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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.

Is the COVID-19 Crisis a “Mehrling’s Moment”?

Derivatives Market as the Achilles’ Heel of the Fed’s Interventions

By Elham Saeidinezhad | Some describe the global financial crisis as a “Minsky moment” when the inherent instability of credit was exposed for everyone to see. The COVID-19 turmoil, on the other hand, seems to be a “Mehrling moment” since his Money View provided us a unique framework to evaluate the Fed’s responses in action. Over the past couple of months, a new crisis, known as COVID-19, has grown up to become the most widespread shock after the 2008-09 global financial crisis. COVID-19 crisis has sparked historical reactions by the Fed. In essence, the Fed has become the creditor of the “first” resort in the financial market. These interventions evolved swiftly and encompassed several roles and tools of the Fed (Table 1). Thus, it is crucial to measure their effectiveness in stabilizing the financial market.

In most cases, economists assessed these actions by studying the change in size or composition of the Fed’s balance sheet or the extent and the kind of assets that the Fed is supporting. In a historic move, for instance, the Fed is backstopping commercial papers and municipal bonds directly. However, once we use the model of “Market-Based Credit,” proposed by Perry Mehrling, it becomes clear that these supports exclude an essential player in this system, which is derivative dealers. This exclusion might be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis.

What system of central bank intervention would make sense if the COVID-19 crisis significantly crushed the market-based credit? This piece employs Perry Mehrling’s stylized model of the market-based credit system to think about this question. Table 1 classifies the Fed’s interventions based on the main actors in this model and their function. These players are investment banks, asset managers, money dealers, and derivative dealers. In this financial market, investment banks invest in capital market instruments, such as mortgage-backed securities (MBS) and other asset-backed securities (ABS). To hedge against the risks, they hold derivatives such as Interest Rate Swaps (IRS), Foreign exchange Swaps (FXS), and Credit Default Swaps (CDS). The basic idea of derivatives is to create an instrument that separates the sources of risk from the underlying assets to price (or even sell) them separately. Asset managers, which are the leading investors in this economy, hold these derivatives. Their goal is to achieve their desired risk exposure and return. From the balance sheet perspective, the investment bank is the mirror image of the asset manager in terms of both funding and risk.

This framework highlights the role of intermediaries to focus on liquidity risk. In this model, there are two different yet equally critical financial intermediaries—money dealers, such as money market mutual funds, and the derivative dealers. Money dealers provide dollar funding and set the price of liquidity in the money market. In other words, these dealers transfer the cash from the investors to finance the securities holdings of investment banks. The second intermediary is the derivative dealers. These market makers, in derivatives such as CDS, FXS, and IRS, transfer risk from the investment bank to the asset manager and set the price of risk in the process. They mobilize the risk capacity of asset managers’ capital to bear the risk in assets such as MBS.

After the COVID-19 crisis, the Fed has backstopped all these actors in the market-based credit system, except the derivative dealers (Table 1). The lack of Fed’s support for the derivatives market might be an immature decision. The modern market-based credit system is a collateralized system. To make this system work, there should be a robust mechanism for shifting both assets and the risks. The Fed has employed extensive measures to support the transfer of assets that is essential for the provision of funding liquidity. Financial participants use assets as collaterals to obtain funding liquidity by borrowing from the money dealers. During a financial crisis, however, this mechanism only works if a stable market for risk transfer accompanies it. It is the job of derivative dealers to use their balance sheets to transfer risk and make a market in derivatives. The problem is that fluctuations in the price of assets that derive the value of the derivatives expose them to the price risk.

During a crisis such as COVID-19 turmoil, the heightened price risks lead to the system-wide contraction of the credit. This occurs even if the Fed injects an unprecedented level of liquidity into the system. If the value of assets falls, the investors should make regular payments to the derivative dealers since most derivatives are mark-to-market. They make these payments using their money market deposit account or money market mutual fund (MMMFs). The derivative dealers then use this cash inflow to transfer money to the investment bank that is the ultimate holder of these instruments. In this process, the size of assets and liabilities of the global money dealer (or MMMFs) shrinks, which leads to a system-wide credit contraction.

As a result of the COVID-19 crisis, derivative dealers’ cash outflow is very likely to remain higher than their cash inflow. To manage their cash flow derivative dealers, derive the prices of the “insurance” up, and further reduce the price of capital or assets in the market. This process further worsens the initial problem of falling asset prices despite the Fed’s massive asset purchasing program. The critical point to emphasize here is that the mechanism through which the transfer of the collateral, and the provision of liquidity, happens only works if fluctuations in the value of assets are absorbed by the balance sheets of both money dealers and derivative dealers. Both dealers need continuous access to liquidity to finance their balance sheet operations.

Traditional lender of last resort is one response to these problems. In the aftermath of the COVID-19 crisis, the Fed has indeed backstopped the global money dealer, asset managers and supported continued lending to investment banking. Fed also became the dealer of last resort by supporting the asset prices and preventing the demand for additional collateral by MMMFs. However, the Fed has left derivative dealers and their liquidity needs behind. Importantly, two essential actions are missing from the Fed’s recent market interventions. First, the Fed has not provided any facility that could ease derivative dealers’ funding pressure when financing their liabilities. Second, the Fed has not done enough to prevent derivative dealers from demanding additional collaterals from asset managers and other investors, to protect their positions against the possible future losses.

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

To sum up, shadow banking has three crucial foundations: market-based credit, global banking, and modern finance. The stability of these pillars depends on the price of collateral, price of Eurodollar, and price of derivatives, respectively. In the aftermath of the COVID-19 crisis, the Fed has backstopped the first two dimensions through tools such as the Primary Dealer Credit Facility, Term Asset-Backed Securities Loan Facility, and Central Bank Swap Lines. However, it has left the last foundation, which is the market for derivatives, unattended. According to Money View, this can be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis.

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).

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.