Categories
Elham's Money View Blog

Is Monetary Policy Divorcing from Money Market and Uniting with Capital Market?

By Elham Saeidinezhad

“The pronouncements and actions of the Federal Reserve Board on monetary policy are a charade.” Fischer Black

As the US Department of Treasury builds the points along the yield curve, the bank reserves are losing relevance in explaining short-term money market rates’ behavior. Central banks assume that they can create a close link between the best form of money (reserve) and monetary policy. They use the supply of reserves precisely to achieve the target interest rate. Since the 2008-09 Great Financial Crisis (GFC), however, the relationship between money and monetary policy has become unstable. After the COVID-19 pandemic, for instance, the Fed’s actions more than doubled the supply of bank reserves, from approximately $1.5 trillion in March to more than $3 trillion in June. In theory, such a massive increase in the supply of reserves should reduce the money market rates. Yet, short-term money market rates have been surprisingly steady, despite the enormous increase in reserves during the great lockdown. Fed economists recognize the over-supply of short-term US Treasury bills (a money market instrument) as the leading cause of the puzzling behavior in money market rates and call it “friction.” 

However, for the Money View scholars, dividing the money market from the capital market, assuming that prices in each market are solely determined by its supply and demand flow, has never been an effective way of understanding interest rates. In the Money View world, similar to Fischer Black’s CAPM, the arbitrage condition implies that both the quantity and the price of money are ultimately determined by private dealers borrowing and lending activities that connect different markets rather than the stance of monetary policy alone. Dealers engage in “yield spread arbitrage,” in which they identify apparent mispricing (i.e., temporary fluctuations in supply or demand) at one segment of the yield curve, and takes a position. Dealers take “positions,” which means they speculate on how prices of assets with similar risk structure but different term-to-maturity, will change. In the meantime, they hedge interest rate exposures by taking an opposite position at another segment of the yield curve.

The point to emphasize is that short-term money markets and long-term capital markets are, in fact, not separate. As a result, prices in each market are not solely determined by the flow of supply and demand in that particular market. By taking advantage of the arbitrage opportunity, the dealers act as “porters” of liquidity from one market to another and connect prices in different markets in the process. The instruments that allow the dealers to transfer liquidity and solidify markets are repos and reverse repos, where capital market assets are used as collaterals to borrow from the money market, or vice versa. The Money View’s strength in understanding price dynamics comes from its ability, and willingness, to understand the dealers whose business connects different points of the yield curve and determines the effectiveness of the monetary policy.

During the COVID-19 pandemic, two separate but equally essential developments (aka distortions) occurred along the yield curve. In the long-term capital market, the Treasury has introduced a new class of safe assets, a 20-year Treasury bond, with a high yield (corresponding to the lowest accepted bid price) of 1.22 percent. Effectively, the US Treasury added a new point to the long-term end of the yield curve. In the short-term money market, the Fed injected a massive amount of reserves to reduce money market rates. The standard view suggests that such an increase in the supply of reserves would reduce the money market rates. The idea is that banks are the only institutions that hold these extra reserves. Due to balance sheet constraints, such as banks’ regulatory requirements, higher reserve holding implies higher banks’ costs. Therefore, banks reduce their short-term rates to signal their willingness to lend. In practice, however, short-term rates remained unchanged.

This dynamic in money market rates can be explained by the recent developments in the Treasury market, a segment of the capital market, and actions of the dealers who took advantage of the consequent arbitrage opportunity along the yield curve, i.e., the high spread between the short-term money market and the long-term risk-free Treasury rates. The dealers increased demand in the short-term money market both for hedging, and financing the newly issued Treasury bonds, put upward pressure on short-term rates. In contrast, the Fed’s activities put downward pressure on these rates. Observe that an increase in private demand for short-term funding (due to yield spread arbitrage) and an increase in the supply of reserves by the Fed (due to monetary policy) have opposing effects on short-term rates. Thus, it should not be surprising that despite the excessive reserve supply after the pandemic, the money market rates have remained stable. Understanding this kind of arbitrage along the yield curve is essential in understanding the behavior of short-term rates and the monetary policy’s effectiveness.

What is missing in this literature, but emphasized in the Money View framework, is acknowledging the hybridity between the money market and the capital market. The close link between the US Treasury market and the money market is a feature of the shadow banking or the new market-based finance. It is no friction. More importantly, the dealers’ search for “arbitrage” opportunities implies that individual securities markets are not separate. Speculators are joining the different markets into a single market. In doing so, they bring about a result that is no part of their intention, namely liquidity. As the Treasury creates an additional risk-free, liquid, point along the yield curve, it creates more arbitrage opportunities. Such developments make the yield curve an even more critical tool of examining the monetary policy effects. In the meantime, the traditional framework of supply and demand for bank reserves to control the short-term money market rate is losing its pertinence.

LINK TO ECONOMIC QUESTIONS

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

What Can Explain the Tale of Two FX Swap Rates in the Offshore Dollar Funding Market?

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

By Elham Saeidinezhad

Mary Stigum once said, “Don’t fight the Fed!” There is perhaps no better advice that someone can give to an investor than to heed these words.

After the COVID-19 crisis, most aspects of the dollar funding market have shown some bizarre developments. In particular, the LIBOR-OIS spread, which used to be the primary measure of the cost of dollar funding globally, is losing its relevance. This spread has been sidelined by the strong bond between the rivals, namely CP/CD ratio and the FX swap basis. The problem is that such a switch, if proved to be premature, could create uncertainty, rather than stability, in the financial market. The COVID-19 crisis has already mystified the relationship between these two key dollar funding rates – CP/CD and FX swap basis- in at least two ways. First, even though they should logically track each other tightly according to the arbitrage conditions, they diverged markedly during the pandemic episode. Second, an unusual anomaly had emerged in the FX swap markets, when the market signaled a US dollar premium and discount simultaneously.  For the scholars of Money View, these so-called anomalies are a legitimate child of the modern international monetary system where agents are disciplined, or rewarded, based on their position in the hierarchy. This hierarchy is created by the hand of God, aka the Fed, whose impact on nearly all financial assets and the money market, in particular, is so unmistakable. In this monetary system, a Darwinian inequality, which is determined by how close a country is to the sole issuer of the US dollar, the Fed, is an inherent quality of the system.

Most of these developments ultimately have their roots in dislocations in the banking system. At the heart of the issue is that a decade after the GFC, the private US Banks are still pulling back from supplying offshore dollar funding. Banks’ reluctance to lend has widened the LIBOR-OIS spread and made the Eurodollar market less attractive. Money market funds are filling the void and becoming the leading providers of dollar funding globally. Consequently, the CP/CD ratio, which measures the cost of borrowing from money market funds, has replaced a bank-centric, LIBOR-OIS spread and has become one of the primary indicators of offshore dollar funding costs.

The market for offshore dollar funding is also facing displacements on the demand side. International investors, including non-US banks, appear to utilize the FX swap market as the primary source of raising dollar funding. Traditionally, the bank-centric market for Eurodollar deposits was the one-stop-shop for these investors. Such a switch has made the FX swap basis, or “the basis,” another significant thermometer for calculating the cost of global dollar funding. This piece shows that this shift of reliance from banks to market-based finance to obtain dollar funding has created odd trends in the dollar funding costs.

Further, in the world of market-based finance, channeling dollars to non-banks is not straightforward as unlike banks, non-banks are not allowed to transact directly with the central bank. Even though the Fed started such a direct relationship through Money Market Mutual Fund Liquidity Facility or MMLF, the pandemic revealed that there are attendant difficulties, both in principle and in practice. Banks’ defiance to be stable providers of the dollar funding has created such irregularities in this market and difficulties for the central bankers.

The first peculiar trend in the global dollar funding is that the FX swap basis has continuously remained non-zero after the pandemic, defying the arbitrage condition. The FX swap basis is the difference between the dollar interest rate in the money market and the implied dollar interest rate from the FX swap market where someone borrows dollars by pledging another currency collateral. Arbitrage suggests that any differences between these two rates should be short-lived as there is always an arbitrageur, usually a carry trader, inclined to borrow from the market that offers a low rate and lend in the other market, where the rate is high. The carry trader will earn a nearly risk-free spread in the process. A negative (positive) basis means that borrowing dollars through FX swaps is more expensive (cheaper) than borrowing in the dollar money market.

Even so, the most significant irregularity in the FX swap markets had emerged when the market signaled a US dollar premium and a discount simultaneously.  The key to deciphering this complexity is to carefully examine the two interest rates that anchor FX swap pricing. The first component of the FX swap basis reflects the cost of raising dollar funding directly from the banks. In the international monetary system, not all banks are created equal. For the US banks who have direct access to the Fed’s liquidity facilities and a few other high-powered non-US banks, whose national central banks have swap lines with the Fed, the borrowing cost is close to a risk-free interest rate (OIS). At the same time, other non-US banks who do not have any access to the central bank’s dollar liquidity facilities should borrow from the unsecured Eurodollar market, and pay a higher rate, called LIBOR.

As a result, for corporations that do not have credit lines with the banks that are at the top of the hierarchy, borrowing from the banking system might be more expensive than the FX swap market. For these countries, the US dollar trades at a discount in the FX swap market. Contrarily, when banks finance their dollar lending activities at a risk-free rate, the OIS rate, borrowing from banks might be less more expensive for the firms. In this case, the US dollar trades at a premium in the FX swap market. To sum up, how connected, or disconnected, a country’s banking system is to the sole issuer of the dollar, i.e., the Fed, partially determines whether the US dollar funding is cheaper in the money market or the FX swap market.

The other crucial interest rate that anchors FX swap pricing and is at the heart of this anomaly in the FX swap market is the “implied US dollar interest rate in the FX swap market.”  This implied rate, as the name suggests, reflects the cost of obtaining dollar funding indirectly. In this case, the firms initially issue non-bank domestic money market instruments, such as commercial papers (CP) or certificates of deposits (CDs), to raise national currency and convert the proceeds to the US dollar. Commercial paper (CP) is a form of short-term unsecured debt commonly issued by banks and non-financial corporations and primarily held by prime money market funds (MMFs). Similarly, certificates of deposit (CDs) are unsecured debt instruments issued by banks and largely held by non-bank investors, including prime MMFs. Both instruments are important sources of funding for international firms, including non-US banks. The economic justification of this approach highly depends on the active presence of Money Market Funds (MMFs), and their ability and willingness, to purchase short-term money market instruments, such as CPs or CDs.

To elaborate on this point, let’s use an example. Let us assume that a Japanese firm wants to raise $750 million. The first strategy is to borrow dollars directly from a Japanese bank that has access to the global dollar funding market. Another competing strategy is to raise this money by issuing yen-denominated commercial paper, and then use those yens as collateral, and swap them for fixed-rate dollars of the same term. The latter approach is only economically viable if there are prime MMFs that are able and willing, to purchase that CP, or CD, that are issued by that firm, at a desirable rate. It also depends on FX swap dealers’ ability and willingness to use their balance sheet to find a party wanting to do the flip side of this swap. If for any reason these prime MMFs decide to withdraw from the CP or CD market, which has been the case after the COVID-19 crisis, then the cost of choosing this strategy to raise dollar funding is unequivocally high for this Japanese firm. This implies that the disruptions in the CP/CD markets, caused by the inability of the MMFs to be the major buyer in these markets, echo globally via the FX swap market.

On the other hand, if prime MMFs continue to supply liquidity by purchasing CPs, raising dollar funding indirectly via the FX swap market becomes an economically attractive solution for our Japanese firm. This is especially true when the regional banks cannot finance their offshore dollar lending activities at the OIS rate and ask for higher rates. In this case, rather than directly going to a bank, a borrower might raise national currency by issuing CP and swap the national currency into fixed-rate dollars in the FX swap market. Quite the contrary, if issuing short-term money market instruments in the domestic financial market is expensive, due to the withdrawal of MMFs from this market, for instance, the investors in that particular region might find the banking system the only viable option to obtain dollar funding even when the bank rates are high. For such countries, the high cost of bank-lending, and the shortage of bank-centric dollar funding, is an essential threat to the monetary stability of the firms, and the domestic monetary system as a whole.

After the COVID-19 crisis, it is like a tug of war emerged between OIS rates and the LIBORs as to which type of interest rate that anchor FX swap pricing. Following the pandemic, the LIBOR-OIS spread widened significantly and this war was intensified. Money View declares the winner, even before the war ends, to be the bankers, and non-bankers, who have direct, or at least secure path to the Fed’s balance sheet. Marcy Stigum, in her seminal book, made it clear not to fight the Fed and emphasized the powerful role of the Federal Reserve in the monetary system! Time and time again, investors have learned that it is fruitless to ignore the Fed’s powerful influence. Yet, some authors put little effort into trying to gain a better understanding of this powerful institution. They see the Fed as too complex, secretive, and mysterious to be readily understood. This list does not include Money View scholars. In the Money View framework, the US banks that have access to the Fed’s balance sheet are at the highest layer of the private banking hierarchy. Following them are a few non-US banks that have indirect access to the Fed’s swap lines through their national central bank. For the rest of the world, having access to the world reserve currency only depends on the mercy of the Gods.

link to economic questions
Categories
Elham's Money View Blog Search For Stable Liquidity Providers Series

What Exactly is the Function of Banks if They are (also) Absent from the Wholesale Money Market? In Search of More Stable Liquidity Providers

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

By Elham Saeidinezhad

The COVID-19 crisis has revealed the resiliency of the banking system compared to the Great Financial Crisis (GFC). At the same time, it also put banks’ absence from typically bank-centric markets on display. Banks have already demonstrated their objection to passing credit to small-and-medium enterprises (SMEs). In doing so, they rejected their traditional role as financial intermediaries for the retail depositors. This phenomenon is not surprising for scholars of “Money View”. The rise of market-based finance coincides with the fading role of banks as financial intermediaries. Money View asserts that banks have switched their business model to become the lenders and dealers in the interbank lending and the repo market, both wholesale markets, respectively. Banks lend to each other via the interbank lending market and use the proceeds to make a market in funding liquidity via the repo market.

Aftermath the COVID-19 crisis, however, an episode in the market for term funding cast a dark shadow over such doctrine. The issue is that it appears that interbank lending no longer serves as the significant marginal source of term funding for banks. Money Market Funds (MMFs) filled the void in other wholesale money markets, such as markets for commercial paper and the repo market. After the pandemic, MMFs curtailed their repo lending, both with dealers and in the cleared repo segment, to accommodate outflows. This decision by MMFs increased the cost of term dollar funding in the wholesale money market. This distortion was contained only when the Fed directly assisted MMFs through Money Market Mutual Fund Liquidity Facility or MMLF. Money View emphasizes the unique role of banks in the liquidity hierarchy since their liabilities (bank deposits) are a means of payment. Yet, such developments call into question the exact role of banks, who have unique access to the Fed’s balance sheet, in the financial system. Some scholars warned that instruments, such as the repo, suck out liquidity when it most needed. A deeper look might reveal that it is not money market instruments that are at fault for creating liquidity issues but the inconsistency between the banks’ perceived, and actual significance, as providers of liquidity during a crisis.

There are two kinds of MMFs: prime and government. The former issue shares as their liabilities and hold corporate bonds as their assets while the latter use the shares to finance their holding of safe government debts. By construction, the shares have the same risk structure as the underlying pool of government bonds or corporate bonds. In doing so, the MMFs act as a form of financial intermediaries. However, this kind of intermediation is different from a classic, textbook, one. MMFs mainly use diversification to pool risk and not so much to transform it. Traditional financial intermediaries, on the other hand, use their balance sheet to transform risk- they turn liquid liabilities (overnight checkable deposits) into illiquid assets (long term loans). There is some liquidity benefit for the mutual fund shareholder from diversification. But such a business model implies that MMFs have to keep cash or lines of credit, which reduces their return. 

To improve the profit margin, MMFs have also become active providers of liquidity in the market for term funding, using instruments such as commercial paper (CP) and the repo. Commercial paper (CP) is an unsecured promissory note with a fixed maturity, usually three months. The issuer, mostly banks and non-financial institutions, promises to pay the buyer some fixed amount on some future date but pledges no assets, only her liquidity and established earning power, guaranteeing that promise. Investment companies, principally money funds and mutual funds, are the single biggest class of investors in commercial paper. Similarly, MMFs are also active in the repo market. They usually lend cash to the repo market, both through dealers and cleared repo segments. At its early stages, the CP market was a local market that tended, by investment banking standards, to be populated by less sophisticated, less intense, less motivated people. Also, MMFs were just one of several essential players in the repo market. The COVID-19 crisis, however, revealed a structural change in both markets, where MMFs have become the primary providers of dollar funding to banks.

It all started when the pandemic forced the MMFs to readjust their portfolio to meet their cash outflow commitments. In the CP market, MMFs reduced their holding of CP in favor of holding risk-free assets such as government securities. In the repo market, they curtailed their repo lending both to dealers and in the cleared segment of the market. Originally, such developments were not considered a threat to financial stability. In this market, banks were regarded as the primary providers of dollar funding. The models of market-based finance, such as the one provided by Money View framework, tend to highlight banks’ function as dealers in the wholesale money market, and the main providers of funding liquidity. In these models, banks set the price of funding liquidity and earn an inside spread. Banks borrow from the interbank lending market and pay an overnight rate. They then lend the proceeds in the term-funding market (mostly through repo), and earn term rate. Further, more traditional models of bank-based financial systems depict banks as financial intermediaries between depositors and borrowers. Regardless of which model to trust, since the pandemic did not create significant disturbances in the banking system, it was expected that the banks would pick up the slack quickly after MMFs retracted from the market.

The problem is that the coronavirus casts doubt on both models, and highlights the shadowy role of banks in providing funding liquidity. The experience with the PPP loans to SMEs shows that banks are no longer traditional financial intermediaries in the retail money market. At the same time, the developments in the wholesale money market demonstrate that it is MMFs, and no longer banks, who are the primary providers of term funding and determine the price of dollar funding. A possible explanation could be that on the one hand, banks have difficulty raising overnight funding via the interbank lending market. On the other hand, their balance sheet constraints discourage them from performing their function as money market dealers and supply term funding to the rest of the financial system. The bottom line is that the pandemic has revealed that MMFs, rather than large banks, had become vital providers of US dollar funding for other banks and non-bank financial institutions. Such discoveries emphasize the instability of funding liquidity in bank-centric wholesale and retail money markets.

The withdrawals of MMFs from providing term funding to banks in the CP markets, and their decision to decease their reverse repo positions (lending cash against Treasuries as collateral) with dealers (mostly large banks), translated into a persistent increase of US dollar funding costs globally. Even though it was not surprising in the beginning to see a tension in the wholesale money market due to the withdrawal of the MMFs, the Fed was stunned by the extent of the turbulences. This is what caused the Fed to start filling the void that was created by MMFs’ withdrawal directly by creating new facilities such as MMLF. According to the BIS data, by mid-March, the cost of borrowing US funding widened to levels second only to those during the GFC even though, unlike the GFC, the banking system was not the primary source of distress. A key reason is that MMFs have come to play an essential role in determining US dollar funding both in a secured repo market and an unsecured CP market. In other words, interbank lending no longer serves as a significant source of funding for banks. Instead, non-bank institutional investors such as MMFs constitute the most critical wholesale funding providers for banks. The strength of MMFs, not the large, cash-rich, banks, has, therefore, become an essential measure of bank funding conditions. 

The wide swings in dollar funding costs, caused by MMFs’ withdrawal from these markets, hampered the transmission of the Fed’s rate cuts and other facilities aimed at providing stimulus to the economy in the face of the shock. With banks’ capacity as dealers were impaired, and MMFs role was diminished, the Fed took over this function of dealer of last resort in the wholesale money market. Interestingly, the Fed acted as a dealer of last resort via its MMLF facility rather than assuming the role of banks in this market. The goal was to put an explicit floor on the CP’s price and then directly purchase three-month CP from issuers via Commercial Paper Funding Facility (CPFF). These operations also have broader implications for the future of central bank financial policies that might include MMFs rather than banks. The Fed’s choice of policies aftermath the pandemic was the unofficial acknowledgment that it is MMFs’ role, rather than banks’, that has become a crucial barometer for measuring the health of the market for dollar funding. Such revelation demands us to ask a delicate question of what precisely the banks’ function has become in the modern financial system. In other words, is it justifiable to keep providing the exclusive privilege of having access to the central bank’s balance sheet to the banks?

link to economic questions
Categories
Elham's Money View Blog

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.

link to economic questions
Categories
Elham's Money View Blog

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.

Categories
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. 

Categories
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.

link to economic questions website
Categories
Elham's Money View Blog

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.

LINK TO ECONOMIC QUESTIONS
Categories
Elham's Money View Blog

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.

link to economic questions
Categories
Elham's Money View Blog

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
link to economic questions