The dismantling of the economy’s legal infrastructure III: Derivatives [Updated]

Derivatives are financial contracts that do not involve direct investment in productive activity, as stocks and bonds do, but instead reference such contracts (or other phenomena including stock market indexes and even the weather). In short, they are called derivatives, because their value is derivative from that of other assets. While derivatives contracts take many forms, for the purposes of this post it is enough to understand a specific derivative, a futures contact. A futures contract is a standardized contract to purchase/sell a specific amount of a specific asset at a specific price on a specific future date.

Consider an example, in which I agree in December 2018 to sell 100 shares of Apple stock at a price of $150 a share (the current market price) on May 15, 2019. I will call the person who takes the other side of this agreement, my counterparty. Whether the market price of Apple is $140 or $158 on May 15 does not affect the price at which our contract will settle, because the whole point of a futures contract is to fix the price of the contract on the future date. For the purposes of discussion let’s assume that the price on May 15 turns out to be $158. Since I sell my shares at $150, I have $800 less, that is $8 less per share, than I would have if I had simply waited to sell my shares. Similarly, my counterparty has $800 more than she would have if she had simply waited to buy the shares.

Why would I have chosen to enter into this contract? If I owned Apple shares maybe I knew in December that I would need the money on May 15, but didn’t want to sell in December for tax purposes and was worried that the price would fall in the meanwhile. Alternatively, maybe I don’t own Apple shares, but have reason to believe that the price is going to fall over the next six months and want to have the opportunity to sell shares that I will be able to purchase at low price (as I expect to be the case in May) while selling at high price. In the first case, I am protecting myself against risk of loss – or hedging, and in the second case I am speculating on the price of the shares.

Why would my counterparty have chosen to enter into this contract? Perhaps, she expects the price of Apple shares to go up over the next six months, but doesn’t have the money to buy them now and wants to lock in today’s price on a contract that can be paid for when her funds are available. In other words, she is speculating on the price of the shares, since she could simply wait and buy the shares when her funds are available. (A retail investor would not be hedging, since that would imply some kind of an obligation to possess shares in May that aren’t owned in December. By contrast, a financial professional might have such an obligation and be using such a position to hedge an exposure.)

Thus, a crucial aspect of a derivatives contract is that the same contract can be used either to hedge an exposure – i.e. to insure against an existing risk – or it can be used to speculate on a change in prices. The derivatives contract itself will not give any indication how it is being used. If the owner of shares enters into a contract to sell them in the future, that is a means of protecting the owner against the risk of loss, and it would not be considered a wagering contract under the traditional law governing derivatives. Traditional gambling law applied only to derivatives where no contract participant was hedging, but instead both were speculating (in opposite directions) on a price movement.

With this introduction let’s get into some details.

Britain’s Gaming Act of 1845 laid a cornerstone of Anglo-American securities regulation: wagers, including derivatives that could be characterized as wagers, were void and could not be enforced as contracts. The reasoning behind this approach was cost-benefit analysis. Because a wager, by definition, involved two parties who did not have a real economic interest or productive purpose at stake, the benefit of enforcement was necessarily small and deemed not to be worthy of the costly expense of judicial resources (H.C. 1844: v-vi; see also testimony of Daniel Whittle Harvey, Esq., Commissioner of the City Police Force, Honorable Mr. Justice Patteson, and John Bush, Esq., Attorney and Solicitor).

In Britain, as in the US, the real world implications of a law are often determined only after the courts have interpreted the text of the law and developed a legal test that will be used to apply the law. In 1851, Grizewood v. Blane, 138 Eng Rep 578, 584 (C.B.), interpreted the 1845 Act, establishing a seminal precedent that would undergird Anglo-American securities law for the better part of a century: if one of the parties genuinely intended to deliver/receive the underlying asset (typically a question of fact for the jury), the transaction was not a wager, but instead a valid contract. Over the next 50 years many US state legislatures adopted similar gaming laws and many US courts cited Grizewood v. Blane on the interpretation of such statutes with respect to financial transactions. The Supreme Court affirmed this interpretation in Irwin v. Williar, 110 US 499 (1884).[1]

Let us apply this legal test to the example given in the introductory paragraphs. If I am hedging my need to sell 100 shares of Apple in May, then the whole point of the transaction is that I expect to sell (and deliver) my shares. On the other hand, if I am speculating, then I don’t have any shares to sell, and it’s easiest to just pay the difference between the contract price and the actual price in May. In this example, I pay my counterparty $800 without a transfer of shares. The fact that I own shares and need to sell them in May would be strong evidence of my intent to deliver, and therefore that the contract is not a wager. By contrast, the absence of any such evidence together with the presence of a pattern of entering into futures contracts and settling differences without ever taking ownership of shares is likely to be viewed as evidence that I am speculating. If the same is also true of my counterparty, then the derivative is a wager. As noted, in practice the evidence on each party’s intent was typically submitted to the jury so the jury could make the factual determination with respect to each party.

During this period derivatives contracts, particularly those that were typically settled by paying price differences, were at risk of being deemed unenforceable in court. Because settling by paying price difference was common on the Exchanges, they had to develop their own mechanism by which they could enforce the claims of parties to these contracts.[2] That mechanism was margin, which is a synonym for collateral.[3] Upon entering into a derivatives contract a trader was asked to post to the exchange margin that would cover a portion of the value that the trader might end up owing on it. And on a regular basis the exchange would reevaluate the contract and change the amount of margin that must be posted to reflect how the contract had changed value over time. In this way, if the trader went bankrupt the exchange had the means to make sure payment was still made on the contract.

In short, the system of margining derivatives contracts was designed for an environment where legal enforcement of contracts was not likely to be available to traders. This alternate system for ensuring payment on derivatives conflicted with the bankruptcy code which sought to catalog all of a bankrupt’s assets and distribute them fairly across creditors. The Supreme Court in 1876 created a carve-out for exchanges, allowing them to process transactions according to their rules and indeed even allowing them to use the proceeds from the sale of the bankrupt’s seat on the exchange to settle any remaining debts on the exchange – all outside the reach of the bankruptcy court (Hyde v. Woods, 94 US 523, 1876). This special status was preserved for commodities exchanges when the Bankruptcy Code was revised in 1978 by allowing commodities brokers to foreclose on margin despite a bankruptcy. In 1982 the contractual rights set forth by the rules of securities exchanges were also exempted from bankruptcy (Pub. L. No. 97-222).

In the early 20th c. the invention of the telegraph posed an existential crisis for the Exchanges as their prices were instantly transmitted for off-exchange trading, threatening not just members’ income, but the price discovery process itself (Levy 2006). This led in 1905 to a Supreme Court determination that exchange-traded contracts were a special category due to the important role they play in setting prices for the business world, CBOT v. Christie Grain, 198 US 236 (1905). This decision distinguished exchange-traded contracts from off-exchange contracts and deemed only the former legally enforceable. The wagering laws that had been enacted at the state level continued to apply to derivatives contracts that were not traded on an exchange.

The Commodities Exchange Act of 1936 was therefore building on existing law when it prohibited trade in derivatives referencing commodities with two exceptions: exchange-traded contracts and contracts where the intent was to deliver the underlying.[4] In 1974 when the CFTC was created and tasked with enforcing the Act, the definition of a commodity was deliberately amended to cover not just virtually all goods, but also “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in … .” In short, the CFTC was granted jurisdiction over derivatives referencing virtually anything, except for categories that would be explicitly excluded, including currencies, government bonds and mortgages that were considered the domain of banks, and options on securities that were removed to the sole jurisdiction of the SEC.[5]

As a result, during the 1980s there were two tiers of regulation governing derivatives. At the Federal level the CFTC Act made derivatives presumptively illegal, unless they were traded on an exchange, the intent was to deliver the underlying, or they were explicitly excluded from the CFTC’s jurisdiction. And at the state level derivatives contracts were void unless they either served to insure one party from an existing risk or the intent was to deliver the underlying.[6]

At the same time, subsequent to the Savings and Loan crisis there were growing markets in new categories of derivatives, interest rates swaps which reference Treasuries, and foreign exchange swaps. The 1974 Treasury Amendment’s exemption of commercial banking activities excluded some such derivatives from the CFTC’s jurisdiction. By 1985, however, products outside the exemption were being developed, and US investment banks were prominent dealers in this market alongside three major commercial banks. These dealers formed the International Swaps Dealers Association (ISDA) with the explicit goals of standardizing the unregulated contracts to facilitate trade, and addressing accounting and regulatory issues. Effectively the ISDA was acting as a Self-Regulatory Organization (SRO) like the National Association of Securities Dealers, but without any supervising regulator. The market grew rapidly and increased tenfold from 1986 to 1990. (Sissoko 2017).

In 1990 at the request of the ISDA the Bankruptcy Code was amended to exempt interest rate and currency swaps as well as “any other similar agreement” from provisions of the Code (Pub. L. No. 101-311). Observe that, whereas the original Bankruptcy Code exemptions had only been granted to the contractual rights created by the rules of the regulated Exchanges (and related SROs), in 1990 these exemptions were granted to unregulated financial contracts and to contractual rights founded in common law; in short, this new exemption was much broader than the 1982 exemption. Having opened this breach in the financial regulatory structure, industry lobbyists spent the next decade and half forcing the gap open as wide as possible.

A 1992 law granted the CFTC the power to exempt any contract from its oversight and by doing so to preempt the application to the exempt contract “of any State or local law that prohibits or regulates gaming or the operation of ‘bucket shops’” (Futures Trading Practices Act, Pub. L. No. 102-546). The structure of this exemption power was unwise, and set a dangerous precedent. In order for the CFTC to exempt a contract from its own oversight, it also had to exempt the contract from one aspect of the traditional State law regulating securities contracts. In short, instead of treating the law that had supported economic activity for more than a century as valuable infrastructure, the 1992 law treated it as disposable. As a result, even the subject experts who staffed the CFTC were not given the choice of exempting a contract from CFTC oversight while at the same time leaving in place traditional state-based restrictions on wagering-type contracts.

In 1993 the CFTC exempted interest rate and currency swaps as well as “any other similar agreement” with the qualifications that they could not be standardized, fungible contracts and that they not be traded through a multilateral execution facility (58 FR 5587 at 5589 (Jan. 22, 1993)). By 1998 the swaps market had evolved such that it was no longer evident that the contracts complied with the qualifications on the exemption, and scandals that had led to litigation indicated that unwitting participants had in some cases been defrauded. When the CFTC proposed to revisit the question of regulating of the swaps market, stating explicitly that any such regulation would only be prospective (63 FR 26, May 12, 1998), industry lobbyists has sufficient influence at the Federal Reserve and Treasury to successfully pressure Congress to enact a six-month moratorium on the CFTC release (Greenberger 2018: 21-23).

The final outcome of the full-bore industry response to the CFTC’s proposal to evaluate the need for regulation of swaps was the enactment of the Commodities Futures Modernization Act of 2000 (CFMA; Pub. L. No. 106-554), which excluded not just interest rate and currency swaps, but financial derivatives more generally from the Commodity Exchange Act – as long as they were traded by “eligible contract participants,” roughly speaking entities with more than $10 million in assets. By excluding these derivatives from the Act itself, they were not just removed from the jurisdiction of the CFTC, but also from the CEA’s anti-fraud and anti-manipulation provisions. Furthermore, when it came to the application of State law excluded contracts were treated like contracts that had been exempted as per the 1992 FTPA; in other words, the CFMA explicitly preempted any application of state gambling law to excluded contracts (Greenberger 2018: 27-28).[7]

Pause for a moment to consider the hubris embedded in the CFMA. At least the 1992 FTPA had left the discretion to the subject experts at the CFTC to determine whether or not to exempt contracts from both oversight and state law. In the CFMA Congress assumed that it had the ability to judge not just whether the excluded contracts should be subject to the CFTC’s oversight but also whether they should be exempt from the State law and common law that had served the economy well for more than a century. And this decision was taken without even commissioning a study of the reasoning behind the use of the traditional wagering law to restrain securities markets. (One is reminded of Chesterton’s fence: “If you don’t see the use of something. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”)

Although the CFMA established over-the-counter derivatives as an entirely unregulated market and allowed to the ISDA to organize that market unsupervised and without the constraints on anti-competitive practices that had been adopted throughout the financial system in the 1930s, this was not, however, enough.

The margining system that had been developed to enable the earliest exchanges to enforce their contracts without relying on the legal system could be used to create leverage that was invisible to the Federal Reserve, which was still using theoretic frameworks appropriate to unsecured interbank lending, and had not yet mastered the implications of the growing use of margin by the biggest financial participants. With the Fed blind not just to the risks of the derivatives margining system but also to the extent of its growth, commercial and investment banks could take on an unregulated form of leverage.

It seems unlikely that many of the financial industry lobbyists saw the big picture of what they were doing when they lobbied for the 2005 bankruptcy act. Most likely they simply saw an opportunity to shift the rules in a way that would be profitable for them and went for it, without a thought for the broader economy at all.

The outcome was legal reform of the Bankruptcy Code as it affected financial institutions that was just as stunning in its implications as the CFMA had been with respect to derivatives regulation: In an early paper I dubbed this legislation “The No Derivative Left Behind Act of 2005” (Sissoko 2010). The goal of the reform was to make it possible for the broker-dealer banks to manage collateral, not contract by contract, but in a way that would make the collateral as mobile as possible. The banks wanted to be able to aggregate all the margin posted by a certain counterparty on all of its contracts and deal with it as a whole. Since the broker-dealers (but for the most part not their clients) could reuse – or rehypothecate – the margin that was posted to them, the ability to aggregate collateral positions would free up more collateral for the broker-dealers to reuse. Reusing margin is a way for a bank to leverage its balance sheet.

The ability to aggregate collateral positions was created by, first, granting exemption from the Bankruptcy Code to master agreements that were designed to bring a wide variety of different contracts under a single netting agreement, and, second, by revising the specific terms of the bankruptcy exemptions granted to the different types of contract so that they would be uniform – and thus amenable to aggregation. Unsurprisingly the way the various terms were made uniform was by taking the broadest grant of exemption from the Bankruptcy Code and applying it to the various contracts (Sissoko 2010).

For example, exemption from the Bankruptcy Code for options on securities had been limited as was noted above to contractual rights established by the rules of a securities exchange. This was expanded to include the terms that applied to swaps and thus to the more general contractual rights that exist under common law. This was a vast change in the applicability of the Bankruptcy Code exemptions.

Other revisions in the 2005 Act also broadened its reach: to allow for new products to be developed, each type of exempt contract was defined to include similar contracts. One practitioner’s comment on the new definition of a swap was: “Read literally this language cedes the content of the definition to the players in the market.” Kettering (2008: 1712). In addition, before the 2005 Act exempt repurchase agreements had been limited for the most part to those referencing Treasuries and Agencies. After the Act, repurchase agreements on securities and mortgages had been included in the definition of securities, and were therefore exempt.

Like the CFMA, the hubris implied by this law boggles the mind. The bankruptcy exemptions had been created to facilitate the operation of Exchanges because they could not rely on the courts to enforce their speculative contracts. The whole logic of this financial structure was turned on its head by applying the exemptions to off-exchange contracts, that had already been exempted from the state and common law governing speculative contracts. Not only this, but this brand-new, ill-considered financial structure was not applied to some very narrow set of contracts, but it was applied to a vast range of contracts and was designed to make it easy for the interested parties who had lobbied for the law to expand the range of contracts at will.

Just three years after the law was passed, the implications of establishing a vast unregulated financial market with extraordinary privileges under the Bankruptcy Code were realized. The repurchase agreement market which was a core part of the margining system for this unregulated market experienced a massive run and came close to bringing down the financial system entirely. The margining system was saved only by the Federal Reserve’s unprecedented measures.

With the Dodd-Frank Act supervision has been extended over these instruments, and many have been forced to trade on exchanges. The basic incoherence of this new financial structure remains, however. Off-exchange contracts are still exempt from provisions of the Bankruptcy Code and from state wagering laws. The central banks are struggling to develop a theoretic framework that can allow them to manage the new system of margin-based interbank lending successfully. It remains to be seen if the growth rates achieved under the old system can be attained under the new one.

[1] Note that Kreitner (2000)’s discussion of the intersection between securities regulation and wagering law starts with Williar, and this case apparently does not offer the best explanation of the logic underlying this form of securities regulation. Kreitner (2000) argues that moral rather than economic considerations drove this form of securities regulation.

[2] As Levy (2006) observes, while there are many cases arguing that exchange-traded contracts were void as wagers in the late 19th century, not one of them is brought by a member of the exchange. That is, they are all brought by the clients of exchange members.

[3] In 1865 the Chicago Board of Trade introduced the first standardized futures contract together with the requirement that a “performance bond,” which serves the same function as margin, be posted by futures traders.

[4] Derivatives were covered by the term “contracts for future delivery,” but the law was careful to state that “The term ‘future delivery’ does not include any sale of any cash commodity for deferred shipment or delivery,” thus creating what was known as the “forward contract exclusion.” (as currently encoded, 7 U.S.C. 1(a)(27))

[5] The bank contracts were exempted in the 1974 Treasury Amendment to the CEA and securities with the 1982 enactment of the Shad Johnson Accord (GAO 2000).

[6] Because the era of federal common law had ended in 1938, the exchange trading exemption to state wagering laws was unsettled.

[7] In current law this exclusion is found in 7 USC s. 16(e)(2).

Note: Updated January 14 2019 to add more explanatory text regarding derivatives.

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Collateralized shadow banking: still at risk of fire sales

A few basic points about shadow banking ten years after the crisis:

“What shadow banking is” isn’t very complicated if banking is defined as “borrowing short to lend long”

What makes banks unstable is that their liabilities are on demand (i.e. they borrow short) while their assets pay out only over the course of years (i.e. they lend long). A principle reason that we are worried about “shadow” banks is that they have the same instability as banks, but lack the protections in the form of a strict regulatory regime and a lender of last resort. When shadow banks have this instability it is because they borrow short to lend long.

This approach makes it easy to understand the world of shadow banking, because there are only a limited number of financial instruments that are used to borrow on a short-term basis. Thus, for the most part shadow banks have to finance themselves on the commercial paper market (unsecured financing) or on the repo market (secured financing) or, especially for investment banks, via derivatives collateral (e.g. that is posted by prime brokerage clients). These are the major sources of wholesale short-term funding.

So typically when a financial product is subject to losses due to a run-prone (and therefore classified as a shadow bank), it’s because of the product’s relationship to the commercial paper market, to the repo market, and/or to the derivatives market.* The latter two, which comprise the collateralized segment of shadow banking, are the most complicated, because the run can come from many different directions: that is, lenders may stop lending (e.g. Lehman Bros), borrowers who post collateral may stop posting collateral (e.g. novation at Bear Stearns), and for derivatives contracts conditions may shift so that suddenly collateral posting requirements increase (e.g. AIG).

Collateralized shadow banking is governed by ISDA protocols and contracts, not the traditional law governing debt

While repos have been around for centuries, a “repo market” in which anyone can participate and where collateral other than government debt is posted is a relatively new phenomenon. Similarly derivatives contracts have been subject to margin requirements for more than a century, but in the past these contracts were exchange-traded and exchanges set the rules both for margin and for eligibility to trade on the exchange.

Thus, what made repo and derivatives financially innovative in the 1980s and 1990s was that suddenly there were unregulated over the counter (OTC) markets in them. What “unregulated” really meant, however, was that the big banks wrote the rules for this market themselves in the form of International Swaps and Derivatives Association (ISDA) protocols and contracts.

In the early days of repo and derivatives it was far from clear that they wouldn’t fall under the existing regulatory regime as securities (regulated by the SEC), or as commodities and/or futures (regulated by the CFTC). (The legal definitions of the SEC’s and the CFTC’s jurisdiction was deliberately made very broad in the implementing legislation, so an intuitive understanding of these terms will not coincide with their legal definitions.) Similarly, it was far from clear that the collateral posted in these OTC contracts would not be subject to the standard terms in the bankruptcy code governing collateralized debt. (Kettering who describes repos in this era as too big to fail products is great on this.)

Thus, one of the ISDA’s first projects was lobbying in the US for exceptions to the existing regulatory regime. Progress was incremental, but a long series of legislative amendments to the financial regulatory regime starting in 1982 and culminating in the bankruptcy reform act of 2005 effectively placed the whole system of repo and margin collateral outside the financial regulatory regime that had been set up in the 1930s and 1940s (for details see here, or ungated). These reforms also exempted these contracts from the bankruptcy code’s protections for debtors (see here or ungated).

Where the US led others followed. Gabor (2016) documents how Germany and Britain came to adopt the US model of collateralized lending, despite the central banks’ serious reservations about the system’s implications for financial stability. The world economy entered into 2008 with repo and derivatives markets effectively subject only to the private “regulation” of ISDA protocols and contracts.

Despite reforms, the instability at the heart of the collateralized shadow banking system has yet to be addressed

We saw in 2008 how the collateralized shadow banking system relies extremely heavily on the central bank for stability. (Federal Reserve programs to support the repo market included the TSLF and the PDCF.  Data released by the Fed indicates that at the peak of the crisis it accepted substantial amounts of very risky collateral.)

Indeed the International Capital Markets Association has put it quite bluntly that it considers the systemic risk associated with fire sales in repo and derivatives markets to be a problem that “the authorities” are expected to step in and address.

“The question is how to mitigate such systemic liquidity risk. We believe that systemic risks require systemic responses. In this case, the authorities can be expected to intervene as lenders of last resort to ensure the liquidity of the system as a whole. For their part, market users should be expected to remain creditworthy and to have liquidity buffers sufficient to sustain themselves until official intervention restores sufficient liquidity to obviate the need for fire sales.”

In short, the collateralized shadow banking system is constructed on the expectation of a “Fed put”. Instead of attempting to build a robust infrastructure of debt, shadow banking embraces the risk of fire sales and expects the governments that don’t make the shadow banking rules to bail it out.

The only sure-fire way to eliminate the risk of fire sales is to reduce the financial system’s reliance on repo- and margin-type contracts that allow a decline in the value of collateral to be a trigger for demanding additional funds. Based on financial market history this would almost certainly require an increase in the use of unsecured interbank debt markets. However, not much progress has been made on this front, especially since the EU’s proposed Financial Transactions Tax stalled in 2015.

On the other hand, significant reforms have been made since 2008 (Please let me know if I’ve left out anything important.) :

  • Collateral has shifted mostly to sovereign debt. This helps stabilize the market, but perhaps only temporarily as a broad range of collateral is still officially acceptable (so deterioration of the quality of collateral can creep in).
  • Approximately 50% of derivatives now are held with central counterparties. (The estimate is based on a 2015 BIS report.) This reduces the risk that the failure of a small market participant sets off a chain of failures that results in a fire sale. There is some concern however that fire sale risk has been transformed into the risk of a failure of a central counterparty.
  • Derivatives are now officially regulated by either the CFTC or the SEC and and there has been an effort to harmonize OTC margining requirements internationally.
  • Under pressure from regulators a voluntary stay protocol has been developed by the ISDA that is designed to work with the regulators’ special resolution regimes and to limit the right to terminate a contract due the default of a related entity. In the US systemically important banks are required to include this protocol in their OTC derivatives contracts.
  • Bank liquidity regulations have been adopted that limit the degree to which regulated banks are exposed to significant risk in these markets.

Notice that these new regulations embrace the basic framework of collateralized shadow banking: much of the focus is on making sure that enough collateral is being used. Special rules are designed to protect the largest banks and the banking system more generally. But aside from protecting the banks, it’s not clear that significant measures have been taken to eliminate the risk of fire sales that originate outside the banking system. Assuming that these regulations are effective at protecting the banks, this raises the question: Who bears the fire sale risk in this new environment?

Thanks to @kiffmeister for requesting that I write up this blogpost.

* While one can usually figure this out after the run has occurred, current regulation does not necessarily make the relevant information available before a run has occurred. Mutual funds are a case in point: the vast majority of them have so little exposure to repo and derivatives markets that it can be ignored, but the few that take on significant risk may have disclosures that are hard to distinguish ex ante from the ones that don’t (e.g. Oppenheimer Core Bond Fund in 2008).

Collateral and Monetary Policy: A Puzzle

A stylized fact about post-crisis economies is that asset markets have become segmented with “safe assets” trading differently from assets more generally. I have argued elsewhere that the collateralization of financial sector liabilities has played an important role in this segmentation of markets.

I believe that this creates a puzzle for the implementation of monetary policy that provides at least a partial explanation for why we are stuck at the zero lower bound. Consider the consequences of an increase in the policy rate by 25 bps. This has the effect of lowering the price of ultra-short-term Treasury debt, and particularly when combined with a general policy of raising the policy rate over a period of months or years this policy should have the effect of lowering the price of longer term Treasuries as well (due to the fact that long-term yields can be arbitraged by rolling over short-term debt).

A decline in the price of long-term Treasuries will have the effect of reducing the dollar value of the stock of outstanding Treasuries (as long as the Treasury does not have a policy of responding to the price effects of monetary policy by issuing more Treasuries). But now consider what happens in the –segmented — market for Treasury debt. Assuming that demand for Treasuries is downward sloping, then the fact that contractionary monetary policy tends to shrink the stock of Treasuries itself puts upward pressure on the price of Treasuries that, particularly when demand for Treasuries is inelastic, will tend to offset and may even entirely counteract the tendency for the yield on long-term Treasuries to rise. (Presumably in a world where markets aren’t segmented demand for Treasuries is fairly elastic and shifts into other financial assets quash this effect.)

In short, a world where safe assets trade in segmented markets may be one where implementing monetary policy using the interest rate as a policy tool is particularly difficult. Can short-term and long-term safe assets become segmented markets as well? Given arbitrage, it’s hard to imagine how this is possible.

These thoughts are, of course, motivated by the behavior of Treasury yields following the Federal Reserves 25 bp rate hike in December 2015.fredgraph

 

What Gorton and Holmstrom get right and get wrong

Mark Thoma directs us to David Warsh on Gorton and Holmstrom’s view of the role of banking. I’ve written about this view in several places. My own view of banking is very different and here is a quick summary of my key points.

The source of Gorton and Holmstrom’s errors: Taking U.S. banking history as a model

In my view Gorton and Holmstrom err by basing their view of what banking is on the pre-Fed U.S banking system. Nobody argues that the U.S. represented a “state-of-the-art” banking system in the late 19th century. In fact, in the late 19th century the U.S. banking system was still recovering from the reputational consequences of the combination of state and bank defaults in the 1840s that had led many Europeans to conclude that American institutions facilitated fraud. By the end of the 19th century, however, the U.S. did have access to European markets and there is evidence that the U.S. banking system relied heavily on the much more advanced European banking system for liquidity (e.g. the flow of European capital during seasonal fluctuations). Indeed, the crisis of 1907, during which the none-too-respected U.S. banking system was at least partially cut off from the London money market, was so severe, it led to the decision to emulate European banking by establishing the Federal Reserve.

What Gorton and Holmstrom get right: the fundamental difference between money market and capital market liabilities, or as Warsh puts it: “Two fundamentally different financial systems [are] at work in the world”

In particular, it is essential for the debt that circulates on the money market to be price stable or “safe.” This distinguishes money markets are from capital markets, where price discovery is essential. Holmstrom writes:

Among economists, the mistake is to apply to money markets the lessons and logic of stock markets. … Stock markets are … aimed at sharing and allocating aggregate risk … [and this] requires a market that is good at price discovery. … [By contrast,] The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by … obviat[ing] the need for price discovery.

What Gorton and Holmstrom get wrong:

1.  The historical mechanisms by which the banking system created “safe” money market assets.

Holmstrom writes: “Opacity is a natural feature of money markets and can in some instances enhance liquidity.” This is the basic thesis of Gorton and Holmstrom’s work.

A study of the early 20th century London money market indicates, however that the best way to create safe money market assets is to (i) offset the implications of “opacity” by aligning incentives: any bank originating or selling a money market asset is liable for its full value, and (ii) establish a central bank that (a) has the capacity to expand liquidity and thereby prevent a crisis of confidence from causing a shift to a “bad” equilibrium, and (b) controls the assets that are traded on the money market by (1) establishing a policy of providing central bank liquidity only against assets guaranteed by at least two banks, and (2) withdrawing support from assets guaranteed by low-quality originators. (ii)(b) plays a crucial role in making the money market safe: no bank can discount its own paper at the central bank, so it has to hold the paper of other banks; at the same time, no bank wants to hold paper that the central bank will reject. Thus, the London money market was designed to ensure that the banks police each other — and there is no American-style problem of competition causing the origination practices of banks to deteriorate.

The Gorton-Holmstrom approach is based on the historical U.S. banking system and sometimes assumes that deterioration of origination quality is inevitable — it is this deterioration that is “fixed” by financial crises, which have the effect of publicizing information and thereby resetting the financial system. In short, by showing us how a banking system can function in the presence of both opacity and misaligned incentives, Gorton and Holmstrom show us how a low-quality banking system, like that in the late 19th century U.S. which could only create opaque (not safe) assets, can be better than no banking system.

Surely, however, what we want to understand is how to have a high-quality banking system. The kind of system represented by the London market is ruled out by assumption in the Gorton-Holmstrom framework which focuses on collateralized rather than unsecured debt. An alternative model for high-quality banking may be given by the 1930s reforms in the U.S. which improved the origination practices of U.S. banks and — temporarily at least — stopped the continuous lurching of the U.S. banking system from one crisis to another that is implied by opaque (rather than safe) money market assets.

2. Gorton and Holmstrom err by focusing on collateral rather than on overlapping guarantees.

Holmstrom writes: “Trading in debt that is sufficiently over-collateralised is a cheap way to avoid
adverse selection.” His error, however is to use both language and a model that emphasize collateral in the literal sense. The best form of “over-collateralization” for a $10,000 privately-issued bill is to add to the borrower’s liability the personal guarantee of Jamie Dimon — or even better both Jamie Dimon and Warren Buffett. This is the principle on which the London money market was built (and because both extended liability for bank shares and management ownership of shares was the norm until the 1950s in Britain, personal liability played a non-negligible role in the way the banking system worked). This is rather obviously an excellent mechanism for ensuring that money market debt is “safe.”

The fact that it may seem outlandish in 21st century America to require that a bank manager have some of his/her personal wealth at stake whenever a money market asset is originated, is really just evidence of the degree to which origination practices have deteriorated in the U.S.

Note also that there is no reason to believe that the high-quality money market I am describing will result in restricted credit. Nothing prevents banks from making the same loans they do now; the only issue is whether the loans are suitable for trade on the money market. Given that our current money market is very heavily reliant on government (including agency) assets and that these would continue to be suitable money market assets, there is little reason to believe that the high-quality money market I am describing will offer less liquidity that our current money market. On the other hand, it will offer less liquidity than, say, the 2006 money market — but I would argue that this characteristic is a plus, not a minus.

3. Holmstrom errs by focusing on debt vs. equity, rather than money markets vs. capital markets

Holmstrom claims that: “Equity is information-sensitive while debt is not.” He clearly was not holding GM bonds in the first decade of the current century. A more sensible statement (which is also consistent with the general theme of his essay) is that capital market assets including both equity and long-term debt are information sensitive, whereas it is desirable for money market assets not to be informationally sensitive.

Conclusion

In short, I argue that in a well-structured banking system money market assets are informationally insensitive because they are safe. For institutionally-challenged countries, a second-best banking system may well be that presented by Gorton and Holmstrom, where money markets assets are “safe” — at least temporarily — because they are informationally insensitive.

In my view, however, we should establish that a first-best banking system is unattainable, before settling on the second-best solution proposed by Gorton and Holmstrom.

The Shadow Banking System is an Unstable Funding System for Banks, Not Assets

There are many definitions of shadow banking. A New York Federal Reserve Bank monograph effectively equates shadow banking to securitization, or the process by which individual loans are packaged into bundles, used to issue a wide variety of collateralized assets, and sold to investors. The New York Fed monograph is often used to demonstrate how complicated and virtually incomprehensible the shadow banking system is – it includes a “map” of the shadow banking system that, for legibility, the authors recommend printing as a 36” by 48” poster.[1]

More commonly, however, the term shadow banking refers to the use of money market instruments to provide short-term finance to long-term assets,[2] and thus focuses attention on bank runs and on the fact that shadow banks can face such runs, just as traditional banks do. For this reason securitization should not be equated with shadow banking, because a significant portion of private sector securitized assets were financed on a long-term rather than on a short-term basis.[3] This post will limit its focus – as does most of the literature on shadow banking – to the role played by money markets in longer-term finance.

This post finds that our current money markets play only a very small role in the direct finance of private sector long-term assets and for the most part are used as a financing system for investment banks. In short, the “market-based” credit system that some equate with the shadow banking system,[4] is very small – and relies heavily on commercial bank guarantees. To the degree that a substantial shadow banking system continues to exist, it does not fund long-term assets directly, but instead provides wholesale funding for investment banks, and to a lesser degree commercial banks.

To be clear, the focus here is on finance of private sector banks and assets. Thus, although Fannie Mae and Freddie Mac played a very important historical role in the development of the shadow banking system, by pioneering the practice of financing long-term mortgage debt on money markets through the issue and roll over of short-term debt that was at least nominally a private-sector obligation,[5] they now officially have government support, and, for the purposes of this paper their debt is treated not as part of the shadow banking system, but as a government obligation.

This post provides a simple framework for understanding the shadow banking system that is organized around  the two instruments, commercial paper and repurchase agreements, that play an important role in money markets and that are, very roughly, comparable to deposits. Studying how these instruments are used not only allows a distinction to be drawn between the direct finance of assets and the finance of assets that sit on bank balance sheets, but also makes clear why the shadow banking system is unstable.

This analysis finds that the money market instruments have in the past played three roles: they have funded banks and non-financial firms directly, they have funded assets that lie off bank balance sheets, and in order to play these roles, they have created a need for commercial bank guarantees that induce lenders to lend off-balance-sheet or  in the case of tri-party repo to investment banks. In practice, the direct funding of assets now takes place only on a very small scale.

Because the two money market instruments, commercial paper and repurchase agreements (repos), are both short-term, it is easy for those who invest in them to “run,” or to decide that they no longer wish to invest their funds with a specific issuer or, indeed, in privately issued money market assets at all. Because these investors can always choose to put their money in Treasury bills or bank deposits, runs in the money markets are associated with unmanageably sudden shifts in investor preferences across short-term assets. In short, a fundamental attribute of the shadow banking system is that the decisions of money market investors can destabilize the money markets.

Money market mutual funds  and enhanced cash funds (that promise liquidity, but are less regulated than money market funds) are the most obvious money market investors, but the buy-side of the money market is composed of a huge array of institutional investment funds, corporations, and government bodies that have funds they wish to keep in liquid form. All of these entities can be part of a run in the shadow banking system. In addition, as will be explained in detail below, in the repo market it is possible for the recipients of funds, such as prime brokerage clients and banks in the interdealer market, to run.

Now that the basic instability of the money markets has been established, the next step in understanding the shadow banking system is to understand the different ways in which commercial paper and repo-based instruments are used; this is discussed in sub-part A. The following sub-parts evaluate what shadow banking does, and discuss why it is more unstable than traditional banking.

A.  Shadow Banking Instruments

1.  Commercial Paper

a.  Unsecured

Commercial paper is traditionally an unsecured obligation to make a payment that has a maturity of one year or less. It is analogous to the commercial bills that were used to finance economic activity in 19th c. Britain, and indeed has existed in one form or another for centuries.

i.  Issued by financial institutions

A little over half the commercial paper issued in the United States, or approximately $550 billion, is issued directly by financial institutions.[6] Because this market-based funding source is much less stable as a funding source than retail deposits, it is categorized along with other bank funding sources that are prone to runs as wholesale funding. The case of Lehman Bros. illustrates the instability of this form of funding. When Lehman declared bankruptcy, its commercial paper went into default, and set off a run by investors who feared money market mutual fund losses on money funds that invested in commercial paper; as a result the commercial paper market itself faced a run.

ii.  Issued by non-financial corporations

Approximately one quarter of commercial paper is unsecured and issued by non-financial corporations. Because non-financial corporations have less access to liquidity than banks, there is a risk that when their commercial paper is due they will be unable to roll it over into a new issue and will be unable to honor their commercial paper obligations due to this liquidity risk. For this reason, almost all non-financial commercial paper is protected by a liquidity facility provided by a bank, which promises to retire the commercial paper if the issuer is unable to do so. Observe that when Lehman failed, the run on commercial paper was not carefully targeted to financial commercial paper, and as a result non-financial commercial paper was subject to a run as well.

b.  Collateralized: Asset Backed Commercial Paper

In recent decades, sponsoring banks have moved assets that they originated into financing vehicles that are “bankruptcy-remote,” or not available to the sponsor’s creditors in the event that the sponsor declares bankruptcy. In addition, in theory any support that would be provided by the sponsor to the vehicle was defined in a contract, so the sponsor had contractually limited exposure to the vehicle’s liabilities.[7] Thus, these vehicles were designed as a means of removing assets from the sponsoring bank’s balance sheet.

The ABCP market was one of the key markets that collapsed in the early days of the financial crisis – from $1.2 trillion outstanding in early August 2007 to $905 billion three months later. Since then the market has continued to decline slowly, and it now hovers around $250 billion.

Because these vehicles finance long-term assets they face the same liquidity risk as non-financial issuers when issuing commercial paper. In addition these vehicles face credit risk in the event that the value of the assets falls below the value of the commercial paper, and the vehicle is no longer fully collateralized. Both liquidity and credit risk must be addressed before the vehicle can receive a credit rating that is high enough for it to issue asset-backed commercial paper (ABCP) that is secured by the assets in the vehicle. The three principal means by which liquidity and credit risk were resolved are discussed below.

i.  Bank supported ABCP:  Conduits

Prior to the financial crisis most ABCP was issued by ABCP conduits that were sponsored by banks. The banks typically provided both a liquidity facility, which guaranteed that the commercial paper would be retired even if it could not be rolled over, and a credit facility, which promised to honor some fraction of the commercial paper in the event that the value of the collateral fell too low to cover the costs of repaying the commercial paper.

In August 2007 when the crisis started there was a sudden loss in confidence in the ABCP market and many conduits could not roll over their commercial paper. The banks had to step in and honor the liquidity guarantees that had been made – and in order to do so they had to seek regulatory exemptions that are documented by the Federal Reserve.[8]

ii.  Liability structure supported ABCP: SIVs, LPFCs, etc.

Some ABCP-issuing vehicles guaranteed the payment of ABCP by funding the assets with a combination of bonds, medium-term notes and ABCP. These vehicles took many forms; the most common were called  structured investment vehicles (SIVs).

The concept behind these vehicles was that, in the event that the commercial paper could not be rolled over or the value of the assets fell below a trigger point, assets would have to be sold to pay off the ABCP and any losses would fall to the longer term debt holders. In 2007 most SIVs hit their triggers and were unwound. Because of the losses that were incurred by both longer-term and commercial paper investors (after lawsuits determined the allocation of proceeds), they are no longer a popular investment product.

iii.  Repo Conduits – discussed below

2.  Repurchase Agreements

A repurchase agreement (repo) is a simultaneous agreement to sell an asset today and to repurchase it a specific date and time in the future. It has the same economic effect as a collateralized loan. Typically the amount lent is less than the value of the collateral;[9] the percentage difference is called a haircut.

There are two repo markets: the bilateral repo market and the tri-party repo market. In the bilateral repo market the lender must have the capacity to receive and manage the collateral, whereas in the tri-party repo market the tri-party clearing banks, JP Morgan Chase and Bank of New York Mellon, provide collateral management services for the lenders. Money market investors like mutual funds lend only on the tri-party repo market where the principal borrowers are the dealer banks (although a few hedge funds and private institutions are credit-worthy enough to be accepted as counterparties on this market).[10]

The clearing banks also provide bank guarantees of liquidity to the tri-party repo market. Because it is the broker-dealers that borrow heavily on this market and because every trade in the market is unwound at the start of each trading day giving the borrowers access to their assets during the day, the two tri-party clearing banks extend credit to the borrowers during the day until the trades are rewound in the late afternoon. Thus the tri-party clearing banks provide a guarantee to the market and bear the risk of a broker-dealer failure during the day.[11] While reform of the tri-party repo market has been high on the Federal Reserve’s agenda, five years after the financial crisis 70% of the market is still being financed by the clearing banks on an intraday basis.[12]

On the bilateral market, where the lender must manage the collateral, the dealer banks are the lenders. The borrowers are prime brokerage clients, such as hedge funds, and other dealers.

As a result of this structure, funding generally enters the repo market via tri-party repo and the dealer banks, then, distribute this funding more broadly to their prime brokerage clients on the bilateral repo market. Thus, when a hedge fund buys an asset on margin, it borrows a significant fraction of the purchase price from the dealer bank that is its broker and posts the asset as collateral for the loan in a repo transaction. The dealer bank can then repo the asset on the tri-party repo market so that the dealer bank is effectively intermediating lending from the tri-party market to its client and earning an interest rate spread for the intermediation services. When the asset is of a type that cannot be used as collateral in the tri-party repo market, the dealer may choose to use the asset to raise funds on the inter-dealer segment of the bilateral repo market.

The dealer banks also hold collateral that is posted against derivatives contracts by other dealers and by prime brokerage clients. Whereas the inter-dealer derivatives contracts may have symmetrical collateral posting requirements, prime brokerage clients have typically been required to post collateral without having the right to require that dealer bank follow the same rule when the balance on the derivatives contracts is in the brokerage client’s favor. As a result a dealer bank is almost certain to receive collateral from its prime brokerage services when its client accounts are aggregated. The collateral posted by prime brokerage clients can then be used by the dealer to borrow in the tri-party repo market. As a result of this structure collateral posting by prime brokerage clients on their derivatives liabilities is also a form of financing for the dealer banks.

Thus, dealers often finance their own inventories, their prime brokerage clients’ assets, and any collateral that is posted against derivatives liabilities by other dealers or prime brokerage clients on the tri-party repo market.

The repo market is very different from the ABCP market and from commercial paper markets in general, because a run in one of the latter markets can only be caused by end investors. In the repo market a run can be started either by end investors or by other dealers and/or prime brokerage clients. Darrell Duffie has explained the many channels by which funding can be withdrawn in a repo market. These include: brokerage clients can move their accounts – together with all the collateral they have posted – to another dealer; dealers or brokerage clients who are derivatives counterparties can seek a novation (i.e. transfer) of a derivatives contract in order to post collateral to or expect payment from a more creditworthy dealer; dealers or brokerage clients may seek to reduce new exposures by entering into derivatives contracts that will require a dealer to post collateral; or repo lenders may increase haircuts or stop lending entirely to the dealer.[13] In short, the repo market is subject to inter-dealer and brokerage client runs, as well as to runs by repo investors.

In 2008 it is very clear that both Bear Stearns and Lehman faced a withdrawal of funding from other dealers, from brokerage clients, and from end investors in the repo market.[14]

3.  Repo Conduits

A repo conduit is a bankruptcy remote financing vehicle. The vehicle issues commercial paper that is backed by a repo with a maturity that matches the commercial paper. Thus, a repo conduit is backed primarily by the credit of the repo counterparty. Only if the repo counterparty fails to pay, can the repo conduit foreclose on the repo collateral. Because the term of the repo matches the term of the commercial paper, rating agencies do not require that a repo conduit have a backup liquidity facility.

The credit rating of a repo conduit typically is based entirely on the credit of the repo counterparty.[15] For this reason, repo conduits can be used – by institutions with high credit ratings – to finance assets that would not be eligible for tri-party repo financing.

B.  What Does Shadow Banking Do?

1.  Shadow Banking is a Funding Mechanism for Banks

The most important role of the shadow banking system is to provide wholesale funding for banks. Unsecured wholesale funding is provided when a bank issues commercial paper. Secured wholesale funding is provided when a investment bank uses the tri-party repo market to finance inventories, the assets of brokerage clients, and any collateral posted by counterparties in derivatives transactions.

As of Dec. 31, 2013, financial institutions raised $550 billion unsecured on financial commercial paper markets and the dealer banks used the tri-party repo market to borrow on a secured basis close to $1.6 trillion. 80% of the collateral posted is Treasuries and Agencies. Only $330 billion of private sector assets are financed on this market.

2.  Shadow Banking is a Funding Mechanism for Assets

Before the crisis, the shadow banking system played an important role in funding assets with liabilities that were secured by assets that were held off of bank balance sheets in bankruptcy remote vehicles. When this secured asset funding relied on bank support, it was usually provided by ABCP conduits. When this secured asset funding was made possible by a tiered liability structure, it was provided by SIVs and similar vehicles. When this secured asset funding relied on a maturity-matched repo, it was provided by a repo conduit.

Before the crisis the ABCP market was the most important source of shadow bank funding of private sector assets. (Not only did the tri-party repo market fund private sector assets that were for the most part on dealer bank balance sheets, but it was dominated by Treasuries and Agencies and thus played a relatively small role in financing private sector assets even indirectly.[16]) In post-crisis markets vehicles like ABCP and repo conduits are financing far fewer assets than they did before the crisis. The ABCP market is continuing its slow but steady decline over time and now hovers in volume around $250 billion.

3.  Shadow Banking Allows Money Market Issuers to Rent Bank Credit and Allows Banks to Avoid Capital Requirements

When assets were directly financed by the shadow banking system, it was usually because financing vehicles paid a small fee to “rent” a commercial bank’s credit rating by purchasing a guarantee of the vehicle’s liabilities. Because these guarantees were off-balance sheet, the bank was able to avoid the capital requirements that would have been imposed if the bank had done the lending itself. The role played by the clearing banks in the tri-party repo market is similar: they provide intraday credit in order to give dealer banks access to their assets during the day, but face no capital charge for the credit. Thus, a key function played by shadow banking is the arbitrage of capital regulations.[17]

The liquidity and credit facilities provided by banks to ABCP conduits are examples of unsecured bank guarantees.[18] By contrast, the tri-party clearing banks provide secured guarantees. The intra-day credit that the clearing banks provide to the dealer banks is secured by the collateral that has been posted on the tri-party repo market. Banks may also issue guarantees in the form of swaps that offset the market risk of collateral; these guarantees may be secured or unsecured depending on the derivative contract.

The collapse of the ABCP market since regulators have become attuned to the problem of regulatory arbitrage of capital requirements is just another piece of evidence that the vast majority of financing on the ABCP market at its peak was not driven by economic efficiencies, but by regulatory arbitrage as banks used liquidity and credit facilities to take on credit risk, while avoiding capital requirements. Indeed, the industry reaction to the 2004 Final Regulation governing such liquidity facilities – which resulted in a “reinterpretation” of the regulation that effectively gutted it – is also evidence of the importance of regulatory arbitrage to this market.[19]

C.  Collateralized Money Markets Are More Unstable Than Traditional Banks

The use of collateral in repo markets makes them particularly unstable for two reasons: leverage and the fact that not just lenders, but borrowers, can start a run.

When the price of the collateral in a repo contract falls, the borrower is typically required to post more collateral within a day, and, in the event that the collateral call is not met, the collateral that was posted can be liquidated immediately. While this description shows how quickly market price changes can be reflected in the sale of collateral on repo markets, it does not take the leverage that is ubiquitous on repo markets into account. Because of leverage small changes in the market price of an assets can force the borrower to sell off a large fraction of the borrower’s holding of that asset.

An example (drawn from a Fitch Ratings report) will make the instability inherent in repo market finance more clear.[20] Consider a borrower with a $5 million equity stake, which uses repo markets to finance the purchase of a $105 million portfolio of corporate bonds on which the lender imposes a 5% haircut, so that $1 can be borrowed for every $1.05 in collateral repo’d. The borrower will therefore have a leverage ratio of 21 to 1. A 2% decline in the value of the portfolio would reduce the total portfolio value to $102.9 million, reducing the equity in the portfolio to $2.9 million. If we assume that the borrower has no additional equity to contribute, the borrower can now only finance a $60.9 million portfolio at a 5% haircut. In short, because of the leverage inherent in using repo markets to finance assets, a 2% drop in portfolio value can force a sale of 42% of the assets held. Note that this example doesn’t take into account the possibility that the lender increases the haircut on the repo, which would mean that even more of the assets had to be sold. In short, once a borrower has maximized the use of leverage on repo markets – whether the borrower does this intentionally in order to “maximize” returns or simply ends up in this situation after the collateral has declined in price – very small declines in price can force the borrower to sell a significant fraction of the assets. If the borrower is a large market participant, such as an investment bank, this is likely to be the first step in a liquidity spiral, where asset sales further reduce the value of the collateral and trigger additional assets sales.

Not only does leverage make repo markets inherently unstable, but, in addition, a key characteristic distinguishing the repo market from unsecured credit markets generally is that not only the lenders, but also the borrowers, can start a run. The use of collateral in bilateral repo markets makes a borrower run possible, because the collateral can be rehypothecated, or posted as collateral in a subsequent loan by the recipient of the collateral. In short, the collateral posted by borrowers in the bilateral repo market is a source of liquidity for the lender.

When borrowers decide that they don’t want to be exposed to a troubled lender that may not be able to return the borrowers’ collateral in the event that it fails, the borrowers may seek to transfer their accounts to a lender who is not troubled. When the borrowers’ accounts are transferred, the collateral they have posted it transferred with the accounts, and the troubled lender loses the liquidity that was provided by that collateral.

As a result of this property of the repo market, the dealer bank failures of 2008 were characterized by “runs” by both prime brokerage clients and other dealers, none of whom wanted to be exposed to a failing bank. In fact, Krishnamurthy, Nagel, & Orlov conclude that the evidence supports the view that the 2008 crisis looks more like an inter-dealer credit crunch than a run by end investors on the two firms.[21] For these authors one factor distinguishing the two types of runs is the fact that the dealers are well-informed market participants, whereas end investors typically must decide whether to pull out of the market based on very limited information.[22] In short, it is possible that, far from being comparable to bank runs, the runs that took place in 2008 were runs that started with the most informed participants in financial markets.

Thus, there are two very important differences that make the repo market more unstable than unsecured funding markets. Not only does leverage mean that a small decline in price can easily force a large sale of asste, but in the bilateral repo market a run can be started not only by lenders, but also by borrowers.

In conclusion, it is misleading to describe the shadow banking system that exists today as “money market funding of capital market lending” and to focus on it as a means of financing assets,[23] because at present by far the most important use of shadow banking instruments is to provide wholesale funding for dealer banks and through them indirect financing of assets that sit on their balance sheets. Although the view that shadow banking finances assets directly may have held some truth prior to the crisis when $1.2 trillion of ABCP financed bankruptcy remote vehicles, today, to the degree that shadow banking disintermediates commercial banks, it does so by reintermediating investment banks – using a form of funding that is even more unstable than deposits.

The key question that regulators have yet to answer is whether this collateralized wholesale funding market is a valuable addition to the financial system or whether the risk of instability that accompanies it is so great that lending on this wholesale market should be curtailed.


[1] Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, & Hayley Boesky, Author’s Note in Shadow Banking, NYFRB Staff Rep. No. 458 (July 2010).

[2] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker (Nov. 2013).

[3] For example, although only $35 billion of private label residential mortgage-backed securities have been issued since 2008, at the end of 2013 more than $1 trillion of such securities remained outstanding. Data from SIFMA: http://www.sifma.org/uploadedFiles/Research/Statistics/StatisticsFiles/SF-US-Mortgage-Related-SIFMA.xls?n=47986.

[4] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker 2 (Nov. 2013).

[5] See Frank Fabozzi & Michael Fleming, U.S. Treasury and Agency Securities 11 (April 2004), available at http://www.newyorkfed.org/cfcbsweb/Treasuries_and_agencies.pdf.

[6] Federal Reserve Commercial Paper Release, Outstanding

[7] In practice, banks sometimes supported these vehicles even in the absence of a contractual obligation to do so, and sometimes did not.

[8] See the letters granting JPMorgan Chase & Co., Citigroup Inc., and Bank of America Corp. Regulation W exemptions that are dated August 20, 2007, available at the Federal Reserve website: http://www.federalreserve.gov/boarddocs/legalint/FederalReserveAct/2007/.

[9] Note that in securities lending, where institutional investors provide high-quality, high-demand collateral like Treasuries to the market, haircuts frequently go in the reverse direction. That is, more money must be lent than the value of the collateral in order to induce the securities lenders to lend.

[10] Tobias Adrian, Brian Begalle , Adam Copeland , Antoine Martin, Repo and Securities Lending, Federal Res. Bank of NY Staff Report No. 529, Feb. 2013 at 5-6.

[11] Adam Copeland, Darrell Duffie, Antoine Martin, and Susan McLaughlin, Key Mechanics of The U.S. Tri-Party Repo Market, 18 FRBNY Economic Policy Review 17, 22, 24 (2012).

[12] William C. Dudley, speech, Introductory Remarks at Workshop on “Fire Sales” as a Driver of Systemic Risk in Tri-Party Repo and Other Secured Funding Markets, Oct. 4, 2013.

[13] Darrell Duffie, How Big Banks Fail 23 – 42 (2011). See also William Dudley, More Lessons From the Crisis, Remarks at the Ctr. for Econ. Policy Studies Symposium, (Nov. 13, 2009), available at http://www.newyorkfed.org/newsevents/speeches/2009/dud091113.html; Adam Copeland, Antoine Martin & Michael Walker, The Tri-Party Repo Market before the 2010 Reforms 56-58 (Fed. Res. Bank of N.Y. Staff Rep. No. 477, 2010).
Duffie observes that when there is a repo market run, the coup de grace is almost always given by a clearing bank when it responds to concerns about a firm’s financial position by exercising its right to offset aggressively, by for example demanding collateral for intraday exposures or refusing to give access to deposits. Duffie, supra note 9, at 41¬-42.  See also Tobias Adrian & Adam Ashcraft, Shadow Banking Regulation 17 (Fed. Res. Bank of N.Y. Staff Report No. 559, 2012).

[14] Duffie, at 23-42.

[15] Moody’s Revises Approach To Counterparty Rating Actions In Repo ABCP Conduits, Oct. 21, 2009, available at http://www.cranedata.com/archives/all-articles/2541/

[16] Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo 22 (NBER Working Paper No. w17768, 2012).

[17] Carolyn Sissoko, Note, Is financial regulation structurally biased to favor deregulation, 86 Southern California Law Review 365 (2013). Sissoko also has a discussion of the broader literature on the role of regulatory arbitrage in the ABCP market.

[18] See id. for details.

[19] See Sissoko, Deregulatory Bias at.

[20] Fitch Ratings, at 8.

[21] Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo 19,22 (NBER Working Paper No. w17768, 2012).

[22] Id. at 6.

[23] Perry Mehrling, Zoltan Pozsar, James Sweeney, and Daniel Neilson, Bagehot was a Shadow Banker (Nov. 2013).

Is modern finance the source of secular stagnation?

The recent discussion of secular stagnation has once again brought up the question of whether there is a “savings glut” that is aggravating our problems. To the degree that a savings glut exists, it generally has the property that it is focused on the safest assets. That is, for reasons that remain unclear, the collapse of returns on safe assets has not be sufficient to turn this “savings glut” into a vast flow of funds into real-economy risky assets.

I believe that there has been too little discussion of the possibility that the marginal “investors” who have created the savings glut are to be found in the financial industry itself. Although it is certainly true that after the Asian crisis developing countries became net savers — and I do not discount this factor in the flow of savings — at the same time there was a significant transformation of the financial industry. The growth of derivatives was accompanied by the growth of the collateralization of derivatives and the latter phenomenon accelerated after the LTCM crisis which took place one year after the Asian crisis. Thus a non-trivial component of the “savings glut” is likely to be the demand for collateral of the financial industry itself. This source of demand can also explain the strong preference for “safe” assets, since risky assets can easily become worthless as collateral in a liquidity crisis.

If my thesis is right, then Basel III is probably aggravating the “savings glut” problem by increasing the demand for collateral on the part of financial institutions. Thus there has recently been discussion of the existence of a collateral shortage, which sounds to me like the mirror view of a savings glut. (Note that the question of a collateral shortage is complicated by the fact that collateral circulates just like deposits in a banking system, but this issue goes beyond what I want to address in this post.)

One problem with a “savings glut” that is generated in significant part by a demand for assets to be used as collateral is that it is likely to create a segmented markets effect: that is, a significant demand for highly rated assets can coexist with very tepid demand for typical, real-economy, somewhat risky assets that don’t have good characteristics as collateral. This kind of demand for assets is unlikely to play a part in economic recovery by supporting an increase in lending.

The basic problem is this: If the role of the banking system in the economy is to manage and to bear risk for the rest of the economy, then trying to make the banking system “safe” by requiring it to hold vast amounts of collateral and by making it distribute to others the risk that it is supposed to be bearing may actually prevent it from performing its role in the economy. If our banking system is no longer capable of bearing good old-fashioned credit risk, but must find others upon whom to lay that risk, then we should not be surprised that the outcome is low levels of lending to the real economy, low investment, and poor growth. In short, we cannot make the financial system “safe,” by discouraging it from carrying real economy risk, because that undermines economic growth and the performance of all assets.

How the 2005 bankruptcy reforms guarantee unfair returns to derivatives counterparties (and our largest banks)

The effects of the derivatives safe harbors in bankruptcy that protect financially sophisticated creditors at the expense of the bankrupt company’s other creditors (and were greatly expanded by the no-derivative-left-behind act of 2005 — a.k.a. BAPCPA) are demonstrated by this Lehman Brothers lawsuit.

The former purpose of the bankruptcy process was to guarantee that all creditors receive no more than they are due under the law given that the bankrupt debtor is unable to meet all of its obligations.  The modern bankruptcy process allows derivative and repo counterparties to foreclose on any collateral posted to them. While theoretically they must demonstrate that the collateral they have taken was no more than was owed to them, the imprecision inherent in the process of marking complex assets to market clearly gives these counterparties the upper hand. In the event that discussion fails to result in the return of improperly seized collateral, the bankrupt debtor must sue the counterparty to get what is due the other creditors, as the Lehman lawsuit aptly illustrates.

It is a trivial matter to show using economic analysis that the costs to the bankrupt debtor of suing will guarantee that the vast majority of derivative and repo counterparties will be able to keep more collateral than they are due (unless they were undercollateralized at the date of default). In short the bankruptcy process now favors financially sophisticated creditors over trade creditors and debt-holders, not only because the financially sophisticated are able to negotiate more favorable contracts before bankruptcy, but also because they are able to take more than they are due under the law once a company enters bankruptcy.

Update 5-8-13: Matt Levine has done the yeoman’s job of reading some Lehman-related legal complaints and appears to reach similar conclusions.

Update 5-15-13: This article leaves the impression that that best targets for a lawsuit regarding the closing of a derivative contract are those who can’t afford expensive legal advice.