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Is Money View Ready to Be on Trial for its Assumptions about the Payment System?

A Review of Perry Mehrling’s Paper on the Law of Reflux

By Elham Saeidinezhad

Perry Mehrling’s new paper, “Payment vs. Funding: The Law of Reflux for Today,” is a seminal contribution to the “Money View” literature. This approach, which is put forward by Mehrling himself, highlights the importance of today’s cash flow for the survival of financial participants. Using Money View, this paper examines the implications of Fullarton’s 1844 “Law of Reflux” for today’s monetary system. Mehrling uses balance sheets to show that at the heart of the discrepancy between John Maynard Keynes’ and James Tobin’s view of money creation is their attention to two separate equilibrium conditions. The former focuses on the economy when the initial payment takes place. At the same time, the latter is concerned about the adjustments in the interest rates and asset prices when the funding is finalized.

To provide such insights into several controversies about the limits of money finance, Mehrling’s analysis relies intensely on one of the fundamental premises of the Money View; the notion that the payment system that enables the cash flow to transfer from a deficit agent to the surplus agent is essentially a credit system. However, when we investigate the future that the Money View faces, this sentiment is likely to be threatened by a few factors that are revolutionizing financial markets. These elements include but are not limited to the Fed’s Tapering and post-crisis financial regulations that constrain banks’ ability to create new credit. These restrictions force the payment system to rely less on credit and more on reserves. Hence, the future of Money View will hinge on its ability to function under new circumstances where the payment system is no longer a credit system. This puzzle should be investigated by those of us who consider ourselves as students of this View.

Mehrling, in his influential paper, puts on his historical and monetary hats to clarify a long-standing debate amongst Keynesian economists on the money creation process. In understanding the effect of money on the economy, “old” Keynesians’ primary focus has been on the market interest rate and asset prices when the initial payment is taking place. In other words, their chief concern is how asset prices change to make the new payment position an equilibrium. To answer this question, they use the “liquidity preference framework” and argue that asset prices are set as a markup over the money rate of interest. The idea is that once the new purchasing power is created, the final funding can happen without changing asset prices or interest rates. The reason is that the initial increase in the money supply remains entirely in circulation by creating a new demand for liquid balances for various reasons. Put it differently, although the new money will not disappear on the final settlement date, the excess supply of money will be eliminated by the growing demand for money. In this situation, there is no reflux of the new purchasing power.

In contrast, the new Keynesian orthodoxy, established by James Tobin, examines the effects of money creation on the economy by focusing on the final position rather than the initial payment. At this equilibrium, the interest rate and asset prices will be adjusted to ensure the final settlement, otherwise known as funding. In the process, they create discipline in the monetary system. Using the “Liquidity preference framework”, these economists argue that the new purchasing power will be used to purchase long-term securities such as bonds. In other words, the newly created money will be absorbed by portfolio rebalancing, which leads to a new portfolio equilibrium. In this new equilibrium, the interbank credit will be replaced by a long-term asset, and the initial payment is funded by new long-term lending, all outside the traditional banking system. Tobin’s version of Keynesianism extracted from both the flux of bank credit expansion and the reflux of subsequent contraction by only focusing on the final funding equilibrium. It also shifts between one funding equilibrium and another since he is only interested in final positions. In the new view, bank checkable deposits are just one funding liability, among others, and their survival in the monetary system entirely depends on the portfolio preferences of asset managers.

The problem is that both views abstract from the cash flows that enable a continuous payment system. These cash flows are critical to a successful transition from one equilibrium to another. Money View labels these cash flows as “liquidity” and puts it at the center of its analysis. Liquidity enables the economy to seamlessly transfer from initial equilibrium, when the payment takes place, to the final equilibrium, when the final funding happens, by ensuring the continuity of the payment system. In the initial equilibrium, payment takes place since banks expand their balance sheets and create new money. In this case, the deficit bank can borrow from the surplus bank in the interbank lending market. To clear the final settlement, the banks can take advantage of their access to the central bank’s balance sheet if they still have short positions in reserve. Mehrling uses these balance sheets operations to show that it is credit, rather than currency or reserves, that creates a continuous payment system. In other words, a credit-based payment system lets the financial transactions go through even when the buyers do not have means of payment today. These transactions, that depend on agents’ access to liquidity, move the economy from the initial equilibrium to the ultimate funding equilibrium. 

The notion that the “payment system is a credit system” is a defining characteristic of Money View. However, a few developments in the financial market, generated by post-crisis interventions, are threatening the robustness of this critical assumption. The issue is that the Fed’s Tapering operations have reduced the level of reserves in the banking system. In the meantime, post-crisis financial regulations have produced a balance sheet constrained for the banking system, including surplus banks. These macroprudential requirements demand banks to keep a certain level of High-Quality Liquid Assets (HQLA) such as reserves. At the same time, the Global Financial Crisis has only worsened the stigma attached to using the discount loan. Banks have, therefore, become reluctant to borrow from the Fed to avoid sending wrong signals to the regulators regarding their liquidity status. These factors constrained banks’ ability to expand their balance sheets to make new loans to the deficit agents by making this activity more expensive. As a result, banks, who are the leading providers of the payment system, have been relying less on credit and more on reserves to finance this financial service.

Most recently, Zoltan Pozsar, a prominent scholar of the Money View, has warned us that if these trends continue, the payment system will not be a credit system anymore. Those of us who study Money View realize that the assumption that a payment system is a credit system is the cornerstone of the Money View approach. Yet, the current developments in the financial ecosystem are fundamentally remodeling the very microstructure that has initially given birth to this conjecture. It is our job, therefore, as Money View scholars, to prepare this framework for a future that is going to put its premises on trial. 

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Where Does Profit Come from in the Payments Industry?

“Don’t be seduced into thinking that that which does not make a profit is without value.”

Arthur Miller

By Elham Saeidinezhad

The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment system during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.

Traditionally, the banking system provides payment services by being prepared to trade currency for deposits and vice versa, at a fixed price par. However, when we try to understand the economics of banks’ function as providers of payment systems, we quickly face a puzzle. The question is how banks manage to make markets in currency and deposits at a fixed price and a zero spread. In other words, what incentivizes banks to provide this crucial service. Typically, what enables the banks to offer payment systems, despite its negligible earnings, is their complementary and profitable role of being dealers in liquidity. Banks are in additional business, the business of bearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They cannot change the price of deposits in terms of currency. Still, they can expand and contract the number of deposits because deposits are their own liability, and they can expand and contract the quantity of currency because of their access to the discount window at the Fed. 

This two-tier monetary system, with the central bank serving as the banker to commercial banks, is the essence of the account-based payment system and creates flexibility for the banks. This flexibility enables banks to provide payment systems despite the fact the price is fixed, and their profit from this function is negligible. It also differentiates banks, who are dealers in the money market, from other kinds of dealers such as security dealers. Security dealers’ ability to establish very long positions in securities and cash is limited due to their restricted access to funding liquidity. The profit that these dealers earn comes from setting an ask price that is higher than the bid price. This profit is called inside spread. Banks, on the other hand, make an inside spread that is equal to zero when providing payment since currency and deposits trade at par. However, they are not constrained by the number of deposits or currency they can create. In other words, although they have less flexibility on price, they have more flexibility in quantity. This flexibility comes from banks’ direct access to the central banks’ liquidity facilities. Their exclusive access to the central banks’ liquidity facilities also ensures the finality of payments, where payment is deemed to be final and irrevocable so that individuals and businesses can make payments in full confidence.

The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve). 

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Is the Recent Buyback Spree Creating Liquidity Problems for the Dealers?

“You are a side effect,” Van Houten continued, “of an evolutionary process that cares little for individual lives. You are a failed experiment in mutation.”


― John Green, The Fault in Our Stars

By Elham Saeidinezhad

The anxiaties about large financial corporations’ debt-funded payouts- aka “stock buybacks”- is reemerging a decade after the financial crisis. Companies on the S&P 500 have poured more than $5.3 trillion into repurchasing their own shares since 2010. The root cause of most concerns is that stock buybacks do not contribute to the productive capacities of the firm. Indeed, these distributions to stockholders disrupt the growth dynamic that links the productivity and pay of the labor force. Besides, these payments that come on top of dividends could weaken the firms’ credit quality. These analyses, however, fail to
appreciate the cascade effect that will hurt the dealers’ liquidity positions due to higher stock prices. Understanding this side effect has become even more significant as the share of major financial corporations, including JPMorgan, are trading at records, and are getting very expensive. That high-class problem should concern dealers who are providing market liquidity for these stocks and establishing short positions in the process. Dealers charge a fee to handle trades between the buyers and
sellers of securities. Higher stock prices make it more expensive for short selling dealers to settle the positions by repurchasing securities on the open market. If stocks become too high-priced, it might reduce dealers’ ability and willingness to provide market liquidity to the system. This chain of events that threatens the state of market liquidity is missing from the standard analysis of share buybacks. 

At the very heart of the discussion about share buybacks lay the question of how companies should use their cash. In a buyback, a company uses its cash to buy its own existing shares and becomes the biggest demander of its own stock. Firms usually repurchase their own stocks when they have surplus cash flow or earnings, which
exceed those needed to finance positive net present value investment
opportunities. The primary beneficiaries of these operations are shareholders who receive extra cash payments on top of dividends. The critical feature of stock buybacks is that it can be a self-fulfilling prophecy for the stock price. Since each remaining share gets a more significant piece of the profit and value, the companies bid up the share values and boost their own stock prices. The artificially high stock  prices can create liquidity andsettlement problems for the dealers who are making market for the stocks and have established short positions in the process.

Short selling is used by market makers to provide market liquidity in
response to unanticipated demand or to hedge the risk of a long position in the same security or a related security. On the settlement date, when the contract expires, the dealer must closeout- or settle- the
position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market. If the prices
become too high, they will not have enough capital to secure their short sales. At this point, whoever clears their trade will force them to liquidate. If they continue losing money, dealers face severe liquidity problems, and they may go bankrupt. The result would be an illiquid market. To sum up, in recent years, buybacks by public firms have become an essential technique for distributing earnings to shareholders. Not surprisingly, this trend has started a heated debate amongst the critiques. The problem, however, is that most analyzes have failed to capture the effect of these operations on dealers’ market-making capacity, and the state of market liquidity, when share prices become too high. 

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Is Transiting to SOFR Affecting Firms’ Survival and Liquidity Constraints?

“Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful.” Margaret J. Wheatley

By Elham Saeidinezhad

In 2017, after a manipulation scandal, the former FCA Chief Executive Andrew Bailey called for replacing LIBOR and had made clear that the publication of LIBOR is not guaranteed beyond 2021. A new rate created by the Fed—known as the secured overnight financing rate, or SOFR- seems to pull ahead in the race to replace LIBOR. However, finding a substitute has been a very challenging task for banks, regulators, and investors. The primary worries about the transition away from the LIBOR have been whether the replacement is going to reflect the risks from short-term lending and will be supported by a liquid market that behaves predictably. Most of these concerns are rooted in the future. However, a less examined yet more immediate result of this structural change might be the current instabilities in the market for short-term borrowing. In other words, this transition to SOFR creates daily fluctuations in market prices for derivatives such as futures that are mark-to-market and in the process affects firms’ funding and liquidity requirements. Understanding these side effects might be a key to understanding the puzzling situation that the Fed is currently facing which is the turbulence in the repo market.

This shift to the post-Libor financial market has important implications for the prices of the futures contracts and firms’ liquidity constraints. Futures are derivatives that take or hedge a position on the general level of interest rates. They are also “Mark-to-Market,” which means that, whenever the futures prices change, daily payments must be made.  The collateral underlying the futures contract, as well as the futures contract itself, are both marked to market every day and requires daily cash payments. LIBOR, or London Interbank Offer Rate, is used as a reference for setting the interest rate on approximately $200 trillion of financial contracts ranging from home mortgages to corporate loans. However, about $190 trillion of the $200 trillion in financial deals linked to LIBOR are in the futures market.  As a result, during this transition period, the price of these contracts swings daily, as the market perceives the future value of the alternative rate to be.  In the process, these fluctuations in prices generate cash flows that affect liquidity and funding positions of a variety of firms that use futures contracts, including hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.

To sum up, the shift from LIBOR to SOFR not only is changing market structure but also generating cash flow consequences that are putting extra pressure on money market rates.  While banks and exchanges are expanding a market for secondary financial products tied to the SOFR, they are using futures to hedge investors from losing money or protecting borrowers from an unexpected rise in their payments. In doing so, they make futures prices swing. These fluctuations in prices generate cash flows that affect liquidity positions of firms that invest in futures contracts. Money markets, such as the repo, secure the short-term funding that is required by these firms to meet their cash flow commitments. In the process of easing worries, banks are consistently changing the market price of the futures, generating new payment requirements, and putting pressure on the short-term funding markets. To evaluate the effects of this transition better, we might have to switch our framework from the traditional “Finance View” to “Money View.” The reason is that the former view emphasizes the role of future cash flows on current asset prices while the latter framework studies the impact of today’s cash flow requirements on the firm’s survival constraints.

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When it Comes to Sovereign Debt, What is the Real Concern? Level or Liquidity?

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?” Adam Smith

By Elham Saeidinezhad

The anxieties around the European debt crisis (often also referred to as eurozone crisis) seems to be a thing of the past. Eurozone sovereigns have secured record-high order books for their new government bond issues. However, emerging balance-sheet constraints have limited the primary dealers’ ability to stay in the market and might support the view that sovereign bond liquidity is diminishing. The standard models of sovereign default identify the origins of a sovereign debt crisis to be bad “fundamentals,” such as high debt levels and expectations. These models ignore the critical features of market structures, such as liquidity and primary dealers, that underlie these fundamentals. Primary dealers – the banks appointed by national debt agencies to help them borrow from investors- act as market makers in government bond auctions. These primary dealers provide market liquidity and set the price of government bonds. Most recently, however, primary dealers are leaving Europe’s bond markets due to increased pressure on their balance sheets. These exits could decrease sovereign bonds’ liquidity and increase the cost of borrowing for the governments. It can sow the seeds of the next financial crisis in the process. Put it differently, primary dealers’ decision to exit from this market might be acting as a warning sign of a new crisis in the making. 

Standard economic theories emphasize the role of bad fundamentals such as high debt levels in creating expectations of government default and reaching to a bad-equilibrium. The sentiment is that the sovereign debt crisis is a self-fulfilling catastrophe in nature that is caused by market expectations of default on sovereign debt. In other words, governments can be subjected to the same dynamics of fickle expectations that create run on the banks and destabilize banks. This is particularly true when a government borrows from the capital market over whom it has relatively little influence. Mathematically, this implies that high debt levels lead to “multiple equilibria” in which the debt level might not be sustainable. Therefore, there will not be a crisis as long as the economy reaches a good equilibrium where no default is expected, and the interest rate is the risk-free rate. The problem with these models is that they put so much weight on the role of expectations and fundamentals while entirely abstract from specific market characteristics and constituencies such as market liquidity and dealers.

Primary dealers use their balance-sheets to determine bond prices and the cost of borrowing for the governments. In doing so, they create market liquidity for the bonds. Primary dealers buy government bonds directly from a government’s debt management office and help governments raise money from investors by pricing and selling debt. They typically are also entrusted with maintaining secondary trading activity, which entails holding some of those bonds on their balance sheets for a period. In Europe, several billion euros of European government bonds are sold every week to primary dealers through auctions, which they then sell on. However, tighter regulations, such as MiFID II, since the financial crisis has made primary dealing less profitable because of the extra capital that banks now must hold against possible losses. Also, the European Central Bank’s €2.6tn quantitative easing program has meant national central banks absorbed large volumes of debt and lowered the supply of the bonds. These factors lead the number of primary dealers in 11 EU countries to be the lowest since Afme began collecting data in 2006. 

This decision by the dealers to exit the market can increase the cost of borrowing for the governments and decrease sovereign bonds’ liquidity. As a result, regardless of the type of equilibrium, the economy is at, and what the debt level is, the dealers’ decision to leave the market could reduce governments’ capacity to repay or refinance their debt without the support of third parties like the European Central Bank (ECB) or the International Monetary Fund (IMF). Economics models that study the sovereign debt crisis abstracts from the role of primary dealers in government bonds. Therefore, it should hardly be surprising to see that these models would not be able to warn us about a future crisis that is rooted in the diminished liquidity in the sovereign debt market.

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Is Debt a Sin?

By Elham Saeidinezhad

“Oh, sinnerman, where you gonna run to?
Sinnerman where you gonna run to?
Where you gonna run to?
All on that day
We got to run to the rock”
Nina Simone

In the recent world bank report published in the first week of January, the Washington D.C.-based group said there had been four waves of government debt accumulation over the last 50 years. In 2018, for instance, global debt climbed to a record high of about 230% of gross domestic product (GDP). The critical drivers of the national debt level are government expenditures on welfare programs such as health insurance, education, and social security. The report, aligned with the premises of standard macroeconomic theories, warns that these episodes will not have a happy ending. The recommendation, therefore, is to reduce these public programs.  The issue is that these results are generated by unrealistic assumptions about interest rates and the economics of financial institutions that motivates supply-demand frameworks. Once we consider more sensible assumptions about interest rates and financial institutions’ business models, there might be a more happy ending for governments’ initiatives to support welfare programs.

To elaborate on this point, let’s start by understanding the “Market for loanable funds” model that is the most preliminary yet well-known supply and demand framework to study the effects of government debt. This theory predicts that higher government budget deficit reduces national saving, which is the source of the supply of loanable funds. Because the public debt does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loans. As a result, the supply-demand framework suggests that in the new equilibria, the interest rate will rise. Higher interest rates, in return, crowd out private investment by increasing borrowing costs. This process will create a vicious cycle that undermines economic growth since investment is one of the main components of aggregate output.

The challenge is that these models are based on very unreliable assumptions. First, they assume that there is only one type of financial institution in the market for loans. These institutions’ only resource to make these loans is the savers’ money. In reality, however, rather than being merely an intermediary between the savers and the borrowers, financial institutions use their balance sheets to create different types of private credit.  Further, these theories propose that demand and supply forces in the credit market are the primary determinant of the interest rate. In modern economies, nevertheless, the interest rate is set by the ability and willingness of these institutions to use their balance sheets and continue making the market for new loans. This ability depends on factors such as their access to short-term funding rather than supply and demand forces. To sum up, once we take more realistic assumptions into account, we might find a happier ending for governments’ decisions to finance programs such as health insurance and unemployment benefit that enhance public welfare.

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Is the Fed Losing Steam in Controlling Interest Rate?

By Elham Saeidinezhad

As the final countdown to bring in 2020 begins, new concerns have emerged regarding the Fed’s continuous ability to control the interest rate. Developments in the financial market such as growing U.S. budget deficit, investors’ increased cash hoarding desire, and pressures on the money market rates such as repo rates are urging these fears.  The sentiment is that the Fed’s control over interest rate determines the price of reserves, which in turn eliminates any form of excess supply or excess demand in the market for reserve. In doing so, the Fed maintains its authority to stabilize the money market where the price of short-term funding is determined. The problem is that in modern finance, most financial participants finance their liquidity requirements mainly through selling their securities holdings, or using them as collateral, rather than demanding for reserves directly.  In other words, the availability of market liquidity, which refers to the ability to raise some money by selling holdings of financial assets, has a higher priority than the supply of reserves. Therefore, as Perry Mehrling argues, and this blog highlights, the central bank watchers’ focus should deviate from the Fed’s ability to control the price of reserves, which is federal funds rate, to its ability to affect market and funding liquidity. This also entails an intellectual migration from a supply and demand framework toward a Flow of Funds accounting perspective.

To understand this point, let’s start by understanding the standard monetary economics view of the interest rate. In this framework, the money rate of interest is determined directly by the supply and demand for state money or reserves. The idea is that the Fed can accurately target the federal funds rate to control supply and demand for the money even though this interbank lending rate is determined in the market. The notion that the reserve balances held at the Fed are the ultimate means of interbank settlement gives the Fed this power. This sentiment of “monetary liquidity” got upheld in postwar economic discussion. The further integration of the money supply and demand framework with the “Liquidity preference” framework of Keynes made it an integral part of the standard economist’s toolkit. The issue is that this analytical strategy overlooks the role of borrowing and private credit in the money market by treating the money rate of interest as determined directly by the supply and demand for reserves. In modern finance, however, the dishoarding of money balances is only one way of satisfying the liquidity needs when cash outflow (use of funds) is larger than cash inflow (source of funds).

The other two methods are borrowing or selling financial assets. The former requires access to “funding liquidity,” and the latter involves the availability of “market liquidity.” More importantly, the dealers supply both liquidities. Banks provide funding liquidity by acting as dealers in the money market and earning the spread between overnight rate and term rates. In the process, they set the price of funding liquidity which is the short-term interest rate. Securities dealers, on the other hand, provide market liquidity and determine asset prices by taking on price risk and making the inside spread, which is the difference between the bid and ask prices. In doing so, both dealers take the deficit players’ settlement issues onto their own balance sheets and set short-term and long-term interest rates respectively. To sum up, it is crucial to observe that first, liquidity is a form of credit, not reserve money. Second, the interest rate, or price of liquidity, is determined by the expansion of dealer balance sheets on both sides rather than supply and demand for reserves.

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What Exactly is the Function of the FX Market? A $6 Trillion Per Day Question

By Elham Saeidinezhad

“I am a hybrid. I do independent films and also do Hollywood films – I love them both.”  Spike Lee

According to the recent series of reports published by the Bank for International Settlements (BIS) on December 10th, 2019, trading in global Foreign Exchange (FX) markets reached $6.6 trillion per day in April 2019, up from $5.1 trillion in April 2016. To put the size of this market into perspective, the annual world GDP is around $80 trillion. The main instrument that dominates the FX trading is the FX swap.  On the contrary, the forward contracts form only a small portion of the whole market.  Capturing this difference in market share, standard finance theories tend to put more weight on the FX swaps. In doing so, they sometimes overlook the importance of forward contracts for the FX swaps market. However, once we consider the economics of dealers’ function in the FX market, the hybridity between these two instruments becomes essential. Most FX swaps are liquid and easily tradable only because of the dealers’ ability to manage their cash flows in the future by entering a forward contract with an FX forward dealer. The former aims at keeping a matched book and hedging against the FX risk, and the latter is a speculative dealer who takes on this risk for a fee. In other words, the ability and willingness of the FX swap dealer to make the market depend on the costs and easiness of entering a forward contract.

To understand the essential hybridity between these two instruments, let’s examine what connects these two markets. In an FX swap contract, two parties exchange two currencies today at the spot exchange rate and commit to reverse the exchange at some pre-agreed future date and price. The FX swap dealers– mostly large banks with branches in different countries-  are trading both sides of the market. Their presence in the market enable corporations to borrow at a currency that is cheaper and then swap the proceeds with the currency that they need. In this market, the dealer posts bid and ask prices for these FX swaps and rely on its access to the forward contracts and interbank market in Eurodollar deposits to hedge any mismatches in its balance sheets. FX forward contracts trade two currencies at a pre-agreed future date and price. The dealer who makes the market in the FX forward contract is a speculative dealer who takes the opposite position and provides the hedge for the FX swap dealer. The critical detail is that the speculative dealer provides the hedge since it expects to profit from this transaction. This profit comes from the expectation that the forward exchange rate is going to be higher than the expected spot rate. In other words, speculative dealer’s profit depends on the degree and the direction of the failure of uncovered interest parity (UIP). UIP states that the forward exchange rate will be equal to the expected spot rate since there will be an unexploited arbitrage opportunity otherwise.  The point of all this is to show that dealers will make a market in the FX swap markets only if they can depend on speculative dealers in the forward market to hedge their unmatched exposures.

Further, this hybridity between the FX swap and the related forward market highlights the role of the FX market as a wholesale funding market. The FX swap dealer sets the costs of financing in foreign currencies for the corporates. In doing so, the dealer earns the spread between bid-ask rates for the FX swap. Importantly, the FX swap dealer’s profit is determined by its access to the interbank Eurodollar funding, as well as its own hedging costs. The latter is settled by the FX forward dealer, who helps the FX swap dealer with cash flow management by taking a speculative position.  In doing so, the FX forward dealer acts as the private dealer of near last resort in the FX swap market and absorbs the imbalances in the FX swap markets on its balance sheets. The failure of the UIP is the source of expected profit for this speculative dealer. By fixing the costs of doing business for the FX swap dealer, the FX forward market affects the prices in the FX swap market. To sum up, once we consider the role of dealers in the FX market, we realize that FX forward and FX swap markets are entirely intertwined, and the dealers’ interactions in these markets ultimately determine the costs of foreign currency financings.

Discussion Questions:

  1. What are the main differences between FX swaps and FX forwards?
  2. What connects the dealers in the FX swaps and the FX forwards market?
  3. What makes the FX market a funding market?
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Can Shadow Banking Replace Traditional Banking? We Will See Soon Enough

By Elham Saeidinezhad

“A person often meets his destiny on the road he took to avoid it.” Jean De La Fontaine

The shift in the provision of financial intermediation away from traditional banks towards the shadow banking system highlights the evolving structure of the financial market. The recent disorder in the short-term repo market has created new openings for money managers. Money managers, such as money market funds and investment funds, are hoarding unusually large amounts of cash in anticipation of the excessive demand for liquidity on December 31st. In doing so, they are planning to serve both as the primary cash providers and the lender of near last resort in the repo market. Traditionally, the latter is the role that the large banks are inclined to have in the repo market. This shift in market structure from banking to shadow banking system seems to be the unintended consequence of the Fed’s tapering and regulatory requirements. It is also no accident that the change in the investment strategy of money managers coincides with the unwillingness of the large banks to borrow from the discount window of the Fed. This reluctance by banks cost the financial system the recent turmoil in the overnight lending market in September. The repo market experiment at the end of December, where money managers are preparing to take over the banks’ role, will be a real-world stress test of this new system.

In this piece, we focus on three factors that derive these changes in the market structure. These forces include Basel III regulatory requirements, Fed’s tapering, and the reluctance of banks to use the discount window to prevent the run on them. Post-crisis macroprudential requirements demand banks to keep a certain level of High-Quality Liquid Assets (HQLA) such as reserves. For example, JPMorgan Chase keeps about $120 billion in reserves at the Fed and will not let it dip below $60 billion on any given day. These requirements reduced banks’ ability to be intermediaries between the Fed and other players. Further, the Fed’s tapering that involved the reduction of the Fed asset purchases reduced the amounts of reserves in the banking system. These factors constrained banks’ ability to provide cash in the repo market during September turbulences. Meanwhile, although the amounts of reserves in the system have shrunk, banks are reluctant to use the Fed’s credit facilities, including the discount window. The Global Financial Crisis has only worsened the stigma attached to using the discount loan for at least two reasons: first, the Dodd-Frank requires the name of the banks that borrow from the discount window to be released. Second, banks are worried that borrowing money from the Fed spur a run on these institutions.

Soon, the resilience of the most critical market for short-term borrowing will be tested when stress hits the system under a new condition. In this unique situation, when there is excessive demand for the cash, both the primary provider of funding liquidity and the lender of near last resort will be shadow banking system, who does not have the Fed’s backstop, rather than the large banks, who do. Perry Mehrling defines shadow banking as the money market funding of capital market lending. In this system, money market funds are primary providers of the funding liquidity. These funds are plotting to seize the new opportunity of becoming the lender of near last resort in December mostly because the large banks did not intervene when the repo rates hiked in September. The main question that remains to be answered is whether this new system will survive extensive pressure. After all, the bolstered role of shadow banking in the repo market is an unintended, rather than planned, consequences of post-crisis macroeconomic and regulatory changes.

Discussion Questions:

  1. Which regulatory requirements have constrained the ability of the banks to lend to the repo market?
  2. What does the lender of near last resort mean?
  3. Who are the main players in the shadow banking system?
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Elham's Money View Blog

Should the Fed Open its Balance Sheet to the Securities Dealers? A Lesson from the Recent Wild Swings in the Repo Rate

By Elham Saeidinezhad

“The secret of change is to focus all of your energy not on fighting the old, but on building the new” -Socrates

If the Fed’s understanding of the existing problems in the repo market is weak or incomplete, it might attempt to solve the wrong problems, and then implement the wrong solution. Financial participants and the Fed alike are trying to comprehend what triggered the short-term rates in the repo market to rise to 10 percent overnight from nearly 2 percent in September. The “liquidity shortage” that was created by the inaction of large banks to lend cash in the face of the excessive liquidity demands on that day is marked as one of the “triggers.” Since then, the Fed is seeking to tackle the liquidity shortage by lending cash to eligible banks and offering its own repo trades at target rates. Most recently, for example, the Federal Reserve Bank of New York injected $68.343 billion to the financial market on Friday, November 15th, in the form of repurchase agreements.

These large banks are intermediaries between the Fed and the rest of the system, and the idea is that they will re-lend this money in the repo market. Nonetheless, while the Fed is weighing the recent “triggering” stories, it might be approaching the issue with a wrong perspective.  What we saw in the repo market in September has been a tragedy in the making as a result of both the Fed’s own “Tapering” that started in 2013 and the post-Crisis Basel III regulatory framework. The former reduced the number of reserves in the system while the latter put a strain on the balance sheets of the large banks and dampened their ability to lend to the market. Under these conditions, when the liquidity needs are higher than usual, the securities dealers, who are the main demanders of cash in the repo market, face a liquidity crunch. In the process, they put upward pressure on repo rates. The problem is that the Fed tends to overlook the balance sheet constraints that the banks face when examining the current developments in the wholesale money market. Once taking balance sheet restrictions into account, a more structural solution might involve opening the Fed’s balance sheets to the securities dealers. 

To elaborate on this point, let us start by understanding the relationship between the interbank lending market and the repo market. The cash-rich lenders in the repo market are mostly hedge funds and other wholesale money managers, while the demanders for cash are securities dealers. The securities dealers use the repo market to finance their securities holdings while providing market-liquidity. Whenever the demand for cash is higher than its supply, banks enter the repo market to fill the gap by expanding their own balance sheet. Before the financial crisis, the banks used to finance these operations by using the Fed’s intraday credit facility and then settle these payments overnight by borrowing from other banks. After the crisis, banks stopped using these credit facilities to avoid being penalized by regulators. Regulatory requirements such as Liquidity Coverage Ratio (LCR), which requires banks to hold high-quality liquid assets, mostly reserves, limits the ability of large banks to engage in such operations due to the higher costs imposed on their balance sheets. 

At the same time, the Fed’s Tapering reduced the number of reserves that these large banks are holding as a whole. The combination of these factors reduced banks’ ability to enter the repo market and lend on margin whenever there is a shortage of liquidity. In these circumstances, it should not be surprising that these banks did not seize the arbitrage opportunity when the shock hit the repo market in September even though they seem to be rich in reserves. The Fed’s tendency to discount the balance sheet limitations that the banks face when studying the current events in the repo market might prove to be costly. The Fed’s “taper tantrum” has reduced the number of reserves in the system while the regulations have created balance sheets constraints for large banks, who are the lender of the near-last resort in the repo market. These balance sheet restrictions lead to liquidity problems for the rest of the system and especially the dealers.

In a market-based economy, where the price of capital and collateral depends on the state of market-liquidity, the survival of the financial market depends on well-functioning securities dealers. These dealers create market-liquidity by financing their securities position in the repo market. Therefore, if the securities dealers’ access to the funding-liquidity becomes uncertain or very expensive at times, it might endanger the whole financial system. To sum up, given the recent structural changes in the financial ecosystem and banks’ business models, it might be time for the Fed to think about more structural solutions, such as opening its balance sheet directly to the securities dealers. After all, it is not accidental that the Fed’s continuous liquidity injections have not been entirely successful in stabilizing the repo market considering that the large banks have minimal balance sheet space to channel these reserves.

Discussion Questions:

  1. What was the main source of financing for large banks before the financial crisis? Did it change after the crisis?
  2. Why do Basel III regulatory requirements want banks to hold more liquid assets?
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