Tag: Funding Liquidity

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Elham's Money View Blog

Is the Recent Buyback Spree Creating Liquidity Problems for the Dealers?

“You are a side effect,” Van Houten continued, “of an evolutionary process that cares little for individual lives. You are a failed experiment in mutation.”


― John Green, The Fault in Our Stars

By Elham Saeidinezhad

The anxiaties about large financial corporations’ debt-funded payouts- aka “stock buybacks”- is reemerging a decade after the financial crisis. Companies on the S&P 500 have poured more than $5.3 trillion into repurchasing their own shares since 2010. The root cause of most concerns is that stock buybacks do not contribute to the productive capacities of the firm. Indeed, these distributions to stockholders disrupt the growth dynamic that links the productivity and pay of the labor force. Besides, these payments that come on top of dividends could weaken the firms’ credit quality. These analyses, however, fail to
appreciate the cascade effect that will hurt the dealers’ liquidity positions due to higher stock prices. Understanding this side effect has become even more significant as the share of major financial corporations, including JPMorgan, are trading at records, and are getting very expensive. That high-class problem should concern dealers who are providing market liquidity for these stocks and establishing short positions in the process. Dealers charge a fee to handle trades between the buyers and
sellers of securities. Higher stock prices make it more expensive for short selling dealers to settle the positions by repurchasing securities on the open market. If stocks become too high-priced, it might reduce dealers’ ability and willingness to provide market liquidity to the system. This chain of events that threatens the state of market liquidity is missing from the standard analysis of share buybacks. 

At the very heart of the discussion about share buybacks lay the question of how companies should use their cash. In a buyback, a company uses its cash to buy its own existing shares and becomes the biggest demander of its own stock. Firms usually repurchase their own stocks when they have surplus cash flow or earnings, which
exceed those needed to finance positive net present value investment
opportunities. The primary beneficiaries of these operations are shareholders who receive extra cash payments on top of dividends. The critical feature of stock buybacks is that it can be a self-fulfilling prophecy for the stock price. Since each remaining share gets a more significant piece of the profit and value, the companies bid up the share values and boost their own stock prices. The artificially high stock  prices can create liquidity andsettlement problems for the dealers who are making market for the stocks and have established short positions in the process.

Short selling is used by market makers to provide market liquidity in
response to unanticipated demand or to hedge the risk of a long position in the same security or a related security. On the settlement date, when the contract expires, the dealer must closeout- or settle- the
position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market. If the prices
become too high, they will not have enough capital to secure their short sales. At this point, whoever clears their trade will force them to liquidate. If they continue losing money, dealers face severe liquidity problems, and they may go bankrupt. The result would be an illiquid market. To sum up, in recent years, buybacks by public firms have become an essential technique for distributing earnings to shareholders. Not surprisingly, this trend has started a heated debate amongst the critiques. The problem, however, is that most analyzes have failed to capture the effect of these operations on dealers’ market-making capacity, and the state of market liquidity, when share prices become too high. 

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

By Elham Saeidinezhad

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

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

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

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

Discussion Questions:

  1. What are the main differences between FX swaps and FX forwards?
  2. What connects the dealers in the FX swaps and the FX forwards market?
  3. What makes the FX market a funding market?
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Elham's Money View Blog

Can Shadow Banking Replace Traditional Banking? We Will See Soon Enough

By Elham Saeidinezhad

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

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

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

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

Discussion Questions:

  1. Which regulatory requirements have constrained the ability of the banks to lend to the repo market?
  2. What does the lender of near last resort mean?
  3. Who are the main players in the shadow banking system?
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