Liquidity transformation is a crucial function for many banks and non-bank financial intermediaries. It is a balance sheet operation where the firm creates liquid liabilities financed by illiquid assets. However, liquidity transformation is a risky operation. For policymakers and macroeconomists, the main risk is to financial stability caused by systemic liquidation of assets, also called “firesale.” In this paper, I emphasize an essential characteristic of firesale that is less explored—the order of liquidation. The order of liquidation refers to the sequence at which financial assets are converted into cash or cash equivalents- when the funds face significant cash outflow. Normally, economists explain assets’ order of liquidation by using theories of capital structure. However, the financial market episodes, such as March 2020 “Cash for Dash,” have revealed that firms’ behaviors are not in line with the predictions of such classical theories. Capital structure theories, such as “Pecking Order” and “Trade-off,” argue that fund managers should use their cash holding as the first line of defense during a liquidity crunch before selling their least liquid asset. In contrast to such prophecies, during the recent financial turmoil, funds liquidated their least liquid assets, even US Treasuries, first, before unhoarding their cash and cash equivalents. In this paper, I explore a few reasons that generated the failure of these theories when explaining funds’ behavior during a liquidity crisis. I also explain why Money View can be used to build an alternative framework.
Traditional capital structure theories such as pecking order differentiate financial assets based on their “adverse selection” and “information costs” rather than their “liquidity.” The pecking order theory is from Myers (1984) and Myers and Majluf (1984). Since it is famous, I will be brief. Assume that there are two funding sources available to firms whenever they hit their survival constraint: cash (or retained earnings) and securities (including debt and equity). Cash has no “adverse selection” problem, while securities, primarily equity, are subject to serious adverse selection problems. Compared to equity, debt securities have only a minor adverse selection problem. From the point of view of an external investor, equity is strictly riskier than debt. Both have an adverse selection risk premium, but that premium is significant on equity. Therefore, an outside investor will demand a higher rate of return on equity than on debt. From the perspective of the firm’s managers, the focus of our paper, cash is a better source of funds than is securities. Accordingly, the firm would prefer to fund all its payments using “cash” if possible. The firm will sell securities only if there is an inadequate amount of cash.
In the trade-off theory, another popular conventional capital structure theory, a firm’s decision is a trade-off between tax-advantage and capital-related costs. In a world that firms follow trade-off theory, their primary consideration is a balance between bankruptcy cost and tax benefits of debt. According to this approach, the firm might optimize its financing strategies, including whether to make the payments using cash or securities, by considering tax and bankruptcy costs. In most cases, these theories suggest that the firms prefer to use their cash holdings to meet their financial obligations. They use securities as the first resort only if the tax benefit of high leverage exceeds the additional financial risk and higher risk premiums. The main difference between pecking order theory and trade-off theory is that while the former emphasizes the adverse selection costs, the latter highlights the high costs of holding extra capital. Nonetheless, similar to the pecking order theory, the trade-off theory predicts that firms prefer to use their cash buffers rather than hoarding them during a financial crisis.
After the COVID-19 crisis, such predictions became false, and both theories underwent a crisis of their own. A careful examination of how funds, especially intermediaries such as Money Market Funds, or MMFs, adjusted their portfolios due to liquidity management revealed that they use securities rather than cash as the first line of defense against redemptions. Indeed, such collective behavior created the system-wide “dash for cash” episode in March 2020. On that day, few funds drew down their cash buffers to meet investor redemptions. However, contrary to pecking order and trade-off theories, most funds that faced redemptions responded by selling securities rather than cash. Indeed, they sold more of the underlying securities than was strictly necessary to meet those redemptions. As a result, these funds ended March 2020 with higher cash levels instead of drawing down their cash buffers.
Such episodes cast doubt on the conventional theories of capital structure for liquidity management, which argues that funds draw on cash balances first and sell securities only as a last resort. Yet, they align with Money View’s vision of the financial hierarchy. Money View asserts that during the financial crisis, preservation of cash, the most liquid asset located at the top of the hierarchy, will be given higher priority. During regular times, the private dealing system conceals such priorities. In these periods, the private dealing system uses its balance sheets to absorb trade imbalances due to the change in preferences to hold cash versus securities. Whenever the demand for cash exceeds that of securities, the dealers maintain price continuity by absorbing the excess securities into their balance sheets. Price continuity is a characteristic of a liquid market in which the bid-ask spread, or difference between offer prices from buyers and requested prices from sellers, is relatively small. Price continuity reflects a liquid market. In the process, they can conceal the financial hierarchy from being in full display.
During the financial crisis, this hierarchy will be revealed for everyone to see. In such periods, the dealers cannot or are unwilling to use their job correctly. Due to the market-wide pressing need to meet payment obligations, the trade imbalances show up as an increased “qualitative” difference between cash and securities. In the course of this differentiation, there is bound to be an increase in the demand for cash rather than securities, a situation similar to the “liquidity trap.” A liquidity trap is a situation, described in Keynesian economics, in which, after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields so low a rate of interest. In this environment, investors would prefer to reduce the holding of their less liquid assets, including US Treasuries, before using their cash reserves to make their upcoming payments. Thus, securities will be liquidated first, and cash will be used only as a last resort.
The key to understanding such behaviors by funds is recognizing that the difference in the quality of the financial instruments’ issuers creates a natural hierarchy of financial assets. This qualitative difference will be heightened during a crisis and determines the capital structure of the funds, and the “order of liquidation” of the assets, for liquidity management purposes. When the payments are due and liquidity is scarce, firms sell illiquid assets ahead of drawing down the cash balances. In the process, they disrupt money markets, including repo markets, as they put upward pressure on the price of cash in terms of securities. Thus, during a crisis, the liability of the central banks becomes the most attractive asset to own. On the other hand, securities, the IOUs of the private sector, become the less desirable asset to hold for asset managers.
So why do standard theories of capital structure fail to explain firms’ behavior during a liquidity crisis? First, they focus on the “fallacious” type of functions and costs during a liquidity crunch. While the dealers’ “market-making” function and liquidity are at the heart of Money View, the standard capital structure theories stress the “financial intermediation” and “adverse selection costs.” In this world, the “ordering” of financial assets to be liquidated may stem from sources such as agency conflicts and taxes. For Money View, however, what determines the order of firesaled assets, and the asset managers’ portfolio is less the agency costs and more the qualitative advantage of one asset than another. The assets’ status determines such qualitative differences in the financial hierarchy. By disregarding the role of dealers, standard capital structure models omit the important information that the qualitative difference between cash and credit will be heightened, and the preference will be changed during a crisis.
Such oversight, mixed with the existing confusion about the non-bank intermediaries’ business model, will be fatal for understanding their behavior during a crisis. The difficulty is that standard finance theories assume that non-bank intermediaries, such as MMFs, are in the business of “financial intermediation,” where the risk is transferred from security-rich agents to cash-rich ones. Such an analysis is correct at first glance. However, nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by price changes rather than by traditional intermediation. A careful review of the MMFs balance sheets can confirm this viewpoint. Such examination reveals that these funds, rather than transforming the risks, “pool” them. Risk transformation is a defining characteristic of financial intermediation. Yet, even though it appears that an MMF is an intermediary, it is mainly just pooling risk through diversification and not much transforming risk.
Comprehending the MMF’s business as pooling the risks rather than transforming them is essential for understanding the amount of cash they prefer to hold. The MMF shares have the same risk properties as the underlying pool of bonds or stocks by construction. There is some benefit for the MMF shareholders from diversification. There is also some liquidity benefit, perhaps because open-end funds typically promise to buy back shares at NAV. But that means that MMFs have to keep cash or lines of credit for the purpose, even though it will lower their return and increase the costs for the shareholders.
Finally, another important factor that drives conventional theories’ failure is their concern about the cash flow patterns in the future and the dismissal of the cash obligations today. This is the idea behind the discounting of future cash flows. The weighted average cost of capital (WACC), generally used in these theories, is at the heart of discounting future cash flows. In finance, discounted cash flow analysis is a method of valuing security, project, company, or asset using the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management, and patent valuation. In this world, the only “type” of cash flow that matters is the one that belongs to a distant future rather than the present, when firms should make today’s payments. On the contrary, the present, not the future, and its corresponding cash flow patterns, is what Money View is concerned about. In Money View’s world, the firm should be able to pay its daily obligations. If it does not have continuous access to liquidity and cannot meet its cash commitments, there will be no future.
The pecking order theory derives much of its influence from a view that it fits naturally with several facts about how companies use external finance. Notably, this capital structure theory derives support from “indirect” sources of evidence such as Eckbo (1986). Whenever the theories are rejected, the conventional literature usually attributes the problem to cosmetic factors, such as the changing population of public firms, rather than fundamental ones. Even if the pecking order theory is not strictly correct, they argue that it still does a better job of organizing the available evidence than other theories. The idea is that the pecking order theory, at its worst, is the generalized version of the trade-off theory. Unfortunately, none of these theories can explain the behavior of firms during a crisis, when firms should rebalance their capital structure to manage their liquidity needs.
The status of classical theories, despite their failures to explain different crises, is symptomatic of a hierarchy in the schools of economic thought. Nonetheless, they are unable to provide strong capital structure theories as they focus on fallacious premises such as the adverse selection or capital costs of an asset. To build theories that best explain the financing choices of corporates, economists should emphasize the hierarchical nature of financial instruments that reliably determines the order of liquidation of financial assets. In this regard, Money View seems to be positioned as an excellent alternative to standard theories. After all, the main pillars of this framework are financial hierarchy, dealers, and liquidity management.
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.
“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. ↩
“Investors persist in trading despite their dismal long-run trading record partly because the argument seduces them that because prices are as likely to go up as down (or as likely to go down as up), trading based on purely random selection rules will produce neutral performance… Apparently, this idea is alluring; nonetheless, it is wrong. The key to understanding the fallacy is the market-maker.”
Jack Treynor (using Walter Bagehot as his Pseudonym) in The Only Game In Town.
By Elham Saeidinezhad
Value investing, or alternatively called “value-based dealing,” is suffering its worst run in at least two centuries. The COVID-19 pandemic intensified a decade of struggles for this popular strategy to buy cheap stocks in often unpopular enterprises and sell them when the stock price reverts to “fundamental value.” Such a statement might be a nuisance for the followers of the Capital Asset Pricing Model (CAPM). However, for liquidity whisperers, such as “Money Viewers,” such a development flags a structural shift in the financial market. In the capital market, the market structure is moving away from being a private dealing system towards becoming a public one. In this future, the Fed- a government agency- would be the market liquidity provider of the first resort, even in the absence of systemic risk. As soon as there is a security sell-off or a hike in the funding rate, it will be the Fed, rather than Berkshire Hathaway, who uses its balance sheet and increases monetary base to purchase cheap securities from the dealers and absorb the trade imbalances. The resulting expansion in the Fed’s balance sheet, and monetary liabilities, would also alter the money market. The excessive reserve floating around could transform the money market, and the payment system, from being a credit system into a money-centric one. In part 1, I lay out the theoretical reasons blinding CAPM disciples from envisioning such a brave new future. In part 2, I will explain why the value investors are singing their farewell song in the market.
Jack Treynor, initially under the pseudo name Walter Bagehot, developed a model to show that security dealers rely on value investing funds to provide continuous market liquidity. Security dealers are willing to supply market liquidity at any time because they expect value-based dealers’ support during a market sell-off or upon hitting their finance limit. A sell-off occurs when a large volume of securities are sold and absorbed in the balance sheet of security dealers in a short period of time. A finance limit is a situation when a security dealer’s access to funding liquidity is curtailed. In these circumstances, security dealers expect value investors to act as market liquidity providers of near last resort by purchasing dealers excess inventories. It is such interdependence that makes a private dealing system the pillar of market-liquidity provision.
In CAPM, however, such interconnectedness is neither required nor recognized. Instead, CAPM asserts that risk-return tradeoff determines asset prices. However, this seemingly pure intuition has generated actual confusion. The “type” of risk that produces return has been the subject of intense debates, even among the model’s founders. Sharpe and Schlaifer argued that the market risk (the covariance) is recognizably the essential insight of CAPM for stock pricing. They reasoned that all investors have the same information and the same risk preferences. As long as portfolios are diversified enough, there is no need to value security-specific risks as the market has already reached equilibrium. The prices are already the reflection of the assets’ fundamental value. For John Lintern, on the other hand, it was more natural to abstract from business cycle fluctuations (or market risk) and focused on firm-specific risk (the variance) instead. His stated rationale for doing so was to abstract from the noise introduced by speculation. The empirical evidence’s inconsistency on the equilibrium and acknowledging the speculators’ role was probably why Sharpe later shifted away from his equilibrium argument. In his latest works, Sharpe derived his asset pricing formula from the relationship between the return on individual security and the return on any efficient portfolio containing that security.
CAPM might be confused about the kind of risk that matters the most for asset pricing. But its punchline is clear- liquidity does not matter. The model’s central assumption is that all investors can borrow and lend at a risk-free rate, regardless of the amount borrowed or lent. In other words, liquidity provision is given, continuous, and free. By assuming free liquidity, CAPM disregards any “finance limit” for security dealers and downplays the importance of value investing, as a matter of logic. In the CAPM, security dealers have constant and free access to funding liquidity. Therefore, there is no need for value investors to backstop asset prices when dealers reach their finance limit, a situation that would never occur in CAPM’s world.
Jack Treynor and Fischer Black partnered to emphasize value-based dealers’ importance in asset pricing. In this area, both men continued to write for the Financial Analysts Journal (FAJ). Treynor, writing under the pseudonym Walter Bagehot, thinks about the economics of the dealer function in his “The Only Game in Town” paper, and Black responds with his visionary “Toward a Fully Automated Stock Exchange.” At the root of this lifelong dialogue lies a desire to clarify a dichotomy inside CAPM.
Fischer, despite his belief in CAPM, argued that the “noise,” a notion that market prices deviate from the fundamental value, is a reality that the CAPM, built on the market efficiency idea, should reconcile with. He offered a now-famous opinion that we should consider stock prices to be informative if they are between “one-half” and “twice” their fundamental values. Mathematician Benoit Mandelbrot supported such an observation. He showed that individual asset prices fluctuate more widely than a normal distribution. Mandelbrot used this finding, later known as the problem of “fat tails” or too many outliers, to call for “a radically new approach to the problem of price variation.”
From Money View’s perspective, both the efficient market hypothesis and Manderbrot’s “fat tails” hypothesis capture parts of the data’s empirical characterization. CAPM, rooted in the efficient market hypothesis, captures the arbitrage trading, which is partially responsible for asset price changes. Similarly, fat tails, or fluctuations in asset prices, are just as permanent a feature of the data. In other words, in the world of Money View, arbitrage trading and constant deviations from fundamental value go together as a package and as a matter of theoretical logic. Arbitrageurs connect different markets and transfer market liquidity from one market to another. Simultaneously, despite what CAPM claims, their operation is not “risk-free” and exposes them to certain risks, including liquidity risk. As a result, when arbitrageurs face risks that are too great to ignore, they reduce their activities and generate trade imbalances in different markets.
Security dealers who are making markets in those securities are the entities that should absorb these trade imbalances in their balance sheets. At some point, if this process continues, their long position pushes them to their finance limit-a point at which it becomes too expensive for security dealers to finance their inventories. To compensate for the risk of reaching this point and deter potential sellers, dealers reduce their prices dramatically. This is what Mandelbrot called the “fat tails” hypothesis. At this point, dealers stop making the market unless value investors intervene to support the private dealing system by purchasing a large number of securities or block trades. In doing so, they become market liquidity providers of last resort. For decades, value-based dealers used their balance sheets and capital to purchase these securities at a discounted price. The idea was to hold them for a long time and sell them in the market when prices return to fundamental value. The problem is that the value investing business, which is the private dealing system’s pillar of stability, is collapsing. In recent decades, value-oriented stocks have underperformed growth stocks and the S&P 500.
The approach of favoring bargains — typically judged by comparing a stock price to the value of the firm’s assets — has a long history. But in the financial market, nothing lasts forever. In the equilibrium world, imagined by CAPM, any deviation from fundamental value must offer an opportunity for “risk-free” profit somewhere. It might be hard to exploit, but profit-seeking arbitrageurs will always be “able” and “willing” to do it as a matter of logic. Fisher Black-Jack Treynor dialogue, and their admission of dealers’ function, is a crucial step away from pure CAPM and reveals an important fallacy at the heart of this framework. Like any model based on the efficient market hypothesis, CAPM abstracts from liquidity risk that both dealers and arbitragers face.
Money View pushes this dialogue even further and asserts that at any moment, security prices depend on the dealers’ inventories and their daily access to funding liquidity, rather than security-specific risk or market risk. If Fischer Black was a futurist, Perry Mehrling, the founder of “Money View,” lives in the “present.” For Fischer Black, CAPM will become true in the “future,” and he decided to devote his life to realizing this ideal future. Perry Mehrling, on the other hand, considers the overnight funding liquidity that enables the private dealing system to provide continuous market liquidity as an ideal system already. As value investing is declining, Money View scholars should start reimagining the prospect of the market liquidity and asset pricing outside the sphere of the private dealing system even though, sadly, it is the future that neither Fischer nor Perry was looking forward to.
“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.
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?
“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.
The unprecedented increase in the Fed’s involvement since the COVID-19 crisis has affected how financial markets function. The Fed has supported most corners of the financial market in an astonishingly short period. In the meantime, there have been growing anxieties that the Fed has not used its arsenals to help the derivatives market yet. To calm market sentiment, on March 27, 2020, regulatory agencies, led by the Fed, have taken steps to support market liquidity in the derivatives market by easing capital requirements for market makers- typically banks or investment banks. The agencies permit these firms to use a more indulgent methodology when measuring credit risk derivatives to account for the post-COVID-19 crisis credit loss. The goal is to encourage the provision of counterparty services to institutional hedgers while preventing dealers that are marginally solvent from becoming insolvent as a result of the increased counterparty credit exposure.
These are the facts, but how shall we understand them? These accommodative rulings reveal that from the Fed’s perspective, the primary function of derivatives contracts is a store of value. As stores of value, financial instruments are a form of long-term investment that is thought to be better than money. Over time, they generate increases in wealth that, on average, exceed those we can obtain from holding cash in most of its forms. If the value of these long-term assets falls, the primary threat to financial stability is an insolvency crisis. The insolvency crisis happens when the balance sheet is not symmetrical: the side that shows what the banks own, the Assets, is less valuable than Liabilities and Equity (i.e. banks’ capital). From the Fed’s point of view, this fearful asymmetry is the principal catastrophe that can happen due to current surge in the counterparty credit risk.
From the Money View perspective, what is most troubling about this entire debate, is the unrelenting emphasis on solvency, not liquidity, and the following implicit assumption of efficient markets. The underlying cause of this bias is dismissing the other two inherent functions of derivatives, which are means of payment and means of transferring risk. This is not an accident but rather a byproduct of dealer-free models that are based on the premises of the efficient market hypothesis. Standard asset pricing models consider derivative contracts as financial assets that in the future, can generate cash flows. Derivatives’ prices are equal to their “fundamental value,” which is the present value of these future cash flows. In this dealer-free world, the present is too short to have any time value and the current deviation of price from the fundamental value only indicates potential market dislocations. On the contrary, from a dealer-centric point of view, such as the Money View, daily price changes can be fatal as they may call into question how smoothly US dollar funding conditions are. In other words, short-term fluctuations in derivative prices are not merely temporary market dislocations. Rather, they show the state of dealers’ balance sheet capacities and their access to liquidity.
To keep us focused on liquidity, we start by Fischer Black and his revolutionary idea of finance and then turn to the Money View. From Fischer Black’s perspective, a financial asset, such as a long-term corporate bond, could be sold as at least three separate instruments. The asset itself can be used as collateral to provide the necessary funding liquidity. The other instrument is interest rate swaps (IRS) that would shift the interest rate risk. The third instrument is a credit default swap (CDS) that would transfer the risk of default from the issuer of the derivative to the derivative holder. Importantly, although most derivatives do not require any initial payment, investors must post margin daily to protect the counterparties from the price risk. For Fischer Black, the key to understanding a credit derivative is that it is the price of insurance on risky assets and is one of the determinants of the asset prices. Therefore, derivatives are instrumental to the success of the Fed’s interventions; to make the financial system work smoothly, there should be a robust mechanism for shifting both assets and the risks. By focusing on transferring risks and intra-day liquidity requirements, Fischer Black’s understanding of the derivatives market already echoes the premises of modern finance more than the Fed’s does.
The Money View starts where Fischer Black ended and extends his ideas to complete the big picture. Fischer Black considers derivatives chiefly as instruments for transferring risk. Money View, on the other hand, recognizes that there is hybridity between risk transfer and means of payment capacities of the derivatives. Further, the Money View uses analytical tools, such as balance sheet and Treynor Model, to shed new light on asset prices and derivatives. Using the Treynor Model to understand the economics of dealer’s function, this framework shows that asset prices are determined by the dealers’ inventory positions as well as their access to funding liquidity. Using balance sheets to translate derivatives, and their cash flow patterns, into parallel loans, the Money View demonstrates that the derivatives’ main role is cash flow management. In other words, derivatives’ primary function is to ensure that firms can continuously meet their survival constraint, both now and in the future.
The parallel loan construction treats derivatives, such as a CDS, as a swap of IOUs. The issuer of the derivatives makes periodic payments, as a kind of insurance premium, to the derivative dealers, who have long positions in those derivatives, whenever the debt issuer, makes periodic interest payment. The time pattern of the derivatives holders’ payments is the mirror image and the inverse of the debtors. This creates a counterparty risk for derivatives dealers. If the debtor defaults, the derivatives dealers face a loss as they must pay the liquidation value of the bond. Compared to the small periodic payments, the liquidation value is significant as it is equal to the face value. The recent announcements by the Fed and other regulatory agencies allow derivatives holders, especially banks and investment banks, to use a more relaxed approach when measuring counterparty credit risk. Put it differently, firms are allowed to keep less capital today to shield themselves against such losses in the future. Regulators’ primary concern is to uphold the value of banks’ assets to cement their solvent status.
Yet, from the point of view of the derivatives dealers who are sellers of these insurances, liquidity is the leading concern. It is possible to create portfolios of such swaps, which pool the idiosyncratic default risk so that the risk of the pool is less than the risk of each asset. This diversification reduces the counterparty “credit” risk even though it does not eliminate it. However, they are severely exposed to liquidity risk. These banks receive a stream of small payments but face the possibility of having to make a single large payment in the event of default. Liquidity risk is a dire threat during the COVID-19 crisis because of two intertwined forces. First, there is a heightened probability that we will see a cascade of defaults by the debtors aftermath of the crisis. These defaults imply that banks must be equipped to pay a considerable amount of money to the issuers of these derivatives. The second force that contributes to this liquidity risk is the possibility that the money market funding dries up, and the dealers cannot raise funding.
Derivatives have three functions. They act as stores of value, a means of payment, and a transfer of risk. Thus, they offer two of the three uses of money. Remember that money is a means of payment, a unit of account, and a store of value. But financial instruments have a third function that can make them very different from money: They allow for the transfer of risk. Regulators’ focus is mostly on one of these functions- store of value. The store of value implies that these financial instruments are reported as long-term assets on a company’s balance sheet and their main function is to transfer purchasing power into the future. When it comes to the derivatives market, regulators’ main concern is credit risks and the resulting long-term solvency problems. On the contrary, Money View uses the balance sheet approach to show the hybridity between means of payment and transferring risk functions of derivatives. This hybridity highlights that the firms use insurance instruments to shift the risk today and manage cash flow in the future. In this world, after a shock happens, it is access to liquidity, rather than the symmetry of the balance sheet, that keeps trading banks, and derivatives dealers, in business.
“Don’t be seduced into thinking that that which does
not make a profit is without value.”
Arthur Miller
By Elham Saeidinezhad
The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment system during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.
Traditionally, the banking system provides payment services by being prepared to trade currency for deposits and vice versa, at a fixed price par. However, when we try to understand the economics of banks’ function as providers of payment systems, we quickly face a puzzle. The question is how banks manage to make markets in currency and deposits at a fixed price and a zero spread. In other words, what incentivizes banks to provide this crucial service. Typically, what enables the banks to offer payment systems, despite its negligible earnings, is their complementary and profitable role of being dealers in liquidity. Banks are in additional business, the business of bearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They cannot change the price of deposits in terms of currency. Still, they can expand and contract the number of deposits because deposits are their own liability, and they can expand and contract the quantity of currency because of their access to the discount window at the Fed.
This two-tier monetary system, with the central bank
serving as the banker to commercial banks, is the essence of the account-based payment
system and creates flexibility for the banks. This flexibility enables banks
to provide payment systems despite the fact the price is fixed, and their
profit from this function is negligible. It also differentiates banks, who are
dealers in the money market, from other kinds of dealers such as security
dealers. Security dealers’ ability to establish very long positions in
securities and cash is limited due to their restricted access to funding
liquidity. The profit that these dealers earn comes from setting an ask price
that is higher than the bid price. This profit is called inside spread. Banks,
on the other hand, make an inside spread that is equal to zero when providing
payment since currency and deposits trade at par. However, they are not
constrained by the number of deposits or currency they can create. In other
words, although they have less flexibility on price, they have more flexibility
in quantity. This flexibility comes from banks’ direct access to the central
banks’ liquidity facilities. Their exclusive access to the central banks’
liquidity facilities also ensures the finality of
payments, where
payment is deemed to be final and irrevocable so that individuals and
businesses can make payments in full confidence.
The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve).
