“Prophesy as much as you like, but always hedge. – Oliver Wendell Holmes, 1861”
Hedge fund trading strategies provide a blueprint for understanding regional banks’ Asset-Liability Management (ALM), such as SVB’s. During the hedge-fund crisis of 1998, market participants were given a glimpse into the trading strategies used by large hedge funds, such as Long Term Capital Management (LTCM). Few of these strategies were as popular or painful as “fixed-income arbitrage.” As a highly leveraged strategy, fixed-income arbitrage effectively bets on the shape of the yield curve. Despite its big role in the LTCM’s fall, the regulators have not internalized this strategy, and its dangers, well enough. In fact, the so-called puzzling facts about the SVB’s business model would make sense once examined as a hedge fund with a “fixed-income arbitrage” strategy. For instance, unlike the traditional model of deposit taking, SVB invested most of the deposits in fixed-income securities. In addition, SVB was unusually exposed to interest rate risks when failed. These characteristics could be explained through the mechanics of fixed-income arbitrage trading. Indeed, the small margins and the massive exposure to interest rate movement are why this strategy is known as “picking up nickels in front of a steamroller.” The problem with becoming a hedge fund for a bank is that a hedge fund can lock up liquidity and ensure investors do not run. Banks do not have such an option, and when they face the run, they either put pressure on the government’s insurance schemes or the stability of the financial system, or both.
An anomaly in the business model of the SVB is that, for a bank, it had a lot of safe fixed-income securities. SVB had about $190 billion of deposits and invested nearly $120 billion of that money in Treasury and agency mortgage-backed securities (MBS). However, this mystery would be resolved once we consider SVB a hedge fund. Hedge funds, including the doomed LTCM, function based on different strategies, including “fixed-income arbitrage” trading. 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 would gain in value, which justifies purchasing government-backed securities such as Treasuries and MBS. Nontheless, the fund hedges the position by entering the relevant swaps to turn such a strategy into “riskless” arbitrage trading. In this case, the fund would enter an IRS and become 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. Nonetheless, and most importantly, the fixed-income securities’ capital gain would compensate for such a 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.
However, as LTCM’s failure showed, two critical vulnerabilities are implied in such an apparent risk-less strategy. 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. This aspect, known to the hedge fund watchers, could explain the behavior of the SVB’s managers to drop the interest rate hedges. In mid-2022, the managers suddenly dropped the interest rate hedges without providing reasonable economic justifications. However, labeling this decision as mere poor risk management can be misleading. The mechanics of the fixed-income strategy explain this behavior more accurately. SVB’s decision to liquidate the swap positions coincided with when the market consensus on the Fed shifted. Fed watchers started to believe a more hawkish tone of the central bank. Fed would tolerate a slight recession and will not reduce rates without substantial evidence of inflation falling. In this environment, it becomes too expensive for the fund that has bet on the fall in interest rate to maintain the hedging aspect of the portfolio.
To understand this point, let us go through an example together. Let us assume that a hedge fund manager takes a long position in 1000 2-year Treasuries for $200. His unhedged position is worth 1,000 × $200 = $200,000. The bond’s annual payout is 6% or 3% semiannually. The bond Duration is 2 years, so the fund would expect to receive the principal after 2 years. After the first year, the amount earned, assuming reinvestment of the interest in a different asset, will be: $200,000 × .06 = $12,000. After two years, the fund’s earnings are $12,000 × 2= $24,000. However, the risks in the above transaction include: (a) not being paid back the face value of the municipal bond and (b) not receiving the promised interest. To hedge this Duration risk, the manager must short a 2-year IRS with a notional value of $200,000. The fund negotiates so that the fixed rate in the IRS is less than the 6% in annual interest, let us say %5.9.
The final hedged position results in the following short cash position for the first year: $200,000 × .059 = $11,800, and for the two years, the fund will pay a total of $11,800 × 2 = $23,600. In this example, if the manager has to pay out a total of $23,600 to hedge his duration risk, we must subtract this amount from the anticipated interest made on the bond: $24,000 −$23,600 = $400. Thus $400 is the net profit made on this transaction. Profits generated through fixed-income arbitrage transactions are often so small that managers drop the hedge when the interest rates move in the wrong direction for a relatively consistent period. This explains the use and the drop of the IRS by the SVB.
An essential problem with fixed-income arbitrage is that maintaining the hedges can be unsustainable for firms adopting this strategy. In addition, empirical evidence shows that the so-called arbitrage opportunity might not be riskless. In fact, the deep losses, and extra returns, might be less due to the high leverage and more a reflection of more profound risks, such as market risks, inherent in the nature of such strategies. Fixed income arbitrage is assumed to be a riskless, market-neutral investment strategy. This strategy is considered market-neutral as it consists of a short position in a swap and an offsetting long position in a Treasury bond with the same maturity (or vice versa). In actuality, however, this strategy is subject to the risk of a significant widening in the fixed (swap rate)-floating (SOFR rate) spread. Suppose this spread is correlated with market factors, which in most cases, it is. In that case, the excess returns may represent compensation for this strategy’s underlying market risk. In other words, this fixed-income arbitrage strategy has little or no riskless arbitrage component.
In addition, this strategy has exposure to a wide array of price risks. In particular, the strategy has exposure to the stock market, the banking industry, the Treasury bond market, and the corporate bond market. In particular, the researchers have shown that the excess returns for these fixed-income arbitrage strategies are related to excess returns for the stock market, excess returns for bank stocks, and excess returns for Treasury and corporate bonds. This suggests that the risk of a significant financial event or crisis is a risk that is priced throughout many financial markets. Thus, the financial-event risk may be a critical source of the widely-documented commonalities in risk premia across different asset classes. These results are consistent with the view that the financial players, including the market-makers and their balance sheet positions, play a central role in asset pricing.
One practice that connects the regional banks’ business model with hedge funds is the Ponzi aspect of their businesses. Both types of firms rely on the continuity of short funding to finance their assets. For hedge funds, the cash inflow is in the form of capital from the investors, while in the case of the banks, it is depositors’ money. Nonetheless, there is one more similarity between these two that is even more fundamental yet is more obscured. At first glance, it might look like regional banks’ holding of fixed-income securities was an attempt to invest in safe assets. However, after examining the SVB’s business models and their managers’ narratives, these investments start to look more and more like the “fixed-income arbitrage” strategy of hedge funds and less like their investing in safe assets. This strategy tries to exploit mispricing amongst fixed-income securities. It is based on the firms’ understanding and modeling of the term structure of interest rate. In doing so, it creates excessively high exposure to interest rate risk. This is because if the fund is betting on the shape of the yield curve, it becomes at the mercy of its financial model’s predictions. If these models are incorrect, interest rate movements will crush their profits. Unfortunately, this is what happened with SVB.
When the dust settles, SVB might be more like a hedge fund than a bank. However, banks becoming hedge funds have implications for financial stability. For example, their business model could be concealed from the untrained eyes of the regulators as long as deposits flow into the regional bank. However, once the profit margin collapsed, the bank had to drop the strategy of acting like a hedge fund as it was no longer hedged. Nonetheless, the difference between a hedge fund and a bank is that hedge funds are designed to earn lots of money and disappear. Therefore, no one misses them once they disappear. However, banks serve a public function, have a government backstop, and occupy a vital role in the financial system. As a result, adopting such a short-term, high-risk-high-profit business model for such an important institution is dangerous for financial stability.
Most importantly, banks, if they decide to restrict people’s access to their deposits, they generate a banking crisis. On the other hand, hedge funds often impose lock-up periods, such as several years in which investments cannot be withdrawn. Many also employ redemption notices requiring investors to provide notice weeks or months before their desire to redeem funds. These restrictions limit investors’ liquidity but, in turn, enable the funds to invest in illiquid assets where returns may be higher without worrying about meeting unanticipated demands for redemptions. The events leading to the banking disruption of March 2023 suggest that market participants or regulators needed to adequately internalize essential lessons from the 1998 hedge fund crisis case. If they did, they could recognize the fixed-income strategy at the heart of the SVB’s business model.
“[Interest Rate Swap] is a perfect example of the gains that can be realized from specialization along the lines of comparative advantage. Triple-A and single-B can together reduce their joint costs of borrowing by each borrowing in the market in which they get the best terms; then, using a swap, they can divvy up the savings they have realized, and each ends up with the type of liability they wanted in the first place.” Says Marcia Stigum (1978)
Silicon Valley Bank (SVB) was born on October 17, 1983. It was announced dead by the FDIC and other government agencies on March 1o, 2023. Nonetheless, SVB’s failure began an intriguing postmortem debate on bank runs. Many discussions have been conducted on essential issues such as the roots of the crisis, the nature of government bailouts, and recrafting bank regulation (such as making liquidity measures such as liquidity coverage ratio (LCR) time-sensitive). However, one of the standard narratives indicates that the SVB’s doomed fate is determined by the classic type of depositors who follow herd behavior and are primarily driven by human psychology and panic.
However, the March 2023 banking crisis revealed that modern depositors’ behavior, including their decision to run on a bank, is less driven by the animal spirit and more by the actual information in banks’ financial statements. In other words, modern depositors’ behavior has shifted from being uninformed and displaying herd behavior to becoming individually informed and information-derived. This distinction between traditional, uninformed depositors and modern, informed ones has essential implications for the measures to stop the bank run. Given the nature of the modern depositors, banks’ usage, and reporting of hedges, including interest rate futures and swaps, would be a better option to stop a run on a bank and a banking crisis in general than other classic solutions such as deposit insurance. In addition, accounting for the structural change in the type of depositors, from uninformed to informed, could open new avenues, such as using derivatives, to improve financial stability in the future.
Most standard narratives of the March 2023 bank run are based mainly on classic models such as the Diamond-Dybvig Model of bank runs. In this model, the assumption is that the depositors are uninformed. To such depositors, as long as they did not reach the $250,000 threshold, putting money in a bank appeared as safe as buying Treasuries. Both investments had full government backing. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. As their behavior is driven by “animal spirit” rather than a particular detail in banks’ financial statements, “any” worries, imaginary or real, about the viability of such insurance, if believed by enough people, could lead to a run on a bank. In this environment, the model suggests that even though some banks tend to stop the convertibility of checkable deposits to currency, the best option to stop a bank run would be “deposit insurance.”
In contrast to the assumption of such models, the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks are characterized as informed, finance-savvy, well-informed, and informed. They are known to use all the available information and extensively tweet about every detail and footnote in the financial statements of their bankers. For instance, in the case of SVB, they examined the bank’s balance sheet, “marked to market” its assets, and noticed its exposure to interest rate risk. Moreover, they initiated the run on the bank once the bank reported virtually no interest rate hedges on its massive bond portfolio. In other words, the run on the SVB revealed that modern depositors’ behavior is less driven by the animal spirit and psychology and is indeed informed.
This distinction between traditional, uninformed depositors and modern, rational ones has essential implications for the measures to stop the bank run. It opens the door for derivatives to be considered as a private-risk management tool that enhances financial stability. One of the most significant risks to SVB’s business model was catering to a rational group of investors who treated bank deposits as a form of investment vehicle and continuously checked the bank’s balance sheet. This change from uninformed to rational (well-informed) depositors is a continuation of the existing evolution in banking. In the first phase of this structural change, “retail” depositors were replaced by “institutional” ones such as pension funds. The main difference between these two was the amount of cash they would inject into the banking system.
Nonetheless, both were uninformed. They cared not about the banks’ financial condition and balance sheets to which they gave their money. Instead, they just wanted the top rate available on an FDIC-insured deposit. To this depositor, as long as she did not breach the $250,000 mark, putting money in a bank appeared as safe as buying Treasuries. Moreover, both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, found they were flooded with money if they posted attractive rates. This is a pretty good picture of things in the fifties.
After the Great Financial Crisis (GFC), and the strengthening of the liquidity and capital ratios, systemically important banks, such as JPMorgan Chase, Credit Suisse, and Bank of America, restructured their business models to become market makers in wholesale money markets. They minimized their deposit-taking activity. As a result, medium-sized and large regional banks changed their business model to pick up the slack. For these banks, retail deposits were a dead end. Nontheless, attracting large deposits per se was not the only goal when it came to institutional deposits. Instead, they sought “well-informed” clients such as tech, crypto, venture capitalists (VCs), and startups. Therefore, banks such as SVB, Signature, and Silvergate preferred serving highly specialized, local, and finance-savvy depositors. These regional banks structured their business models to become the Bank of Crypto, VCs, or Startups.
If the change in systemically important banks’ business model transformed the market-making business, large, regional banks’ restructuring changed the banking and deposit-taking world. On the liability side, the modern banking era started with the “death of the retail deposits.” This evolution was revealed in the balance sheet of the SVB. On the liability side, much of the recent SVB’s deposit growth was driven by VCs and startup businesses. These depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities.
On the asset side, SVB and other specialized banks that served rational depositors were outside the business of making loans. Indeed, startups and crypto customers do not have good collaterals like fixed assets or recurring cash flows. As a result, they are less-reliable corporate borrowers. Nonetheless, the most important reason was that these customers did not need loans. Instead, equity investors provided them with a constant supply of cash. Marcy Stigum, in the late 1970s, called this a “death of loans.” The idea is that top corporate customers have access to public and private market credit, where they can borrow more cheaply than banks. Banks have adjusted to the loss of this business by instead purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.
This change from uninformed to rational depositors and the corresponding assets-liabilities strategies contributed to the ongoing banking mania in at least two hybrid ways. On the one hand, serving rational depositors who do not need loans implies the large-scale addition of long-term bonds backed by the US government to the banks’ portfolios. The result is that these specialized banks are unusually exposed to “interest-rate risk.” When interest rates go up, most banks have to pay more interest on deposits but get paid more interest on their loans and end up profiting from rising interest rates. On the other hand, banks such as SVB and Signature own a lot of long-duration bonds. These bonds’ market value goes down as rates go up. Every bank has some mix of this — every bank borrows short to lend long; that is what banking is — but many banks end up more balanced. At the same time, rational depositors, unlike traditional ones, continuously pay attention to the financial statements of the banks and the footnotes. As a result, they constantly “mark to market” the banks’ financial assets and extremely penalize the banks whenever the fair value of their assets is at a loss.
Let us use an example to understand this point and its systemic importance. 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 announced a rate hike from 0% to 2%. 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. A rational depositor, in 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. If the bank has a bond with a face value of $100, this type of depositor 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. Rational people notice, tweet, and write long threads. Then, they start a bank run. This characterization explains the behavior of SVB’s depositors, mainly from the tech and VC industries. As rates went up fast, SVB’s depositors, who were all on Twitter a lot, read the footnotes on the notices on the financial statements of the SVB and started to write long threads on the topic that SVB was insolvent. As a result, they all pulled their money out at once.
Rational depositors, not unlike traders and capital market investors, use all the available information and continuously mark to market the balance sheet of financial institutions. Unfortunately, in doing so, they heightened the bank’s exposure to interest rate risks, especially for the banks that invest in fixed-income securities, such as government bonds. However, this opens up an opportunity for using interest rate hedges to stop the run on the banks. Interest rate hedges are often in the form of swaps, a financial instrument that effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. These can be important for banks like SVB because many of their investments are tied to fixed-income bonds like mortgages or Treasuries.
When rates go up, fixed-income bonds fall in value, as with SVB. Why do bond prices respond to interest rate fluctuations? Remember that in a competitive market, all securities offer investors fair expected rates of return. If a bond is issued with a 5% coupon when competitive yields are 5%, then it sells at par value. If the market rate raises to 8%, however, who would be willing to pay a par value for a bond that only offers a 5% coupon bond? The bond price must fall until its expected return increases to the competitive return of 8%. In this environment, the fair value of the bonds will fall. Even if the investors are intended to hold these assets until maturity, which indicates they would still earn the par value, a mark-to-market method reduces the fair value of these investors’ assets.
However, once these available-for-sale, outstanding bonds are combined with interest rate hedges, such as swaps, their value can be protected against interest rate movements. One of the swaps’ functions is to transform the nature of an asset. Consider SVB in our 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% for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup. We assume it agrees to enter into a swap where it pays the fixed rate (3.2%) and receives floating plus 0.1%. Its position would then have three sets of cash flows. First, it earns 3.2% from the bonds. Second, it receives floating under the terms of the swap. And third, it pays 3.2% under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1% (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2% into assets earning the floating rate plus 10 basis points. In the real world, however, SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. Instead, it terminated or let expire rate hedges on more than $14 billion of securities throughout the year, the company said in its year-end financial report. Being unhedged was SVB’s fatal sin that its depositors did not forgive.
In this piece, I shed light on a corner of the crisis that has made this run on the bank different from the classic ones. In the current banking crisis, the collective behavior of the depositors to withdraw their cash from these banks, more than being driven by pure speculation and panic, is driven by depositors’ careful examination of the banks’ financial statements. In other words, in this crisis, we are dealing with rational depositors rather than uninformed ones. Although small, this detail would change the best approach towards stopping the run on the banks, away from deposit insurance towards using derivatives. The influential Diamond-Dybvig Model posits that deposit insurance is the best way to deal with bank runs. Accordingly, in March 2023, after the SVB’s failure, the government introduced extraordinary measures to extend the deposit insurance “to all the deposits” and disregard the $250,000 threshold. Nonetheless, despite the government’s all-in approach to providing deposit insurance, such a state-backed promise did not stop the run on the other banks.
The US government’s failure to calm the market, despite offering full-blown deposit insurance, calls for a new framework beyond the classic Diamond-Dybvig Model, where the depositors choose to remain uninformed about the financial health of their bankers. The SVB’s tragedy revealed a modern financial system made by modern, well-informed depositors. These depositors treat their deposits as a form of investment vehicle. In this new financial reality, what stops the run on a bank is a proper hedging strategy that is reported in the bank’s financial statement instead of government-backed insurance. In a strange twist, the March 2023 banking crisis teaches us that the regional banking market structure has moved in the direction that a private risk-management solution, available through the derivative markets, would be a superior resolution than the government-backed insurance for financial stability. Every cloud, even if it includes a cascade of bank runs, seems to have a silver lining.
Footnote: While writing this piece, I am visiting my family in Iran. My access to the internet is nonexistent. However, a student of mine sent me all the articles through text messages. Like always, my students are my main drivers and backers in my intellectual journey.
There is a consensus amongst the economist that the shadow banking system and the repurchase agreements (repos) have become the pinnacle of the dollar funding. In the repo market, access to liquidity depends on the firms’ idiosyncratic access to high-quality collateral, mainly U.S. Treasuries, as well as the systemic capacity to reuse collateral. Yet, the emergence of the repo market, which is considered an offshore credit system, and the expectations of higher inflation, have sparked debates about the demise of the dollar. The idea is that the repo market is becoming less attractive from an accounting and risk perspective for a small group of global banks, working as workhorses of the dollar funding network. The regulatory movement after the Great Financial Crisis (GFC), including leverage ratio requirements and liquidity buffers, depressed their ability to take counterparty risks, including that of the repo contracts. Instead, large banks are driven to reduce the costs of maintaining large balance sheets.
This note argues that the concerns about the future of the dollar might be excessive. The new monetary architecture does not structurally reduce the improtance of the U.S. government liabilities as the key to global funding. Instead, the traditional status of the dollar as the world’s reserve currency is replaced by the U.S. Treausies’ modern function as the world’s safest asset and the pinnacle of the repo market. Lastly, I put the interactions between the Fed’s roles as the manager of the government’s debt on the one hand and monetary policy architect on the other at the center of the analysis. Recognizing the interconnectedness could deepen our understanding of the Fed’s control over U.S. Treasuries.
As a result of the Bretton Woods Agreement, the dollar was officially crowned the world’s reserve currency. Instead of gold reserves, other countries accumulated reserves of dollars, the liability of the U.S. government. Till the mid-1980s, the dollar was at the top of the monetary hierarchy in both onshore and offshore financial systems. In the meantime, the dollar’s reserve status remained in an natural way. Outside the U.S., a few large global banks were supplying dollar funding to the rest of the world. This offshore bank-oriented system was called the Eurodollar market. In the U.S., the Federal Funds market, an interbank lending market, became the pinnacle of the onshore dollar funding system. The Fed conducted a simple monetary policy, detached from the capital market, and managed exclusively within the traditional banking system.
Ultimately, events never quite followed this smooth pattern, which in retrospect may not be regretted. The growth of shadow banking system meant that international investors reduced their reliance on bank loans in the Eurodollar markte. Instead, they turned to the repo market and the FX swaps market. In the U.S., the rise of the repo market implied that the U.S. monetary policy should slowly leak into capital market and directly targe the security dealers. At the heart of this structural break was the growing acceptance of the securities as collaterals.
Classical monetary economics proved to be handicapped in detecting this architectural development. According to theories, the supply of the dollar is determined in the market for the loanable funds where large banks act as financial intermediaries and stand between savers and borrowers. In the process, they set the price of the dollar funding. Regarding the global value of the dollar, as long as the Fed’s credibility in stabilizing prices exceeds its peers, and Treasury keeps its promises to pay, the global demand for the dollar will be significant. And the dollar will maintain its world reserve currency status. These models totally overlooked the role of market-makers, also called dealers, in providing short-term liquidity. However, the rise of the shadow banking system made such an abstraction a deadly flaw. In the new structure, the dealers became the de facto providers of the dollar funding.
Shadow banking created a system where the dealers in the money market funded the securities lending activities of the security dealers in the capital market. This switch from traditional banking to shadow banking unveiled an inherent duality in the nature of the Fed. The Fed is tasked to strike a balance between two rival roles: On the one hand, the Fed is the Treasury’s banker and partially manages U.S. debt. On the other hand, it is the bankers’ bank and designs monetary policy. After the financial crises of the 1980s and 1990s, the Fed tried to keep these roles divided as separate arms of macroeconomic policy. The idea was that the links between U.S. debt management and liquidity are weak, as the money market and capital market are not interconnected parts of the financial ecosystem. This weak link allowed for greater separation between monetary policy and national debt management.
The GFC shattered this judgment and exposed at least two features of shadow banking. First, in the new structure, the monetary condition is determined in the repo market rather than the banking system. The repo market is very large and the vast majority of which is backed by U.S. Treasuries. This market finances the financial market’s primary dealers’ large holdings of fixed-income securities. Second, in the new system, U.S. Treasuries replaced the dollar. The repo instruments are essentially short-term loans secured by liquid “collateral”. Although hedge funds and other types of institutional investors are important suppliers of collateral, the single most important issuer of high quality, liquid collateral, is the U.S. Treasury.
U.S. Treasury securities have become the new dollar. Hence, its velocity began to matter. The velocity of collateral, including U.S. Treasuries, is the ratio of the total pledged collateral received by the large banks (that is eligible to be reused), divided by the primary collateral (ie, sourced via reverse repos, securities borrowing, prime brokerage, and derivative margins). Before the GFC, the use (and reuse) of pledged collateral was comparable with the velocity of monetary aggregates like M2. The “reusability” of the collateral became instrumental to overcome the good collateral deficit.
After the GFC, the velocity of collateral shrank due to the Fed’s QE policies (involving purchases of bonds) and financial regulations that restricted good collateral availability. Nontheless, the availability of collateral surpassed the importance of private credit-creation in the traditional banking system. It also started to leak into the monetary policy decision-making process as the Fed started to consider the Treasury market condition when crafting its policies. At first glance, the Treasury market’s infiltration into monetary policy indicates a structural shift in central banking. First, the Treasury market is a component of the capital market, not the money market. Second, the conventional view of the Fed’s relationship with the Treasury governs that its responsibilities are mainly limited to managing the Treasury account at the Fed, running auctions, and acting as U.S. Treasuries registrar.
However, a thorough study of the traditional monetary policy would paint a different picture of the Fed and the U.S. Treasuries. Modern finance is only making the Fed’s role as a de-facto U.S. national debt manager explicit. The Fed’s primary monetary policy tool, the open market operation, is essentially monetizing national debt. Essentially, the tool enabled the Fed to monetize some portion of the national debt to control the quantity of bank reserves. The ability to control the level of bank reserves permitted the Fed to limit the level of bank intermediation and private credit creation. This allowed the Fed to focus on compromising between two objectives of price stability and full employment.
What is less understood is that the open market operation also helped the Fed’s two roles, Treasury’s bank and the bankers’ bank, to coexist privately. As private bankers’ bank, the Fed designs monetary policy to control the funding costs. As the Treasury’s bank, the Fed is implicitly responsible for U.S. debt management. The open market operation enabled the Fed to control money market rates while monetizing some portion of the national debt. The traditional monetary system simply helped the Fed to conceal its intentions as Treasury’s bank when designing monetary policy.
The point to emphasize is that the traditional central banking was only hiding the Fed’s dual intentions. The Fed could in theory monetize anything— from gold to scrap metals—but it has stuck largely to Treasury IOUs. One reason is that, unlike gold, there has never been any shortage of them. Also, they are highly liquid so the Fed can sell them with as much ease as it buys them. But, a third, and equally important reason is that in doing so, the Fed explicitly fulfilled its “role” as the manager of the U.S. national debt. All this correctly suggests that the Fed, despite its lofty position at the pinnacle of the financial system, has always been, and is, none other than one more type of financial intermediary between the government and the banking system.
The high-level relationship between the Treasury and the Fed is “inherent” and at the heart of monetary policy. Yet, nowhere along the central banking learning curve has been a meaningful examination of the right balances between the Fed’s two roles. The big assumption has been that these functions are distinctly separated from each other. This hypothesis held in the past when the banks stood between savers and borrowers as financial intermediaries. In this pre-shadow banking world, the money market and capital market were not interconnected.
Yet, the GFC revealed that more than 85 percent of the lending was based on securities lending and other credit products, including the repo. In repo, broker-dealers, hedge funds, and banks construct short-term transactions. They put up collateral—mostly U.S. Treasury securities —with an agreement to buy them back the next day or week for slightly more, and invest the proceeds in the interim. The design and conduct of the monetary policy intimately deepened on the availability and price of the U.S. Treasuries, issues at the heart of the U.S. national debt management.
The U.S. debt management and monetary policy reunion happened in the repo market. In a sense, repo is a “reserve-less currency system,” in the global funding supply chain. It is the antithesis of the reserve currency. In traditional reserve currency, central banks and major financial institutions hold a large amount of currency to use for international transactions. It is also ledger money which indicates that the repo transactions, including the securities lending of its, are computed digitally by the broker-dealers. The repo market is a credit-based system that is a reserve-less, currency-less form of ledger money.
In this world of securities lending, which has replaced traditional bank lending, the key instrument is not the dollar but the U.S. Treasury securities that are used as collateral. The U.S. national debt is being used to secure funding for private institutional investors. Sometimes lenders repledge them to other lenders and take out repo loans of their own. And the cycle goes on. Known as rehypothecation, these transfers used to be done once or twice for each posted asset but are now sometimes done six to eight times, each time creating a new money supply. This process is the de-facto modern money creation—and equally depends on the Fed’s role as Treasury’s bank and bankers’ bank.
Understanding how modern money creation works has implications for the dollar’s status in the international monetary system. Some might argue that the dollar is losing its status as the global reserve currency. They refer to the collateralized repo market and argue that this market allows international banks operating outside the supervision of the Fed to create US dollar currency. Hence, the repo, not the dollar, is the real reserve currency. Such statements overlook the repo market’s structural reliance on the U.S. Treasury securities and neglect the Fed’s role as the de-facto manager of these securities. Shadow banking merely replaced the dollar with the U.S. Treasuries as the world’s key to funding gate. In the meantime, it combined the Fed’s two roles that used to be separate. Indeed, the shadow banking system has increased the importance of U.S. institutions.
The rising dominance of the repo market in the global funding supply chain, and the decline in collateral velocity, implies that the viability of the modern Eurodollar system depends on the U.S. government’s IOUs more than any time in history. US Treasuries, the IOU of the US government, is the most high-quality collateral. When times are good, repos work fine: The agreements expire without problems and the collateral gets passed back down the chain smoothly. But eventually, low-quality collateral lurks into the system. That’s fine, until markets hit an inevitable rough patch, like, March 2020 “Dash for Cash” episode. We saw this collateral problem in action. In March credit spreads between good and junkier debt widened and Treasury prices spiked as yields plummeted because of the buying frenzy. The interest rate on one-month Treasurys dropped from 1.61% on Feb. 18 to 0.00% on March 28. That was the scramble for good collateral. The reliance on the repo market to get funding indicates that no one will take the low-quality securities, and everyone struggles for good collateral. So whenever uncertainty is high, there will be a frenetic dash to buy Treasurys—like musical chairs with six to eight buyers eagerly eyeing one chair.
Who has access to cheap credit? And who does not? Compared to small businesses and households, global banks disproportionately benefited from the Fed’s liquidity provision measures. Yet, this distributional issue at the heart of the liquidity provision programs is excluded from analyzing the recession-fighting measures’ distributional footprints. After the great financial crisis (GFC) and the Covid-19 pandemic, the Fed’s focus has been on the asset purchasing programs and their impacts on the “real variables” such as wealth. The concern has been whether the asset-purchasing measures have benefited the wealthy disproportionately by boosting asset prices. Yet, the Fed seems unconcerned about the unequal distribution of cheap credits and the impacts of its “liquidity facilities.” Such oversight is paradoxical. On the one hand, the Fed is increasing its effort to tackle the rising inequality resulting from its unconventional schemes. On the other hand, its liquidity facilities are being directed towards shadow banking rather than short-term consumers loans. A concerned Fed about inequality should monitor the distributional footprints of their policies on access to cheap debt rather than wealth accumulation.
Dismissing the effects of unequal access to cheap credit on inequality is not an intellectual mishap. Instead, it has its root in an old idea in monetary economics- the quantity theory of money– that asserts money is neutral. According to monetary neutrality, money, and credit, that cover the daily cash-flow commitments are veils. In search of the “veil of money,” the quantity theory takes two necessary steps: first, it disregards the payment systems as mere plumbing behind the transactions in the real economy. Second, the quantity theory proposes the policymakers disregard the availability of money and credit as a consideration in the design of the monetary policy. After all, it is financial intermediaries’ job to provide credit to the rest of the economy. Instead, monetary policy should be concerned with real targets, such as inflation and unemployment.
Nonetheless, the reality of the financial markets makes the Fed anxious about the liquidity spiral. In these times, the Fed follows the spirit of Walter Bagehot’s “lender of last resort” doctrine and facilitates cheap credits to intermediaries. When designing such measures, the Fed’s concern is to encourage financial intermediaries to continue the “flow of funds” from the surplus agents, including the Fed, to the deficit units. The idea is that the intermediaries’ balance sheets will absorb any mismatch between the demand-supply of credit. Whenever there is a mismatch, a financial intermediary, traditionally a bank, should be persuaded to give up “current” cash for a mere promise of “future” cash. The Fed’s power of persuasion lies in the generosity of its liquidity programs.
The Fed’s hyperfocus on restoring intermediaries’ lending initiatives during crises deviates its attention from asking the fundamental question of “whom these intermediaries really lend to?” The problem is that for both banks and non-bank financial intermediaries, lending to the real economy has become a side business rather than a primary concern. In terms of non-bank intermediaries, such as MMFs, most short-term funding is directed towards shadow banking businesses of the global banks. Banks, the traditional financial intermediaries, in return, use the unsecured, short-term liquidity to finance their near-risk-free arbitrage positions. In other words, when it comes to the “type” of borrowers that the financial intermediaries fund, households, and small-and-medium businesses are considered trivial and unprofitable. As a result, most of the funding goes to the large banks’ lucrative shadow banking activities. The Fed unrealistically relies on financial intermediaries to provide cheap and equitable credit to the economy. In this hypothetical world, consumers’ liquidity requirements should be resolved within the banking system.
This trust in financial intermediation partially explains the tendency to overlook the equitability of access to cheap credit. But it is only part of the story. Another factor behind such an intellectual bias is the economists’ anxiety about the “value of money” in the long run. When it comes to the design of monetary policy, the quantity theory is obsessed by the notion that the only aim of monetary theory is to explain those phenomena which cause the value of money to alter. This tension has crept inside of modern financial theories. On the one hand, unlike quantity theory, modern finance recognizes credit as an indispensable aspect of finance. But, on the other hand, in line with the quantity theory’s spirit, the models’ main concern is “value.”
The modern problem has shifted from explaining any “general value” of money to how and when access to money changes the “market value” of financial assets and their issuers’ balance sheets. However, these models only favor a specific type of agent. In this Wicksellian world, adopted by the Fed, agents’ access to cheap credit is essential only if their default could undermine asset prices. Otherwise, their credit conditions will be systemically inconsequential, hence neutral. By definition, such an agent can only be an “institutional” investor who’s big enough so that its financial status has systemic importance. Households and small- and medium businesses are not qualified to enter this financial world. The retail depositors’ omission from the financial models is not a glitch but a byproduct of mainstream monetary economics.
The point to emphasize is that the Fed’s models are inherently neutral about the distributional impacts of credit. They are built on the idea that despite retail credit’s significance for retail payment systems, their impacts on the economic transactions are insignificant. This is because the extent of retail credit availability does not affect real variables, including output and employment, as the demand for this “type” of credit will have proportional effects on all prices stated in money terms. On the contrary, wholesale credit underpin inequality as it changes the income and wealth accumulated over time and determines real economic activities.
The macroeconomic models encourage central bankers to neglect any conditions under which money is neutral. The growing focus on inequality in the economic debate has gone hand in hand to change perspective in macroeconomic modeling. Notably, recent research has moved away from macroeconomic models based on a single representative agent. Instead, it has focused on frameworks incorporating heterogeneity in skills or wealth among households. The idea is that this shift should allow researchers to explore how macroeconomic shocks and stabilization policies affect inequality.
The issue is that most changes to macroeconomic modeling are cosmetical rather than fundamental. Despite the developments, the models still examine inequality through income and wealth disparity rather than equitable access to cheap funding. For small businesses and non-rich consumers, the models identify wealth as negligible. Nonetheless, they assume the consumption is sensitive to income changes, and consumers react little to changes in the credit conditions and interest rates. Thus, in these models, traditional policy prescriptions change to target inequality only when household wealth changes.
At the heart of the hesitation to seriously examine distributional impacts of equitable access to credit is the economists’ understanding that access to credit is only necessary for the day-to-day operation of the payments system. Credit does not change the level of income and wealth. In these theories, the central concern has always been, and is, solvency rather than liquidity. In doing so, these models dismiss the reality that an agent’s liquidity problems, if not financed on time and at a reasonable price, could lead to liquidations of assets and hence insolvency. In other words, retail units’ access to credit daily affects not only the retail payments system but also the units’ financial wealth. Even from the mainstream perspective, a change in wealth level would influence the level of inequality. Furthermore, as the economy is a system of interlocking balance sheets in which individuals depend on one another’s promises to pay (financial assets), their access to funding also determines the financial wealth of those who depend on the validations of such cash commitments.
Such a misunderstanding about the link between credit accessibility and inequality is a natural byproduct of macroeconomic models that omit the payment systems and the daily cash flow requirement. Disregarding payment systems has produced spurious results about inequality. In these models, access to liquidity, and the smooth payment systems, is only a technicality, plumbing behind the monetary system, and has no “real” effects on the macroeconomy.
The point to emphasize is that everything about the payment system, and access to credit, is “real”: first, inthe economy as a whole, there is a pattern of cash flows emerging from the “real” side, production and consumption, and trade. A well-functioning financial market enables these cash flows to meet the cash commitments. Second, at any moment, problems of mismatch between cash flows and cash commitments show up as upward pressure on the short-term money market rate of interest, another “real” variable.
The nature of funding is evolving, and central banking is catching up. The central question is whether actual cash flows are enough to cover the promised cash commitments at any moment in time. For such conditions to be fulfilled, consumers’ access to credit is required. Otherwise, the option is to liquidate accumulations of assets and a reduction in their wealth. The point to emphasize is that those whose access to credit is denied are the ones who have to borrow no matter what it costs. Such inconsistencies show up in the money market where people unable to make payments from their current cash flow face the problem of raising cash, either by borrowing from the credit market or liquidating their assets.
The result of all this pushing and pulling is the change in the value of financial wealth, and therefore inequality. Regarding the distributional effects of monetary policy, central bankers should be concerned about the effects of monetary policy on unequal access to credit in addition to the income and wealth distribution. The survival constraint, i.e., agents’ liquidity requirements to meet their cash commitments, must be met today and at every moment in the future.
To sum up, in this piece, I revisited the basics of monetary economics and draw lessons that concern the connection between inequality, credit, and central banking. Previously, I wroteabout the far-reaching developments in financial intermediation, where non-banks, rather than banks, have become the primary distributors of credit to the real economy. However, what is still missing is the distributional effects of the credit provision rather than asset purchasing programs. The Fed tends to overlook a “distributional” issue at the heart of the credit provision process. Such an omission is the byproduct of the traditional theories that suggest money and credit are neutral. The traditional theories also assert that the payment system is a veil and should not be considered in the design of the monetary policy. To correct the course of monetary policy, the Fed has to target the recipients of credit rather than its providers explicitly. In this sense, my analysis is squarely in the tradition of what Schumpeter (1954) called “monetary analysis” and Mehrling (2013) called “Money View” – the presumption that money is not a veil and that understanding how it functions is necessary to understand how the economy works.
The Fed is banking on non-bank intermediaries, such as money market funds (MMFs), rather than banks for monetary normalization. The short-term funding market reset after the famous FOMC meeting on June 16, 2021. The Fed explicitly brought forward forecasts for tighter monetary policy and boosted inflation projections. However, it is essential to understand what lies beneath the Fed’s message. Examining the “timing” of the Fed’s normalization and the primary “beneficiaries” unveils a modified FRB/US model to include the structural change in the intermediation business. Non-bank intermediaries, including MMFs, have become primary lenders in the housing market and accept deposits. In doing so, they have replaced banks as credit providers to the economy and have boosted their role in transmitting monetary policy. Following the pandemic, the timing of the Fed’s policies can be explained by the MMFs’ balance sheet problems. This shift in the Fed’s focus towards non-bank intermediaries has implications for the banks. Even though normalization tactics are universally strengthening MMFs, there are creating liability problems for the banking system.
A long-standing trend in macro-finance, the increased presence of the MMFs in the market for loanable funds, alters the Fed’s FRB/US model and informs this decision. The FRB/US model, in use by the Fed since 1996, is a large-scale model of the US economy featuring optimizing behavior by households and firms and detailed descriptions of the real economy and the financial sector. One distinctive feature of the Fed’s model compared to dynamic stochastic general equilibrium (DSGE) models is the ability to switch between alternative assumptions about economic agents’ expectations formation and roles. When it comes to the critical question of “who funds the real economy?” it is sensible to assume that non-bank financial entities, including MMFs, have replaced banks to manage deposits and lend. On their liabilities side, MMFs have become the savers’ de-facto money managers. This industry looks after $4tn of savings for individuals and businesses. On their asset sides, they have become primary lenders in significant markets such as housing, where the Fed keeps a close watch on.
Traditionally, two essential components of the FRB/US model, the financial market and the real economy, depended on the banks lending behavior. The financial sector is captured through monetary policy developments. Monetary policy was modeled as a simple rule for the federal funds rate, an interbank lending rate, subject to the zero lower bound on nominal interest rates. A variety of interest rates, including conventional 30-year residential mortgage rates, assumed to be set by the banks’ lending activities, informs the “federal funds target.” To capture aggregate economic activity, the FRB/US model assumed the level of spending in the model depends on intermediate-term consumer loan rates, again set by the banking system. The recent FOMC announcement sent a strong signal that the FRB/US model has been modified to capture the fading role of the banks in funding the economy and setting the rates.
One of the factors behind the declining role of the banking system in financing the economy is the depositors’ inclination to leave banks. Notably, most of this institutional run on the banking system is self-inflicted. After the pandemic, the Fed and government stimulus packages pointed to an influx of deposits that could enter the banking system. However, due to banks’ balance sheet constraints, managing deposits is costly for at least two reasons. First, the scarcity of balance sheet space implies banks have to forgo the more lucrative and unorthodox business opportunities if they accept deposits. Second, as the size of banks’ balance sheets increases, banks are required to hold more capital and liquid assets. Both are expensive as they reduce banks’ returns on equity. These prudential requirements are more binding for the large, cash-rich banks. Thus, post COVID-19 pandemic, cash-rich banks advised corporate clients to move money out of their firms and deposit them in MMFs. Pushing deposits into MMFs was preferable as it would reduce the size of banks’ balance sheets. The idea was that non-bank money managers, who are not under the Fed’s regulatory radar, would be able and willing to manage the liquidity.
Effectively, bankers orchestrated run on their own banks by turning away deposits. Had the Fed overlooked such “unnatural” actions by banks, they could undermine financial stability in the long run. Therefore, after the COVID-19 pandemic, the Fed expanded access to the reverse repo programs to include non-bank money managers, such as MMFs. In doing so, the Fed signaled the critical status of the MMF industry. The Fed also crafted its policies to strengthen the balance sheet of these funds. For example, Fed lifted limits on the amount of financial cash the companies could park at the central bank from $30bn to $80bn. The absence of profitable investments has compelled MMFs to use this opportunity and place more assets with the reverse repurchase program. The goal was to drain liquidity from the system, slow down the downward pressure on the short-term rates, and improve the industry’s profit margin. The Fed’s balance sheet access drove the MMFs to a higher layer of the monetary hierarchy.
The Fed might have improved the position of the MMFs in the monetary hierarchy. However, it could not expand the ability of the MMFs to invest the money fast enough. The mismatch between the size of the MMFs and the amount of liquidity in circulation created balance sheet problems for the industry. On the liabilities side, the money under management has increased dramatically as the large-scale economic stimulus from the Fed and the US government created excess demand for short-dated Treasuries and other securities. Therefore, assets in so-called government MMFs, whose investments are limited to Treasuries, jumped above $4tn for the first time. But, on the asset side, it was a shortage of profitable investments. The issue was that too much money was chasing short-term debt, just as the US Treasury started to scale back its issuance of such bills. This combination created downward pressure on the rates. The industry was not large enough to service a large amount of cash in the system under such a low-interest-rate environment.
The downward pressure on rates was intensified despite the Fed’s effort to include the MMFs in the reserve repurchase (RRP) facility. The dearth of suitable investments has compelled MMFs to place more assets with an overnight Fed facility. Yet, as the RRP facility paid no interest, it could not resolve a fundamental threat to the economics of the MMF industry, the lack of profitable investment opportunities. Once the post-pandemic monetary policy stance made the economics of the MMF industry alarmingly unsustainable, the Fed chose to start the normalization process and increase the RRP rates. The point to emphasize is that the timing of the Fed’s monetary policy normalization matches the developments in the MMF industry.
This shift in the Fed’s focus away from the banks and towards the MMFs yields mixed results for the banks, although it is unequivocally helping MMFs. First, the increase in RRP has strengthened the asset side of MMFs’ balance sheets as the policy has created a positive-yielding place to invest their enormous money under management. Second, other normalization policies, such as the rise in the federal funds rate and interest on excess reserve (IOER), are increasing rates, especially on the short-term assets, such as repo instruments. This adjustment has been critical for the smooth functioning of the MMFs as the repo rate was another staple source of income for the industry. Repo rate, the rate at which investors swap Treasuries and other high-quality collateral for cash in the repo market, had also turned negative at times. Overall, the policies that supported MMFs also improved the state of the short-term funding as the MMF industry plays a crucial role in the market for short-term funding.
The Fed policies are creating problems for the liabilities side of specific types of banks, bond-heavy banks. As Zoltan Pozsar noted, the Fed’s recent move to stimulate the economy through the RRP rate hurts banks’ liabilities. Such policies encourage large corporate clients to direct cash into MMFs. The recently generated outflow following the normalization process is being forced on both cash-rich and bond-heavy banks. This outflow is in addition to the trend above, where cash-rich banks have deliberately pushed the deposits outside their balance sheets and orchestrated the “run on their own banks.” The critical point is that while cash-rich banks’ business model encourages such outflows, they will create balance sheet crises for the bond-heavy banks, which rely on these deposits to finance their long-term securities. The Fed recognizes that bond-heavy banks can not handle the outflows. Still, the non-bank financial intermediaries have become the center of the Fed’s policies as the main financiers of the real economy.
The Fed is relying on non-bank intermediaries rather than banks for monetary normalization. To this end, the Fed has modified its FRB/US model to capture MMFs as the source of credit creation. The new signals evolve within the new monetary framework are suggesting that new identification is here to stay. First, the financial market echoed and rewarded the Fed after making such adjustments to assume financial intermediation. The market for short-term funding was reset shortly after the Fed’s announcements. The corrections in the capital market, both in stocks and bonds, were smooth as well. Second, after all, the Fed’s transition to primarily monitor MMFs balance sheet is less of a forward-looking act and more of an adjustment to a pre-existing condition. Researchers and global market-watchers are reaching a consensus that non-bank financial intermediaries are becoming the de-facto money lenders of the first resort to the real economy. Therefore, it is not accidental that the policy that restored the short-term funding market was the one that directly supported the MMFs rather than banks. Here’s a piece of good news for the Fed. Although the Fed’s traditional, bank-centric, “policy” tools, including fed funds target, are losing their grip on the market, its new, non-bank-centric “technical” tools, such as RRP, are able to restore the Fed’s control and credibility.
“Money is pre-eminently a sanctuary, a haven for resourcesthat would otherwise go into more perilous uses.” Gurley and Shaw
Cryptocurrencies, which first emerged in the wake of the global financial crisis, offered a vision of “money” free from central bank and intermediaries’ control. The idea is that crypto liberates both private parties and non-major central banks from the fundamental need to be as close as possible to the Fed, the ultimate controller and issuer of the world’s means of the final settlement. In other words, crypto flattens the monetary hierarchy and creates a structural break from Money View’s claim that money is inherently hierarchical. In this essay, I argue that cryptocurrency is not flattening the “existing” monetary system. It creates a parallel, unstable monetary arrangement based on personnel, such as Elon Musk, rather than institutions, including central banks, and false economic prophecies. First, it assumes “scarcity of money” is the source of its value. Second, it “eliminates intermediaries,” such as dealers and banks, and relies on crypto exchanges that act as brokers to set prices. And third, it aims at stabilizing the crypto prices by guaranteeing “convertibility” while liberating itself from the central banks who make such guarantees possible under distress.
Crypto is built on a virtual hierarchy. When it comes to instruments, though, the system is mostly flat. Different cryptos are treated equally. Yet, it remains hierarchical when it comes to the relative position of its players. Similar to the original monetary system, different agents belong to different layers of the hierarchy. In contrast to it, a few high-net-worth individuals rather than institutions are at the top of it. However, the most fundamental problem is its economic foundations, which are mostly misguided monetary prophecies.
The Crypto market is built on weak foundations to support the “value,” “price,” and “convertibility” of the virtual currency. To preserve the value of the virtual currency, advocates often point to the limited supply of bitcoin and the mathematics which governs it in stark contrast to fiat money’s model of unlimited expansion regardless of underlying economic realities. It’s an unpopular position with Money View scholars who don’t view scarcity as a pressing issue. Instead, the fundamentals such as liquidity or convertibility determine the value of these monetary instruments. However, the convertibility guarantor of the last resort is the central bankers, who are circumvented in the crypto-mania.
The degree of liquidity or “moneyness” depends on how close these instruments are to the ultimate money or currency. Ultimately, the Fed’s unlimited power to create it by expanding its balance sheets puts the currency at the top of the hierarchy. The actual art of central banking would obviously be in response to shocks, or crises, in the financial and economic environment. During such periods, a central bank had not only to ensure its own solvency but the solvency of the entire banking system. For this reason, they had to hold disproportionate amounts of gold and currency. The point to emphasize is that while they stood ready to help other banks with cash and gold on demand, they could not expect the same service in return.
Further, central bankers’ unique position to expand their balance sheets to create reserves allow them to accommodate liquidity needs without the risk of being depleted. Yet, if a central bank had to protect itself against liquidity drain, it has tools such as discount-rate policy and open market operations. Also, central bankers in most countries can supply currency on-demand with reciprocal help from other banks. In this world, the Fed was and will remain first among equals.
The mistake of connecting the value of money to limited supply is as old as money itself. In 1911, Allyn Young made it tolerably clear that money is not primarily a thing that is valued for itself. The materials that made money, such as gold, other metals, or a computer code, are not the source of value for money. The valuable materials merely make it all the more certain that money itself may be “passed on,” that someone may always be found who is willing to take it in exchange for goods or services. The “passing on” feature becomes the hallmark of Allyn Young’s solutions to the mystery of money. Money’s value comes from holders’ willingness to pass it on, which is its purchasing power. It also depends on its ability to serve as a “standard of payment” or “standard of deferred payments.” Therefore, any commodity that serves as money is wanted, not for permanent use, but for passing on.
What differentiates the “means of payment” from the “purchasing power” functions is their sensitivity to the “macroeconomic conditions.” Inflation, an essential barometer of the economy, might deteriorate the value of the conventional monetary instruments relative to the inflation-indexed ones as it disproportionally reduces the former instruments’ purchasing power. Yet, its impact on their function as “means of payments” is less notable. For instance, we need more “currency” to purchase the same basket of goods and services when inflation is high, reducing currency’s purchasing power. Yet, even in this period, the currency will be accepted as means of payment.
Young warned against an old and widespread illusion that the government’s authority or the limited quantity gives the money its value. Half a century later, Gurley and Shaw (1961) criticized the quantity theory of money based on similar grounds. Specifically, they argued against the theory’s premise that the quantity of money determines money’s purchasing power, and therefore value. Such a misconception, emphasized in the quantity theory of money and built in the crypto architecture, can only be applied to an economic system handicapped by rigidities and irrationalities. In this economy, any increase in demand for money would be satisfied by deflation, even if it will retard the economic development rather than by growth in nominal money. Paradoxically, similar to the quantity theory of money, crypto-economics denies money a significant role in the economy. In other words, crypto-economics assumes that money, including cryptocurrency, is “neutral.”
Relying on the “neutrality” of money, and therefore scarcity doctrine, maintain value has real economic consequences. Monetary neutrality is objectionable even concerning an economy in which the neoclassical ground rules of analysis are appropriate on at least two grounds. First, the quantity theory underestimates the real impact of monetary policy in the long run. The theory ignores the effects of the central bank’s manipulation of the nominal money on permanent capital gains or losses. These capital gains and losses enduringly affect the aggregate spendings, including spending on capital and new technologies, and hence come to grips with real aspects of the economy in the long run.
Second, monetary neutrality overlooks the role of financial intermediaries in the monetary system. In this system, financial intermediaries continuously intervene in the flow of financial assets from borrowers to lenders. In addition, they regulate the rate and pattern of private financial-asset accumulation, the real quantity of money, and real balances desired, hence any demands for goods and labor that are sensitive to the real value of financial variables. In the quantity theory of money, financial intermediaries that affect wealth accumulation and the real side of the economy are reduced to a fixed variable, called the velocity.
To stabilize the prices, crypto economists rely on a common misconception that crypto exchanges set prices. Yet, by design, the crypto exchanges’ ability to set the prices and reduce their volatility is minimal. These exchanges’ business model is more similar to the functions of the brokers, who merely profit from commissions and listing fees and do not use their balance sheets to absorb market imbalances and therefore stabilize the market prices. If these exchanges acted like dealers, however, they could set the prices. But in doing so, they had to use their balance sheets and be exposed to the price risks. Given the current price volatility in the cryptocurrency market, the exchanges have no incentive to become dealers.
This dealer-free market implies that the exchange rate of a cryptocurrency usually depends on the actions of sellers and buyers. Each exchange merely calculates the price based on the supply and demand of its users. In other words, there’s no official global price. The point to emphasize is that this feature, the lack of an official “market price,” and intermediaries— banks and dealers–, is inherent in this virtual system. The absence of dealers, and other intermediaries, is a natural consequence of the virtual currency markets’ structural feature, called the decentralized finance (DeFi).
DeFi is an umbrella term for financial services offered on public blockchains. Like traditional intermediaries, DeFi allows clients to borrow, lend, earn interest, and trade assets and derivatives. This service is often used by clients seeking to use their crypto as collateral to increase their leverage and return. They borrow against their crypto holdings to place even larger bets in this market. In the process, they expose the lenders to the “credit risk.” In non-crypto segments of the financial market, credit risk can be contained either through intermediaries, including banks and dealers, or swaps. Both mechanisms are absent in the crypto market even though the risk and leverage are intolerably present.
In the market for monetary instruments, intermediation has always played a key role. The main reason for all the intermediation for any financial instrument is that the mix of securities, or IOUs, issued by funds-deficit agents is unattractive to many surplus agents. Financial intermediaries can offer such attractive securities for several reasons. First, they pool the funds of many investors in a highly diversified portfolio, thereby reducing risk and overcoming the minimum denominations problem. Second, intermediaries can manage cash flows. Intermediaries provide a reasonable safety in the payments system as the cash outflows are likely to be met by cash inflows. The cryptocurrency is not equipped to circumvent intermediaries.
Historically, major banks with their expertise in analyzing corporate and other credits were a natural for the intermediary business, both in the traditional market for loanable funds and the swaps market. The advantage of the swaps is that they are custom-tailored deals, often arranged by one or more intermediaries. Banks could with comfort accept the credit risk of dealing with many lesser credits, and at the same time, their names were acceptable to all potential swap parties. The dealers joined the banks and became the modern intermediaries in the interest rate, FX, and credit default swaps market. Similar to the banks, they transferred the risks from one party to the other and set the price of risk in the process. DeFi cuts these middlemen, and the risk-transfer mechanism, without providing an alternative.
The shapers of crypto finance also rely on “stablecoins” to resolve the issue of convertibility. Stablecoins have seen a massive surge in popularity mainly because they are used in DeFi transactions, aiming to eliminate intermediaries. They are cryptocurrencies where the price is designed to be pegged to fiat money. They are assumed to connect the virtual monetary system and the real one. The problem is that the private support to maintain this par, especially during the crisis, is too invisible to exist. Most recently, the New York Attorney General investigation found that starting no later than mid-2017, Tether, the most reliable Stablecoin, had no access to banking anywhere in the world, and so for periods held no reserves to back tethers in circulation at the rate of one dollar for every Tether.
The paradox is that the stability of the crypto market and DeFi ultimately depends on centralized finance and central bankers. Like traditional banks, DeFi applications allow users to borrow, lend, earn interest, and trade assets and derivatives, among other things. Yet, it differs from traditional banks because it is connected to no centralized system and wholesale market. Therefore, unlike banks, DeFi does not have access to the ultimate funding source, the Fed’s balance sheet. Therefore, their promises to maintain the “par” between stablecoins and fiat currencies are as unstable as their guarantors’ access to liquidity. Unless Elon Musk or other top influencers in the virtual hierarchy are willing to absorb the imbalances of the whole system into their balance sheet, the virtual currency, like the fiat one, begs for the mercy of the Fed when hit by a crisis. The question is whether Elon Musk will be willing to act as the crypto market’s lender and dealer of last resort during a crisis?
Those who have long positions in crypto and guarantee convertibility of the stablecoins, like traditional deficit agents, require constant access to the funding liquidity. Central banks’ role in providing liquidity during a crisis is central to a modern economic system and not a mere convenience to be tolerated. Further, the ongoing dilemma to maintain the “par” between deposits and currencies has made the original payment system vulnerable. This central issue is the primary justification for the existence of the intermediaries and the banks. Without fixing the “par” and “convertibility” problems, the freedom from intermediaries and central banks, which is the most ideologically appealing feature of crypto, will become its Achilles Hill. The crypto market has cut the intermediaries, including central banks, banks, and dealers, in its payment system without resolving the fundamental problems of the existing system. Unless crypto backers believe in blanket immunity to a crisis, a paradoxical position for the prodigy child of the capitalist system, crypto may become the victim of its ambitions, not unlike the tragedy of Macbeth. Mcbeth dramatizes the damaging physical and psychological effects of political ambition on those who seek power for its own sake.
“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. ↩
“From long experience, Fed technicians knew that the Fed could not control money supply with the precision envisioned in textbooks.” Marcy Stigum
In the last decade, monetary policy wrestled with the problem of low inflation and has become a tale of three cities: interest rate, asset purchasing, and the yield curve. The fight to reach the Fed’s inflation target started by lowering the overnight federal funds rate to a historically low level. The so-called “zero-lower bound restriction” pushed the Fed to alternative policy tools, including large-scale purchases of financial assets (“quantitative and qualitative easing”). This policy had several elements: first, a commitment to massive asset purchases that would increase the monetary base; second, a promise to lengthen the maturity of the central banks’ holdings andflatten the yield curve. However, in combination with low inflation (actual and expected), such actions have translated into persistently low real interest rates at both the yield curve’s long and short ends, and at times, the inversion of the yield curve. The “whatever it takes” large-scale asset purchasing programs of central banks were pushing the long-term yields into clear negative territory. Outside the U.S., and especially in Japan, central banks stepped up their fight against deflation by adopting a new policy called “Yield Curve Control,” which explicitly puts a cap on long-term rates. Even though the Fed so far resisted following the Bank of Japan’s footsteps, the yield curve control is the first move towards building a world that “Money View” re-imagines for central banking. The yield curve control embraces the “dealer of last resort” role of the Fed to increase its leverage over the yield curve, a chain of the private dealers. In the meantime, it reduces the Fed’s trace in the capital market and does not create as many dislocations in asset prices.
To understand this point, let’s start by translating monetary policy’s evolution into the language of Money View. In the traditional monetary policy, the Fed uses its control of reserve (at the top of the hierarchy of money) to affect credit expansion (at the bottom of the hierarchy). It also controls the fed funds rate (at the short end of the term structure) in an attempt to influence the bond rate of interest (at the long end). When credit is growing too rapidly, the Fed raises the federal fund’s target to impose discipline in the financial market. In standard times, this would immediately lower the money market dealers’ profit. This kind of dealer borrows at an overnight funding market to lend in the lend in term (i.e., three-month) market. The goal is to earn the liquidity spread.
After the Fed’s implementation of contractionary monetary policy, to compensate for the higher financing cost, money market dealers raise the term interest rate by the full amount (and perhaps a bit more to compensate for anticipated future tightening as well). This term-rate is the funding cost for another kind of dealer, called security dealers. Security dealers borrow from the term-market (repo market) to lend to the long-term capital market. Such operations involve the purchase of securities that requires financing. Higher funding cost implies that security dealers are willing to hold existing security inventories only at a lower price, and increasing long-term yield. This chain of events sketches a monetary policy transmission that happens through the yield curve. The point to emphasize here is that in determining the yield curve, the private credit market, not the Fed, sets rates and prices. The Fed has only some leverage over the system.
After the GFC, as the rates hit zero-lower bound, the Fed started to lose its leverage. In a very low-interest-rate condition, preferences shift in favor of money and against securities. One way to put it is that the surplus agents become reluctant to” delay settlement” and lower their credit market investment. They don’t want promises to pay (i.e., holding securities), and want money instead. In this environment, to keep making the market and providing liquidity, money market, and security dealers, who borrow to finance their short and long-term inventories, respectively, should be able to buy time. During this extended-time period, prices are pushed away from equilibrium. Often, the market makers face this kind of trouble and turn to the banks for refinancing. After GFC, however, the very low-interest rates mean that banks themselves run into trouble.
In a normal crisis, as the dealer system absorbs the imbalances due to the shift in preferences into its balance sheet, the Fed tried to do the same thing and take the problem off the balance sheet of the banking system. The Fed usually does so by expanding its balance sheet. The Fed’s willingness to lend to the banks at a rate lower than they would lend to each other makes it possible for the banks to lend to the dealers at a rate lower than they would otherwise charge. Putting a ceiling on the money rate of interest thus indirectly puts a floor on asset prices. In a severe crisis, however, this transmission usually breaks down. That is why after the GFC, the Fed used its leverage to put a floor on asset prices directly by buying them, rather than indirectly by helping the banks to finance dealers’ purchases.
The fundamental question to be answered is whether the Fed has any leverage over the private dealing system when interest rates are historically low. The Fed’s advantage is that it creates reserves, so there can be no short squeeze on the Fed. When the Fed helps the banks, it expands reserves. Hence the money supply grows. We have seen that the market makers are long securities and short cash. What the Fed does is to backstop those short positions by shorting cash itself. However, the Fed’s leverage over the private dealer system is asymmetric. The Fed’s magic mostly works when the Fed decides to increase elasticity in the credit market. The Fed has lost its alchemy to create discipline in the market when needed. When the rates are already very low, credit contraction happens neither quickly nor easily if the Fed increases the rates by a few basis points. Indeed, only if the Fed raises the rates high enough, it can get some leverage over this system, causing credit contraction. Short of an aggressive rate hike, the dealer system increases the spread slightly but not enough to not change the quantity of supplied credit. In other words, the Fed’s actions do not translate automatically into a chain of credit contraction, and the Fed does not have control over the yield curve. The Fed knows that, and that is why it has entered large-scale asset purchasing programs. But it is the tactful yet minimal purchases of long-term assets, rather than massive ones, that can restore the Fed’s control over the yield curve. Otherwise, the Fed’s actions could push the long-term rates into negative territory and lead to a constant inversion of the yield curve.
The yield curve control aims at controlling interest rates along some portion of the yield curve. This policy’s design has some elements of the interest rate policy and asset purchasing program. Similar to interest rate policy, it targets short-term interest rates. Comparable with the asset purchasing program, yield curve control aim at controlling the long-term interest rate. However, it mainly incorporates essential elements of a “channel” or “corridor” system. This policy targets longer-term rates directly by imposing interest rate caps on particular maturities. Like a “corridor system,” the long-term yield’s target would typically be set within a bound created by a target price that establishes a floor for the long-term assets. Because bond prices and yields are inversely related, this also implies a ceiling for targeted maturities. If bond prices (yields) of targeted maturities remain above (below) the floor, the central bank does nothing. However, if prices fall (rise) below (above) the floor, the central bank buys targeted-maturity bonds, increasing the demand and the bonds’ price. This approach requires the central bank to use this powerful tool tactfully rather than massively. The central bank only intervenes to purchase certain assets when the interest rates on different maturities are higher than target rates. Such a strategy reduces central banks’ footprint in the capital market and prevents yield curve inversion- that has become a typical episode after the GFC.
The “paradox of the yield curve” argues that the Fed’s hesitation to adopt the yield curve control to regulate the longer-term rates contradicts its decision to employ a corridor framework to control the overnight rate. Once the FOMC determines a target interest rate, the Fed already sets the discount rate above the target interest rate and the interest-on-reserve rate below. These two rates form a “corridor” that will contain the market interest rate; the target rate is often (but not always) set in the middle of this corridor. Open market operations are then used as needed to change the supply of reserve balances so that the market interest rate is as close as possible to the target. A corridor operating framework can help a central bank achieve a target policy rate in an environment in which reserves are anything but scarce, and the central bank has used its balance sheet as a policy instrument independent of the policy interest rate.
In the world of Money View, the corridor system has the advantage of enabling the Fed to act as a value-based dealer, or as Mehrling put it, “dealer of last resort,” without massively purchasing assets and constantly distorting asset prices. The value-based dealer’s primary role is to put a ceiling and floor on the price of assets when the dealer system has already reached their finance limits. Such a system can effectively stabilize the rate near its target. Stigum made clear that standard economic theory has no perfect answer to how the Fed gets leverage over the real economy. The question is why the Fed is willing to embrace the frameworks that flatten the yield curve and reduce its influence. In the meantime, it is hesitant to adopt the “yield curve control,” even though this framework boosts the Fed’s leverage by empowering the Fed to set an explicit cap on longer-term rates.
In this year’s Jackson Hole meeting, the Fed announced a formal shift away from previously articulated longer-run inflation objective of 2 percent towards achieving inflation that averages 2 percent over time. The new accord aims at addressing the shortfalls of the low “natural rate” and persistently low inflation. More or less, all academic debates in that meeting were organized as arguments about the appropriate quantitative settings for a Taylor rule. The rule’s underlying idea is that the “market” tends to set the nominal interest rate equal to the natural rate plus expected inflation. The Fed’s role in this equation is to reduce or increase this market rate by changing the short-term federal funds rate whenever the inflation deviates from the target. The goal is to stabilize the long-run inflation. The Fed believes that the recent secular decline in natural rates relative to the historical average has constrained the power of the federal funds rate to achieve this mandate. The expectation is that the Fed’s decision to tolerate a temporary overshooting of the longer-run inflation to keep inflation and inflation expectations centered on 2 percent following periods when inflation has been persistently below 2 percent will address the framework’s constant failure and restore the magic of central banking. However, the ongoing issue with the Taylor rule-based monetary policy frameworks, including the recent one, is that they require the Fed to overlook the trends in the credit market, and only focus on the developments in the real economy, such as inflation or past inflation deviations, when setting the short-term interest rates. Rectifying such blind spots is what money view scholars were hoping for when the Fed announced its intention to review the monetary policy framework.
The logic behind the new framework, known as the average inflation targeting strategy, is that inflation undershooting makes achieving the target unlikely in the long run as it pushes the inflation expectations below the target. This being the case, when there is a long period of inflation undershooting the target, the Fed should act to undo the undershooting by overshooting the target for some time. The Fed sold forecast (or average) targeting to the public as a better way of accomplishing its mandate compared to the alternative strategies as the new framework makes the Fed more “history-dependent.” Translated into the money view language, however, the new inflation-targeting approach onlydelays the process of imposing excessive discipline in the money market when the consumer price index rises faster than the inflation target and providing excessive elasticity when prices are growing slower than the inflation target.
From the money view perspective, the idea that the interest rate should not consider private credit market trends will undermine central banking’s power in the future, as it has done in the past. The problem we face is not that the Fed failed to follow an appropriate version of Taylor rule. Rather, and most critically, these policies tend to abstract from the plumbing behind the wall, namely the payment system, by disregarding the credit market. Such a bias may have not been significant in the old days when the payment system was mostly a reserve-based system. In the old world, even though it was mostly involuntarily, the Fed used to manage the payment system through its daily interventions in the market for reserves. In the modern financial system, however, the payment system is a credit system, and its quality depends on the level of elasticity and discipline in the private credit market.
The long dominance of economics and finance views imply that modern policymakers have lost sight of the Fed’s historical mission to manage the balance between discipline and elasticity in the payment system. Instead of monitoring the balance between discipline and elasticity in the credit market, the modern Fed attempts to keep the bank rate of interest in line with an ideal “natural rate” of interest, introduced by Knut Wicksell. In Wicksellians’ world, in contrast to the money view, securing the continuous flow of credit in the economy through the payment system is not part of the Fed’s mandate. Instead, the Fed’s primary function is to ensure it does not choose a “money rate” of interest different from the “natural rate” of interest (profit rate capital). If lower, then the differential creates an incentive for new capital investment, and the new spending tends to cause inflation. If prices are rising, then the money rate is too low and should be increased; if prices are falling, then the money rate is too high and should be decreased. To sum up, Wicksellians do not consider private credit to be intrinsically unstable. Inflation, on the other hand, is viewed as the source of inherent instability. Further, they see no systemic relation between the payment system and the credit market as the payment system simply reflects the level of transactions in the real economy.
The clash between the standard economic view and money view is a battle between two different world views. Wicksell’s academic way of looking at the world had clear implications for monetary policy: set the money rate equal to the natural rate and then stand back and let markets work. Unfortunately, the natural rate is not observable, but the missed payments and higher costs of borrowing are. In the money view perspective, the Fed should use its alchemy to strike a balance between elasticity and discipline in the credit market to ensure a continuous payment system. The money view barometer to understand the credit market cycle is asset prices, another observable variable. Since the crash can occur in commodities, financial assets, and even real assets, the money view does not tell us which assets to watch. However, it emphasizes that the assets that are not supported by a dealer system (such as residential housing) are more vulnerable to changes in credit conditions. These assets are most likely to become overvalued on the upside and suffer the most extensive correction on the downside. A central bank that understands its role as setting interest rates to meet inflation targets tends to exacerbate this natural tendency toward instability. These policymakers could create unnaturally excessive discipline when credit condition is already tight or vice versa while looking for a natural rate of interest.
The COVID-19 crisis has revealed the resiliency of the banking system compared to the Great Financial Crisis (GFC). At the same time, it also put banks’ absence from typically bank-centric markets on display. Banks have already demonstrated their objection to passing credit to small-and-medium enterprises (SMEs). In doing so, they rejected their traditional role as financial intermediaries for the retail depositors. This phenomenon is not surprising for scholars of “Money View”. The rise of market-based finance coincides with the fading role of banks as financial intermediaries. Money View asserts that banks have switched their business model to become the lenders and dealers in the interbank lending and the repo market, both wholesale markets, respectively. Banks lend to each other via the interbank lending market and use the proceeds to make a market in funding liquidity via the repo market.
Aftermath the COVID-19 crisis, however, an episode in the market for term funding cast a dark shadow over such doctrine. The issue is that it appears thatinterbank lending no longer serves as the significant marginal source of term funding for banks. Money Market Funds (MMFs) filled the void in other wholesale money markets, such as markets for commercial paper and the repo market. After the pandemic, MMFs curtailed their repo lending, both with dealers and in the cleared repo segment, to accommodate outflows. This decision by MMFs increased the cost of term dollar funding in the wholesale money market. This distortion was contained only when the Fed directly assisted MMFs through Money Market Mutual Fund Liquidity Facility or MMLF. Money View emphasizes the unique role of banks in the liquidity hierarchy since their liabilities (bank deposits) are a means of payment. Yet, such developments call into question the exact role of banks, who have unique access to the Fed’s balance sheet, in the financial system. Some scholars warned that instruments, such as the repo, suck out liquidity when it most needed. A deeper look might reveal that it is not money market instruments that are at fault for creating liquidity issues but the inconsistency between the banks’ perceived, and actual significance, as providers of liquidity during a crisis.
There are two kinds of MMFs: prime and government. The former issue shares as their liabilities and hold corporate bonds as their assets while the latter use the shares to finance their holding of safe government debts. By construction, the shares have the same risk structure as the underlying pool of government bonds or corporate bonds. In doing so, the MMFs act as a form of financial intermediaries. However, this kind of intermediation is different from a classic, textbook, one. MMFs mainly use diversification to pool risk and not so much to transform it. Traditional financial intermediaries, on the other hand, use their balance sheet to transform risk- they turn liquid liabilities (overnight checkable deposits) into illiquid assets (long term loans). There is some liquidity benefit for the mutual fund shareholder from diversification. But such a business model implies that MMFs have to keep cash or lines of credit, which reduces their return.
To improve the profit margin, MMFs have also become active providers of liquidity in the market for term funding, using instruments such as commercial paper (CP) and the repo. Commercial paper (CP) is an unsecured promissory note with a fixed maturity, usually three months. The issuer, mostly banks and non-financial institutions, promises to pay the buyer some fixed amount on some future date but pledges no assets, only her liquidity and established earning power, guaranteeing that promise. Investment companies, principally money funds and mutual funds, are the single biggest class of investors in commercial paper. Similarly, MMFs are also active in the repo market. They usually lend cash to the repo market, both through dealers and cleared repo segments. At its early stages, the CP market was a local market that tended, by investment banking standards, to be populated by less sophisticated, less intense, less motivated people. Also, MMFs were just one of several essential players in the repo market. The COVID-19 crisis, however, revealed a structural change in both markets, where MMFs have become the primary providers of dollar funding to banks.
It all started when the pandemic forced the MMFs to readjust their portfolio to meet their cash outflow commitments. In the CP market, MMFs reduced their holding of CP in favor of holding risk-free assets such as government securities. In the repo market, they curtailed their repo lending both to dealers and in the cleared segment of the market. Originally, such developments were not considered a threat to financial stability. In this market, banks were regarded as the primary providers of dollar funding. The models of market-based finance, such as the one provided by Money View framework, tend to highlight banks’ function as dealers in the wholesalemoney market, and the main providers of funding liquidity. In these models, banks set the price of funding liquidity and earn an inside spread. Banks borrow from the interbank lending market and pay an overnight rate. They then lend the proceeds in the term-funding market (mostly through repo), and earn term rate. Further, more traditional models of bank-based financial systems depict banks as financial intermediaries between depositors and borrowers. Regardless of which model to trust, since the pandemic did not create significant disturbances in the banking system, it was expected that the banks would pick up the slack quickly after MMFs retracted from the market.
The problem is that the coronavirus casts doubt on both models, and highlights the shadowy role of banks in providing funding liquidity. The experience with the PPP loans to SMEs shows that banks are no longer traditional financial intermediaries in the retail money market. At the same time, the developments in the wholesale money market demonstrate that it is MMFs, and no longer banks, who are the primary providers of term funding and determine the price of dollar funding. A possible explanation could be that on the one hand, banks have difficulty raising overnight funding via the interbank lending market. On the other hand, their balance sheet constraints discourage them from performing their function as money market dealers and supply term funding to the rest of the financial system. The bottom line is that the pandemic has revealed that MMFs, rather than large banks, had become vital providers of US dollar funding for other banks and non-bank financial institutions. Such discoveries emphasize the instability of funding liquidity in bank-centric wholesale and retail money markets.
The withdrawals of MMFs from providing term funding to banks in the CP markets, and their decision to decease their reverse repo positions (lending cash against Treasuries as collateral) with dealers (mostly large banks), translated into a persistent increase of US dollar funding costs globally. Even though it was not surprising in the beginning to see a tension in the wholesale money market due to the withdrawal of the MMFs, the Fed was stunned by the extent of the turbulences. This is what caused the Fed to start filling the void that was created by MMFs’ withdrawal directly by creating new facilities such as MMLF. According to the BIS data, by mid-March, the cost of borrowing US funding widened to levels second only to those during the GFC even though, unlike the GFC, the banking system was not the primary source of distress. A key reason is that MMFs have come to play an essential role in determining US dollar funding both in a secured repo market and an unsecured CP market.In other words, interbank lendingno longer serves as a significant source of funding for banks.Instead, non-bank institutional investors such as MMFs constitute the most critical wholesale funding providers for banks. The strength of MMFs, not the large, cash-rich, banks, has, therefore, become an essential measure of bank funding conditions.
The wide swings in dollar funding costs, caused by MMFs’ withdrawal from these markets, hampered the transmission of the Fed’s rate cuts and other facilities aimed at providing stimulus to the economy in the face of the shock. With banks’ capacity as dealers were impaired, and MMFs role was diminished, the Fed took over this function of dealer of last resort in the wholesale money market. Interestingly, the Fed acted as a dealer of last resort via its MMLF facility rather than assuming the role of banks in this market. The goal was to put an explicit floor on the CP’s price and then directly purchase three-month CP from issuers via Commercial Paper Funding Facility (CPFF). These operations also have broader implications for the future of central bank financial policies that might include MMFs rather thanbanks. The Fed’s choice of policies aftermath the pandemic was the unofficial acknowledgment that it is MMFs’ role, rather than banks’, that has become a crucial barometer for measuring the health of the market for dollar funding. Such revelation demands us to ask a delicate question of what precisely the banks’ function has become in the modern financial system. In other words, is it justifiable to keep providing the exclusive privilege of having access to the central bank’s balance sheet to the banks?
