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Is the Government’s Ambiguity About the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans?

By Elham Saeidinezhad

The COVID-19 crisis has created numerous risks for small and medium enterprises (SMEs). The only certainty for SMEs has been that the government’s support has been too flawed to mitigate the shock. The program’s crash is not an accident. As mentioned in the previous Money View blog, one of the PPP loan design flaws is the government’s reliance on banks to act traditionally and intermediate credit to SMEs. Another essential, yet not well-understood design flaw at the heart of the PPP loan program is its ambiguity about the secondary market. The structure I propose to resolve such uncertainty focuses on the explicit government guarantee for the securitization of the PPP loans, similar to the GSE’s role in the mortgage finance system.

Such flaws are the byproduct of the central bank’s tendency to isolate shadow banking, and its related activities, from traditional banking. These kinds of bias would not exist in the “Money View” framework, where shadow banking is a function rather than an entity. “Money market funding of capital market lending” is a business deal that can happen in the balance sheet of any entity- including banks and central banks. One way to identify a shadow banker from a traditional banker is to focus on their sources and uses of finance. A traditional banker is simply a credit intermediary. Her alchemy is to facilitate economic growth by bridging any potential mismatch between the kind of liabilities that borrowers want to issue (use of finance) and the nature of assets that creditors want to hold (source of funding). Nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by “price changes” in the capital market, where securities are traded, rather than by traditional intermediation. Further, banks are reluctant to act as a financial intermediary for retail depositors as they have already switched to their more lucrative role as money market dealers.

Modern finance emphasizes that no risk is eliminated in the process of “credit intermediation,” only transferred, and sometimes quite opaquely. Such a conviction gave birth to the rise of market-based finance. In this world, a shadow banker, sometimes a bank, uses its source of funding, usually overnight loans, to supply “term-funding” in the wholesale money market. In doing so, it acts as a dealer in the wholesale money market. Also, financial engineering techniques, such as securitization, by splitting the securitized assets into different tranches, allows a shadow banker to “enhance credit ” while transferring risks to those who can shoulder them. The magic of securitization enables a shadow banker to tap capital-market credit in the secondary market. Ignoring the secondary market is a fatal problem in the design of PPP loans.

To understand the government pandemic stimulus program for the SMEs, let’s start by understanding the PPP loan structure. The U.S. Treasury, along with financial regulators such as the Fed, adopted two measures to facilitate aid to SMEs under the CARES Act. First, the Fed announced the formation of the Paycheck Protection Program Loan Facility (the “PPPLF”). This program enables insured depository institutions to obtain financing from the Fed collateralized by Paycheck Protection Program (“PPP”) loans. The point to emphasize here is that the Fed, in essence, is the ultimate financier of such loans as banks could use the credits to SMEs as collateral to finance their lending from the Fed. Second, PPP loans are assigned a zero-percent risk-weight for purposes of U.S. risk-based capital requirements. This feature is essentially making PPP loans exempt from risk-based (but not leverage) capital requirements when held by a banking organization subject to U.S. capital requirements. 

Despite the promising appearance of such programs, the money is not flowing towards SMEs. One of the deadly flaws of this program is that it overlooks the importance of the secondary market. Specifically, ambiguity exists regarding the Small Business Administration (SBA)’s role in the secondary market due to the nature of the PPP loans and how they are regulated. The CARES Act provides that PPP loans are a traditional form of the SBA guaranteed loan. Such a statement implies that the PPP loans would not be 100% guaranteed in the secondary market as the SBA guaranteed loans are subject to certain conditions that should be satisfied by the borrower. First, the SBA wants to ensure that the entity claiming a right to payment from the SBA holds a valid title to the SBA loan. Second, the SBA requires the borrower to fulfill the PPP’s forgiveness requirements. Securitization requires the consent of the SBA. What is not mentioned in the CARES Act is that the SBA’s existing regulations restrict the ability of such loans to be transferred in the secondary market. Such restrictions block the credit to flow to the SMEs.

Under such circumstances, free transfer of PPPs in the secondary market could result in chaos when the PPP loans are later presented to the SBA by the holder for forgiveness or guarantee. Some might propose to ask for approval from the SBA before the securitization process. Yet, prior approval requirements for loan transfers, even though it might reduce the confusion mentioned above, hinder the ability to transfer newly originated PPP loans into the secondary market. Given that the PPP entails a massive amount of loans – $349 billion – to be originated in a short period, transfer restrictions could have a material impact on the ability to get much-needed funding to small businesses quickly. The program’s failure to notice such a conflict is a byproduct of the government’s tendency to ignore the role of the secondary market in the success of programs that aims at providing credit to retail depositors.

A potential solution would be for a government agency, such as the Small Business Administration (SBA), to guarantee the PPP loans in the secondary market in the same manner as Fannie Mae and Freddie Mac do for the mortgage loans. Fannie Mae and Freddie Mac are government-sponsored enterprises (the GSEs) that purchase mortgages from banks and use securitization to enhance the flow of credit in the mortgage market. The GSEs help the flow of credit as they have a de facto subsidy from the government. The market believes that the government will step in to guarantee their debt if they become insolvent. For the case of the PPP loans, instead of banks keeping the loans on their balance sheet until the loan was repaid, the bank who made the loan to the SMEs (the originator) should be able to sell the loan to the SBA. The SBA then would package the PPP loans and sells the payment rights to investors. The point to emphasize here is that the government both finance such loans in the primary market- the Fed accepts the PPP loans as collateral from banks- and ensures the flow of credit by securitizing them in the secondary market. Such a mechanism provides an unambiguous and ultimate guarantee for the PPP loans in the credit market that the government aims at offering anyways. This kind of explicit government guarantee could also help the smooth flow of credit to SMEs, which has been the original goal of the government in the first place.

Money View, through its recognition of banks as money market dealers in market-based finance and originators of securitized assets, could shed some light on the origins of those complications. Previously in the Money View blog, I proposed a potential solution to circumvent banks and directly injecting credit to the SMEs, through tools such as central bank digital currencies (CBDC). In this piece, the proposal is to adopt the design of the mortgage finance system to provide unambiguous government support and resolve the perplexities regarding marketing PPP loans in the secondary market. Until this confusion is resolved, banking entities with regulatory or internal funding constraints may be unwilling to originate PPP loans without a clear path for obtaining financing or otherwise transferring such credits into the secondary market. Such failures come at the expense of retail depositors, including small businesses.

Acknowledgment: Writing this piece would not be possible without a fruitful exchange that I had with Dr. Rafael Lima Sakr, a Teaching Fellow at Edinburgh Law School.

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Forget About the “Corona Bond.” Should the ECB Purchase Eurozone Government Bond ETFs?

By Elham Saeidinezhad

In recent history, one of a few constants about the European Union (EU) is that it follows the U.S. footstep after any disaster. After the COVID-19 crisis, the Fed expanded the scope and duration of the Municipal Liquidity Facility (MLF) to ease the fiscal conditions of the states and the cities. The facility enables lending to states and municipalities to help manage cash flow stresses caused by the coronavirus pandemic. In a similar move, the ECB expanded its support for the virus-hit EU economies in response to the coronavirus pandemic. Initiatives such as Pandemic Emergency Purchase Programme (PEPP) allow the ECB to open the door to buy Greek sovereign bonds for the first time since the country’s sovereign debt crisis by announcing a waiver for its debt. 

There the similarity ends. While the market sentiment about the Fed’s support program for municipals is very positive, a few caveats in the ECB’s program have made the Union vulnerable to a market run. Fitch has just cut Italy’s credit rating to just above junk. The problem is that unlike the U.S., the European Union is only a monetary union, and it does not have a fiscal union. The investors’ prevailing view is that the ECB is not doing enough to support governments of southern Europe, such as Spain, Italy, and Greece, who are hardest hit by the virus. Anxieties about the Union’s fiscal stability are behind repeated calls for the European Union to issue common eurozone bonds or “corona bond.” Yet, the political case, especially from Northern European countries, is firmly against such plans. Further, despite the extreme financial needs of the Southern countries, the ECB is reluctant to lift its self-imposed limits not to buy more than a third of the eligible sovereign bonds of any single country and to purchase sovereign bonds in proportion to the weight of each country’s investment in its capital. This unwillingness is also a political choice rather than an economic necessity.

It is in that context that this piece proposes the ECB to include the Eurozone government bond ETF to its asset purchasing program. Purchasing government debts via the medium of the ETFs can provide the key to the thorny dilemma that is shaking the foundation of the European Union. It can also be the right step towards creating a borrowing system that would allow poorer EU nations to take out cheap loans with the more affluent members guaranteeing the funds would be returned. The unity of EU members faces a new, painful test with the coronavirus crisis. This is why the Italian Prime Minister Guiseppe Conte warned that if the bloc fails to stand up to it, the entire project might “lose its foundations.” The ECB’s decision to purchase Eurozone sovereign debt ETFs would provide an equal opportunity for all the EU countries to meet the COVID-19 excessive financial requirements at an acceptable price. Further, compared to the corona bond, it is less politically incorrect and more common amongst the central bankers, including those at the Fed and the Bank of Japan.

In the index fund ecosystem, the ETFs are more liquid and easier to trade than the basket of underlying bonds. What lies behind this “liquidity transformation” is the different equilibrium structure and the efficiency properties in markets for these two asset classes. In other words, the dealers make markets for these assets under various market conditions. In the market for sovereign bonds, the debt that is issued by governments, especially countries with lower credit ratings, do not trade very much. So, the dealers expect to establish long positions in these bonds. Such positions expose them to the counterparty risk and the high cost of holding inventories. Higher price risk and funding costs are correlated with an increase in spreads for dealers. Higher bid-ask spreads, in turn, makes trading of sovereign debt securities, especially those issued by countries such as Italy, Spain, Portugal, and Greece, more expensive and less attractive.

On the contrary, the ETFs, including the Eurozone government bond ETFs, are considerably more tradable than the underlying bonds for at least two reasons. First, the ETF functions as the “price discovery” vehicle because this is where investors choose to transact. The economists call the ETF a price discovery vehicle since it reveals the prices that best match the buyers with the sellers. At these prices, the buying and selling quantities are just in balance, and the dealers’ profitability is maximized. According to Treynor Model, these “market prices” are the closest thing to the “fundamental value” as they balance the supply and demand. Such an equilibrium structure has implications for the dealers. The make markers in the ETFs are more likely to have a “matched book,” which means that their liabilities are the same as their assets and are hedged against the price risk. The instruments that are traded under such efficiency properties, including the ETFs, enjoy a high level of market liquidity.

Second, traders, such as asset managers, who want to sell the ETF, would not need to be worried about the underlying illiquid bonds. Long before investors require to acquire these bonds, the sponsor of the ETF, known as “authorized participants” will be buying the securities that the ETF wants to hold. Traditionally, authorized participants are large banks. They earn bid-ask spreads by providing market liquidity for these underlying securities in the secondary market or service fees collected from clients yearning to execute primary trades. Providing this service is not risk-free. Mehrling makes clear that the problem is that supporting markets in this way requires the ability to expand banks’ balance sheets on both sides, buying the unwanted assets and funding that purchase with borrowed money. The strength of banks to do that on their account is now severely limited. Despite such balance sheet constraints, by acting as “dealers of near last resort,” banks provide an additional line of defense in the risk management system of the asset managers. Banks make it less likely for the investors to end up purchasing the illiquid underlying assets.

That the alchemists have created another accident in waiting has been a fear of bond market mavens and regulators for several years. Yet, in the era of COVID-19, the alchemy of the ETF liquidity could dampen the crisis in making by boosting virus-hit countries’ financial capacity. Rising debt across Europe due to the COVID-19 crisis could imperil the sustainability of public finances. This makes Treasury bonds issued by countries such as Greece, Spain, Portugal, and Italy less tradable. Such uncertainty would increase the funding costs of external bond issuance by sovereigns. The ECB’s attempt to purchase Eurozone government bonds ETFs could partially resolve such funding problems during the crisis. Further, such operations are less risky than buying the underlying assets.

Some might argue the ETFs create an illusion of liquidity and expose the affluent members of the ECB to an unacceptably high level of defaults by the weakest members. Yet, at least two “real” elements, namely the price discovery process and the existence of authorized participants who act as the dealers of the near last resort, allows the ETFs to conduct liquidity transformation and become less risky than the underlying bonds. Passive investing sometimes is called as “worse than Marxism.” The argument is that at least communists tried to allocate resources efficiently, while index funds just blindly invest according to an arbitrary benchmark’s formula. Yet, devouring capitalism might be the most efficient way for the ECB to circumvent political obstacles and save European capitalism from itself.

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Elham's Money View Blog Search For Stable Liquidity Providers Series

Can Central Bank Digital Currency Contain COVID-19 Crisis by Saving Small Businesses?

By Elham Saeidinezhad and Jack Krupinski

This Piece Is Part of the “Search For Stable Liquidity Providers” Series. It is also a follow up to our previous Money View article on the banking system during the COVID-19 crisis.

The COVID-19 crisis created numerous financial market dislocations in the U.S., including in the market for government support. The federal government’s Paycheck Protection Program offered small businesses hundreds of billions of dollars so they could keep paying employees. The program failed to a great extent. Big companies got small business relief money. The thorny problem for policymakers to solve is that the government support program is rooted in the faith that banks are willing to participate in. Banks were anticipated to act as an intermediary and transfer funds from the government to the small businesses. Yet, in the modern financial system, banks have already shifted gear away from their traditional role as a financial intermediary between surplus and deficit agents. Part l used the “Money View” and a historical lens to explain why banks are reluctant to be financial intermediaries and are more in tune with their modern function as dealers in the wholesale money markets. In Part ll, we are going to propose a possible resolution to this perplexity. In a monetary system where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most, including small and medium enterprises, who have no access to the capital market.

The history of central banking began with a simple task of managing the quantity of money. Yet, central bankers shortly faced a paradox between managing “survival constraint” in the financial market and the real economy. On the one hand, for banks, the survival constraint in the financial market takes the concrete form of a “reserve constraint” because banks settle net payments using their reserve accounts at the central bank. On the other hand, according to the monetarist idea, for money to have a real purchasing power in terms of goods and services, it should be scarce. Developed by the classical economists in the nineteenth and early twentieth centuries, the quantity theory of money asserted that the quantity of money should only reflect the level of transactions in the real economy.

The hybridity between the payment system and the central bank money created such a practical dilemma. Monetarist idea disregarded such hybridity and demanded that the central bank abandon its concern about the financial market and focus only on controlling the never-materializing threat of inflation. The monetarist idea was doomed to failure for its conjectures about the financial market, and its illusion of inflation. In the race to dominate the whole economy, an efficiently functioning financial market soon became a pre-condition to economic growth. In such a circumstance, the central bank must inject reserves or else risk a breakdown of the payments system. Any ambiguity about the liquidity problems (the survival constraint) for highly leveraged financial institutions would undermine central banks’ authority to maintain the monetary and financial stability for the whole economy. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn’t take much of a write-down to produce technical insolvency.

This essential hybridity, and the binding reality of reserve constraint, gave birth to two parallel phenomena. In the public sphere, the urge to control the scarce reserves originated monetary policy. The advantage that the central bank had over the financial system arose ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. Central bankers recognized that they could use this scarcity to affect the price of money, the interest rate, in the banking system. It is the central bank’s control over the price and availability of funds at this moment of necessity that is the source of its control over the financial system. The central bank started to utilize its balance sheet to impose discipline when there was an excess supply of money, and to offer elasticity when the shortage of cash is imposing excessive discipline. But ultimately central bank was small relative to the system it engages. Because the central bank was not all-powerful, it must choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter. Such difficult tasks motivated people to call central banking as the “art,” rather than the “science”.

In the private domain, the scarcity of central bank money significantly increased the reliance on the banking system liabilities. By acting as a special kind of intermediary, banks rose to the challenge of providing funding liquidity to the real economy. Their financial intermediation role also enabled them to establish the retail payment system. For a long time, the banking system’s major task was to manage this relationship between the (retail) payment system and the quantity of money. To do so, they transferred the funds from the surplus agents to the deficit agents and absorbed the imbalances into their own balance sheets. To strike a balance between the payment obligations, and the quantity of money, banks started to create their private money, which is called credit. Banks recognized that insufficient liquidity could lead to a cascade of missed payments and the failure of the payment system as a whole.

For a while, banks’ adoption of the intermediary role appeared to provide a partial solution to the puzzle faced by the central bankers. Banks’ traditional role, as a financial intermediary, connected them with the retail depositors. In the process, they offered a retail payment- usually involve transactions between two consumers, between consumers and small businesses, or between two small to medium enterprises. In this brave new world, managing the payment services in the financial system became analogous to the management of the economy as a whole.

Most recently, the COVID-19 crisis has tested this partial equilibrium again. In the aftermath of the COVID-19 outbreak, both the Fed and the U.S. Treasury coordinated their fiscal and monetary actions to support small businesses and keep them afloat in this challenging time. So far, a design flaw at the heart of the CARES Act, which is an over-reliance on the banking system to transfer these funds to small businesses, has created a disappointing result. This failure caught central bankers and the governments by surprise and revealed a fatal flaw in their support packages. At the heart of this misunderstanding is the fact that banks have already switched their business models to reflect a payment system that has been divided into two parts: wholesale and retail. Banks have changed the gear towards providing wholesale payment-those made between financial institutions (e.g., banks, pension funds, insurance companies) and/or large (often multinational) corporations- and away from retail payment. They are so taken with their new functions as dealers in the money market and originators of asset-backed securities in the modern market-based finance that their traditional role of being a financial intermediary has become a less important part of their activities. In other words, by design, small businesses could not get the aid money as banks are not willing to use their balance sheets to lend to these small enterprises anymore.

In this context, the broader access to central bank money by small businesses could create new opportunities for retail payments and the way the central bank maintains monetary and financial stability. Currently, households and (non-financial) companies are only able to use central bank money in the form of banknotes. Central bank digital currency (CBDC) would enable them to hold central bank money in electronic form and use it to make payments. This would increase the availability and utility of central bank money, allowing it to be used in a much more extensive range of situations than physical cash. Central bank money (whether cash, central bank reserves or potentially CBDC) plays a fundamental role in supporting monetary and financial stability by acting as a risk-free form of money that provides the ultimate means of settlement for all payments in the economy. This means that the introduction of CBDC could enhance the way the central bank maintains monetary and financial stability by providing a new form of central bank money and new payment infrastructure. This could have a range of benefits, including strengthening the pass-through of monetary policy changes to the broader economy, especially to small businesses and other retail depositors, and increasing the resilience of the payment system.

This increased availability of central bank money is likely to lead to some substitution away from the forms of payment currently used by households and businesses (i.e., cash and bank deposits). If this substitution was extensive, it could reduce the reliance on commercial bank funding, and the level of credit that banks could provide as CBDC would automatically give access to central bank money to non-banks. This would potentially be useful in conducting an unconventional monetary policy. For example, the COVID-19 precipitated increased demand for dollars both domestically and internationally. Small businesses in the U.S. are increasingly looking for liquidity through programs such as the Paycheck Protection Program Liquidity Facility (PPPLF) so that those businesses can keep workers employed. In the global dollar funding market, central banks swap lines with the Fed sent dollars into other countries, but transferring those dollars to end-users would be even easier for central banks if they could bypass the commercial banking system.

Further, CBDC can be used as intraday liquidity by its holders, whereas liquidity-absorbing instruments cannot achieve the same, or can do so only imperfectly. At the moment, there is no other short-term money market instrument featuring the liquidity and creditworthiness of CBDC. The central bank would thus use its comparative advantage as a liquidity provider when issuing CBDC. The introduction of CBDC could also decrease liquidity risk because any agent could immediately settle obligations to pay with the highest form of money.

If individuals can hold current accounts with the central bank, why would anyone hold an account with high st commercial banks? Banks can still offer other services that a CBDC account may not provide (e.g., overdrafts, credit facilities, etc.). Moreover, the rates offered on deposits by banks would likely increase to retain customers. Consumer banking preferences tend to be sticky, so even with the availability of CBDC, people will probably trust the commercial banking system enough to keep deposits in their bank. However, in times of crisis, when people flee for the highest form of money (central bank money), “digital runs” on banks could cause problems. The central bank would likely have to increase lending to commercial banks or expand open market operations to sustain an adequate level of reserves. This would ultimately affect the size and composition of balance sheets for both central banks and commercial banks, and it would force central banks to take a more active role in the economy, for better or worse.

As part 1 pointed out, banks are already reluctant to play the traditional role of financial intermediary. The addition of CBDC would likely cause people to substitute away from bank deposits, further reducing the reliance on commercial banks as intermediaries.  CBDC poses some risks (e.g., disintermediation, digital bank runs, cybersecurity), but it would offer some new channels through which to conduct unconventional monetary policy. For example, the interest paid on CBDC could put an effective floor on money market rates. Because CBDC is risk-free (i.e., at the top of the money hierarchy), it would be preferred to other short-term debt instruments unless the yields of these instruments increased. While less reliance on banks by small businesses would contract bank funding, banks would also have more balance sheet freedom to engage in “market-making” operations, improving market liquidity. More importantly, it creates a direct liquidity channel between the central banks, such as the Fed, and non-bank institutions such as small and medium enterprises. Because central banks need not be motivated by profit, they could pay interest on CBDC without imposing fees and minimum balance requirements that profit-seeking banks employ (in general, providing a payment system is unprofitable, so banks extort profit wherever possible). In a sense, CBDC would be the manifestation of money as a public good. Everyone would have ready access to a risk-free store of value, which is especially relevant in the uncertain economic times precipitated by the COVID-19. 

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Elham's Money View Blog Search For Stable Liquidity Providers Series

In a World Where Banks Do Not Aspire to be Intermediaries, Is It Time to Cut Out the Middlemen? (Part I)

This Piece Is Part of the “Search For Stable Liquidity Providers” Series.

By Elham Saeidinezhad

“Bankers have an image problem.” Marcy Stigum

Despite the extraordinary quick and far-reaching responses by the Fed and US Treasury, to save the economy following the crisis, the market sentiment is that “Money isn’t flowing yet.” Banks, considered as intermediaries between the government and troubled firms, have been told to use the liberated funds to boost financing for individuals and businesses in need. However, large banks are reluctant, and to a lesser extent unable, to make new loans even though regulators have relaxed capital rules imposed in the wake of the last crisis. This paradox highlights a reality that has already been emphasized by Mehrling and Stigum but erred in the economic orthodoxy.

To understand this reluctance by the banks, we must preface with a careful look at banking. In the modern financial system, banks are “dealers” or “market makers” in the money market rather than intermediaries between deficit and surplus agents. In many markets such as the UK and US, these government support programs are built based on the belief that banks are both willing and able to switch to their traditional role of being financial intermediaries seamlessly. This intermediation function enables banks to become instruments of state aid, distributing free or cheap lending to businesses that need it, underpinned by government guarantees.  This piece (Part l) uses the Money View and a historical lens to explain why banks are not inspired anymore to be financial intermediaries. In Part ll, we are going to propose a possible resolution to this perplexity. In a financial structure where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most.

Stigum once observed that bankers have, at times, an image problem. They are seen as the culprits behind the high-interest rates that borrowers must pay and as acting in ways that could put the financial system and the economy at risk, perhaps by lending to risky borrowers, when interest rates are low. Both charges reflect the constant evolution in banks’ business models that lead to a few severe misconceptions over the years. The first delusion is about the banks’ primary function. Despite the common belief, banks are not intermediaries between surplus and deficit agents anymore. In this new system, banks’ primary role is to act as dealers in money market securities, in governments, in municipal securities, and various derivative products. Further, several large banks have extensive operations for clearing money market trades for nonbank dealers. A final important activity for money center banks is foreign operations of two sorts: participating in the broad international capital market known as the Euromarket and operating within the confines of foreign capital markets (accepting deposits and making loans denominated in local currencies). 

Structural changes that have taken place on corporates’ capital structure and the emergence of market-based finance have led to this reconstruction in the banking system. To begin with, the corporate treasurers switched sources of corporate financing for many corporates from a bank loan to money market instruments such as commercial papers. In the late 1970s and early 1980s, when rates were high, and quality-yield spreads were consequently wide, firms needing working capital began to use the sale of open market commercial paper as a substitute for bank loans. Once firms that had previously borrowed at banks short term were introduced to the paper market, they found that most of the time, it paid them to borrow there. This was the case since money obtained in the credit market was cheaper than bank loans except when the short-term interest rate was being held by political pressure, or due to a crisis, at an artificially low level.

The other significant change in market structure was the rise of “money market mutual funds.” These funds provide more lucrative investment opportunities for depositors, especially for institutional investors, compared to what bank deposits tend to offer. This loss of large deposits led bank holding companies to also borrow in the commercial paper market to fund bank operations. The death of the deposits and the commercial loans made the traditional lending business for the banks less attractive. The lower returns caused the advent of the securitization market and the “pooling” of assets, such as mortgages and other consumer loans. Banks gradually shifted their business model from a traditional “originate-and-hold” to an “originate-to-distribute” in which banks and other lenders could originate loans and quickly sell them into securitization pools. The goal was to increase the return of making new loans, such as mortgages, to their clients and became the originators of securitized assets.

The critical aspect of these developments is that they are mainly off-balance sheet profit centers. In August 1970, the Fed ruled that funds channeled to a member bank that was raised through the sale of commercial paper by the bank’s holding company or any of its affiliates or subsidiaries were subject to a reserve requirement. This ruling eliminated the sale of bank holding company paper for such purposes. Today, bank holding companies, which are active issuers of commercial paper, use the money obtained from the sale of such paper to fund off-balance sheet, nonbank, activities. Off-balance sheet operations do not require substantial funding from the bank when the contracts are initiated, while traditional activities such as lending must be fully funded. Further, most of the financing of traditional activities happens through a stable base of money, such as bank capital and deposits. Yet, borrowing is the primary source of funding off-balance sheet activities.

To be relevant in the new market-based credit system, and compensate for the loss of their traditional business lines, the banks started to change their main role from being financial intermediaries to becoming dealers in money market instruments and originators of securitized assets. In doing so, instead of making commercial loans, they provide liquidity backup facilities on commercial paper issuance. Also, to enhance the profitability of making consumer loans, such as mortgages, banks have turned to securitization business and have became the originators of securitized loans. 

In the aftermath of the COVID-19 outbreak, the Fed, along with US Treasury, has provided numerous liquidity facilities to help illiquid small and medium enterprises. These programs are designed to channel funds to every corner of the economy through banks. For such a rescue package to become successful, these banks have to resume their traditional financial intermediary role to transfer funds from the government (the surplus agents) to SMEs (the deficit agents) who need cash for payroll financing. Regulators, in return, allow banks to enjoy lower capital requirements and looser risk-management standards. On the surface, this sounds like a deal made in heaven.

In reality, however, even though banks have received regulatory leniency, and extra funds, for their critical role as intermediaries in this rescue package, they give the government the cold shoulder. Banks are very reluctant to extend new credits and approve new loans. It is easy to portray banks as villains. However, a more productive task would be to understand the underlying reasons behind banks’ unwillingness. The problem is that despite what the Fed and the Treasury seem to assume, banks are no longer in the business of providing “direct” liquidity to financial and non-financial institutions. The era of engaging in traditional banking operations, such as accepting deposits and lending, has ended. Instead, they provide indirect finance through their role as money market dealers and originators of securitized assets.

In this dealer-centric, wholesale, world, banks are nobody’s agents but profits’. Being a dealer and earning a spread as a dealer is a much more profitable business. More importantly, even though banks might not face regulatory scrutiny if these loans end up being nonperforming, making such loans will take their balance sheet space, which is already a scarce commodity for these banks. Such factors imply that in this brave new world, the opportunity cost of being the agent of good is high. Banks would have to give up on some of their lucrative dealing businesses as such operation requires balance sheet space. This is the reason why financial atheists have already started to warn that banks should not be shamed into a do-gooder lending binge.

Large banks rejected the notion that they should use their freed-up equity capital as a basis for higher leverage, borrowing $5tn of funds to spray at the economy and keep the flames of coronavirus at bay. Stigum once said that bankers have an image problem. Having an image problem does not seem to be one of the banks’ issues anymore. The COVID-19 crisis made it very clear that banks are very comfortable with their lucrative roles as dealers in the money market and originators of assets in the capital market, and have no intention to be do-gooders as financial intermediaries. These developments could suggest that it is time to cut out banks as middlemen. To this end, central bank digital currency (CBDC) could be a potential solution as it allows central banks to bypass banks to inject liquidity into the system during a period of heightened financial distress such as the COVID-19 crisis.

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Should the Fed Add FX Swaps to its Asset Purchasing Programs?

By Elham Saeidinezhad and Jack Krupinski*

“As Stigum reminded us, the market for Eurodollar deposits follows the sun around the globe. Therefore, no one, including and especially the Fed, can hide from its rays.”

The COVID-19 crisis renewed the heated debate on whether the US dollar could lose its status as the world’s dominant currency. Still, in present conditions, without loss of generality, the world reserve currency is the dollar. The exorbitant privilege implies that the deficit agents globally need to acquire dollars. These players probably have a small reserve holding, usually in the form of US Treasury securities. Still, more generally, they will need to purchase dollars in a global foreign exchange (FX) markets to finance their dollar-denominated assets. One of the significant determinants of the dollar funding costs that these investors face is the cost of hedging foreign exchange risk. Traditionally, the market for the Eurodollar deposits has been the final destination for these non-US investors. However, after the great financial crisis, investors have turned to a particular, and important segment of the FX market, called the FX swap market, to raise dollar funding. This shift in the behavior of foreign investors might have repercussions for the rates in the US money market.

The point to emphasize is that the price of Eurodollar funding, used to discipline the behavior of the foreign deficit agents, can affect the US domestic money market. This usage of FX swap markets by foreign investors to overcome US dollar funding shortages could move short-term domestic rates from the Fed’s target range. Higher rates could impair liquidity in US money markets by increasing the financing cost for US investors. To maintain the FX swap rate at a desirable level, and keep the Fed Funds rate at a target range, the Fed might have to include FX derivatives in its asset purchasing programs.

The use of the FX swap market to raise dollar funding depends on the relative costs in the FX swap and the Eurodollar market. This relative cost is represented in the spread between the FX swap rate and LIBOR. The “FX swap-implied rate” or “FX swap rate” is the cost of raising foreign currency via the FX derivatives market. While the “FX swap rate” is the primary indicator that measures the cost of borrowing in the FX swap market, the “FX-hedged yield curve” represents that. The “FX-hedged yield curve” adjusts the yield curve to reflect the cost of financing for hedged international investors and represents the hedged return. On the other hand, LIBOR, or probably SOFR in the post-LIBOR era, is the cost of raising dollar directly from the market for Eurodollar deposits.

In tranquil times, arbitrage, and the corresponding Covered Interest Parity condition, implies that investors are indifferent in tapping either market to raise funding. On the contrary, during periods when the bank balance sheet capacity is scarce, the demand of investors shifts strongly toward a particular market as the spread between LIBOR and FX swap rate increases sharply. More specifically, when the FX swap rate for a given currency is less than the cost of raising dollar directly from the market for Eurodollar deposits, institutions will tend to borrow from the FX swap market rather than using the money market. Likewise, a higher FX swap rate would discourage the use of FX swaps in financing.

By focusing on the dollar funding, it is evident that the FX swap market is fundamentally a money market, not a capital market, for at least two reasons. First, the overwhelming majority of the market is short-term. Second, it determines the cost of Eurodollar funding, both directly and indirectly, by providing an alternative route of funding. It is no accident that since the beginning of the COVID-19 outbreak, indicators of dollar funding costs in foreign exchange markets, including “FX swap-implied rate”, have risen sharply, approaching levels last seen during the great financial crisis. During crises, non-US banks usually finance their US dollar assets by tapping the FX swap market, where someone borrows dollars using FX derivatives by pledging another currency as collateral. In this period, heightened uncertainty leads US banks that face liquidity shortage to hoard liquid assets rather than lend to foreigners. Such coordinated decisions by the US banks put upward pressure on FX swap rates.

The FX swap market also affects the cost of Eurodollar funding indirectly through the FX dealers. In essence, most deficit agents might acquire dollars by relying entirely on the private FX dealing system. Two different types of dealers in the FX market are typical FX dealers and speculative dealers. The FX dealer system expedites settlement by expanding credit. In the current international order, the FX dealer usually has to provide dollar funding. The dealer creates a dollar liability that the deficit agent buys at the spot exchange rate using local currency, to pay the surplus country. The result is the expansion of the dealer’s balance sheet and its exposure to FX risk. The FX risk, or exchange risk, is a risk that the dollar price of the dealer’s new FX asset might fall. The bid-ask spread that the FX dealer earns reflects this price risk and the resulting cost of hedging.

As a hedge against this price risk, the dealer enters an FX swap market to purchase an offsetting forward exchange contract from a speculative dealer. As Stigum shows, and Mehrling emphasizes, the FX dealer borrows term FX currencies and lends term dollars. As a result of entering into a forward contract, the FX dealer has a “matched book”—if the dollar price of its new FX spot asset falls, then so also will the dollar value of its new FX term liability. It does, however, still face liquidity risk since maintaining the hedge requires rolling over its spot dollar liability position until the maturity of its term dollar asset position. A “speculative” dealer provides the forward hedge to the FX dealer. This dealer faces exposure to exchange risk and might use a futures position, or an FX options position to hedge. The point to emphasize here is that the hedging cost of the speculative dealer affects the price that the normal FX dealer faces when entering a forward contract and ultimately determines the price of Eurodollar funding. 

The critical question is, what connects the domestic US markets with the Euromarkets as mentioned earlier? In different maturity ranges, US and Eurodollar rates track each other extraordinarily closely over time. In other words, even though spreads widen and narrow, and sometimes rates cross, the main trends up and down are always the same in both markets. Stigum (2007) suggests that there is no doubt that this consistency in rates is the work of arbitrage.

Two sorts of arbitrages are used to link US and Eurodollar rates, technical and transitory. Opportunities for technical arbitrage vanished with the movement of CHIPS to same-day settlement and payment finality. Transitory arbitrages, in contrast, are money flows that occur in response to temporary discrepancies that arise between US and Eurodollar rates because rates in the two markets are being affected by differing supply and demand pressures. Much transitory arbitrage used to be carried on by banks that actively borrow and lend funds in both markets. The arbitrage that banks do between the domestic and Eurodollar markets is referred to as soft arbitrage. In making funding choices, domestic versus Eurodollars, US banks always compare relative costs on an all-in basis.

But that still leaves open the question of where the primary impetus for rate changes typically comes from. Put it differently, are changes in US rates pushing Eurodollar rates up and down, or vice versa? A British Eurobanker has a brief answer: “Rarely does the tail wag the dog. The US money market is the dog, the Eurodollar market, the tail.” The statement has been a truth for most parts before the great financial crisis. The fact of this statement has created a foreign contingent of Fed watchers. However, the direction of this effect might have reversed after the great financial crisis.  In other words, some longer-term shifts have made the US money market respond to the developments in the Eurodollar funding.

This was one of the lessons from the US repo-market turmoil. On Monday, September 16, and Tuesday, September 17, Overnight Treasury general collateral (GC) repurchase-agreement (repo) rates surprisingly surged to almost 10%. Two factors made these developments extraordinary: First, the banks, who act as a dealer of near last resort in this market due to their direct access to the Fed’s balance sheets, did not inject liquidity. Second, this time around, the Secured Overnight Financing Rate (SOFR), which is replacing LIBOR to measure the cost of Eurodollar financing, also increased significantly, leading the Fed to intervene directly in the repo market.

Credit Suisse’ Zoltan Poszar points out that an increase in the supply of US Treasuries along with the inversion in the FX-hedged yield of Treasuries has created such anomalies in the US money market.  Earlier last year, an increase in hedging costs caused the inversion of a curve that represents the FX-hedged yield of Treasuries at different maturities. Post- great financial crisis, the size of foreign demands for US assets, including the US Treasury bonds, increased significantly. For these investors, the cost of FX swaps is the primary factor that affects their demand for US assets since that hedge return, called FX-hedged yield, is an important component of total return on investment. This FX-hedged yield ultimately drives investment decisions as hedge introduces an extra cash flow that a domestic bond investment does not have. This additional hedge return affects liquidity considerations because hedging generates its own cash flows.

The yield-curve inversion disincentivizes foreign investors, mostly carry traders, trying to earn a margin from borrowing short term to buy Treasuries (i.e., lending longer-term). Demand for Eurodollars—which are required by deficit agents to settle payment obligations—is very high right now, which has caused the FX Swap rate-LIBOR spread to widen. The demand to directly raise dollars through FX swaps has driven the price increase, but this also affects investors who typically use FX swaps to hedge dollar investments. As the hedge return falls (it is negative for the Euro), it becomes less profitable for foreign investors to buy Treasury debt. More importantly, for foreign investors, the point at which this trade becomes unprofitable has been reached way before the yield curve inverted, as they had to pay for hedging costs (in yen or euro). This then forces Treasuries onto the balance sheets of primary dealers and have repercussions in the domestic money market as it creates balance sheet constraints for these large banks. This constraint led banks with ample reserves to be unwilling to lend money to each other for an interest rate of up to 10% when they would only receive 1.8% from the Fed.

This seems like some type of “crowding out,” in which demand for dollar funding via the FX swap has driven up the price of the derivative and crowded out those investors who would typically use the swap as a hedging tool. Because it is more costly to hedge dollar investments, there is a risk that demand for US Treasuries will decrease. This problem is driven by the “dual-purpose” of the FX swaps. By directly buying this derivative, the Fed can stabilize prices and encourage foreign investors to keep buying Treasuries by increasing hedge return. Beyond acting to stabilize the global financial market, the Fed has a direct domestic interest in intervening in the FX market because of the spillover into US money markets.

The yield curve that the Fed should start to influence is the FX-hedged yield of Treasuries, rather than the Treasury yield curve since it encompasses the costs of US dollar funding for foreigners. Because of the spillover of FX swap turbulences to the US money markets, the FX swap rate will influence the US domestic money market. If we’re right about funding stresses and the direction of effects, the Fed might have to start adding FX swaps to its asset purchasing program. This decision could bridge the imbalance in the FX swap market and offer foreign investors a better yield. The safe asset – US Treasuries – is significantly funded by foreign investors, and if the FX swap market pulls balance sheet and funding away from them, the safe asset will go on sale. Treasury yields can spike, and the Fed will have to shift from buying bills to buying what matters– FX derivatives. Such ideas might make some people- especially those who believe that keeping the dollar as the world’s reserve currency is a massive drag on the struggling US economy and label the dollar’s international status as an “an exorbitant burden,”- uncomfortable. However, as Stigum reminded us, the market for Eurodollar deposits follows the sun around the globe. Therefore, no one, including and especially the Fed, can hide from its rays.

*Jack Krupinski is a student at UCLA, studying Mathematics and Economics. He is pursuing an actuarial associateship and is working to develop a statistical understanding of risk. Jack’s economic research interests involve using the “Money View” and empirical methods to analyze international finance and monetary policy.

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Why Does “Solvency” Rule in the Derivatives Trading?

Hint: It Should Not

By Elham Saeidinezhad

The unprecedented increase in the Fed’s involvement since the COVID-19 crisis has affected how financial markets function. The Fed has supported most corners of the financial market in an astonishingly short period. In the meantime, there have been growing anxieties that the Fed has not used its arsenals to help the derivatives market yet. To calm market sentiment, on March 27, 2020, regulatory agencies, led by the Fed, have taken steps to support market liquidity in the derivatives market by easing capital requirements for market makers- typically banks or investment banks. The agencies permit these firms to use a more indulgent methodology when measuring credit risk derivatives to account for the post-COVID-19 crisis credit loss. The goal is to encourage the provision of counterparty services to institutional hedgers while preventing dealers that are marginally solvent from becoming insolvent as a result of the increased counterparty credit exposure.

These are the facts, but how shall we understand them? These accommodative rulings reveal that from the Fed’s perspective, the primary function of derivatives contracts is a store of value. As stores of value, financial instruments are a form of long-term investment that is thought to be better than money. Over time, they generate increases in wealth that, on average, exceed those we can obtain from holding cash in most of its forms. If the value of these long-term assets falls, the primary threat to financial stability is an insolvency crisis. The insolvency crisis happens when the balance sheet is not symmetrical: the side that shows what the banks own, the Assets, is less valuable than Liabilities and Equity (i.e. banks’ capital). From the Fed’s point of view, this fearful asymmetry is the principal catastrophe that can happen due to current surge in the counterparty credit risk.

From the Money View perspective, what is most troubling about this entire debate, is the unrelenting emphasis on solvency, not liquidity, and the following implicit assumption of efficient markets. The underlying cause of this bias is dismissing the other two inherent functions of derivatives, which are means of payment and means of transferring risk. This is not an accident but rather a byproduct of dealer-free models that are based on the premises of the efficient market hypothesis. Standard asset pricing models consider derivative contracts as financial assets that in the future, can generate cash flows. Derivatives’ prices are equal to their “fundamental value,” which is the present value of these future cash flows. In this dealer-free world, the present is too short to have any time value and the current deviation of price from the fundamental value only indicates potential market dislocations. On the contrary, from a dealer-centric point of view, such as the Money View, daily price changes can be fatal as they may call into question how smoothly US dollar funding conditions are. In other words, short-term fluctuations in derivative prices are not merely temporary market dislocations. Rather, they show the state of dealers’ balance sheet capacities and their access to liquidity.

To keep us focused on liquidity, we start by Fischer Black and his revolutionary idea of finance and then turn to the Money View. From Fischer Black’s perspective, a financial asset, such as a long-term corporate bond, could be sold as at least three separate instruments. The asset itself can be used as collateral to provide the necessary funding liquidity. The other instrument is interest rate swaps (IRS) that would shift the interest rate risk. The third instrument is a credit default swap (CDS) that would transfer the risk of default from the issuer of the derivative to the derivative holder. Importantly, although most derivatives do not require any initial payment, investors must post margin daily to protect the counterparties from the price risk. For Fischer Black, the key to understanding a credit derivative is that it is the price of insurance on risky assets and is one of the determinants of the asset prices. Therefore, derivatives are instrumental to the success of the Fed’s interventions; to make the financial system work smoothly, there should be a robust mechanism for shifting both assets and the risks. By focusing on transferring risks and intra-day liquidity requirements, Fischer Black’s understanding of the derivatives market already echoes the premises of modern finance more than the Fed’s does.

The Money View starts where Fischer Black ended and extends his ideas to complete the big picture. Fischer Black considers derivatives chiefly as instruments for transferring risk. Money View, on the other hand, recognizes that there is hybridity between risk transfer and means of payment capacities of the derivatives. Further, the Money View uses analytical tools, such as balance sheet and Treynor Model, to shed new light on asset prices and derivatives. Using the Treynor Model to understand the economics of dealer’s function, this framework shows that asset prices are determined by the dealers’ inventory positions as well as their access to funding liquidity. Using balance sheets to translate derivatives, and their cash flow patterns, into parallel loans, the Money View demonstrates that the derivatives’ main role is cash flow management. In other words, derivatives’ primary function is to ensure that firms can continuously meet their survival constraint, both now and in the future.

The parallel loan construction treats derivatives, such as a CDS, as a swap of IOUs. The issuer of the derivatives makes periodic payments, as a kind of insurance premium, to the derivative dealers, who have long positions in those derivatives, whenever the debt issuer, makes periodic interest payment. The time pattern of the derivatives holders’ payments is the mirror image and the inverse of the debtors. This creates a counterparty risk for derivatives dealers. If the debtor defaults, the derivatives dealers face a loss as they must pay the liquidation value of the bond. Compared to the small periodic payments, the liquidation value is significant as it is equal to the face value. The recent announcements by the Fed and other regulatory agencies allow derivatives holders, especially banks and investment banks, to use a more relaxed approach when measuring counterparty credit risk. Put it differently, firms are allowed to keep less capital today to shield themselves against such losses in the future. Regulators’ primary concern is to uphold the value of banks’ assets to cement their solvent status.

Yet, from the point of view of the derivatives dealers who are sellers of these insurances, liquidity is the leading concern. It is possible to create portfolios of such swaps, which pool the idiosyncratic default risk so that the risk of the pool is less than the risk of each asset. This diversification reduces the counterparty “credit” risk even though it does not eliminate it. However, they are severely exposed to liquidity risk. These banks receive a stream of small payments but face the possibility of having to make a single large payment in the event of default. Liquidity risk is a dire threat during the COVID-19 crisis because of two intertwined forces. First, there is a heightened probability that we will see a cascade of defaults by the debtors aftermath of the crisis. These defaults imply that banks must be equipped to pay a considerable amount of money to the issuers of these derivatives. The second force that contributes to this liquidity risk is the possibility that the money market funding dries up, and the dealers cannot raise funding.

Derivatives have three functions. They act as stores of value, a means of payment, and a transfer of risk. Thus, they offer two of the three uses of money. Remember that money is a means of payment, a unit of account, and a store of value. But financial instruments have a third function that can make them very different from money: They allow for the transfer of risk. Regulators’ focus is mostly on one of these functions- store of value. The store of value implies that these financial instruments are reported as long-term assets on a company’s balance sheet and their main function is to transfer purchasing power into the future. When it comes to the derivatives market, regulators’ main concern is credit risks and the resulting long-term solvency problems. On the contrary, Money View uses the balance sheet approach to show the hybridity between means of payment and transferring risk functions of derivatives. This hybridity highlights that the firms use insurance instruments to shift the risk today and manage cash flow in the future. In this world, after a shock happens, it is access to liquidity, rather than the symmetry of the balance sheet, that keeps trading banks, and derivatives dealers, in business.

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Is COVID-19 Crisis a “Mehrling’s Moment”?

Derivatives Market as the Achilles’ Heel of the Fed’s Interventions

By Elham Saeidinezhad

Some describe the global financial crisis as a “Minsky’s moment” when credit’s inherent instability was exposed for everyone to see. The COVID-19 turmoil, on the other hand, is a “Mehrling’s moment” since his Money View provided us a unique framework to evaluate the Fed’s responses in action. Over the past couple of months, a new crisis, known as COVID-19, has grown up to become the most widespread shock after the 2008-09 global financial crisis. COVID-19 crisis has sparked historical reactions by the Fed. In essence, the Fed has become the creditor of the “first” resort in the financial market. These interventions evolved swiftly and encompassed several roles and tools of the Fed (Table 1). Thus, it is crucial to measure their effectiveness in stabilizing the financial market.

In most cases, economists assessed these actions by studying the change in size or composition of the Fed’s balance sheet or the extent and the kind of assets that the Fed is supporting. In a historic move, for instance, the Fed is backstopping commercial papers and municipal bonds directly. However, once we use the model of “Market-Based Credit,” proposed by Perry Mehrling, it becomes clear that these supports exclude an essential player in this system, which is derivative dealers. This exclusion might be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis. 

What system of central bank intervention would make sense if the COVID-19 crisis significantly crushed the market-based credit? This piece employs Perry Mehrling’s stylized model of the market-based credit system to think about this question. Table 1 classifies the Fed’s interventions based on the main actors in this model and their function. These players are investment banks, asset managers, money dealers, and derivative dealers. In this financial market, investment banks invest in capital market instruments, such as mortgage-backed securities (MBS) and other asset-backed securities (ABS). To hedge against the risks, they hold derivatives such as Interest Rate Swaps (IRS), Foreign exchange Swaps (FXS), and Credit Default Swaps (CDS). The basic idea of derivatives is to create an instrument that separates the sources of risk from the underlying assets to price (or even sell) them separately. Asset managers, which are the leading investors in this economy, hold these derivatives. Their goal is to achieve their desired risk exposure and return. From the balance sheet perspective, the investment bank is the asset manager’s mirror image in terms of both funding and risk.

This framework highlights the role of intermediaries to focus on liquidity risk. There are two different yet equally critical financial intermediaries in this model—money dealers, such as money market mutual funds, and derivative dealers. Money dealers provide dollar funding and set the price of liquidity in the money market. In other words, these dealers transfer the cash from the investors to finance the securities holdings of investment banks. The second intermediary is the derivative dealers. In derivatives such as CDS, FXS, and IRS, these market makers transfer risk from the investment bank to the asset manager and set the price of risk in the process. They mobilize the risk capacity of asset managers’ capital to bear the risk in the assets such as MBS.  

After the COVID-19 crisis, the Fed has backstopped all these actors in the market-based credit system, except the derivative dealers (Table 1). The lack of Fed’s support for the derivatives market might be an immature decision. The modern market-based credit system is a collateralized system. There should be a robust mechanism for shifting both assets and the risks to make this system work. The Fed has employed extensive measures to support the transfer of assets essential for the provision of funding liquidity. Financial participants use assets as collaterals to obtain funding liquidity by borrowing from the money dealers. However, during a financial crisis, this mechanism only works if a stable market for risk transfer accompanies it. It is the job of derivative dealers to use their balance sheets to transfer risk and make a market in derivatives. The problem is that fluctuations in the price of assets that derive the derivatives’ value expose them to the price risk.

During a crisis such as COVID-19 turmoil, the heightened price risks lead to the system-wide contraction of the credit. This occurs even if the Fed injects an unprecedented level of liquidity into the system. If the value of assets falls, the investors should make regular payments to the derivative dealers since most derivatives are mark-to-market. They make these payments using their money market deposit account or money market mutual fund (MMMFs). The derivative dealers then use this cash inflow to transfer money to the investment bank that is the ultimate holder of these instruments. In this process, the size of assets and liabilities of the global money dealer (or MMMFs) shrinks, which leads to a system-wide credit contraction. 

As a result of the COVID-19 crisis, derivative dealers’ cash outflow is very likely to remain higher than their cash inflow. To manage their cash flow, derivative dealers derive the “insurance” prices up and further reduce the price of capital or assets in the market. This process further worsens the initial problem of falling asset prices despite the Fed’s massive asset purchasing programs. The critical point to emphasize here is that the mechanism through which the transfer of the collateral, and the provision of liquidity, happens only works if fluctuations in the value of assets are absorbed by the balance sheets of both money dealer and derivative dealers. Both dealers need continuous access to liquidity to finance their balance sheet operations.

Traditional lender of last resort is one response to these problems. In the aftermath of the COVID-19 crisis, the Fed has backstopped the global money dealer and asset managers and supported continued lending to investment banking. Fed also became the dealer of last resort by supporting the asset prices and preventing the demand for additional collateral by MMMFs. However, the Fed has left derivative dealers and their liquidity needs behind. Importantly, two essential actions are missing from the Fed’s recent market interventions. First, the Fed has not provided any facility that could ease derivative dealers’ funding pressure when financing their liabilities. Second, the Fed has not done enough to prevent derivative dealers from demanding additional collaterals from asset managers and other investors, to protect their positions against the possible future losses. 

The critical point is that in market-based finance where the collateral secures funding, the market value of collateral plays a crucial role in financial stability. This market value has two components: 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 price of diverse assets such as asset-backed securities, commercial papers, and municipal bonds. However, it has not offered any support yet for backstopping the price of derivatives. In other words, while the Fed has provided support for the cash markets, it overlooked the market liquidity 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 so, consequently, undermining their use as collateral in the market-based credit.

To sum up, shadow banking has three crucial foundations: market-based credit, global banking, and modern finance. The stability of these pillars depends on the price of collateral (liquidity), price of Eurodollar (international liquidity), and the price of derivatives (risk), respectively. In the aftermath of the COVID-19 crisis, the Fed has backstopped the first two dimensions through tools such as the Primary Dealer Credit Facility, Term Asset-Backed Securities Loan Facility, and Central Bank Swap Lines. However, it has left the last foundation, which is the market for derivatives, unattended. According to Money View, this can be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis. 

Download Table: Fed’s responses to the Covid-19 Crisis: A Money View Classification (As of March 25, 2020) (Pdf document)Download
Download Table: Fed’s responses to the Covid-19 Crisis: A Money View Classification (As of March 25, 2020) (Word document) Download
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Is Monetary System as Systemic and International as Coronavirus?

This piece was originally part of “Special Edition Roundtable: Money in the Time of Coronavirus” by JustMoney.org platform.

By Elham Saeidinezhad

The coronavirus crisis has sparked different policy responses from different countries. The common thread among these reactions is that states are putting globalization on pause. Yet, re-establishment of central bank swap lines is making “money,” chiefly Eurodollars, the first element that has become more global in the wake of the Coronavirus outbreak. This is not an unexpected phenomenon for those of us who are armed with insights from the Perry Mehrling’s “Money View” framework. The fact that the monetary system is inherently international explains why the Fed reinstalled its standing U.S. dollar liquidity swap line arrangements with five other central banks just after it lowered its domestic federal fund’s target to zero percent. However, the crisis also forces us to see global dollar funding from a lens closer to home: the fact that the Eurodollar market, at its core, is a domestic macro-financial linkage. In other words, its breakdown is a source of systemic risk within communities as it disrupts the two-way connection between the real economy and the financial sector. This perspective clarifies the Fed’s reactions to the crisis in hand. It also helps us understand the recent debate in the economics profession about the future of central bank tools.

The Great Financial Crisis of 2008-09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The Coronavirus crisis is testing this understanding on a global scale. Most of the literature highlights the impact of sharp fluctuations in long-term fundamentals such as asset prices and capital flows on the financial positions of firms and the economy. In doing so, economists underestimate the effects of disturbances in the Eurodollar market, which provides short-term dollar funding globally, on real economic activities such as trade. These miscalculations, which flow from economists’ natural approach to money as a veil over the real economy, could be costly. Foreign banks play a significant role in the wholesale Eurodollar market to raise US dollar financing for their clients. These clients, usually multinational corporations, are part of a global supply chain that covers different activities from receiving an order to producing the final goods and services. Depending on their financial positions, these firms either wish to hold large dollar balances or receive dollar-denominated loans. The deficit firms use the dollar funding to make payments for their purchases. The surplus firms, on the other hand, expect to receive payments in the dollar after selling their products. The interconnectedness between the payment system and global supply chains causes the Eurodollar market to act as a bridge between the real economy and the financial sector.

The Coronavirus outbreak is putting a strain on this link, both domestically and globally: it is disrupting the supply chain, forcing every firm along the chain to become a deficit agent in the process. The supply chain moves products or services from one supplier to another and is essentially the sum of all firms’ sales. These sales (revenues) are, in effect, a measure of payments, the majority of which occur in the Eurodollar market. A sharp shock to sales, as a result of the outbreak, precipitates a lower ability to make payments. When an output is not being shipped, a producer of final goods in China does not have dollar funding to pay the suppliers of intermediate products. As a result, firms in other countries do not have dollars either. The trauma that the coronavirus crisis injects into manufacturing and other industries thus lead to missed payments internationally. Missed payments will make more firms become deficit agents. This includes banks, which are lower down in the hierarchy, and the central banks, which are responsible for relaxing the survival constraints for the banking system. By focusing on the payments system and Eurodollar market, we are able to see the “survival constraint” in action.

The question for monetary policy is how far central banks decide to relax that survival constraint by lowering the bank rate. This is why central banks, including the Fed, are reducing interest rates to zero percent. However, the ability to relax the survival constraint for banks further down in the hierarchy depends also on the strength of foreign central banks to inject dollar funding into their financial system. The Fed has therefore re-established the dollar swap line with five other major central banks. The swap lines are available standing facilities and serve as a vital liquidity backstop to ease strains in global funding markets. The point to hold on to here is that the U.S. central bank is at a level in the hierarchy above other central banks

Central banks’ main concern is about missed payments of U.S. dollars, as they can deal with missed payments in local currency efficiently. In normal circumstances, the fact that non-U.S. central banks hold foreign exchange reserves enables them to intervene in the market seamlessly if private FX dealers are unable to do so. In these periods, customer-led demand causes some banks to have a natural surplus position (more dollar deposits than loans) and other banks to have an inherent deficit position (more dollar loans than deposits). FX dealers connect the deficit banks with the surplus banks by absorbing the imbalances into their balance sheets. Financial globalization has enabled each FX dealer to resolve the imbalance by doing business with some U.S. banks, but it seems more natural all around for them to do business with each other. During this crisis, however, even U.S. banks have started to feel the liquidity crunch due to the negative impacts of the outbreak on financial conditions. When U.S. banks pull back from market-making in the Eurodollar market, there will be a shortage of dollar funding globally. Traditionally, in these circumstances, foreign central banks assume the role of the lender of last resort to lend dollars to both banks and non-banks in their jurisdiction. However, the severity of the Coronavirus crisis is creating a growing risk that such intermediation will fracture. This is the case as speculators and investors alike have become uncertain of the size of foreign central banks’ dollar reserve holding.

To address these concerns, the Fed has re-established swap lines to lend dollars to other central banks, which then lend it to banks. These particular swap lines arrangements were originally designed to help the funding needs of banks during 2008. However, these swap lines might be inadequate to ease the tension in the market. The problem is that the geographic reach of the swap lines is too narrow. The Fed has swap lines only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. The reason is that the 2008-09 financial crisis affected many banks in these particular jurisdictions severely and their economies were closely intertwined with the US financial system. But the breadth of the current crisis is more extensive as every country along the supply chain is struggling to get dollars. In other words, the Fed’s dollar swap lines should become more global, and the international hierarchy needs to flatten.

To ease the pressure of missed payments internationally, and prevent the systemic risk outbreak domestically, the Fed and its five major central bank partners have coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. These tools help to mitigate the effects of strains on the supply chain, both domestically and abroad. Such temporary agreements have been part of central banks’ set of monetary policy instruments for decades. The main lessons from the Coronavirus outbreak for central bank watchers is that swap lines and central bank collaborations are here to stay – indeed, they should become more expansive than before. These operations are becoming a permanent tool of monetary policy as financial stability becomes a more natural mandate of the central banks. As Zoltan Pozsar has recently shown, the supply chain of goods and services is the reverse of the dollar funding payment system. Central banks’ collaboration prevents this hybridity from becoming a source of systemic risk, both domestically and internationally.

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Update: On March 19, 2020, the Fed announced the establishment of temporary U.S. dollar liquidity arrangements with other central banks such as Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank (Norway), the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank (Sweden).

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Elham's Money View Blog

Is “Tokenisation” Our Apparatus Towards a Dealer Free Financial Market?

By Elham Saeidinezhad

The death of the Jimmy Stewart style “traditional banking system” was accelerated by the birth of securitization in the financial market. Securitization made the underlying assets, such as mortgage loans, “tradable” or “liquid.” Most recently, however, a new trend, called “tokenization,” i.e., the conversion of securities into digital tokens, is emerging that is decidedly different from the earlier development. While securitization created a dealer centric system of market-based credit that raise funds from investors, tokenization is a step towards building a “dealer free” world that reduces fees for investors. In this world, dealers’ liquidity provision is replaced by “smart” or “self-executing” contracts, protocols, or code that self-execute when certain conditions are met. The absence of dealers in this structure is not consequential in standard times. When markets are stable, people assume the mechanical convertibility of the tokenized asset into its underlying securities. However, the financial crisis threatens this confidence in the convertibility principle and could lead to massive settlement failures. These systemic failures evaporate liquidity and create extensive adjustments in asset prices. Such an outcome will be responded by policymakers who try to limit these adverse feedback loops. But the critical question that is remained to be answered is the central banks will save whom and which, not a very smart contract.

New technologies created money and assets. For centuries, these assets, mostly short-term commercial papers, were without liquidity and relied upon the process of “self-liquidation.” However, the modern financial market, governed by the American doctrine, improved this outdated practice and relied on “shiftability” or “market liquidity” instead. Shiftability (or salability) of long-term financial securities ensured that these assets could be used to meet cash flow requirements, or survival constraints, before their maturity dates. The primary providers of liquidity in this market are security dealers who use their balance sheets to absorb trade imbalances. The triumph of shiftability view, because of depression and war, has given birth to the “asset-backed securities” and securitization. This process can encompass any financial asset and promotes liquidity in the marketplace.

ABS market continues to evolve into new securitization deals and more innovative offerings in the future. Tokenization is the next quantum leap in asset-based securitization. Tokenization refers to the process of issuing a blockchain token that digitally represents a real tradable asset such as security. This process, in many ways, is like the traditional securitization with a twist. The “self-executing” feature of these contracts discount the role of dealers and enable these assets to be traded in secondary markets by automatically matching buyers with sellers. The idea is that eliminating dealers will increase “efficiency” and reduce trading costs. 

The issue is that digital tokens may be convertible to securities, in the sense that the issuer of digital tokens holds some securities on hand, but that does not mean that these tokenized assets represent securities or are at the same hierarchical level as them. When an asset (such as a digital token) is backed by another asset (such as security), it is still a promise to pay. The credibility of these promises is an issue here, just as in the case of other credit instruments, and the liquidity of the tokenized instruments can help to enhance credibility. In modern market-based finance, which is a byproduct of securitization, the state of liquidity depends on the security dealers who take the imbalances into their balance sheets and provide market liquidity. 

The only constant in this evolving system is the natural hierarchy of money. Tokenization disregards this inherent feature of finance and aims at moving towards a dealer free world. A key motivation is to create a “super asset” by lowering the estimated $17–24 billion spent annually on trade processing. The problem is that by considering dealers as “frictions” in the financial market, tokenization is creating a super asset with no liquidity during the financial crisis. Such shiftability ultimately depends on security dealers and other speculators who are willing to buy assets that traders are willing to sell and vice versa and use their balance sheets when no one else in the market does. Tokenization could jeopardize the state of liquidity in the system by bypassing the dealers in the name of increasing efficiency. 

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Elham's Money View Blog

Promises All the Way Down: A Primer on the Money View

This post is originally part of a symposium on the Methods of Political Economy in Law and Political Economy Blog.

By Elham Saeidinezhad

It has long been tempting for economists to imagine “the economy” as a giant machine for producing and distributing “value.” Finance, on this view, is just the part of the device that takes the output that is not consumed by end-users (the “savings”) and redirects it back to the productive parts of the machine (as “investment”). Our financial system is an ornate series of mechanisms to collect the value we’ve saved up and invest it into producing yet more value. Financial products of all sorts—including money itself—are just the form that value takes when it is in the transition from savings to investment. What matters is the “real” economy—where the money is the veil, and the things of value are produced and distributed.

What if this were exactly backwards? What if money and finance were understood not as the residuum of past economic activity—as a thing among other things—but rather as the way humans manage ongoing relationships between each other in a world of fundamental uncertainty? These are the sorts of questions asked by the economist Perry Mehrling (and Hyman Minsky before him). These inquiries provided a framework that has allowed him to answer many of the issues that mystify neoclassical economics.

On Mehrling’s “Money View,” every (natural or artificial) person engaged in economic activity is understood in terms of her financial position, that is, in terms of the obligations she owes others (her “liabilities”) and the obligations owed to her (her “assets”). In modern economies, obligations primarily take the form of money and credit instruments. Every actor must manage the inflow and outflow of obligations (called “cash flow management”) such that she can settle up with others when her obligations to them come due. If she can, she is a “going concern” that continues to operate normally. If she cannot, she must scramble to avoid some form of financial failure—bankruptcy being the most common. After all, as Mehrling argues, “liquidity kills you quick.” This “survival constraint” binds not only today but also at every moment in the future. Thus, generally, the problem of satisfying the survival constraint is a problem of matching up the time pattern of assets (obligations owed to an actor) with the time pattern of liabilities (obligations an actor owed to others). The central question is whether, at any moment in time, there is enough cash inflow to pay for the cash flows.

For the Money View, these cash flows are at the heart of the financial market. In other words, the financial system is essentially a payment system that enables the transfer of value to happen even when a debtor does not own the means of payment today. Payment takes place in two stages. When one actor promises something for another, the initial payment takes place—the thing promised is the former’s liability and the latter’s asset. When the promise is kept, the transaction is settled (or funded), and the original asset and liability are canceled.

The Hierarchy of Debt-Money

What makes finance somewhat confusing is that all the promises in question are promises to pay, which means that both the payment and the settlement process involve the transfer of financial assets. To learn when an asset is functioning as a means of payment and when it is operating as a form of settlement requires understanding that, as Mehrling has argued, “always and everywhere, monetary systems are hierarchical.” If a financial instrument is higher up the hierarchy than another, the former can be used to settle a transaction in the latter. At the top of the hierarchy is the final means of settlement—an asset that everybody within a given financial system will accept. The conventional term for this type of asset is “money.” In the modern world, money takes the form of central bank reserves—i.e., obligations issued by a state. The international monetary system dictates the same hierarchy for different state currencies, with the dollar as the top of this pyramid. What controls this hierarchy in financial instruments and differentiates money (means of final settlement) from credit (a promise to pay, a means of delaying final settlement), is their degree of “liquidness” and their closeness to the most stable money: the U.S. central bank reserves.

Instruments such as bank deposits are more money-like compared to the others since they are promises to pay currency on demand. Securities, on the other hand, are promises to pay currency over some time horizon in the future, so they are even more attenuated promises to pay. Mehrling argues that the payments system hides this hierarchy by enabling the firms to use credit today to postpone the final settlement into the future.

The Money View vs. Quantity and Portfolio Theories

Viewing the world from this perspective allows us to see details about financial markets and beyond, that the lens of neoclassical economics does not. For instance, the lack of attention to payment systems in standard monetary theories is a byproduct of overlooking the essential hierarchy of finance. Models such as Quantity Theory of Money that explore the equilibrium amount of money in the system systematically disregards the level of reserves that are required for the payment system to continuously “convert” bank deposits (which are at the lower layer of the hierarchy) into currency on demand.

Further, unlike the Money View, the Portfolio Choice Theory (such as that developed by James Tobin), which is at the heart of asset pricing models, entirely abstracts from the role of dealers in supplying market liquidity. These models assume an invisible hand that provides market liquidity for free in the capital market. From the lens of supply and demand, this is a logical conclusion. Since a supplier can always find a buyer who is willing to buy that security at a market price, there is no job for an intermediary dealer to arrange this transaction. The Money View, on the other hand, identifies the dealers’ function as the suppliers of market liquidity—the clearinghouse through which debts and credits flow—which makes them the primary determinant of asset prices.

The Search for Stable Money

The Money View’s picture of conventional monetary policy operations is very distinct from an image that a trained monetary economist has in mind. From the Money View’s perspective, throughout the credit cycle, one constant is the central bank’s job to balance elasticity and discipline in the monetary system as a way of controlling the flow of credit. What shapes the dynamic of elasticity and discipline in the financial system is the daily imbalances in payment flows and the need of every agent in the system to meet a “survival” or “reserve constraint.”

In normal times, if a central bank, such as the Fed, wants to tighten, it raises the federal fund target. Raising the cost of the most liquid form of money in the system will then resonate down the monetary hierarchy. It immediately lowers the profitability of money market dealers (unless the term interest rate rises by the full amount). Because money market dealers set the funding cost for dealers in capital markets (i.e. because they are a level up in the hierarchy of money), capital market dealers will face pressure to raise asset prices and long-term interest rates. These security dealers are willing to hold existing security inventories only at a lower price, hence higher expected profit. Thus the centrally determined price of money changes the value of stocks.

Central Bankers as Shadow Bankers

The Money View’s can also help us see how the essence of credit has shifted from credit that runs through regulated banks to “market-based credit” through a shadow banking system that provides money market funding for capital market investing. Shadow banking system faces the same problems of liquidity and solvency risk that the traditional banking system faces, but without the government backstops at the top of the hierarchy (via Fed lender of last resort payouts and FDIC deposit insurance). Instead, the shadow banking system relies mainly on dealers in derivatives and in wholesale lending. Having taken on responsibility for financing the shadow banks, which financed the subprime mortgage market, these dealers began to run into problems during the financial crisis. Mehrling argues that the reality of the financial system dictates Fed to reimagine its role from a lender last resort to banks to the dealer of last resort to the shadow banking system.

Conclusion

We have been living in the Money View world, a world where almost everything that matters happens in the present. Ours is a world in which cash inflows must be adequate to meet cash outflows (the survival or liquidity constraint) for a single day. This is a period that is too short for creating any elasticity or discipline in production or consumption, the usual subject matter of economics, so we have abstracted from them. Doing so has blinded us to many important aspects of the system we live in. In our world, “the present determines the present.”

This piece is also featured in justmoney.org website