Elham Saeidinezhad

On September 28, 2023, the Bank of England opened permanent liquidity facilities to nonbanking financial entities—such as pension funds, insurers, and investment funds—many of whom are part of the interest rate swap (IRS) market. The move is unprecedented. Historically, the Bank of England and other Western central banks have assisted banks in managing their cash outflows by creating facilities catering to liquid assets’ usability. IRS are contracts to exchange cash flows based on interest rate differentials. When introduced in the 1980s, these were not were not considered a cash management tool, and swap market participants were excluded from liquidity programs. Why the sudden shift? 

In what follows, I reevaluate the function of IRS in the global financial system. Swaps are widely conceptualized as hedging instruments, where a fixed-rate payer/floating-rate receiver can offset bond devaluation caused by interest rate fluctuation. They are also understood as a speculative tool which investors use to establish a leveraged position with regard to a bond without holding any positions in the underlying asset. 

But the Bank of England’s actions suggest that alternative mechanisms are at work. Drawing on a forthcoming interview with one of the world’s largest IRS dealers, Ralph Axel, I make the case that IRS perform a far more significant function than hitherto realized—they are used to fill funding gaps and compensate for failures in the repurchase agreement (repo) market. 

Considering IRS as synthetic repos opens up new possibilities for understanding funding liquidity and designing alternative funding solutions. The two main types of liquidity are market liquidity and funding liquidity. Traditionally, market liquidity is measured multidimensionally and by attributes such as immediacy, depth, and breadth. At the same time, when it comes to funding liquidity, economic theories only look at one measurement: the availability of funds. But given that investors heavily rely on swaps, funding liquidity needs to be comprehensively evaluated, considering the availability of cash, associated costs, duration of the loan agreement, and the nature of fixed versus floating rates.

Looking at funding liquidity from multiple angles provides a more nuanced understanding of the state of the repo market. The repo market has traditionally been a reliable source for providing all elements of funding. However, investors are demonstrating a preference for swaps, in order to access some aspects of funding liquidity. This shift suggests that swaps have become a viable alternative to traditional wholesale money markets and that not all dimensions of liquidity can be obtained through the repo market alone. Examining the swap market structure can provide valuable insights into the overall funding landscape.

This development has significant implications. In particular, the shift away from the repo market has led to a greater dependence on private credit and market-based finance for funding liquidity. In developed economies such as the US and the UK, most derivatives and swap activities are carried out by non-banking financial institutions such as pension funds, alternative investment funds, and hedge funds. These institutions offer elements of funding that cannot be obtained from the repo market, demanding the support of central banks as lenders-of-last-resort. This, then, is the shifting microstructure underpinning the Bank of England’s recent policies. 

Swaps as modern repos

A swap is a portfolio of multiple and sequential “Forward Rate Agreements” (FRAs). As shown in the figures below, an FRA is an agreement between two parties on a fixed interest rate to be paid/received at a future start date against a reference (floating) rate. 

In practice, the FRA comprises two parallel loans: a fixed-rate loan, and a floating-rate loan. Let’s say bank A promises to pay Bank B a rate of 5 percent on a $200 million three-month deposit to be received in two months. When the time comes, Bank A will have to make that cash payment to Bank B should the three-month rate remain below 5 percent. However, should the three-month rate rise above 5 percent, Bank B will have to make a cash payment to Bank A. The amount of the cash payment thus equals the difference between 5 percent and the three-month rate on the day the FRA settled, multiplied by $200 million and a quarter of a year.

Conversely, a repo is a loan secured by collateral in the form of securities. One side lends money, and the other side lends (or reverses out) securities. Perhaps counterintuitively, this loan effectively mirrors the structure of the IRS through the exchange between a floating and fixed-rate entity. The swap’s fixed-rate payer is comparable to the repo’s cash-rich lender (such as a money market fund or MMF), and its floating-rate payer replicates the cash-borrowing agent (such as a hedge fund). This parallel is exhibited in the two figures below:

Figure 1: Financial Flows of a Swap

Figure 2: Financial Flows of a Repo

In this way swaps can enable the lending of excess fixed-income securities. If a triple-A-rated corporation enters into a swap contract with a triple-B-rated corporation, the former can trade its greater access to fixed-income securities for the latter’s better rates in the cash market. 

Crucially, the swap’s replication portfolio (cash loans + coupon bonds) generates cash flows similar to those of a holding repo. Investors swap fixed-income securities for cash in an overnight or term (i.e., three-month) repo. Furthermore, like the sequential exchanges in a swap, repo contracts usually roll over for some time. Analytically, individual swap settlements can thus be interpreted and understood as synthetic repos. 

The beauty of a synthetic repo analogy is that it clearly shows the funding utility of swaps. The two parties, intermediated by a swap dealer, may use swaps to lend their surplus balances. In the case of the fixed-payer, this means that the party, similar to a typical hedge fund in the repo market, has “too many” bonds in hand, and relatively speaking, fewer cash reserves.

Why are swaps substituting repos? 

Repo markets are one of the largest sources of funding and risk transformation in the U.S. financial system. But despite their size, repo rates have proven to be increasingly unpredictable and subject to extreme intraday spikes. A notable example occurred on September 17, 2019, when the intraday repo rate rose thirty times the same spread the preceding week.

This sudden spike was in part the result of short-term disruptions, including the settlement of Treasury debt issuances on September 16. But it also reflected structural changes that have decreased the flexibility of repo markets to offer attractive funding solutions. One of the major factors for this was the modification of the business models of large banks in the aftermath of 2008. Since they were obligated to hold higher levels of reserves and liquidity due to regulatory programs such as the Liquidity Coverage Ratio (LCR), banks have shifted their priorities from external to internal lending, in turn making them less flexible in their offerings of money market loans, including repo lending. 

In the repo market, banks prefer to hold reserves instead of Treasuries to satisfy their High Quality Liquid Asset (HQLA) requirements. In response, repo market makers have shifted their priority from external to internal lending. These banks increase their flexibility in sourcing funds internally, becoming less flexible in repo lending as they stop obtaining cash from other parts of the firm.

Internal frictions that curbed banks’ desire to offer attractive money market loans caused the spillovers from the repo market to the Foreign Exchange (FX) swaps market. Some spillover between these markets naturally resulted from foreign banks choosing to source U.S. dollars in FX swaps instead of repo. But the FX swaps market is heavily intermediated by the same banks active in repo. These banks increased lending in FX Swaps relative to repo despite a smaller rate increase, implying that frictions in banks’ ability to optimally reallocate funds in the wholesale money market led to these adjustments. Like the FX swap market, the interest rate swap market is another synthetic funding market that accommodates spillovers and investors from the repo market.

Beyond mimicking repos, then, swaps also have several advantages over them. Most importantly, their engineering opens diverse opportunities to shift funds across the financial system. A company that has decided to borrow at short-term floating rates can either issue short-term debt, like commercial paper or issue long-term floating-rate debt. While both options offer the desired interest rate exposure, commercial paper comes with the risk of limited access and liquidity issues. Long-term floating-rate debt solves the liquidity issue, but the market is relatively small and illiquid. 

A solution for these corporations is to issue fixed-rate debt and then receive fixed and pay floating in a swap. The net effect of the fixed debt and the swap is floating-rate funding. It’s far more appealing to issue fixed-rate debt and then receive fixed and pay floating in a swap—fixed debt combined with the swap effectively gives floating-rate funding. In addition, these transactions also avoid noting liability on company balance sheets, and give companies access to narrower bid-ask spreads, since the width of the dealers’ bid-ask spread in the swap is inherently constrained. Swaps offer a more flexible way to shift funds across the financial system.

Regulatory challenges

Swaps can be reconstructed indirectly (or synthetically) by holding two instruments: a floating-rate loan (such as a short-term bank loan) and a fixed-income security (such as a coupon bond). Importantly, these two instruments are explicitly involved in constructing the repo as well. In other words, individual swap settlements can be thought of as synthetic repos.

This insight—that swaps’ cash flow replicates repos—provides a valuable shortcut to swap market structure and broader financial stability. Importantly, the market’s reliance on swaps for providing funding makes the Fed’s crisis-fighting task more complex. In a wholesale money market, the funding provision is relatively straightforward. In the repo, for instance, funds move from the cash-rich (such as MMFs) balance sheet to cash-deficit (such as hedge funds) institutions. The intermediation happens via the balance sheet of a repo dealer. In this setting, during financial distress, central banks inject cash into the system either by becoming the dealer of last resort (and trade directly with the dealers) or by becoming the lender of last resort (and lend to the so-called cash-rich players.)

However, a swap-centric funding market structure is considerably more complex and less transparent. Notably, it is entirely off-balance sheets. The role of players and the direction of funding are also blurred within this marketplace—unlike in the money market, where access to cash determines who the lender is, in swap-centric financing, the lender is determined based on her “comparative advantage” in the capital and money markets. Synthetic lending happens by those with comparatively better access to the floating-rate market. The problem is that these institutions, by definition, are less credit-worthy and have lower credit ratings than their counterparts. In other words, the lenders of synthetic funding by construction are the low-quality firms with higher credit risks.

Synthetic funding also adds additional layers to funding provision. Money markets are a direct source of funding, but they may not always offer reasonable rates. On the other hand, synthetic funding can provide more flexible solutions, such as better rates or the conversion of fixed to floating rates, and vice versa. This flexibility is crucial for investors, especially when borrowing against future income becomes difficult due to unattractive funding liquidity rates or other factors. In such cases, the money market can provide imperfect solutions. However, combining money market funding with swaps can make the rates and other attributes, such as fixed vs. floating of the fundings, more appealing and better aligned with the future cash inflow stream of borrowers. The repo-swap combo is an ideal funding solution for investors in such situations.

The substitution of the IRS for repos represents a new market structure, which involves more complex funding and higher reliance on risky firms to provide affordable liquidity. It can, therefore, create important practical and political obstacles for the Fed during a period of funding squeeze—it is unclear whether the Fed’s established role as lender or/and dealer of last resort is enough to backstop such a complex and opaque funding system. The present gap in policymakers’ understanding of these developments can lead to binding regulatory consequences that impair funding conditions or make them unequipped to fight the next funding crisis.

Elham Saeidinezhad

Have interest rate swaps (IRS) become the modern repurchase agreements (repos)? In the latest essay in the ongoing series on Market Microstructures, I argue that shifts in the liquidity market have fundamentally altered the function of IRS in the global financial system. Today, IRS are used to fill funding gaps and compensate for failures in the repo market. 

The following interview with Ralph Axel, an interest rate strategist at Bank of America (BofA), builds on this analysis, providing insights into the fixed-income market. Extensive experience in sales and trading desks has given Axel a thorough understanding of market structures, models, and risks. Below, we delve into the market structure of interest swaps, its connection with the wholesale money market, and regulator responses. 

An interview with Ralph Axel 

ELHAM SAEIDINEZHAD: Bank of America, which is a big player in the fixed-income market, is known for being one of the largest dealers in IRS—financial contracts in which parties exchange fixed interest payments with floating ones based on a notional amount. They create markets in IRS and sell them to participants such as asset managers and primary dealers, and they also make markets in fixed-income futures, and Treasury securities. 

Let’s examine the market structure for IRS. What is the dominant force that is fundamentally altering the market structure?

RALPH AXEL:  In recent years, the Commodities Futures Trading Commission (CFTC) has discussed introducing new regulatory rules. These are aimed at examining the creation of new products for trading and defining capital requirements for swap dealers and major swap participants. The discussions are ongoing, with the CFTC working to ensure that new products benefit the market, while also considering the capital requirements of those involved in transactions. The CFTC aims to promote efficient markets while strengthening participant’s balance sheets.

ES: These rules are separate from those introduced after the 2007-08 Great Financial Crisis (GFC), which were focused on increasing transparency in the market in the aftermath of GFC. Regulators have now shifted their attention.

RA: Since the financial crisis of 2008, increasing transparency has been a crucial goal. In order to achieve this, regulators have implemented margin rules for high-quality collateral and clearing rules to push trades towards central counterparties (CCPs). These measures help create visibility, which was sorely lacking in 2008. It took a lot of work to know where IRS were located, who was facing whom, and what collateral types were used. Clearing and margin requirements have been at the forefront of regulators’ efforts to improve risk reporting, measurement, and tracking.

Recently, regulatory focus has shifted towards strengthening swap participants’ balance sheets through higher capital requirements and closer examination of new products that may be considered swaps.

ES: As someone who follows the markets closely, do you think these regulations are necessary?

RA: These additional swap regulations aim to address issues in the repo market, albeit indirectly. I will later explain how the IRS and repo markets are connected. Going back to your question on regulation, in the repo market, current regulatory proposals that aim to push for repo clearing seem unnecessary.  In the swap market, the existing mandates introduced in Dodd-Frank and Basel III have already led to a smooth transition into swap clearing. Clearing swaps involves directly or indirectly submitting the swaps transactions to a Derivatives Clearing Organization (“DCO”) registered with the CFTC. In the government fixed-income market, for instance, the Government Securities Clearing Corporation (GSCC) has played a key role in this, handling government securities swaps with ease. In general, this process has been successful and has led to the development of relatively robust swap markets.

ES: What is driving regulators to impose more restrictions on the IRS market? I am specifically thinking about capital requirements and new product rules that the industry has criticized.

RA: The new regulatory interventions, although happening in the swap market, are not intended so much to fix the IRS structure but to stabilize the repo market. The repo market is a crucial wholesale funding market that helps to move cash around the financial system. The swap market plays a major role in enabling the flow of funds through the repo market. Therefore, regulators pay close attention to the happenings in this market.

In the repo market, regulators, particularly the US Securities and Exchange Commission (SEC), advocate for the central clearing of the repo and US Treasuries to promote transparency. Similarly, the CFTC also pushes for increased swap clearing to enhance transparency in the IRS market. In addition to these mandates, the CFTC has implemented new capital requirements to improve the risk management and risk-absorbing capacity of the swap dealers and major swap participants. These regulatory developments positively impact both the repo and IRS markets.

ES: You mentioned that swaps are crucial infrastructures supporting the repo market. The relationship between wholesale funding and swap markets is fundamental to the functioning of the financial system. Strangely, this connection is often disregarded in academic discussions. How do swaps make it easier to facilitate wholesale funding?

RA: It is possible to observe a connection between the IRS market and the repo market by examining the business model of major swap participants. These entities, including asset managers and primary dealers, frequently use repos to raise funds and manage liquidity. In fact, asset managers constitute almost a quarter of the participating firms in the repo market, while primary dealers account for nearly 50 percent of the participation. These entities use interest rate-sensitive fixed-income securities, such as US Treasuries, as high-quality collateral to obtain cash in the repo market.

Asset managers need to access funding through fixed-income securities. However, their funding depends on these securities’ price, which exposes them to price risks. To mitigate this risk, IRS can be used as a hedging solution. In the meantime, the repo market determines the funding costs for these firms, which are represented by the interest rates. At times, the repo market may offer unattractive or high rates, which interest rate swaps can mitigate. This process, known as interest rate management, enables asset managers to exchange these rates for more desirable and attractive rates. It is important to note that the conditions of the IRS market can impact the functioning of the repo market.

But again, from an operational standpoint, it is striking how well the wholesale funding functions when you look at repo markets. 

ES: The repo market is currently functioning well. However, as you previously mentioned, asset managers could use swaps to manage their funding costs if the repo market were to offer unattractive rates. This is a crucial function of swaps in the funding market.

RA: An IRS is a financial instrument that helps entities manage their interest payments, including those related to activities in the repo market. Additionally, swaps help asset managers manage cash flow. For instance, asset managers can use IRS if they need to adjust their portfolio’s duration. Duration refers to the average time it takes to receive all of a bond’s cash flows, weighted by the present value of each cash flow. It is the payment-weighted point in time at which an investor can expect to regain their original investment. Liquid swap markets partially exist because swaps provide these essential funding-centric services.

ES: Interestingly, IRS are often overlooked as a funding strategy. 

RA: Yes, non-practitioners sometimes do not recognize the IRS market’s full potential. Typically, swaps are used either to hedge or speculate, which are their more classic functions. Hedging is an important because it can be used by both financial and non-financial corporate entities. For instance, if IBM plans to issue a bond within the next year and wants to avoid a situation where interest rates rise by 100 basis points, it can hedge today using the swaps market. This enables companies to plan more precisely for the future, leading to a smoother business cycle, even outside financial markets.

ES: Should we expect spillover effects between the repo/US Treasuries and swaps markets due to regulatory developments such as clearing mandates?

RA:  It is important to note that anything that limits the accessibility of high-quality collateral, including US Treasuries, for entities such as asset managers will increase the cost of repo funding. This increase in cost will also have implications in the IRS market. This is because the cost of managing the interest rate risks associated with these fundings will also increase. Similarly, any factor that increases the hedging costs will also cause an increase in the funding costs. Therefore, it is crucial to be meticulous when creating clearing/regulatory rules that affect the expenses of derivatives and repos. The functioning of the swaps and repo market are closely related.

ES: The costs from the swap market, where interest rate management takes place, spill over to the repo market, where access to funding is provided, and vice versa. Regarding the new regulations on clearing mandates, are practitioners concerned about the costs that the restrictions may bring?

RA: A more important question that needs to be addressed—who bears the costs? Specifically, when it comes to clearing, regulators must clarify who is responsible for bearing the costs. Are clearing house owners or capital owners on the hook? Additionally, how is the cost distributed among the participants? These are important questions.

ES: Our focus has been on asset managers, but the Silicon Valley Bank (SVB) failure shows that banks also extensively use IRS. Can you explain banks’ applications for swaps?

RA: The banking system holds approximately 17 trillion in deposits and frequently adjusts its fixed and floating rate exposures on both the asset and liability sides. Banks may opt for a fixed-to-floating rate swap through the IRS market to match their overall balance sheet interest rate exposure more effectively. The system is functioning well as these entities can trade swaps in a relatively liquid manner without encountering significant difficulties in determining market pricing, executing trades, determining trade size, and exiting positions without disrupting the markets.

During the pandemic in 2020, swaps functioned properly while the cash market (i.e., the US Treasury market) needed the intervention of the Fed. Because people could not exit the market smoothly and functionally, the Fed had to buy many Treasuries. The current swap market is not in an emergency that requires fixing. However, it should be improved, simplified, and made fairer over time.

ES: During the pandemic, you mentioned that investors faced difficulty in selling US Treasury holdings while they more smoothly unwound their swap positions. Although financial theories offer various ways for investors to exit swap contracts, what are the most commonly used methods in practice?

RA: If a client has a swaps position initiated a few months or years ago, they usually approach a “swap dealer.” Like the BofA trading desk, these dealers could be large or smaller swaps dealers. These dealers have standardized pricing methods, crucial for clearing and enabling clients to exit their positions. The client would provide their swap’s payment schedule and maturity date, and the dealers would make a market in the swap. The client could enter or exit the swap, just like trading any other financial asset.

ES: Earlier, you mentioned that the swap market was resilient during the pandemic because participants could smoothly enter or exit swap positions. Liquidity is a service offered by swap dealers such as BofA, vital in making the market for interest rate swaps. Can you tell us more about their business model and whether there will be any significant changes to their transactions or model due to regulatory changes in the near future?

RA: We have trading desks for various financial instruments like IRS, repos, treasury securities, mortgages, corporate investments, high yield, commodities, and currencies. Each desk has a different business model. Generally, businesses require a certain amount of capital to operate, which can generate a certain return, making it attractive or unattractive. Sometimes, a business may not have a high return on equity, but it’s still important to keep it running as it provides a vital side service to other attractive businesses. Decision are made not only based on a business’s its return on equity but also on how it fits into the overall capital market operations. Swaps and cleared products are crucial to meet the demands of our client base. Interest rate risk and sensitivity are inherent in the fixed-income market, which makes swap dealers a fundamental part of the financial market infrastructure.

ES: Standardization is a significant side effect of clearing mandates. Does standardization make the market-making more accessible, attractive, or challenging?

RA: Standardization is very important. The value of any market lies in how usefully it facilitates trade. You can trade less standardized assets. But as you move away from the standardized products, the markets become less deep. And the pricing becomes more volatile, and liquidity deteriorates. We see that in many markets—Treasuries, mortgages, etc.—that started standardization before the swaps market. That is why important markets, such as mortgage-backed securities (MBS) and Treasury markets, are highly standardized.

As you move away from standardized products, markets become less deep, and your pricing and liquidity are lower. This is why the IRS market is also growing highly standardized. We only have a financial system because the market can fulfill a need. We have a swaps market because so many entities have financial risk and the need to manage interest rates. They need to exchange fixed payments for floating payments. Everyone benefits if you have a IRS market that exchanges fixed for floating rate payments. But as it becomes more specialized, the number of people open to using the market declines—it becomes less valuable.

ES: I want us to focus on the hedging momentarily. Some practitioners differentiate between hedging and risk management. In academic and policy discussions, they are often used interchangeably. Are there any differences between these two terms?

 RA: Risk management is a broader concept than hedging. Usually, when hedging, there are very specific instruments whose risk profile is changed. Let’s say a bank has a mortgage-backed security sensitive to interest rates. That’s a specific interest rate exposure, so they might trade a swap specifically geared towards reducing the interest rate exposure on that mortgage-backed security. Risk management more broadly incorporates more generic ideas. 

Borrowing costs are a function of the overall interest rate level and its specific credit profile. As a corporation borrowing money in capital markets doesn’t know precisely what its borrowing costs will be next year, it can’t perfectly hedge. Likewise, as its credit profile can change in a year, it can’t really hedge—it can only hedge the approximate overall level of interest rates. Risk management tends to be performed by corporations that wants to manage overall exposure to borrowing costs by locking in their costs through a fixed tenure swap. That’s different from hedging the interest rate risk on a specific security.

ES: I am also curious about the role of CPPs in all of this, including hedging. A CCP becomes a counterparty to trades with clients that are different market participants. Recent reports from the CFTC display concern for the behavioral diversity among CCP clients—hedge funds, asset managers, insurance companies, pension funds, and so on. Should we be concerned about this?

 RA: I think the more, the merrier. If you only had banks in the swap market, they would likely all go the same way—if they are generally making thirty-year fixed-rate loans, they all have similar risk exposure. They will all want to go in the same direction in the swap market to offset it. That would create a lopsided demand; you wouldn’t have many players or entities wanting to take the other side of that trade. When banks, hedge funds, insurance companies, asset managers, and corporations take different risks in different directions, the chances of a balanced market is much greater. Diverse entities spread risks, which is extremely important.

ES: We started our conversation by discussing regulations and collateral (margin) rules. I want us to go return to that point. One of the things that the CFTC is trying to understand is whether there is a causal relationship between margin requirements and the liquidity of the IRS market—whether margin requirements create funding issues in the market. What do you think about this relationship between margin requirement and liquidity?

 RA: We have seen some problems with margin requirements. In the UK, pension funds struggled to meet margin requirements because the market had huge moves. The prices of assets declined significantly, and they were asked to put more margin in to protect against default. Suddenly, these funds were not able to make their margins. It’s thus important to have somewhat predictable margin requirements. If volatility picks up suddenly, you have margin requirements that were not projected or planned. That can be disruptive; if you can’t meet your margin requirements, you must unwind your position in the clearing house.

That forced liquidation, sometimes called fire sales, is a risk. You can have caused liquidation problems for other reasons, like suddenly needing to meet liabilities. We want to minimize fire sales because they significantly impact the prices and liquidated assets and carry chain effects. We must figure out ways to reduce the risk of fire sales and forced liquidation by making margining more transparent and predictable. It’s very tough to do that because margin requirements move with volatility, but it is important to make margining less disruptive.

ES: Finally, I want to discuss the hierarchy of financial instruments, where cash is at the top. CFTC reports mention that market practitioners prefer to hold cash as collateral and seem pretty puzzled about it. Is this the case, and if so, why?

 RA: Cash doesn’t have price risk, and everything else does. If you post treasuries and their price decreases, you might need to post more. That’s the main problem with non-cash—it has this exposure that can make it less valuable. The problem is that to get cash, you often have to borrow it; entities rarely have lots of cash sitting around because it’s an expensive thing to do. So, practitioners face a tough choice on the right collateral to use.

Treasury bills have minimal price risk, while thirty-year bonds have a lot of price risk. Then you might have other types of securities, like government bonds issued by Germany or Canada, and so on. These might have the same property of moneyness as T bills or cash. It is undoubtedly essential to have some flexibility in the collateral types used. 

One of the great things about insurance companies in the United States is that they naturally hold a lot of corporate bonds of various types. It’s beneficial that many insurance companies have collateral arrangements that allow them to post those corporate bonds. If something happens with a margin call for an insurance company, they typically will be able to adjust the margin to, let’s say, an increased margin requirement because they’ll post more of the assets that they already own, they don’t have to go out and find these assets to post.

Elham Saeidinezhad

Perceptions are shifting regarding the US fixed-income market. In September 2019, interest rates on overnight repos unexpectedly spiked, leading the Federal Reserve Bank of New York to inject $75 billion in liquidity. In March 2020, the Covid-19 pandemic triggered a wave of securities selling, prompting the Fed to purchase over $1 trillion in securities. These events have raised concerns about market stability.

In response, regulators have mandated that Treasury and repo transactions be cleared through clearinghouses. However, many participants, such as hedge funds, lack direct access to central counterparties (CCPs) and rely on dealing banks to connect them. Dealers, citing potential costs, have begun to ditch such clients. An intentional yet indirect consequence of these regulatory policies is the reduced participation of hedge funds in this market.

The issue, however, stems from a misdiagnosis of the underlying problem. The prevailing understanding attributes this instability to the behavior of alternative investment funds like hedge funds engaging in “basis trades,” framing liquidity as the key issue in the Treasury market. However, drawing on insights from my interview with seasoned fixed-income portfolio manager Mohsen Fahmi, this piece argues that the market suffers from a different problem altogether: specifically, a chronic inefficiency in the hedging market that could potentially lead to a systemic failure of fixed-income risk management strategies.

Locating risks hidden in plain sight within pragmatic risk management practices involves broadening our perspective. We need to view investment funds’ business models, including traditional ones like bond funds and alternative ones like hedge funds, as responses to changes in market structures rather than in isolation. This perspective allows us to see these business models as vehicles that transfer inefficiencies and opportunities from one market, such as the derivatives market, to other markets, such as the Treasuries cash market.

Bond mutual funds are major players in the US Treasury market.  The primary risk they encounter is the interest rate risk. Fund managers often use derivatives like options and interest rate swaps to hedge against this risk. These hedging tools have proven effective as their duration matches that of the underlying assets. For fixed-income fund managers with long-term investments, the Treasury options and interest rate swap markets used to offer contracts with durations matching their portfolios. However, the market for Treasury options is disappearing, affecting fixed-income fund managers with long-term investments. Additionally, as an earlier interview with Ralph Axel (the rate strategist at BofA, one of the largest swap dealers) demonstrated, the swap market is also shifting toward catering to different types of clients, particularly those with shorter-term investments.

The inability of options and interest rate swaps markets to offer the exact duration leaves an important gap in fixed-income risk management—“duration drift”—the unhedged portion of the portfolio due to the mismatch between the durations of the derivatives and the assets. Moreover, these risks are usually hidden through hedge accounting conventions that enable inefficient hedges to remain unreported.

To tackle inefficiencies in the options and swaps markets, there has been a shift in hedging demands towards the futures market. Shorter contracts in interest rate swaps and the disappearance of options force fixed-income asset managers to construct their hedging strategies based on futures. This shift generates extra demand for such contracts and increases basis points that hedge funds exploit. However, this behavior of hedge fund managers is just the tip of the iceberg. The larger hazard is shaped by the distortions in the fixed-income derivatives market. Consequently, the solution to stabilize the market lies not in the US Treasury cash market but in its hedging markets.

Instead of focusing on restricting the actions of hedge funds, regulators should learn from risk managers of mutual funds to develop a tool that measures the extent of hedging inefficiencies system-wide. Such a tool can become a new indicator of systemic risks in the fixed-income market. By developing and implementing tools to measure hidden hedging inefficiencies, regulators can gain better insights into creating a more stable and resilient financial system.

How regulators see hedge funds in the Treasury market

The shift in fixed-income fund managers’ portfolios toward US Treasury futures has caused prices to diverge from the related underlying asset, a Treasury security, leading to what is known as “basis.” Normally, policymakers and academics treat such deviations as short-lived phenomena, or sunspots, rather than structural issues. These deviations are expected to be resolved through arbitrage activities, which help the market correct itself, and the prices revert to their baseline and fundamental levels.

However, regulators’ problem with hedge fund arbitrage strategies is that they are orchestrated in a way that siphons liquidity from the market. The key to understanding this hostility towards hedge funds compared to a theoretical arbitrager is “leverage.” Regulators’ adverse view of hedge funds as arbitrageurs stems from their reliance on leveraged funding. Alternative investment funds conduct the arbitrage through “basis trades”—borrowing from the repo market to buy US Treasury securities at a lower price and simultaneously selling US Treasury futures at a higher price.

Regulators at the SEC and the Fed are worried that basis trade strategies are often made possible by low or zero haircuts on repo financing, which could result in liquidity crises. The high leverage utilized by hedge funds implies that if market conditions change suddenly, these funds might be compelled to quickly liquidate their positions, triggering “fire sales” that could destabilize the market. This withdrawal of liquidity by hedge fund arbitrage destabilizes the market rather than helping it return to equilibrium and market-clearing conditions.

Moreover, regulators also point fingers at traditional funds, such as fixed-income asset managers. They argue that these managers have shifted to the futures market due to their increased appetite and leverage, disregarding these funds’ pragmatic risk management considerations. In summary, the behavior of both traditional and alternative fund managers is seen as a key factor in heightened volatility in the US Treasury and repo markets.

However, the problem with this view is that regulators are focusing too much on funds as a self-contained problem rather than as a symptom of a much deeper issue in other segments of the fixed-income market structure. This perspective overlooks underlying structural issues in fixed-income markets, such as changes in the availability and terms of hedging instruments like swaps and options. These changes force fund managers to adopt different strategies, including the increased use of futures, which can inadvertently contribute to market volatility. By not addressing these root causes, regulatory efforts may fail to achieve true financial stability.

Duration drift: a hidden risk in fixed-income risk management

Examining how fund business models interact with market structure, rather than solely focusing on fund behavior, allows us to uncover how these funds’ practical management solutions risk becoming key drivers of instability in the Treasury market. Although Treasury securities are widely regarded as the world’s safest assets, they pose a risk to fixed-income fund managers: their prices move inversely to interest rates.

This risk originates from the evolution of the term structure or yield curve. The term structure represents the relationship between a bond’s term to maturity (when the final and largest payment is made) and its yield to maturity (mostly capturing the bond’s interim, yet smaller, payments). The value of these two sets of cash flows, determining the value of securities, moves inversely to interest rates. This inverse relationship impacts the portfolio’s overall return and necessitates sophisticated hedging solutions to mitigate risks.

For held-to-maturity securities, these risks impact the book value. However, the price risk becomes evident when securities are available-for-sale and fund managers liquidate them before maturity. In such cases, the fixed-income portfolio is exposed to market price and interest rate fluctuations. Interest rate hedging tools like swaps can help mitigate this risk. When the hedging is efficient, the fund’s return can stabilize and become comparable to a fixed benchmark. In fixed-income portfolios, derivatives effectively make the funds risk-free by synthetically aligning the bonds’ duration with the fund manager’s holding period.

The key to effective fixed-income risk management and creating a de facto risk-free asset is identifying derivatives that can synthetically align the fund’s fixed durations with increasingly varying investment periods. Ideally, these derivatives should have the same duration as the fixed-income assets. In the past, the interest rate swaps and options markets were liquid at every maturity, providing fixed-income managers with valuable tools for managing duration risks. As a result, these derivatives were widely popular for this purpose.

Incorporating such derivatives, especially those that match the bonds’ duration, helps establish adjacent points on the yield curve. These points form a vector of differences between portfolio and benchmark exposures that are highly correlated and typically move in opposite directions. This relationship allows fund managers to offset risk positions effectively, ensuring the portfolio’s return remains stable and comparable to a fixed benchmark, thus creating a near-risk-free investment environment.

For instance, if interest rates rise, the difference between the bond portfolio and benchmark returns becomes negative. Simultaneously, the difference between the swaps and benchmark returns turns positive. In an ideal hedge scenario, these opposing movements are equal in magnitude and cancel each other out. Therefore, combining swaps with bonds can help mitigate exposure to term structure risks, stabilizing the portfolio’s overall performance.

When the durations do not align—when the maturity of an underlying asset does not match the hedging instrument—the small period of time left out of the contract generates a hedge risk. For instance, a mismatch occurs when an interest rate swap that hedges a 10-year Treasury security matures in 8 years. This mismatch especially exposes bonds with longer terms to maturity.¹

Traditionally, the swap and option markets could offer near-perfect matches for most points on the yield curve, ensuring effective risk management. Recently, however, the size of the Treasury options market has been shrinking. It has also become more challenging for risk managers to find swaps that precisely match the maturity dates of their funds’ underlying assets. This phenomenon, known as “duration drift,” poses a significant challenge to effective risk management.

The unhedged portion of the funds’ duration can lead to a loss of value as interest rates fluctuate, and to the failure of the overall hedging process. When hedging methods like swaps or options result in duration drift, risk managers assess the extent of these drifts to devise additional strategies rather than leaving them unaddressed. Treasury futures, in particular, offer a cost-effective alternative to swaps for duration hedging.

Understanding and managing duration drifts is crucial for comprehending why fixed-income risk managers have increased their demand for Treasury futures. However, this nuanced aspect of pragmatic risk management often becomes a mere footnote in financial statements and hedge accounting conventions. This oversight is concerning because small losses from hedging inefficiencies in individual funds can become systematic if duration drift is widespread in the fixed-income market.

Effective regulation should prioritize the systemic implications of duration drift. Recognizing and addressing the causes and effects of duration drift can lead to more robust financial regulations. In such a market structure, focusing on less structural issues, such as hedge funds’ basis trading strategies, would only distract regulators from achieving the financial stability goals.

Hedge accounting: the art of hiding inefficient risk management

Just as the derivatives crises of the mid-1990s emerged as a result of inadequate reporting rules, duration drifts characteristic of contemporary swap markets can pose systemic risks given bookkeeping standards. The most critical flaw at the heart of swap accounting is precisely concerned with short-term, “ineffective” hedges like those constituting duration drift. In the past, these small hedges were generally ignored by accountants. While some recent reforms do aim at making hedge ineffectiveness more apparent in the financial statements, these measures have not been fully successful.²

Hedge ineffectiveness due to underhedging the floating-loan cash flow can go unreported as it is not a realized loss yet. Hedge accounting means that gains and losses on exposures and effective hedges of those exposures are recognized in net income in the same periods. As the swap cash flow will not affect or change the cash flow of the underlying asset, and the liquidity issues arising from the inefficient hedge have not materialized yet, the accounting of the swap can conform to the accounting for the hedged item. The swap does not need to do so if the hedged item is not marked to market daily for accounting purposes.

Similarly, for overhedging, a swap’s fair value is reported on the balance sheet and income statement. Thus, the very notion that the fair value of the swap implies hedge ineffectiveness need not be reported as a separate line in either statement. 

Accountants may hide the risks, but the risk managers must face them. The challenge lies in finding practical risk management solutions to address the unresolved risks. This is because certain areas of exposure may still need further hedging while others are already over-hedged.³

Policy implications

Pragmatic risk management considerations provide a different perspective on Treasury market vulnerabilities than basis trading. In November, our interview with Bank of America strategist Ralph Axel revealed a significant shift in the swap market structure. Rather than being used as a hedge, swaps are now largely used to provide synthetic short-term funding. Whereas portfolio managers used to constitute the biggest clients of swap dealers, a new wave of clients, especially alternative investment funds such as open-ended funds, is turning to swap markets for access to funding.⁴

The shift in swaps from hedging to funding has already started to show cracks in the system. Historically, traditional bond funds used swaps for hedging purposes, while alternative investment funds relied on the repo market for funding. As the efficiency of the repo market declined, alternative asset managers began turning to synthetic and indirect funding instruments such as swaps. This shift has disrupted the market structure for more traditional funds, introducing inefficiencies and distortions in their hedging strategies.

This shift in the function of the swap has impacted swap durations. A swap for funding involves applying the interest rate swap to a portion of the debt rather than the entire amount. This is known as a partial hedge and involves very short-term durations. As a result, swap markets for longer-term maturity, popular amongst fixed-income risk managers, are no longer liquid, and portfolio managers cannot enter the exact contract they seek. Instead, the contracts offered in the swap market are either just below or just above the desired length—in line with the needs of closed- and open-ended alternative funds.

Bond fund managers are adapting to changes in the swap market structure by turning to other derivatives, such as futures. This recent shift has caused price pressure on these derivatives. Additionally, since these strategies are classified as partial hedges, they remain unreported under hedge accounting conventions. This allows managers to avoid showing unnecessary volatilities in profit or loss due to changes in the hedging instrument’s fair value. However, from a financial stability perspective, this accounting convention creates an information gap and hides risks in financial markets, such as those caused by duration drift.

Measuring the extent of duration drift can effectively estimate hidden vulnerabilities in the Treasury market. It can also explain the additional price pressure on futures contracts and the motivation behind basis trading. Without capable valuation models and accounting conventions to capture these risks, regulators should introduce new tools that can display and estimate duration drift. Such tools would be more effective in stabilizing the Treasury market than imposing restrictions on private investment funds.

This is especially critical given the new wave of regulatory pressure. For instance, the Securities and Exchange Commission (SEC) has recently implemented new rules requiring most US Treasury transactions to be cleared by the end of 2025, even though the Fixed Income Clearing Corporation (FICC) is currently the sole clearinghouse for US Treasury securities and repos.

Restructuring the Treasuries market to rely on one central counterparty for handling the entire market could lead to significant systemic risks beyond the usual concentration risks associated with CCPs. While concentration risk may be manageable if the underlying risks are well understood, unresolved fixed-income risk management issues and duration drift could create a blind spot, exacerbating potential concentration risk in CCPs. This presents concerns about not only the concentration of known risks but also hidden risks like duration drift in CCPs that may not be apparent to regulators.

Risk managers of large fixed-income funds, such as bond and pension funds, closely monitor duration drift and its potential impact. Regulators should learn from these practices to develop a tool that measures the extent of duration drift system-wide as a new indicator of systemic risks in the fixed-income market. By developing and implementing tools to measure duration drift, regulators can gain better insights into the market’s underlying risks and proactively address them. This approach will help ensure a more stable and resilient financial system capable of effectively managing known and hidden risks.Footnotes

1.  To understand this point, we must first understand the concept of “convexity”—the degree and direction of interest rate exposure. The price of bonds with all maturities, hence their returns, are sensitive to changes in interest rates (a concept behind modified duration). For instance, if the interest rate increases by 1 basis point, the price, hence the return, of a 1-year bond could decline by 5 percent while the return of the same type of bond, which matures in 10 years, could decline by 35 percent. In other words, the convexity of holding returns implies that interest rate exposures increase as bonds’ maturity rises. 
   Another perspective on convexity is that a one-unit rise in the duration of short-term bonds increases exposure to interest rate risks, albeit to a lesser extent than a comparable increase for longer-term bonds. Analytically, this implies that long-term bond funds’ exposure to changes in the term structure cannot be efficiently mitigated by hedging instruments like swaps, which may have similar but not exact maturity dates. This limitation arises because even minor disparities in durations become crucial on the long end of the yield curve when it comes to exposure to interest rate risk.↩
2.  Suppose a fund has an interest rate swap that only partially hedges its aggregate exposure. The fund holds a balance sheet that, at the end of your 0: The floating loan is default-risk-free and expires in 3-years. It also earns the SOFR rate each year, and the accrued interest rate is received at the end of each year, while the principal $100 is received at the end of year 3. The fixed-rate bond cannot be prepaid, is credit riskless, has a three-year term, and pays interest at a 10 percent annual rate. Accrued interest is paid at the end of each year, and the principal of $90 is paid at the end of year 3. To hedge, the fund enters a receive-fixed/pay-floating interest rate swap at the beginning of year 1. The swap is credit riskless, and it has a 3-year term and a notional principal of $95. The floating payments out each year are based on SOFR during the year. The fixed payments are based on a fixed-rate of 10 percent. The swap has no initial value. Changes in SOFR occur only at the end of each year, so the end of- year rate applies during the next year. Let us assume that the realizations of SOFR are: end year 0, 10 percent; end year 1, 12 percent; and end year 2, 11 percent. The yield curve is flat, so that the current (t=0) SOFR can be used to discount all the future payments on the swap, the floating-rate loans, and the fixed-rate debt for fair valuing of these items. Relatedly, expected future rates equal the current rate so that the current SOFR can be used to forecast the interest receipts on the floating-rate loans and the cash flows on the swap.  The fund can designate a receive-fixed/pay-floating swap as either a fair value hedge of its fixed-rate debt or a cash flow hedge of its floating-rate loans. At first glance, the swap would appear to be an effective hedge in both cases. However, it would be partly ineffective due to the notional amount of the swap ($95) being greater than the principal of the fixed-rate bond ($90) and less than the principal of the floating-rate loans ($100). In this example, a mismatch has occurred between the principal amounts of the items being hedged and the swaps being used to hedge them. When this happens, the effectiveness of the hedge is reduced.  It’s important to note that the hedge’s ineffectiveness can stem from factors beyond mismatched principal amounts, including basis risk and differing maturities. From an accounting perspective, fixing such inefficiency can be relatively simple. In the case of notional amount mismatch, that leads to underhedging and over-hedging of cash flow and notional values,  for instance, the accounting convention in most cases allows for not direct reporting such mismatches, as if such discrepancies do not exist.↩
3. It is worth noting that detecting the hidden hedge mismatches, concealed via financial accounting practices, becomes much more challenging when the mismatch exists between the maturity of the underlying asset and the swap or duration drift. In this setting, simply rescaling the hedged item or hedge generally will not reduce these sources of hedge ineffectiveness.↩
4. Whereas mainstream funds mainly invest in mainstream assets like listed equities and bonds, these alternative funds invest in private equity, hedge funds, venture capital, real estate, energy, infrastructure, credit, and related assets. Among alternative funds, “open-ended” investments require access to short-term funding, while “closed-ended” investments demand long-term arrangements.↩

Original Link: https://www.phenomenalworld.org/interviews/mohsen-fahmi/

Responding to market instability, US regulators have mandated that Treasury and repo transactions be cleared through clearinghouses. The prevailing understanding attributes this instability to the behavior of alternative investment funds like hedge funds engaging in “basis trades,” framing liquidity as the key issue in the Treasury market. 

In the following interview, Mohsen Fahmi questions this assumption. Fahmi is a veteran multi-asset fund manager with extensive experience managing global portfolios. He was the lead manager for all of Pimco’s enhanced equity portfolios (StocksPlus) as well as a member of its Dynamic Bond team. He was also a member of Pimco’s investment committee, which sets parameters and risk targets for the entire firm’s portfolios. He recently retired from Pimco—one of the world’s largest fixed-income investment firms with assets totaling $2 trillion— after a career in trading and investment management that spanned thirty-five years. Previously, Fahmi spent eleven years at Moore Capital Management and held positions at Salomon Brothers, Goldman Sachs, and J.P. Morgan. He currently serves as one of the nine Board of Guardians for the Sarawak Sovereign Wealth Future Fund.

Below, Fahmi and Elham Saeidinezhad discuss the structure of the US Treasury market—the largest segment of the fixed-income market. This interview accompanies Saeidinezhad’s investigation of the US Treasury market, part of her ongoing series studying market microstructures. 

An interview with Mohsen Fahmi

ELHAM SAEIDINEZHAD: Let’s start with your perceptions on the evolution of the fixed-income market since you began managing it in 1986.

MOHSEN FAHMI: I can primarily comment on the Treasury market, the most critical component. Nothing else in fixed income can work without a well-functioning, liquid, deep Treasury market. Any market brings together actors with varying objectives, capital requirements, risk tolerance, and constraints. When designing a market structure, regulators must account for these sometimes-competing interests and continue to adapt and correct imperfections over time. The market is so dynamic and changing that even if [regulators] believe they have designed a well functioning market, they should still learn from the market’s evolution over time.

ES: What is the most critical change in the Treasuries market structure?

MF: When we look at Treasury markets, one obvious fact is that Treasury debt has exploded in recent years. In the early 1960s, the amount of Treasury debt held by the public—excluding government entities—was about $260 billion.

ES: Who was holding those debts at the time?

MF: It was held through pension funds, banks, and mutual funds, as well as individuals. Today, that same measure is $26 trillion.  So, there’s 100 times more debt in public hands today compared to sixty years ago (even if we look at the ratio of debt-to-GDP, the numbers remain impressive).

ES: This raises a question about market structure. Who are the most important players?

MF: Primary dealers are essential in this ecosystem. In the US, “primary dealers” like banks and securities firms are authorized to deal directly with the Fed in bidding for auctions and buying and selling securities. Back in the 60s, the number of primary dealers was eighteen. By 1988, the number of primary dealers peaked at forty-six. Since then, the number has declined due to mergers or bankruptcy (think Lehman Brothers or Merrill Lynch). As a result of these tendencies, the number of primary dealers fell back to seventeen in 2008 and has stabilized at twenty-four since. 

ES: From a financial stability perspective, how should we interpret this change involving primary dealers?

MF: One of the critical issues in the Treasury market today is that the size of the debt has exploded one hundred times, while the number of dealers has mostly stayed the same. This is true of any market: if I told you that the demand for meat or vegetables has grown by one hundred fold, but we have the same number of supermarkets, you would sense that something doesn’t add up. We are set up for friction and market dysfunction. 

ES: This is extremely important. In financial theories, these so-called “sunspots” or market frictions are considered bugs, not features, of the system. However, we acknowledge that the mismatch between the growth rate of Treasury debt and the number of primary dealers has been a fixture of the system and, indeed, a financial friction.

MF: In the aftermath of 2008, Congress and the public wanted to ensure that a collapse of that nature would never happen again. We got 500 pages of regulations intended to protect the banks from themselves and thereby protect the government and the public from incurring losses to bail them out. But as with anything in life, there were unintended consequences.  

ES: Could you elaborate on the role of the Dodd-Frank Act in this context? This is crucial, especially given the SEC’s recent efforts to further regulate the Treasury market. It is essential to learn from the lessons of Dodd-Frank during this pivotal moment for the Treasury market structure.

MF: Dodd-Frank said that banks and dealers should not take proprietary risk but only facilitate customer transactions. That was meant to smooth the market so that it doesn’t fluctuate dramatically between good and bad days. 

ES: In other words, regulators aimed to increase market liquidity by changing dealers’ behavior. The idea was that if dealers focused on customer trades rather than proprietary trading, it would lead to a deeper market.

MF: The unintended consequences of Dodd-Frank were that those banks no longer smooth out the price action in the market. Therefore, you have air pockets in which the banks step back and effectively stop selling or buying, leaving investors who wanted to trade unable to readjust their risk exposure or hedge themselves. This has impacted market liquidity. No one can buy or sell if the Treasury market freezes and stops trading.  

ES: Another vital shift in Treasury market structure.

MF: These are indeed two significant shifts in the structure of the Treasury Market—a fewer number of dealers and less ability to take risks.

ES: How should we solve that?

MF: One way would be for the Fed and the Treasury to intervene as the buyer and seller of last resort. When the markets stopped functioning in March 2020 during the Covid pandemic, the Fed came through with temporary measures to introduce liquidity to the market. But for most Western countries there are better solutions than this. You want the government to refrain from intervening, whether temporarily or permanently, to fix the most important price in the market, which is the price of money.

ES: To reiterate what you mentioned, the Fed acting as the dealer of last resort, which has become standard, should not be considered a preferable approach in advanced capital markets and economies.

MF: A preferable solution would be to allow and encourage nonbanks or non-primary dealers to take that risk—welcoming hedge fund participation or even private individuals. If we don’t want the public sector to absorb the risk, and we don’t want the banks to take that risk, then it has to be someone other than the banks. 

ES: This is very interesting, and I agree: we need more hedge funds and private funds present, rather than less, in the Treasury market. This is especially important given that one of the critical drivers of the current wave of Treasury market regulations is to curb hedge fund presence.

MF: There is also a third option, which is to move away from the intermediaries. With new technology, we can connect buyers and sellers directly. So if PIMCO is buying and BlackRock is selling, why do we need Morgan Stanley, JP Morgan, or Goldman Sachs to be an intermediary and absorb the risks? This hasn’t happened yet because of information discovery, privacy or competition concerns, and protection against the credit quality of counterparty risk. All of this can be handled by financial technology. 

ES: Would we transfer this role from a financial institution to tech companies in this case?

MF: The line of demarcation between financial and tech is blurry and arbitrary. Apple has Apple Pay, and banks have massive investments in technology. 

ES:  I want to connect this point (the third solution) to the first (the public solution). Some people might prefer the Fed as a key player rather than Silicon Valley in the US Treasury market. Please elaborate on why you think the first option is still less appealing compared to the third option.

MF: After 2008, the Fed, along with most other central banks, cut interest rates to zero (in the case of Europe and Japan, they were negative). That wasn’t enough, so they did quantitative easing by buying billions and billions of securities from the market to drive down long rates (for mortgages, corporations, and so on). When they saw that even this wasn’t enough, they came up with the idea of “forward guidance,” which promises  low rates for a given period in the future. 

This is problematic because no one knows what the future will bring. Nonetheless, market participants generally believed those authorities. But sooner or later, the fundamentals changed: we had one or two percent inflation that subsequently exploded in a very short period of time, peaking at nine or ten percent. And I think many of these institutions are now regretting their decisions.

 US mortgage rates have gone from 2.5 percent to 7. 5 percent. I think that is disastrous, and it could have been prevented if forward guidance hadn’t superficially pegged rates to 2.5 percent in the first place. They might have been 4 percent because the market needed to build a risk premium against the future. If you allow market forces to work, the process may be noisy in the short run, but that’s not bad. In the medium to long run, it will be smoother.

ES: Let us now connect this dynamic, which essentially involves how yield curves are shaped, to the role of fixed-income portfolio managers. Fixed-income portfolio managers play a fundamental role in the financial system, yet there needs to be more familiarity with their role. How do these interventions impact your role as a portfolio manager?

MF: When central banks announce lower rates,  as a portfolio manager, you are torn between knowing that the rates will remain low for a while and yet also knowing they will ultimately rise from artificially low levels. And so you want to be careful and use your own fundamental assessment of the appropriate monetary policy. That leads to tension.

Ideally, for a well-functioning market, you want a balanced market. Balanced means you want some people to be bullish, some to be bearish, some to be long, and some to be short. This requires diversity of opinions and diversity of objectives. The reduction in the number of dealers has also meant a reduction in this diversity. The analysts are also using the same data and models taken from the Fed and analyzing it in the same Excel spreadsheets. So we end up with less diversity of opinion and, therefore, a less balanced market.

Additionally, over the last twenty years or so, there’s been an explosion in passive money management, using exchange-traded funds (ETFs) and so on. When a substantial percentage of the market is passive, the market size that gets traded is relatively small, destabilizing the market. So all of these factors together result in a less balanced market. That explains why the ten-year Treasury can go from 1 percent a couple of years ago to almost 5 percent.  

ES: This is amazing. So, the dual function of having fewer dealers and more ETFs is reducing the diversity of opinion, which is a crucial aspect of the price discovery process in the fixed-income market. I haven’t seen anyone else connecting these two points. ​​

This increases the price risk in the market. The primary type of such risk in the fixed-income market is interest rate risk. Has the derivatives market caught up in providing hedging solutions to protect investors against these new market risks?

MF: Derivative markets play a vital role. Generally speaking, they are deep enough to provide investors with many ways to hedge and adjust exposures. In general, they’re performing reasonably well. But again, there are unintended consequences. The accounting profession has a sure way to treat hedging. If you don’t show that hedge A is associated with security B, you cannot offset them against each other. Sometimes, this drives investors or even corporate CEOs to avoid hedging because they’re concerned about the accounting consequences. So you get a chasm between the economic consequences of a hedge versus the accounting consequences of a hedge.

The second piece is that ideally you want a “complete” market—a market in which you can hedge any security against any outcome for any period. Arguably, the treasury market is becoming less complete. In the 1980s and 90s, you could buy and sell options on specific Treasury bonds. That market of Treasury options no longer exists. Instead, options trading has migrated to the futures exchanges. So you can buy options on bond futures but not on specific bonds. Without getting too much into the weeds, a “ten-year” note contract is actually driven by a seven-year treasury bond, which creates anomalies.

ES: Why has the option and other interest rate hedging market segments disappeared, and why is there no option for a ten-year future?

MF: The concept is the cheapest to deliver for any future contract. If I sell you corn to be delivered in Kansas City, we may need to know exactly what variety of corn I can provide. There’s a conversion matrix that assigns a price for each possible variety. But because these are not set in stone, the seller of a futures contract always delivers the lowest quality per dollar. So it happens that the ten-year contract when it was created was a ten-year contract. However, because  rates have been declining for the last forty years, delivering the shortest possible bond within the maturity bucket was always advantageous. That caused the ten-year note contract to effectively shrink to seven years. The Chicago exchanges tried to invent a ten-year contract, but it kind of fizzled. That’s because everyone is familiar with the seven-year contract, and it isn’t easy to get people to switch. 

ES: Why did the options on the cash Treasuries disappear again?

MF: If an investor buys a put option on the ten-year Treasury and I’m working as an options trader at JP Morgan, I will sell them that option but hedge myself by going short on that security. Since I’m carrying two sides of the trade, and it requires me to be able to borrow, the repo market needs to be well functioning. And when you do a repo, you’re taking counterparty risk. In addition, the balance sheet gets bloated with both sides of the trade. So, over the years, that market has essentially disappeared.

ES: Would you elaborate on this point? Can we say that the push for counterparties is a factor in the disappearance of the options market and that the push for standardization might have the sort of adverse impact you’re describing?

MF: Yes. Standardization is good, but you can only standardize a limited number of securities. The equity market is complete right now because if you as an investor want to buy or sell a call option or a put option on Google, I’m not going to tell you Amazon is like Google. They may be similar in some respects, but they’re different. Contrast that with the Treasury market, where any strategist will tell you that an eight-and-a-half-year bond  is almost identical to a ten-year bond. That makes it more efficient to have three or four or five hedging instruments rather than a hundred or 200 instruments with insufficient liquidity.

ES: From a financial stability perspective, what are the consequences of this market imbalance? 

MF: This is a vulnerability in the making that we are already seeing. In March 2023, we had the regional bank crisis, where several huge regional banks collapsed in a span of days. Why did it happen? It’s not because they made bad loans. It’s not because they were speculating in the stock market. It’s not because they lent money to a developing country that went under. It was because they bought Treasury bonds. Why did they have such huge imbalances? Partly because the CEOs of those banks believed the promises of the various monetary authoritiesthat rates would be low forever. And so, they were happy buying bonds at 1.5 percent, not realizing they would suffer a considerable loss when they went to 4 percent. But the imbalances are also partly because of their unwillingness or inability to deploy effective hedges.

Banks have a held-to-maturity account, they have an available-for-sale account, and they have a trading account. And once you put bonds in one account, you’re not supposed to move them from one to the other. Otherwise, your accountants will not be happy. The IRS may be unhappy.  Therefore, they put many of those bonds in a held-to-maturity account to avoid the unfavorable market-to-market. But by doing that, they got stuck with them. And so they couldn’t sell them after they fell five points. They had to wait until they fell thirty points, and in the process, they went bankrupt or got taken over for a nominal amount.

ES: This is a fantastic point and a very different perspective from the mainstream view of a cascade of bank failures: banks failed partially because they believed in the Fed and its forward guidance. 

On Monday, July 8, at NYU Stern: A symposium hosted by JFI and the Yale Project on Financial Stability.

A Jain Family Institute (JFI) Market Microstructure & Yale School of Management Financial Stability Program (YPFS) Symposium hosted by Volatility & Risk Institute at NYU Stern

Date: Monday, July 8
Location: KMEC 1-70, Henry Kaufman Management Center, NYU Stern
Organizing Committee:
Elham Saeidinezhad (JFI, Columbia and NYU Stern)
Steven Kelly (Yale Program on Financial Stability)
Itai Dreifuss (Columbia, BlackRock)

RSVP: Seating is limited. Please email editorial@jainfamilyinstitute.org with “Market Microstructure” in the subject line if you would like to attend.

Overview

This symposium, “Market Microstructure and Financial Stability: Is There a Link?” is a joint initiative by JFI and YPFS. This collaborative effort aims to facilitate an open dialogue between financial stability experts and market practitioners to discuss the relationship between market microstructure and financial stability. JFI’s Market Microstructure project focuses on the infrastructures that connect markets and engage practitioners, whereas YPFS’s unique financial stability perspective is based on the firsthand experiences of policymakers during crisis management. The symposium aims to bridge the gap between market participants and policymakers.

Panels

Session I: Private Credit Market Structure and Financial Stability

Panelists

• Kevin Meyer, Churchill Asset Management LLC
• Fang Cai, Federal Reserve Board
• James Snyder, Sidley Austin LLC 
• Kevin McPartland, Coalition Greenwich
• Daniel Sullivan, PwC  (Moderator) 

Panel Description

The private credit market allows institutional investors to access private debt instruments, which are rapidly expanding. For instance, in the market for financing leveraged buyouts (LBOs), the size of the debt market based on public ratings, such as the broadly syndicated loan (BSL), is decreasing while the share of funding from the private credit market is increasing (Figure 1). The same trend is occurring for non-LBO transactions financed in the BSL market compared to those in the private market (Figure 1). In this context, the panels will discuss whether shifting credit pricing and provision from public to private financial markets can impact financial stability.

Session II: Inefficiencies in US Treasury Market Hedging and Financial Stability

Panelists

• Nathaniel Wuerffel, Head of Market Structure – BNY Mellon 
• Amar Reganti, Wellington Management, Fixed-Income Strategist
• Samim Ghamami, SEC
• Steven Kelly, Associate Director of Research, Yale Program for Financial Stability
• Eric Wallerstein, Chief Markets Strategist at Yardeni Research, Inc. (Moderator)

Panel Description

High-profile, high-volatility events in March 2020 and March 2023 have heightened concerns regarding the safety of the US Treasury market. While financial stability experts attribute these events to leveraged funds’ behavior, such as bond funds’ “leveraged portfolio” and hedge funds’ “basis trading strategy,” this overlooks the market’s underlying vulnerability and the factors driving basis trading. The conventional explanation points to fixed-income fund managers increasing risk tolerance by shifting portfolios from US Treasury securities to UST futures, causing a price divergence known as “basis.” However, this may stem from managers’ challenges in finding effective hedges through interest rate swaps due to a duration mismatch, termed “duration drift.” In this panel, we discuss whether regulators underestimate the extent of mismatch in alternative markets sought by bond managers, leading to underreporting and financial stability risks in the US Treasury market.

Session III: Interest Rate Swaps’ Role in Short-Term Funding

Panelists

• Joshua Younger, Federal Reserve Bank of New York, Senior Policy Advisor
• Mark Cabana, Bank of America, Interest Rate Strategist
• Jordan Brooks, Co-Head of the Macro Strategies Group, AQR Capital Management & NYU 
• Elham Saeidinezhad, Columbia University, JFI Fellow (Moderator)

Panel Description

Swaps are often considered instruments used for hedging, where a party that pays a fixed rate and receives a floating rate can offset the devaluation of bonds caused by fluctuations in interest rates. However, swaps can serve a far more significant purpose than previously believed. They can be used to fill funding gaps and compensate for failures in the repo market. By considering swaps as a type of synthetic repos, we can gain a better understanding of funding liquidity and develop alternative funding solutions. This shift suggests that swaps have become a viable alternative to traditional wholesale money markets and that the repo market alone cannot provide all dimensions of liquidity. In this discussion, the panel examines the structure of the swap market and its role in the overall funding landscape. They also consider the effectiveness of central bankers in stabilizing markets during times of heightened volatility.

Session IV: Payment System Design and Intraday Credit Solutions

Panelists

• Michael Brady, JPMorgan & Chase
• Susan Mclaughlin, Yale Program on Financial Stability
• Aaron Klein,  Brookings Institution
• Hannah Lang, Reuters  (Moderator) 

Panel Description

This panel will discuss how the firms’ credit needs and payment system structures interact to impact financial stability. The panelists will focus on new payment-related initiatives such as the Fed’s Policy on Payment System Risk. This policy has two primary goals: first, to standardize the design of public and private infrastructures that support the payment system, and second, to enhance the efficiency of public emergency liquidity provisions. These provisions, including the discount window, help private entities manage payment challenges during systemic financial distress. The payment system infrastructure is a public-private hybrid, meaning entities with different priorities and business models must work together to ensure the smooth daily settlement of retail and wholesale payments. Additionally, the Fed is responsible for easing liquidity pressures on this infrastructure by providing temporary intraday credit to private institutions. This panel will evaluate the effectiveness of the design and the payment system’s resilience against systemic risks.

Keynote Panel

Market Microstructure and Financial Stability: Is There a Link? A Conversation between Richard Berner and Shyam Rajan

Shyam Rajan is the Global Head of Fixed Income for Citadel Securities. With responsibility for the firm’s fixed income risk and research functions, Shyam oversees the institutional sales and trading business, as well as the quantitative research, algo, and independent principal strategies teams. 

Richard Berner is a Clinical Professor of Management Practice in the Department of Finance and, with Professor Robert Engle, is a Co-Director of the Stern Volatility and Risk Institute. Professor Berner served as the first director of the Office of Financial Research (OFR) from 2013 until 2017. He was a counselor to the Secretary of the Treasury from April 2011 to 2013.

See here for more information on JFI Market Microstructures, including the first piece of the series.