Tag: Derivatives

Elham's Money View Blog Hot Spots and Hedges

Banks as Alternative Investment Funds?

Post author By Elham Saeidinezhad
Post date April 1, 2023

By Elham Saeidinezhad

This piece is published initially in Phenomenal World Publications.

Executive Summary

In this piece, I examine SVB’s business model as a model of modern commercial banking. SVB has failed, but its business model will be reincarnated as modern banking. So, what would be modern commercial banking?

Liability Management

– The nature of depositors in large commercial banks shifts from uninformed to informed, such as fund managers.

– Bank’s behavior makes deposit-taking activity into a Ponzi scheme than traditional banking.

Asset Management

– Traditional bank loans to businesses will die. Instead, the banks lend to alternative investment managers themselves through financial engineering methods such as “subscription lines.” This makes banks an investor in the PE world rather than a creditor.

– This business is not that lucrative unless the fund managers default and bankers become the de-facto investors.

– Nonetheless, the loan directly to fund managers and the resulting relationship with them brings a stream of large deposits to such banks, hence the Ponzi.

– Banks invest heavily in fixed-income securities. Nonetheless, the investment strategy is not based on holding safe assets but on following hedge funds’ trading strategies, such as “fixed-income arbitrage.”

-In other words, banks’ investment in fixed-income and hedging strategies will be a bet on the arbitrage opportunities implied in the interest rate term structure. In doing so, they become excessively exposed to interest rate risk.

Vulnerabilities/Structural Shifts

– Lots of unknown ones.

– It will be the death of “Held-to-Maturity” accounting and the birth of “marked-to-market” ones.

-Informed investors keep mark to market banks’ assets and become ultrasensitive to interest rate risks and unrealized losses.

-In other words, banks will become a mixture of investment funds, such as hedge funds and PE funds, but with public support.

Introduction

Silicon Valley Bank’s (SVB) short lifespan—from October 17, 1983 to March 10, 2023—has been witness to crucial transformations in the world of modern banking. The bank’s collapse has sparked wide ranging reflections on the roots of the crisis, the utility of government bailouts, and appropriate responses. I identify two crucial shifts in the banking system exemplified by the Bank’s fall. On the liability side of SVB’s balance sheets, the shift from uninformed to informed depositors renders hedging against interest rate risk more critical. On the asset side, a strategy of “fixed income arbitrage” means that regional banks fell into similar difficulties as hedge funds—one in which low profits rendered betting on the shape of the yield curve too expensive to maintain.

From uninformed to informed investor

Among a number of channels, the crisis has been interpreted according to the classic Diamond-Dybvig Model. This model assumes that depositors in a particular bank are uninformed: as long as they do not reach the $250,000 threshold, they do not distinguish between depositing money in a bank and buying treasuries, given that both investments are backed by the government. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. Driven by “animal spirit” rather than the details of financial statements, they are capable of generating a run on the bank based on “any” worries, imaginary or real. The surest way to stop a bank run, the model thus argues, is through deposit insurance, which stabilizes investor confidence.

However, recent events deviated significantly from these expectations. Rather than being motivated by a herd driven shift in “animal spirits,” the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks were informed. Even prior to the run, they were known to extensively tweet about each detail and footnote in the financial statements of their bankers. In the case of SVB, for instance, they examined the bank’s balance sheet and “marked to market” its assets, revealing its exposure to interest rate risk. When the bank reported virtually no interest rate hedges on its massive bond portfolio, investors depositors instigated a bank run.

This distinction between traditional, uninformed depositors and modern, informed ones reflects a revolution in the structure of contemporary banking. In the first phase of this structural change, which took place during the 1950s, “retail” depositors were replaced by “institutional” ones such as pension funds. Though institutional investors injected far greater amounts of cash, they ultimately remained uninformed. They cared little about the financial condition and balance sheets of the banks that received their deposits, and instead prioritized the rate available on an FDIC-insured deposit. So long as they did not breach the $250,000 limit, putting money in a bank appeared as safe as buying Treasuries—particularly given that both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, were flooded with money so long as they posted attractive rates.

With the strengthening of liquidity ratios in the aftermath of 2008, systemically important financial institutions like JPMorgan Chase, Credit Suisse, and Bank of America increasingly transformed into market makers in wholesale money markets, buying and selling securities for their own accounts and thereby minimizing their deposit-taking activity. Liquidity requirements like liquidity coverage ratio (LCR) required banks to have enough high-quality liquid assets to survive thirty days of deposit outflows in a stress scenario. In doing so, they rendered short-term deposits, and the illiquid assets they fund, less appealing.

Big banks coped with these liquidity requirements by reducing deposit-taking activities, leaving medium-sized and large regional banks to pick up the slack. These banks sought to compensate for greater deposit-taking through other financial pursuits. In particular, they were betting on higher returns and attracting new deposits from a piece of financial engineering known as “fund subscription lines.” These credit facilities were different from a traditional business loan on three main fronts. First, a subscription line is a loan to venture capitalists (VC) and private equity fund managers themselves rather than the actual businesses. Second, unlike traditional corporate loans that use the firms’ assets as collaterals, subscription lines are secured against unfounded capital commitments by private equity investors. Finally, banks anticipate returns not through interest accrual but capital gains once the investment is finalized. In other words, subscription lines transformed regional banks into private equity investors rather than creditors.

Subscription lines appealed to venture capital and private equity because they enabled them to manage their cash flows and increase the internal rate of returns on their investments without issuing a capital call to their investors. As such, they increasingly constituted the primary clientele for subscription lines. While big banks fundamentally altered the market-making business, large regional banks’ changed the banking and deposit-taking world. On the liability side, the current banking era started with the “death of the retail deposits.” On the asset side, the trend continued with the death of traditional loans. Instead, VCs and startup depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities. In this environment, regional banks, such as SVB, used Ponzi-like schemes, such as the fund subscription lines, to maintain the steady stream of deposits and become a stakeholder in the alternative investment world.

Marcy Stigum called this the “death of loans” in the late 1970s. This shift transformed banks’ asset management beyond their embrace of subscription lines. SVB and other specialized banks that served informed depositors practically eliminated their loan-giving activity. Lacking fixed assets or recurring cash flows, startups, and crypto investors were less reliable corporate borrowers. But more importantly, these customers did not need loans—equity investors provided them with a constant supply of cash. Consequently, banks shift their operations from issuing loans to purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

The shifts in the nature of depositors, from uninformed to informed, and the assets-liabilities management of banks contributed to the current banking mania. As a result of the large-scale addition of long-term bonds backed by the US government to banks’ portfolios, these specialized banks are unusually exposed to “interest-rate risk.” While most banks earn a higher interest on their loans during interest rate hikes, banks like SVB and Signature are stuck with long-duration bonds whose value goes down as rates go up. Every bank borrows short to lend long, but many banks ultimately strike a balance. Moreover, informed depositors continuously pay attention to the financial statements and footnotes of the banks in which they deposit. As a result, they constantly “mark to market” the banks’ financial assets and penalize them whenever the fair value of their assets is at a loss.

A brief example demonstrates the systemic importance of this point. Let us assume that a bank has $100 worth of deposits as its liabilities. On the asset side, the bank uses cash to purchase a government bond worth $100. In the meantime, the Fed announces a rate hike from 0 percent to 2 percent. A traditional depositor would account for the bank’s assets “at cost,” using the price the bank paid to purchase those bonds, in this case, $100. This is especially true if the bank has announced that these assets are intended to be “held to maturity.” An informed depositor, by contrast, continuously “marks to market” the value of the bank’s assets. In this case, they account for the value of the bonds at their fair market value. When interest rates go up, this value falls: if a bond is issued with a 5 percent coupon and the market rate rises to 8 percent, demand for the 5 percent bond declines. Consequently, its price must fall until its expected return matches the competitive return of 8 percent. Informed depositors know this—if the bank has a bond with a face value of $100, they will check the market price for that bond when the Fed announces its interest rate policy. If, for instance, it is $97, then the bank’s asset is only worth $97 on its balance sheet. The other $3 is gone, and the bank is considered insolvent. Informed depositors notice—they write long tweet threads, initiating a bank run. In doing so, they heighten the bank’s exposure to interest rate risks, particularly if the bank is invested in fixed-income securities, such as government bonds.

Fortunately, this shift also opens up new directions for bank run management: interest rate hedges. Often in the form of swaps, this financial instrument effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. Once available for sale, the value of outstanding bonds can be protected if combined with interest rate hedges like swaps. Swaps transform the nature of an asset by converting a fixed-income investment into a floating-rate one and vice versa.

Consider SVB in our earlier example. A proper swap could transform SVB’s bonds earning a fixed interest rate into an asset earning a floating interest rate. Suppose SVB owned $100 million in bonds that will provide 3.2 percent for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup, and enters into a swap where it pays the fixed rate (3.2 percent) and receives floating plus 0.1 percent. Its position would then have three sets of cash flows: it receives 3.2 percent from the bonds, and the floating rate under the terms of the swap, and pays 3.2 percent under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1 percent percent (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2 percent into assets earning the floating rate plus 10 basis points.

The real question underpinning the current crisis then, is why SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. On the contrary, its year-end financial report notes that it terminated or let expire rate hedges on more than $14 billion of securities throughout the year. The US government’s offer of unlimited deposit insurance has failed to calm markets, in part because it assumes the uninformed depositor behavior characteristic of the Diamond-Dybvig Model. But in reality, the banking world has changed: well-informed depositors treat their deposits as an investment vehicle. In this new financial reality, bank runs may be better dealt with using a proper hedging strategy. Strangely, the crisis teaches us that the current regional banking market structure may be better served by a private risk-management solution, available through the derivative markets.

Regional banks as the new hedge funds

The hedge fund crisis of 1998 offers a blueprint for understanding regional banks’ asset-liability management today. At the time, funds like Long Term Capital Management (LTCM) relied on a very popular, and very painful, strategy known as “fixed-income arbitrage.” This strategy uses the model of the term structure of interest rate (yield curve) to identify and exploit “mispricing” among fixed-income securities.

For instance, let us assume that the firm’s reading of the Fed is that the central bank pivots toward cutting rates sooner than the market expects. In this case, the firm’s models show a yield curve below the market yield curve. The difference between these two is the so-called “mispricing.” In this environment, when rates are expected to fall, the fixed-income securities gain in value, justifying the purchase of government-backed securities like Treasuries and mortgage-backed securities. Nonetheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund enters an interest rate swap (IRS) and becomes a fixed-payer and floating-receiver. If the hedge fund’s prediction is correct, the IRS will generate slight cash outflows for the fund. In this case, the floating rate (determining the value of the fund’s cash inflow) would fall while the fixed rate (setting the cash outflow value) would remain unchanged. Most importantly, the fixed-income securities’ capital gain would compensate for the slight fall in the value of the IRS. Alternatively, if the hedge fund’s bet was wrong and rates increased instead, the IRS value would rise and neutralize the loss in the fixed-income securities’ fair value. Fixed-income arbitrage has its roots in the fixed-income trading desks of most brokerage houses and investment banks.

As LTCM’s failure showed, the strategy contains critical vulnerabilities. First, profits generated through fixed-income arbitrage transactions are often so small that managers have to use substantial leverage to generate significant levels of return for the fund. As a result, even a slight movement in the interest rate in the wrong direction could make hedging too expensive to be maintained. With small profit margins and greater exposure to interest rate movement, fixed-income arbitrage has been described as “picking up nickels in front of a steamroller.”

There are many reasons to think SVB’s business model has come to resemble that of hedge funds. Unlike the traditional model of deposit taking, SVB invested most deposits in fixed-income securities. Of its $190 billion in deposits, it had invested $120 billion into Treasury and agency mortgage-backed securities. Conscious of the limitations of fixed-income arbitrage, SVB’s managers suddenly dropped the interest rate hedges without providing reasonable economic justifications in mid-2022. But attributing this decision to poor risk management can be misleading. SVB’s decision to liquidate the swap positions coincided with a shift in the market consensus on the Fed—towards the perspective that the Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. The shift made it too expensive to bet on the fall in interest rates.

But this strategy becomes even more dangerous in the hands of a bank. Whereas a hedge fund can lock up liquidity and ensure investors do not run, banks can only pressure government insurance schemes or threaten the stability of the financial system. While hedge funds can impose momentary lock-up periods, bank restrictions on deposits access generate a broader banking crisis. Finally, hedge funds can employ redemption notices which require investors to give weeks or months of notice before redeeming funds, thereby enabling investment in illiquid, high-return assets.

The transformation of banks into hedge funds thus bears enormous implications for financial stability. Their investment strategies are yet to be identified by regulators—so long as deposits flow into the regional bank, it can maintain its hedges. But unlike hedge funds, which are expected to periodically disappear, banks are meant to serve a public function, have a government backstop, and occupy a vital role in the financial system. For the sake of financial stability, they should not be engaging in a short-term, high risk, and high profit business model.

Through the shift to informed investors, and the utilization of hedge fund investment practices, the SVB crisis holds significant consequences for the structure of contemporary banking, and the tools available to prevent future collapse.

Tags Banking Crisis, Banks, Derivatives, Hedge Funds, Interest Rate, Money View, Private Equities, SVB

Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #2: Has March 2023 Banking Crisis Exposed Interest Rate Risk as the New Liquidity Risk?

Post author By Elham Saeidinezhad
Post date March 21, 2023

“Street Speaks in Swap Land” — Marcy Stigum

The collapse of Silicon Valley Bank (SVB), and its aftermaths, in March 2023, showed a structural change in the business model and the risk structure of deposit-taking institutions. In 2008, Great Financial Crisis (GFC) revealed that the banking system’s balance sheets are ingrained with liquidity risk. Bankers borrowed in the short-term, liquid money markets to invest in long-term illiquid assets with high yields. In contrast, the March 2023 crisis showed that deposit-taking institutions had shifted their gear towards investing in liquid assets such as government bonds. In doing so, they have become hedge funds in disguise. Nonetheless, instead of noticing such changes in banking structure, regulators assessed commercial banks based on the lessons of the GFC. They were considered safe as long as they had healthy liquidity and leverage ratios and were funded by deposits. By over-relying on the lessons of the GFC, the regulators and bankers’ risk managers alike disregarded a risk that every hedge fund manager and fixed-income investor is alerted by: interest rate risk.

Interest rate risk was disregarded in the narrative of financial stability. Moreover, GFC was partially to blame. GFC exposed the extent of liquidity risk in the banking system. The liquidity mismatch between the banks’ assets (long-term illiquid assets) and liabilities (short-term money market instruments) became known as the hot spot of banking. The liquidity mismatch would cause a solvency problem if the bank, for instance, needed to sell some of its assets quickly to manage its daily survival constraints and cash flows. In this case, illiquid assets would go through a fire sale process not because they had lost their potential income or become less attractive but simply because they did not have a liquid market. Such circumstances led to Bagehot’s dictum that to avert panic, central banks should lend early and freely (i.e., without limit), to solvent firms, against good collateral, and at “high rates.” In this context, it should not be surprising that the Fed and FDIC provided extensive liquidity provisions, including offering blanket deposit insurance, after the March 2023 banking crisis started.

Nevertheless, such facilities have yet to calm the market. The failure of liquidity provision to stabilize the market in the March 2023 banking crisis is partially generated by the intellectual mismatch between the root of the banks’ vulnerability (interest rate risk) and the proposed remedies (liquidity backstops). The reason is the change in the banks’ business model. Commercial banks started to hold excessively safe assets, such as government bonds, to prevent a GFC-like crisis and escape regulatory pressure. Government bonds may not have default risk. They are also liquid. However, their market value goes down when rates rise. In addition, rising interest rates generally force banks to raise deposit rates or lose funds to alternatives such as money-market funds. For banks, that was only an issue if the bonds were not adequately hedged and had to be sold to redeem deposits, which is exactly what happened to SVB. The signature relied more on loans, but it also experienced a run on its uninsured deposits.

Regional banks’ business model exposes them to unusually high interest rate risks. Regional banks’ liabilities are mostly deposits from modern corporates such as Venture Capitals (VCs), Startups, and Crypto firms. These corporate depositors do not need a bank loan. Instead, they can raise cheap funding through equity, IPOs, and other capital market techniques. As a result, banks use their cash to purchase a very high level of interest-sensitive fixed-income assets such as bonds. The classic problem with holding a large portfolio of fixed-income assets is that when rates go up, they fall in value, as with SVB’s assets. At the same time, as deposits pay competitive rates, higher rates increase the value of banks’ liabilities. This is called “interest rate risk.” All types of deposit-taking activities involve a certain level of interest rate exposure. However, commercial banks’ portfolios used to be more diversified as they also made floating-rate corporate loans. As a result, their balance sheets were less sensitive to interest rate changes in the past.

The heightened sensitivity of banks’ assets to interest rate risks could stay unrecognized by more traditional depositors who treat checkable deposits as safe as government liability. However, like equity investors, corporate clients use all the available information to continuously mark-to-market bank assets. When interest rate is volatile, as was the case in the past few years as a result of the Fed’s policies, bond prices change dramatically. If these assets are marked to market, their fair value sometimes falls below their book value. More informed and rational depositors are impatient and reactive to such developments. As was the case for the SVB, they could hugely penalize the banks by collectively withdrawing their funds and creating a run on a bank. The SVB-derived banking crisis showed that compared to other depositors in history, these new and individually rational types of corporate depositors could collectively create a more unstable banking system.

As a result, regulators are deciding how to secure this segment of the banking system that is unusually exposed to interest rate risk. Nonetheless, regulators should consider more innovative risk management approaches instead of returning to the standard regulatory toolkits, such as stress tests. For example, they could require the banks with such a business model to use interest rate swaps (IRS). First, from a risk management perspective, IRS can provide interest rate hedges. As corporate depositors continuously mark-to-market banks’ financial positions, neutralization could help calm their nerves when interest rates are highly volatile. IRS could also act as a cash management tool. The parallel loan structure of the IRS synthetically transforms the banks’ fixed-income assets into floating-rate- assets to match deposits’ cash flows.

From a classic risk-management perspective, swaps would neutralize the interest rate risks. To understand this point, let us go through an example. Suppose a regional bank tends to issue a $ 1 million deposit at a floating rate. The bank uses this fund to purchase a fixed-income bond. However, additional liability (deposit) at the variable rate will undermine compliance between interest rate-sensitive assets and liabilities. In the event of rising interest rates in the market, banks’ cash outflows and cash inflows increase. The cash outflow increases as the banks make higher interest payments to the depositors. The value of the cash inflow increases too. Even though the bonds generate fixed cash flows, these payments will be reinvested at a higher interest rate and earn a higher income. However, let us assume that the value of the liabilities will be greater than the increase in the income value by one million dollars. The result is a decline in the net interest margin and bankers’ profitability.

To avoid this risk, the banker can convert $ 1 million of liabilities with variable interest rates in the $ 1 million liability insensitive to interest rate movements, tiding interest-sensitive assets to interest-sensitive liabilities. Entering into an interest rate swap will enable her this. Therefore, the banker will contract an interest rate swap under which she will be required to pay at a fixed rate and receives at a variable rate. Variable income from the swap will equal the losses from the additional variable liability, and the net result will be a fixed obligation from the swap. In other words, profit/loss in swap would neutralize variable income from bonds, and the net result will be an interest-insensitive asset and liability because of the swap.

Another way to think of the swap is as a tool that matches cash inflows and outflows synthetically. The mechanics of the swaps can allow the banks to convert their bond holding (that earns fixed income) into repo lending (that earns a floating rate), albeit synthetically. Buying an IRS (being a fixed-payer, floating-receiver) by the bank is like borrowing in the bond market to lend the proceeds in the short-term money market. Banking is the equivalent of borrowing short and lending long. In contrast, IRS is equivalent to borrowing long and lending short. In this scenario, the swap position increases in value when the floating interest rate rises and generates the cash flows required to neutralize the cash flow mismatch between the banks’ assets and liabilities.

Historically, risk managers and regulators have often tried treating such risk as an “accounting” problem. As a result, positions were converted into risk equivalents and added together. For example, in fixed-income markets, participants have, for many years, scaled their positions into units of a common duration. Each position is converted into a basis—for example, a number of “10-year duration equivalents”—which should have equal sensitivity to the main source of fixed income risk, a parallel movement in interest rates. In this case, risk managers and regulators use indicators such as the delta (the net interest rate sensitivity), the vega (the net volatility sensitivity), and the gamma (change in delta concerning a one bp change in interest rates).

While these bits of information are essential to understanding and managing the position, they do not provide an adequate basis for risk management. Over the past several years, the accounting approach to risk management has been largely supplanted by using “stress” tests. Stress tests are the output of an exercise in which positions are revalued in scenarios where the market risk factors sustain significant moves. No doubt, using stress tests improves a situation of not knowing what might happen in such circumstances. However, significant limitations in stress testing need to be recognized.

What are their important limitations? First, it is sometimes unclear which dimensions of risk need to be considered. Also, stress tests do not reveal the relative probabilities of different events. For example, a position with negative gamma that loses money in significant moves in either direction will look bad in extreme scenarios but generally look very attractive when only local moves are considered. In any case, the shrewd banker can tailor his positions to look attractive relative to any particular set of scenarios or, given the opportunity, can find a set of scenarios for which a particular set of positions looks attractive. Moreover, in complex portfolios, there are many scenarios to look at; in fact, it may be virtually impossible to know which risk factors need to be considered. Furthermore, even if an exhaustive set of scenarios is considered, how does the trader or risk manager know how to consider the risk reduction resulting from the diversification of the risk factors? Thus, while stress testing is useful, it often leaves large gaps in understanding risk.

The ongoing banking crisis shows that while we mistakenly disregarded liquidity risk as an anomaly before the GFC, we made the same mistake regarding the interest rate exposure until the collapse of the SVB. As long as banks held safe, liquid assets, the interest rate mismatch between assets and liabilities was considered systemically unimportant. It is true that in modern finance, liquidity kills banks quickly, and liquidity facilities save lives. Nonetheless, the SVB crisis shows that we are also moving towards a parallel world, where interest rate risk evaporates a whole banking ecosystem. In this environment, looking at other instruments, such as swaps, and other players, such as swap dealers, that can neutralize the interest rate risk would be more logical. The neutralization aspect of the IRS can provide a robust financial stability tool to hedge against systemically critical hot spots.

Nonetheless, at least two critical issues should be extensively discussed to better understand swaps’ potential as a tool to strengthen financial stability. First, the economic benefit of the interest rate swaps results from the principle of comparative advantage. Interest rate swaps are voluntary market transactions by two parties. Nonetheless, this comparative advantage is generated by market imperfections such as differential information and institutional restrictions. The idea is that significant factors contribute to the differences in transaction costs in both the fixed-rate and the floating-rate markets across national boundaries, which, in turn, provide economic incentives to engage in an interest-rate swap, is true “a market failure.” Second, any systemic usage of swaps would engage swap dealers and require expanding the Fed’s formal relationship with such dealers.

Tags Banks, Dealers, Derivatives, FINANCIAL CRISIS, Interest Rate, March 2023 Banking Crisis, Monetary Policy, Money View, SVB, Swaps

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

Market Makers and Risk Managers After 2008

Post author By Elham Saeidinezhad
Post date June 6, 2021

This piece is originally published in the Phenomenal World Publication series, Jain Family Institute.

“The most significant economic event of the era since World War II is something that has not happened.” — Hyman Minsky, 1982

In the 1945 film It’s A Wonderful Life, banker protagonist George Bailey (played by Jimmy Stewart) struggles to exchange his well-functioning loans for cash. He lacks convertibility—known as liquidity risk in modern finance—and so cannot pay impatient depositors. Like any traditional financial intermediary, Bailey seeks to transform short-term debts (deposits) into long-term assets (loans). In the eyes of traditional macroeconomics, a run on the bank could be prevented if Bailey had borrowed money from the Fed, and used the bank’s assets as collateral. In the late-nineteenth-century, British journalist Walter Bagehot argued that the Fed acts as a “lender of last resort,” injecting liquidity into the banking system. As long as a bank was perceived solvent, then, its access to the Fed’s credit facilities would be almost guaranteed. In an economy like the one in It’s A Wonderful Life, the primary question was whether people could get their money out in the case of a crisis. And for a long time, Bagehot’s rule, “lend freely, against good collateral, but at a high rate,” maintained the Fed’s control over the money market and helped end banking panics and systemic banking crises.

That control evaporated on September 15, 2008, with the collapse of Lehman Brothers. On that day, an enormous spike in interbank lending rates was caused not by a run on a bank, but by the failure of an illiquid securities dealer. This new generation of financial intermediaries were scarcely related to traditional counterparties—their lending model was riskier, and they did not accept deposits.¹ Instead, these intermediaries synchronized their actions with central banks’ interest rate policies, buying more loans if monetary conditions were expansive and asking borrowers to repay loans if these conditions were contractive. They financed their operations in the wholesale money market, and most of their lending activities were to capital market investors rather than potential homeowners. When Lehman Brothers failed, domestic and foreign banks could no longer borrow in the money markets to pay creditors. The Fed soon realized that its lender of last resort activities were incapable of influencing the financial market.² The crisis of 2008-09 called for measures beyond Bagehot’s principle. It revealed not only how partial our understanding of the contemporary financial system is, but how inadequate the tools we have available are for managing it.

Re-conceptualizing the Contemporary Financial System

Prior to the financial crisis, the emerging hybrid system of shadow banking went largely unmonitored. Shadow banking is a market-based credit system in which market-making activities replace traditional intermediation.³ A shadow banker acts more like a dealer who trades in new or outstanding securities to provide liquidity and set prices. In this system, short-term liquidity raised in the wholesale money market funds long-term capital market assets. The payment system reinforces this hybridity between the capital market and the money market. Investors use capital market assets as collateral to raise funds and make payments. The integrity of the payment system therefore depends on collateral acceptability in securities lending. Since the crisis, collateral has been criticized for rendering financial institutions vulnerable to firesales and loss of asset value. The Fed declined to save Lehman Brothers, a securities dealer, because the alternative would have encouraged others to make toxic loans, too. Like in Voltaire’s Candide, the head of a general was cut off to discourage the others.

The crisis also revealed the vulnerabilities of contemporary risk management. Modern risk management practices depend largely on hedging derivatives. Hedging is somewhat analogous to taking out an insurance policy; at its heart are derivatives dealers who act as counterparties and set prices. Derivatives, including options, swaps, futures, and forward contracts, reduce the risk of adverse price movements in underlying assets. The crisis exposed their fragile nature—dealers’ willingness to bear risk decreased following losses on their portfolios. These concerns left many firms frozen out of the market, forcing them to terminate or reduce their hedging programs. Rationing of hedging activity increased firms’ reliance on lines of credit. As liquidity was scarce, over-reliance on credit lines further strained firms’ risk management. In the meantime, rising hedging costs prevented them from hedging further. Derivatives dealers were essential players in setting these costs. During the crisis, dealers found it more expensive to finance their balance sheet activities and in return, they increased the fees. As a result of this cycle, firms were less and less able to use derivatives for managing risks.

Most financial economists analyze risk management through cash flow patterns. The timing of cash flow is critical because the value of most derivatives is adjusted daily to reflect their market value (they are mark-to-market). This requires a daily cash settlement process for all gains and losses to ensure that margin (collateral) requirements are being met. If the current market value causes the margin account to fall below its required level, the trader will be faced with a margin call. If the value of the derivatives falls at the end of the day, the margin account of the investors who have long positions in derivatives will be decreased. Conversely, an increase in value results in an increase in the investors’ margin account who hold the long positions. All of these activities involve cash flow.

But in order to properly conceptualize the functioning of contemporary risk management practices, we need to follow in Hyman Minsky’s footsteps and look at business cycles.⁴ The standard macroeconomic framing begins from the position of a representative risk-averse investor. Because the investor is risk-averse, they neither buy nor sell in equilibrium, and consequently, there is no need to consider hedging and the resulting cash flow arrangements. By contrast, Minsky developed a taxonomy to rank corporate debt quality: hedge finance, speculative finance, and Ponzi finance. Hedge finance is associated with the quality of the debt in the economy and occurs when the cash from a firm’s operating activities is greater than the cash needed for its scheduled debt-servicing payments. A speculative firm’s income is sufficient to pay the interest, but it should borrow to pay the principal. A firm is Ponzi if its income is less than the amount needed to pay all interest on the due dates. The Ponzi firm must either increase its leverage or liquidate some of its assets to pay interest on time. Within this scheme, hedge finance represents the greatest degree of financial stability.

Minsky’s categorization scheme emphasizes the inherent instability of credit. In periods of economic euphoria, the quantity of debt increases because the lenders and investors become less risk-averse and more willing to make loans that had previously seemed too risky. During economic slowdowns, overall corporate profits decline, and many firms experience lower revenues.⁵ This opens the way for a “mania,” in which some in the hedge finance group move into speculative finance, and some firms that had been in speculative finance move into Ponzi finance.

Regulatory Responses to the Crisis: Identifying and Managing Risk

But why should a central banker worry about the market for hedging? After all, finance is inherently about embracing risk. In a financial crisis, however, these risks become systemic. Systemic risk is the possibility that an event at the company level could trigger the collapse of an entire industry or economy. Post-2008 regulatory efforts are therefore aimed at identifying systemic risk before it unravels.

The desire to identify the origins and nature of risks is as old as finance itself. ⁶In his widely cited 1982 article , Fischer Black distinguished between the risks of complex instruments and the trades that reduce those risks—“hedges.”⁷ But less widely cited is his conviction that financial models, such as the capital asset pricing model (CAPM), are frequently not equipped to separate these risks.⁸⁹

The same argument could be made for identifying systemic risk.¹⁰ To monitor systemic risk, the Fed and other regulators use central clearing, capital standards, and stress-testing. However, these practices are imperfect diagnostic tools. Indeed, clearinghouses may have become the single most significant weakness of the new financial architecture. In order to reduce credit risk and monitor systemic risk, clearinghouses ensure swaps by serving as a buyer to every seller and a seller to every buyer. However, they generally require a high degree of standardization, a process that remains poorly defined in practice. Done correctly, the focus on clearing standardized products will reduce risk; done incorrectly, it may concentrate risks and make them systemic. Standardization can undermine effective risk management if it constrains the ability of investors to modify derivatives to reflect their particular activities.

Regulators also require the banks, including the dealer banks, to hold more capital. A capital requirement is the amount of capital a bank or another financial institution has to have according to its financial regulator. To capture capital requirement, most macroeconomic models abstract from liquidity to focus on solvency. Solvency risk is the risk that the business cannot meet its financial obligations for full value even after disposal of its capital. The models assert that as long as the assets are worth more than liabilities, firms should survive. The abstraction from liquidity risk means that by design, macroeconomic models cannot capture “cash flow mismatch,” which is at the heart of financial theories of risk management. This mismatch arises when the cash flows needed to settle liabilities are not equal to the timing of the assets’ cash flows.

The other tool that the Fed uses to monitor systemic risk regularly is macroprudential stress-testing. The Comprehensive Capital Analysis and Review (CCAR) is an annual exercise by the Fed to assess whether the largest bank holding companies have enough capital to continue operations during financial stress. The test also evaluates whether banks can account for their unique risks. However, regulatory stress testing practice is an imperfect tool. Most importantly, these tests abstract away from over-the-counter derivatives—minimally regulated financial contracts among dealer banks— that might contribute to systemic risk. Alternatively, the testing frameworks may not capture network interconnections until it is too late.

The experience of the 2008 financial crisis has revealed the ways in which our current financial infrastructure departs from our theorization of it in textbooks. It also reveals that the analytical and diagnostic tools available to us are inadequate to identifying systemic risk. The Fed’s current tools reflect its activities as the “financial regulator.” But at present, the Fed lacks tools based on its role as lender of last resort, which would enable it to manage the risk rather than imperfectly monitor it. In the following sections, I examine the importance, and economics, of derivatives dealers in managing financial markets’ risks, and propose a tool that extends the Fed’s credit facilities to derivatives dealers during a crisis.

Derivatives Dealers: The Risk Managers of First and Last Resort

Over the course of seventeen years, Bernie Madoff defrauded thousands of investors out of tens of billions of dollars. In a Shakespearean twist, the SEC started to investigate Madoff in 2009 after his sons told the authorities that their father had confessed that his asset management was a massive Ponzi scheme. Madoff pleaded guilty to 11 federal felony counts, including securities fraud and money laundering.

Bernie Madoff paints a dire portrait of the market making in securities. In world of shadow banking, derivatives dealers are the risk managers of first resort. They make the market in hedging derivatives and determine the hedging costs. Like every other dealer, their capacity to trade depends on their ability to access funding liquidity. Unlike most other dealers, there is no room for them in the Fed’s rescue packages during a financial crisis.

Derivatives dealers are at the heart of the financial risk supply chain for two reasons: they determine the cost of hedging, and they act as counterparties to firms’ hedging programs.¹¹ Hedgers use financial derivatives briefly (until an opportunity for a similar reverse transaction arises) or in the long term. In identifying an efficient hedging instrument, they consider liquidity, cost, and correlation to market movements of original risk. Derivatives connect the firms’ ability and willingness to manage risk with the derivatives dealers’ financial condition. In particular, dealers’ continuous access to liquidity enables them to act as counterparties. As intermediaries in risk, dealers use their balance sheets and transfer the risks from risk-averse investors to those with flexible risk appetite, looking for higher returns. In the absence of this intervention, risk-averse investors would neither be willing nor able to manage these risks.

This approach towards risk management concentrates risks in the balance sheets of the derivatives dealers.¹² The derivative dealers’ job is to transfer them to the system’s ultimate risk holders. In a typical market-based financial system, investment banks purchase capital market assets, such as mortgage-backed securities (MBS). These hedgers are typically risk-averse and use financial derivatives such as Interest Rate Swaps (IRS), Foreign exchange Swaps (FXS), and Credit Default Swaps (CDS). These derivatives’ primary purpose is to price, or even sell, risks separately and isolate the sources of risk from the underlying assets. Asset managers, who look for higher returns and therefore have a more flexible risk tolerance, hold these derivatives. It is derivatives dealers’ job to make the market in instruments such as CDS, FXS, and IRS. In the process, they provide liquidity and set the price of risk. They also determine the risk-premium for the underlying assets. Crucially, by acting as intermediaries, derivatives dealers tend to absorb the unwanted risks in their own balance sheets.

During a credit crunch, derivatives dealers’ access to funding is limited, making it costly to finance inventories. At the same time, their cash inflow is usually interrupted, and their cash outflow comes to exceed it.¹³ There are two ways in which they can respond: either they stop acting as intermediaries, or they manage their cash flow by increasing “insurance” premiums, pushing up hedging costs exactly when risk management is most needed. Both of these ultimately transmit the effects to the rest of the financial market. Higher risk premiums which lower the value of underlying assets could lead to a system-wide credit contraction. In the money market, a sudden disruption in the derivatives market would raise the risk premium, impair collateral prices, and increase funding costs.

The increase in risk premium also disrupts the payment system. Derivatives are “mark-to-market,” so if asset prices fall, investors make regular payments to the derivative dealers who transfer them to ultimate risk holders. A system-wide credit contraction might make it very difficult for some investors to make those payments. This faulty circuit continues even if the Fed injects an unprecedented level of liquidity into the system and pursues significant asset purchasing programs. The under-examined hybridity between the market for assets and the market for risks make derivatives markets the Fed’s concern. There will not be a stable capital valuation in the absence of a continuous risk transfer. In other words, the transfer of collateral, used as the mean of payments, depends on the conditions of both the money market and derivatives dealers.

Understanding Financial Assets as Collateral

Maintaining the integrity of the payment system is one of the oldest responsibilities of central bankers. In order to do this effectively, we should recognize financial assets for what they actually do, rather than what economists think they ought to do. Most macroeconomists categorize financial assets primarily as storers of value. But in modern finance, investors want to hold financial assets that can be traded without excessive loss. In other words, they use financial assets as “collaterals” to access credit. Wall Street treats financial assets not as long-term investment vehicles but as short-term trading instruments.

Contemporary financial assets also serve new economic functions. Contrary to the present and fundamental value doctrines, a financial asset today is not valuable in and of itself. Just like any form of money, it is valuable because it passes on. Contemporary financial assets are therefore the backbone of a well-functioning payment system.

The critical point is that in market-based finance, the collateral’s market value plays a crucial role in financial stability. This market value is determined by the value of the asset and the price of underlying risks. The Fed has already embraced its dealer of last resort role partially to support the cost of diverse assets such as asset-backed securities, commercial papers, and municipal bonds. However, it has not yet offered any support for backstopping the price of derivatives. In other words, while the Fed has provided support for most non-bank intermediaries, it overlooked the liquidity conditions in the derivatives market. The point of such intervention is not so much to eliminate the risk from the market. Instead, the goal is to prevent a liquidity spiral from destabilizing the price of assets and, consequently, undermining their use as collateral in the market-based credit.

In 2008, AIG was the world’s largest insurance company and a bank owner. Its insurance business and bank subsidiary made it one of the largest derivatives dealers. It had written billions of dollars of credit default swaps (CDSs), which guaranteed buyers in case some of the bonds they owned went into default. The goal was to ensure that the owner of the swap would be paid whole. Some investors who owned the bonds of Lehman had bought the CDSs to minimize the loss if Lehman defaulted on its bonds. The day after Lehman failed, the Fed lent $85 billion to AIG, stabilizing it and containing the crisis. However, this decision was due to the company’s importance in markets for municipal bonds, commercial papers, and money market mutual funds. If the Fed was not unwilling to do the same for derivatives dealers, it might have been able to alleviate near-term risks generated from the systemic losses on derivatives.

After the COVID-19 pandemic, the Fed extended credit facilities to critical financial intermediaries, but excluded market makers in risk. But in a financialized economy, the business cycle is nothing more than extreme corrections to the price of capital. Before a crash, investors’ risk tolerance becomes flexible—they ignore the possibility for market corrections or rapid changes in an asset’s market price after the establishment of an equilibrium price. As a result of this bias, investors’ expectations of asset prices form more slowly than actual changes in asset prices. Hedging would save these biased investors, and if done appropriately, they could help stabilize the business cycle. However, the Fed has no formal tool that enables it to support derivatives dealers in providing hedging services. It cannot act as the “ultimate” risk manager in the system.

The Dealer Option: Connecting the Fed with the Ultimate Risk Managers

Charles Kindleberger argued that financial crises cannot be stopped, but only contained. The dealer option proposed in this paper would enable the Fed to control the supply chain of risk.¹⁴ It extends credit facilities to a specific type of financial intermediaries: options dealers. This extension does not include financial speculators of various stripes and nonfinancial corporations—the so-called “end-users” of derivatives—seeking to hedge commercial risks. The options dealers’ importance comes from their paradoxical effects on financial stability. Since Dodd-Frank increased firms’ capital cost in favor of risk mitigation techniques like hedging, these companies are crucial to policy because they buy protection from options dealers in centrally cleared markets.

The problem is that options dealers’ role as counterparty to hedging firms could create fragility and magnify the market risk.¹⁵ In equilibrium, the risk is transferred through the option supply chain to dealers, who are left with the ultimate task to manage their risk exposure using dynamic hedging techniques. The dynamic nature of these activities means options dealers contribute to daily volatility when they balance their exposures. During a crisis, these actions lead to increasing market fragility. The “dealer option” empowers the Fed to become the lender of last resort to the financial system’s ultimate risk managers. This instrument extends many benefits that banks receive by having an account at the Fed to these dealers. Some of these benefits include having access to reserves, receiving interest on reserves, and in very desperate times, access to the Fed’s liquidity facilities. The goal is to strike a balance between the fragility and stability they impose on the market.¹⁶

Containing liquidity risk is at the heart of the dealer option. The daily cash flow that the options contracts generate could contribute to asset fire sales during a crisis—options contracts are subject to mark-to-market rules, and fluctuations in the value of assets that dealers hold generate daily cash flows. If dealers do not have enough liquidity to make daily payments, known as margin calls, they will sell the underlying assets. Asset fire sales might also arise because most market makers have an institutional mandate to hedge their positions by the end of the trading day. Depending on the price changes, the hedging activities require dealers to buy or sell the underlying asset. Most dealers hedge by selling shares of the underlying asset if the underlying asset’s value drops, potentially giving rise to firesale momentum. Limited market liquidity during a crisis means that the possibility of firesale is larger when dealers do not have enough liquidity to meet their cash flow requirements. The dealer option could stop this cycle. In this structure, the Fed’s function to provide backstops for derivatives dealers can reduce firesales’ risk and contain market fragility during a credit crunch.

The tool is based on Perry Mehrling’s Money View framework, Morgan Ricks, John Crawford, and Lev Menand’s Public Option proposal, and Katharina Pistor’s Legal Theory of Finance (LTF). The public option suggests opening the Fed’s balance sheet to non-banks and the public. On the other hand, the Money View emphasizes the importance of managing the timing of cash flows and calls any mismatches liquidity risk. Like the Finance view of the world, the Money View asserts that the goal is to meet “survival constraints” at all times.

The LTF builds on the Money View through four essential premises: first, financial markets are a rule-bound system¹⁷; The more an entity solidifies its position within the marketplace, the higher the government’s level of responsibility. Second, there is an essential hybridity between states and markets; in a financial crisis, only Fed’s balance sheet—with its unlimited access to high-powered money—can guarantee full convertibility from financial assets into currency. Third, the law is what makes enforcement of financial instruments possible. On the other hand, these enforcements also have the capacity to bring the financial system down. Finally, LTF law is elastic, meaning that legal constraints can be relaxed or tightened depending on the economy’s health.

Calling the Fed to intervene in the derivatives market, the “dealer option” emphasizes the financial system’s hybridity. The law does not currently require central banks to offer convertibility to most assets. In most cases, they are explicitly barred from doing so. Legal restrictions like this could be preventing effective policy options from restoring financial stability. The dealer option would defy such restrictions and allow derivatives dealers to have an account at the Fed. The Fed’s traditional indirect backstopping channel has proven to be inadequate during most financial crises. Banks tend to reduce or sometimes cease their liquidity provision during a crisis. Accounting for such shifts in banks’ business models, the dealer option allows the Fed to directly backstop the leading players in the supply chain of risk. Importantly, these benefits would only be accessible for derivatives dealers once a recession is looming or already in full effect, when unconventional monetary policy tools are used.

Whether a lender of last resort should provide liquidity to forestall panic has been debated for more than two hundred years. Those who oppose the provision of liquidity from a lender of last resort argue that the knowledge that such credits will be available encourages speculation. Those who want a lender of last resort worry more about coping with the current crisis and reducing the likelihood that a liquidity crisis will cascade into a solvency crisis and trigger a severe recession. After the 2008 crisis, the use of derivatives for hedging has greatly increased due to the growing emphasis on risk management. Solvency II, Dodd-Frank, and the EMIR Risk Mitigation Regulation increased the cost of capital in favor of risk mitigation techniques, including hedging and reducing counterparty risk. The risk is transferred over the option supply chain to market makers, who are left with the ultimate task to manage their risk exposure. The dealer option offers liquidity to these dealers during a crisis when the imbalances are huge. Currently, there is no lender of last resort for the market for risk because there is neither a consensus about the systemic importance of shadow banking nor any model adequately equipped to distinguish between hedge finance, speculative finance, and Ponzi finance.

Shadow banking has three foundations: liquid assets, global dollar funding, and risk management. So far, the Fed has left the last foundation unattended. In order to design tools that fill the void between risk management and crisis prevention, we must understand the financial ecosystem as it really is, and not as we want it to be.

Saeidinezhad, E., 2020. “When it Comes to Market Liquidity, What if Private Dealing System is Not ‘The Only Game in Town’ Anymore? (Part I).” Available at: https://elhamsaeidinezhad.com ↩
Stigum, M., 2007. Stigum’s Money Market. McGraw-Hill Professional Publishing ↩
Saeidinezhad, E., 2020. “When it Comes to Market Liquidity, What if Private Dealing System is Not ‘The Only Game in Town’ Anymore? (Part II).” Available at: https://elhamsaeidinezhad.com ↩
Minsky, Hyman P. 1986. Stabilizing an unstable economy. New Haven: Yale University Press. ↩
Mian, A, and Sufi, A., 2010. “The Great Recession: Lessons fromMicroeconomic Data.” American Economic Review, 100 (2): 51-56. ↩
Mehrling, P., 2011. Fischer Black and the Revolutionary Idea of Finance. Wiley Publications; ISBN: 978-1-118-20356-9 ↩
Black, F., 1982. “General Equilibrium and Business Cycles.” NBER Working Paper No. w0950. ↩
Scholes, M. S., 1995. “Fischer Black. Journal of Finance,” American Finance Association, vol. 50(5), pages 1359-1370, December. ↩
Black, F., 1989. “Equilibrium Exchange Rate Hedging.” NBER Working Paper No. w2947. ↩
Schwarcz, S., 2008. “Identifying and Managing Systemic Risk: An Assessment of Our Progress.” Harvard Business Law Review. ↩
Canadian Derivatives Institute., 2018. “Corporate Hedging During the Financial Crisis.” Working paper; WP 18-04. ↩
Wayne, G and Kothar, S. P., 2003. “How Much Do Firms Hedge With Derivatives?” Journal of Financial Economics 70 (2003) 423–461 ↩
Gary, G., and Metrick, A., 2012. “Securitized Banking and the Run on Repo.” Journal of Financial Economics, Volume 104, Issue 3, Pages 425-451, ISSN 0304-405X. ↩
Aliber, Robert Z., and Kindleberger, C., 2011. Manias, Panics, and Crashes: a History of Financial Crises.New York: Palgrave Macmillan ↩
Barbon, A., and Buraschi, A., 2020. “Gamma Fragility.” The University of St.Gallen, School of Finance Research Paper No. 2020/05. ↩
Mehrling, P., 2011. The New Lombard Street: How the Fed Became the Dealer of Last Resort. Princeton; Oxford: Princeton University Press. ↩
Pistor, K. 2013a. “Law in Finance, Journal of Comparative Economics,” Elsevier, vol. 41(2), pages 311-314. ↩

Footnotes

Title	Risks and Crises
Authors	Elham Saeidinezhad
Date	2021-06-02
Collection	Analysis
Filed Under	finance crises
In Series

Tags Dealers, Derivatives, Federal Reserve, Funding Liquidity, lender of last resort, Market Liquidity, Money View, Risk Management, security dealers

Elham's Money View Blog

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

Post author By Elham Saeidinezhad
Post date April 7, 2020

By Elham Saeidinezhad and Jack Krupinski*

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Tags COVID-19, Dealers, Derivatives, FINANCIAL CRISIS, Funding Liquidity, FX Market, Money View

Elham's Money View Blog

Why Does “Solvency” Rule in the Derivatives Trading?

Post author By Elham Saeidinezhad
Post date March 29, 2020

Hint: It Should Not

By Elham Saeidinezhad

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

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

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

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

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

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

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

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

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Tags COVID-19, Derivatives, Funding Liquidity, Market Liquidity, Money View, Solvency

Elham's Money View Blog

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

Post author By Elham Saeidinezhad
Post date March 26, 2020

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

By Elham Saeidinezhad

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

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

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

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

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

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

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

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

The critical point is that in market-based finance where the collateral secures funding, the market value of collateral plays a crucial role in financial stability. This market value has two components: the value of the asset and the price of underlying risks. The Fed has already embraced its dealer of last resort role partially to support the price of diverse assets such as asset-backed securities, commercial papers, and municipal bonds. However, it has not offered any support yet for backstopping the price of derivatives. In other words, while the Fed has provided support for the cash markets, it overlooked the market liquidity in the derivatives market. The point of such intervention is not so much to eliminate the risk from the market. Instead, the goal is to prevent a liquidity spiral from destabilizing the price of assets and so, consequently, undermining their use as collateral in the market-based credit.

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

Download Table: Fed’s responses to the Covid-19 Crisis: A Money View Classification (As of March 25, 2020) (Pdf document)Download

Download Table: Fed’s responses to the Covid-19 Crisis: A Money View Classification (As of March 25, 2020) (Word document) Download

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Tags Banks, COVID-19, Dealers, Derivatives, Federal Reserve, Future of Money, Money View

Elham's Money View Blog

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

Post author By Elham Saeidinezhad
Post date January 31, 2020

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

By Elham Saeidinezhad

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

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

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

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Tags Derivatives, Interest Rate, Money View

Elham's Money View Blog

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

Post author By Elham Saeidinezhad
Post date January 31, 2020

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:

What are the main differences between FX swaps and FX forwards?
What connects the dealers in the FX swaps and the FX forwards market?
What makes the FX market a funding market?

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Tags Derivatives, Funding Liquidity, FX Market, Money View