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Reduce Bank Fear, Use Fed As Clearinghouse

The US Federal Reserve needs to step into the market for short term borrowing in order to give banks the confidence to resume trading with each other, traders say.

"The US Treasury has already implemented a guarantee program to prevent a run on money market funds. Several commentators (including our New York team) have proposed that the Fed play a similar role in the repo market, acting as a clearinghouse for trades and removing counterparty risk," Merrill Lynch wrote in a note to clients Sept 26.

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Banks have become reluctant to lend to one another for fear they do not know whether the other bank (the counterparty) will have enough money to make good on the trades. Installing the Federal Reserve as a clearing firm in between the banks would reduce that fear.

The reduction of that fear would allow the aggressive selling in banks like Wachovia and others to subside, traders say.

"This will allow us to see what everybody has without fear of collapse, " said Jon Najarian, co-founder of Optionmonster.com. "And fear is our biggest problem right now."

Reporting by CNBC's Dylan Ratigan.

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