There are only a handful of global experts on how the Eurodollar markets, dollar swaps, ghost banks and money market funds interact with central banks. International monetary and economic expert Robert McCauley, a senior research associate with the Global History of Capitalism project, is among them. He sent us a useful account of the extraordinary measures taken by central banks like the Federal Reserve to stabilize the securities markets and how exceptional they are compared to recent precedents.
A key observation is that, while the Fed has not yet exhausted its options in this area, some of the measures it is currently experimenting with are about to open a new chapter in central bank support for the securities markets. .
McCauley warns, however, that the goal should not only be to support security prices. This particularly applies to the corporate bond market, where a sudden shortage of market makers dedicated to bond ETFs (called authorized participants) creates an urgent need for the central bank to act as an authorized participant of last resort in the purpose of maintaining the market. liquidity.
McCauley’s notes follow below.
How can a central bank stabilize the securities markets?
The motivation of central banks to intervene in the securities markets is clear: faced with disruptions in the securities markets, the real economy faces threats of disruption of credit flows, unnecessary defaults and sales incendiary.
Fifty years ago, the Fed could respond to the default of a large commercial paper (CP) issuer by opening the bank discount window. Easy access to Fed credit allowed banks to finance industrial companies that were unable to roll over the expiring CP. Today we see companies relying on the formal line of credit system which was introduced as a safety net for the CP market after the Penn Central rail crisis in 1970. Last week the Fed opened the discount window as wide as possible, just as it has done from the start. then.
However, at the time of the Penn Central crisis, the major weekly reporting banks were able to increase their business loans by 3% to compensate for a 10% drop in nonbank CP. A bank lender of last resort could therefore, in practice, support a substantial securities market all at once.
Today, the US corporate bond market – much of which is slightly larger than the junk – stands at $ 7 billion, according to the US corporate bond index Bloomberg Barclays. Its sheer size means that last resort loans to banks are likely to have a hard time stopping disruptions in the securities markets.
Going beyond the banking system with its last resort credit is therefore essential for central banks like the Fed.
But what options do central banks really have to stabilize the securities markets?
In reality, there are only five: 1) acting as lender of last resort to securities companies, 2) acting as lender of last resort for investment funds, 3) acting as as a securities broker of last resort, 4) acting as a subscriber of securities of last resort and finally 5) acting as a buyer of securities of last resort.
By Monday, March 23, the Fed had implemented programs under three of these five options. He backed away from another and it is not hard to imagine that he will soon experience the last one.
Act as a “lender of last resort to brokerage firms”
The Fed returned to its 2008 playbook last week by resuming its role as lender of last resort to securities companies. The Prime Broker’s Credit Facility funnels guaranteed the Fed’s credit for up to 90 days to its designated prime brokers. The collateral can include stocks, which is otherwise a no-go for the bank discount window.
Act as a “lender of last resort to investment funds”
While the holding companies of Bank of New York and Goldman Sachs have recently come to the rescue of their money market funds, the Fed has yet to lend to investment funds. In the United States, such central bank action would require the use of emergency powers under Article 13.3 with the approval of the Treasury.
However, a recent precedent for official support for investment funds is the Treasury’s guarantee of the Exchange Stabilization Fund (ESF) of the nominal value of liabilities of money market funds after Lehman’s default in September 2008.
This, combined with the purchase and subscription of CP by the Fed, succeeded in stopping the rush for money market funds. The only other precedent was the Bank of Japan’s funding of investment funds in the mid-1960s during the Yamaichi crisis.
Act as a “broker of last resort”
Whatever its intentions, in its March 18 snapshot of the balance sheet, the Fed looked very much like a stock broker of last resort. The central bank stepped in to become a middleman on both sides of the repo market to the tune of $ 234 billion – which is known in the industry to manage a matching book. On the one hand, foreign central banks and money market funds as cash lenders; on the other, stock brokers as cash borrowers. It is important to note that this balance emerged when the Fed loaned money to prevent market forces from raising short-term rates rather than by intent to maintain the repo market per se.
The Systemic Risk Board, an advisory body made up of former government officials and financial experts, is now urging central banks to take on this role more broadly.
Act as a “subscriber of last resort securities”
The Federal Reserve took over the role it played as a last resort underwriter for CP in 2008-2009 with its offer last week to buy CP directly from businesses. For a small subscription fee of 10 basis points, the Fed will now buy CP if the primary issuer cannot sell it on the market at less than 2% from overnight rates. This time, the Exchange Stabilization Fund (ESF) provides a layer of Treasury capital to protect the Fed from losses. The last time the Fed made this offer, it walked away with a profit.
On March 23, the Fed extended its role as a subscriber of last resort further down the yield curve when it decided to support the issuance of investment grade corporate bonds or loans with terms of up to ‘at four. Again, the ESF takes the equity risk. But this intervention in the primary corporate bond market, as well as the secondary market operation below, opens a new chapter in central bank support for the securities markets.
Act as a “buyer of securities of last resort”
The precedent for acting as a buyer of securities of last resort occurred in 2008-09 when the Boston Federal Reserve Bank made non-recourse loans to depositories to finance the purchase of asset-backed CPs from mutual funds.
On March 18, the Fed announced a similar but broader program under which the Boston Fed would make non-recourse loans to any CP-guaranteed bank purchased from money market mutual funds.
On March 20, the Fed added municipal paper to the program.
On March 23, the Fed announced that it would buy investment grade US corporate bonds or exchange funds traded on the secondary market. Again, the ESF would offer an equity risk tranche.
All of these actions in the security markets are important.
But it is important to note that the hundreds of billions of dollars in programs announced to date may not be sufficient to support the market for dollar-denominated corporate bonds. Not only are there $ 7 trillion in US corporate bonds, but the Bank for International Settlements (BIS) estimates that the dollar bonds of non-US residents other than banks have gone from $ 2.5 trillion to end of 2008 to $ 6.2 trillion in September 2019. Treasurers and agencies, the global dollar bond market is worth tens of trillions of dollars.
And while corporate bond purchases by the Fed can prevent short-term market foreclosures by offering a bond offering in the face of mutual fund redemptions, over time, they don’t add up. thing to the overall market liquidity. Corporate bonds purchased on the secondary market essentially end up in a special Fed vehicle.
To revive liquidity, the Fed could possibly redirect the program to a secondary market liquidity program. In this regard, one option is for the Fed to buy and sell corporate bonds on the secondary market in order to narrow spreads and further encourage private markets. The Fed could even use these purchases and sales to arbitrate the prices of heavily traded exchange-traded funds and the prices of poorly traded underlying bonds, where large spreads have apparently widened. This would allow the Fed to become the authorized participant in the ETF market as a last resort, doing so by supporting the liquidity of securities, not just their price.
It remains to be seen whether the Fed is going in that direction, of course. What we can be sure of is that further measures to stabilize the securities markets are coming.