Traders Are Beginning to Suspect a Saudi Connection to the Repo Market Meltdown

The repo market, which powers trillions in overnight borrowing by the world’s biggest banks and financial institutions, came within a hair of full-blown meltdown in September. Despite the Federal Reserve Bank’s commitment on Friday to pump billions into the market well into next year, the underlying problem at the heart of the liquidity crisis remains.

But what put overnight repo markets on the brink in the first place, given that these markets have been mostly stable the last decade? A combination of large corporate tax payments and Treasury bond issuance is seen as a potential cause—though not everyone is buying it.

A new explanation, however, is gaining momentum that Saudi Arabia, a prominent participant in some short-term dollar funding markets, played a yet unappreciated part in the repo crisis.

The mid-September repo market turmoil came shortly after the September 14th attacks on the Saudi oil fields at Khurais and Abqaiq, and several senior repo bankers who spoke to Fortune report that some of the repo stress stemmed from foreign flows tied to Saudi petrodollars.

The theory? Saudi Aramco, in the aftermath of the bombing raids on September 14, withdrew billions of dollars from accounts it holds in short-term dollar funding markets—either to fund a reconstruction of its damaged infrastructure or simply to build up dollars reserves as a backstop against further disruptions.

That came as an additional $83 billion of cash drained out of money markets for corporate tax payments and Treasury auction settlements around September 16 and 17, the first days of market activity following the attacks—delivering the triple whammy that caught many repo bankers, and even the New York Fed, off guard.

The New York Fed declined to comment for this story.

It’s well known that the Saudis play an outsized role in money markets, large enough to throw the markets off kilter.

First, a bit of number-crunching. Based on the country’s publicly reported money holdings through the Saudi Arabian Monetary Authority, Saudi Arabia holds around $500 billion in total reserves, $186 billion of which is held in deposits abroad. Economists estimate that about 80% of that is made up of dollars, putting dollar-holdings outside Saudi Arabia at $160 billion.

International economists calculate only about 10-15% of that $160 billion shows up in publicly disclosed data from US banks. That ties the remaining $140 billion to offshore dollar-funding markets—equivalent to nearly 15% of the daily $1 trillion in official transactions in overnight Treasury repo markets. If the Saudis did pull a substantial amount of its short-term dollar funding, say even $20 billion, it’s likely that it would have caused strain in markets.

“It is relatively speaking unusual for a country with $500 billion in total reserves to keep 40% of that in deposits. Clearly, the Saudis are a big part of the money markets, and as a result, it’s not crazy to think if there’s a disruption in the money markets, it might be a function of Saudi activity,” said Brad Setser, senior fellow for international economics at the Council on Foreign Relations.

Not everybody is buying the Saudi theory, however. Or at least not all of it.

A Saudi move, no matter how massive, likely cannot explain the entirety of that first mid-September repo spike. On the one hand, simply moving dollars between bank accounts shouldn’t in theory put a substantial strain on repo markets. Likewise, economists say it is improbable that the Saudis would pull so much cash out of repo markets in a single day or two, and that they would be more likely to slowly withdraw over an extended period of time.

“I think the fundamental issue was that the banking system reached a point of reserve scarcity, or at least a temporary point of reserve scarcity,” said Mark Cabana, head of US short rates strategy at Bank of America. “Might Saudi flows have been a marginal exacerbator? Yeah that’s possible. But it’s not, in my view, a material proximate cause.”

It will be exceedingly difficult for market sleuths to fully confirm their hunches. Saudi Arabia is opaque about where it keeps, and how it invests, its petrodollars (as are the U.S. banks that manage their funds). It’s no Norway, which signals to the markets through its commodity-driven sovereign wealth fund where it’s parking its earnings.

Vital as they are, the repo markets, in the U.S. and offshore, are only somewhat transparent.

Regardless of whether Saudi Arabia helped drive the repo crisis or not, experts note that, even if unrelated to US financial stability, foreign shocks to the U.S. money markets could wind up becoming an American problem, forcing the Fed to jump in and paper up short-term funding markets.

“Foreign flows are going to play a role in the potential funding pressures that may arise going forward,” said Greg Hertrich, head of depository strategies at Nomura. “So when I think about this most recent iteration, it’s hard to determine causality versus correlation in the shock. But rational people would think there is little doubt that foreign flows have the potential to have an impact on short-term funding markets.”

And, as the dramatic events of mid-September showed, the health of the repo market is an important indicator for the health of the larger U.S. economy.

“September 16th felt like an elaborate game of musical chairs,” said one veteran repo banker who works at one of the country’s largest insurance companies, which routinely lends out securities that it does not actively trade into the repo markets. “In between all the factors that brewed into a perfect storm, you had highly significant flows of money moving around the reserve system and lots of volatility in its wake.”

“I’ve been in the repo market for 30 years,” he continued, “and I can safely say that this was one of the top five worst days the market has seen in that time frame.”