There are only a handful of global experts on how eurodollar markets, dollar swaps, shadow banks and money market funds interact with central banks. International monetary and economic expert Robert McCauley, a senior research associate at the Global History of Capitalism project, is one of them. He’s sent us a useful account of the extraordinary moves central banks like the Federal Reserve are now taking to stabilise securities markets and how exceptional they are in relation to recent precedents.
A key observation is that while the Fed hasn’t yet exhausted its options in this arena, some of the moves it is now experimenting with are on the verge of opening a new chapter in central bank support for securities markets.
McCauley cautions, however, that the objective shouldn’t just be security price support. This especially applies to the corporate bond market, where a sudden dearth of dedicated market makers for bond ETFs (known as authorised participants) is creating an urgent need for the central bank to step in as authorised participant of last resort in a bid to maintain market liquidity.
McCauley’s notes follow below.
How can a central bank stabilise security markets?
Central banks’ motivation to intervene in security markets is clear: in the face of runs on securities markets, the real economy faces threats of disruption of credit flows, unnecessary defaults and fire sales.
Fifty years ago, the Fed could respond to the default of a large issuer of commercial paper (CP) by opening the discount window to banks. Easy access to Fed credit allowed banks to fund industrial firms that were unable to roll over maturing CP. Today we see firms drawing down on the system of formal credit lines that was introduced as a backstop for the CP market following the Penn Central railroad crisis of 1970. Last week the Fed opened the discount window as wide as possible, just as it did back then.
At the time of the Penn Central crisis, however, it was possible for the big weekly reporting banks to expand their corporate loans by 3 per cent in order to offset a 10 per cent decline in nonbank CP. A bank lender of last resort could in practice therefore backstop a substantial securities market in one move.
Today, the US corporate bond market — much of it rated just a notch higher than junk — amounts to $7tn, according to the Bloomberg Barclays US corporate bond index. Its sheer size means last-resort lending to banks is likely to struggle to stop runs on security 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 when it comes to stabilising securities markets?
In reality, there are only five: 1) Acting as a lender of last resort to securities firms, 2) acting as a lender of last resort to investment funds, 3) acting as a securities dealer of last resort, 4) acting as a securities underwriter of last resort and finally 5) acting as a securities buyer of last resort.
By Monday 23 March, the Fed had put in place programmes under three of those five options. It has been backing into another and it is not hard to imagine it will soon experiment with the last one.
Acting as a “lender of last resort to securities firms”
The Fed returned to its 2008 playbook last week by reprising its role as last resort lender to securities firms. The Primary Dealer Credit Facility funnels collateralised Fed credit for up to 90 days to its designated primary dealers. Collateral can include equities, which is otherwise a no-go for the bank discount window.
Acting as a “lender of last resort to investment funds”
While the holding companies of Bank of New York and Goldman Sachs recently came to the rescue of their money market funds, the Fed has not yet lent to investment funds. In the US, central bank action of this sort would require the use of emergency Section 13.3 powers with Treasury approval.
Nonetheless a recent precedent for official support of investment funds is the Treasury’s Exchange Stabilisation Fund (ESF) guarantee of the par value of money market fund liabilities after the Lehman default in September 2008.
This, in combination with the Fed’s, in effect, purchasing and underwriting of CP, successfully stopped the run on money market funds. The only other precedent was the Bank of Japan’s funding of investment trusts in the mid-1960s during the Yamaichi crisis.
Acting as a “securities dealer of last resort”
Whatever its intentions, at its March 18 balance sheet snapshot, the Fed looked very much like a securities dealer of last resort. The central bank has stepped in to intermediate on both sides of the repo market to the extent of $234bn — this is known in the industry as running a matched book. On one side are foreign central banks and money market funds as cash lenders; on the other are securities dealers as cash borrowers. It’s important to stress this balance arose as the Fed lent cash to stop market forces from lifting short-term rates rather than from an intention to keep the repo market going per se.
The Systemic Risk Council, an advisory body made up of former government officials and financial experts, is now urging central banks to take on this role more broadly.
Acting as a “securities underwriter of last resort”
The Federal Reserve reprised the role it played as underwriter of last resort for CP back in 2008-09 with its offer last week to buy CP directly from firms. For a small underwriting fee of 10 basis points, the Fed will now buy CP if the prime issuer cannot sell it in the market at less than 2 per cent over overnight rates. This time the Exchange Stabilization Fund (ESF) is providing a layer of Treasury equity to shield the Fed from losses. The last time the Fed made this offer it walked away with a profit.
On March 20, the Fed added municipal paper to the programme.
On March 23, the Fed extended its role as underwriter of last resort further out the yield curve when it moved to support the issuance of investment grade corporate bonds or loans of up to four year’s maturity. Again, the ESF takes equity risk. But this intervention in the primary corporate bond market, along with the secondary market operation below, opens a new chapter in central bank support for securities markets.
Acting as a “securities buyer of last resort”
The precedent for acting as a securities buyer of last resort occurred in 2008-09 when the Federal Reserve Bank of Boston made non-recourse loans to custodians to finance the purchase of asset-backed CP from mutual funds.
On March 18, the Fed announced a similar but broader programme under which the Boston Fed would make non-recourse loans to any bank secured by CP bought from money market mutual funds.
On March 23, the Fed announced that it would buy US investment grade corporate bonds or exchange traded funds in the secondary market. Again, the ESF would be providing a slice of equity risk.
All these actions in security markets are important.
But it’s important to stress that the hundreds of billions of dollars of programmes announced so far may not be enough to backstop the dollar-denominated corporate bond market outright. Not only are there $7 trillion in US corporate bonds, the Bank for International Settlements (BIS) counts dollar bonds outstanding of non-US residents other than banks as having grown from $2.5 trillion at end-2008 to $6.2 trillion in September 2019. Beyond US Treasuries and agencies, the global dollar bond market amounts to tens of trillions of dollars.
And while Fed purchases of corporate bonds can prevent market seizures in the short-term by providing a bid for bonds in the face of mutual fund redemptions, over time they do little to add liquidity to the market overall. Corporate bonds purchased in the secondary market, in essence, end up parked in a Fed special purpose vehicle.
To revive liquidity the Fed could eventually repurpose the programme into a secondary market liquidity scheme. One option, in this regard, is for the Fed to buy and sell corporate bonds in the secondary market in order to narrow spreads and to encourage more private market-making. The Fed could even use such buying and selling to arbitrage the prices of highly traded exchange traded funds and the prices of the poorly traded underlying bonds, where wide gaps have apparently opened. This would see the Fed become the ETF market’s authorised participant of last resort, in so doing backstopping the liquidity of securities, not just their price.
Whether the Fed moves in that direction, of course, remains to be seen. What we can be sure of is that more measures to stabilise securities markets are coming.