Adds analyst comment, context background, bullets

By Gertrude Chavez-Dreyfuss

NEW YORK, May 6 (Reuters) - The Treasury Borrowing Advisory Committee (TBAC) discussed this week a proposal for the U.S. Treasury to invest in the overnight repurchase or repo market, a potentially significant shift in cash management policy that carries broad implications for financial market liquidity.

Committee members debated whether the Treasury should lend its excess cash in the repo market "to generate investment returns while maintaining prudent risk management and avoiding market disruptions."

The discussion on Tuesday was noted in meeting minutes released on Wednesday.

When the Treasury accumulates large balances at the Federal Reserve, that cash is essentially withdrawn from the private financial system, draining reserves and tightening overall market conditions. This dynamic can contribute to volatility in short-term funding markets, particularly during periods of stress.

By being a lender in the repo market, the Treasury recycles that cash back into the banking system. This then reduces pressure on repo markets during periods of elevated demand such as the end of the month or quarter.

"By having a large cash balance, the Treasury is sucking out reserves from the system that can cause liquidity issues," said Jan Nevruzi, U.S. rates strategist at TD Securities in New York.

"You can effectively sterilize or limit that impact by providing cash in the repo market. It's like injecting reserves back into the system."

MANAGING US CASH BALANCES

TBAC is a private-sector advisory group that counsels the U.S. Treasury Department on government financing, debt issuance strategy and overall market functioning.

The proposed move from the Treasury reflects a growing focus on optimizing the Treasury's large and often volatile cash balance, particularly as borrowing needs remain elevated.

The Treasury typically keeps all its cash with the Fed under the Treasury General Account (TGA), a policy that began in 2008. The Fed pays no interest on that account.

The TGA in general holds a level of cash sufficient to cover one week of Treasury outflows, a TBAC presentation showed, subject to a minimum balance of $150 billion. The current TGA sits at around $879 billion.

Higher Treasury cash balances generally correspond to a decline in bank reserves. To build those balances, the Treasury typically issues bills, notes or bonds.

Investors - including banks, hedge funds, and households - purchase these securities using funds held in bank accounts. The banks then settle these transactions by transferring reserves from their accounts at the Fed into the TGA.

SPREAD BETWEEN REPO RATE AND IORB

The minutes also indicated that the "economic viability of investing in the repo market" would depend on the spread between the interest rate Treasury earns on repo investments and the rate the Fed pays on reserve balances.

Currently the overnight repo rate or the Secured Overnight Financing Rate is 3.62%, while the Fed pays 3.65% for interest on reserve balances (IORB) held at the central bank. That's a spread of 3 basis points.

Under this scenario, Treasury would actually earn less lending into the repo market than what banks earn on their reserve balances at the Fed. That said, the Treasury does not receive IORB in exactly the same way commercial banks do.

Analysts noted that the comparison between repo lending versus holding deposits at the Fed is more about the opportunity cost to the overall financial system and whether Treasury repo lending meaningfully improves market functioning.

"This thing is still a ways away because it has not been included formally in a questionnaire to primary dealers just yet," said Angelo Manolatos, U.S. macro strategist at Wells Fargo in Charlotte, North Carolina.

"It's a topic that has been getting a little bit more attention recently with potential changes to the Fed's balance sheet."

The Fed also began slowing - and then effectively halting - the runoff of its balance sheet in December, or the practice of allowing securities to mature without using the proceeds to buy more, reversing part of its long-running quantitative tightening program. Policymakers cited signs of tightening liquidity last year, when repo rates periodically moved higher, as a reason for the shift.