The unwillingness of the top four U.S. banks to lend cash combined with a burst of demand from hedge funds for secured funding could explain a recent spike in U.S. money market rates, the Bank for International Settlements said.

Cash available to banks for short-term funding all but dried up in late September, and interest rates deep in the plumbing of U.S. financial markets climbed into double digits.

That forced the Fed to make an emergency injection of billions of dollars for the first time since the 2008 financial crisis.

While the exact cause of the squeeze is unclear – with explanations ranging from large withdrawals for quarterly tax payments to a big settlement of a trade in U.S. Treasuries – BIS analysts said the growing reliance on the biggest U.S. banks to keep the repo market functioning may have been a big factor.

The repo market underpins much of the U.S. financial system, helping ensure banks have liquidity to meet their daily operational needs.

In a repo trade, Wall Street firms and banks offer U.S. Treasuries and other high-quality securities as collateral to raise cash, often just overnight, to finance their trading and lending. The next day, borrowers repay the loans plus what is typically a nominal rate of interest and get their bonds back. In other words they repurchase, or repo, the bonds.

In late September, interest rates shot up to as high as 10 percent for some overnight loans, more than four times the Fed's policy rate, and raising concerns about the fragility of U.S. dollar funding markets.

After the U.S. Federal Reserve began to run down its four trillion U.S. dollars plus balance sheet from October 2017, banks' cash reserves at the Fed also contracted, while their holdings of U.S. Treasuries grew rapidly, the BIS said.

That reduction in cash holdings at the Fed sped up after the U.S. debt ceiling was suspended in early August.

The U.S. Treasury drained more than 120 billion U.S. dollars of reserves from August 14 to September 17, reducing the cash buffers of the big four banks and hence their willingness to lend in the repo market, the BIS found.

"Banks get used to a protracted period of abundant excess reserves, withdrawing them may result in unpredictable and sudden market adjustments. It is as if a muscle had atrophied," said Claudio Borio, head of the monetary and economic department at BIS.

That rush for short-dated secured funding was exacerbated by hedge funds that had ramped up their Treasury repos to fund arbitrage trades between cash bonds and derivatives.

(With input from Reuters)