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From the outside, pinned to the glass window pane settled in place long ago by conventional Economics, looking inward at these mechanics created only confusion and unsettling angst. Outwardly, everything finally seemed to be going in the right direction. Yet, there continued to pile up these weird signposts contributing toward an uneasy feeling.

While it sure sounds familiar, this was also the summer of taper.

We have been conditioned to see interest rates backward from how they are: down isn’t good stimulus, and up doesn’t put the brakes on anything. Yet, the myth persists that lower interest rates equate to loosening in the textbook description, rising yields and the like equivalent to removing the punchbowl from the festivities of wide monetary accommodation.

Thus, when then-Federal Reserve Chairman Ben Bernanke in May 2013 hinted at something like taper, interest rates in the US (and worldwide) set off on a dizzying journey in the wrong direction from conventional belief – therefore, tantrum. The analogy of the punchbowl, originally carved out of myth for the stock market, had been imported into the bond market by way of the QE era’s uncorrected misconceptions.

While longer-term UST rates were moving higher later in 2013, short-term UST bill rates were moving lower. The opposite way from when the Fed had earlier claimed it was “twisting” the yield curve during Operation Twist (2011-12), then selling bills and buying notes or bonds attempting to contort the curve flatter by raising short-term rates and pushing long run yields lower. The 2013 “taper tantrum” curve suddenly twisted itself much steeper when bill rates sunk and selling at the longer end pushed those yields significantly higher.

Not only that, repo rates related to longer-term UST notes, the 7- and 10-year maturities, in particular, had become ultra-low; to the point that the specialness on certain individual securities were downwards of the -3% repo fails penalty. We’re seeing this again now.

Most important of all, rates at the long end didn’t end up rising very far or for very long – even though the FOMC would actually get to tapering its QE’s in December ’13. Less bond buying in practice and bond prices…go up?

The textbook approach rendered useless by a tangle of factors and conditions not contained within any of its pages.

To begin piecing together the answers, we have to start first with money dealers. These are global banks – more accurately, subsidiaries of global banks both foreign and domestic – whose purpose is to intermediate in money and markets (and money markets). To do so, however, requires a series of complicated calculations which all figure back upon the intangible, superficially amorphous property of balance sheet capacity.

This eurodollar system I’ve been attempting to describe for so many years isn’t naturally a currency system at all; at times I’ve likened it more to a computer network. One reason for the unfamiliarity with traditional currency arrangements is simply the lack of any actual currency in it; there are no, practically none, physical Federal Reserve Notes or paper dollars of any kind (nor any gold).

If I am a bank in Singapore and I need dollars to lend to a local company so it can enter the global marketplace to either buy goods or invest its own surplus cash overseas, and I transact with another bank in the Cayman Islands who claims able to obtain them – a claim is all that’s required – no dollars ever exchange hands. Instead, a bank asset is created for the lender, a liability to the borrower.

Whether or not the transaction ends up taking place depends solely on the bank balance sheet idiosyncrasies for each of those banks; rather than, as is commonly imagined, the physical availability of dollars or any tangible currency.

For the cash lender, our fictional firm in the Caymans, they are relieved of any obligation to store or get hold of physical paper. Whether or not it can make this “dollar” loan depends instead upon several factors, including the risks associated with it, all of which fall back upon the use of spare balance sheet capacity when slotting what would be categorized as an interbank loan into it.

Would this additional asset, a risky proposition, be easily absorbed on its balance sheet according to existing limitations (set most often by mathematical descriptions of fundamental realities like volatility and loss probabilities, things like VaR which seek to describe and then enforce internal “control” over these complex, currency-like but currency-less relationships)? Can the Caymans bank lend balance sheet space (the creation of this loan/asset) to Singapore such that it doesn’t upset internal (and external, such as regulations) balance sheet guidelines?

This is no less of a question for the counterparty over in Asia attempting to borrow “dollars.” It proposes to create a liability which has to pass muster for more often liquidity-focused characteristics on this side of its balance sheet.

What begins is a series of rational calculations, both formal and informal, designed to maximize efficiency on both sides, normalized to the basics of financial risk, return, and expected usage. In modern practice, this has become near instantaneous – most of the time.

Governing much of these individual transactions are the modern conventions of mitigation, those instruments and methods which only seem modern but trace back in origin to the very birth of money and banking. While in the precrisis era there were credit default swaps and the like (nothing more than insurance or loss guarantees), the most widely used now as then is simple collateral.

Except, collateral isn’t simple at all; and hasn’t been for a very long time. The Cayman Islands cash lender may only be able to lend “dollars” if the Singapore borrower posts security first; therefore, the perceived (and mathematically calculated) low risk associated with secured rather than unsecured lending might be the only way to work in this new asset to the constrained balance sheet. The higher risk of an unsecured arrangement might violate internal rules and covenants, and thus take up too much scarce (capital and metric-expensive) balance sheet space.

Most often, though, banks like the one we are imagining in Singapore don’t have spare UST’s (the highest form of US$ collateral, where T-bills are the highest form of the highest form) just lying around on its own balance sheet. The city’s monetary authority probably does, though, as do any number of especially US-based banks operating as dealers in global repo and interbank markets.

For a fee, these dealers will source a UST security and “lend” it to the Singapore bank so that it can then be pledged as collateral to the Cayman Islands bank such that this cash borrower can create an interbank loan asset that doesn’t upset any balance sheet guidelines and restrictions – even though this specific transaction is predicated upon a collateral instrument that doesn’t “belong” to the counterparty pledging it.

It has almost certainly been repledged already.

More often than not, the US-based dealer doesn’t own the asset, either; rather, it has obtained the bond, note, or bill by borrowing from an insurance company or pension fund, or through its prime brokerage business where customers have granted special permission to re-use assets to which they’ve acquired title. If not those sources, the dealer might just borrow securities from other dealers.

How, when, and why dealers do this relates to their own balance sheet constraints; since, at the end of the day, they are engaging in risky activities in many ways the same as if they were borrowing and re-lending cash. No actual dollars here either, this collateral side of global money affairs is in every way its own currency-like ecosystem likewise totally dependent upon idiosyncratic (that often end up as systemic, procyclical factors) balance sheet guidelines and rules.

Just like the Cayman Islands bank has to judge the use of its limited balance sheet capacity in making this loan of “cash” to Singapore, the US dealer has to similarly consider the use of its limited balance sheet capacity in making this loan of “collateral” to the very same place.

In theory this is enormously complex, but in practice it has become pretty much standard such that, by and large, these kinds of transactions are repeated seamlessly on a daily basis. The Singapore bank ostensibly seeking US$ cash has arranged an overnight interbank repo loan from the Caymans where the collateral is sourced by borrowing from a US-based dealer.

At the opening of business the next day, each part of that process is repeated (rolled over)…including a bunch of stuff that takes place before the collateral is ever electronically (it’s never physically moved) transferred into Singapore.   

If balance sheet capacity generically is governed by risk, including judgements about volatility, then anything in the world, real or imagined, which could upset perceptions of risk and volatility might have a cascading effect upon balance sheet capacities far and wide (again, procyclical). On the one hand, this may cause the bank in the Cayman Islands to tighten up balance sheet space because each potential asset is now looked at, judged, and calculated to be a little riskier; thereby taking up a little bit more balance sheet space.

In our repo arrangement, that shouldn’t be the case because this interbank loan is secured by topflight collateral. Changing perceptions aside, from the Caymans this transaction should continue to go through (rolled over) with little problem.

Over in Singapore, however, forgive me for writing it this way, what’s the security for the dealer’s security that has been secured by other means before it ever becomes collateral with seizure rights by this bank in the Caymans? What’s the dealer’s collateral for the collateral it is repledging to be collateral further on after it having already been repledged into its use?

The cash side here is collateralized while the collateral side is, well, uncollateralized (even though what is being borrowed and lent is itself collateral). There is no repo-like option for the collateral side of repo. Or is there?

More collateral.

Our simple hypothetical model of interbank activity between Singapore and the Cayman Islands isn’t realistic; we can’t get caught up thinking of transactions as one-to-one, or as conducted strictly on an individual trade basis. These are aggregated as portfolios of securities matched by flows of collateral and virtual cash.

This bank in Singapore likely has more than one local corporation seeking dollar-based funding. Arranging instead for dollar loans for many companies, the bank creates a portfolio of largely longer-term dollar loans (getting compensated by the spread potential presented by maturity transformation) which are funded from a variety of interbank (eurodollar) sources; not just a single repo loan from a bank in the Caymans, but several with banks all over the world along with currency swaps and other derivative types of financing to blend out an “optimal” balance sheet liquidity strategy.

Each of these dollar liabilities (on the Singapore bank’s balance sheet) is short run by nature (thus, the maturity transformation). To keep these liabilities rolling over and portfolio funding running smoothly without interruption, the bank has relationships with multiple dealers, too, supplying collateral from its own repledged and rehypothecated sources. To secure these borrowed securities, the Singapore bank has, indeed, posted collateral of its own kind to each of them (this was the real Lehman Brothers story I wrote about not long ago).

In other words, to secure (meaning borrow) enough collateral to fund all its dollar needs, to keep up all these illiquid dollar loans it already made to local companies, the Singapore bank initially posts a small margin of collateral with the dealers in order to secure a much larger pool of borrowed securities available to be further repledged (a weird sort of collateral leverage).

For one thing, if the dealer’s balance sheet becomes further constrained in any way, including that it can’t source collateral itself to repledge to Singapore, what happens to the bank in Singapore? It gets hit with a collateral call on both sides; endangering the repos borrowing cash at the same time it must post more collateral to the dealers to keep the same level of collateral repledged in those repos (or swaps, since most of those are likewise collateralized).

You can see where we’re heading here; if anything should disrupt these collateral streams, the issues this would create are: 1. Not easy to identify; 2. Not fixable by cash, “cash”, or in any way the Federal Reserve’s bank reserves.

These currency-like properties of the collateral side of the global money system mean that it is a currency without backstop; governed only by the dealers who are central to it. This link is, therefore, paramount. Dealer balance sheet capacities are crucial to collateral chains and availability, therefore repo and derivatives, and, in the end, the whole darn global reserve currency system (and the global economy depending upon it).

It has taken many, many years too long, but officials are finally realizing they better wake up about this secured financing transaction (SFT) world. I’ve written before about the Europeans’ ultra-slow investigation into these, and will now note there has been some limited scholarship (nothing more) produced finally on the US side. One such paper, written only in October last year by Sebastian Infante and Zack Saravay of the Federal Reserve Board (What Drives U.S. Treasury Re-use?), begins by noting this damning deficiency:

“Despite the prevalence of U.S. Treasury re-use, its importance for market functioning, and the financial stability risks it poses, the empirical literature on what drives re-use is scant.”

Among the paper’s contentions (backed up by conclusions and regressions, FWIW):

“Furthermore, high levels of collateral re-use can contribute to pro-cyclicality. When market conditions deteriorate, market participants become more reluctant to extend new secured loans or roll over existing transactions. As a result, there will be less collateral available for re-use, and re-use will drop, intensifying the contraction in secured financing activity.”

You might even call this a collateral bottleneck. Situated in the middle intermediating collateral streams (chains of repledged securities) are dealers governed by their own constraints, acting often pro-cyclically by reacting to the same perceptions and/or change in conditions. As one consequence, Infante and Saravay find:

“These papers highlight that restrictions on dealers’ balance sheets reduced their capacity to intermediate the market, which severely affected market functioning. These insights are consistent with our observation that dealers’ Treasury long positions increase more than their reverse repo, resulting in a large drop in Treasury re-use.”

According to their data, gleaned from confidential call reports, during GFC2 last March “Treasury re-use reached its lowest point on record.” No wonder OTR bills were hugely sought after, their prices exploding during repo hours on the worst mornings of the disaster. Not quite as bad as September and October 2008, to be sure, but not as far off as you’ve been led to believe.

Unfortunately, the authors come to the conclusion that Fed actions last year in their view alleviated much of the problem (by employing a contradictory explanation, an argument I don’t have space to get into here).

Among the most prevalent factors, however, yet more evidence that QE causes problems by removing collateral – and, therefore, initially, creating a larger need for dealers to have to intermediate by re-pledging further and further, therefore lengthening the collateral chains even more (“…a $33 billion dollar increase in weekly Fed purchases leads to a 0.5 increase in the collateral chain.”)

In other words, as the central bank removes bonds (or bills, as in the case of 2019’s not-QE) from dealers the system has to respond by re-using existing sources that much more in order to compensate to keep up the same level of monetary activity; making the collateral system, potentially, that much more fragile should something go wrong (like March 2020).

“These observations combined suggest that the central bank can effectively reduce the interconnectedness of the financial system by reducing the size of its balance sheet.” [emphasis added]

In that way, monetary authorities should therefore seek to at least understand some balance between this downside to QE with any upside created when bond buying removes collateral in order to increase the systemic level of bank reserves. Officials currently haven’t demonstrated either of those things; that they recognize outside “scant” academic work how they might be contributing to systemic weaknesses while at the same time realizing the upside to more bank reserves is itself limited (if not non-existent).

As with our Caymans/Singapore example, what’s the use of bank reserves? No one asked Lehman Brothers back then, either.

Thus, in 2021, rising T-bill prices (falling yields) while reflationary selling (rising yields) takes hold in notes and bonds (as well as recent repo specialness) easily recalls the same as 2013’s twisting curve. And for the same reasons. I wrote just one month after “taper”, in June 2013:

“I have been pounding the table for months about QE and its inverse relationship with vital banking liquidity. In engaging in Large Scale Asset Purchases (LSAP) central banks, particularly in the US and Japan, are playing a very dangerous game. Despite conventional “wisdom” that when a central bank engages in such a monetary easing program it must lead to an increase in liquidity (how could “money printing” not?), such a belief is far too simplistic. QE is actually the opposite of liquidity.”

History repeats because academic research into one of the most crucial aspects to the global monetary system and the historical economic breakdown(s) this produced remains “scant?” Imagine how it has taken thirteen, almost fourteen years to uncover just the front door.

It would be incredibly hard to believe if not for the established fact that the Economics textbook had been written in stone, perceived to be derived from immutable laws of an unchanging, static, overly-simplified world described perfectly by a priestly class of unscientific pretenders. They wave their magic wand of bank reserves while the actual monetary system wants to know where all the UST’s went.

As I keep saying, sure, reflation comes and goes (in 2013, the “goes” came very quick), but watch the bills realizing what’s all behind them. Even the academics are inching closer to realizing this.


Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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