Five Key Trends That Are Causing the Slowdown in Liquidity

While liquidity has remained abundant in the last several years, recent quarterly trends point downwards as more entities are paying a higher rate in the Secured Overnight Financing (“SOFR”) market. Since September, the 75th percentile of SOFR has been trading more than 5bps over its median, peaking recently over 8 basis points and signaling a logjam in the liquidity superhighway. But what is causing the funding traffic jam? In the latest edition of the Dynex Angle, we explore what’s causing the slowdown in liquidity, from tightening regulations to a slowdown in central bank deposits. Read on to uncover the five key trends that are slowing the fund flow.

1) Market Volatility: Just like unexpected roadblocks or accidents can cause sudden traffic jams, market volatility can disrupt the smooth flow of funds. Changes in interest rates, regulatory adjustments, and economic uncertainties meld together and can lead to fluctuations in market activity. The Fed and market participants are usually able to adjust to these events. The Fed authorized the use of the Standing Repo Facility (”SRF”) as a release valve for market volatility-related liquidity traffic jams. So far, that valve hasn’t needed to be used, but in case of emergency, there is a whopping $500 billion available to the markets should the need arise.

A line and area chart titled "SOFR Rates market shows signs of traffic jam" depicts the SOFR (Secured Overnight Financing Rate) and the spread between the 75th percentile and the average SOFR from 2020 to 2025. The SOFR (10-day moving average) is shown in blue, and the 75th percentile (10-day moving average) is shown in green. The pink shaded area represents the spread between the 75th percentile and the average SOFR, which has been consistently trading 5-10 basis points above the average. The chart shows a sharp rise in SOFR rates starting in 2022, with the spread widening through 2024.

2) Regulatory Changes: New regulations, such as the Basel III Endgame, can impact the number of lanes open on the liquidity superhighway. These regulations increase the demand for high-quality liquid assets (HQLAs), making it more challenging for banks to manage their liquidity needs. The regulations also incentivize banks to limit using their balance sheets for “high risk weight” activities.

3) Quarter-End Effects: At the end of each quarter, banks need to manage their capital ratios carefully, and this can cause a temporary traffic jam. Borrowers must find other ways to get liquidity, and lenders may receive lower rates. At Dynex, we manage this risk by making sure we have very little exposure to rolling financing at or near quarter ends.

4) Central Bank Policies: Central banks play a crucial role in determining the number of lanes open on the liquidity superhighway. For example, the Federal Reserve uses its overnight reverse repurchase agreement (ON RRP) facility to control short-term interest rates and manage liquidity in the banking system. This is a key metric that we are following at Dynex – we believe it’s a great barometer for analyzing the overall liquidity in the system.

5) Technological Advancements: Innovations in financial technology, such as the blockchain, can improve the efficiency and transparency of transactions on the liquidity superhighway. These advancements can help streamline the settlement process, reduce operational risks, and enhance collateral management. At Dynex, we’ve used reverse repurchase agreements - or reverse repos - as critical instruments in the financing market, which has helped us manage liquidity and stabilize short-term interest rates. The latest research indicates robust growth and increasing sophistication in this market, driven by regulatory changes, central bank policies, and technological advancements. As the market continues to evolve, the team at Dynex will stay on top of emerging trends and adapt our investment strategies accordingly.