“Money is pre-eminently a sanctuary, a haven for resourcesthat would otherwise go into more perilous uses.” Gurley and Shaw
Cryptocurrencies, which first emerged in the wake of the global financial crisis, offered a vision of “money” free from central bank and intermediaries’ control. The idea is that crypto liberates both private parties and non-major central banks from the fundamental need to be as close as possible to the Fed, the ultimate controller and issuer of the world’s means of the final settlement. In other words, crypto flattens the monetary hierarchy and creates a structural break from Money View’s claim that money is inherently hierarchical. In this essay, I argue that cryptocurrency is not flattening the “existing” monetary system. It creates a parallel, unstable monetary arrangement based on personnel, such as Elon Musk, rather than institutions, including central banks, and false economic prophecies. First, it assumes “scarcity of money” is the source of its value. Second, it “eliminates intermediaries,” such as dealers and banks, and relies on crypto exchanges that act as brokers to set prices. And third, it aims at stabilizing the crypto prices by guaranteeing “convertibility” while liberating itself from the central banks who make such guarantees possible under distress.
Crypto is built on a virtual hierarchy. When it comes to instruments, though, the system is mostly flat. Different cryptos are treated equally. Yet, it remains hierarchical when it comes to the relative position of its players. Similar to the original monetary system, different agents belong to different layers of the hierarchy. In contrast to it, a few high-net-worth individuals rather than institutions are at the top of it. However, the most fundamental problem is its economic foundations, which are mostly misguided monetary prophecies.
The Crypto market is built on weak foundations to support the “value,” “price,” and “convertibility” of the virtual currency. To preserve the value of the virtual currency, advocates often point to the limited supply of bitcoin and the mathematics which governs it in stark contrast to fiat money’s model of unlimited expansion regardless of underlying economic realities. It’s an unpopular position with Money View scholars who don’t view scarcity as a pressing issue. Instead, the fundamentals such as liquidity or convertibility determine the value of these monetary instruments. However, the convertibility guarantor of the last resort is the central bankers, who are circumvented in the crypto-mania.
The degree of liquidity or “moneyness” depends on how close these instruments are to the ultimate money or currency. Ultimately, the Fed’s unlimited power to create it by expanding its balance sheets puts the currency at the top of the hierarchy. The actual art of central banking would obviously be in response to shocks, or crises, in the financial and economic environment. During such periods, a central bank had not only to ensure its own solvency but the solvency of the entire banking system. For this reason, they had to hold disproportionate amounts of gold and currency. The point to emphasize is that while they stood ready to help other banks with cash and gold on demand, they could not expect the same service in return.
Further, central bankers’ unique position to expand their balance sheets to create reserves allow them to accommodate liquidity needs without the risk of being depleted. Yet, if a central bank had to protect itself against liquidity drain, it has tools such as discount-rate policy and open market operations. Also, central bankers in most countries can supply currency on-demand with reciprocal help from other banks. In this world, the Fed was and will remain first among equals.
The mistake of connecting the value of money to limited supply is as old as money itself. In 1911, Allyn Young made it tolerably clear that money is not primarily a thing that is valued for itself. The materials that made money, such as gold, other metals, or a computer code, are not the source of value for money. The valuable materials merely make it all the more certain that money itself may be “passed on,” that someone may always be found who is willing to take it in exchange for goods or services. The “passing on” feature becomes the hallmark of Allyn Young’s solutions to the mystery of money. Money’s value comes from holders’ willingness to pass it on, which is its purchasing power. It also depends on its ability to serve as a “standard of payment” or “standard of deferred payments.” Therefore, any commodity that serves as money is wanted, not for permanent use, but for passing on.
What differentiates the “means of payment” from the “purchasing power” functions is their sensitivity to the “macroeconomic conditions.” Inflation, an essential barometer of the economy, might deteriorate the value of the conventional monetary instruments relative to the inflation-indexed ones as it disproportionally reduces the former instruments’ purchasing power. Yet, its impact on their function as “means of payments” is less notable. For instance, we need more “currency” to purchase the same basket of goods and services when inflation is high, reducing currency’s purchasing power. Yet, even in this period, the currency will be accepted as means of payment.
Young warned against an old and widespread illusion that the government’s authority or the limited quantity gives the money its value. Half a century later, Gurley and Shaw (1961) criticized the quantity theory of money based on similar grounds. Specifically, they argued against the theory’s premise that the quantity of money determines money’s purchasing power, and therefore value. Such a misconception, emphasized in the quantity theory of money and built in the crypto architecture, can only be applied to an economic system handicapped by rigidities and irrationalities. In this economy, any increase in demand for money would be satisfied by deflation, even if it will retard the economic development rather than by growth in nominal money. Paradoxically, similar to the quantity theory of money, crypto-economics denies money a significant role in the economy. In other words, crypto-economics assumes that money, including cryptocurrency, is “neutral.”
Relying on the “neutrality” of money, and therefore scarcity doctrine, maintain value has real economic consequences. Monetary neutrality is objectionable even concerning an economy in which the neoclassical ground rules of analysis are appropriate on at least two grounds. First, the quantity theory underestimates the real impact of monetary policy in the long run. The theory ignores the effects of the central bank’s manipulation of the nominal money on permanent capital gains or losses. These capital gains and losses enduringly affect the aggregate spendings, including spending on capital and new technologies, and hence come to grips with real aspects of the economy in the long run.
Second, monetary neutrality overlooks the role of financial intermediaries in the monetary system. In this system, financial intermediaries continuously intervene in the flow of financial assets from borrowers to lenders. In addition, they regulate the rate and pattern of private financial-asset accumulation, the real quantity of money, and real balances desired, hence any demands for goods and labor that are sensitive to the real value of financial variables. In the quantity theory of money, financial intermediaries that affect wealth accumulation and the real side of the economy are reduced to a fixed variable, called the velocity.
To stabilize the prices, crypto economists rely on a common misconception that crypto exchanges set prices. Yet, by design, the crypto exchanges’ ability to set the prices and reduce their volatility is minimal. These exchanges’ business model is more similar to the functions of the brokers, who merely profit from commissions and listing fees and do not use their balance sheets to absorb market imbalances and therefore stabilize the market prices. If these exchanges acted like dealers, however, they could set the prices. But in doing so, they had to use their balance sheets and be exposed to the price risks. Given the current price volatility in the cryptocurrency market, the exchanges have no incentive to become dealers.
This dealer-free market implies that the exchange rate of a cryptocurrency usually depends on the actions of sellers and buyers. Each exchange merely calculates the price based on the supply and demand of its users. In other words, there’s no official global price. The point to emphasize is that this feature, the lack of an official “market price,” and intermediaries— banks and dealers–, is inherent in this virtual system. The absence of dealers, and other intermediaries, is a natural consequence of the virtual currency markets’ structural feature, called the decentralized finance (DeFi).
DeFi is an umbrella term for financial services offered on public blockchains. Like traditional intermediaries, DeFi allows clients to borrow, lend, earn interest, and trade assets and derivatives. This service is often used by clients seeking to use their crypto as collateral to increase their leverage and return. They borrow against their crypto holdings to place even larger bets in this market. In the process, they expose the lenders to the “credit risk.” In non-crypto segments of the financial market, credit risk can be contained either through intermediaries, including banks and dealers, or swaps. Both mechanisms are absent in the crypto market even though the risk and leverage are intolerably present.
In the market for monetary instruments, intermediation has always played a key role. The main reason for all the intermediation for any financial instrument is that the mix of securities, or IOUs, issued by funds-deficit agents is unattractive to many surplus agents. Financial intermediaries can offer such attractive securities for several reasons. First, they pool the funds of many investors in a highly diversified portfolio, thereby reducing risk and overcoming the minimum denominations problem. Second, intermediaries can manage cash flows. Intermediaries provide a reasonable safety in the payments system as the cash outflows are likely to be met by cash inflows. The cryptocurrency is not equipped to circumvent intermediaries.
Historically, major banks with their expertise in analyzing corporate and other credits were a natural for the intermediary business, both in the traditional market for loanable funds and the swaps market. The advantage of the swaps is that they are custom-tailored deals, often arranged by one or more intermediaries. Banks could with comfort accept the credit risk of dealing with many lesser credits, and at the same time, their names were acceptable to all potential swap parties. The dealers joined the banks and became the modern intermediaries in the interest rate, FX, and credit default swaps market. Similar to the banks, they transferred the risks from one party to the other and set the price of risk in the process. DeFi cuts these middlemen, and the risk-transfer mechanism, without providing an alternative.
The shapers of crypto finance also rely on “stablecoins” to resolve the issue of convertibility. Stablecoins have seen a massive surge in popularity mainly because they are used in DeFi transactions, aiming to eliminate intermediaries. They are cryptocurrencies where the price is designed to be pegged to fiat money. They are assumed to connect the virtual monetary system and the real one. The problem is that the private support to maintain this par, especially during the crisis, is too invisible to exist. Most recently, the New York Attorney General investigation found that starting no later than mid-2017, Tether, the most reliable Stablecoin, had no access to banking anywhere in the world, and so for periods held no reserves to back tethers in circulation at the rate of one dollar for every Tether.
The paradox is that the stability of the crypto market and DeFi ultimately depends on centralized finance and central bankers. Like traditional banks, DeFi applications allow users to borrow, lend, earn interest, and trade assets and derivatives, among other things. Yet, it differs from traditional banks because it is connected to no centralized system and wholesale market. Therefore, unlike banks, DeFi does not have access to the ultimate funding source, the Fed’s balance sheet. Therefore, their promises to maintain the “par” between stablecoins and fiat currencies are as unstable as their guarantors’ access to liquidity. Unless Elon Musk or other top influencers in the virtual hierarchy are willing to absorb the imbalances of the whole system into their balance sheet, the virtual currency, like the fiat one, begs for the mercy of the Fed when hit by a crisis. The question is whether Elon Musk will be willing to act as the crypto market’s lender and dealer of last resort during a crisis?
Those who have long positions in crypto and guarantee convertibility of the stablecoins, like traditional deficit agents, require constant access to the funding liquidity. Central banks’ role in providing liquidity during a crisis is central to a modern economic system and not a mere convenience to be tolerated. Further, the ongoing dilemma to maintain the “par” between deposits and currencies has made the original payment system vulnerable. This central issue is the primary justification for the existence of the intermediaries and the banks. Without fixing the “par” and “convertibility” problems, the freedom from intermediaries and central banks, which is the most ideologically appealing feature of crypto, will become its Achilles Hill. The crypto market has cut the intermediaries, including central banks, banks, and dealers, in its payment system without resolving the fundamental problems of the existing system. Unless crypto backers believe in blanket immunity to a crisis, a paradoxical position for the prodigy child of the capitalist system, crypto may become the victim of its ambitions, not unlike the tragedy of Macbeth. Mcbeth dramatizes the damaging physical and psychological effects of political ambition on those who seek power for its own sake.
“The most significant economic event of the era since World War II is something that has not happened.” — Hyman Minsky, 1982
In the 1945 film It’s A Wonderful Life, banker protagonist George Bailey (played by Jimmy Stewart) struggles to exchange his well-functioning loans for cash. He lacks convertibility—known as liquidity risk in modern finance—and so cannot pay impatient depositors. Like any traditional financial intermediary, Bailey seeks to transform short-term debts (deposits) into long-term assets (loans). In the eyes of traditional macroeconomics, a run on the bank could be prevented if Bailey had borrowed money from the Fed, and used the bank’s assets as collateral. In the late-nineteenth-century, British journalist Walter Bagehot argued that the Fed acts as a “lender of last resort,” injecting liquidity into the banking system. As long as a bank was perceived solvent, then, its access to the Fed’s credit facilities would be almost guaranteed. In an economy like the one in It’s A Wonderful Life, the primary question was whether people could get their money out in the case of a crisis. And for a long time, Bagehot’s rule, “lend freely, against good collateral, but at a high rate,” maintained the Fed’s control over the money market and helped end banking panics and systemic banking crises.
That control evaporated on September 15, 2008, with the collapse of Lehman Brothers. On that day, an enormous spike in interbank lending rates was caused not by a run on a bank, but by the failure of an illiquid securities dealer. This new generation of financial intermediaries were scarcely related to traditional counterparties—their lending model was riskier, and they did not accept deposits.1 Instead, these intermediaries synchronized their actions with central banks’ interest rate policies, buying more loans if monetary conditions were expansive and asking borrowers to repay loans if these conditions were contractive. They financed their operations in the wholesale money market, and most of their lending activities were to capital market investors rather than potential homeowners. When Lehman Brothers failed, domestic and foreign banks could no longer borrow in the money markets to pay creditors. The Fed soon realized that its lender of last resort activities were incapable of influencing the financial market.2 The crisis of 2008-09 called for measures beyond Bagehot’s principle. It revealed not only how partial our understanding of the contemporary financial system is, but how inadequate the tools we have available are for managing it.
Re-conceptualizing the Contemporary Financial System
Prior to the financial crisis, the emerging hybrid system of shadow banking went largely unmonitored. Shadow banking is a market-based credit system in which market-making activities replace traditional intermediation.3 A shadow banker acts more like a dealer who trades in new or outstanding securities to provide liquidity and set prices. In this system, short-term liquidity raised in the wholesale money market funds long-term capital market assets. The payment system reinforces this hybridity between the capital market and the money market. Investors use capital market assets as collateral to raise funds and make payments. The integrity of the payment system therefore depends on collateral acceptability in securities lending. Since the crisis, collateral has been criticized for rendering financial institutions vulnerable to firesales and loss of asset value. The Fed declined to save Lehman Brothers, a securities dealer, because the alternative would have encouraged others to make toxic loans, too. Like in Voltaire’s Candide, the head of a general was cut off to discourage the others.
The crisis also revealed the vulnerabilities of contemporary risk management. Modern risk management practices depend largely on hedging derivatives. Hedging is somewhat analogous to taking out an insurance policy; at its heart are derivatives dealers who act as counterparties and set prices. Derivatives, including options, swaps, futures, and forward contracts, reduce the risk of adverse price movements in underlying assets. The crisis exposed their fragile nature—dealers’ willingness to bear risk decreased following losses on their portfolios. These concerns left many firms frozen out of the market, forcing them to terminate or reduce their hedging programs. Rationing of hedging activity increased firms’ reliance on lines of credit. As liquidity was scarce, over-reliance on credit lines further strained firms’ risk management. In the meantime, rising hedging costs prevented them from hedging further. Derivatives dealers were essential players in setting these costs. During the crisis, dealers found it more expensive to finance their balance sheet activities and in return, they increased the fees. As a result of this cycle, firms were less and less able to use derivatives for managing risks.
Most financial economists analyze risk management through cash flow patterns. The timing of cash flow is critical because the value of most derivatives is adjusted daily to reflect their market value (they are mark-to-market). This requires a daily cash settlement process for all gains and losses to ensure that margin (collateral) requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call. If the value of the derivatives falls at the end of the day, the margin account of the investors who have long positions in derivatives will be decreased. Conversely, an increase in value results in an increase in the investors’ margin account who hold the long positions. All of these activities involve cash flow.
But in order to properly conceptualize the functioning of contemporary risk management practices, we need to follow in Hyman Minsky’s footsteps and look at business cycles.4 The standard macroeconomic framing begins from the position of a representative risk-averse investor. Because the investor is risk-averse, they neither buy nor sell in equilibrium, and consequently, there is no need to consider hedging and the resulting cash flow arrangements. By contrast, Minsky developed a taxonomy to rank corporate debt quality: hedge finance, speculative finance, and Ponzi finance. Hedge finance is associated with the quality of the debt in the economy and occurs when the cash from a firm’s operating activities is greater than the cash needed for its scheduled debt-servicing payments. A speculative firm’s income is sufficient to pay the interest, but it should borrow to pay the principal. A firm is Ponzi if its income is less than the amount needed to pay all interest on the due dates. The Ponzi firm must either increase its leverage or liquidate some of its assets to pay interest on time. Within this scheme, hedge finance represents the greatest degree of financial stability.
Minsky’s categorization scheme emphasizes the inherent instability of credit. In periods of economic euphoria, the quantity of debt increases because the lenders and investors become less risk-averse and more willing to make loans that had previously seemed too risky. During economic slowdowns, overall corporate profits decline, and many firms experience lower revenues.5 This opens the way for a “mania,” in which some in the hedge finance group move into speculative finance, and some firms that had been in speculative finance move into Ponzi finance.
Regulatory Responses to the Crisis: Identifying and Managing Risk
But why should a central banker worry about the market for hedging? After all, finance is inherently about embracing risk. In a financial crisis, however, these risks become systemic. Systemic risk is the possibility that an event at the company level could trigger the collapse of an entire industry or economy. Post-2008 regulatory efforts are therefore aimed at identifying systemic risk before it unravels.
The desire to identify the origins and nature of risks is as old as finance itself. 6In his widely cited 1982 article , Fischer Black distinguished between the risks of complex instruments and the trades that reduce those risks—“hedges.”7 But less widely cited is his conviction that financial models, such as the capital asset pricing model (CAPM), are frequently not equipped to separate these risks.89
The same argument could be made for identifying systemic risk.10 To monitor systemic risk, the Fed and other regulators use central clearing, capital standards, and stress-testing. However, these practices are imperfect diagnostic tools. Indeed, clearinghouses may have become the single most significant weakness of the new financial architecture. In order to reduce credit risk and monitor systemic risk, clearinghouses ensure swaps by serving as a buyer to every seller and a seller to every buyer. However, they generally require a high degree of standardization, a process that remains poorly defined in practice. Done correctly, the focus on clearing standardized products will reduce risk; done incorrectly, it may concentrate risks and make them systemic. Standardization can undermine effective risk management if it constrains the ability of investors to modify derivatives to reflect their particular activities.
Regulators also require the banks, including the dealer banks, to hold more capital. A capital requirement is the amount of capital a bank or another financial institution has to have according to its financial regulator. To capture capital requirement, most macroeconomic models abstract from liquidity to focus on solvency. Solvency risk is the risk that the business cannot meet its financial obligations for full value even after disposal of its capital. The models assert that as long as the assets are worth more than liabilities, firms should survive. The abstraction from liquidity risk means that by design, macroeconomic models cannot capture “cash flow mismatch,” which is at the heart of financial theories of risk management. This mismatch arises when the cash flows needed to settle liabilities are not equal to the timing of the assets’ cash flows.
The other tool that the Fed uses to monitor systemic risk regularly is macroprudential stress-testing. The Comprehensive Capital Analysis and Review (CCAR) is an annual exercise by the Fed to assess whether the largest bank holding companies have enough capital to continue operations during financial stress. The test also evaluates whether banks can account for their unique risks. However, regulatory stress testing practice is an imperfect tool. Most importantly, these tests abstract away from over-the-counter derivatives—minimally regulated financial contracts among dealer banks— that might contribute to systemic risk. Alternatively, the testing frameworks may not capture network interconnections until it is too late.
The experience of the 2008 financial crisis has revealed the ways in which our current financial infrastructure departs from our theorization of it in textbooks. It also reveals that the analytical and diagnostic tools available to us are inadequate to identifying systemic risk. The Fed’s current tools reflect its activities as the “financial regulator.” But at present, the Fed lacks tools based on its role as lender of last resort, which would enable it to manage the risk rather than imperfectly monitor it. In the following sections, I examine the importance, and economics, of derivatives dealers in managing financial markets’ risks, and propose a tool that extends the Fed’s credit facilities to derivatives dealers during a crisis.
Derivatives Dealers: The Risk Managers of First and Last Resort
Over the course of seventeen years, Bernie Madoff defrauded thousands of investors out of tens of billions of dollars. In a Shakespearean twist, the SEC started to investigate Madoff in 2009 after his sons told the authorities that their father had confessed that his asset management was a massive Ponzi scheme. Madoff pleaded guilty to 11 federal felony counts, including securities fraud and money laundering.
Bernie Madoff paints a dire portrait of the market making in securities. In world of shadow banking, derivatives dealers are the risk managers of first resort. They make the market in hedging derivatives and determine the hedging costs. Like every other dealer, their capacity to trade depends on their ability to access funding liquidity. Unlike most other dealers, there is no room for them in the Fed’s rescue packages during a financial crisis.
Derivatives dealers are at the heart of the financial risk supply chain for two reasons: they determine the cost of hedging, and they act as counterparties to firms’ hedging programs.11 Hedgers use financial derivatives briefly (until an opportunity for a similar reverse transaction arises) or in the long term. In identifying an efficient hedging instrument, they consider liquidity, cost, and correlation to market movements of original risk. Derivatives connect the firms’ ability and willingness to manage risk with the derivatives dealers’ financial condition. In particular, dealers’ continuous access to liquidity enables them to act as counterparties. As intermediaries in risk, dealers use their balance sheets and transfer the risks from risk-averse investors to those with flexible risk appetite, looking for higher returns. In the absence of this intervention, risk-averse investors would neither be willing nor able to manage these risks.
This approach towards risk management concentrates risks in the balance sheets of the derivatives dealers.12 The derivative dealers’ job is to transfer them to the system’s ultimate risk holders. In a typical market-based financial system, investment banks purchase capital market assets, such as mortgage-backed securities (MBS). These hedgers are typically risk-averse and use financial derivatives such as Interest Rate Swaps (IRS), Foreign exchange Swaps (FXS), and Credit Default Swaps (CDS). These derivatives’ primary purpose is to price, or even sell, risks separately and isolate the sources of risk from the underlying assets. Asset managers, who look for higher returns and therefore have a more flexible risk tolerance, hold these derivatives. It is derivatives dealers’ job to make the market in instruments such as CDS, FXS, and IRS. In the process, they provide liquidity and set the price of risk. They also determine the risk-premium for the underlying assets. Crucially, by acting as intermediaries, derivatives dealers tend to absorb the unwanted risks in their own balance sheets.
During a credit crunch, derivatives dealers’ access to funding is limited, making it costly to finance inventories. At the same time, their cash inflow is usually interrupted, and their cash outflow comes to exceed it.13 There are two ways in which they can respond: either they stop acting as intermediaries, or they manage their cash flow by increasing “insurance” premiums, pushing up hedging costs exactly when risk management is most needed. Both of these ultimately transmit the effects to the rest of the financial market. Higher risk premiums which lower the value of underlying assets could lead to a system-wide credit contraction. In the money market, a sudden disruption in the derivatives market would raise the risk premium, impair collateral prices, and increase funding costs.
The increase in risk premium also disrupts the payment system. Derivatives are “mark-to-market,” so if asset prices fall, investors make regular payments to the derivative dealers who transfer them to ultimate risk holders. A system-wide credit contraction might make it very difficult for some investors to make those payments. This faulty circuit continues even if the Fed injects an unprecedented level of liquidity into the system and pursues significant asset purchasing programs. The under-examined hybridity between the market for assets and the market for risks make derivatives markets the Fed’s concern. There will not be a stable capital valuation in the absence of a continuous risk transfer. In other words, the transfer of collateral, used as the mean of payments, depends on the conditions of both the money market and derivatives dealers.
Understanding Financial Assets as Collateral
Maintaining the integrity of the payment system is one of the oldest responsibilities of central bankers. In order to do this effectively, we should recognize financial assets for what they actually do, rather than what economists think they ought to do. Most macroeconomists categorize financial assets primarily as storers of value. But in modern finance, investors want to hold financial assets that can be traded without excessive loss. In other words, they use financial assets as “collaterals” to access credit. Wall Street treats financial assets not as long-term investment vehicles but as short-term trading instruments.
Contemporary financial assets also serve new economic functions. Contrary to the present and fundamental value doctrines, a financial asset today is not valuable in and of itself. Just like any form of money, it is valuable because it passes on. Contemporary financial assets are therefore the backbone of a well-functioning payment system.
The critical point is that in market-based finance, the collateral’s market value plays a crucial role in financial stability. This market value is determined by the value of the asset and the price of underlying risks. The Fed has already embraced its dealer of last resort role partially to support the cost of diverse assets such as asset-backed securities, commercial papers, and municipal bonds. However, it has not yet offered any support for backstopping the price of derivatives. In other words, while the Fed has provided support for most non-bank intermediaries, it overlooked the liquidity conditions in the derivatives market. The point of such intervention is not so much to eliminate the risk from the market. Instead, the goal is to prevent a liquidity spiral from destabilizing the price of assets and, consequently, undermining their use as collateral in the market-based credit.
In 2008, AIG was the world’s largest insurance company and a bank owner. Its insurance business and bank subsidiary made it one of the largest derivatives dealers. It had written billions of dollars of credit default swaps (CDSs), which guaranteed buyers in case some of the bonds they owned went into default. The goal was to ensure that the owner of the swap would be paid whole. Some investors who owned the bonds of Lehman had bought the CDSs to minimize the loss if Lehman defaulted on its bonds. The day after Lehman failed, the Fed lent $85 billion to AIG, stabilizing it and containing the crisis. However, this decision was due to the company’s importance in markets for municipal bonds, commercial papers, and money market mutual funds. If the Fed was not unwilling to do the same for derivatives dealers, it might have been able to alleviate near-term risks generated from the systemic losses on derivatives.
After the COVID-19 pandemic, the Fed extended credit facilities to critical financial intermediaries, but excluded market makers in risk. But in a financialized economy, the business cycle is nothing more than extreme corrections to the price of capital. Before a crash, investors’ risk tolerance becomes flexible—they ignore the possibility for market corrections or rapid changes in an asset’s market price after the establishment of an equilibrium price. As a result of this bias, investors’ expectations of asset prices form more slowly than actual changes in asset prices. Hedging would save these biased investors, and if done appropriately, they could help stabilize the business cycle. However, the Fed has no formal tool that enables it to support derivatives dealers in providing hedging services. It cannot act as the “ultimate” risk manager in the system.
The Dealer Option: Connecting the Fed with the Ultimate Risk Managers
Charles Kindleberger argued that financial crises cannot be stopped, but only contained. The dealer option proposed in this paper would enable the Fed to control the supply chain of risk.14 It extends credit facilities to a specific type of financial intermediaries: options dealers. This extension does not include financial speculators of various stripes and nonfinancial corporations—the so-called “end-users” of derivatives—seeking to hedge commercial risks. The options dealers’ importance comes from their paradoxical effects on financial stability. Since Dodd-Frank increased firms’ capital cost in favor of risk mitigation techniques like hedging, these companies are crucial to policy because they buy protection from options dealers in centrally cleared markets.
The problem is that options dealers’ role as counterparty to hedging firms could create fragility and magnify the market risk.15 In equilibrium, the risk is transferred through the option supply chain to dealers, who are left with the ultimate task to manage their risk exposure using dynamic hedging techniques. The dynamic nature of these activities means options dealers contribute to daily volatility when they balance their exposures. During a crisis, these actions lead to increasing market fragility. The “dealer option” empowers the Fed to become the lender of last resort to the financial system’s ultimate risk managers. This instrument extends many benefits that banks receive by having an account at the Fed to these dealers. Some of these benefits include having access to reserves, receiving interest on reserves, and in very desperate times, access to the Fed’s liquidity facilities. The goal is to strike a balance between the fragility and stability they impose on the market.16
Containing liquidity risk is at the heart of the dealer option. The daily cash flow that the options contracts generate could contribute to asset fire sales during a crisis—options contracts are subject to mark-to-market rules, and fluctuations in the value of assets that dealers hold generate daily cash flows. If dealers do not have enough liquidity to make daily payments, known as margin calls, they will sell the underlying assets. Asset fire sales might also arise because most market makers have an institutional mandate to hedge their positions by the end of the trading day. Depending on the price changes, the hedging activities require dealers to buy or sell the underlying asset. Most dealers hedge by selling shares of the underlying asset if the underlying asset’s value drops, potentially giving rise to firesale momentum. Limited market liquidity during a crisis means that the possibility of firesale is larger when dealers do not have enough liquidity to meet their cash flow requirements. The dealer option could stop this cycle. In this structure, the Fed’s function to provide backstops for derivatives dealers can reduce firesales’ risk and contain market fragility during a credit crunch.
The tool is based on Perry Mehrling’s Money View framework, Morgan Ricks, John Crawford, and Lev Menand’s Public Option proposal, and Katharina Pistor’s Legal Theory of Finance (LTF). The public option suggests opening the Fed’s balance sheet to non-banks and the public. On the other hand, the Money View emphasizes the importance of managing the timing of cash flows and calls any mismatches liquidity risk. Like the Finance view of the world, the Money View asserts that the goal is to meet “survival constraints” at all times.
The LTF builds on the Money View through four essential premises: first, financial markets are a rule-bound system17; The more an entity solidifies its position within the marketplace, the higher the government’s level of responsibility. Second, there is an essential hybridity between states and markets; in a financial crisis, only Fed’s balance sheet—with its unlimited access to high-powered money—can guarantee full convertibility from financial assets into currency. Third, the law is what makes enforcement of financial instruments possible. On the other hand, these enforcements also have the capacity to bring the financial system down. Finally, LTF law is elastic, meaning that legal constraints can be relaxed or tightened depending on the economy’s health.
Calling the Fed to intervene in the derivatives market, the “dealer option” emphasizes the financial system’s hybridity. The law does not currently require central banks to offer convertibility to most assets. In most cases, they are explicitly barred from doing so. Legal restrictions like this could be preventing effective policy options from restoring financial stability. The dealer option would defy such restrictions and allow derivatives dealers to have an account at the Fed. The Fed’s traditional indirect backstopping channel has proven to be inadequate during most financial crises. Banks tend to reduce or sometimes cease their liquidity provision during a crisis. Accounting for such shifts in banks’ business models, the dealer option allows the Fed to directly backstop the leading players in the supply chain of risk. Importantly, these benefits would only be accessible for derivatives dealers once a recession is looming or already in full effect, when unconventional monetary policy tools are used.
Whether a lender of last resort should provide liquidity to forestall panic has been debated for more than two hundred years. Those who oppose the provision of liquidity from a lender of last resort argue that the knowledge that such credits will be available encourages speculation. Those who want a lender of last resort worry more about coping with the current crisis and reducing the likelihood that a liquidity crisis will cascade into a solvency crisis and trigger a severe recession. After the 2008 crisis, the use of derivatives for hedging has greatly increased due to the growing emphasis on risk management. Solvency II, Dodd-Frank, and the EMIR Risk Mitigation Regulation increased the cost of capital in favor of risk mitigation techniques, including hedging and reducing counterparty risk. The risk is transferred over the option supply chain to market makers, who are left with the ultimate task to manage their risk exposure. The dealer option offers liquidity to these dealers during a crisis when the imbalances are huge. Currently, there is no lender of last resort for the market for risk because there is neither a consensus about the systemic importance of shadow banking nor any model adequately equipped to distinguish between hedge finance, speculative finance, and Ponzi finance.
Shadow banking has three foundations: liquid assets, global dollar funding, and risk management. So far, the Fed has left the last foundation unattended. In order to design tools that fill the void between risk management and crisis prevention, we must understand the financial ecosystem as it really is, and not as we want it to be.
Saeidinezhad, E., 2020. “When it Comes to Market Liquidity, What if Private Dealing System is Not ‘The Only Game in Town’ Anymore? (Part I).” Available at: https://elhamsaeidinezhad.com↩
Stigum, M., 2007. Stigum’s Money Market. McGraw-Hill Professional Publishing ↩
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“Investors persist in trading despite their dismal long-run trading record partly because the argument seduces them that because prices are as likely to go up as down (or as likely to go down as up), trading based on purely random selection rules will produce neutral performance… Apparently, this idea is alluring; nonetheless, it is wrong. The key to understanding the fallacy is the market-maker.”
Jack Treynor (using Walter Bagehot as his Pseudonym) in The Only Game In Town.
By Elham Saeidinezhad
Value investing, or alternatively called “value-based dealing,” is suffering its worst run in at least two centuries. The COVID-19 pandemic intensified a decade of struggles for this popular strategy to buy cheap stocks in often unpopular enterprises and sell them when the stock price reverts to “fundamental value.” Such a statement might be a nuisance for the followers of the Capital Asset Pricing Model (CAPM). However, for liquidity whisperers, such as “Money Viewers,” such a development flags a structural shift in the financial market. In the capital market, the market structure is moving away from being a private dealing system towards becoming a public one. In this future, the Fed- a government agency- would be the market liquidity provider of the first resort, even in the absence of systemic risk. As soon as there is a security sell-off or a hike in the funding rate, it will be the Fed, rather than Berkshire Hathaway, who uses its balance sheet and increases monetary base to purchase cheap securities from the dealers and absorb the trade imbalances. The resulting expansion in the Fed’s balance sheet, and monetary liabilities, would also alter the money market. The excessive reserve floating around could transform the money market, and the payment system, from being a credit system into a money-centric one. In part 1, I lay out the theoretical reasons blinding CAPM disciples from envisioning such a brave new future. In part 2, I will explain why the value investors are singing their farewell song in the market.
Jack Treynor, initially under the pseudo name Walter Bagehot, developed a model to show that security dealers rely on value investing funds to provide continuous market liquidity. Security dealers are willing to supply market liquidity at any time because they expect value-based dealers’ support during a market sell-off or upon hitting their finance limit. A sell-off occurs when a large volume of securities are sold and absorbed in the balance sheet of security dealers in a short period of time. A finance limit is a situation when a security dealer’s access to funding liquidity is curtailed. In these circumstances, security dealers expect value investors to act as market liquidity providers of near last resort by purchasing dealers excess inventories. It is such interdependence that makes a private dealing system the pillar of market-liquidity provision.
In CAPM, however, such interconnectedness is neither required nor recognized. Instead, CAPM asserts that risk-return tradeoff determines asset prices. However, this seemingly pure intuition has generated actual confusion. The “type” of risk that produces return has been the subject of intense debates, even among the model’s founders. Sharpe and Schlaifer argued that the market risk (the covariance) is recognizably the essential insight of CAPM for stock pricing. They reasoned that all investors have the same information and the same risk preferences. As long as portfolios are diversified enough, there is no need to value security-specific risks as the market has already reached equilibrium. The prices are already the reflection of the assets’ fundamental value. For John Lintern, on the other hand, it was more natural to abstract from business cycle fluctuations (or market risk) and focused on firm-specific risk (the variance) instead. His stated rationale for doing so was to abstract from the noise introduced by speculation. The empirical evidence’s inconsistency on the equilibrium and acknowledging the speculators’ role was probably why Sharpe later shifted away from his equilibrium argument. In his latest works, Sharpe derived his asset pricing formula from the relationship between the return on individual security and the return on any efficient portfolio containing that security.
CAPM might be confused about the kind of risk that matters the most for asset pricing. But its punchline is clear- liquidity does not matter. The model’s central assumption is that all investors can borrow and lend at a risk-free rate, regardless of the amount borrowed or lent. In other words, liquidity provision is given, continuous, and free. By assuming free liquidity, CAPM disregards any “finance limit” for security dealers and downplays the importance of value investing, as a matter of logic. In the CAPM, security dealers have constant and free access to funding liquidity. Therefore, there is no need for value investors to backstop asset prices when dealers reach their finance limit, a situation that would never occur in CAPM’s world.
Jack Treynor and Fischer Black partnered to emphasize value-based dealers’ importance in asset pricing. In this area, both men continued to write for the Financial Analysts Journal (FAJ). Treynor, writing under the pseudonym Walter Bagehot, thinks about the economics of the dealer function in his “The Only Game in Town” paper, and Black responds with his visionary “Toward a Fully Automated Stock Exchange.” At the root of this lifelong dialogue lies a desire to clarify a dichotomy inside CAPM.
Fischer, despite his belief in CAPM, argued that the “noise,” a notion that market prices deviate from the fundamental value, is a reality that the CAPM, built on the market efficiency idea, should reconcile with. He offered a now-famous opinion that we should consider stock prices to be informative if they are between “one-half” and “twice” their fundamental values. Mathematician Benoit Mandelbrot supported such an observation. He showed that individual asset prices fluctuate more widely than a normal distribution. Mandelbrot used this finding, later known as the problem of “fat tails” or too many outliers, to call for “a radically new approach to the problem of price variation.”
From Money View’s perspective, both the efficient market hypothesis and Manderbrot’s “fat tails” hypothesis capture parts of the data’s empirical characterization. CAPM, rooted in the efficient market hypothesis, captures the arbitrage trading, which is partially responsible for asset price changes. Similarly, fat tails, or fluctuations in asset prices, are just as permanent a feature of the data. In other words, in the world of Money View, arbitrage trading and constant deviations from fundamental value go together as a package and as a matter of theoretical logic. Arbitrageurs connect different markets and transfer market liquidity from one market to another. Simultaneously, despite what CAPM claims, their operation is not “risk-free” and exposes them to certain risks, including liquidity risk. As a result, when arbitrageurs face risks that are too great to ignore, they reduce their activities and generate trade imbalances in different markets.
Security dealers who are making markets in those securities are the entities that should absorb these trade imbalances in their balance sheets. At some point, if this process continues, their long position pushes them to their finance limit-a point at which it becomes too expensive for security dealers to finance their inventories. To compensate for the risk of reaching this point and deter potential sellers, dealers reduce their prices dramatically. This is what Mandelbrot called the “fat tails” hypothesis. At this point, dealers stop making the market unless value investors intervene to support the private dealing system by purchasing a large number of securities or block trades. In doing so, they become market liquidity providers of last resort. For decades, value-based dealers used their balance sheets and capital to purchase these securities at a discounted price. The idea was to hold them for a long time and sell them in the market when prices return to fundamental value. The problem is that the value investing business, which is the private dealing system’s pillar of stability, is collapsing. In recent decades, value-oriented stocks have underperformed growth stocks and the S&P 500.
The approach of favoring bargains — typically judged by comparing a stock price to the value of the firm’s assets — has a long history. But in the financial market, nothing lasts forever. In the equilibrium world, imagined by CAPM, any deviation from fundamental value must offer an opportunity for “risk-free” profit somewhere. It might be hard to exploit, but profit-seeking arbitrageurs will always be “able” and “willing” to do it as a matter of logic. Fisher Black-Jack Treynor dialogue, and their admission of dealers’ function, is a crucial step away from pure CAPM and reveals an important fallacy at the heart of this framework. Like any model based on the efficient market hypothesis, CAPM abstracts from liquidity risk that both dealers and arbitragers face.
Money View pushes this dialogue even further and asserts that at any moment, security prices depend on the dealers’ inventories and their daily access to funding liquidity, rather than security-specific risk or market risk. If Fischer Black was a futurist, Perry Mehrling, the founder of “Money View,” lives in the “present.” For Fischer Black, CAPM will become true in the “future,” and he decided to devote his life to realizing this ideal future. Perry Mehrling, on the other hand, considers the overnight funding liquidity that enables the private dealing system to provide continuous market liquidity as an ideal system already. As value investing is declining, Money View scholars should start reimagining the prospect of the market liquidity and asset pricing outside the sphere of the private dealing system even though, sadly, it is the future that neither Fischer nor Perry was looking forward to.
By Jack Krupinski (This Money View piece is by my students,Jack Krupinski. Jack is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics.)
Financialization and electronification are long term economic trends and are here to stay. It’s essential to study how these trends will alter the world’s largest market—the foreign exchange (FX) market. In the past, electronification expanded access to the FX markets and diversified the demand side. Technological developments have recently started to change the FX market’s supply side, away from the traditional FX dealing banks towards principal trading firms (PTFs). Once the sole providers of liquidity in FX markets, dealers are facing increased competition from PTFs. These firms use algorithmic, high-frequency trading to leverage speed as a substitute for balance sheet capacity, which is traditionally used to determine FX dealers’ comparative advantage. Prime brokerage services were critical in allowing such non-banks to infiltrate the once impenetrable inter-dealer market. Paradoxically, traditional dealers were the very institutions that have offered prime brokerage services to PTFs, allowing them to use the dealers’ names and credit lines while accessing trading platforms. The rise of algorithmic market markers at the expense of small FX dealers is a potential threat to long-term stability in the FX market, as PTFs’ resilience to shocks is mostly untested. The PTFs presence in the market, and the resulting narrow spreads, could create an illusion of free liquidity during normal times. However, during a crisis, such an illusion will evaporate, and the lack of enough dealers in the market could increase the price of liquidity dramatically.
In normal times, PTFs’ presence could create an “illusion of free liquidity” in the FX market. The increasing presence of algorithmic market makers would increase the supply of immediacy services (a feature of market liquidity) in the FX market and compress liquidity premia. Because liquidity providers must directly compete for market share on electronic trading platforms, the liquidity price would be compressed to near zero. This phenomenon manifests in a narrower inside spread when the market is stable. The FX market’s electronification makes it artificially easier for buyers and sellers to search for the most attractive rates. Simultaneously, PFTs’ function makes market-making more competitive and reduces dealer profitability as liquidity providers. The inside spread represents the price that buyers and sellers of liquidity face, and it also serves as the dealers’ profit incentive to make markets. As a narrower inside spread makes every transaction less profitable for market makers, traditional dealers, especially the smaller ones, should either find new revenue sources or exit the market.
During a financial crisis, such as post-COVID-19 turmoil in the financial market, such developments can lead to extremely high and volatile prices. The increased role of PTFs in the FX market could push smaller dealers to exit the market. Reduced profitability forces traditional FX dealers to adopt a new business model, but small dealers are most likely unable to make the necessary changes to remain competitive. Because a narrower inside spread reduces dealers’ compensation for providing liquidity, their willingness to carry exchange rate risk has correspondingly declined. Additionally, the post-GFC regulatory reforms reduced the balance sheet capacity of dealers by requiring more capital buffers. Scarce balance sheet space has increased the opportunity cost of dealing.
Further, narrower inside spreads and the increased cost of dealing have encouraged FX dealers to offer prime brokerage services to leveraged institutional investors. The goal is to generate new revenue streams through fixed fees. PTFs have used prime brokerage to access the inter-dealer market and compete against small and medium dealers as liquidity providers. Order flow internalization is another strategy that large dealers have used to increase profitability. Rather than immediately hedge FX exposures in the inter-dealer market, dealers can wait for offsetting order flow from their client bases to balance their inventories—an efficient method to reduce fixed transaction costs. However, greater internalization reinforces the concentration of dealing with just a few large banks, as smaller dealers do not have the order flow volume to internalize a comparable percentage of trades.
Algorithmic traders could also intensify the riskiness of the market for FX derivatives. Compared to the small FX dealers they are replacing, algorithmic market makers face greater risk from hedging markets and exposure to volatile currencies. According to Mehrling’s FX dealer model, matched book dealers primarily use the forward market to hedge their positions in spot or swap markets and mitigate exchange rate risk. On the other hand, PTFs concentrate more on market-making activity in forward markets and use a diverse array of asset classes to hedge these exposures. Hedging across asset classes introduces more correlation risk—the likelihood of loss from a disparity between the estimated and actual correlation between two assets—than a traditional forward contract hedge. Since the provision of market liquidity relies on dealers’ ability to hedge their currency risk exposures, greater correlation risk in hedging markets is a systemic threat to the FX market’s smooth functioning. Additionally, PTFs supply more liquidity in EME currency markets, which have traditionally been illiquid and volatile compared to the major currencies. In combination with greater risk from hedging across asset classes, exposure to volatile currencies increases the probability of an adverse shock disrupting FX markets.
While correlation risk and exposure to volatile currencies has increased, new FX market makers lack the safety buffers that help traditional FX dealers mitigate shocks. Because the PTF market-making model utilizes high transaction speed to replace balance sheet capacity, there is a little buffer to absorb losses in an adverse exchange rate movement. Hence, algorithmic market makers are even more inclined than traditional dealers to pursue a balanced inventory. Since market liquidity, particularly during times of significant imbalances in supply and demand, hinges on market-makers’ willingness and ability to take inventory risks, a lack of risk tolerance among PTFs harms market robustness. Moreover, the algorithms that govern PTF market-making tend to withdraw from markets altogether after aggressively offloading their positions in the face of uncertainty. This destabilizing feature of algorithmic trading catalyzed the 2010 Flash Crash in the stock market. Although the Flash Crash only lasted for 30 minutes, flighty algorithms’ tendency to prematurely withdraw liquidity has the potential to spur more enduring market dislocations.
The weakening inter-dealer market will compound any dislocations that may occur as a result of liquidity withdrawal by PTFs. When changing fundamentals drive one-sided order flow, dealers will not internalize trades, and they will have to mitigate their exposure in the inter-dealer FX market. Increased dealer concentration may reduce market-making capacity during these periods of stress, as inventory risks become more challenging to redistribute in a sparser inter-dealer market. During crisis times, the absence of small and medium dealers will disrupt the price discovery process. If dealers cannot appropriately price and transfer risks amongst themselves, then impaired market liquidity will persist and affect deficit agents’ ability to meet their FX liabilities.
For many years, the FX market’s foundation has been built upon a competitive and deep inter-dealer market. The current phase of electronification and financialization is pressuring this long-standing system. The inter-dealer market is declining in volume due to dealer consolidation and competition from non-bank liquidity providers. Because the new market makers lack the balance sheet capacity and regulatory constraints of traditional FX dealers, their behavior in crisis times is less predictable. Moreover, the rise of non-bank market makers like PTFs has come at the expense of small and medium-sized FX dealers. Such a development undermines the economics of dealers’ function and reduces dealers’ ability to normalize the market should algorithmic traders withdraw liquidity. As the FX market is further financialized and trading shifts to more volatile EME currencies, risks must be appropriately priced and transferred. The new market makers must be up to the task.
Jack Krupinski is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics. He pursues an actuarial associateship and has passed the first two actuarial exams (Probability and Financial Mathematics). Jack is working to develop a statistical understanding of risk, which can be applied in an actuarial and research role. Jack’s economic research interests involve using “Money View” and empirical methods to analyze international finance and monetary policy.
Jack is currently working as a research assistant for Professor Roger Farmer in the economics department at UCLA and serves as a TA for the rerun of Prof. Mehrling’s Money and Banking Course on the IVY2.0 platform. In the past, he has co-authored blog posts about central bank digital currency and FX derivatives markets with Professor Saeidinezhad. Jack hopes to attend graduate school after receiving his UCLA degree in Spring 2021. Jack is a member of the club tennis team at UCLA, and he worked as a tennis instructor for four years before assuming his current role as a research assistant. His other hobbies include hiking, kayaking, basketball, reading, and baking.
“A broker is foolish if he offers a price when there is nothing on the offer side good to the guy on the phone who wants to buy. We may have an offering, but we say none.” Marcy Stigum
By Elham Saeidinezhad
Before the slow but eventual repeal of Glass-Steagall in 1999, U.S. commercial banks were institutions whose mission was to accept deposits, make loans, and choose trade-exempt securities. In other words, banks were Cecchetti’s “Financial intermediaries.” The repeal of Glass-Steagall allowed banks to enter the arena so long as they become financial holding companies. More precisely, the Act permitted banks, securities firms, and insurance companies to affiliate with investment bankers.Investment banks, also called non-bank dealers, were allowed to use their balance sheets to trade and underwrite both exempt and non-exempt securities and make the market in both the capital market and the money market instruments. Becoming a dealer brought significant changes to the industry. Unlike traditional banks, investment banks, or merchant banks, as the British call it, can cover activities that require considerably less capital. Second, the profit comes from quoting different bid-ask prices and underwriting new securities, rather than earning fees.
However, the post-COVID-19 crisis has accelerated an existing trend in the banking industry. Recent transactions highlight a shift in power balance away from the investment banking arm and market-making operations. In the primary markets, banks are expanding their brokerage role to earn fees. In the secondary market, banks have started to transform their businesses and diversify away from market-making activities into fee-based brokerages such as cash management, credit cards, and retail savings accounts. Two of the underlying reasons behind this shift are “balance sheet constraints” and declining credit costs that reduced banks’ profit as dealers and improved their fee-based businesses. From the “Money View” perspective, this shift in the bank’s activities away from market-making towards brokerage has repercussions. First, it adversely affects the state of “liquidity.” Second, it creates a less democratic financial market as it excludes smaller agents from benefiting from the financial market. Finally, it disrupts payment flows, given the credit character of the payments system.
When a banker acts as a broker, its income depends on fee-based businesses such as monthly account fees and fees for late credit card payments, unauthorized overdrafts, mergers, and issuing IPOs. These fees are independent of the level of the interest rate. A broker puts together potential buyers and sellers from his sheet, much in the way that real estate brokers do with their listing sheets and client listings. Brokers keep lists of the prices bid by potential buyers and offered by potential sellers, and they look for matches. Goldman, Merrill, and Lehman, all big dealers in commercial paper, wear their agent hat almost all the time when they sell commercial paper. Dealers, by contrast, take positions themselves by expanding their balance sheets. They earn the spread between bid-ask prices (or interest rates). When a bank puts on its hat as a dealer (principal), that means the dealer is buying for and selling using its position. Put another way, in a trade; the dealer is the customer’s counterparty, not its agent.
Moving towards brokerage activity has adverse effects on liquidity. Banks are maintaining their dealer role in the primary market while abandoning the secondary market. In the primary market, part of the banks’ role as market makers involves underwriting new issues. In this market, dealers act as a one-sided dealer. As the bank only sells the newly issued securities, she does not provide liquidity. In the secondary market, however, banks act as two-sided dealers and supply liquidity. Dealer banks supply funding liquidity in the short-term money market and the market liquidity in the long-term capital market. The mission is to earn spreads by always quoting bids and offers at which they are willing to buy and sell. Some of these quotes are to other dealers. In many sectors of the money market, there is an inside market among dealers.
As opposed to the bond market, the money market is a wholesale market for high-quality, short-term debt instruments, or IOUs. In the money market, dealing banks make markets in many money market instruments. Money market instruments are credit elements that lend elasticity to the payment system. Deficit agents, who do not have adequate cash at the moment, have to borrow from the money market to make the payment. Money market dealers expand the elasticity daily and enable the deficit agents to make payments to surplus agents. Given the credit element in the payment, it is not stretching the truth to say that these short-term credit instruments, not the reserves, are the actual ultimate means of payment. Money market dealers resolve the “payments management” problem by enabling deficit agents to make payments before they receive payments.
Further, when dealers trade, they usually do not even know who their counterparty is. However, if banks become brokers, they need to “fine-tune” quotes because it matters who is selling and buying. Brokers prefer to trade with big investors and reduce their ties with smaller businesses. This is what Stigum called “line problems.” She explains a scenario where the Citi London offered to sell 6-month money at the bid rate quoted by a broker, and then, the bidding bank told the broker she changed her mind but had forgotten to call. In this situation, which is a typical one in the Eurodollar market, the broker would be committed to completing her bid by finding Citi a buyer at that price. Otherwise, the broker would sell Citi’s money at a lower rate and pay a difference equal to Citi’s dollar amount and would lose by selling at that rate. Since brokers operate on thin margins, a broker wouldn’t be around long if she often got “stuffed.” Good brokers take care to avoid errors by choosing their counterparties carefully.
After the COVID-19 pandemic, falling interest rates, the lower overall demand for credit, and regulatory requirements that limit the use of balance sheets have reduced banks’ profits as dealers. In the meantime, the banks’ fee-based businesses that include credit cards late-fees, public offerings, and mergers have become more attractive. The point to emphasize here is that the brokerage business does not involve providing liquidity and making the market while supplying liquidity in the money and capital market is the source of dealer banks’ revenue. Further, brokers tend to only trade with large corporations, while dealers’ supply of liquidity usually does not depend on who their counterparty is. Finally, as the payment system is much closer to a credit system than a money system, its well-functioning relies on money market instruments’ liquidity. Modern banks may wear one of two hats, agent (broker) or principal (dealers), in dealing with financial market instruments. The problem is that only one of these hats allows banks to make the market, facilitate the payment system, and democratize access to the credit market.
“From long experience, Fed technicians knew that the Fed could not control money supply with the precision envisioned in textbooks.” Marcy Stigum
In the last decade, monetary policy wrestled with the problem of low inflation and has become a tale of three cities: interest rate, asset purchasing, and the yield curve. The fight to reach the Fed’s inflation target started by lowering the overnight federal funds rate to a historically low level. The so-called “zero-lower bound restriction” pushed the Fed to alternative policy tools, including large-scale purchases of financial assets (“quantitative and qualitative easing”). This policy had several elements: first, a commitment to massive asset purchases that would increase the monetary base; second, a promise to lengthen the maturity of the central banks’ holdings andflatten the yield curve. However, in combination with low inflation (actual and expected), such actions have translated into persistently low real interest rates at both the yield curve’s long and short ends, and at times, the inversion of the yield curve. The “whatever it takes” large-scale asset purchasing programs of central banks were pushing the long-term yields into clear negative territory. Outside the U.S., and especially in Japan, central banks stepped up their fight against deflation by adopting a new policy called “Yield Curve Control,” which explicitly puts a cap on long-term rates. Even though the Fed so far resisted following the Bank of Japan’s footsteps, the yield curve control is the first move towards building a world that “Money View” re-imagines for central banking. The yield curve control embraces the “dealer of last resort” role of the Fed to increase its leverage over the yield curve, a chain of the private dealers. In the meantime, it reduces the Fed’s trace in the capital market and does not create as many dislocations in asset prices.
To understand this point, let’s start by translating monetary policy’s evolution into the language of Money View. In the traditional monetary policy, the Fed uses its control of reserve (at the top of the hierarchy of money) to affect credit expansion (at the bottom of the hierarchy). It also controls the fed funds rate (at the short end of the term structure) in an attempt to influence the bond rate of interest (at the long end). When credit is growing too rapidly, the Fed raises the federal fund’s target to impose discipline in the financial market. In standard times, this would immediately lower the money market dealers’ profit. This kind of dealer borrows at an overnight funding market to lend in the lend in term (i.e., three-month) market. The goal is to earn the liquidity spread.
After the Fed’s implementation of contractionary monetary policy, to compensate for the higher financing cost, money market dealers raise the term interest rate by the full amount (and perhaps a bit more to compensate for anticipated future tightening as well). This term-rate is the funding cost for another kind of dealer, called security dealers. Security dealers borrow from the term-market (repo market) to lend to the long-term capital market. Such operations involve the purchase of securities that requires financing. Higher funding cost implies that security dealers are willing to hold existing security inventories only at a lower price, and increasing long-term yield. This chain of events sketches a monetary policy transmission that happens through the yield curve. The point to emphasize here is that in determining the yield curve, the private credit market, not the Fed, sets rates and prices. The Fed has only some leverage over the system.
After the GFC, as the rates hit zero-lower bound, the Fed started to lose its leverage. In a very low-interest-rate condition, preferences shift in favor of money and against securities. One way to put it is that the surplus agents become reluctant to” delay settlement” and lower their credit market investment. They don’t want promises to pay (i.e., holding securities), and want money instead. In this environment, to keep making the market and providing liquidity, money market, and security dealers, who borrow to finance their short and long-term inventories, respectively, should be able to buy time. During this extended-time period, prices are pushed away from equilibrium. Often, the market makers face this kind of trouble and turn to the banks for refinancing. After GFC, however, the very low-interest rates mean that banks themselves run into trouble.
In a normal crisis, as the dealer system absorbs the imbalances due to the shift in preferences into its balance sheet, the Fed tried to do the same thing and take the problem off the balance sheet of the banking system. The Fed usually does so by expanding its balance sheet. The Fed’s willingness to lend to the banks at a rate lower than they would lend to each other makes it possible for the banks to lend to the dealers at a rate lower than they would otherwise charge. Putting a ceiling on the money rate of interest thus indirectly puts a floor on asset prices. In a severe crisis, however, this transmission usually breaks down. That is why after the GFC, the Fed used its leverage to put a floor on asset prices directly by buying them, rather than indirectly by helping the banks to finance dealers’ purchases.
The fundamental question to be answered is whether the Fed has any leverage over the private dealing system when interest rates are historically low. The Fed’s advantage is that it creates reserves, so there can be no short squeeze on the Fed. When the Fed helps the banks, it expands reserves. Hence the money supply grows. We have seen that the market makers are long securities and short cash. What the Fed does is to backstop those short positions by shorting cash itself. However, the Fed’s leverage over the private dealer system is asymmetric. The Fed’s magic mostly works when the Fed decides to increase elasticity in the credit market. The Fed has lost its alchemy to create discipline in the market when needed. When the rates are already very low, credit contraction happens neither quickly nor easily if the Fed increases the rates by a few basis points. Indeed, only if the Fed raises the rates high enough, it can get some leverage over this system, causing credit contraction. Short of an aggressive rate hike, the dealer system increases the spread slightly but not enough to not change the quantity of supplied credit. In other words, the Fed’s actions do not translate automatically into a chain of credit contraction, and the Fed does not have control over the yield curve. The Fed knows that, and that is why it has entered large-scale asset purchasing programs. But it is the tactful yet minimal purchases of long-term assets, rather than massive ones, that can restore the Fed’s control over the yield curve. Otherwise, the Fed’s actions could push the long-term rates into negative territory and lead to a constant inversion of the yield curve.
The yield curve control aims at controlling interest rates along some portion of the yield curve. This policy’s design has some elements of the interest rate policy and asset purchasing program. Similar to interest rate policy, it targets short-term interest rates. Comparable with the asset purchasing program, yield curve control aim at controlling the long-term interest rate. However, it mainly incorporates essential elements of a “channel” or “corridor” system. This policy targets longer-term rates directly by imposing interest rate caps on particular maturities. Like a “corridor system,” the long-term yield’s target would typically be set within a bound created by a target price that establishes a floor for the long-term assets. Because bond prices and yields are inversely related, this also implies a ceiling for targeted maturities. If bond prices (yields) of targeted maturities remain above (below) the floor, the central bank does nothing. However, if prices fall (rise) below (above) the floor, the central bank buys targeted-maturity bonds, increasing the demand and the bonds’ price. This approach requires the central bank to use this powerful tool tactfully rather than massively. The central bank only intervenes to purchase certain assets when the interest rates on different maturities are higher than target rates. Such a strategy reduces central banks’ footprint in the capital market and prevents yield curve inversion- that has become a typical episode after the GFC.
The “paradox of the yield curve” argues that the Fed’s hesitation to adopt the yield curve control to regulate the longer-term rates contradicts its decision to employ a corridor framework to control the overnight rate. Once the FOMC determines a target interest rate, the Fed already sets the discount rate above the target interest rate and the interest-on-reserve rate below. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. A corridor operating framework can help a central bank achieve a target policy rate in an environment in which reserves are anything but scarce, and the central bank has used its balance sheet as a policy instrument independent of the policy interest rate.
In the world of Money View, the corridor system has the advantage of enabling the Fed to act as a value-based dealer, or as Mehrling put it, “dealer of last resort,” without massively purchasing assets and constantly distorting asset prices. The value-based dealer’s primary role is to put a ceiling and floor on the price of assets when the dealer system has already reached their finance limits. Such a system can effectively stabilize the rate near its target. Stigum made clear that standard economic theory has no perfect answer to how the Fed gets leverage over the real economy. The question is why the Fed is willing to embrace the frameworks that flatten the yield curve and reduce its influence. In the meantime, it is hesitant to adopt the “yield curve control,” even though this framework boosts the Fed’s leverage by empowering the Fed to set an explicit cap on longer-term rates.
In this year’s Jackson Hole meeting, the Fed announced a formal shift away from previously articulated longer-run inflation objective of 2 percent towards achieving inflation that averages 2 percent over time. The new accord aims at addressing the shortfalls of the low “natural rate” and persistently low inflation. More or less, all academic debates in that meeting were organized as arguments about the appropriate quantitative settings for a Taylor rule. The rule’s underlying idea is that the “market” tends to set the nominal interest rate equal to the natural rate plus expected inflation. The Fed’s role in this equation is to reduce or increase this market rate by changing the short-term federal funds rate whenever the inflation deviates from the target. The goal is to stabilize the long-run inflation. The Fed believes that the recent secular decline in natural rates relative to the historical average has constrained the power of the federal funds rate to achieve this mandate. The expectation is that the Fed’s decision to tolerate a temporary overshooting of the longer-run inflation to keep inflation and inflation expectations centered on 2 percent following periods when inflation has been persistently below 2 percent will address the framework’s constant failure and restore the magic of central banking. However, the ongoing issue with the Taylor rule-based monetary policy frameworks, including the recent one, is that they require the Fed to overlook the trends in the credit market, and only focus on the developments in the real economy, such as inflation or past inflation deviations, when setting the short-term interest rates. Rectifying such blind spots is what money view scholars were hoping for when the Fed announced its intention to review the monetary policy framework.
The logic behind the new framework, known as the average inflation targeting strategy, is that inflation undershooting makes achieving the target unlikely in the long run as it pushes the inflation expectations below the target. This being the case, when there is a long period of inflation undershooting the target, the Fed should act to undo the undershooting by overshooting the target for some time. The Fed sold forecast (or average) targeting to the public as a better way of accomplishing its mandate compared to the alternative strategies as the new framework makes the Fed more “history-dependent.” Translated into the money view language, however, the new inflation-targeting approach onlydelays the process of imposing excessive discipline in the money market when the consumer price index rises faster than the inflation target and providing excessive elasticity when prices are growing slower than the inflation target.
From the money view perspective, the idea that the interest rate should not consider private credit market trends will undermine central banking’s power in the future, as it has done in the past. The problem we face is not that the Fed failed to follow an appropriate version of Taylor rule. Rather, and most critically, these policies tend to abstract from the plumbing behind the wall, namely the payment system, by disregarding the credit market. Such a bias may have not been significant in the old days when the payment system was mostly a reserve-based system. In the old world, even though it was mostly involuntarily, the Fed used to manage the payment system through its daily interventions in the market for reserves. In the modern financial system, however, the payment system is a credit system, and its quality depends on the level of elasticity and discipline in the private credit market.
The long dominance of economics and finance views imply that modern policymakers have lost sight of the Fed’s historical mission to manage the balance between discipline and elasticity in the payment system. Instead of monitoring the balance between discipline and elasticity in the credit market, the modern Fed attempts to keep the bank rate of interest in line with an ideal “natural rate” of interest, introduced by Knut Wicksell. In Wicksellians’ world, in contrast to the money view, securing the continuous flow of credit in the economy through the payment system is not part of the Fed’s mandate. Instead, the Fed’s primary function is to ensure it does not choose a “money rate” of interest different from the “natural rate” of interest (profit rate capital). If lower, then the differential creates an incentive for new capital investment, and the new spending tends to cause inflation. If prices are rising, then the money rate is too low and should be increased; if prices are falling, then the money rate is too high and should be decreased. To sum up, Wicksellians do not consider private credit to be intrinsically unstable. Inflation, on the other hand, is viewed as the source of inherent instability. Further, they see no systemic relation between the payment system and the credit market as the payment system simply reflects the level of transactions in the real economy.
The clash between the standard economic view and money view is a battle between two different world views. Wicksell’s academic way of looking at the world had clear implications for monetary policy: set the money rate equal to the natural rate and then stand back and let markets work. Unfortunately, the natural rate is not observable, but the missed payments and higher costs of borrowing are. In the money view perspective, the Fed should use its alchemy to strike a balance between elasticity and discipline in the credit market to ensure a continuous payment system. The money view barometer to understand the credit market cycle is asset prices, another observable variable. Since the crash can occur in commodities, financial assets, and even real assets, the money view does not tell us which assets to watch. However, it emphasizes that the assets that are not supported by a dealer system (such as residential housing) are more vulnerable to changes in credit conditions. These assets are most likely to become overvalued on the upside and suffer the most extensive correction on the downside. A central bank that understands its role as setting interest rates to meet inflation targets tends to exacerbate this natural tendency toward instability. These policymakers could create unnaturally excessive discipline when credit condition is already tight or vice versa while looking for a natural rate of interest.
“The pronouncements and actions of the Federal Reserve Board on monetary policy are a charade.” Fischer Black
As the US Department of Treasury builds the points along the yield curve, the bank reserves are losing relevance in explaining short-term money market rates’ behavior. Central banks assume that they can create a close link between the best form of money (reserve) and monetary policy. They use the supply of reserves precisely to achieve the target interest rate. Since the 2008-09 Great Financial Crisis (GFC), however, the relationship between money and monetary policy has become unstable. After the COVID-19 pandemic, for instance, the Fed’s actions more than doubled the supply of bank reserves, from approximately $1.5 trillion in March to more than $3 trillion in June. In theory, such a massive increase in the supply of reserves should reduce the money market rates. Yet, short-term money market rates have been surprisingly steady, despite the enormous increase in reserves during the great lockdown. Fed economists recognize the over-supply of short-term US Treasury bills (a money market instrument) as the leading cause of the puzzling behavior in money market rates and call it “friction.”
However, for the Money View scholars, dividing the money market from the capital market, assuming that prices in each market are solely determined by its supply and demand flow, has never been an effective way of understanding interest rates. In the Money View world, similar to Fischer Black’s CAPM, the arbitrage condition implies that both the quantity and the price of money are ultimately determined by private dealers borrowing and lending activities that connect different markets rather than the stance of monetary policy alone. Dealers engage in “yield spread arbitrage,” in which they identify apparent mispricing (i.e., temporary fluctuations in supply or demand) at one segment of the yield curve, and takes a position. Dealers take “positions,” which means they speculate on how prices of assets with similar risk structure but different term-to-maturity, will change. In the meantime, they hedge interest rate exposures by taking an opposite position at another segment of the yield curve.
The point to emphasize is that short-term money markets and long-term capital markets are, in fact, not separate. As a result, prices in each market are not solely determined by the flow of supply and demand in that particular market. By taking advantage of the arbitrage opportunity, the dealers act as “porters” of liquidity from one market to another and connect prices in different markets in the process. The instruments that allow the dealers to transfer liquidity and solidify markets are repos and reverse repos, where capital market assets are used as collaterals to borrow from the money market, or vice versa. The Money View’s strength in understanding price dynamics comes from its ability, and willingness, to understand the dealers whose business connects different points of the yield curve and determines the effectiveness of the monetary policy.
During the COVID-19 pandemic, two separate but equally essential developments (aka distortions) occurred along the yield curve. In the long-term capital market, the Treasury has introduced a new class of safe assets, a 20-year Treasury bond, with a high yield (corresponding to the lowest accepted bid price) of 1.22 percent. Effectively, the US Treasury added a new point to the long-term end of the yield curve. In the short-term money market, the Fed injected a massive amount of reserves to reduce money market rates. The standard view suggests that such an increase in the supply of reserves would reduce the money market rates. The idea is that banks are the only institutions that hold these extra reserves. Due to balance sheet constraints, such as banks’ regulatory requirements, higher reserve holding implies higher banks’ costs. Therefore, banks reduce their short-term rates to signal their willingness to lend. In practice, however, short-term rates remained unchanged.
This dynamic in money market rates can be explained by the recent developments in the Treasury market, a segment of the capital market, and actions of the dealers who took advantage of the consequent arbitrage opportunity along the yield curve, i.e., the high spread between the short-term money market and the long-term risk-free Treasury rates. The dealers increased demand in the short-term money market both for hedging, and financing the newly issued Treasury bonds, put upward pressure on short-term rates. In contrast, the Fed’s activities put downward pressure on these rates. Observe that an increase in private demand for short-term funding (due to yield spread arbitrage) and an increase in the supply of reserves by the Fed (due to monetary policy) have opposing effects on short-term rates. Thus, it should not be surprising that despite the excessive reserve supply after the pandemic, the money market rates have remained stable. Understanding this kind of arbitrage along the yield curve is essential in understanding the behavior of short-term rates and the monetary policy’s effectiveness.
What is missing in this literature, but emphasized in the Money View framework, is acknowledging the hybridity between the money market and the capital market. The close link between the US Treasury market and the money market is a feature of the shadow banking or the new market-based finance. It is no friction. More importantly, the dealers’ search for “arbitrage” opportunities implies that individual securities markets are not separate. Speculators are joining the different markets into a single market. In doing so, they bring about a result that is no part of their intention, namely liquidity. As the Treasury creates an additional risk-free, liquid, point along the yield curve, it creates more arbitrage opportunities. Such developments make the yield curve an even more critical tool of examining the monetary policy effects. In the meantime, the traditional framework of supply and demand for bank reserves to control the short-term money market rate is losing its pertinence.
Mary Stigum once said, “Don’t fight the Fed!” There is perhaps no better advice that someone can give to an investor than to heed these words.
After the COVID-19 crisis, most aspects of the dollar funding market have shown some bizarre developments. In particular, the LIBOR-OIS spread, which used to be the primary measure of the cost of dollar funding globally, is losing its relevance. This spread has been sidelined by the strong bond between the rivals, namely CP/CD ratio and the FX swap basis. The problem is that such a switch, if proved to be premature, could create uncertainty, rather than stability, in the financial market. The COVID-19 crisis has already mystified the relationship between these two key dollar funding rates – CP/CD and FX swap basis- in at least two ways. First, even though they should logically track each other tightly according to the arbitrage conditions, they diverged markedly during the pandemic episode. Second, an unusual anomaly had emerged in the FX swap markets, when the market signaled a US dollar premium and discount simultaneously. For the scholars of Money View, these so-called anomalies are a legitimate child of the modern international monetary system where agents are disciplined, or rewarded, based on their position in the hierarchy. This hierarchy is created by the hand of God, aka the Fed, whose impact on nearly all financial assets and the money market, in particular, is so unmistakable. In this monetary system, a Darwinian inequality, which is determined by how close a country is to the sole issuer of the US dollar, the Fed, is an inherent quality of the system.
Most of these developments ultimately have their roots in dislocations in the banking system. At the heart of the issue is that a decade after the GFC, the private US Banks are still pulling back from supplying offshore dollar funding. Banks’ reluctance to lend has widened the LIBOR-OIS spread and made the Eurodollar market less attractive. Money market funds are filling the void and becoming the leading providers of dollar funding globally. Consequently, the CP/CD ratio, which measures the cost of borrowing from money market funds, has replaced a bank-centric, LIBOR-OIS spread and has become one of the primary indicators of offshore dollar funding costs.
The market for offshore dollar funding is also facing displacements on the demand side. International investors, including non-US banks, appear to utilize the FX swap market as the primary source of raising dollar funding. Traditionally, the bank-centric market for Eurodollar deposits was the one-stop-shop for these investors. Such a switch has made the FX swap basis, or “the basis,” another significant thermometer for calculating the cost of global dollar funding. This piece shows that this shift of reliance from banks to market-based finance to obtain dollar funding has created odd trends in the dollar funding costs.
Further, in the world of market-based finance, channeling dollars to non-banks is not straightforward as unlike banks, non-banks are not allowed to transact directly with the central bank. Even though the Fed started such a direct relationship through Money Market Mutual Fund Liquidity Facility or MMLF, the pandemic revealed that there are attendant difficulties, both in principle and in practice. Banks’ defiance to be stable providers of the dollar funding has created such irregularities in this market and difficulties for the central bankers.
The first peculiar trend in the global dollar funding is that the FX swap basis has continuously remained non-zero after the pandemic, defying the arbitrage condition. The FX swap basis is the difference between the dollar interest rate in the money market and the implied dollar interest rate from the FX swap market where someone borrows dollars by pledging another currency collateral. Arbitrage suggests that any differences between these two rates should be short-lived as there is always an arbitrageur, usually a carry trader, inclined to borrow from the market that offers a low rate and lend in the other market, where the rate is high. The carry trader will earn a nearly risk-free spread in the process. A negative (positive) basis means that borrowing dollars through FX swaps is more expensive (cheaper) than borrowing in the dollar money market.
Even so, the most significant irregularity in the FX swap markets had emerged when the market signaled a US dollar premium and a discount simultaneously. The key to deciphering this complexity is to carefully examinethe two interest rates that anchor FX swap pricing. The first component of the FX swap basis reflects the cost of raising dollar fundingdirectly from the banks. In the international monetary system, not all banks are created equal. For the US banks who have direct access to the Fed’s liquidity facilities and a few other high-powered non-US banks, whose national central banks have swap lines with the Fed, the borrowing cost is close to a risk-free interest rate (OIS). At the same time, other non-US banks who do not have any access to the central bank’s dollar liquidity facilities should borrow from the unsecured Eurodollar market, and pay a higher rate, called LIBOR.
As a result, for corporations that do not have credit lines with the banks that are at the top of the hierarchy, borrowing from the banking system might be more expensive than the FX swap market. For these countries, the US dollar trades at a discount in the FX swap market. Contrarily, when banks finance their dollar lending activities at a risk-free rate, the OIS rate, borrowing from banks might be less more expensive for the firms. In this case, the US dollar trades at a premium in the FX swap market. To sum up, how connected, or disconnected, a country’s banking system is to the sole issuer of the dollar, i.e., the Fed, partially determines whether the US dollar funding is cheaper in the money market or the FX swap market.
The other crucial interest rate that anchors FX swap pricing and is at the heart of this anomaly in the FX swap market is the “implied US dollar interest rate in the FX swap market.” This implied rate, as the name suggests, reflects the cost of obtaining dollar funding indirectly. In this case, the firms initially issue non-bank domestic money market instruments, such as commercial papers (CP) or certificates of deposits (CDs), to raise national currency and convert the proceeds to the US dollar. Commercial paper (CP) is a form of short-term unsecured debt commonly issued by banks and non-financial corporations and primarily held by prime money market funds (MMFs). Similarly, certificates of deposit (CDs) are unsecured debt instruments issued by banks and largely held by non-bank investors, including prime MMFs. Both instruments are important sources of funding for international firms, including non-US banks. The economic justification of this approach highly depends on the active presence of Money Market Funds (MMFs), and their ability and willingness, to purchase short-term money market instruments, such as CPs or CDs.
To elaborate on this point, let’s use an example. Let us assume that a Japanese firm wants to raise $750 million. The first strategy is to borrow dollars directly from a Japanese bank that has access to the global dollar funding market. Another competing strategy is to raise this money by issuing yen-denominated commercial paper, and then use those yens as collateral, and swap them for fixed-rate dollars of the same term. The latter approach is only economically viable if there are prime MMFs that are able and willing, to purchase that CP, or CD, that are issued by that firm, at a desirable rate. It also depends on FX swap dealers’ ability and willingness to use their balance sheet to find a party wanting to do the flip side of this swap. If for any reason these prime MMFs decide to withdraw from the CP or CD market, which has been the case after the COVID-19 crisis, then the cost of choosing this strategy to raise dollar funding is unequivocally high for this Japanese firm. This implies that the disruptions in the CP/CD markets, caused by the inability of the MMFs to be the major buyer in these markets, echo globally via the FX swap market.
On the other hand, if prime MMFs continue to supply liquidity by purchasing CPs, raising dollar funding indirectly via the FX swap market becomes an economically attractive solution for our Japanese firm. This is especially true when the regional banks cannot finance their offshore dollar lending activities at the OIS rate and ask for higher rates. In this case, rather than directly going to a bank, a borrower might raise national currency by issuing CP and swap the national currency into fixed-rate dollars in the FX swap market. Quite the contrary, if issuing short-term money market instruments in the domestic financial market is expensive, due to the withdrawal of MMFs from this market, for instance, the investors in that particular region might find the banking system the only viable option to obtain dollar funding even when the bank rates are high. For such countries, the high cost of bank-lending, and the shortage of bank-centric dollar funding, is an essential threat to the monetary stability of the firms, and the domestic monetary system as a whole.
After the COVID-19 crisis, it is like a tug of war emerged between OIS rates and the LIBORs as to which type of interest rate that anchor FX swap pricing. Following the pandemic, the LIBOR-OIS spread widened significantly and this war was intensified. Money View declares the winner, even before the war ends, to be the bankers, and non-bankers, who have direct, or at least secure path to the Fed’s balance sheet. Marcy Stigum, in her seminal book, made it clear not to fight the Fed and emphasized the powerful role of the Federal Reserve in the monetary system! Time and time again, investors have learned that it is fruitless to ignore the Fed’s powerful influence. Yet, some authors put little effort into trying to gain a better understanding of this powerful institution. They see the Fed as too complex, secretive, and mysterious to be readily understood. This list does not include Money View scholars. In the Money View framework, the US banks that have access to the Fed’s balance sheet are at the highest layer of the private banking hierarchy. Following them are a few non-US banks that have indirect access to the Fed’s swap lines through their national central bank. For the rest of the world, having access to the world reserve currency only depends on the mercy of the Gods.
The COVID-19 crisis has revealed the resiliency of the banking system compared to the Great Financial Crisis (GFC). At the same time, it also put banks’ absence from typically bank-centric markets on display. Banks have already demonstrated their objection to passing credit to small-and-medium enterprises (SMEs). In doing so, they rejected their traditional role as financial intermediaries for the retail depositors. This phenomenon is not surprising for scholars of “Money View”. The rise of market-based finance coincides with the fading role of banks as financial intermediaries. Money View asserts that banks have switched their business model to become the lenders and dealers in the interbank lending and the repo market, both wholesale markets, respectively. Banks lend to each other via the interbank lending market and use the proceeds to make a market in funding liquidity via the repo market.
Aftermath the COVID-19 crisis, however, an episode in the market for term funding cast a dark shadow over such doctrine. The issue is that it appears thatinterbank lending no longer serves as the significant marginal source of term funding for banks. Money Market Funds (MMFs) filled the void in other wholesale money markets, such as markets for commercial paper and the repo market. After the pandemic, MMFs curtailed their repo lending, both with dealers and in the cleared repo segment, to accommodate outflows. This decision by MMFs increased the cost of term dollar funding in the wholesale money market. This distortion was contained only when the Fed directly assisted MMFs through Money Market Mutual Fund Liquidity Facility or MMLF. Money View emphasizes the unique role of banks in the liquidity hierarchy since their liabilities (bank deposits) are a means of payment. Yet, such developments call into question the exact role of banks, who have unique access to the Fed’s balance sheet, in the financial system. Some scholars warned that instruments, such as the repo, suck out liquidity when it most needed. A deeper look might reveal that it is not money market instruments that are at fault for creating liquidity issues but the inconsistency between the banks’ perceived, and actual significance, as providers of liquidity during a crisis.
There are two kinds of MMFs: prime and government. The former issue shares as their liabilities and hold corporate bonds as their assets while the latter use the shares to finance their holding of safe government debts. By construction, the shares have the same risk structure as the underlying pool of government bonds or corporate bonds. In doing so, the MMFs act as a form of financial intermediaries. However, this kind of intermediation is different from a classic, textbook, one. MMFs mainly use diversification to pool risk and not so much to transform it. Traditional financial intermediaries, on the other hand, use their balance sheet to transform risk- they turn liquid liabilities (overnight checkable deposits) into illiquid assets (long term loans). There is some liquidity benefit for the mutual fund shareholder from diversification. But such a business model implies that MMFs have to keep cash or lines of credit, which reduces their return.
To improve the profit margin, MMFs have also become active providers of liquidity in the market for term funding, using instruments such as commercial paper (CP) and the repo. Commercial paper (CP) is an unsecured promissory note with a fixed maturity, usually three months. The issuer, mostly banks and non-financial institutions, promises to pay the buyer some fixed amount on some future date but pledges no assets, only her liquidity and established earning power, guaranteeing that promise. Investment companies, principally money funds and mutual funds, are the single biggest class of investors in commercial paper. Similarly, MMFs are also active in the repo market. They usually lend cash to the repo market, both through dealers and cleared repo segments. At its early stages, the CP market was a local market that tended, by investment banking standards, to be populated by less sophisticated, less intense, less motivated people. Also, MMFs were just one of several essential players in the repo market. The COVID-19 crisis, however, revealed a structural change in both markets, where MMFs have become the primary providers of dollar funding to banks.
It all started when the pandemic forced the MMFs to readjust their portfolio to meet their cash outflow commitments. In the CP market, MMFs reduced their holding of CP in favor of holding risk-free assets such as government securities. In the repo market, they curtailed their repo lending both to dealers and in the cleared segment of the market. Originally, such developments were not considered a threat to financial stability. In this market, banks were regarded as the primary providers of dollar funding. The models of market-based finance, such as the one provided by Money View framework, tend to highlight banks’ function as dealers in the wholesalemoney market, and the main providers of funding liquidity. In these models, banks set the price of funding liquidity and earn an inside spread. Banks borrow from the interbank lending market and pay an overnight rate. They then lend the proceeds in the term-funding market (mostly through repo), and earn term rate. Further, more traditional models of bank-based financial systems depict banks as financial intermediaries between depositors and borrowers. Regardless of which model to trust, since the pandemic did not create significant disturbances in the banking system, it was expected that the banks would pick up the slack quickly after MMFs retracted from the market.
The problem is that the coronavirus casts doubt on both models, and highlights the shadowy role of banks in providing funding liquidity. The experience with the PPP loans to SMEs shows that banks are no longer traditional financial intermediaries in the retail money market. At the same time, the developments in the wholesale money market demonstrate that it is MMFs, and no longer banks, who are the primary providers of term funding and determine the price of dollar funding. A possible explanation could be that on the one hand, banks have difficulty raising overnight funding via the interbank lending market. On the other hand, their balance sheet constraints discourage them from performing their function as money market dealers and supply term funding to the rest of the financial system. The bottom line is that the pandemic has revealed that MMFs, rather than large banks, had become vital providers of US dollar funding for other banks and non-bank financial institutions. Such discoveries emphasize the instability of funding liquidity in bank-centric wholesale and retail money markets.
The withdrawals of MMFs from providing term funding to banks in the CP markets, and their decision to decease their reverse repo positions (lending cash against Treasuries as collateral) with dealers (mostly large banks), translated into a persistent increase of US dollar funding costs globally. Even though it was not surprising in the beginning to see a tension in the wholesale money market due to the withdrawal of the MMFs, the Fed was stunned by the extent of the turbulences. This is what caused the Fed to start filling the void that was created by MMFs’ withdrawal directly by creating new facilities such as MMLF. According to the BIS data, by mid-March, the cost of borrowing US funding widened to levels second only to those during the GFC even though, unlike the GFC, the banking system was not the primary source of distress. A key reason is that MMFs have come to play an essential role in determining US dollar funding both in a secured repo market and an unsecured CP market.In other words, interbank lendingno longer serves as a significant source of funding for banks.Instead, non-bank institutional investors such as MMFs constitute the most critical wholesale funding providers for banks. The strength of MMFs, not the large, cash-rich, banks, has, therefore, become an essential measure of bank funding conditions.
The wide swings in dollar funding costs, caused by MMFs’ withdrawal from these markets, hampered the transmission of the Fed’s rate cuts and other facilities aimed at providing stimulus to the economy in the face of the shock. With banks’ capacity as dealers were impaired, and MMFs role was diminished, the Fed took over this function of dealer of last resort in the wholesale money market. Interestingly, the Fed acted as a dealer of last resort via its MMLF facility rather than assuming the role of banks in this market. The goal was to put an explicit floor on the CP’s price and then directly purchase three-month CP from issuers via Commercial Paper Funding Facility (CPFF). These operations also have broader implications for the future of central bank financial policies that might include MMFs rather thanbanks. The Fed’s choice of policies aftermath the pandemic was the unofficial acknowledgment that it is MMFs’ role, rather than banks’, that has become a crucial barometer for measuring the health of the market for dollar funding. Such revelation demands us to ask a delicate question of what precisely the banks’ function has become in the modern financial system. In other words, is it justifiable to keep providing the exclusive privilege of having access to the central bank’s balance sheet to the banks?
