Our debt markets can be stabilized without the regular Fed intervention we have seen since the financial crisis, read here. This market instability is the result of credit markets being left unprotected by misguided monetary and regulatory policy. The Fed is unlikely to reverse its recent policy and regulatory decisions, but the negative effects of these policies can be reversed by adapting successful private sector initiatives in the equity and futures markets to provide a stable haven short-term bond investors.
This article provides a roadmap from two private sector successes – passive equity ETFs and Eurodollar futures – to a financial instrument to calm the choppy short-term debt market traded on the market.
How Debt Markets Became So Vulnerable
Debt markets have been in regular crisis mode since the financial crisis of 2007-2008. Due to this constant regime of disasters, UK debt markets (read here) and the United States has been regularly placed on life support by monetary authorities. What caused this weakness in the financial system?
The Fed’s management of debt market stability. The two regulatory sources of the current volatility in the debt market are
- Super easy money. Central bank monetary policies were aimed at recovering from the crisis, but were maintained long after the crisis was over.
- Regulations distancing commercial banks from their traditional role in debt market risk management.
Super easy money. The Fed, striving to find an even more expansive version of easy money than a zero policy rate, invented a two-instrument monetary policy – injecting interest-bearing reserves into the banking system in tandem with zero policy rate. This extreme version of easy money was quickly adopted by central banks in other developed countries.
Whatever the virtue of super-easy money during a financial crisis, the policy was maintained for almost 15 years – long after the crisis – creating a generation of private sector risk takers who were never held back. by the normal costs of capital (read here).
Remove banks from debt markets. Then, despite market volatility threatened by extreme monetary policy, the Fed inhibited the most important stabilizer of market risk, the commercial banking sector’s management of private sector risk-taking, in two stages.
- First, the Fed increased the regulatory capital banks issuing wholesale bank deposits must hold. This has reduced commercial banks’ willingness to trade in the deposit market – at deviations from relatively tame and stable wholesale deposit rates such as the London Interbank Offered Rate (LIBOR) and the yield on certificates of deposit ( CD) national wholesale negotiable. Wholesale deposits have become a non-factor in risk management – ultimately ending the largest futures contract, Eurodollars, and all LIBOR-based hedging.
- Second, the capital costs to banks of holding stocks of marketable debt securities, including short-term debt and treasury bonds, have also been increased by regulation. This reduced the ability of banks to create markets for commercial paper and other debt securities, which further reduced the liquidity of the debt market.
Central bank policies have left debt markets with only one liquid debt instrument, overnight repurchase agreements. Borrowers were left with only relatively illiquid sources of money-type assets at market price, such as commercial paper, and institutional investors were left with only one offering from investment houses – mutual funds from the money market (MMMF).
Risk management has become the domain of the ill-prepared shadow banking system.
Wholesale debt markets lack a stable haven
It is useful to compare the debt markets to the supposedly riskier equity markets. Why were the collapses in debt portfolio values and the resulting central bank bailouts not accompanied by similar crashes and bailouts in stock markets? Equity portfolios are not collapsing en masse like large asset-backed liabilities do.
In the United States, Prime Money Market Mutual Funds (Prime MMMFs) are the problematic remaining source of daily liquidity for institutions seeking unsecured short-term private sector yield. MMMF premiums have become the leading corporate debt-backed wholesale investment despite their post-crisis collapses because they have not been squeezed out of risk management by regulators as banks have been. But these MMMF premiums are vulnerable to massive redemptions and have forced Fed intervention twice, during the financial crisis and again during the COVID crisis.
Stock market heaven. Equity markets are less vulnerable because private sector investment designers have built a haven designed to withstand large drawdowns – passive equity funds and ETFs. Passive equity funds have a crucial property for their stability. There is no “bullet breaking” in equity markets – no underlying individual stock prices that simultaneously crush investors’ redemptions in passive equity funds.
What would a debt-based haven look like?
Two markets suggest a direction for investment funds looking to be a haven for the short-term debt market – LIBOR-based Eurodollar futures and passive common stock ETFs.
Term liquidity. LIBOR dominated the pricing of short-term private sector debt long after the London deposit market dried up because of its importance as an index for pricing short-term debt – particularly on derivatives and consumer debt markets. The important lesson of trading Eurodollar futures is that an index can be an effective basis for pricing if its associated futures market is liquid, even when the spot market itself is illiquid.
Liquidity based on practical yield. Individual passive ETFs are successful because they offer a significant convenience return. These ETFs do not compete on price, but rather by matching the value and performance of the S&P 500 stock index at a very low transaction cost. Passive ETFs have no incentive to leverage their assets to amplify returns. ETF users seek the stability and predictability of passive ETFs. Leveraged risk-taking in this market is anathema to investors.
A short-term debt paradise will not compete for clients with Prime MMMFs. Like passive ETFs, the appeal of a debt haven would be its reliability as a price for short-term private sector debt that is both an accurate reflection of market conditions and a safe haven for investments. .
Competition for yield in a debt-based fund ultimately encourages funds to take risks that create dramatic losses in one fund or another. This is the key difference between passive index funds and other equity-based funds. Passive equity funds compete on cost, not return. There is no incentive to take advantage of the returns of a passive ETF.
Debt investments designed to replicate the properties of passive equity funds in the debt market would not compete with users by seeking to provide a higher return. Like passive ETFs, it would survive by offering a risk profile that cannot be matched by leverage.
The demise of LIBOR and its rapid replacement by the imperfect alternative, the Secured Overnight Funding Rate (SOFR), point to a potential safe haven that would provide security without losing the benefits of a private sector futures index – a corporate rate highly diversified standardized short term. debt fund that matches the average returns and risks of the commercial paper futures market.
A stable fund with a closing price that meets the three criteria below would be a source of stability in the commercial paper market that LIBOR once provided so imperfectly. Required properties include
- Values that reflect average market returns and the diversified risk of term commercial paper.
- Deliverable in settlement of a forward contract. The instrument need not be liquid itself.
- A diversified portfolio of debt with zero leverage. No competition with other funds based on performance.
Debt market turmoil need not be the constant concern it has been since the financial crisis. We need only adapt two lessons from 21st century markets.
- Markets will accept a financial instrument that provides only an average return if it promises stability during crises and serves as an important indicator of financial conditions.
- Financial instruments do not need to be liquid themselves. They can be successful if they establish a liquid futures market.
Regulators have left debt markets unprotected. To secure these markets, an exchange can provide bond investors with a stable, unleveraged and diversified diversified debt instrument such as an equity ETF. This instrument can in turn provide a liquid source of hedging by establishing a liquid futures market with an index of market conditions, as Eurodollar futures did before the demise of LIBOR.