight Repurchase Agreement on October 31, 2025. From the long-term chart, the anomaly of this movement becomes clear

Did the system work — can we rest easy?

The effectiveness of the arbitrage mechanism observed on October 31, 2025 raises deeper questions about the structural stability of the financial system. While one can appreciate the technical elegance of the Standing Repo Facility (SRF) in mitigating contingent liquidity tensions, a crucial question emerges: what underlying factors are generating pressures on overnight rates?

In other words, what market reality is the SRF temporarily masking? And what made such a direct central bank intervention necessary in a context of Quantitative Tightening?

The arbitrage worked perfectly from a technical standpoint: operators effectively captured the expected risk-free spread. However, this operational success should not cloud the reading of fundamentals. The fact that SOFR exceeded the SRF rate by 37 basis points suggests a structural liquidity shortage, rather than a temporary misalignment.

In this scenario, the Federal Reserve, through the SRF, is not merely acting as a lender of last resort but ends up creating a permanent liquidity provision channel that operates — at least in appearance — in the opposite direction to the monetary drainage policy inherent in tightening. This is far from a marginal point: the SRF, despite being conceived as a temporary, very short-term intervention tool, highlights just how structurally dependent the financial system remains on the central bank.

After years of monetary expansion and abundant liquidity, the market appears to have internalized this dependence, making the boundary between stability and systemic fragility increasingly thin.

Early warnings from Fed leadership: an alarm bell

The October 31 episode takes on even greater significance in light of statements made in the days immediately prior by Lorie K. Logan, President of the Federal Reserve Bank of Dallas.

Her observations do not appear to be mere technical commentary, but rather a genuine preemptive warning:

"I expect an increase in SRF usage in the coming period. We may observe some temporary pressure around the fiscal date and quarter-end." (August 2025)

Particularly revealing was her expression of disappointment at operators' inaction in the face of obvious arbitrage opportunities:

"I was disappointed to see that rates on a large portion of repo operations exceeded the SRF rate at certain points this week and no one took advantage of it. Dealers should increase their readiness to access the SRF in response to rate changes."

The language used by Logan goes beyond simple technical observation: it almost sounds like a call to order directed at market operators, as if the Fed were signaling that the SRF mechanism is not merely an emergency tool but an expected structural element of the new monetary regime. Even more significant was her implicit admission of the instrument's limitations:

"If the recent surge in repo operations does not prove to be temporary… the Fed will need to restart Quantitative Easing to maintain ample bank reserves."

The real concern emerges when we analyze the most recent statements by Lorie K. Logan, which reveal an irreversible transformation of the banking system:

"Banks have become less adept at managing reserves after years of abundant liquidity… Compared to the pre-pandemic period, the Fed now must provide more reserves than it would have previously."

This admission is particularly alarming: the banking sector has not simply adapted to the abundant liquidity of the QE years — it has become structurally dependent on it. What Logan describes is not a simple technical observation but confirmation that years of expansionary monetary policies have created a monster that can no longer be tamed. Banks have built their profit models on foundations of unlimited liquidity, and now every attempt at normalization risks bringing the entire edifice crashing down.

This phenomenon raises an uncomfortable question: are we witnessing the creation of a permanently artificial financial system, where the Fed is no longer a regulator but an indispensable provider of liquidity, regardless of actual economic conditions? The real risk is not a temporary crisis, but a system that has lost the ability to self-regulate.

But where does the liquidity crisis originate? Continued in Part Two of this article.