What is the reverse repo facility?

The Overnight Reverse Repo (ON RRP) facility is a tool operated by the Federal Reserve Bank of New York that allows eligible counterparties, primarily money market funds, government-sponsored enterprises, and primary dealers, to deposit excess cash at the Fed overnight. In return, the Fed provides Treasury securities as collateral and pays interest at a set rate. The facility effectively absorbs excess liquidity from the financial system.

The ON RRP plays a critical role in the Fed's interest rate control framework. By offering a risk-free overnight return to money market funds (which cannot hold reserves directly at the Fed), the ON RRP establishes a floor under short-term rates. Without it, excess liquidity in the system would push rates below the Fed's target range, undermining the effectiveness of monetary policy.

The ON RRP's usage surged to over $2.5 trillion in late 2022, reflecting the massive liquidity injected during the COVID-era QE programs. Money market funds had more cash than the Treasury bill market could absorb, so they parked the excess at the Fed. Since then, ON RRP usage has declined as Treasury bill issuance increased (providing alternative investments for money funds) and as QT drained reserves from the system.

The decline in ON RRP usage is a critical signal for liquidity conditions. The ON RRP acts as a buffer that absorbs QT's impact before it bites into bank reserves. As long as money funds are reducing their ON RRP deposits, QT is draining the "excess" liquidity cushion rather than the "necessary" liquidity that banks need to function. When the ON RRP is fully drained, further QT directly reduces bank reserves, increasing the risk of funding stress.

For market participants, tracking ON RRP levels provides a real-time gauge of liquidity conditions and an early warning system for potential QT-related stress. The near-complete depletion of the ON RRP in late 2024 was a key factor in the Fed's decision to slow the pace of QT, as policymakers sought to avoid a repeat of the September 2019 repo market stress that occurred when reserves became scarce.