– Page 10 of 22 – Blog of the Young Scholars Initiative

Where Does Profit Come from in the Payments Industry?

“Don’t be seduced into thinking that that which does not make a profit is without value.”
Arthur Miller

The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment systems during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.

Traditionally, the banking system provides payment services by being prepared to trade currency for deposits and vice versa, at a fixed price par. However, when we try to understand the economics of banks’ function as providers of payment systems, we quickly face a puzzle. The question is how banks manage to make markets in currency and deposits at a fixed price and a zero spread. In other words, what incentivizes banks to provide this crucial service. Typically, what enables the banks to offer payment systems, despite its negligible earnings, is their complementary and profitable role of being dealers in liquidity. Banks are in additional business, the business of bearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They cannot change the price of deposits in terms of currency. Still, they can expand and contract the number of deposits because deposits are their own liability, and they can expand and contract the quantity of currency because of their access to the discount window at the Fed.

This two-tier monetary system, with the central bank serving as the banker to commercial banks, is the essence of the account-based payment system and creates flexibility for the banks. This flexibility enables banks to provide payment systems despite the fact the price is fixed, and their profit from this function is negligible. It also differentiates banks, who are dealers in the money market, from other kinds of dealers such as security dealers. Security dealers’ ability to establish very long positions in securities and cash is limited due to their restricted access to funding liquidity. The profit that these dealers earn comes from setting an asking price that is higher than the bid price. This profit is called inside spread. Banks, on the other hand, make an inside spread that is equal to zero when providing payment since currency and deposits trade at par. However, they are not constrained by the number of deposits or currency they can create. In other words, although they have less flexibility in price, they have more flexibility in quantity. This flexibility comes from banks’ direct access to the central banks’ liquidity facilities. Their exclusive access to the central banks’ liquidity facilities also ensures the finality of payments, where payment is deemed to be final and irrevocable so that individuals and businesses can make payments in full confidence.

The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve).

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

How to Present your Work

Many of us have to do a lot of speaking over the course of our career. Being able to give an effective talk is a huge asset for any person, but for academics in particular. Opportunities hang on our ability to not just carry out great research but to talk about it. Here are three key points you can use to improve your presentations, whether you are explaining your Ph.D. to a group of peers, or you are addressing an auditorium full of people.

Tell a story

Many of us are tempted to structure our presentation the same way as we structure our paper. So, we present the literature, frame our approach as distinct, copy our equations into our slides, and write out our findings. But we are often better off with a presentation that frames our work as a story; this way, our audience is much more likely to take in and remember our ideas.

You may think your work doesn’t have a story, but Lynn Parramore, Senior Research Analyst, can help you find it. Writing and working with economists whose ideas are often buried under jargon, she knows how to pull out the narrative. In this video, Lynn explains to you how to do this yourself.

Manage your delivery

We can all think of a professor whose voice put us to sleep, no matter how interesting the underlying subject matter might have been. So, pitch, pace, and attitude is critical if you want to keep your audience engaged. Jackie Pocklington, Professor of Business and Technical English at Beuth University of Applied Sciences (and father of Jay Pocklington!) is full of great tips on this, including:

Make sure that YOU are the source of the information; not your slides.

This means only putting keywords on the slides, and using them as a teaser. Announce a page before clicking it, not after. Otherwise you end up telling people something they just read.

Watch the end of your sentences

Nerves or habits may cause the tone of our voice to rise at the end of our sentences. But this is not how we naturally speak. Therefore, correcting this to make sentences to go down at the end can make a dramatic difference to your delivery.

Drop the perfectionism.

Many of us feel that we need to deliver a perfect presentation; no mistakes, and nothing forgotten. But focusing all our attention on avoiding mistakes leaves little room to think about our delivery. Remember that when you’re an audience member, you don’t demand perfection either. If a speaker makes a mistake and corrects themselves to serve us well, we might even like them more.

Don’t underestimate the need for preparation

Some people seem like they can pull brilliant speeches out of thin air, but chances are that they have spent more time preparing than you think. The Official TED Guide to Public Speaking discusses various strategies for preparation, ranging from the memorization of every word, to talking from bullet points. All require careful preparation. Therefore, figure out what type of preparation strategy works for you, and make the time to carry it out; you owe it to your audience.

As with everything, the more you do it, the better you get. If you’re looking for a way to practice, the Young Scholars Initiative offers friendly audiences in a multitude of workshops and convenings every year. Moreover, keep an eye out on the calendar for an opportunity to present your work, and become the killer speaker you have the potential to be.

A New Chapter for Economic Questions

We are thrilled to announce that Economic Questions will serve the Young Scholars Initiative (YSI) as its community blog.

YSI, an initiative of the Institute for New Economic Thinking, is a global community over graduate students, young professionals and researchers. YSI envisions economic thinking that is free of intellectual barriers, resonates with reality, and serves our global society.

To advance towards this mission, YSI is building a research community without the intellectual barriers that had stifled the economics discipline; a playground of ideas. Its members have never set a definition for New Economic Thinking. Instead, they are committed to a special approach: one in which economics is defined by the questions it seeks to answer, not by the method or analytical tool applied.

Members of YSI explore their questions in collaborative projects, such as workshops, conferences and online webinars. Participating in YSI projects provides the opportunity to develop one’s research interests, create partnerships with institutions in their field, and form lasting relationships; key ingredients to flourish as a new economic thinker.

With this approach, YSI has grown to one of the most important early career networks in the field. With 10000 members in 125 countries, the community now reaches far and wide. As of early 2020, YSI has 150 projects running across 21 working groups, each focusing on a different set of questions.

In a community where there is so much activity, and so many young scholars coming together, there is a vast amount of stories to be heard, experiences to be shared, and insights to be exchanged. With short articles on YSI’s members and activities, this is what economic questions will help to facilitate.

For those of you who are new to YSI, welcome to the community! If you are interested, you are invited to register on ysi.ineteconomics.org, and to explore the working groups and the projects they are doing.

For those of you who are already a part of YSI, welcome to Economic Questions! Please let us know what content you would be interested in seeing, if you have ideas you’d like to contribute, or new economic thinkers that you’d like us to feature. Feel free to comment on the articles, or contact us directly at contact@economicquestions.org

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

“You are a side effect,” Van Houten continued, “of an evolutionary process that cares little for individual lives. You are a failed experiment in mutation.”
― John Green, The Fault in Our Stars

By Elham Saeidinezhad | The anxieties about large financial corporations’ debt-funded payouts—aka “stock buybacks”—are 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, is 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 and settlement problems for the dealers who are creating a 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 analyses 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.

Is Transiting to SOFR Affecting Firms’ Survival and Liquidity Constraints?

“Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful.”
Margaret J. Wheatley

In 2017, after a manipulation scandal, the former FCA Chief Executive Andrew Bailey called for replacing LIBOR and had made clear that the publication of LIBOR is not guaranteed beyond 2021. A new rate created by the Fed—known as the secured overnight financing rate, or SOFR- seems to pull ahead in the race to replace LIBOR. However, finding a substitute has been a very challenging task for banks, regulators, and investors. The primary worries about the transition away from the LIBOR have been whether the replacement is going to reflect the risks from short-term lending and will be supported by a liquid market that behaves predictably. Most of these concerns are rooted in the future. However, a less examined yet more immediate result of this structural change might be the current instabilities in the market for short-term borrowing. In other words, this transition to SOFR creates daily fluctuations in market prices for derivatives such as futures that are mark-to-market and in the process affects firms’ funding and liquidity requirements. This side effect might be one of the underlying causes of a challenge that the Fed is currently facing, which is understanding the turbulences in the repo market.

This shift to the post-Libor financial market has important implications for the prices of the futures contracts and firms’ liquidity constraints. Futures are derivatives that take or hedge a position on the general level of interest rates. They are also “Mark-to-Market,” which means that, whenever the futures prices change, daily payments must be made. The collateral underlying the futures contract, as well as the futures contract itself, are both marked to market every day and requires daily cash payments. LIBOR, or London Interbank Offer Rate, is used as a reference for setting the interest rate on approximately $200 trillion of financial contracts ranging from home mortgages to corporate loans. However, about $190 trillion of the $200 trillion in financial deals linked to LIBOR are in the futures market. As a result, during this transition period, the price of these contracts swings daily, as the market perceives what the future value of alternative rate to be. In process, these fluctuations in prices generate cash flows that affect liquidity and funding positions of a variety of firms that use futures contracts, including hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.

To sum up, the shift from LIBOR to SOFR not only is changing market structure but also generating cash flow consequences that are putting extra pressure on money market rates. While banks and exchanges are expanding a market for secondary financial products tied to the SOFR, they are using futures to hedge investors from losing money or protecting borrowers from an unexpectedly rise on their payments. In doing so, they make futures prices swing. These fluctuations in prices generate cash flows that affect liquidity positions of firms that invest in futures contracts. Money markets, such as the repo, secure the short-term funding that is required by these firms to meet their cash flow commitments. In the process of easing worries, banks are consistently changing the market price of the futures, generating new payment requirements, and putting pressure on short-term funding market. To evaluate the effects of this transition better, we might have to switch our framework from the traditional “Finance View” to “Money View.” The reason is that the former view emphasizes the role of future cash flows on current asset prices while the latter framework studies the impact of today’s cash flow requirements on the firm’s survival constraints.

Meet Magali Brosio, a Young Scholar and Feminist Economist

Every so often, we highlight one of the members of the YSI community. We share their story, their aspirations, and what new economic thinking means to them. This time, we cover Magali Brosio, a young scholar from Argentina, with a wide range of professional and academic experience in feminist economics and beyond. In YSI, Magali is organizer for the Gender and Economics Working Group, and spearheads the YSI Inclusivity and Diversity Advisory Team.

What has your path been, as a young scholar?

When I was young I actually dreamt about being a surgeon! But when it was time to register for university, I ended up choosing economics. Partly because I was eager to learn from a variety of disciplines (such as history, philosophy, statistics) but mainly because I wanted to understand what was going on—in my country, in my region, and in the world. I wanted to understand the economic system and how to make things better. And I never regretted it!

Since then, it’s been a combination of academic and professional work in many countries. When I was still at the University of Buenos Aires, I started working as a research assistant for the leading employers’ organization, focusing on industrial and labor policy, Then, I moved to Turin (Italy) for a Master’s degree in Applied Labour Economics for Development. At that time, I became interested in gender and started working on that, mostly through a media platform that a co-founded called Economía Femini(s)ta.

Upon return to Argentina, I first worked for a think tank called CIPPEC, focusing on economic development. Later, I became a research consultant for UN Women. I then relocated to the US to work at the intersection of gender, human rights and economic policy in CWGL, a research center based at Rutgers University. Since 2017 I have been actively involved with the YSI Gender and Economics Working Group, first as a member and then as an organizer. Being able to discuss my research with young scholars from all over the world and hear about what others were doing, sparked in me the desire to go back to academia. This is why I am now in the UK, doing a PhD in Law at the University of Birmingham.

Although I am grateful for the path I took, it was not always easy. Not everyone viewed my “mixed background” (combining academic and non-academic experience) as a strength. When I decided to go back to the academic world, I faced some resistance when trying to prove the value of my non-academic work. But I still think that it was the right approach, both personally and professionally. What I learned outside the university actually contributed a lot to my development as a researcher. And I was fortunate enough to find a PhD program and supervisors that agree with me!

Who has influenced you along the way?

Many people! My peers at university, who spent long hours discussing a wide range of topics in economics sometimes taught me more than the classroom. But also my “superiors,” although I don’t really like that word. I have been fortunate to work with amazing professors, mentors, supervisors and bosses who took the time to teach me with patience and kindness, while respecting and valuing my knowledge and treating me like an equal. In particular, Corina Rodriguez Enriquez and Radhika Balakrishnan have been amazing mentors in my (ongoing) development as a feminist economist.

What is some of the most interesting research/work you have been able to do?

As a research assistant for UN Women, I contributed to their flagship report Turning promises into action: Gender equality in the 2030 Agenda for Sustainable Development, which allowed me to explore a wide array of topics, from gender-responsive budgeting to the impact of climate change on women living in rural areas. This was a steppingstone for me, as it helped me to gain expertise in feminist economics, and inspired my current research.

In my PhD, I now study the participation of women from the Global South in global governance, using the Sustainable Development Goals (SDGs) as a case study. As legal indicators play an increasingly important role in development, I am interested in the barriers that women face when trying to engage in discussions deemed as “technical” and “nonpolitical.” I am curious how their priorities and needs are reflected in the current SDG targets and indicators.

What do you hope to see more of in the economic discipline, or what does New Economic Thinking mean to you?

In the first place, I would like to see a better understanding of how gender relations operate in the economic system. Despite the important developments within feminist economics, most of the economic analyses still ignore the gendered effects of economic phenomena or policies.

Secondly, I’d really like to see more interdisciplinary research. I’ve always thought this and now that I’m working as a postgraduate researcher within the Law School in my University, I know for a fact that there are so many valuable tools for our work that fall outside the scope of what we traditionally consider “Economics”. I have personally seen the benefits of taking courses across disciplines and institutions, of discussing research with those of different backgrounds, and attending conferences from different disciplines, and I hope that will become more common practice.

Contact Magali Brosio via the Young Scholars Directory

Meet Arjun Jayadev, Senior Economist at INET

Every so often, we highlight one of the senior scholars that has supported the Young Scholars Initiative as a mentor. We share their perspective on the discipline, their past experiences as a young scholar and their thoughts on New Economic Thinking. This time, we talk to Arjun Jayadev, Senior Economist at INET and Professor at Azim Premji University in Bangalore. Arjun works on Macroeconomics, the Economics of Power, Finance and Distribution.

How did you get involved in the subject of economics?

I would say somewhat by accident. I liked economics, I did well in economics, but I was planning on getting a master’s and return to India to become an IAS officer. But I got to grad school and unlike many people, I really enjoyed my first two years immensely. That was partly because I had done my undergraduate by correspondence, so I hadn’t had any teachers for economics there. So when I got to UMass Amherst, where we had fantastic teachers and a really amazing curriculum, I really started having a great time. Plus, it appealed to me that economics as a discipline is “on the edge of science, and on the edge of history”, as Hicks puts it. I really felt that at UMass. Also, there was a great openness and ability to do many different kinds of courses and adopt and explore different perspectives. So I took classes for about 4 years! And the path afterward turned out to be surprisingly smooth. I think partly because I came from heterodox school and there’s actually a demand for heterodox economists and not such a large supply, I had a number of offers. So the market really worked for me. And after grad school, I lucked out to be in a great department (UMass Boston). I did what I really wanted to do, and it never felt like I was chasing publications.

That is unusual! How do you explain the horror stories we hear from other people?

Partly, I think it depends on what kind of program you’re in. If you’re at a “top program”, you’re learning things at a very advanced level, which can be really tough and not seem relevant to the social issues you are interested in. But what is probably worse is if you’re at a place that is not a top program but is trying very hard to be one. Because then you’re constantly trying to emulate something which you’re never going to feel good enough at. I think those are the programs that really grind the graduate students; they make them jump through hoops. Which is awful not just during those two years, but also in the long run. Because having gone through that is what later makes people extremely resentful if you criticize their work or they feel that their work fails to explain the world. They come to feel that since they’ve gone through hell for it, it must be worth something. On top of that, they end up in a crowded field, where it’s difficult to be seen. Whereas if you’re willing to stand outside the mainstream, at a program that is not trying to compete with the top, your experience may be better, and you may actually be seen more easily. Of course, your chances of being ‘accepted’ in the economics mainstream is very low indeed, but that’s not the purpose of taking an alternative path anyway.

How do you see your role as teacher and mentor?

For me, it’s very important that the students feel like they are participants in the process, from very early on. I’m their guide, but I want them to feel responsible for the research; it needs to be their ideas and their sense of understanding. I also try to help them deal with the concept of prestige; many young people struggle with this. Students I have seen fall into a trap of constantly thinking about the way a job market paper is going to go, how people think of you, and get swamped with the corrosive hierarchy that’s associated with that. And then it becomes very hard to look at your paper as a genuine scientific inquiry. Instead, it becomes a vehicle to attain some kind of status, and of course that is determined by so many other things than the quality of your paper.

I also really enjoy teaching–especially undergraduates. Due to the incentive structures in the field, many people view teaching as something to get out of the way. But if you have a class of dozens of young students in front of you, that is actually a significant group of current and future academics to be distributing your work to, and something to take delight in.

What differences do you observe now between young scholars in India versus the US?

Significant differences, but perhaps most interestingly, in the way that they go about their work. The grad students that I meet in India tend to be closer to something real in the world than those in the US, in the sense that they are dealing with a concrete problem that they wish to understand (say, irrigation in a particular state) rather than the problem being an instantiation of a larger theoretical or empirical approach. In North America, I think the job market makes it such that you have to write a paper in a particular way so people are trained first in the general way of going about answering questions and the topic at hand is answered in that general framework. The flip side of that is that the technical training that you receive in the West is extremely strong. That skill is much stronger in the US than it is in India. And the intellectual center for economics is still in the US, which makes the flow of ideas really go only one way.

What are some of the challenges you see in the area of new economic thinking?

I do think one of the challenges is that those outside the mainstream have a tendency to remain insular and critical. Which is okay to an extent–critical perspectives are important–but the most exciting things I think are positive impulses, where you are pursuing interesting questions and gaining new insight about the world; I think the focus should be there.

Another issue is that in mainstream economics, at least for development, micro, and labor, there are things like identification, which people coalesce around as a technical way to prove mastery. It allows for a clear understanding of the problems that students can be taught to solve, and once they do that, they can be considered capable and certified. The equivalent is much harder in alternative frameworks. Students there are not always sure how to approach their work. I have seen people working very hard but not be able to produce because they were not sure what their “craft” really is. There are not a lot of models to emulate. So they often fall back to producing something that is primarily ‘critical’ which is less useful.

How do you see the discipline progressing? Would you encourage someone to enter?

There are some areas of economics that are still very problematic; where there seems to be pure self-referentiality and no engagement with the world. But others have made a lot of progress and are valuable. Fields like micro, development, or labor have become incredibly productive and useful in the past 20-25 years, and I would really encourage people to enter that-at any place. In general, there are a lot of interesting people you learn a lot from; many of whom were not widely known in my student years. Social media helps with this, though it is a double-edged sword. In terms of pedagogy, there is slow but meaningful change. In terms of the field, the aftermath of the continued economic and political crises since 2008 have led to many different voices coming through. Places like INET have allowed those people to surface, which certainly improves the climate for new people coming in. I feel very positive about that, and there is no doubt that at this moment in time is one in which economists can fulfill very important roles.

If there is a specific new economic thinker that you’d like to see featured here, let us know! Share your thoughts in the comments below, or email us at contact@economicquestions.org

When it comes to sovereign debt, what is the real concern? Level or Liquidity?

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?”
Adam Smith

By Elham Saeidinezhad | The anxieties around the European debt crisis (often also referred to as eurozone crisis) seem to be a thing of the past. Eurozone sovereigns have secured record-high order books for their new government bond issues. However, emerging balance-sheet constraints have limited the primary dealers’ ability to stay in the market and might support the view that sovereign bond liquidity is diminishing. The standard models of sovereign default identify the origins of a sovereign debt crisis to be bad “fundamentals,” such as high debt levels and expectations. These models ignore the critical features of market structures, such as liquidity and primary dealers, that underlie these fundamentals. Primary dealers – the banks appointed by national debt agencies to help them borrow from investors- act as market makers in government bond auctions. These primary dealers provide market liquidity and set the price of government bonds. Most recently, however, primary dealers are leaving Europe’s bond markets due to increased pressure on their balance-sheets. These exits could decrease sovereign bonds’ liquidity and increase the cost of borrowing for the governments. It can sow the seeds of the next financial crisis in the process. Put it differently, primary dealers’ decision to exit from this market might be acting as a warning sign of a new crisis in the making.

Standard economic theories emphasize the role of bad fundamentals such as high debt levels in creating expectations of government default and reaching to a bad-equilibrium. The sentiment is that the sovereign debt crisis is a self-fulfilling catastrophe in nature that is caused by market expectations of default on sovereign debt. In other words, governments can be subjected to the same dynamics of fickle expectations that create run on the banks and destabilize banks. This is particularly true when a government borrows from the capital market over whom it has relatively little influence. Mathematically, this implies that high debt levels lead to “multiple equilibria” in which the debt level might not be sustainable. Therefore, there will not be a crisis as long as the economy reaches a good equilibrium where no default is expected, and the interest rate is the risk-free rate. The problem with these models is that they put so much weight on the role of expectations and fundamentals while entirely abstract from specific market characteristics and constituencies such as market liquidity and dealers.

Primary dealers use their balance-sheets to determine bond prices and the cost of borrowing for the governments. In doing so, they create market liquidity for the bonds. Primary dealers buy government bonds directly from a government’s debt management office and help governments raise money from investors by pricing and selling debt. They typically are also entrusted with maintaining secondary trading activity, which entails holding some of those bonds on their balance sheets for a period. In Europe, several billion euros of European government bonds are sold every week to primary dealers through auctions, which they then sell on. However, tighter regulations, such as MiFID II, since the financial crisis has made primary dealing less profitable because of the extra capital that banks now must hold against possible losses. Also, the European Central Bank’s €2.6tn quantitative easing program has meant national central banks absorbed large volumes of debt and lowered the supply of the bonds. These factors lead the number of primary dealers in 11 EU countries to be the lowest since Afme began collecting data in 2006.

This decision by the dealers to exit the market can increase the cost of borrowing for the governments and decrease sovereign bonds’ liquidity. As a result, regardless of the type of equilibrium the economy is at, and what the debt level is, the dealers’ decision to leave the market could reduce governments’ capacity to repay or refinance their debt without the support of third parties like the European Central Bank (ECB) or the International Monetary Fund (IMF). Economics models that study the sovereign debt crisis abstracts from the role of primary dealers in government bonds. Therefore, it should hardly be surprising to see that these models would not be able to warn us about a future crisis that is rooted in the diminished liquidity in the sovereign debt market.