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

By Elham Saeidinezhad

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

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

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

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

Discussion Questions:

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

By Elham Saeidinezhad

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

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

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

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

Discussion Questions:

  1. Which regulatory requirements have constrained the ability of the banks to lend to the repo market?
  2. What does the lender of near last resort mean?
  3. Who are the main players in the shadow banking system?
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Should the Fed Open its Balance Sheet to the Securities Dealers? A Lesson from the Recent Wild Swings in the Repo Rate

By Elham Saeidinezhad

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

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

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

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

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

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

Discussion Questions:

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

By Elham Saeidinezhad

“No matter how much suffering you went through, you never wanted to let go of those memories.”
― Haruki Murakami

Following the Global Financial Crisis (GFC), most central banks around the world are facing pressing challenges to reach the inflation target. Most recently, for example, Bank of Japan’s Governor Kuroda warned against threats to price stability and added more pointed language about a possible interest-rate cut. He promised to keep a close watch on the inflation target. As a result, the views are quietly shifting from targeting an inflation level to alternative approaches such as “average inflation targeting.” The more fundamental issue, however, is the fact that the target has never been sustainably achieved even though it has been in place since 2012. Against this backdrop, this is the right moment to steer the debate away from how to reach the 2 percent inflation target towards why we continuously fail to do so. Inflation targeting, enabled by Taylor Rule and based on rational expectations hypothesis, assumes that the public announcement of a medium-term target for inflation shapes the expectations of the future price level. However, once accounting for the financialization of modern economies, it becomes clear that it is not central banks’ abilities to form inflation expectations, but the extent of their influences on securities prices, that equip them to stabilize price levels. Nonetheless, central banks’ magic power to affect inflation might have mostly vanished.

To elaborate on this point, let’s start by defining inflation targeting and its premises. Inflation targeting is a monetary policy framework that aims at getting inflation to 2 percent and recognizes the readings above and below as universally undesirable. The structure that allows central banks to achieve the target is called “Taylor Rule,”- a principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate. The premise of this model is that central banks adjust the short-term interest rate and the quantity of reserves in the inter-bank lending market to influence components of the real economy, such as investment, trade balance, and consumption on residential housing through different channels. These channels are called “monetary transmission mechanisms” collectively and their ultimate goal is to achieve price and output stability.  This structure used to work in the old times when banks used reserves as a primary source of funding to lend to the real economy.

Today, arguably, we are living in a market liquidity system where most of the expenditures in the economy are financed in the capital market through a process known as “securitization.” In these circumstances, when the central bank changes the short-term interest rate and alters the spread between the overnight rate and the term rate, it effectively influences the incentives for dealers in both the money market and the capital market. The money market dealers establish the price of funding liquidity while the securities dealers determine the price of capital, including mortgage-backed securities (MBS). When the central bank increases the rates, it tightens the spread for money market dealers. In response, money market dealers increase the term interest rates and make it more expensive for securities dealers to finance their inventories. This process puts downward pressure on securities prices, including the price of MBS, which in turn increases the interest rates on the underlying loans such as mortgage and auto loans. Measuring the strength of these effects on the prices of the corresponding assets such as houses is notoriously difficult. To conclude, in modern economies, the interest rates on bank loans in most cases are not determined in the overnight domestic money market, where the central bank is the dominant player, but the global capital market. Thus, it is not the ability of monetary authorities to change inflation expectations, but the extent of their effect on securities prices that asset price stability. To retrieve their strength to influence the economy, central banks should start by fixing their understanding of the transmission structure of the monetary policy. Even so, central banks’ magic to affect the price level might have gone for the most part.

Discussion Questions:

  1. What is the main intellectual obstacle in fully understanding the extent of central banks’ power to influence price level?
  2. How are mortgage rates determined in advanced economies such as the U.S.?
  3. What is the main premise of Taylor Rule and Inflation Targeting?
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Central Counterparties: When Monetary Policy is Not Enough

By Elham Saeidinezhad

The overall picture of the U.S. economy, though far from stable, is hardly threatening. For instance, U.S. payrolls grew by 128,000 in October. Nevertheless, the Fed cut the interest rate for the third consecutive quarter in late October. The turmoil in the repo market in September seems to be a significant stressor for the Fed. The Fed started to add large amounts of liquidity to markets about seven weeks ago after repo markets faced a shortage of money that sent short-term borrowing rates soaring. The Fed’s focus has been on loosening credit conditions in the market for short-term funding. However, these measures might not be enough to save all systemically important financial institutions in this market, including clearinghouses (known as CCPs) that clear repo contracts, from becoming illiquid.

The least well-understood effects of the recent instabilities in the repo market are on the CCPs. Fixed-income financing, also known as a repo, is a type of short-term funding in which the counterparties, usually securities dealers, borrows cash by posting collateral. After the financial crisis, regulators required repo transactions between dealers to be centrally cleared through CCPs. Consequently, the risk concentration within CCPs has grown dramatically. In a typical cleared repo trade, a CCP would borrow $100 from a cash-rich lender (e.g., a money market fund) and then on-lend the proceeds to a cash borrower (e.g., a securities dealer) in exchange for collateral. As part of this, the CCP would have to put up its own capital against $100 of repo exposure. During a liquidity crunch, when cash is scarce and rates are high, cash borrowers, including securities dealers who do not have access to the Fed’s balance sheets, are more likely to default. A cascade of such defaults can make CCPs illiquid even though the collaterals should help CCPs to remain solvent at least at the beginning of the liquidity spiral.

At the heart of this problem is the simple fact that securities dealers are both the cash borrowers in the repo market and the providers of market liquidity. As the matter of Lehman-Brothers revealed, securities dealers’ ability to continue providing market liquidity vastly depends on their access to funding liquidity or cash. The vanishing market liquidity would compromise CCPs’ financial positions during the financial crisis. In the case of systematic defaults, CCPs can sell the collaterals to protect their capital. In the process, they might become illiquid for at least two reasons: first, if the dealers stop making the market, which is the case during the financial crisis, CCPs might not be able to sell these collaterals quickly enough to pay back the original loans. Second, the sale of the collaterals could lead to a phenomenon known as “firesale” which involves selling these assets at hugely discounted prices. CCP’s temporary cash flow problems could create a permanent solvency crisis if they cannot sell the collaterals cheaply, quickly, and without changing the market price.

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Is Libra Money? Depends on Where in Credit Cycle We Are

By Elham Saeidinezhad

“What institutions build, they can destroy.” Anonymous

Mark Zuckerberg’s testimony to Congress on October 24th, 2019, created anxieties on whether Facebook would circumvent financial regulators as it readies its planned cryptocurrency, Libra. This concern by policymakers was logical, given the magnitude of the 2008-09 global financial crisis and its effects on the international monetary system. The company’s promise to move forward with Libra only when they had explicit approval from all U.S. financial regulators seem to calm some of those fears. However, a more fundamental enigma at the heart of Libra is a classical puzzle in monetary economics of what is the nature of “money” and its relationship with the payment system. When examining Libra, we have too often overlooked the fact that although the medium of exchange and the means of payments coincide with each other when the financial condition is stable, they are not the same. In doing so, we have lost some valuable insights into Libra’s state during a financial crisis.

To shed some light on this mystery, let’s start by focusing on the technical definition of the monetary system, which is money plus the settlement mechanisms to execute payments. In mainstream economic literature, the focus is totally on money and its role as a “medium of exchange.” Therefore, as long as people “trust” Libra and use it to purchase goods and services, the monetary system should work seamlessly. During economic and credit expansion, when the financial market is elastic, mainstream interpretation of the monetary system seems to work. The problem is that during the financial crisis, guaranteeing this trust is a complicated task. Under these circumstances, the precondition for a well-functioning monetary system is the trust that payments will be executed, and the object functioning as a medium of exchange is convertible to the means of final payments.

This condition has substantial implications for the position of Libra in the future financial crisis.  On the one hand, alongside regulatory agencies, central banks’ role in backstopping the payment system becomes critical in securing convertibility and trust. On the other hand, Libra is a decentralized currency that is issued by private entities. Therefore, when confidence evaporates in the financial market, it is very likely that Libra cannot be converted to the means of final payments unless it receives a public bailout. The hiccup is that in the process of understanding Libra as a form of money, we have too often ignored the more intangible aspect of the monetary system- the payment system. The danger is that the public will pay the bill.

Discussion Questions:

  1. In your opinion, why do standard economic theories tend to overlook payment systems in their models?
  2. What is the prerequisite for Libra to continue its function as a currency when a severe financial crisis hit the economy?
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Quantitative Easing: No Words to Describe It

By Elham Saeidinezhad

“Words have no power to impress the mind without the exquisite horror of their reality.” – Edgar Allan Poe

The experience of the global financial crisis (GFC) was a painful reminder that central banks were not equipped to save the modern financial markets from failing. To this end, the Fed reimagined its role by employing “unconventional tools” to restore market liquidity and stopping the freefall. While the Fed used to flush the banking system with liquidity in earlier crises, it was engaged in the outright purchases of long-term government bonds and mortgage-backed securities (MBS) during the GFC. This procedure was later known as ‘’Quantitative Easing” or QE. Similarly, to respond to the most recent turbulences in the repo market, the Fed has started the same kind of operations by purchasing short-dated government bills from September. The difference, however, is their resistance to label this procedure as a QE.

The experience of the global financial crisis (GFC) was a painful reminder that central banks were not equipped to save the modern financial markets from failing. To this end, the Fed reimagined its role by employing “unconventional tools” to restore market liquidity and stopping the freefall. While the Fed used to flush the banking system with liquidity in earlier crises, it was engaged in the outright purchases of long-term government bonds and mortgage-backed securities (MBS) during the GFC. This procedure was later known as ‘’Quantitative Easing” or QE. Similarly, to respond to the most recent turbulences in the repo market, the Fed has started the same kind of operations by purchasing short-dated government bills from September. The difference, however, is their resistance to label this procedure as a QE.

Regardless of whether or not to call it a QE, the seismic shift in the Fed’s role away from being a lender of last resort to the banks towards the dealer of last resort in the capital market continues a decade after the GFC. This new role of the Fed reflects the evolving nature of the financial market where liquidity provision has shifted from the business model of the large banks to nonbanks. These nonbanks, who are collectively known as ‘’shadow banking system,” are mostly dealers who are financing their long term investments in the capital market by borrowing in the wholesale money market using short term instruments such as repo.

Capturing this evolution is a welcome development in the world of central banking. The point is that QE is a new normal way of executing monetary policy and is better-adjusted to deal with fluctuations in the financial system. Against this background, it seems like we have to start calling the asset-purchasing program of the Fed what it is: a permanent tool of implementing monetary policy. This task of reimaging central banking has been long overdue, and QE is a first step in the right direction. Besides, it is here to stay.

Discussion Questions:

1. What is the main difference between the Fed’s QE and the new round of asset purchasing program?

2. Do you think the Fed should react to liquidity problems outside the traditional banking system?

3. Do you think the growth of the shadow banking system in the financial market should be curbed using financial regulations?

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About Me

Elham Saeidinezhad, Ph.D.

I am a Term Assistant Professor of Economics at Barnard College, Columbia University. I also teach “The Financial System,” also called modern Money and Banking, at Economics Department, NYU Stern. In addition to my teaching commitments, I am a “Market Structure Research Fellow” at Jain Family Institute. In this fellowship, I examine the research from major financial institutions, monitor the shifts in financial market structures, and write about their implications for financial stability and the future of central banking. In the world of online teaching platforms, I can be found as an instructor for the “Introduction to Macroeconomics” course at the Outlier where I teach three chapters on International Finance, Economics of Money and Credit, and Central Banking.

Before joining Barnard College, I have been a lecturer of Economics at the UCLA  Economics Department, a research economist in the International Finance and Macroeconomics research group at Milken Institute, Santa Monica, and a postdoctoral fellow at the Institute for New Economic Thinking (INET), New York. I supervised undergraduate students and taught Money and Banking, Macroeconomic Theory, and Monetary Economics at UCLA. At Milken Institute, I investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. As a postdoctoral fellow, I worked closely with Prof. Perry Mehrling and studied his “Money View,” a framework that examines the realities of the modern monetary system based on the models of market microstructure. The central focus of the framework is liquidity. I obtained my Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013.

My recent research lies at the intersection of Monetary Theory, and Financial Economics, with particular attention to liquidity and financial engineering. My research design is to apply the Money View, which synthesizes the modern features of our monetary and financial system, to examine the evolution of the financial market. I also write a weekly Money View Column for the Institute for New Economic Thinking (INET) Economic Questions website. Moreover, I love teaching, and I love my students. I teach courses such as Monetary Economics, Central Banking, Money and Banking, Financial Economics, Microeconomics, and Macroeconomics. I am excited about educating my students and debating ideas with them. I believe I have learned more from my students than from anyone else.

I can be reached via email <elham.saeidinezhad@gmail.com> , <esaeidin@barnard.edu>, <elham.saeidinezhad@stern.nyu.edu> , <elham.saeidinezhad@jfiresearch.org>, LinkedIn and Twitter <@elham_saeidi>

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