Liquidity lowdown: Overnight lending – The dynamics of secured vs unsecured

The market for overnight lending is becoming ever more thought-provoking as the correlation of interest rates offered between unsecured and secured lending are becoming almost intertwined.

The demand for overnight cash has never been greater as the Bank of England (BoE) continues to reduce its balance sheet and drain liquidity from the system. At its height, the BoE’s Asset Purchase Facility (APF) held a nominal value of gilts in excess of £750bn, but has reduced this by over £80bn in 2024 with no slowdown of gilt sales in 2025. All of this has implications for the overnight lending market as it indicates an abundance of collateral and a relative scarcity of cash. As markets are edging closer to equilibrium reserve levels, some investors have called for the BoE to halt active bond sales to prevent any strain in markets. 

Under normal market conditions, one would expect unsecured overnight lending to command a higher rate of interest for investors, as they expose themselves to the credit default risk of the issuer, with no collateral backing. Currently we are finding that reverse repos – which are generally secured by high quality collateral – are offering levels higher than those on unsecured overnight lending. 

Treasury desks of financial institutions are having to increase the interest they pay on unsecured borrowings to attract overnight cash from investors, which is a sign that liquidity is draining from the system, although the fact that funds are wanting to take longer duration in a rate falling environment will drain overnight liquidity to some extent. Unsecured overnight lending also encounters significant competition from the well collateralised repo market, as investors (including us) commonly utilise both avenues for overnight lending to meet their daily liquidity needs.

Reverse repurchase agreements offer a secure way of lending cash, where the lender receives high-quality collateral – typically sovereign debt instruments such as gilts – in exchange for providing short-term liquidity. This level of security makes reverse repurchase agreements particularly  attractive to investors, although until the BoE began their programme of gilt sales in 2022, that came at a cost. Markets were used to years of abundant liquidity, meaning banks were less willing to offer attractive levels to borrow cash from investors. But the tables have practically turned now, with reverse repurchase agreements often providing investors with better interest rates  than unsecured overnight lending. 

This level of security makes reverse repurchase agreements particularly attractive to investors

Why rates on overnight lending won’t go much higher than Bank Rate

Banks will typically borrow cash from investors, or depositors, and lodge that cash at the BoE at official Bank Rate, which is currently 4.25% in the UK. The spread between Bank Rate and the rate which banks pay to investors will be their profit.  Whilst some banks are willing to accept deposits at Bank Rate, we do not foresee rates going much higher. 

Although periodic spikes in repo rates are not uncommon, we also do not foresee interest rates on repos climbing much higher either. The BoE repo facility has seen increasing usage since it was introduced in October 2022 in response to the LDI / pension fund crisis, which left asset managers having to fire sale assets to raise cash for collateral payments on long-dated derivative trades. This facility aims to ease liquidity pressure, as it allows banks to borrow cash at Bank Rate which in turn ensures that short-term money market rates do not deviate significantly from Bank Rate. Therefore, with this cap of rates on excess demand, we do not anticipate any material upward pressure on overnight interest rates in the near future, because banks have alternative sources of funding beyond just investors. 

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