Tag: Market Liquidity

Elham's Money View Blog Hot Spots and Hedges

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

Post author By Elham Saeidinezhad
Post date March 17, 2023

“[Interest Rate Swap] is a perfect example of the gains that can be realized from specialization along the lines of comparative advantage. Triple-A and single-B can together reduce their joint costs of borrowing by each borrowing in the market in which they get the best terms; then, using a swap, they can divvy up the savings they have realized, and each ends up with the type of liability they wanted in the first place.” Says Marcia Stigum (1978)

Silicon Valley Bank (SVB) was born on October 17, 1983. It was announced dead by the FDIC and other government agencies on March 1o, 2023. Nonetheless, SVB’s failure began an intriguing postmortem debate on bank runs. Many discussions have been conducted on essential issues such as the roots of the crisis, the nature of government bailouts, and recrafting bank regulation (such as making liquidity measures such as liquidity coverage ratio (LCR) time-sensitive). However, one of the standard narratives indicates that the SVB’s doomed fate is determined by the classic type of depositors who follow herd behavior and are primarily driven by human psychology and panic.

However, the March 2023 banking crisis revealed that modern depositors’ behavior, including their decision to run on a bank, is less driven by the animal spirit and more by the actual information in banks’ financial statements. In other words, modern depositors’ behavior has shifted from being uninformed and displaying herd behavior to becoming individually informed and information-derived. This distinction between traditional, uninformed depositors and modern, informed ones has essential implications for the measures to stop the bank run. Given the nature of the modern depositors, banks’ usage, and reporting of hedges, including interest rate futures and swaps, would be a better option to stop a run on a bank and a banking crisis in general than other classic solutions such as deposit insurance. In addition, accounting for the structural change in the type of depositors, from uninformed to informed, could open new avenues, such as using derivatives, to improve financial stability in the future.

Most standard narratives of the March 2023 bank run are based mainly on classic models such as the Diamond-Dybvig Model of bank runs. In this model, the assumption is that the depositors are uninformed. To such depositors, as long as they did not reach the $250,000 threshold, putting money in a bank appeared as safe as buying Treasuries. Both investments had full government backing. As a result, they do not need to evaluate the financial health of their deposit-taking institutions. As their behavior is driven by “animal spirit” rather than a particular detail in banks’ financial statements, “any” worries, imaginary or real, about the viability of such insurance, if believed by enough people, could lead to a run on a bank. In this environment, the model suggests that even though some banks tend to stop the convertibility of checkable deposits to currency, the best option to stop a bank run would be “deposit insurance.”

In contrast to the assumption of such models, the depositors who initiated the runs on SVB, Signature, Silvergate, and other regional banks are characterized as informed, finance-savvy, well-informed, and informed. They are known to use all the available information and extensively tweet about every detail and footnote in the financial statements of their bankers. For instance, in the case of SVB, they examined the bank’s balance sheet, “marked to market” its assets, and noticed its exposure to interest rate risk. Moreover, they initiated the run on the bank once the bank reported virtually no interest rate hedges on its massive bond portfolio. In other words, the run on the SVB revealed that modern depositors’ behavior is less driven by the animal spirit and psychology and is indeed informed.

This distinction between traditional, uninformed depositors and modern, rational ones has essential implications for the measures to stop the bank run. It opens the door for derivatives to be considered as a private-risk management tool that enhances financial stability. One of the most significant risks to SVB’s business model was catering to a rational group of investors who treated bank deposits as a form of investment vehicle and continuously checked the bank’s balance sheet. This change from uninformed to rational (well-informed) depositors is a continuation of the existing evolution in banking. In the first phase of this structural change, “retail” depositors were replaced by “institutional” ones such as pension funds. The main difference between these two was the amount of cash they would inject into the banking system.

Nonetheless, both were uninformed. They cared not about the banks’ financial condition and balance sheets to which they gave their money. Instead, they just wanted the top rate available on an FDIC-insured deposit. To this depositor, as long as she did not breach the $250,000 mark, putting money in a bank appeared as safe as buying Treasuries. Moreover, both investments had full government backing. Consequently, banks around the country, including the shaky and the sick, found they were flooded with money if they posted attractive rates. This is a pretty good picture of things in the fifties.

After the Great Financial Crisis (GFC), and the strengthening of the liquidity and capital ratios, systemically important banks, such as JPMorgan Chase, Credit Suisse, and Bank of America, restructured their business models to become market makers in wholesale money markets. They minimized their deposit-taking activity. As a result, medium-sized and large regional banks changed their business model to pick up the slack. For these banks, retail deposits were a dead end. Nontheless, attracting large deposits per se was not the only goal when it came to institutional deposits. Instead, they sought “well-informed” clients such as tech, crypto, venture capitalists (VCs), and startups. Therefore, banks such as SVB, Signature, and Silvergate preferred serving highly specialized, local, and finance-savvy depositors. These regional banks structured their business models to become the Bank of Crypto, VCs, or Startups.

If the change in systemically important banks’ business model transformed the market-making business, large, regional banks’ restructuring changed the banking and deposit-taking world. On the liability side, the modern banking era started with the “death of the retail deposits.” This evolution was revealed in the balance sheet of the SVB. On the liability side, much of the recent SVB’s deposit growth was driven by VCs and startup businesses. These depositors obtained liquidity through liquidity events, such as IPOs, secondary offerings, SPAC fundraising, venture capital investments, acquisitions, and other fundraising activities.

On the asset side, SVB and other specialized banks that served rational depositors were outside the business of making loans. Indeed, startups and crypto customers do not have good collaterals like fixed assets or recurring cash flows. As a result, they are less-reliable corporate borrowers. Nonetheless, the most important reason was that these customers did not need loans. Instead, equity investors provided them with a constant supply of cash. Marcy Stigum, in the late 1970s, called this a “death of loans.” The idea is that top corporate customers have access to public and private market credit, where they can borrow more cheaply than banks. Banks have adjusted to the loss of this business by instead purchasing fixed-income securities. In the case of SVB, government bonds became a large portion of the bank portfolio.

This change from uninformed to rational depositors and the corresponding assets-liabilities strategies contributed to the ongoing banking mania in at least two hybrid ways. On the one hand, serving rational depositors who do not need loans implies the large-scale addition of long-term bonds backed by the US government to the banks’ portfolios. The result is that these specialized banks are unusually exposed to “interest-rate risk.” When interest rates go up, most banks have to pay more interest on deposits but get paid more interest on their loans and end up profiting from rising interest rates. On the other hand, banks such as SVB and Signature own a lot of long-duration bonds. These bonds’ market value goes down as rates go up. Every bank has some mix of this — every bank borrows short to lend long; that is what banking is — but many banks end up more balanced. At the same time, rational depositors, unlike traditional ones, continuously pay attention to the financial statements of the banks and the footnotes. As a result, they constantly “mark to market” the banks’ financial assets and extremely penalize the banks whenever the fair value of their assets is at a loss.

Let us use an example to understand this point and its systemic importance. Let us assume that a bank has $100 worth of deposits as its liabilities. On the asset side, the bank uses cash to purchase a government bond worth $100. In the meantime, the Fed announced a rate hike from 0% to 2%. A traditional depositor would account for the bank’s assets “at cost,” using the price the bank paid to purchase those bonds, in this case, $100. A rational depositor, in contrast, continuously marks to market the value of the bank’s assets. In this case, they account for the value of the bonds at their fair market value. If the bank has a bond with a face value of $100, this type of depositor will check the market price for that bond when the Fed announces its interest rate policy. If, for instance, it is $97, then the bank’s asset is only worth $97 on its balance sheet. The other $3 is gone, and the bank is considered insolvent. Rational people notice, tweet, and write long threads. Then, they start a bank run. This characterization explains the behavior of SVB’s depositors, mainly from the tech and VC industries. As rates went up fast, SVB’s depositors, who were all on Twitter a lot, read the footnotes on the notices on the financial statements of the SVB and started to write long threads on the topic that SVB was insolvent. As a result, they all pulled their money out at once.

Rational depositors, not unlike traders and capital market investors, use all the available information and continuously mark to market the balance sheet of financial institutions. Unfortunately, in doing so, they heightened the bank’s exposure to interest rate risks, especially for the banks that invest in fixed-income securities, such as government bonds. However, this opens up an opportunity for using interest rate hedges to stop the run on the banks. Interest rate hedges are often in the form of swaps, a financial instrument that effectively turns an investor’s fixed-rate loans or bonds into floating rates by paying a third party. These can be important for banks like SVB because many of their investments are tied to fixed-income bonds like mortgages or Treasuries.

When rates go up, fixed-income bonds fall in value, as with SVB. Why do bond prices respond to interest rate fluctuations? Remember that in a competitive market, all securities offer investors fair expected rates of return. If a bond is issued with a 5% coupon when competitive yields are 5%, then it sells at par value. If the market rate raises to 8%, however, who would be willing to pay a par value for a bond that only offers a 5% coupon bond? The bond price must fall until its expected return increases to the competitive return of 8%. In this environment, the fair value of the bonds will fall. Even if the investors are intended to hold these assets until maturity, which indicates they would still earn the par value, a mark-to-market method reduces the fair value of these investors’ assets.

However, once these available-for-sale, outstanding bonds are combined with interest rate hedges, such as swaps, their value can be protected against interest rate movements. One of the swaps’ functions is to transform the nature of an asset. Consider SVB in our example. A proper swap could transform SVB’s bonds earning a fixed interest rate into an asset earning a floating interest rate. Suppose SVB owned $100 million in bonds that will provide 3.2% for two years and wishes to switch to the floating rate. It contacts a swap dealer, such as Citigroup. We assume it agrees to enter into a swap where it pays the fixed rate (3.2%) and receives floating plus 0.1%. Its position would then have three sets of cash flows. First, it earns 3.2% from the bonds. Second, it receives floating under the terms of the swap. And third, it pays 3.2% under the terms of the swap. These three sets of cash flow net out to an interest rate payment of floating plus 0.1% (or floating plus 10 basis points). Thus, for SVB, the swap could transform assets earning a fixed rate of 3.2% into assets earning the floating rate plus 10 basis points. In the real world, however, SVB reported virtually no interest rate hedges on its massive bond portfolio at the end of 2022. Instead, it terminated or let expire rate hedges on more than $14 billion of securities throughout the year, the company said in its year-end financial report. Being unhedged was SVB’s fatal sin that its depositors did not forgive.

In this piece, I shed light on a corner of the crisis that has made this run on the bank different from the classic ones. In the current banking crisis, the collective behavior of the depositors to withdraw their cash from these banks, more than being driven by pure speculation and panic, is driven by depositors’ careful examination of the banks’ financial statements. In other words, in this crisis, we are dealing with rational depositors rather than uninformed ones. Although small, this detail would change the best approach towards stopping the run on the banks, away from deposit insurance towards using derivatives. The influential Diamond-Dybvig Model posits that deposit insurance is the best way to deal with bank runs. Accordingly, in March 2023, after the SVB’s failure, the government introduced extraordinary measures to extend the deposit insurance “to all the deposits” and disregard the $250,000 threshold. Nonetheless, despite the government’s all-in approach to providing deposit insurance, such a state-backed promise did not stop the run on the other banks.

The US government’s failure to calm the market, despite offering full-blown deposit insurance, calls for a new framework beyond the classic Diamond-Dybvig Model, where the depositors choose to remain uninformed about the financial health of their bankers. The SVB’s tragedy revealed a modern financial system made by modern, well-informed depositors. These depositors treat their deposits as a form of investment vehicle. In this new financial reality, what stops the run on a bank is a proper hedging strategy that is reported in the bank’s financial statement instead of government-backed insurance. In a strange twist, the March 2023 banking crisis teaches us that the regional banking market structure has moved in the direction that a private risk-management solution, available through the derivative markets, would be a superior resolution than the government-backed insurance for financial stability. Every cloud, even if it includes a cascade of bank runs, seems to have a silver lining.

Footnote: While writing this piece, I am visiting my family in Iran. My access to the internet is nonexistent. However, a student of mine sent me all the articles through text messages. Like always, my students are my main drivers and backers in my intellectual journey.

Tags Bank Run, Derivative, Federal Reserve, FINANCIAL CRISIS, Market Liquidity, Money View, SVB

Elham's Money View Blog

Can “Money View” Provide an Alternative Theory of Capital Structure?

Post author By Elham Saeidinezhad
Post date July 29, 2021

By Elham Saeidinezhad

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.

Tags Capital Structure, Dealers, Financial Intermediation, Funding Liquidity, Market Liquidity, Money View, security dealers

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

Market Makers and Risk Managers After 2008

Post author By Elham Saeidinezhad
Post date June 6, 2021

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

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

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

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

Re-conceptualizing the Contemporary Financial System

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

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

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

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

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

Regulatory Responses to the Crisis: Identifying and Managing Risk

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

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

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

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

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

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

Derivatives Dealers: The Risk Managers of First and Last Resort

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

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

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

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

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

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

Understanding Financial Assets as Collateral

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Footnotes

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

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

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

When it Comes to Market Liquidity, What if Private Dealing System is Not “The Only Game in Town” Anymore? (Part 1)

Post author By Elham Saeidinezhad
Post date November 15, 2020

A Tribute to Value Investing

“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.

Tags COVID-19, Dealers, Funding Liquidity, Market Liquidity, Money View, Value Investing

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

Can Algorithmic Market Makers Safely Replace FX Dealers as Liquidity Providers?

Post author By Elham Saeidinezhad
Post date November 9, 2020
1 Comment on Can Algorithmic Market Makers Safely Replace FX Dealers as Liquidity Providers?

By Jack Krupinski
(This Money View piece is by my students, Jack Krupinski. Jack is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics.)

Financialization and electronification are long term economic trends and are here to stay. It’s essential to study how these trends will alter the world’s largest market—the foreign exchange (FX) market. In the past, electronification expanded access to the FX markets and diversified the demand side. Technological developments have recently started to change the FX market’s supply side, away from the traditional FX dealing banks towards principal trading firms (PTFs). Once the sole providers of liquidity in FX markets, dealers are facing increased competition from PTFs. These firms use algorithmic, high-frequency trading to leverage speed as a substitute for balance sheet capacity, which is traditionally used to determine FX dealers’ comparative advantage. Prime brokerage services were critical in allowing such non-banks to infiltrate the once impenetrable inter-dealer market. Paradoxically, traditional dealers were the very institutions that have offered prime brokerage services to PTFs, allowing them to use the dealers’ names and credit lines while accessing trading platforms. The rise of algorithmic market markers at the expense of small FX dealers is a potential threat to long-term stability in the FX market, as PTFs’ resilience to shocks is mostly untested. The PTFs presence in the market, and the resulting narrow spreads, could create an illusion of free liquidity during normal times. However, during a crisis, such an illusion will evaporate, and the lack of enough dealers in the market could increase the price of liquidity dramatically.

In normal times, PTFs’ presence could create an “illusion of free liquidity” in the FX market. The increasing presence of algorithmic market makers would increase the supply of immediacy services (a feature of market liquidity) in the FX market and compress liquidity premia. Because liquidity providers must directly compete for market share on electronic trading platforms, the liquidity price would be compressed to near zero. This phenomenon manifests in a narrower inside spread when the market is stable. The FX market’s electronification makes it artificially easier for buyers and sellers to search for the most attractive rates. Simultaneously, PFTs’ function makes market-making more competitive and reduces dealer profitability as liquidity providers. The inside spread represents the price that buyers and sellers of liquidity face, and it also serves as the dealers’ profit incentive to make markets. As a narrower inside spread makes every transaction less profitable for market makers, traditional dealers, especially the smaller ones, should either find new revenue sources or exit the market.

During a financial crisis, such as post-COVID-19 turmoil in the financial market, such developments can lead to extremely high and volatile prices. The increased role of PTFs in the FX market could push smaller dealers to exit the market. Reduced profitability forces traditional FX dealers to adopt a new business model, but small dealers are most likely unable to make the necessary changes to remain competitive. Because a narrower inside spread reduces dealers’ compensation for providing liquidity, their willingness to carry exchange rate risk has correspondingly declined. Additionally, the post-GFC regulatory reforms reduced the balance sheet capacity of dealers by requiring more capital buffers. Scarce balance sheet space has increased the opportunity cost of dealing.

Further, narrower inside spreads and the increased cost of dealing have encouraged FX dealers to offer prime brokerage services to leveraged institutional investors. The goal is to generate new revenue streams through fixed fees. PTFs have used prime brokerage to access the inter-dealer market and compete against small and medium dealers as liquidity providers. Order flow internalization is another strategy that large dealers have used to increase profitability. Rather than immediately hedge FX exposures in the inter-dealer market, dealers can wait for offsetting order flow from their client bases to balance their inventories—an efficient method to reduce fixed transaction costs. However, greater internalization reinforces the concentration of dealing with just a few large banks, as smaller dealers do not have the order flow volume to internalize a comparable percentage of trades.

Algorithmic traders could also intensify the riskiness of the market for FX derivatives. Compared to the small FX dealers they are replacing, algorithmic market makers face greater risk from hedging markets and exposure to volatile currencies. According to Mehrling’s FX dealer model, matched book dealers primarily use the forward market to hedge their positions in spot or swap markets and mitigate exchange rate risk. On the other hand, PTFs concentrate more on market-making activity in forward markets and use a diverse array of asset classes to hedge these exposures. Hedging across asset classes introduces more correlation risk—the likelihood of loss from a disparity between the estimated and actual correlation between two assets—than a traditional forward contract hedge. Since the provision of market liquidity relies on dealers’ ability to hedge their currency risk exposures, greater correlation risk in hedging markets is a systemic threat to the FX market’s smooth functioning. Additionally, PTFs supply more liquidity in EME currency markets, which have traditionally been illiquid and volatile compared to the major currencies. In combination with greater risk from hedging across asset classes, exposure to volatile currencies increases the probability of an adverse shock disrupting FX markets.

While correlation risk and exposure to volatile currencies has increased, new FX market makers lack the safety buffers that help traditional FX dealers mitigate shocks. Because the PTF market-making model utilizes high transaction speed to replace balance sheet capacity, there is a little buffer to absorb losses in an adverse exchange rate movement. Hence, algorithmic market makers are even more inclined than traditional dealers to pursue a balanced inventory. Since market liquidity, particularly during times of significant imbalances in supply and demand, hinges on market-makers’ willingness and ability to take inventory risks, a lack of risk tolerance among PTFs harms market robustness. Moreover, the algorithms that govern PTF market-making tend to withdraw from markets altogether after aggressively offloading their positions in the face of uncertainty. This destabilizing feature of algorithmic trading catalyzed the 2010 Flash Crash in the stock market. Although the Flash Crash only lasted for 30 minutes, flighty algorithms’ tendency to prematurely withdraw liquidity has the potential to spur more enduring market dislocations.

The weakening inter-dealer market will compound any dislocations that may occur as a result of liquidity withdrawal by PTFs. When changing fundamentals drive one-sided order flow, dealers will not internalize trades, and they will have to mitigate their exposure in the inter-dealer FX market. Increased dealer concentration may reduce market-making capacity during these periods of stress, as inventory risks become more challenging to redistribute in a sparser inter-dealer market. During crisis times, the absence of small and medium dealers will disrupt the price discovery process. If dealers cannot appropriately price and transfer risks amongst themselves, then impaired market liquidity will persist and affect deficit agents’ ability to meet their FX liabilities.

For many years, the FX market’s foundation has been built upon a competitive and deep inter-dealer market. The current phase of electronification and financialization is pressuring this long-standing system. The inter-dealer market is declining in volume due to dealer consolidation and competition from non-bank liquidity providers. Because the new market makers lack the balance sheet capacity and regulatory constraints of traditional FX dealers, their behavior in crisis times is less predictable. Moreover, the rise of non-bank market makers like PTFs has come at the expense of small and medium-sized FX dealers. Such a development undermines the economics of dealers’ function and reduces dealers’ ability to normalize the market should algorithmic traders withdraw liquidity. As the FX market is further financialized and trading shifts to more volatile EME currencies, risks must be appropriately priced and transferred. The new market makers must be up to the task.

Link to economic questions website

Jack Krupinski is currently a fourth-year student at UCLA, majoring in Mathematics/Economics with a minor in statistics. He pursues an actuarial associateship and has passed the first two actuarial exams (Probability and Financial Mathematics). Jack is working to develop a statistical understanding of risk, which can be applied in an actuarial and research role. Jack’s economic research interests involve using “Money View” and empirical methods to analyze international finance and monetary policy.

Jack is currently working as a research assistant for Professor Roger Farmer in the economics department at UCLA and serves as a TA for the rerun of Prof. Mehrling’s Money and Banking Course on the IVY2.0 platform. In the past, he has co-authored blog posts about central bank digital currency and FX derivatives markets with Professor Saeidinezhad. Jack hopes to attend graduate school after receiving his UCLA degree in Spring 2021. Jack is a member of the club tennis team at UCLA, and he worked as a tennis instructor for four years before assuming his current role as a research assistant. His other hobbies include hiking, kayaking, basketball, reading, and baking.

Tags Brokers, Dealers, Dollar Funding, FX Market, Market Liquidity, Search For Stable Liquidity Providers, Stable Liquidity

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

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

Post author By Elham Saeidinezhad
Post date October 17, 2020

“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.

Tags Banks, Brokers, COVID-19, Dealers, FINANCIAL CRISIS, Funding Liquidity, Market Liquidity, Money View, Search For Stable Liquidity Providers

Elham's Money View Blog

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

Post author By Elham Saeidinezhad
Post date April 30, 2020

By Elham Saeidinezhad

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

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

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

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

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

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

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

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

Tags COVID-19, Dealers, Debt, ECB, FINANCIAL CRISIS, Market Liquidity, Money View, Treynor Model

Elham's Money View Blog

Why Does “Solvency” Rule in the Derivatives Trading?

Post author By Elham Saeidinezhad
Post date March 29, 2020

Hint: It Should Not

By Elham Saeidinezhad

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

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

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

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

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

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

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

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

link to economic questions

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

Elham's Money View Blog

Is “Tokenisation” Our Apparatus Towards a Dealer Free Financial Market?

Post author By Elham Saeidinezhad
Post date March 7, 2020

By Elham Saeidinezhad

The death of the Jimmy Stewart style “traditional banking system” was accelerated by the birth of securitization in the financial market. Securitization made the underlying assets, such as mortgage loans, “tradable” or “liquid.” Most recently, however, a new trend, called “tokenization,” i.e., the conversion of securities into digital tokens, is emerging that is decidedly different from the earlier development. While securitization created a dealer centric system of market-based credit that raise funds from investors, tokenization is a step towards building a “dealer free” world that reduces fees for investors. In this world, dealers’ liquidity provision is replaced by “smart” or “self-executing” contracts, protocols, or code that self-execute when certain conditions are met. The absence of dealers in this structure is not consequential in standard times. When markets are stable, people assume the mechanical convertibility of the tokenized asset into its underlying securities. However, the financial crisis threatens this confidence in the convertibility principle and could lead to massive settlement failures. These systemic failures evaporate liquidity and create extensive adjustments in asset prices. Such an outcome will be responded by policymakers who try to limit these adverse feedback loops. But the critical question that is remained to be answered is the central banks will save whom and which, not a very smart contract.

New technologies created money and assets. For centuries, these assets, mostly short-term commercial papers, were without liquidity and relied upon the process of “self-liquidation.” However, the modern financial market, governed by the American doctrine, improved this outdated practice and relied on “shiftability” or “market liquidity” instead. Shiftability (or salability) of long-term financial securities ensured that these assets could be used to meet cash flow requirements, or survival constraints, before their maturity dates. The primary providers of liquidity in this market are security dealers who use their balance sheets to absorb trade imbalances. The triumph of shiftability view, because of depression and war, has given birth to the “asset-backed securities” and securitization. This process can encompass any financial asset and promotes liquidity in the marketplace.

ABS market continues to evolve into new securitization deals and more innovative offerings in the future. Tokenization is the next quantum leap in asset-based securitization. Tokenization refers to the process of issuing a blockchain token that digitally represents a real tradable asset such as security. This process, in many ways, is like the traditional securitization with a twist. The “self-executing” feature of these contracts discount the role of dealers and enable these assets to be traded in secondary markets by automatically matching buyers with sellers. The idea is that eliminating dealers will increase “efficiency” and reduce trading costs.

The issue is that digital tokens may be convertible to securities, in the sense that the issuer of digital tokens holds some securities on hand, but that does not mean that these tokenized assets represent securities or are at the same hierarchical level as them. When an asset (such as a digital token) is backed by another asset (such as security), it is still a promise to pay. The credibility of these promises is an issue here, just as in the case of other credit instruments, and the liquidity of the tokenized instruments can help to enhance credibility. In modern market-based finance, which is a byproduct of securitization, the state of liquidity depends on the security dealers who take the imbalances into their balance sheets and provide market liquidity.

The only constant in this evolving system is the natural hierarchy of money. Tokenization disregards this inherent feature of finance and aims at moving towards a dealer free world. A key motivation is to create a “super asset” by lowering the estimated $17–24 billion spent annually on trade processing. The problem is that by considering dealers as “frictions” in the financial market, tokenization is creating a super asset with no liquidity during the financial crisis. Such shiftability ultimately depends on security dealers and other speculators who are willing to buy assets that traders are willing to sell and vice versa and use their balance sheets when no one else in the market does. Tokenization could jeopardize the state of liquidity in the system by bypassing the dealers in the name of increasing efficiency.

Link to economic questions website

Tags Dealers, Fintech, Hierachy, Market Liquidity, Money View

Elham's Money View Blog

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

Post author By Elham Saeidinezhad
Post date February 4, 2020

“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.

link to economic questions website

Tags Dealers, Funding Liquidity, Market Liquidity, Money View