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Can Central Bank Digital Currency Contain COVID-19 Crisis by Saving Small Businesses? (Part 2)

This piece is a follow up to our previous Money View article on the banking system during the COVID-19 crisis.

By Elham Saeidinezhad and Jack Krupinski |The COVID-19 crisis created numerous financial market dislocations in the U.S., including in the market for government support. The federal government’s Paycheck Protection Program offered small businesses hundreds of billions of dollars so they could keep paying employees. The program failed to a great extent. Big companies got small business relief money. The thorny problem for policymakers to solve is that the government support program is rooted in the faith that banks are willing to participate in. Banks were anticipated to act as an intermediary and transfer funds from the government to the small businesses. Yet, in the modern financial system, banks have already shifted gear away from their traditional role as a financial intermediary between surplus and deficit agents. Part l used the “Money View” and a historical lens to explain why banks are reluctant to be financial intermediaries and are more in tune with their modern function as dealers in the wholesale money markets. In Part ll, we are going to propose a possible resolution to this perplexity. In a monetary system where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most, including small and medium enterprises, who have no access to the capital market.

The history of central banking began with a simple task of managing the quantity of money. Yet, central bankers shortly faced a paradox between managing “survival constraint” in the financial market and the real economy. On the one hand, for banks, the survival constraint in the financial market takes the concrete form of a “reserve constraint” because banks settle net payments using their reserve accounts at the central bank. On the other hand, according to the monetarist idea, for money to have a real purchasing power in terms of goods and services, it should be scarce. Developed by the classical economists in the nineteenth and early twentieth centuries, the quantity theory of money asserted that the quantity of money should only reflect the level of transactions in the real economy.

The hybridity between the payment system and the central bank money created such a practical dilemma. Monetarist idea disregarded such hybridity and demanded that the central bank abandon its concern about the financial market and focus only on controlling the never-materializing threat of inflation. The monetarist idea was doomed to failure for its conjectures about the financial market, and its illusion of inflation. In the race to dominate the whole economy, an efficiently functioning financial market soon became a pre-condition to economic growth. In such a circumstance, the central bank must inject reserves or else risk a breakdown of the payments system. Any ambiguity about the liquidity problems (the survival constraint) for highly leveraged financial institutions would undermine central banks’ authority to maintain the monetary and financial stability for the whole economy. For highly leveraged institutions, with financial liabilities many times larger than their capital base, it doesn’t take much of a write-down to produce technical insolvency.

This essential hybridity, and the binding reality of reserve constraint, gave birth to two parallel phenomena. In the public sphere, the urge to control the scarce reserves originated monetary policy. The advantage that the central bank had over the financial system arose ultimately from the fact that a bank that does not have sufficient funds to make a payment must borrow from the central bank. Central bankers recognized that they could use this scarcity to affect the price of money, the interest rate, in the banking system. It is the central bank’s control over the price and availability of funds at this moment of necessity that is the source of its control over the financial system. The central bank started to utilize its balance sheet to impose discipline when there was an excess supply of money, and to offer elasticity when the shortage of cash is imposing excessive discipline. But ultimately central bank was small relative to the system it engages. Because the central bank was not all-powerful, it must choose its policy intervention carefully, with a full appreciation of the origins of the instability that it is trying to counter. Such difficult tasks motivated people to call central banking as the “art,” rather than the “science”.

In the private domain, the scarcity of central bank money significantly increased the reliance on the banking system liabilities. By acting as a special kind of intermediary, banks rose to the challenge of providing funding liquidity to the real economy. Their financial intermediation role also enabled them to establish the retail payment system. For a long time, the banking system’s major task was to manage this relationship between the (retail) payment system and the quantity of money. To do so, they transferred the funds from the surplus agents to the deficit agents and absorbed the imbalances into their own balance sheets. To strike a balance between the payment obligations, and the quantity of money, banks started to create their private money, which is called credit. Banks recognized that insufficient liquidity could lead to a cascade of missed payments and the failure of the payment system as a whole.

For a while, banks’ adoption of the intermediary role appeared to provide a partial solution to the puzzle faced by the central bankers. Banks’ traditional role, as a financial intermediary and providers of indirect finance, connected them with the retail depositors. In the process, they offered a retail payment- usually involve transactions between two consumers, between consumers and small businesses, or between two small to medium enterprises. In this brave new world, managing the payment services in the financial system became analogous to the management of the economy as a whole.

Most recently, the COVID-19 crisis has tested this partial equilibrium again. In the aftermath of the COVID-19 outbreak, both the Fed and the U.S. Treasury coordinated their fiscal and monetary actions to support small businesses and keep them afloat in this challenging time. So far, a design flaw at the heart of the CARES Act, which is an over-reliance on the banking system to transfer these funds to small businesses, has created a disappointing result. This failure caught central bankers and the governments by surprise and revealed a fatal flaw in their support packages. At the heart of this misunderstanding is the fact that banks have already switched their business models to reflect a payment system that has been divided into two parts: wholesale and retail. Banks have changed the gear towards providing wholesale payment-those made between financial institutions (e.g., banks, pension funds, insurance companies) and/or large (often multinational) corporations- and away from retail payment. They are so taken with their new functions as dealers in the money market and originators of asset-backed securities in the modern market-based finance that their traditional role of being a financial intermediary has become a less important part of their activities. In other words, by design, small businesses could not get the aid money as banks are not willing to use their balance sheets to lend to these small enterprises anymore.

In this context, the broader access to central bank money by small businesses could create new opportunities for retail payments and the way the central bank maintains monetary and financial stability. Currently, households and (non-financial) companies are only able to use central bank money in the form of banknotes. Central bank digital currency (CBDC) would enable them to hold central bank money in electronic form and use it to make payments. This would increase the availability and utility of central bank money, allowing it to be used in a much more extensive range of situations than physical cash. Central bank money (whether cash, central bank reserves or potentially CBDC) plays a fundamental role in supporting monetary and financial stability by acting as a risk-free form of money that provides the ultimate means of settlement for all sterling payments in the economy. This means that the introduction of CBDC could enhance the way the central bank maintains monetary and financial stability by providing a new form of central bank money and new payment infrastructure. This could have a range of benefits, including strengthening the pass-through of monetary policy changes to the broader economy, especially to small businesses and other retail depositors, and increasing the resilience of the payment system.

This increased availability of central bank money is likely to lead to some substitution away from the forms of payment currently used by households and businesses (i.e., cash and bank deposits). If this substitution was extensive, it could reduce the reliance on commercial bank funding, and the level of credit that banks could provide as CBDC would automatically give access to central bank money to non-banks. This would potentially be useful in conducting an unconventional monetary policy. For example, the COVID-19 precipitated increased demand for dollars both domestically and internationally. Small businesses in the U.S. are increasingly looking for liquidity through programs such as the Paycheck Protection Program Liquidity Facility (PPPLF) so that those businesses can keep workers employed. In the global dollar funding market, central banks swap lines with the Fed sent dollars into other countries, but transferring those dollars to end-users would be even easier for central banks if they could bypass the commercial banking system.

Further, CBDC can be used as intraday liquidity by its holders, whereas liquidity-absorbing instruments cannot achieve the same, or can do so only imperfectly. At the moment, there is no other short-term money market instrument featuring the liquidity and creditworthiness of CBDC. The central bank would thus use its comparative advantage as a liquidity provider when issuing CBDC. The introduction of CBDC could also decrease liquidity risk because any agent could immediately settle obligations to pay with the highest form of money.

If individuals can hold current accounts with the central bank, why would anyone hold an account with high st commercial banks? Banks can still offer other services that a CBDC account may not provide (e.g., overdrafts, credit facilities, etc.). Moreover, the rates offered on deposits by banks would likely increase to retain customers. Consumer banking preferences tend to be sticky, so even with the availability of CBDC, people will probably trust the commercial banking system enough to keep deposits in their bank. However, in times of crisis, when people flee for the highest form of money (central bank money), “digital runs” on banks could cause problems. The central bank would likely have to increase lending to commercial banks or expand open market operations to sustain an adequate level of reserves. This would ultimately affect the size and composition of balance sheets for both central banks and commercial banks, and it would force central banks to take a more active role in the economy, for better or worse.

As part 1 pointed out, banks are already reluctant to play the traditional role of financial intermediary. The addition of CBDC would likely cause people to substitute away from bank deposits, further reducing the reliance on commercial banks as intermediaries. CBDC poses some risks (e.g., disintermediation, digital bank runs, cybersecurity), but it would offer some new channels through which to conduct unconventional monetary policy. For example, the interest paid on CBDC could put an effective floor on money market rates. Because CBDC is risk-free (i.e., at the top of the money hierarchy), it would be preferred to other short-term debt instruments unless the yields of these instruments increased. While less reliance on banks by small businesses would contract bank funding, banks would also have more balance sheet freedom to engage in “market-making” operations, improving market liquidity. More importantly, it creates a direct liquidity channel between the central banks, such as the Fed, and non-bank institutions such as small and medium enterprises. Because central banks need not be motivated by profit, they could pay interest on CBDC without imposing fees and minimum balance requirements that profit-seeking banks employ (in general, providing a payment system is unprofitable, so banks extort profit wherever possible). In a sense, CBDC would be the manifestation of money as a public good. Everyone would have ready access to a risk-free store of value, which is especially relevant in the uncertain economic times precipitated by the COVID-19.

Jack Krupinski is a student at UCLA, studying Mathematics and Economics. He is pursuing an actuarial associateship and is working to develop a statistical understanding of risk. Jack’s economic research interests involve using the “Money View” and empirical methods to analyze international finance and monetary policy.

New Thinking in the News

Can countries safely print money to combat the crisis? What ethical principles can we rely on in this pandemic? What policy does Soros think the US should implement right away? How does an understanding of gender theory improve our approach to doing economics? This week’s recommended read tackle these themes, and more. Enjoy.

1 | Finding the ‘Common Good’ in a Pandemic in the New York Times, with Michael Sandel

“Think about the two emblematic slogans of the pandemic: “social distancing” and “we’re all in this together.” In ordinary times, these slogans point to competing for ethical principles — setting ourselves apart from one another, and pulling together. As a response to the pandemic, we need both. We need to separate ourselves physically from our friends and co-workers in order to protect everyone, to prevent the virus from spreading. But ethically, these slogans highlight two different approaches to the common good: going it alone, with each of us fending for ourselves, versus hanging together, seeking solidarity. In a highly individualistic society like ours, we don’t do solidarity very well, except in moments of crisis, such as wartime.”

2 | Can We Print Infinite Money to Pause the Economy During the Coronavirus Pandemic? in Vice, featuring David Weil

“What are the consequences of just giving everyone enough cash to survive the next few months? […] It’s complicated.”

3 | With working Americans’ survival at stake, the US is bailing out the richest, in the Guardian, by Morris Pearl and Bill Lazonick

“Amid a humanitarian crisis compounded by mass layoffs and collapsing economic activity, the last course our legislators should be following is the one they appear to be on right now: bailing out shareholders and executives who, while enriching themselves, spent the past decade pushing business corporations to the edge of insolvency.”

4 | George Soros: Guarantee paychecks for all workers displaced by coronavirus to save the economy in the LA Times by George Soros and Eric Beinhocker

“History has shown the strategy works. Thanks to Germany’s “Kurzarbeit” program, unemployment there actually fell from 7.9% to 7% during the Great Recession, while average unemployment in other major developed economies rose by 3%. As a result, the German economy recovered more quickly than those of many other countries.”

5 | The Human-Capital Costs of the Crisis, in Project Syndicate, by Barry Eichengreen

“Unemployment and hardship can also lead to demoralization, depression, and other psychological traumas, lowering affected individuals’ productivity and attractiveness to employers. We saw this in the 1930s, not just in declining rates of labor force participation but also in rising rates of suicide and falling rates of marriage. Here, too, one worries especially about the US, given its relatively limited safety net, its opioid crisis, and its “deaths of despair.”

6 | Ecological and Feminist Economics, an interview with Julie Nelson in Real World Economics Review

“…the mainstream discipline of economics relies on a deeply gendered belief about what makes for good science. Economists like to think of economic life as confined to the market, driven by self-interest and competition, rational and controllable, and intrinsically governed by mathematics and physics-like “laws” not because the economy is intrinsically that way but because these ways of seeing it are all associated with masculinity and toughness. What about production in the home? Care for others and the environment? Human emotions, in the face of a future that is fundamentally unknowable? Ways of understanding that require hands-on investigation and broader sorts of reasoning? Acknowledging these things is, by comparison, seen as womanly and weak. And so those parts of reality and those parts of good science – which I define as open-minded and systematic investigation – were banished.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

In a World Where Banks Do Not Aspire to be Intermediaries, Is It Time to Cut Out the Middlemen? (Part I)

“Bankers have an image problem.”
Marcy Stigum

By Elham Saeidinezhad | Despite the extraordinary quick and far-reaching responses by the Fed and US Treasury, to save the economy following the crisis, the market sentiment is that “Money isn’t flowing yet.” Banks, considered as intermediaries between the government and troubled firms, have been told to use the liberated funds to boost financing for individuals and businesses in need. However, large banks are reluctant, and to a lesser extent unable, to make new loans even though regulators have relaxed capital rules imposed in the wake of the last crisis. This paradox highlights a reality that has already been emphasized by Mehrling and Stigum but erred in the economic orthodoxy.

To understand this reluctance by the banks, we must preface with a careful look at banking. In the modern financial system, banks are “dealers” or “market makers” in the money market rather than intermediaries between deficit and surplus agents. In many markets such as the UK and US, these government support programs are built based on the belief that banks are both willing and able to switch to their traditional role of being financial intermediaries seamlessly. This intermediation function enables banks to become instruments of state aid, distributing free or cheap lending to businesses that need it, underpinned by government guarantees. This piece (Part l) uses the Money View and a historical lens to explain why banks are not inspired anymore to be financial intermediaries. In Part ll, we are going to propose a possible resolution to this perplexity. In a financial structure where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most.

Stigum once observed that bankers have, at times, an image problem. They are seen as the culprits behind the high-interest rates that borrowers must pay and as acting in ways that could put the financial system and the economy at risk, perhaps by lending to risky borrowers, when interest rates are low. Both charges reflect the constant evolution in banks’ business models that lead to a few severe misconceptions over the years. The first delusion is about the banks’ primary function. Despite the common belief, banks are not intermediaries between surplus and deficit agents anymore. In this new system, banks’ primary role is to act as dealers in money market securities, in governments, in municipal securities, and various derivative products. Further, several large banks have extensive operations for clearing money market trades for nonbank dealers. A final important activity for money center banks is foreign operations of two sorts: participating in the broad international capital market known as the Euromarket and operating within the confines of foreign capital markets (accepting deposits and making loans denominated in local currencies).

Structural changes that have taken place on corporates’ capital structure and the emergence of market-based finance have led to this reconstruction in the banking system. To begin with, the corporate treasurers switched sources of corporate financing for many corporates from a bank loan to money market instruments such as commercial papers. In the late 1970s and early 1980s, when rates were high, and quality-yield spreads were consequently wide, firms needing working capital began to use the sale of open market commercial paper as a substitute for bank loans. Once firms that had previously borrowed at banks short term were introduced to the paper market, they found that most of the time, it paid them to borrow there. This was the case since money obtained in the credit market was cheaper than bank loans except when the short-term interest rate was being held by political pressure, or due to a crisis, at an artificially low level.

The other significant change in market structure was the rise of “money market mutual funds.” These funds provide more lucrative investment opportunities for depositors, especially for institutional investors, compared to what bank deposits tend to offer. This loss of large deposits led bank holding companies to also borrow in the commercial paper market to fund bank operations. The death of the deposits and the commercial loans made the traditional lending business for the banks less attractive. The lower returns caused the advent of the securitization market and the “pooling” of assets, such as mortgages and other consumer loans. Banks gradually shifted their business model from a traditional “original and hold” to an “originate-to-distribute” in which banks and other lenders could originate loans and quickly sell them into securitization pools. The goal was to increase the return of making new loans, such as mortgages, to their clients and became the originators of securitized assets.

The critical aspect of these developments is that they are mainly off-balance sheet profit centers. In August 1970, the Fed ruled that funds channeled to a member bank that was raised through the sale of commercial paper by the bank’s holding company or any of its affiliates or subsidiaries were subject to a reserve requirement. This ruling eliminated the sale of bank holding company paper for such purposes. Today, bank holding companies, which are active issuers of commercial paper, use the money obtained from the sale of such paper to fund off-balance sheet, nonbank, activities. Off-balance sheet operations do not require substantial funding from the bank when the contracts are initiated, while traditional activities such as lending must be fully funded. Further, most of the financing of traditional activities happens through a stable base of money, such as bank capital and deposits. Yet, borrowing is the primary source of funding off-balance sheet activities.

To be relevant in the new market-based credit system, and compensate for the loss of their traditional business lines, the banks started to change their main role from being financial intermediaries to becoming dealers in money market instruments and originators of securitized assets. In doing so, instead of making commercial loans, they provide liquidity backup facilities on commercial paper issuance. Also, to enhance the profitability of making consumer loans, such as mortgages, banks have turned to securitization business and have became the originators of securitized loans.

In the aftermath of the COVID-19 outbreak, the Fed, along with US Treasury, has provided numerous liquidity facilities to help illiquid small and medium enterprises. These programs are designed to channel funds to every corner of the economy through banks. For such a rescue package to become successful, these banks have to resume their traditional financial intermediary role to transfer funds from the government (the surplus agents) to SMEs (the deficit agents) who need cash for payroll financing. Regulators, in return, allow banks to enjoy lower capital requirements and looser risk-management standards. On the surface, this sounds like a deal made in heaven.

In reality, however, even though banks have received regulatory leniency, and extra funds, for their critical role as intermediaries in this rescue package, they give the government the cold shoulder. Banks are very reluctant to extend new credits and approve new loans. It is easy to portray banks as villains. However, a more productive task would be to understand the underlying reasons behind banks’ unwillingness. The problem is that despite what the Fed and the Treasury seem to assume, banks are no longer in the business of providing “direct” liquidity to financial and non-financial institutions. The era of engaging in traditional banking operations, such as accepting deposits and lending, has ended. Instead, they provide indirect finance through their role as money market dealers and originators of securitized assets.

In this dealer-centric, wholesale, world, banks are nobody’s agents but profits’. Being a dealer and earning a spread as a dealer is a much more profitable business. More importantly, even though banks might not face regulatory scrutiny if these loans end up being nonperforming, making such loans will take their balance sheet space, which is already a scarce commodity for these banks. Such factors imply that in this brave new world, the opportunity cost of being the agent of good is high. Banks would have to give up on some of their lucrative dealing businesses as such operation requires balance sheet space. This is the reason why financial atheists have already started to warn that banks should not be shamed into a do-gooder lending binge.

Large banks rejected the notion that they should use their freed-up equity capital as a basis for higher leverage, borrowing $5tn of funds to spray at the economy and keep the flames of coronavirus at bay. Stigum once said that bankers have an image problem. Having an image problem does not seem to be one of the banks’ issues anymore. The COVID-19 crisis made it very clear that banks are very comfortable with their lucrative roles as dealers in the money market and originators of assets in the capital market and have no intention to be do-gooders as financial intermediaries. These developments could suggest that it is time to cut out banks as middlemen. To this end, central bank digital currency (CBDC) could be a potential solution as it allows central banks to bypass banks to inject liquidity into the system during a period of heightened financial distress such as the COVID-19 crisis.

New Thinking in the News

This week’s recommended reads illuminate our discussions on the COVID19 crisis, the need for a global response to the economic crisis, and the fundamental questions of capitalism:

1 | How Private-Equity Firms Squeeze Hospital Patients for Profits in the New Yorker, featuring work by Eileen Appelbaum & Rosemary Batt

“Symptoms of the disease can come on quickly, sending patients to the E.R. without much warning. These, Appelbaum warned, are precisely the conditions under which surprise medical billing happens most frequently. And, with so many people flooding hospitals, it seemed only a matter of time before billing horror stories began to appear.”

2 | Solidarity Economics—for the Coronavirus Crisis and Beyond in the American Prospect, by Chris Benner and Manuel Pastor

“We are facing an immediate need to think long-term. In the same way that we need to flatten the contagion curve by spreading out the impact of the coronavirus, we also need to flatten the economic curve, linking short-term interventions with longer-term programs that provide security for families and community, strengthen connections between people and places, and grow employment and the economy.”

3 | Internationalizing the Crisis, in Project Syndicate, in by Joseph Stiglitz

“In the world’s advanced economies, compassion should be sufficient motivation to support a multilateral response. But global action is also a matter of self-interest. As long as the pandemic is still raging anywhere, it will pose a threat – both epidemiological and economic – everywhere.”

4 | Will COVID-19 Remake the World? in Project Syndicate by Dani Rodrik

“In short, COVID-19 may well not alter – much less reverse – tendencies evident before the crisis. Neoliberalism will continue its slow death. Populist autocrats will become even more authoritarian. Hyper-globalization will remain on the defensive as nation-states reclaim policy space. China and the US will continue on their collision course. And the battle within nation-states among oligarchs, authoritarian populists, and liberal internationalists will intensify, while the left struggles to devise a program that appeals to a majority of voters.”

5 | The Fundamental Questions About Capitalism Seem to be Coming Back in Jacobin, featuring Anwar Shaik

“I started off as an aeronautical engineer: you need to understand that you’re part of a big system, and you also need to understand how it works, if you’re going to operate within that system (and perhaps change it). That goes against the logic of orthodox economics, where you start from the individual elements and try to build an understanding from there.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Should the Fed Add FX Swaps to its Asset Purchasing Programs?

By Elham Saeidinezhad and Jack Krupinski

“As Stigum reminded us, the market for Eurodollar deposits follows the sun around the globe. Therefore, no one, including and especially the Fed, can hide from its rays.”

The COVID-19 crisis renewed the heated debate on whether the US dollar could lose its status as the world’s dominant currency. Still, in present conditions, without loss of generality, the world reserve currency is the dollar. The exorbitant privilege implies that the deficit agents globally need to acquire dollars. These players probably have a small reserve holding, usually in the form of US Treasury securities. Still, more generally, they will need to purchase dollars in a global foreign exchange (FX) markets to finance their dollar-denominated assets. One of the significant determinants of the dollar funding costs that these investors face is the cost of hedging foreign exchange risk. Traditionally, the market for the Eurodollar deposits has been the final destination for these non-US investors. However, after the great financial crisis, investors have turned to a particular, and important segment of the FX market, called the FX swap market, to raise dollar funding. This shift in the behavior of foreign investors might have repercussions for the rates in the US money market.

The point to emphasize is that the price of Eurodollar funding, used to discipline the behavior of the foreign deficit agents, can affect the US domestic money market. This usage of FX swap markets by foreign investors to overcome US dollar funding shortages could move short-term domestic rates from the Fed’s target range. Higher rates could impair liquidity in US money markets by increasing the financing cost for US investors. To maintain the FX swap rate at a desirable level, and keep the Fed Funds rate at a target range, the Fed might have to include FX derivatives in its asset purchasing programs.

The use of the FX swap market to raise dollar funding depends on the relative costs in the FX swap and the Eurodollar market. This relative cost is represented in the spread between the FX swap rate and LIBOR. The “FX swap-implied rate” or “FX swap rate” is the cost of raising foreign currency via the FX derivatives market. While the “FX swap rate” is the primary indicator that measures the cost of borrowing in the FX swap market, the “FX-hedged yield curve” represents that. The “FX-hedged yield curve” adjusts the yield curve to reflect the cost of financing for hedged international investors and represents the hedged return. On the other hand, LIBOR, or probably SOFR in the post-LIBOR era, is the cost of raising dollar directly from the market for Eurodollar deposits.

In tranquil times, arbitrage, and the corresponding Covered Interest Parity condition, implies that investors are indifferent in tapping either market to raise funding. On the contrary, during periods when the bank balance sheet capacity is scarce, the demand of investors shifts strongly toward a particular market as the spread between LIBOR and FX swap rate increases sharply. More specifically, when the FX swap rate for a given currency is less than the cost of raising dollar directly from the market for Eurodollar deposits, institutions will tend to borrow from the FX swap market rather than using the money market. Likewise, a higher FX swap rate would discourage the use of FX swaps in financing.

By focusing on the dollar funding, it is evident that the FX swap market is fundamentally a money market, not a capital market, for at least two reasons. First, the overwhelming majority of the market is short-term. Second, it determines the cost of Eurodollar funding, both directly and indirectly, by providing an alternative route of funding. It is no accident that since the beginning of the COVID-19 outbreak, indicators of dollar funding costs in foreign exchange markets, including “FX swap-implied rate”, have risen sharply, approaching levels last seen during the great financial crisis. During crises, non-US banks usually finance their US dollar assets by tapping the FX swap market, where someone borrows dollars using FX derivatives by pledging another currency as collateral. In this period, heightened uncertainty leads US banks that face liquidity shortage to hoard liquid assets rather than lend to foreigners. Such coordinated decisions by the US banks put upward pressure on FX swap rates.

The FX swap market also affects the cost of Eurodollar funding indirectly through the FX dealers. In essence, most deficit agents might acquire dollars by relying entirely on the private FX dealing system. Two different types of dealers in the FX market are typical FX dealers and speculative dealers. The FX dealer system expedites settlement by expanding credit. In the current international order, the FX dealer usually has to provide dollar funding. The dealer creates a dollar liability that the deficit agent buys at the spot exchange rate using local currency, to pay the surplus country. The result is the expansion of the dealer’s balance sheet and its exposure to FX risk. The FX risk, or exchange risk, is a risk that the dollar price of the dealer’s new FX asset might fall. The bid-ask spread that the FX dealer earns reflects this price risk and the resulting cost of hedging.

As a hedge against this price risk, the dealer enters an FX swap market to purchase an offsetting forward exchange contract from a speculative dealer. As Stigum shows, and Mehrling emphasizes, the FX dealer borrows term FX currencies and lends term dollars. As a result of entering into a forward contract, the FX dealer has a “matched book”—if the dollar price of its new FX spot asset falls, then so also will the dollar value of its new FX term liability. It does, however, still face liquidity risk since maintaining the hedge requires rolling over its spot dollar liability position until the maturity of its term dollar asset position. A “speculative” dealer provides the forward hedge to the FX dealer. This dealer faces exposure to exchange risk and might use a futures position, or an FX options position to hedge. The point to emphasize here is that the hedging cost of the speculative dealer affects the price that the normal FX dealer faces when entering a forward contract and ultimately determines the price of Eurodollar funding.

The critical question is, what connects the domestic US markets with the Euromarkets as mentioned earlier? In different maturity ranges, US and Eurodollar rates track each other extraordinarily closely over time. In other words, even though spreads widen and narrow, and sometimes rates cross, the main trends up and down are always the same in both markets. Stigum (2007) suggests that there is no doubt that this consistency in rates is the work of arbitrage.

Two sorts of arbitrages are used to link US and Eurodollar rates, technical and transitory. Opportunities for technical arbitrage vanished with the movement of CHIPS to same-day settlement and payment finality. Transitory arbitrages, in contrast, are money flows that occur in response to temporary discrepancies that arise between US and Eurodollar rates because rates in the two markets are being affected by differing supply and demand pressures. Much transitory arbitrage used to be carried on by banks that actively borrow and lend funds in both markets. The arbitrage that banks do between the domestic and Eurodollar markets is referred to as soft arbitrage. In making funding choices, domestic versus Eurodollars, US banks always compare relative costs on an all-in basis.

But that still leaves open the question of where the primary impetus for rate changes typically comes from. Put it differently, are changes in US rates pushing Eurodollar rates up and down, or vice versa? A British Eurobanker has a brief answer: “Rarely does the tail wag the dog. The US money market is the dog, the Eurodollar market, the tail.” The statement has been a truth for most parts before the great financial crisis. The fact of this statement has created a foreign contingent of Fed watchers. However, the direction of this effect might have reversed after the great financial crisis. In other words, some longer-term shifts have made the US money market respond to the developments in the Eurodollar funding.

This was one of the lessons from the US repo-market turmoil. On Monday, September 16, and Tuesday, September 17, Overnight Treasury general collateral (GC) repurchase-agreement (repo) rates surprisingly surged to almost 10%. Two factors made these developments extraordinary: First, the banks, who act as a dealer of near last resort in this market due to their direct access to the Fed’s balance sheets, did not inject liquidity. Second, this time around, the Secured Overnight Financing Rate (SOFR), which is replacing LIBOR to measure the cost of Eurodollar financing, also increased significantly, leading the Fed to intervene directly in the repo market.

Credit Suisse’ Zoltan Poszar points out that an increase in the supply of US Treasuries along with the inversion in the FX-hedged yield of Treasuries has created such anomalies in the US money market. Earlier last year, an increase in hedging costs caused the inversion of a curve that represents the FX-hedged yield of Treasuries at different maturities. Post- great financial crisis, the size of foreign demands for US assets, including the US Treasury bonds, increased significantly. For these investors, the cost of FX swaps is the primary factor that affects their demand for US assets since that hedge return, called FX-hedged yield, is an important component of total return on investment. This FX-hedged yield ultimately drives investment decisions as hedge introduces an extra cash flow that a domestic bond investment does not have. This additional hedge return affects liquidity considerations because hedging generates its own cash flows.

The yield-curve inversion disincentivizes foreign investors, mostly carry traders, trying to earn a margin from borrowing short term to buy Treasuries (i.e., lending longer-term). Demand for Eurodollars—which are required by deficit agents to settle payment obligations—is very high right now, which has caused the FX Swap rate-LIBOR spread to widen. The demand to directly raise dollars through FX swaps has driven the price increase, but this also affects investors who typically use FX swaps to hedge dollar investments. As the hedge return falls (it is negative for the Euro), it becomes less profitable for foreign investors to buy Treasury debt. More importantly, for foreign investors, the point at which this trade becomes unprofitable has been reached way before the yield curve inverted, as they had to pay for hedging costs (in yen or euro). This then forces Treasuries onto the balance sheets of primary dealers and have repercussions in the domestic money market as it creates balance sheet constraints for these large banks. This constraint led banks with ample reserves to be unwilling to lend money to each other for an interest rate of up to 10% when they would only receive 1.8% from the Fed.

This seems like some type of “crowding out,” in which demand for dollar funding via the FX swap has driven up the price of the derivative and crowded out those investors who would typically use the swap as a hedging tool. Because it is more costly to hedge dollar investments, there is a risk that demand for US Treasuries will decrease. This problem is driven by the “dual-purpose” of the FX swaps. By directly buying this derivative, the Fed can stabilize prices and encourage foreign investors to keep buying Treasuries by increasing hedge return. Beyond acting to stabilize the global financial market, the Fed has a direct domestic interest in intervening in the FX market because of the spillover into US money markets.

The yield curve that the Fed should start to influence is the FX-hedged yield of Treasuries, rather than the Treasury yield curve since it encompasses the costs of US dollar funding for foreigners. Because of the spillover of FX swap turbulences to the US money markets, the FX swap rate will influence the US domestic money market. If we’re right about funding stresses and the direction of effects, the Fed might have to start adding FX swaps to its asset purchasing program. This decision could bridge the imbalance in the FX swap market and offer foreign investors a better yield. The safe asset – US Treasuries – is significantly funded by foreign investors, and if the FX swap market pulls balance sheet and funding away from them, the safe asset will go on sale. Treasury yields can spike, and the Fed will have to shift from buying bills to buying what matters– FX derivatives. Such ideas might make some people- especially those who believe that keeping the dollar as the world’s reserve currency is a massive drag on the struggling US economy and label the dollar’s international status as an “an exorbitant burden,”- uncomfortable. However, as Stigum reminded us, the market for Eurodollar deposits follows the sun around the globe. Therefore, no one, including and especially the Fed, can hide from its rays.

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

Jack Krupinski is a student at UCLA, studying Mathematics and Economics. He is pursuing an actuarial associateship and is working to develop a statistical understanding of risk. Jack’s economic research interests involve using the “Money View” and empirical methods to analyze international finance and monetary policy.

The Social Determinants of Health in the Age of COVID19

With the ongoing pandemic and economic crisis, there is much to discuss. To inform the debates taking place in the YSI community, Luisa Scarcella and Aleksandar Stojanović have kicked off a special webinar series in which to unpack some of the accompanying challenges. For the first session, Luisa invited Professor Sir Michael Marmot, Professor of Epidemiology and Public Health at University College London, Director of the UCL Institute of Health Equity, and Past President of the World Medical Association. His work reveals the interrelated nature of health and socioeconomic inequality; a highly relevant topic today.

When economists talk about health, they usually talk about the healthcare system. They don’t often talk about what makes people sick in the first place. But Marmot does, and he finds that our people’s health is closely tied to the socio-economic conditions they are in; lower socio-economic conditions lead to worse health, and increasing socioeconomic inequality yields a widening health gap. His findings are compelling:

In the developed world, general life expectancy has stagnated since WW2; that is unprecedented for peacetime. But for the lower economic classes, it’s even worse. In the UK, the life expectancy of the poor has been decreasing for a decade now. It’s no coincidence, Marmot argues, that this trend emerged in a context of harsh austerity measures. Having reduced the purchasing power of the underprivileged, healthy living is increasingly out of reach.

Other advanced economies, the US in particular, show similar trends. There, too, structural inequalities give rise to job insecurity, housing insecurity, food insecurity, racism, and violence. These disadvantages translate into worse health for the poor. So, to improve the health of the American people, a better healthcare system would only be the beginning. To actually improve public health, the US would need to address the socio-economic inequalities that underlie it.

These insights offer a fresh take on the national responses to the COVID-19 outbreak, too. Many governmental remedies are receiving criticism for ‘treating the symptom and not the cause,’ echoing Professor Marmot’s plea. On top of that, most nations’ stimulus packages do not sufficiently alleviate the economic despair of the most vulnerable groups, leading to a worsening of the socio-economic conditions that are associated with bad health. The issues Marmot points out may only accelerate during this crisis.

Marmot’s work demonstrates the interconnected nature of many of the societal challenges we study in YSI: socioeconomic inequality, societal fragmentation, the concentration of economic and political power, and ultimately human despair. As Rob Johnson commented: “We must continue trying to understand how and why the political economy produces these conditions and tolerates them.”

A recording of Professor Marmot’s webinar is available here. Marmot’s book, the Health Gap, provides a more detailed account of his findings.

New Thinking in the News

This week’s recommended reads illuminate our discussions on the COVID19 crisis, its economic impact, and the quality of governments’ policy responses:

1 | The Race Between Economics and COVID19 in Project Syndicate, by Mohamed El-Erian

“For years, the economics profession has suffered from a stubborn reluctance to adopt a more multidisciplinary approach. But now that the COVID-19 pandemic is transforming economic life the world over, the profession has no choice but to leave its comfort zone.”

2 | Hospital Bailouts Begin—for Those Owned by Private Equity Firms in the American Prospect, by Eileen Appelbaum & Rosemary Batt

“After compelling hospitals to take on huge piles of debt through leveraged buyouts, private equity firms are poised to line up for taxpayer bailouts.”

3 | Why the Largest Stimulus in History Still Is Not Enough in Barron’s, by Roman Frydman

“As unreliable a guide to economic performance as many consider the stock market to be, this time the market has it right. It is obvious to investors that the problems we face stem from the public-health crisis—and cannot be cured by the “stimulus” package.”

4 | Economic numbers don’t matter right now. Government must help Americans get by in the Guardian by James K. Galbraith

“The economy cannot use stimulus when there is nothing to buy!”

5 | Why Coronavirus Could Hit Rural Areas Harder via Syracuse University, by Sharon Monnat.

“On the one hand, rural parts of the U.S. may be comparatively better off than urban places due to lower population density in rural areas. Lower population density reduces opportunities for virus spread. On the other hand, there are several features of rural populations and places that increase their risk of coronavirus-related mortality and other long-term health impacts.”

Every week, we share a few noteworthy articles that showcase the work of new economic thinkers around the world. Subscribe to receive these shortlists directly to your email inbox.

Why Does “Solvency” Rule in Derivatives Trading?

Hint: It Should Not

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

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

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

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

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

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

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

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