Tag: FINANCIAL CRISIS

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Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #3: Have Regional Banks Become New Hedge Funds with A “Fixed-Income Arbitrage” Strategy?

“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.

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Elham's Money View Blog Hot Spots and Hedges

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

“Street Speaks in Swap Land” — Marcy Stigum

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Elham's Money View Blog Hot Spots and Hedges

Hot Spots and Hedges #1: Have SVB’s Informed Depositors Created a Derivative-Based Solution to Bank Runs?

“[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.

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

Are the Banks Taking Off their Market-Making Hat to Become Brokers?

“A broker is foolish if he offers a price when there is nothing on the offer side good to the guy on the phone who wants to buy. We may have an offering, but we say none.” Marcy Stigum

By Elham Saeidinezhad

Before the slow but eventual repeal of Glass-Steagall in 1999, U.S. commercial banks were institutions whose mission was to accept deposits, make loans, and choose trade-exempt securities. In other words, banks were Cecchetti’s “Financial intermediaries.” The repeal of Glass-Steagall allowed banks to enter the arena so long as they become financial holding companies. More precisely, the Act permitted banks, securities firms, and insurance companies to affiliate with investment bankers. Investment banks, also called non-bank dealers, were allowed to use their balance sheets to trade and underwrite both exempt and non-exempt securities and make the market in both the capital market and the money market instruments. Becoming a dealer brought significant changes to the industry. Unlike traditional banks, investment banks, or merchant banks, as the British call it, can cover activities that require considerably less capital. Second, the profit comes from quoting different bid-ask prices and underwriting new securities, rather than earning fees. 

However, the post-COVID-19 crisis has accelerated an existing trend in the banking industry. Recent transactions highlight a shift in power balance away from the investment banking arm and market-making operations. In the primary markets, banks are expanding their brokerage role to earn fees. In the secondary market, banks have started to transform their businesses and diversify away from market-making activities into fee-based brokerages such as cash management, credit cards, and retail savings accounts. Two of the underlying reasons behind this shift are “balance sheet constraints” and declining credit costs that reduced banks’ profit as dealers and improved their fee-based businesses. From the “Money View” perspective, this shift in the bank’s activities away from market-making towards brokerage has repercussions. First, it adversely affects the state of “liquidity.” Second, it creates a less democratic financial market as it excludes smaller agents from benefiting from the financial market. Finally, it disrupts payment flows, given the credit character of the payments system.

When a banker acts as a broker, its income depends on fee-based businesses such as monthly account fees and fees for late credit card payments, unauthorized overdrafts, mergers, and issuing IPOs. These fees are independent of the level of the interest rate. A broker puts together potential buyers and sellers from his sheet, much in the way that real estate brokers do with their listing sheets and client listings. Brokers keep lists of the prices bid by potential buyers and offered by potential sellers, and they look for matches. Goldman, Merrill, and Lehman, all big dealers in commercial paper, wear their agent hat almost all the time when they sell commercial paper. Dealers, by contrast, take positions themselves by expanding their balance sheets. They earn the spread between bid-ask prices (or interest rates). When a bank puts on its hat as a dealer (principal), that means the dealer is buying for and selling using its position. Put another way, in a trade; the dealer is the customer’s counterparty, not its agent.

Moving towards brokerage activity has adverse effects on liquidity. Banks are maintaining their dealer role in the primary market while abandoning the secondary market. In the primary market, part of the banks’ role as market makers involves underwriting new issues. In this market, dealers act as a one-sided dealer. As the bank only sells the newly issued securities, she does not provide liquidity. In the secondary market, however, banks act as two-sided dealers and supply liquidity. Dealer banks supply funding liquidity in the short-term money market and the market liquidity in the long-term capital market. The mission is to earn spreads by always quoting bids and offers at which they are willing to buy and sell. Some of these quotes are to other dealers. In many sectors of the money market, there is an inside market among dealers. 

As opposed to the bond market, the money market is a wholesale market for high-quality, short-term debt instruments, or IOUs. In the money market, dealing banks make markets in many money market instruments. Money market instruments are credit elements that lend elasticity to the payment system. Deficit agents, who do not have adequate cash at the moment, have to borrow from the money market to make the payment. Money market dealers expand the elasticity daily and enable the deficit agents to make payments to surplus agents. Given the credit element in the payment, it is not stretching the truth to say that these short-term credit instruments, not the reserves, are the actual ultimate means of payment. Money market dealers resolve the “payments management” problem by enabling deficit agents to make payments before they receive payments.

Further, when dealers trade, they usually do not even know who their counterparty is. However, if banks become brokers, they need to “fine-tune” quotes because it matters who is selling and buying. Brokers prefer to trade with big investors and reduce their ties with smaller businesses. This is what Stigum called “line problems.” She explains a scenario where the Citi London offered to sell 6-month money at the bid rate quoted by a broker, and then, the bidding bank told the broker she changed her mind but had forgotten to call. In this situation, which is a typical one in the Eurodollar market, the broker would be committed to completing her bid by finding Citi a buyer at that price. Otherwise, the broker would sell Citi’s money at a lower rate and pay a difference equal to Citi’s dollar amount and would lose by selling at that rate. Since brokers operate on thin margins, a broker wouldn’t be around long if she often got “stuffed.” Good brokers take care to avoid errors by choosing their counterparties carefully. 

After the COVID-19 pandemic, falling interest rates, the lower overall demand for credit, and regulatory requirements that limit the use of balance sheets have reduced banks’ profits as dealers. In the meantime, the banks’ fee-based businesses that include credit cards late-fees, public offerings, and mergers have become more attractive. The point to emphasize here is that the brokerage business does not involve providing liquidity and making the market while supplying liquidity in the money and capital market is the source of dealer banks’ revenue. Further, brokers tend to only trade with large corporations, while dealers’ supply of liquidity usually does not depend on who their counterparty is. Finally, as the payment system is much closer to a credit system than a money system, its well-functioning relies on money market instruments’ liquidity. Modern banks may wear one of two hats, agent (broker) or principal (dealers), in dealing with financial market instruments. The problem is that only one of these hats allows banks to make the market, facilitate the payment system, and democratize access to the credit market.

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

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

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

By Elham Saeidinezhad

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

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

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

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

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

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

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

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

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Is the Government’s Ambiguity About the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans?

By Elham Saeidinezhad

The COVID-19 crisis has created numerous risks for small and medium enterprises (SMEs). The only certainty for SMEs has been that the government’s support has been too flawed to mitigate the shock. The program’s crash is not an accident. As mentioned in the previous Money View blog, one of the PPP loan design flaws is the government’s reliance on banks to act traditionally and intermediate credit to SMEs. Another essential, yet not well-understood design flaw at the heart of the PPP loan program is its ambiguity about the secondary market. The structure I propose to resolve such uncertainty focuses on the explicit government guarantee for the securitization of the PPP loans, similar to the GSE’s role in the mortgage finance system.

Such flaws are the byproduct of the central bank’s tendency to isolate shadow banking, and its related activities, from traditional banking. These kinds of bias would not exist in the “Money View” framework, where shadow banking is a function rather than an entity. “Money market funding of capital market lending” is a business deal that can happen in the balance sheet of any entity- including banks and central banks. One way to identify a shadow banker from a traditional banker is to focus on their sources and uses of finance. A traditional banker is simply a credit intermediary. Her alchemy is to facilitate economic growth by bridging any potential mismatch between the kind of liabilities that borrowers want to issue (use of finance) and the nature of assets that creditors want to hold (source of funding). Nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by “price changes” in the capital market, where securities are traded, rather than by traditional intermediation. Further, banks are reluctant to act as a financial intermediary for retail depositors as they have already switched to their more lucrative role as money market dealers.

Modern finance emphasizes that no risk is eliminated in the process of “credit intermediation,” only transferred, and sometimes quite opaquely. Such a conviction gave birth to the rise of market-based finance. In this world, a shadow banker, sometimes a bank, uses its source of funding, usually overnight loans, to supply “term-funding” in the wholesale money market. In doing so, it acts as a dealer in the wholesale money market. Also, financial engineering techniques, such as securitization, by splitting the securitized assets into different tranches, allows a shadow banker to “enhance credit ” while transferring risks to those who can shoulder them. The magic of securitization enables a shadow banker to tap capital-market credit in the secondary market. Ignoring the secondary market is a fatal problem in the design of PPP loans.

To understand the government pandemic stimulus program for the SMEs, let’s start by understanding the PPP loan structure. The U.S. Treasury, along with financial regulators such as the Fed, adopted two measures to facilitate aid to SMEs under the CARES Act. First, the Fed announced the formation of the Paycheck Protection Program Loan Facility (the “PPPLF”). This program enables insured depository institutions to obtain financing from the Fed collateralized by Paycheck Protection Program (“PPP”) loans. The point to emphasize here is that the Fed, in essence, is the ultimate financier of such loans as banks could use the credits to SMEs as collateral to finance their lending from the Fed. Second, PPP loans are assigned a zero-percent risk-weight for purposes of U.S. risk-based capital requirements. This feature is essentially making PPP loans exempt from risk-based (but not leverage) capital requirements when held by a banking organization subject to U.S. capital requirements. 

Despite the promising appearance of such programs, the money is not flowing towards SMEs. One of the deadly flaws of this program is that it overlooks the importance of the secondary market. Specifically, ambiguity exists regarding the Small Business Administration (SBA)’s role in the secondary market due to the nature of the PPP loans and how they are regulated. The CARES Act provides that PPP loans are a traditional form of the SBA guaranteed loan. Such a statement implies that the PPP loans would not be 100% guaranteed in the secondary market as the SBA guaranteed loans are subject to certain conditions that should be satisfied by the borrower. First, the SBA wants to ensure that the entity claiming a right to payment from the SBA holds a valid title to the SBA loan. Second, the SBA requires the borrower to fulfill the PPP’s forgiveness requirements. Securitization requires the consent of the SBA. What is not mentioned in the CARES Act is that the SBA’s existing regulations restrict the ability of such loans to be transferred in the secondary market. Such restrictions block the credit to flow to the SMEs.

Under such circumstances, free transfer of PPPs in the secondary market could result in chaos when the PPP loans are later presented to the SBA by the holder for forgiveness or guarantee. Some might propose to ask for approval from the SBA before the securitization process. Yet, prior approval requirements for loan transfers, even though it might reduce the confusion mentioned above, hinder the ability to transfer newly originated PPP loans into the secondary market. Given that the PPP entails a massive amount of loans – $349 billion – to be originated in a short period, transfer restrictions could have a material impact on the ability to get much-needed funding to small businesses quickly. The program’s failure to notice such a conflict is a byproduct of the government’s tendency to ignore the role of the secondary market in the success of programs that aims at providing credit to retail depositors.

A potential solution would be for a government agency, such as the Small Business Administration (SBA), to guarantee the PPP loans in the secondary market in the same manner as Fannie Mae and Freddie Mac do for the mortgage loans. Fannie Mae and Freddie Mac are government-sponsored enterprises (the GSEs) that purchase mortgages from banks and use securitization to enhance the flow of credit in the mortgage market. The GSEs help the flow of credit as they have a de facto subsidy from the government. The market believes that the government will step in to guarantee their debt if they become insolvent. For the case of the PPP loans, instead of banks keeping the loans on their balance sheet until the loan was repaid, the bank who made the loan to the SMEs (the originator) should be able to sell the loan to the SBA. The SBA then would package the PPP loans and sells the payment rights to investors. The point to emphasize here is that the government both finance such loans in the primary market- the Fed accepts the PPP loans as collateral from banks- and ensures the flow of credit by securitizing them in the secondary market. Such a mechanism provides an unambiguous and ultimate guarantee for the PPP loans in the credit market that the government aims at offering anyways. This kind of explicit government guarantee could also help the smooth flow of credit to SMEs, which has been the original goal of the government in the first place.

Money View, through its recognition of banks as money market dealers in market-based finance and originators of securitized assets, could shed some light on the origins of those complications. Previously in the Money View blog, I proposed a potential solution to circumvent banks and directly injecting credit to the SMEs, through tools such as central bank digital currencies (CBDC). In this piece, the proposal is to adopt the design of the mortgage finance system to provide unambiguous government support and resolve the perplexities regarding marketing PPP loans in the secondary market. Until this confusion is resolved, banking entities with regulatory or internal funding constraints may be unwilling to originate PPP loans without a clear path for obtaining financing or otherwise transferring such credits into the secondary market. Such failures come at the expense of retail depositors, including small businesses.

Acknowledgment: Writing this piece would not be possible without a fruitful exchange that I had with Dr. Rafael Lima Sakr, a Teaching Fellow at Edinburgh Law School.

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Forget About the “Corona Bond.” Should the ECB Purchase Eurozone Government Bond ETFs?

By Elham Saeidinezhad

In recent history, one of a few constants about the European Union (EU) is that it follows the U.S. footstep after any disaster. After the COVID-19 crisis, the Fed expanded the scope and duration of the Municipal Liquidity Facility (MLF) to ease the fiscal conditions of the states and the cities. The facility enables lending to states and municipalities to help manage cash flow stresses caused by the coronavirus pandemic. In a similar move, the ECB expanded its support for the virus-hit EU economies in response to the coronavirus pandemic. Initiatives such as Pandemic Emergency Purchase Programme (PEPP) allow the ECB to open the door to buy Greek sovereign bonds for the first time since the country’s sovereign debt crisis by announcing a waiver for its debt. 

There the similarity ends. While the market sentiment about the Fed’s support program for municipals is very positive, a few caveats in the ECB’s program have made the Union vulnerable to a market run. Fitch has just cut Italy’s credit rating to just above junk. The problem is that unlike the U.S., the European Union is only a monetary union, and it does not have a fiscal union. The investors’ prevailing view is that the ECB is not doing enough to support governments of southern Europe, such as Spain, Italy, and Greece, who are hardest hit by the virus. Anxieties about the Union’s fiscal stability are behind repeated calls for the European Union to issue common eurozone bonds or “corona bond.” Yet, the political case, especially from Northern European countries, is firmly against such plans. Further, despite the extreme financial needs of the Southern countries, the ECB is reluctant to lift its self-imposed limits not to buy more than a third of the eligible sovereign bonds of any single country and to purchase sovereign bonds in proportion to the weight of each country’s investment in its capital. This unwillingness is also a political choice rather than an economic necessity.

It is in that context that this piece proposes the ECB to include the Eurozone government bond ETF to its asset purchasing program. Purchasing government debts via the medium of the ETFs can provide the key to the thorny dilemma that is shaking the foundation of the European Union. It can also be the right step towards creating a borrowing system that would allow poorer EU nations to take out cheap loans with the more affluent members guaranteeing the funds would be returned. The unity of EU members faces a new, painful test with the coronavirus crisis. This is why the Italian Prime Minister Guiseppe Conte warned that if the bloc fails to stand up to it, the entire project might “lose its foundations.” The ECB’s decision to purchase Eurozone sovereign debt ETFs would provide an equal opportunity for all the EU countries to meet the COVID-19 excessive financial requirements at an acceptable price. Further, compared to the corona bond, it is less politically incorrect and more common amongst the central bankers, including those at the Fed and the Bank of Japan.

In the index fund ecosystem, the ETFs are more liquid and easier to trade than the basket of underlying bonds. What lies behind this “liquidity transformation” is the different equilibrium structure and the efficiency properties in markets for these two asset classes. In other words, the dealers make markets for these assets under various market conditions. In the market for sovereign bonds, the debt that is issued by governments, especially countries with lower credit ratings, do not trade very much. So, the dealers expect to establish long positions in these bonds. Such positions expose them to the counterparty risk and the high cost of holding inventories. Higher price risk and funding costs are correlated with an increase in spreads for dealers. Higher bid-ask spreads, in turn, makes trading of sovereign debt securities, especially those issued by countries such as Italy, Spain, Portugal, and Greece, more expensive and less attractive.

On the contrary, the ETFs, including the Eurozone government bond ETFs, are considerably more tradable than the underlying bonds for at least two reasons. First, the ETF functions as the “price discovery” vehicle because this is where investors choose to transact. The economists call the ETF a price discovery vehicle since it reveals the prices that best match the buyers with the sellers. At these prices, the buying and selling quantities are just in balance, and the dealers’ profitability is maximized. According to Treynor Model, these “market prices” are the closest thing to the “fundamental value” as they balance the supply and demand. Such an equilibrium structure has implications for the dealers. The make markers in the ETFs are more likely to have a “matched book,” which means that their liabilities are the same as their assets and are hedged against the price risk. The instruments that are traded under such efficiency properties, including the ETFs, enjoy a high level of market liquidity.

Second, traders, such as asset managers, who want to sell the ETF, would not need to be worried about the underlying illiquid bonds. Long before investors require to acquire these bonds, the sponsor of the ETF, known as “authorized participants” will be buying the securities that the ETF wants to hold. Traditionally, authorized participants are large banks. They earn bid-ask spreads by providing market liquidity for these underlying securities in the secondary market or service fees collected from clients yearning to execute primary trades. Providing this service is not risk-free. Mehrling makes clear that the problem is that supporting markets in this way requires the ability to expand banks’ balance sheets on both sides, buying the unwanted assets and funding that purchase with borrowed money. The strength of banks to do that on their account is now severely limited. Despite such balance sheet constraints, by acting as “dealers of near last resort,” banks provide an additional line of defense in the risk management system of the asset managers. Banks make it less likely for the investors to end up purchasing the illiquid underlying assets.

That the alchemists have created another accident in waiting has been a fear of bond market mavens and regulators for several years. Yet, in the era of COVID-19, the alchemy of the ETF liquidity could dampen the crisis in making by boosting virus-hit countries’ financial capacity. Rising debt across Europe due to the COVID-19 crisis could imperil the sustainability of public finances. This makes Treasury bonds issued by countries such as Greece, Spain, Portugal, and Italy less tradable. Such uncertainty would increase the funding costs of external bond issuance by sovereigns. The ECB’s attempt to purchase Eurozone government bonds ETFs could partially resolve such funding problems during the crisis. Further, such operations are less risky than buying the underlying assets.

Some might argue the ETFs create an illusion of liquidity and expose the affluent members of the ECB to an unacceptably high level of defaults by the weakest members. Yet, at least two “real” elements, namely the price discovery process and the existence of authorized participants who act as the dealers of the near last resort, allows the ETFs to conduct liquidity transformation and become less risky than the underlying bonds. Passive investing sometimes is called as “worse than Marxism.” The argument is that at least communists tried to allocate resources efficiently, while index funds just blindly invest according to an arbitrary benchmark’s formula. Yet, devouring capitalism might be the most efficient way for the ECB to circumvent political obstacles and save European capitalism from itself.

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

By Elham Saeidinezhad and Jack Krupinski*

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

By Elham Saeidinezhad

“What institutions build, they can destroy.” Anonymous

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

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

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

Discussion Questions:

  1. In your opinion, why do standard economic theories tend to overlook payment systems in their models?
  2. What is the prerequisite for Libra to continue its function as a currency when a severe financial crisis hit the economy?
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