Contents

Preface
Section I Money and Banking
Chapter 1 – Types of Money
Central Bank Reserves
Bank Deposits
Treasuries
Fiat Currency
Common Questions
Chapter 2 – The Money Creators
The Fed
The Commercial Banks
The Treasury
Chapter 3 – The Shadow Banks
Primary Dealers
Money Market Mutual Funds
Exchange Traded Funds
Mortgage REITs
Private Investment Funds
Securitization
Chapter 4 – The Eurodollar Market
 Offshore Dollar Banking
Offshore U.S. Dollar Capital Markets
The World’s Central Bank
Section II Markets
Chapter 5 – Interest Rates
Short-term Interest Rates
Longer-Term Interest Rates
Shape of the Curve
Chapter 6 – Money Markets
Secured Money Markets
Unsecured Money Markets
Chapter 7 – Capital Markets
Equity Markets
Debt Capital Markets
Corporate Bonds
Agency MBS
Treasury Securities
Section III Fed Watching
Chapter 8 – Crisis Monetary Policy
Democratizing the Fed
Reaching Across the Curve
Chapter 9—How to Fed Watch
The New Framework
Preface

I dreamed of working in the financial markets. Unfortunately, I did

not have that dream until after I graduated from Columbia Law
School on the eve of the great financial crisis. While I sat in my office
re-reading a 200-page loan agreement for the fourth time, I was
aware that the world around me was changing. The Dow was
gyrating a few percentage points a day, major financial institutions
were teetering on collapse, and the Fed was printing money in a way
it had never done before. I didn’t understand much of what was
going on, but it was exciting. I wanted to understand how it all
worked.

I applied to over a hundred jobs in the financial markets, but the

post-crisis world was not the best time to join the finance industry.
Every job posting was flooded with resumes from newly laid-off
bankers and traders (and a fair number of lawyers desperate to
escape their tedious careers). Ultimately, I made my transition into
the financial services by going back to school for a master’s in
economics at Oxford University. I had fortunately studied math and
economics in college, so the shift was manageable. After a stint as a
credit analyst, I landed a role as a trader on the Open Markets Desk
of the New York Fed.

My time on the Desk offered me a glimpse behind the curtain as to

how the financial system really worked. This is because the Desk has
two very important responsibilities: gathering market intelligence for
policy makers and executing open market operations.

Gathering market intelligence means having candid conversations

with market participants on how they are viewing the market. The
Desk regularly speaks with virtually every major market participant,
from prominent investment banks to Fortune 500 corporate
treasurers to large hedge funds. In addition, the Desk itself has
access to extensive volumes of confidential data the Fed collects
through its regulatory powers. The qualitative discussions and hard
data give the Desk a substantial edge in understanding financial
markets.

Executing open market operations means implementing the

monetary policies decided by the Federal Open Markets Committee,
such as large-scale asset purchases and FX-swap operations. The
financial panics in 2008 and 2020 that swept through global
markets were only stabilized when the Desk stepped up its
operations. Open market operations basically mean printing money,
sometimes a lot of money.

I took full advantage of my time on the Desk to learn as much as I

could about the monetary system and the broader financial system. I
often noticed that many people, even seasoned professionals, did not
have a very strong understanding of how the monetary system
worked. For example, the Fed’s first foray into quantitative easing in
2008 sent the professional investment community into a frenzy.
Gold prices skyrocketed to all-time highs as investors anticipated
imminent hyperinflation, but not even mild inflation materialized.
The misunderstanding is understandable, as central banking is very
complicated. There is a lot of conflicting information, even from
purported experts. Without my time on the Desk, I would still be
very fuzzy on many aspects of how the monetary system works. I
remember sitting in my law office being intensely interested in
understanding quantitative easing and what the Fed was doing, but
forced to piece things together based on articles and blog posts by
people that appeared to be credible. I couldn’t find better resources.

Central Banking 101 is aimed at teaching the foundational aspects of

central banking, as well as offering an overview of the financial
markets. While intended as a broad introduction, it also includes
special highlighted sections that offer deeper insight for more
knowledgeable readers. Central Banking 101 is the book that I wish I
had been able to read when I first began my journey in
understanding the monetary system and the broader financial
system.

I hope you find it interesting and helpful.

Note, the views I express are my own and do not necessarily reflect
those of the Federal Reserve Bank of New York or the Federal
Reserve System.
Section I Money and Banking
Chapter 1 – Types of Money

What is money? When most people think of money, they picture

rectangular pieces of government-printed paper, known as fiat
currency, decorated with historical figures. Although this is the most
well-known form of money, it is only a small part of what constitutes
money in the modern financial system. Look in your wallet and think
about your day—how much currency do you carry and use? If you are
like most people, then your salary is wired into your bank account
and spent via electronic payments. The numbers that you see in a
bank account are called bank deposits, a separate type of money that
is created by commercial banks, not the government. Bank deposits
are the vast majority of what the public thinks of as money.

In practice, bank deposits can be seamlessly converted into

government-issued fiat currencies in real time at any bank or ATM
machine. But the two are very different. A bank deposit is an “IOU”
from a bank that can become worthless if the issuing bank goes
bankrupt. On the other hand, a $100 dollar bill is issued by the
Federal Reserve, which is part of the U.S. government. That $100 bill
will have value as long as the United States exists. There is much
more money in bank deposits than there is in paper bills, so in
theory, a bank would run out of cash if everyone withdrew their
deposits. But that’s not really an issue because people today feel safe
holding bank deposits, in part because the government provides
$250,000 in FDIC deposit insurance for account holders. This makes
bank deposits as safe as fiat currency for most people.

The third type of money is central bank reserves, a special type of

money issued by the Federal Reserve that only commercial banks can
hold.1 Much like a customer’s bank deposit is an “IOU” from a
commercial bank, a central bank reserve is an “IOU” from the
Federal Reserve. From a commercial bank’s standpoint, currency
and bank reserves are interchangeable. A commercial bank can
convert its bank reserves to fiat currency by calling up the Federal
Reserve and asking for a shipment of currency. A $1000 shipment of
currency would be paid for by a $1000 decline in reserves from its
account at the Fed. Commercial banks use bank reserves when they
pay each other or anyone else who also has a Fed account, and they
use currency or bank deposits to pay everyone else.

The final type of money is Treasuries, which is basically a type of

money that also pays interest. Just like fiat currencies and central
bank reserves, Treasuries are issued by the U.S. government. They
can be readily convertible to bank deposits by selling them in the
market or by using them as collateral for a loan. Imagine that you are
a large institutional investor or very wealthy person with hundreds of
millions of dollars. You are not eligible to hold central bank reserves
because you are not a bank, it would not make sense for you to
deposit all that money at a commercial bank because it far exceeds
FDIC insurance limits, and it would be silly to hold a mountain of fiat
currency at home. For you, Treasuries are money.
In a functional financial system, all forms of money are freely
convertible to each other. When that conversion breaks down, then
serious problems in the financial system emerge. In the following
sections, we will discuss each type of money and provide illustrations
of what happens when their convertibility is impaired.

Quick Primer on Balance Sheet Accounting

A balance sheet gives an overview of a bank’s assets and liabilities.

It is written in double-entry bookkeeping fashion, so every asset is
counterbalanced by a liability. This shows how assets are financed.
Assets are instruments owned by the bank such as loans or
securities that generate cash flow. Liabilities are what the bank
needs to pay back, such as deposits or debt. At the end of the day,
total assets must equal total liabilities plus equity. This means that
a bank’s assets are either funded by the owners (equity) or
borrowings from others (liabilities).

A balance sheet is a good way to understand how a bank works.

Every bank starts out with equity put up by investors on the
liability side, and central bank reserves and currency on the asset
 side. From there, a bank expands its balance sheet by adding
assets and paying for them by creating deposit liabilities. For
example, a bank could make a business loan for $1000. This would
lead to a $1000 loan asset, and a $1000 deposit liability. The bank
simply adds $1000 in deposits to the borrowers account through a
computer. We will discuss how money creation works more detail
in the next chapter.

Commercial Bank Balance Sheet

Assets Liabilities
Reserves Equity
+ $1000 loan +$1000 deposits

The same balance sheet principles apply to a central bank. When

the Fed buys Treasuries or other assets, it pays for them by
creating reserves.

Central Bank Reserves

Central bank reserves are created when the central bank buys
financial assets or makes loans. The central bank is the only entity
that can create central bank reserves, so the total amount of reserves
in the financial system is completely determined by central bank
actions.2 For example, when the Federal Reserve purchases $1 billion
in U.S. Treasury securities, it creates $1 billion in central bank
reserves to pay for them. That happens whether the seller of the
Treasuries is a commercial bank or a nonbank. If the Fed bought the
Treasury security from a commercial bank, then the commercial
bank’s Treasury security asset is exchanged for central bank reserves.
 Commercial Bank Sells Treasuries to Fed

Commercial Bank’s balance sheet

Assets Liabilities
- $1b Treasuries
+ $1b Reserves

Corporation Sells Treasuries to Fed

Commercial Bank’s balance sheet

Assets Liabilities
+ $1b Reserves + $1b deposits to Corp.

Corporation’s balance sheet

Assets Liabilities
- $1b Treasuries
+ $1b Bank deposits

If the Fed purchased the Treasury security from someone who is not
a commercial bank, the situation is slightly different because they do
not have a Fed account and are thus ineligible to hold central bank
reserves. If a corporation sold $1 billion in Treasury securities to the
Fed, then the sale proceeds would be deposited at the commercial
bank that the corporation banks with. The Fed would add $1 billion
in reserves to the commercial bank’s Fed account, and the
commercial bank would add $1 billion to the corporation’s bank
account. At the end of the transaction, the commercial bank would
have a $1 billion in central bank reserves assets, balanced by an
increase in $1 billion in bank deposit liabilities to the corporation.

Central bank reserves never leave the Fed’s balance sheet, but they
get shuffled around daily as commercial banks settle payments with
each other. Suppose the corporation took half of that $1 billion and
made a payment to its supplier who banked with a different bank.
The corporation would see a $500 million decline in its bank account
balance, while its supplier would see a $500 million increase in its
bank account balance. Behind the scenes, the corporation’s bank
would send $500 million in central bank reserves to the supplier’s
bank, who would then credit the supplier’s account with $500
million in bank deposits.

Corporation Pays $500 mil to Supplier

Corporation’s Bank’s Balance Sheet

Assets Liabilities
$1b Reserves $1b deposits to Corp.
- $500 mil Reserves sent to Supplier’s - $500 mil deposits to Corp.
Bank

Corporation’s Balance Sheet

Assets Liabilities
$1b Bank deposits
- $500 mil Bank deposits
+ $500 mil Supplies

Supplier’s Bank’s Balance Sheet

Assets Liabilities
+ $500 mil Reserves from Corporation’s + $500 mil deposits to Supplier
bank

Supplier’s Balance Sheet

Assets Liabilities
- $500 mil Supplies sold to Corporation
+ $500 mil Bank deposits

Prior to the 2008 Financial Crisis, the Fed conducted monetary

policy under a reserve scarcity regime where the Fed controlled
short-term interest rates by making slight adjustments to the level of
reserves in the banking system. There were only around $30 billion
in reserves in the entire banking system, compared to a few trillion
today. The level of reserves increased significantly as the Fed created
reserves to pay for its quantitative easing program, in which they
attempt to influence longer-term rates by buying longer-dated
Treasuries. The Fed now controls short-term interest rates by
adjusting the interest it pays banks on excess reserves and the
offering rate of the Overnight Reverse Repo Facility,3 a program
where participants can loan money to the Fed. The Fed’s operating
framework is described in later sections.

How to Analyze Fed Reserves

Central bank reserves data are released in the weekly H.4.1 on the
Fed’s website. Below is a snapshot of the table that details reserve
balances.

The data shows the aggregate distribution of reserves among

major reserve holder types. Focusing on the first column, which
shows weekly averages as of January 15, 2020, you’ll first note that
currency in circulation is $1.79 trillion. That’s the cumulative
amount of reserves that have been converted to currency. When
commercial banks need currency, they send central bank reserves
 to the Fed, who sends over an armored car with currency. The
reserves are essentially extinguished and replaced with currency.

The next large item is the $265 billion in foreign official and
international accounts. That is the Foreign Repo pool, which is like
a checking account for foreign central banks. Foreign central
banks have the option of depositing their dollars at the New York
Fed, but the transaction is structured as a secured repo loan. The
foreign central bank does not hold reserves (it holds a repo loan,
where it is lending money to the Fed), but when it moves money
out of commercial banks into the Foreign Repo pool, then reserves
leave the banking system into a separate Foreign Repo Facility
account.

The next largest item at $350 billion is the Treasury General

Account (TGA), which is the U.S. Treasury’s checking account.
When payments are made to the U.S. Treasury, such as tax
payments, reserves leave the commercial banking system and
enter into the TGA. The $67.8 billion under “Other” are the reserve
balances of GSEs like Fannie Mae and Designated Financial
Market Utilities like the CME Clearing House. Finally, at the very
bottom is the level of reserves held by commercial banks: $1.68
trillion.

Bank Deposits
Bank deposits are created when a commercial bank creates a loan or
when it buys a financial asset. A common misconception is that a
bank takes in deposits and then lends those deposits out to other
people. Rather than lend out deposits, a bank simply creates bank
deposits out of thin air when it makes a loan.4 This is very similar to
the way a central bank acts when it creates central bank reserves. The
central bank acts as a bank to commercial banks, and commercial
banks act as a bank to nonbanks like individuals and corporations.

However, a meaningful difference is that there are many commercial

banks while there is only one central bank. As there is only one
central bank, all the reserves created stay on the central bank’s
balance sheet and are shuffled among the different reserve accounts
as commercial banks make payments to each other. In the case of
commercial banks, each commercial bank has its own balance sheet
and creates its own deposits. Therefore, it is possible for a depositor
to withdraw a bank deposit and move it off one commercial bank’s
balance sheet onto another commercial bank’s balance sheet. When
this happens, one commercial bank must make a payment to
another. This payment is made in the form of central bank reserves.

Since commercial banks create deposits out of thin air, they will have
many more deposits than central bank reserves. In practice, a
commercial bank both receives and makes large volumes of
payments each day. At the end of the day, the amount of reserves
they have usually doesn’t change that much, so they only need to
hold a small amount of reserves against the deposits they create. This
is known as fractional reserve banking. Should the commercial bank
have more outflows than anticipated, it can always borrow reserves
from another commercial bank or from the Fed to make payments.

While bank deposits are the most common form of money, they are
also the least secure. They are created by the private sector, so they
are not risk-free. Banking crises occur when a bank has made too
many bad loans and becomes insolvent. When that happens, a bank’s
deposits may no longer be convertible to currency at par, so a $100
deposit may not be convertible to $100 in currency as depositors
share in the loan losses. Depositors will panic and try to withdraw
their deposits at the same time, accelerating the bank’s demise.
During the wildcat banking days of the nineteenth century, there was
no unified currency, so each individual commercial bank created its
own deposits and printed its own bank note currency. Bank collapses
were so frequent then that the bank notes each bank created were
only accepted at discounts to face value to account for default risk.

Since then, the U.S. government has made many advancements to

reduce the risk of banking crisis, including bank deposit guarantees,
stronger bank regulation, and emergency loans offered to banks via
the Federal Reserve discount window. Together, these measures
essentially work to make bank deposits more risk-free and “money-
like,” comparable to central bank reserves or currency. In practice,
the $250,000 FDIC deposit guarantee fully covers the deposit
balances of the vast majority of depositors. For these people, bank
deposits are risk-free money.

Central Bank Digital Currency

Central Bank Digital Currencies (CBDC) are an increasingly

popular topic in the central banking community, with almost all
major central banks at least looking into the idea. A CBDC
essentially allows everyone to have an account at the central bank.
Instead of holding bank deposits at a commercial bank, the public
would also have the option of holding something like reserves at
the central bank. A CBDC would potentially replace both physical
currency and bank deposit money.
The core benefits of a CBDC are being touted as security and
efficiency. Instead of bearing the credit risk of commercial bank
deposits, non-banks would be able to hold risk-free deposits at the
central bank. Payments would be faster because everyone would
have an account at the central bank so money would simply be
shuffled between different CBDC accounts. There would be no
need for inter-bank payments.

In practice, the purported benefits of CBDC are illusory.

Government deposit insurance already makes bank deposits safe,
and electronic payments today are already instant and very low
cost. The true purpose of a CDBC is as a policy tool to conduct
fiscal and monetary policy.

CBDCs would give the government virtually complete control over

the monetary system. They would know exactly how much money
everyone has and who they send it to. They could debit or credit
money to anyone’s CBDC account at will. They could lower or raise
the interest rates of anyone’s CBDC account at will. At the
moment, all those powers belong to the private commercial banks.

In a CBDC world tax evasion and money laundering would be

impossible, and the government would be able to manipulate
spending by giving money directly to people. They could also
directly take money away from people as a punishment. If their
models suggested a negative 5% interest rate would stimulate the
economy, then they could apply it instantly to everyone or even
selectively to certain people with the click of a button.
Governments love CBDCs because it significantly increases their
power.
 But from an individual’s perspective, a CBDC would be a historic
blow to privacy and individual liberty.

Treasuries
Treasury securities are unsecured debt issued by the federal
government and are the dominant form of money in the financial
system because they are safe, liquid, and widely accepted. Unlike
bank deposits, they are risk-free because they are fully backed by the
federal government. Unlike central bank reserves, they can be held
by anyone. Unlike fiat currency, they pay interest and can be sent
electronically throughout the world. While a retail investor would
likely hold most of their money in the form of bank deposits, an
institutional investor would use Treasury securities for this purpose.
Treasury securities are essentially money for large investors.

Note that there is a difference in the degree of “moneyness” of

Treasuries when compared to other types of money. $100 in bank
deposits, $100 in central bank reserves, and $100 in currency will
always have a nominal value of $100. However, a purchase of $100
worth of Treasury securities can fluctuate with market pricing.
Longer-dated Treasuries are more sensitive to expected changes in
inflation and interest rates, so their market values fluctuate the most,
while the market value of shorter-dated Treasuries fluctuates very
little. When held to maturity, these fluctuations in value do not
matter, but if sold before maturity they could result in gains or
losses.

Treasuries offer investors an easy way to store large amounts of

money. Investors would not be able to use Treasuries to purchase
groceries, but they can easily convert them to bank deposits by
selling them or borrowing against them. The Treasury cash market
and repo loan market is very liquid and operates around the clock in
all of the world’s financial centers. In practice, investors are not
using their Treasuries to buy real economy items but to make other
investments. To do so, investors can pledge Treasury securities as
collateral at their broker to purchase financial assets. Essentially, an
investor can buy financial assets like stocks or bonds using Treasury
securities.

Treasury securities are how the U.S. Treasury creates money. When
the U.S. Treasury issues $100 in Treasury securities to an investor,
the investor exchanges $100 in bank deposits for $100 in Treasury
securities. From the investor’s perspective, they simply exchanged
one form of money for another. From the Treasury’s perspective, it is
able to purchase goods and services from the real economy by paying
with Treasury securities it created. Following the chain of payments
can help illustrate that.

The investor will have $100 less in bank deposits after their
purchase, and the investor’s commercial bank will send the U.S.
Treasury $100 in central bank reserves on the investor’s behalf to
settle the payment. Note that the U.S. Treasury has an account at the
Fed, so it can also hold central bank reserves. When U.S. Treasury
spends the $100 it borrowed, then that $100 in central bank reserves
ends up back in the commercial banking system. For example,
suppose the U.S. Treasury used the $100 to make a payment to a
doctor for Medicare expenses. Then the doctor’s commercial bank
would receive $100 in central bank reserves from the U.S. Treasury
and in turn add $100 in bank deposits in the doctor’s bank account.
At the end of the day, the amount of bank deposits and central bank
reserves in the banking system is unchanged, but there is now an
additional $100 in Treasury securities outstanding. The investor can
take that $100 in Treasuries and use it to buy other financial assets,
or they can sell it for bank deposits to buy real economy goods.

Treasury Issues $100 in Treasury Securities and then Spends the Money on Medicare
Payments

Treasury’s Balance Sheet

Assets Liabilities
+$100 Reserves +$100 Treasury debt
-$100 Reserves -$100 Medicare payment

Banking System’s Balance Sheet

Assets Liabilities
-$100 Reserves to settle Treasury purchase -$100 Investor’s Deposits to purchase
+ $100 Reserves to Medicare payment Treasuries
+$100 Doctor’s deposits for Medicare
service

Investor’s Balance Sheet

Assets Liabilities
-$100 Bank deposits
+$100 Treasuries

Doctor’s Balance Sheet

Assets Liabilities
- $100 Receivables
+ $100 Bank deposits

In addition to Treasuries, there are other government-issued

securities that have varying degrees of “moneyness.” After
Treasuries, the most liquid and safe assets are Agency RMBS. These
are residential mortgage-backed securities (MBS) that are
guaranteed by the government. While risk-free and actively traded,
they are less liquid than Treasuries. The Fed prefers to conduct
monetary policy by purchasing Treasuries, but they also actively
purchase Agency MBS in their quantitative easing purchases.

When the Treasury Market Breaks

Investors throughout the world expect to be able to take their

Treasuries and easily convert them into bank deposits that can
then be used to make payments. This is comparable to the
expectation everyone has of being able to go to the ATM and
convert their bank deposits to currency. If one day all the ATMs
were to display a “Not Available” sign, then the public would panic.
That was essentially what happened in the Treasury market during
the COVID-19 panic of March 2020.

In March 2020, people throughout the world were scared and they
wanted to hold dollars. Investors were withdrawing from their
investment funds, and foreigners were selling their home currency
for U.S. dollars. To meet these withdrawals, investment funds and
foreign central banks sold their Treasuries just as if they were
withdrawing from an ATM. But in this case, they found that they
could not sell their Treasuries except at sizable discounts. The
ATM machine was broken.

When an institutional investor sells their securities, they call a

dealer and expect the dealer to offer a price. The dealer would
normally buy the security, hold on to it, and then sell it to another
investor, earning the difference between the prices. In March of
2020, a large number of investors called up their dealers and
asked to sell securities. Mortgage REITs, who borrow money to
invest in mortgage securities, were selling large amounts of Agency
MBS to repay those loans. Corporate bond ETFs were trying to sell
their bonds to meet investor withdrawals. Prime money market
funds were trying to sell their commercial paper holdings for the
same reason. Dealers were suddenly flooded with securities and
reaching the regulatory limits of their security inventory holdings.

In the 2008 Financial Crisis, there was a run on the dealers as

investors refused to lend to dealers over concerns of their financial
condition. This led dealers to liquidate their security holdings at
fire sales prices to repay existing loans, aggravating the financial
panic. In response to this, regulators introduced new rules which
made it more difficult for dealers to hold large inventories of
securities and more expensive to hold riskier securities. These
regulations strengthened the financial position of dealers, but in
March 2020, they hampered the dealers’ ability to buy securities
from their clients. The dealers reached their inventory limits and
could not buy any more, even safe Treasury securities.

Investors were aware of the dislocations happening in financial

markets but were surprised that they suddenly could not even sell
Treasury securities. This led to a massive panic where anything
that could be sold, was sold. All financial markets crashed. The
markets did not calm down until the Fed intervened.

In recognition of the balance sheet limitations of dealers, the Fed

did three things. First, the Fed gave bank holding companies a
temporary reprieve of some of the regulations that limited their
balance sheet size. Second, they opened up a new Foreign Repo
Facility to allow foreign central banks to obtain dollars without
selling their Treasury securities. Third, the Fed resumed massive
quantitative easing. The last point was key in stabilizing the
 markets. In the brief span of a few weeks, the Fed purchased
almost $2 trillion in Treasury securities and Agency MBS from the
dealers. These purchases offered a way for dealers to off-load their
large inventory of securities and have room again to purchase
securities from their clients. This restored the “moneyness” of
Treasury securities and significantly helped stabilize the broader
market.

Fiat Currency
Though the term may be unfamiliar, fiat currency needs no
introduction as it is the most visible form of money. Currency is
printed and guaranteed by the government. A depositor can go to a
commercial bank or ATM machine and convert their bank deposits
into currency. Commercial banks in turn make sure their bank
deposits are freely convertible to fiat currency by holding enough
currency in their vaults. Commercial banks that need more can
convert their central bank reserves into currency by calling the Fed.
The Fed stands ready to send armored vehicles loaded with currency
to meet commercial bank needs.

There is one significant advantage that currency holds over other

forms of money—it is outside of the financial system. Like gold or
silver, currency physically exists and is accepted as value regardless
of who holds it. The government controls the everything in the
financial system because it has power over the central bank and
commercial banks. Someone on the wrong side of the law may not be
able to access anything in the financial system, but would still be able
to use the currency stashed beneath their mattress. All other forms of
money are essentially just numbers on a computer screen. In fact,
there is some evidence that a sizable amount of $100 bills are largely
used as a store of value for people who wish avoid government
scrutiny.

Most Currency is Actually Held Abroad

Despite the increasing popularity of electronic payments, the

amount of currency in circulation has steadily increased over the
years to around $20 trillion in 2020. Interestingly, the $100 dollar
bill is the most common bill in circulation. There are 15 billion
$100 bills in circulation, compared to 13 billion $1 bills and 11.5
billion $20 bills. From a dollar value perspective, around 80% of
the $2 trillion in circulation is held in the form of $100 bills.

Despite the large number of $100 bills in circulation, most

Americans rarely use or see a $100 bill in their day-to-day life.
Instead, they frequently see and use $20 or smaller bills. Research
suggests this is because most of the $100 bills are held abroad.5
There are a few reasons why so much dollar currency is held
abroad. Wealthy people in developing countries like Argentina
often prefer to store part of their wealth in major currencies like
the U.S. dollar. This is because developing countries are often
 poorly managed and have double-digit inflation rates. In fact,
some developing countries like El Salvador completely cede their
control of monetary policy and use the dollar as their official
currency. In addition, criminals often hold their assets in the form
of dollar currency because it is easily transportable and difficult to
trace. Police raids on foreign drug cartels have at times uncovered
hundreds of millions of dollar currency.

Globally, dollar currency is held internationally as a store of value,

like gold during the gold-standard era. We currently live in a
dollar-standard world, where the U.S. dollar is widely accepted
throughout the world and perceived to be safe. This led to a boom
in offshore dollar banking, but also in offshore demand for dollar
currency.

Common Questions
This chapter aimed at providing a framework to understand today’s
monetary system. This framework should allow the reader to better
understand the implications of central bank actions and dispel some
of the most common misperceptions. Here are a few common
questions to practice the application of the framework.

Why don’t banks lend out their reserves?

When quantitative easing was first introduced, many market

commentators saw the aggregate level of commercial bank reserves
explode higher and wondered why banks were not “lending out their
reserves.” As discussed, central bank reserves can only be held by
commercial banks and can never leave the Fed’s balance sheet. The
level of central bank reserves held by banks is determined by the
Fed’s actions and is unaffected by the amount of loans made by
commercial banks. In fact, commercial banks are not constrained by
reserves in their decision to make loans because they can always go
out and borrow reserves.

The lending constraint for commercial banks is either regulatory or

due to commercial conditions. Commercial banks are highly
regulated by a myriad of rules that constrain the size of their balance,
the quality of their assets, and the composition of their liabilities.
These regulations make the banking system safer but also limit the
amount of loans available. Commercial banks also are only interested
in lending if they can make a profit, and profitable borrowers are
harder to find during a recession when the likelihood of default is
relatively high. That was the case in the aftermath of the 2008
Financial Crisis.

Will the stock market soar because of all the cash on the sidelines?

Sometimes commentators look at the level of deposits in the banking

system and suggest that financial asset prices will explode when all
that money is spent.

Just as the level of central bank reserves is determined by the Fed, so

the level of bank deposits in the banking system is largely
determined by the collective actions of commercial banks.6 Bank
deposits are created when a commercial bank purchases an asset or
creates a loan, and they are destroyed when the loan or asset is
repaid. The level of bank deposits is thus largely an indicator of the
level of loans made by the banking system.
When an investor purchases stocks or bonds with their bank
deposits, then their bank deposit ends up in the bank account of
whoever sold them the stock or the bond. The total level of the bank
deposits in the banking system is unchanged. The bank deposits are
essentially being shuffled around the commercial banking system,
but they neither increase nor decrease. Large amounts of investment
can occur at both low and high aggregate levels of bank deposits.
Chapter 2 – The Money Creators

In this chapter, we further describe the three creators of money: the

Fed, commercial banks, and the Treasury.

The Fed
The Fed has a duel mandate: full employment and stable prices. In
practice, the Fed doesn’t know what unemployment rate corresponds
to full employment and it hasn’t been able to sustainably reach its 2%
inflation target for over a decade. The Fed’s experience with inflation
is not unlike the experience of other major central banks such as the
Bank of Japan (BOJ) and the European Central Bank (ECB), who
have experimented boldly over the past decade but consistently
failed to reach their inflation targets. The Fed’s efforts to achieve its
duel mandate has also led it to gradually expand its policy tool kit
and engage in unconventional monetary policy, including large-scale
money printing.

The Fed thinks of the economy through the lens of interest rates,
which is the primary tool through which the Fed achieves its
mandate.7 In the eyes of the Fed, there is a thing called r*
(pronounced “r star”), which is the neutral rate of interest at which
the economy is neither expanding nor contracting. When interest
rates are below r*, then the economy is expanding, inflation is rising,
and unemployment is ticking lower. When interest rates are above
r*, then the economy is slowing, inflation is declining, and
unemployment is ticking higher. The Fed employs a small army of
Ph.D. economists to determine what the level of r* is at the moment,
as it changes over time, and then sets out to lower or raise interest
rates to achieve its mandate. The Fed’s money printing is used as
part of its efforts to exert greater control over longer-term interest
rates.

When the economy is in trouble and the Fed’s models show that r* is
currently a very low or even negative number, then the Fed will do
everything it can to get interest rates below r* to promote economic
growth. They will first cut their target overnight interest rate to zero,
then they will try to lower longer-term interest rates by buying lots of
longer-dated Treasury securities, which will then increase the price
of the Treasury securities and correspondingly lower their yields.
Longer-dated Treasury securities are less sensitive to changes in the
overnight interest rate, so the Fed tries to indirectly influence them
through quantitative easing.

The Open Markets Desk

The Open Markets Desk (“the Desk”) is the Fed’s trading desk. It is
primarily responsible for two things: executing open market
operations, like quantitative easing, and collecting market
intelligence.

The Desk collects market intelligence through a wide network of

contacts. Their main contacts are the primary dealers, who are
obligated to speak with the Desk as part of their primary dealer
responsibilities. On a secondary basis, the Desk speaks with
commercial banks, government-sponsored enterprises, hedge
funds, pensions funds, corporate treasurers, and small dealers.
Generally speaking, most significant players in the financial
markets will have a relationship with the Desk. These secondary
sources are not obligated to speak with the Desk like the primary
dealers are, but they are generally happy to maintain a relationship
with the Desk. They understand that the conversations are
confidential and are happy to help the Fed carry out its work.

The market intelligence collected by the Desk is disseminated

across the Federal Reserve system through brief research notes
and daily products. Every day the Desk gives a daily morning call
on developments in the financial markets based on what they have
seen on Bloomberg and gathered from market contacts. The call is
given in the Desk’s briefing room, a large meeting room with a
long wooden desk in the middle and seats along the walls. Fed
officials throughout the Federal Reserve system are invited to dial
in. In times of market stress, these calls are attended by Fed
officials at the highest level. After the call, there is a question and
answer segment where policy makers ask questions and subject
matter experts sitting in the briefing room stand up to answer.

In addition to the daily briefings, Desk subject matter experts

periodically publish research notes on developments in their area
of expertise. These internally published notes are based on the
Fed’s confidential data and market intelligence.

With respect to operations, the Desk is organized by asset classes

much like any other trading floor. The primary asset classes are
Treasuries, Mortgages, and Money Markets. Within each team,
traders operate in a rotational framework, where they have
 different operational responsibilities each week, and sometimes
get a week off to focus on research pieces. This is in part to make
sure everyone knows how to conduct each operation and in part to
keep staff from getting too bored. One week, a trader could be
running the Desk’s reverse repo operation, and the next week, they
could be waking up early to publish the Desk’s benchmark
reference rates.

When the Fed undertakes quantitative easing (QE) it will

announce the quantity, pace, and type of assets it will purchase,
but it does not know beforehand how the market will react. This is
understandable, as market reactions are very difficult to predict
because it is not clear what is already priced into the market. The
Fed will size its program based on internal models and try to
determine the market’s expectations using surveys of a wide range
of market participants. The Fed will then adjust the program on an
ongoing basis, mindful of potential side effects such as buying so
much of a specific security that normal market functioning is
impaired.

When the Fed purchases a financial asset, it pays for it by creating

bank reserves. Nonbanks cannot hold reserves because they do not
have an account at the Fed. When the Fed purchases a financial asset
from a nonbank investor, the Fed sends the payment as reserves to
the investor’s commercial bank. The commercial bank then credits
the investor’s bank account. In this instance, the commercial bank is
acting as an intermediary between the Fed and the investor since the
investor is unable to hold reserves. The Fed’s action of purchasing
assets increases the level of central bank reserves in the system as
well as commercial bank deposits.
The Fed’s goal with QE is to lower longer-term interest rates, with
the increase in reserves and bank deposits being a necessary
byproduct. Academic models suggest that QE is effective in lowering
interest rates and does help boost inflation.8 However, the
experience of the Fed, the BOJ, and the ECB all show that massive
QE, at least by itself, is not enough to sustainably move inflation
higher. All three major central banks have had trouble reaching their
inflation mandates for over a decade but continue to believe in the
utility of QE.

QE appears to lift financial asset prices but not necessarily economic

activity. QE essentially converts Treasuries into bank deposits and
reserves, thus forcing commercial banks as a whole to hold more of
their money in the form of central bank reserves, and it forces
nonbanks as a whole to hold more of their money in the form of bank
deposits. Inflation occurs when demand in the economy pushes
against supply, and money that was held in Treasuries was money
that likely wasn’t going to be spent in the real economy. Forced to
trade in their Treasuries for bank deposits, nonbanks can trade their
bank deposits for higher-yielding corporate debt or speculate on
equity investments. Banks, who have more limited investment
options due to regulation, may trade their reserves for higher-
yielding Agency MBS. The portfolio rebalancing among nonbanks
and banks pushes asset prices higher.

There does not appear to be a limit to the amount of quantitative

easing a central bank can do. While the Fed has purchased a few
trillion in assets, that is only a fraction of U.S. GDP. The BOJ has
purchased assets amounting to over 100% of Japan’s GDP, and there
does not yet appear to be any signs of financial instability or currency
weakness. However, the BOJ’s large government bond holdings have
effectively destroyed the Japanese bond market. Rather than reflect
underlying economic conditions, the Japanese bond market appears
to reflect only the dictates of Japanese policy makers. On some days,
no Japanese government bonds are traded at all.9

Central Banker Community

The international central banking community is surprisingly tight-

knit, with frequent meetings and even staff exchanges occurring on
an ongoing basis. Of course, this is limited to countries on friendly
terms. On the Desk there is always a secondee from each of major
central banks—the ECB, BOJ, and BOE—and often other smaller
central banks. These secondees join the Desk on a temporary basis
for one to two years, during which they are given the same
responsibilities and security clearances as American staff. They are
universally top-notch in their abilities and very pleasant to work
with. They usually receive a significant promotion upon return to
their home central bank.

On a more formal basis, there are monthly conference calls with a

number of central banks on developments in financial markets.
Usually the calls are attended by the BOJ, Bank of England (BOE),
ECB, Swiss National Bank (SNB), and Bank of Canada (BOC).
During the conference calls, staff at each respective bank provide a
very brief update on developments in their home financial markets
and are available to take questions. The Desk has a particularly
close relationship with BOJ, where staff from the BOJ are welcome
to meet daily for discussions on market developments.
 The Desk also has formal high-level meetings periodically with the
ECB and BOJ. These meetings are held on a rotating basis in
Tokyo, Frankfurt, and New York.

The Commercial Banks

A commercial bank is a special type of business that holds a license
from the government to create money. Almost all the money the
general public uses is created by commercial banks. The ability to
create money makes these banks an indispensable part the economy;
when they create more money, there is more economic growth. The
basic business model of a commercial bank is earning the difference
in interest rates between the assets it holds and the liabilities it owes.
The assets a commercial bank holds are typically loans that it
originated, including mortgage, commercial, and consumer loans.
Commercial banks also typically hold high-quality securities like
Treasuries or Agency MBS as investments.

On the liability side, the bulk of commercial bank liabilities are retail
deposits, which are bank deposits owed to individuals. Other
liabilities include wholesale deposits, which are deposits owed to
institutional investors like money market funds. Retail deposits earn
little interest, while wholesale deposits tend to earn market-rate
interest. This is because retail depositors tend to be less sensitive to
interest rates, which means that retail investors keep their deposits
at a bank even if they are earning no interest. In contrast,
institutional investors are very interest-rate sensitive and are willing
to withdraw their deposits to earn slightly higher interest rates
elsewhere. Commercial banks prefer to have more retail deposits
because those lower their interest-rate costs and are more stable.
Institutional investors tend to withdraw their deposits at the first
sign of trouble in the markets, leaving commercial banks that relied
on those deposits scrambling for funding.

Commercial banking sounds like a great business where you can

make loans, create deposits, and watch the interest income roll in.
There is still some work underneath this to make sure things go
smoothly. A commercial bank faces two fundamental problems:
solvency and liquidity. Solvency is making sure the bank deposits it
creates are backed by sound loans, and liquidity is making sure those
deposits are freely convertible to bank deposits created by other
commercial banks and to fiat currency.

In the best scenario, a commercial bank makes a loan to a borrower,

who then dutifully pays back the interest and principal of the loan. In
our fractional reserve banking system, a commercial bank only needs
about $5 of its own money to create $100 in loans and deposits.
When business goes well, the owners of the bank can earn interest on
$100 of loans even if they only invested $5. But if the borrower
defaults on the loan, then the commercial bank must take a loss. In
this example, if $5 worth of loans are defaulted on and written off,
then the commercial bank is insolvent and may have to file for
bankruptcy.

The highly leveraged nature of a commercial bank means they have

the potential to earn lots of money but also to bankrupt themselves
rapidly. It’s no surprise to see that banking crises have erupted
frequently throughout history. As a result, commercial banks must
be very careful when making loans. They make sure that the
borrower is creditworthy by studying the borrowers’ financial
situation and purpose for borrowing, and they often seek additional
guarantees or collateral. For example, mortgage loans are secured by
the house being purchased. In the event of default, the bank can take
the house and sell it to satisfy the loan.

The second problem a commercial bank must solve is liquidity.

Suppose that the bank makes a $100 loan to a creditworthy
borrower, but then the borrower immediately withdraws the money
to pay their supplier, who banks with another commercial bank.
Commercial banks have to make sure they have enough central bank
reserves to settle payments with other commercial banks and that
they have enough currency on hand to meet any depositor
withdrawals. This can be a problem for a commercial bank that has
little reserves or currency on hand and whose assets are illiquid,
meaning they cannot easily be sold. A bank that cannot meet
payments or withdrawals will likely panic its depositors even if it is
fundamentally sound.

To solve liquidity problems, commercial banks carefully study the

daily payments needs of their customers and then seek to hold
enough liquid assets to meet those needs. These assets are usually
central bank reserves, but they can also be Treasury securities or
Agency residential MBS (RMBS). If a bank underestimated its
liquidity, it can still go borrow from another commercial bank or an
institutional investor. As a last resort, a commercial bank can borrow
from the Fed’s discount window. There is a strong stigma associated
with this last option because it suggests the bank is in such dire
straits that no one in the private sector would lend to them.
Discount-window borrowing is the absolute last resort of any
commercial bank.
Here is an example of how payments would work in two scenarios: a
world with only one bank and a world with two banks.

I. A world with only one bank

Alpha Bank’s Balance Sheet

Assets Liabilities
Reserves Equity
+ $1 mill loan to John + $1 mill deposits to John
- $1 mill sent to Tim
+ $1 mill deposits to Tim

Suppose there is only one bank in the entire world, Alpha Bank. John
the farmer goes to Alpha Bank and asks for a loan of $1 million so
that he can pay Tim the lumberjack for some lumber. Alpha Bank
looks over John’s financials, decides he is a good credit risk, and then
grants the loan. With a few keystrokes, Alpha Bank puts $1 million
into John’s bank account. John logs into his bank account, sees the
$1 million, and then sends it to Tim. Since Alpha Bank is the only
bank in the world, Alpha Bank simply goes onto its computer and
moves that $1 million from John’s account to Tim’s account.
Liquidity problems do not exist in a world with only one bank
because everything is done on the bank’s balance sheet.

II. A world with two banks

Suppose that this time there are two banks in the world, Alpha Bank
and Zed Bank. This time, John the farmer banks with Alpha Bank,
but Tim the lumberjack banks with Zed Bank. After Alpha Bank
makes the loan, John logs into his account and requests the $1
million be sent to Tim’s account at Zed Bank. In this case, Alpha
Bank can no longer simply shuffle numbers on its books but will have
to send a payment to Zed Bank. Alpha Bank does this by sending $1
million in central bank reserves to Zed Bank, which receives the
payment and adds $1 million into Tim’s account.

Alpha Bank’s Balance Sheet

Assets Liabilities
Reserves Equity
+ $1 mill loan to John + $1 mill deposits to John
- $1 mill reserves to Zed Bank - $1 mill John sent to Tim

Zed Bank’s Balance Sheet

Assets Liabilities
Reserves Equity
+ $1 reserves from Alpha Bank + $1 mill deposits to Tim

If Alpha Bank does not have enough bank reserves to make this
payment, it will have to borrow the reserves. Alpha Bank can borrow
central bank reserves from Zed Bank and then send them right back
as payment on behalf of Tim. Alpha Bank can also borrow from the
Fed’s discount window as a last resort. Note that Alpha Bank can also
borrow from nonbanks like money market funds, even though
nonbanks cannot hold central bank reserves. This is because the
nonbank’s bank will have to send reserves to Alpha Bank to settle the
loan proceeds. Alpha Bank would book a deposit liability to the
nonbank, balanced by central bank reserves as an asset.

Limits on Credit Creation

It sounds like commercial banks are magic money trees, but there
are limits to the amount of money they can create. These limits come
through regulation and profitability. Since banks are historically
prone to banking crises, they are heavily regulated. In addition to
frequent regulatory reporting, the very largest banks even have
regulators that sit on-site at the bank, supervising their daily actions.
One of the regulations is a leverage ratio, which constrains the size of
a bank’s balance sheet for a given level of loss-absorbing capital. For
example, under a 20x leverage ratio rule, a bank with $5 of capital
can only have $100 worth of assets. The leverage ratio is designed to
make sure a bank holds enough capital to absorb potential losses.

In a broader sense, commercial bank money creation is limited by

the investment opportunities available. The equity investors in a
bank want to earn a high return on their investment, so they want
the bank to make investments that earn higher interest income.
When the economy is booming, many borrowers are willing to pay
high interest rates to fund profitable projects, but in a recession,
there are far fewer worthwhile opportunities. Banks thus create more
money during economic booms. During a recession, a bank may
contract its lending, naturally reducing the supply of money as the
economy has a lower demand for money.

How to Study Banks

A wide range of data on bank balance sheets is publicly available

and can help you understand what is going on in the banking
system. On an individual bank level, U.S. banks publicly report
detailed balance sheet data each quarter on their call reports to the
Federal Financial Institutions Examination Council (FFIEC)
(Form FFIEC 031/041/02). On a national banking-system level,
the Federal Reserve reports aggregated data each week through
their H.8 data release. On a global banking-system level, the Bank
of International Settlements (BIS) reports aggregated data each
quarter in their International Banking Statistics.
Call Reports. The call reports are regulatory filings that all U.S.
commercial banks and U.S. branch offices of foreign banks are
required to file quarterly. They offer quarter-end snapshots of the
balance sheets of banks, including the types of loans and securities
they invest in and the types of deposits they rely on. The filings are
detailed and most useful to an analyst who is trying to figure out if
a particular bank is a good investment. From the report, an analyst
can have a sense of the business model of a bank and how risky it
is. The reports are publicly available on the FFIEC’s website about
6 weeks after each quarter-end.

Weekly H.8. The H.8, titled “Assets and Liabilities of Commercial

Banks in the United States,” is a weekly publication produced by
the Federal Reserve that provides aggregated balance sheet data of
commercial banks located in the U.S. The data is not as detailed as
the call reports but is produced more often and is useful for any
analyst studying macroeconomic trends. For example, during the
2020 COVID-19 crisis, many corporations were reportedly
hoarding cash amidst high degrees of economic uncertainty. Their
actions could be clearly seen in the H.8, where a large spike in
commercial loans showed that corporations were drawing down
their revolving loans for extra cash. The H.8 also clearly illustrated
a surge in aggregate banking sector reserves that reflected the
Fed’s aggressive asset purchases, and a decline in consumer credit
as consumers retrenched amidst record high unemployment.

International Banking Data. The BIS collects data from central

banks throughout the world and publishes aggregated data that
shows how the banking system is structured on an international
level. It publishes two sets of banking statistics: Locational
Banking Statistics (LBS) and Consolidated Banking Statistics
 (CBS). The two sets of data complement each other in that the LBS
shows the activity of banks within a reporting country vis-à-vis
residents in other countries, while the CBS shows the activity of
banks by nationality and their activity vis-à-vis residents in other
countries. For example, the LBS can tell you the level of liabilities
banks located in the U.S. have to residents in France. This would
include the liabilities of U.S. branch offices of French banks,
because the branch offices are located in the U.S. The CBS could
tell you amount of liabilities American banks have to residents in
France, excluding the liabilities of U.S. branch offices of French
banks. The International Banking Data is very high level and most
useful for a macro analyst trying to understand the global financial
system. Indeed, the offshore dollar banking system can only be
understood through the BIS data.

In practice, the public sector will have much better data on

commercial banks than anything the private sector sees.
Regulations enacted in the aftermath of the 2008 Financial Crisis
gave the Federal Reserve and other regulators enormous power to
collect very detailed data at a high frequency, even daily in the case
of the largest banks. This makes banking crises like those of 2008
highly unlikely. Instability usually arises in corners of the market
the regulators are unaware of; today, those corners are the shadow
banking sector, which we will cover in the next chapter.

The Treasury
The Treasury Department is the part of the U.S. government that
collects taxes and issues Treasury securities. The Treasury does not
decide how much debt to issue; that is determined by the federal
government’s deficit, which is a result of decisions by Congress.
Congress enacts legislation that determines the federal government’s
spending and its tax revenues, the difference of which is the deficit.

However, the Treasury does decide how it will go about funding the
deficit. This gives Treasury influence over the shape of the interest-
rate curve, where a decision to issue more longer-dated debt will lead
to a steeper curve and a decision to issue more shorter-dated debt
will lead to a flatter curve. The increase in the supply of debt in any
segment will lower the price of debt in that segment, which leads to
higher yields. The overarching principle of Treasury’s debt
management strategy is to provide the lowest cost of financing to the
taxpayer over time. To that end, Treasury will perform its own
analysis, along with input from the private sector, to determine the
cheapest way to fund the deficit. For example, when the Fed put
downward pressure on longer-dated Treasury yields through
quantitative easing, the Treasury adjusted its issuance towards
longer-dated debt to take advantage of the lower long-term rates.

The Treasury aims to issue debt at a regular and predictable pace,

making slight adjustments in size and frequency on a quarterly basis.
This is important because of the sheer size of annual issuance, which
in recent years is in the trillions of dollars. The market is more easily
able to digest the issuance if it can accurately anticipate the amount
of debt being issued and prepares accordingly. Surprising the market
could lead to yields spiking higher, which would be disruptive. At the
beginning of every quarter, the Treasury will announce its estimated
financing needs, which is based on expected federal outlays, tax
revenues, debt maturities, and the amount of cash on hand it wants
to hold at the end of the quarter. The Treasury aims to hold at least
enough cash to cover five days of outflows.
When unexpected adjustments in debt issuance must be made, then
the Treasury makes up the difference by issuing short-term debt.
This is because the market is more able to digest changes in short-
term debt than longer-term debt. For example, when Congress
passed the $2.2 trillion CARES stimulus package in March 2020, the
Treasury met the bulk of the financing need through $1.5 trillion in
Treasury bills, which are Treasury securities that mature in less than
a year. The bills were easily digested by money market funds, who
have over $4 trillion in assets that constantly need to be rolled over
into short-term investments. On the other hand, the market for
longer-term Treasury securities is populated by investors who have
longer time horizons and are less able to react to short-term
fluctuations. These investors, which include pension funds,
insurance companies, and sovereign funds, will not suddenly have
more money to invest if Treasury issuance surges.

The issuing of Treasury securities is different from central bank

reserves or bank deposits because it is literally backed by nothing but
confidence in the U.S. government. Central bank reserves are backed
by the safe assets they purchased, essentially exchanging one type of
money for another. Bank deposits are backed by loans, which
eventually must be paid back, thus unwinding the amount of money
created. The Treasury issues trillions and trillions of dollars’ worth of
Treasury securities but does not appear to have a plan to repay any of
it. Instead, the amount of Treasury securities outstanding continues
to grow at an accelerating pace. This has an inflationary impact
because goods and services are purchased by printing money, but
this is only one factor among many that determine aggregate
inflation.
Many market participants have looked at the rising levels of U.S.
debt and suggested that a debt crisis is imminent. Yet there are
countries like Japan who have a far higher debt-to-GDP ratio than
the U.S., and Treasury yields have marched relentlessly lower even as
Treasury issuance soared. There is obviously some limit to how much
debt the Treasury can issue, but it’s not clear what the limit is.
Chapter 3 – The Shadow Banks

The term “shadow bank” sounds mysterious and a bit ominous, but
they are just non-commercial-bank businesses that engage in
banking-like activity. Like commercial banks, shadow banks take on
liquidity and credit risk by creating loans or purchasing assets.
However, they cannot create bank deposits the way commercial
banks can, so instead, they borrow from investors to fund their
assets. Rather than being creators of money, shadow banks are
intermediaries.

Shadow banks encompass a wide range of entities that engage in

activities that are generally riskier than those of commercial banks.
As we discussed in the previous chapter, commercial banks are
closely regulated and subject to extensive disclosure requirements.
The largest commercial banks even have regulators on-site each day
monitoring compliance. But these onerous requirements also come
with benefits: commercial banks can borrow from the Fed’s discount
window and their depositors are protected by FDIC deposit
insurance. Shadow banks generally operate under less restrictions
than commercial banks. This can lead to higher returns, but their
investors do not have the same public sector protections. Instead,
investors in shadow banks must rely on alternative private sector
protections. These protections include insurance provided by private
insurers, hedging derivatives like credit default swaps, or assurances
provided by ratings agencies.
The basic business model of a shadow bank is to use shorter-term
loans to invest in longer-dated assets. This mismatch creates an
opportunity for profit as longer-term interest rates are usually higher
than shorter-term interest rates. The shadow bank may also be
earning a risk premium by investing in riskier assets. This bank-like
business model also makes shadow banks vulnerable to bank runs
when their investors refuse to renew their loans. Without access to
the Fed as lender of last resort, shadow banks may have to sell assets
to meet investor withdrawals. During a panic, they would have to sell
assets at large discounts, potentially incurring large losses. The 2008
Financial Crisis and 2020 COVID-19 panic were largely due to runs
on the shadow banking system.

The shadow banking system does not adhere to a rigid definition, but
usually encompasses entities such as dealers, money market funds,
exchange-traded funds (ETFs), investment funds, and securitization
vehicles. In recent decades, the shadow banking system has grown to
be larger and more influential than the traditional commercial
banking system. In the following sections we will introduce a few of
the more notable shadow banks: primary dealers, money market
funds, exchange-traded funds, mortgage REITs, private investment
funds, and securitization vehicles.

Primary Dealers
Primary dealers are a group of dealers that have the privilege of
trading directly with the Federal Reserve. They are the heart of the
financial system and the primary conduit for Federal Reserve open
market operations. The Federal Reserve conducts its monetary
operations exclusively through primary dealers.10 For example, when
the Fed is conducting quantitative easing by buying Treasuries, it
only buys from primary dealers.11 There are currently 24 primary
dealers, almost all affiliated with large foreign or domestic banks.12
This is because primary dealers are required to meet certain
requirements and obligations that can be very costly for smaller
dealers. For example, primary dealers are obligated to make frequent
regulatory disclosures, participate in Treasury security auctions, and
provide market intelligence to the Desk.

Dealers in general are like supermarkets for financial products. A

supermarket buys a whole assortment of goods from producers,
stores them, and then sells them at a markup to consumers. In the
same way, a dealer stands ready to buy a wide range of financial
products like corporate bonds or U.S Treasuries, then holds on to
them until it can find other investors willing to buy the products. The
dealer will fund its inventory of financial products by borrowing
money in the repo market using the financial products as collateral.
These are usually overnight loans that the dealer renews every day
until they are able to find a buyer for the product. Dealers allow
investors to buy and sell securities with ease, without which there
could not be a financial system.

In addition to making markets for financial products, dealers also act

as financial intermediaries, borrowing from one client to lend to
another. For example, a hedge fund may want to take out a one-
month loan from a dealer collateralized by some securities. A dealer
would make the one-month repo loan, then source the money by
borrowing from one of its investor clients using those same securities
as collateral. However, the dealer will likely borrow on an overnight
basis instead of matching the maturity of the two loans. Since the
interest rate for overnight loans is lower than the rate for one-month
loans, the dealer will be able to earn the difference between in
interest it receives from the one-month loan to the hedge fund and
what it pays its investor client for an overnight loan. This type of
transaction is called a matched book repo trade, because the two
repo transactions offset each other.

Dealers are considered a shadow bank because of the financial

intermediation they engage in. The overnight repo loans they borrow
are like commercial bank deposits. They take the proceeds from
those overnight loans and either lend them to clients or use them to
buy securities. This exposes them to risks similar to bank runs where
investors may refuse to renew their overnight loans. When that
happens, the dealers would be forced to sell securities to repay their
overnight loans. As the dealer sells its securities into the market, the
selling could put downward pressure on the price of the securities. If
this occurs on a large scale, the prices of the securities could decline
significantly and spook investors. More investors could refuse to
renew their loans, which in turn would lead to more forced selling.
Soon, you end up with a financial crisis.

That is exactly what happened in 2008. In March 2008, Bear

Stearns, a major investment bank and primary dealer, failed when its
investments in the subprime mortgage market soured. When
investors heard about Bear Stearns’ troubles, they became afraid and
refused to renew their repo loans to Bear Stearns. Bear Stearns was
thus forced to sell its assets at fire sale prices to repay those loans.
This hurt asset prices and led investors to be cautious in their
lending to all dealers. It was only when the Fed stepped in as a lender
of last resort that confidence was restored and market conditions
normalized. The Fed is not usually able to lend to primary dealers,
but in this case exercised its emergency lending powers, known as
13(c) after the section in the Federal Reserve Act authorizing them,
and established the Primary Dealer Liquidity Facility (PDCF).13 The
PDCF was basically a discount-window facility available only to
primary dealers.

How the Fed Bails Out the Shadow Banks

The Fed only transacts with the primary dealers, but, through the
primary dealer system, it is able to indirectly reach deeply into the
dark corners of the financial system. This is because the primary
dealers have relationships with virtually all the major financial
institutions in the world. Fed policy is transmitted through these
relationships.

The primary dealers provide liquidity for these financial

institutions and set the price of that liquidity. When a shadow
bank needs money, it calls up a dealer to either sell the financial
assets it owns outright for cash or borrow against them. A dealer
will quote them a price for the security if they are selling or quote
an interest rate if they are borrowing money.

While retail investors can logon to their trading account and

simply sell their stocks for cash, shadow banks hold many assets
that are not exchange traded. For example, corporate bonds and
Treasury securities are not exchange traded. Pricing for securities
that are not exchange traded are determined by the dealer
community, which prices them using computer models and market
conditions.

The primary dealers buy securities or offer loans using funds they
borrow from other clients, usually money market funds. But they
can also borrow from the Fed. The terms of the financing offered
by the Fed affect the terms they are willing to offer their shadow
bank clients. For example, if primary dealers can borrow from the
Fed at 1%, then the interest rates received by the broader market
won’t be too much higher.

In September 2019, overnight repo rates suddenly spiked from

around 2 percent to over 5 percent in a couple days. Remember,
dealers are highly dependent on overnight loans because their
assets tend to be longer dated securities or loans. The dealer
community was having tremendous trouble finding overnight
money to borrow and was paying through the nose to entice
investors to lend. This panicked the market and prompted the Fed
began to begin conducting routine repo operations with the
primary dealers. In effect, the Fed was willing to lend to primary
dealers in unlimited size at below market rates. The primary
dealers in turn took that cheap money and further lent it into the
market.

During the COVID-19 panic, primary dealers borrowed around

$400 billion from the Fed to pay for assets that their shadow bank
clients were desperate to sell. Recall that hedge funds, mortgage
REITs, and ETFs were all scrambling for cash. In effect, the Fed
indirectly bailed them out through the primary dealer system.

The level of primary dealer repo borrowings from the Fed

gradually tapered off to zero in the second half of 2020. Massive
QE significantly reduced the amount of Treasury and Agency MBS
in the financial system, and thus the demand for primary dealer
cash.
Money Market Mutual Funds
A money market fund (MMF) is a special type of investment fund
that invests only in short-term securities and allows investors to
withdraw their money at any time with next-business-day
availability. MMFs are subject to regulations that tightly control the
credit quality and tenor of the investments they can make. This
makes MMFs a relatively safe investment. Indeed, investors tend to
consider MMF investments to be virtually risk-free. One dollar
invested in a money fund can almost certainly be withdrawn any
business day with no loss. MMF shares are very like bank deposits.

MMFs are broadly divided into two types: government MMFs and
prime MMFs. Government MMFs can only invest in government
securities, while prime MMFs can also invest in nongovernment
securities. In practice, prime MMFs largely invest in government
securities and securities issued by foreign commercial banks. Foreign
commercial banks are active in corporate banking but generally don’t
have a retail business. This means they don’t have a stable retail
deposit base and must instead actively borrow from institutional
investors like prime MMFs to manage their outflows.

Investments made by MMFs tend to be very short term, mostly

overnight but potentially up to a maximum of 397 days. This is in
part due to SEC regulations, which include a number of rules that
limit the maturity profile of a MMF’s portfolio. The rules are
intended to reduce the risk of “bank runs.” Because the assets of
MMFs mature very quickly, there is always plenty of cash from
maturing investments to meet any investor withdrawals. In addition,
MMFs tend to have sizable holdings of short-term government
securities that can easily be sold to meet outflows.

MMF investments are used by a wide range of investors as bank

deposit substitutes. Investors expect to be able to invest $1 in an
MMF, earn market interest rates, and withdraw that $1 when
needed. However, MMFs are not commercial banks, so they do not
have access to the Fed’s discount window and their investors are not
protected by deposit insurance. This lack of government backstop
could leave their investors vulnerable in times of panic, at least in the
case of prime MMFs. In practice, institutional investors are actually
more comfortable leaving large amounts of money with prime MMFs
than with commercial banks. This is because prime MMFs diversify
their exposure by investing in many banks, while leaving large
amounts of money at a single commercial bank concentrates risk.

MMFs are a key source of cash for the shadow banking world. This is
because money invested in an MMF is moved around the financial
system through intermediation chains that can be long. For example,
an investor can invest in an MMF, which then lends to a dealer
through a repo loan, who in turn lends to a hedge fund through a
matched book repo.

When the Money Market Funds Crashed

Investors view MMFs investments like bank deposits—every $1

invested in an MMF can be withdrawn without loss, just like
deposits in a commercial bank checking account. That assumption
failed in September 2008 when one of the largest MMFs, the
Reserve Primary Fund, incurred losses on loans it made to failed
investment bank Lehman Brothers.14 Those losses meant that $1
of investment in the Reserve Primary Fund was worth less than $1.

When investors began to see that they had lost money in their
money market investments, they panicked and withdrew their
money en masse. Within a few days, investors had withdrawn $42
billion from the fund, which had held $65 billion earlier in the
month.15 This forced the Reserve Primary Fund to sell assets in fire
sale conditions to meet investor withdrawals, which led to more
investor losses. Investors then looked around at other prime
MMFs and began to be afraid that other funds might also “break
the buck.”

This led to a run on all prime MMFs, which were major lenders to
commercial banks. Now that commercial banks were losing prime
MMF funding, they were forced raise the interest rates in an
attempt to attract new investors. When the market saw the short-
term interest rates these commercial banks were offering, they
 began to suspect that some banks may be insolvent. This in turn
led to even more panic throughout the financial system.

During this emergency, the Fed and the Treasury stepped in to

calm markets. The Treasury announced a Temporary Guarantee
Program for Money Market Funds, which essentially protected
MMF investors from loss, similar to FDIC bank deposit insurance.
The Fed announced the Money Market Investor Funding Facility,
which would stand ready to buy assets from MMFs in case they
needed to sell assets to meet investor withdrawals. The MMF
complex stabilized following these announcements of government
support.

Exchange Traded Funds

ETFs are investment funds whose shares are traded on an exchange
like a stock. An ETF takes an investor’s money and uses it to
purchase assets such as stocks, bonds, or commodity futures. For
example, a Treasury ETF would issue shares and use the proceeds to
buy Treasury securities. An S&P 500 Index ETF would issue shares
and use the proceeds to buy the stocks underlying the S&P 500
Index. A key benefit of ETFs is their liquidity. Because ETF shares
are traded on an exchange, an investor can sell their shares any time
the market is open.

In theory, the price of a share of an ETF should reflect the value of

the ETF’s assets. An ETF with 100 shares outstanding that holds
$1000 worth of a basket of stocks should have a stock price of $10.
The relationship between the price on an ETF share and its
underlying asset value is policed by institutional investors who make
money by arbitraging the ETF’s share price and underlying fund
asset values. Following the example, if the share price of the ETF
were $9, then an institutional investor could purchase one share and
then request the ETF to redeem that share for 1% of its assets, which
is $10 worth of stock. The institutional investor can then sell that $10
worth of stock on the market and realize a profit of $1. If the share
price of the ETF were instead $11, then the investor could purchase a
basket of stocks that mimic the composition of the ETF’s assets and
then ask the ETF to buy the stock in exchange for 1 share. The
institutional investor can then sell that share on the market for a
profit of $1.

An ETF is shadow bank because, while its shares can be sold any
time the market is open, the assets the ETF holds may not be as
liquid. This is especially true for corporate bond ETFs or ETFs that
hold small cap stocks. Corporate bonds and small cap stocks do not
trade very frequently, so any sudden wave of selling would lead to
very large price moves. In principle, the redemption structure for
ETFs make them less vulnerable to runs because a redemption of an
ETF share yields a basket of securities, so the ETF itself is not subject
to forced selling of its underlying assets. However, should an
institutional investor try to arbitrage the difference by redeeming its
shares for securities and then selling the underlying securities, then
that could lead to a cycle of larger downward price moves that could
lead to more redemptions.

In the 2020 COVID-19 panic, investors sold ETF shares so

aggressively that many ETFs were trading significantly below fund
asset values. Institutional investors were having trouble arbitraging
the differences because market conditions were so poor that even if
they could redeem their ETF shares for the underlying securities,
they could not sell them: there were no buyers for the securities.

Mortgage REITs
Mortgage REITs (mREITs) are investment funds that invest in
mortgage-backed securities, usually Agency MBS securities
guaranteed by Fannie Mae or Freddie Mac. They are classic shadow
banks that take out very short-term loans to invest in very long-term
assets. The typical mREIT will buy mortgage securities that mature
in 15 to 30 years using one-month repo loans that are continually
renewed.

Even with long-term Treasury security yields at historical lows,

mREITs have been able to provide annual interest in excess of 10%.
They are particularly popular with retail investors who are looking
for interest income. mREITs are able to provide those yields through
leverage that can be as high as 8x their capital. For example, an
mREIT could borrow in the repo market at 0.3% at a one-month
tenor and then invest in a 30-year mortgage security yielding 2.5% to
earn a net interest margin of 2.2%. With just 5x leverage that would
yield annual interest income of over 10%. To the extent that the
mortgage securities are guaranteed, then mREITs do not take on any
credit risk. However, they are very vulnerable to bank-run-like
shocks where they are unable to renew their repo loans. Such a shock
occurred during the 2020 COVID-19 panic.

During the 2020 COVID-19 panic, there were significant dislocations

across markets, including the usually very liquid Agency MBS
market. Dealers who had provided repo loans to the mREITs against
Agency MBS collateral became less sure about the value of the
collateral and began demanding that the mREITs put up more cash
as collateral. At the same time, many mREITs had experienced losses
from their interest-rate hedges and were short on cash. To meet
these demands for cash, the mREITs were forced to sell their Agency
RMBS securities at a time when there was very little liquidity in the
market. The fire sale forced prices lower, which in turn led to more
fire sales and forced many mREITs to realize heavy losses. Over the
course of a few weeks, mREIT investors lost over half of their
investment and, in some cases, more.

Private Investment Funds

Private investment funds, such as hedge funds or private equity
funds, take investor money and invest in a broad spectrum of
financial assets. These funds employ a very wide range of strategies,
so it is difficult to generalize. Some invest in illiquid assets that could
include equity of non–publicly traded companies, U.S. dollar–
denominated foreign debt, and farmland across the world. Others
invest in liquid securities such as publicly traded stocks. Investors in
private funds usually cannot withdraw their money on demand but
have agreed to keep it invested in the fund for a certain period of
time. In a sense, private investment funds borrow medium term and
invest long term. This set up allows the funds to avoid fire sales of
their assets to meet investor withdrawals. However, some private
investment funds do employ more aggressive strategies that rely on
short-term borrowing. This behavior would make them vulnerable to
bank run like risks should their lenders decide to not renew their
loans.

Cash-Futures Basis Blow-up

The Treasury market cash-futures basis trade is one where

investors earn money by arbitraging the difference between
pricing on a Treasury futures contract and pricing on a Treasury
security in the cash market. A Treasury futures contract is an
agreement to deliver a Treasury security at a predetermined price
at a specific date in the future. When the Treasury futures prices
are higher than the Treasury cash market, an investor can
potentially profit by selling the Treasury futures, buying Treasuries
in the cash market, and then delivering the purchased cash
Treasuries to satisfy the futures contract at expiration. The
investor would pocket the difference between the futures price and
cash price.

Investors usually put this trade on by financing their cash Treasury

position in the repo market. The trade would be profitable if the
pricing difference between the futures prices and cash prices (the
cash-futures basis) was wide enough to compensate for the
financing costs of the repo loan. The basis is generally very narrow,
so investors must employ a very large amount of leverage to
generate meaningful profits. The trade theoretically locks in a
profit at inception, but there is always the possibility that the basis
widens further before converging at settlement. To the extent that
the repo loans were very short term, an investor would also bear
the risk of repo interest rates rising and thus narrowing or
eliminating the potential profit. Overall, the Treasury cash-futures
basis trade is considered a low-risk trade as both Treasury futures
and Treasury securities move in the same direction and are very
liquid, so an investor could unwind the trade quickly if things went
poorly.

During the COVID-19 panic, the Treasury cash-futures basis trade

went spectacularly wrong.16 During the crisis, interest rates
declined as the Fed lowered its target rate to the zero lower bound
and investors purchased Treasuries in a flight to safety. However,
the Treasury futures market moved much more than the Treasury
 cash market. The Treasury cash market essentially broke as
dealers were no longer able to make markets. This caused the
cash-futures basis to widen significantly and investors to take
heavy losses on their futures positions. Those losses were
magnified by leverage, which could even reach 100x. The relative
value hedge funds that put on the trade were forced to unwind it
by selling their Treasury securities at a time when there was little
market liquidity, further pushing prices down and increasing their
losses. Many hedge funds took enormous losses on these trades.17

Securitization
Securitization is a financing structure where a pool of illiquid
financial assets is funded by issuing bonds to investors. Generally
speaking, a commercial bank originates a loan and then sells it to a
securitization vehicle, who buys the loan using the proceeds of bonds
it issues. The securitization vehicles can buy hundreds or thousands
of loans and issue different bonds, each with distinct risk profiles.
The principal and interest payments from the loans are used to pay
off the bond investors. Different risk profiles are created for each
bond according to the priority in which bonds are paid off, where
bonds that are highest in the payment waterfall are considered the
lowest risk. The owners of the securitization vehicle receive any
leftover payments after all the bond investors are paid off. A
securitization vehicle is like a bank in that it is borrowing from
investors to take on credit and liquidity risk.

The most well-known type of securitized asset are mortgage loans,

but auto loans, credit card loans, and student loans are also common.
Virtually any financial asset that provides a stable cash flow can be
securitized, including assets like fast food chain franchise fees, cell
phone payments or music royalties. Securitization provides investors
an opportunity to invest in a wide range of asset classes and allows
borrowers to tap a wider range of investors.

The rise of securitization played an important role in the 2008

Financial Crisis by fundamentally changing the business model of
many commercial banks. Traditionally, a commercial bank held on
to the loans it originated, so it was careful who it lent to. A
commercial bank could easily end up bankrupt if just 5% of its loan
assets were written off. But the rise of securitization meant a
commercial bank could earn fees by originating a loan and selling it
to a securitization vehicle. Many commercial banks began to
transition their business model from earning interest on loans to
earning fees on originating loans. Since they did not hold the loans
themselves, commercial banks were less interested if a loan soured.
That was a risk borne by the securitization bond investors.

When Shadow Banks Emerge from the Shadows

In August 2007, there was a run in a relatively obscure part of the

shadow banking sector—the Asset-Backed Commercial Paper
(ABCP) market.18 ABCPs are investment vehicles that borrow
short term in the money markets by issuing commercial paper
(which is unsecured debt that usually matures within a few
months) and then investing the proceeds in longer tenor and more
illiquid financial assets. These assets vary according to the ABCP,
but could be bank loans, corporate receivables, or securities. The
ABCP continually issues and rolls over short-term debt to finance
its assets. At a high level, ABCPs are like commercial banks but
funded by short-term money market debt.

However, investors in ABCP did not benefit from the public

protections offered to commercial banks so turned to private
sector sources of protection. ABCP investors did not have the
benefit of stringent banking regulations protecting their
investment, so they relied on the judgement of ratings agencies to
determine how safe their investments were. ABCP investors also
did not benefit from the safety of FDIC deposit insurance, so
instead relied on guarantees from an ABCP’s sponsor. The ABCP’s
sponsor, which is usually a commercial bank, manages the ABCP
and usually stands ready to buy back any ABCP commercial paper
if the ABCP’s assets sour.

In July 2007, a couple large hedge funds with sizable investments

in subprime-mortgage-related assets were liquidated, and in the
first week of August, American Home Mortgage, a large subprime
lender, filed for bankruptcy. That meant an ABCP vehicle that
American Home Mortgage sponsored would lose its guarantees at
a time when the market was losing confidence in the value of
subprime-mortgage-related assets. Market participants began to
worry about the asset quality of the entire ABCP sector and refused
to renew their loans. In July of 2007, ABCPs had $1.163 trillion
assets outstanding, but a month later, that had declined almost
$200 billion to $0.976 trillion.

The panic in the ABCP sector spilled over into the commercial
banking sector through the guarantees made by commercial bank
sponsors. As ABCP investors refused to renew their debt,
commercial banks were forced to step in and finance the assets
held by the ABCPs. This put strains on the liquidity of commercial
banks and also potentially subjected them to credit losses.
Interbank interest rates shot up in reflection of these concerns,
forcing both the Fed and the ECB to step in to calm markets. Both
American and European commercial banks were active as ABCP
sponsors, so the issue crossed national boundaries.

The ABCP market stabilized as central bank actions calmed

investors, but little did investors know that this was only the first
tremors of what would, one year later, be an existential event for
the financial system. The next warning came with the collapse of
Bear Stearns a few months later in early 2008, which was
discussed in an earlier section.

Federal Home Loan Banks: The Government-Backed Shadow

Bank

Government-sponsored enterprises (GSEs) play a large,

important, but often unnoticed role in the financial markets and
the real economy. GSEs are entities that are technically not part of
the federal government but are assumed to be implicitly
guaranteed by it. Unlike private corporations, GSEs are not profit
driven but seek to further public policy goals such as supporting
residential housing. The most well-known GSEs are Fannie and
Freddie, but the largest is actually the Federal Home Loan Bank
(FHLB) system.

The FHLB system was first established in 1932 to support the

housing sector by providing loans to commercial banks. It
currently comprises 11 regional FHLBs who are each organized as
cooperatives. Each FHLB is owned by its member commercial
banks, who must purchase stock in the FHLB to become members.
These commercial banks share in any losses of the FHLB and
receive its profits through dividend payments. Foreign banks are
ineligible for FHLB membership.

FHLBs borrow from institutional investors and then lend to their

member banks. They are essentially government-backed shadow
banks that aim to support commercial banks. In practice, FHLBs
largely borrow on a short-term basis from government MMFs and
lend to member banks at slightly longer tenors. Because they are
implicitly guaranteed by the government, FHLBs are able to
borrow at very low interest rates and pass those low rates along to
their members. These rates are generally lower than what a
member commercial bank can borrow at in the market, especially
if it is a bank with a low credit rating.

FHLBs will lend to a commercial bank as long as it provides

adequate collateral. This makes FHLB loans an important source
of financing when market conditions are poor and private sector
financing becomes scarce. When under stress, commercial banks
will first borrow from the FHLBs and only go to the Fed’s discount
window as a last resort because of the stigma attached to discount-
window borrowing. With around $1 trillion in assets, the FHLB
system has a sizable footprint in the financial system.

Historically, small- and medium-sized banks were the primary

borrowers from the FHLBs. These banks had limited access to
wholesale funding, so FHLB loans were the easiest way for them to
get cheap loans. In recent years, the largest borrowers from FHLBs
have been the biggest U.S. banks.19 This is because big banks are
subject to stricter Basel III regulations that push them to have
stable liabilities. Under Basel III, FHLB loans are considered
stable because FHLBs are government-sponsored enterprises.
Chapter 4 – The Eurodollar Market

Eurodollars are U.S. dollars held outside of the United States. They
are called Eurodollars because the first offshore dollars appeared in
Europe in 1956.20 The Eurodollar market grew in part as a regulatory
arbitrage by commercial banks, but also in response to growing
demand by foreigners for dollars. The Bretton Woods Agreement in
1944 had created a new monetary system that shifted the world from
a gold standard to a U.S. dollar standard. Widespread use of the
dollar grew in tandem with the U.S.’ ascension to a global hegemon
and persisted even as the relative dominance of the U.S. declined
with the establishment of the European Union and rise of China. The
global dollar system extends the influence, and perhaps the
responsibility, of the Fed far beyond the borders of the U.S.
There are offshore markets for euros, yen, and other currencies, but
none of them come close to the size of the offshore U.S. dollar
market. The amount of dollar borrowing by nonbanks residing
outside the U.S. is around $13 trillion, far surpassing the offshore
demand for other major currencies such as the euro and yen.
Looking at official foreign exchange holdings, the U.S. dollar is the
clear favorite with around 60% of all foreign reserves being held in
dollars. There is a clear global demand for dollars that does not exist
for any other currency. That demand can be attributed to a few
factors.

Safety. The U.S. dollar is widely considered to be a global safe haven.

Whenever there is distress in the world, investors rush into the U.S.
dollar. The U.S. dollar is backed by the world’s strongest military,
largest economy, a relatively impartial legal system, and a central
bank that has kept inflation stable for decades. U.S.-based investors
may take all this for granted, but these benefits are not widely seen
elsewhere in the world. Many countries struggle with high inflation
due to poor government management or suffer bouts of existential
risk. For example, Argentina has endured annual inflation rates over
the past years that ranged from 10 to 50%. Consequently, many
Argentinians prefer to hold their savings in dollars. In 2011, the Euro
depreciated significantly against the dollar as concerns emerged that
the European Union may dissolve. Concerns for the future of the
European Union have ebbed and flowed as the U.K. left and anti-EU
political parties gained in popularity in some EU countries.

Trade. Global trade essentially operates on a dollar standard, where

around 50% of global trade is invoiced in dollars and around 40% of
international payments are made in dollars.21 The dollar is used in
trade even when none of the parties are American. For example,
when Japan imports oil from Saudi Arabia, they pay in dollars. When
a Korean electronics manufacturer buys components from a Thai
contractor, the payment is likely to be in dollars. There is a very
strong “network effect” for U.S. dollars, much like paying with
Mastercard or Visa. Everyone accepts dollars, so everyone holds
them.

In addition to international acceptance, a large portion of the world

also has limited exchange rate risk when holdings dollars. This is
because much of the world economy uses currencies that closely
track the dollar, which makes holding dollars a substitute for holding
the local currency. From this perspective, the dollar essentially forms
a “currency bloc” that accounts for over 50% of global GDP.22 The
bloc includes countries like Saudi Arabia, which explicitly pegs its
currency to the dollar, as well as large countries like China and
Mexico, who both previously pegged their currencies to the dollar.

Lower cost. Foreigners sometimes prefer borrowing in dollars when

the interest rates on dollar loans or bonds are lower than those in
their home currency.23 When the Federal Reserve sets short-term
interest rates in the U.S. at a level that is low relative to other
countries, then interest rates of bank loans in dollars also become
relatively low and attractive to foreign borrowers. This is especially
true in emerging markets like China or Brazil, where interest rates on
local currency bank loans can be a few percentage points higher than
loans in dollars. In a similar way, when the Fed conducts
quantitative easing to lower yields on U.S. Treasury securities, then
the borrowing rate for private sector dollar bonds, which are priced
based on Treasury yields, also decline. A foreign borrower may find
that the interest rate they pay for borrowing in dollars is lower than
borrowing in their home currency and decide to borrow in dollars.

Liquidity. Dollar capital markets are the deepest and most liquid in
the world. Many foreign countries do not have capital markets that
are as sophisticated as the dollar capital markets, so they choose
instead to borrow in dollars. For example, Australian banks find it
easier to borrow in U.S. dollars even when they want to invest in
Australian dollar assets. The size of the U.S. dollar capital markets
allows them to access a wide range of investors and more easily
borrow large sums than they could in Australian markets. The
Australian banks would then exchange the U.S. dollars for Australian
dollars in a swap transaction. In other instances, the ease of issuing
dollar debt complements the dollar’s dominant role in global trade. A
foreign corporation holds dollars both because it needs it to make
payments and because issuing dollar-denominated debt is the easiest
for them.

In the same way, holding dollars can be desirable because they are
easy to store. A deep and liquid Treasury market means investors can
easily store even large quantities of dollars risk-free. Recall,
Treasuries are just money that pays interest. Liquidity is a real
concern for institutions or wealthy individuals who have a lot of
money. A big part of the reason China owns trillions in Treasuries
even though they are not very friendly with the U.S. is because they
have no alternative; there is no other market deep enough to hold all
that money.

The discussion above shows why foreigners would want to hold

dollars, but it doesn’t explain why those dollars are held offshore.
There are a few reasons why foreigners hold their dollars offshore.24
Just as Americans have a natural bias to hold dollars in the U.S.,
foreigners have a natural bias to hold dollars in their home country.
This could be because they are more familiar with banks in their
home country, it could be more convenient for them to hold dollars
locally, or it could be they distrust the U.S. government. For
example, the Soviet Union deposited its dollars in London. Holding
dollars offshore is a way for investors to separate currency risk from
country risk. Finally, offshore banks have historically offered higher
interest rates on their deposits than banks in the U.S.

The offshore dollar market comprises offshore dollar banking and

offshore dollar capital markets. Both are sizable at around $6.5
trillion each when taking into account only lending to nonbank
borrowers. The bulk of the lending in the offshore dollar market does
not come from U.S. sources but from other offshore sources. U.S.
resident banks are relatively minor lenders with around $1.6 trillion
in bank credit to offshore nonbank borrowers. Data from the U.S.
Treasury estimates U.S.-based investment funds hold $2.6 trillion of
debt issued by the offshore borrowers, though that also includes
securities issued by bank borrowers.

Banks and investors are willing to lend to offshore borrowers

because it offers them a way to diversify their portfolio and an
opportunity to earn higher returns. Offshore borrowers usually have
a more limited source of dollars, so they are willing to pay higher
interest rates for dollars than a U.S.-resident borrower. Also, many
offshore borrowers are located in emerging markets with higher
economic growth rates that allow them to afford higher interest
rates. Investing offshore also allows banks and investors an
opportunity to diversify their portfolio holdings across countries and
thus reduce political risk.
Offshore Dollar Banking
The offshore dollar banking system can be divided into two
segments: one that exists primarily due to regulatory arbitrage and
one that is centered on the dollar banking needs of foreigners.
Overall, the size of the offshore banking system is around $10 trillion
as of 2018,25 accounting for roughly a third of the size of the global
dollar banking system.26 Note that this is larger than the $6.5 trillion
in offshore dollar bank loans described above because banks will also
hold dollar assets other than loans, such as Treasuries or other debt
securities.

The regulatory-arbitrage segment of the offshore banking system has

ebbed and flowed over the past few decades. In the first phase, U.S.
banks discovered that they could evade onshore banking regulations
by moving their banking activity to offshore banking centers like the
Cayman Islands or London. Offshore dollar deposits were first seen
in London in the 1950s but grew significantly in the 1970s. U.S.
banks at the time were bound by Regulation Q and Regulation D.
Under Regulation Q, U.S. banks were subject to a ceiling on the level
of interest they could pay on their domestic deposits. Under
Regulation D, U.S. banks had to hold a certain amount of central
bank reserves against their deposit liabilities. However, deposits
booked outside the U.S. fell outside of the purview of those
regulations. U.S. banks thus had an incentive to grow their business
offshore where they could offer high interest rates to attract investors
and expand their loan books without worrying about their reserve
ratios. In practice, they would simply have their domestic clients
make deposits in their offshore branch office, and then have the
branch office send the money back onshore to the head office. While
the banking transaction was technically offshore and international, it
was functionally conducted purely within the U.S. banking system.
These flows persisted even as changes to regulation did away with
the regulatory advantages of offshore banking. However, after the
financial crisis, U.S. banks significantly scaled back their offshore
banking as they retrenched and were more mindful of risk
management.
The second wave of regulatory-driven offshore banking came from
the European banks in the years leading up to the financial crisis. At
the time, the European banks were subject to more lenient regulatory
metrics that allowed them to conduct risky trades in much larger
sizes than U.S. banks could.27 The European banks were very
interested in investing in U.S. mortgage-related assets and put on
large positions that were largely funded in the U.S. money markets.
For example, a U.S. office of a European bank would borrow from
U.S. money market funds and send the money back to its European
head office, which would then invest the proceeds back into U.S.
mortgage assets. European banks were essentially borrowing from
onshore U.S. investors and then sending the money back onshore to
invest in U.S. assets. These flows largely unwound after the financial
crisis as European banks took significant losses from their
investments.

The regulatory-driven flows of the offshore banking system were

large, but they were basically different ways of intermediating U.S.
banking flows. Money from U.S.-resident depositors were ultimately
used to fund U.S.-based assets. These flows declined significantly
after the financial crisis as both European and U.S. banks
retrenched. In recent years, most of the offshore dollar banking flows
do not involve the U.S. at all, but are between two foreign entities.28
An example would be a Japanese bank offering a dollar loan to a
Korean company.

These pure offshore flows have always been a significant part of

offshore banking activity, but are now more dominant as regulatory-
driven flows declined. The pure offshore dollar banking model is
comparable to domestic banking, just that it occurs outside of the
U.S. Foreigners want dollars, and so the offshore banking system
creates dollars for them to hold.29 The offshore banks active in
making dollar loans are the same big global foreign banks we often
see in the U.S. U.S. banks in comparison, are less active in making
loans to offshore borrowers.

One very important difference between the offshore dollar banking

world and the domestic world is with the clients that they primarily
serve. The offshore dollar banking world primarily serves
corporations and institutional investors, while the domestic banking
sector primarily serves retail clients. Foreign retail clients transact
primarily in their home country’s currency, so they have limited
dollar needs. This difference in clientele has significant implications
on the funding profile of the offshore banks that operate a dollar
business.

While domestic banks can rely on stable retail deposits, offshore

banks must manage their funding via money markets using
instruments such as institutional certificates of deposit (CDs) and
foreign exchange (FX) swaps. This means offshore dollar banking is
more susceptible to bank runs. In times of financial market turmoil,
retail depositors tend to stay put because their deposits are
guaranteed by the government. But institutional investors have
investments far in excess of any government insurance limits, so they
are very sensitive to financial market conditions and will quickly
move their money out of commercial banks and into risk-free assets
at the first sign of trouble. This means that in times of turmoil,
institutional investors will not roll over their CD and FX-swap
lending, leaving dependent banks scrambling for funding at any cost.
During the COVID-19 panic, foreign banks borrowed almost $500
billion in emergency Fed FX-swap loans to meet their funding needs.

How Does a Foreign Bank Create Dollars?

In our prior examples, we showed how U.S. banks create dollars as

they create loans but settle interbank payments using central bank
reserves. If a foreign bank has an account at the Fed, then it would
operate in the same way. Big foreign banks generally have Fed
accounts, but smaller ones may not. A smaller foreign bank can
build a dollar loan business as well, but it will instead use dollar
deposits at a U.S. bank to settle interbank payments. In effect, the
smaller foreign bank is creating a fractional banking system built
upon a fractional banking system.

For example, suppose a small foreign bank creates a $100 loan to a

foreign company. On its balance sheet the small foreign bank holds
$50 in deposits at BUSA, a big U.S. bank, as its reserves, and owes
the foreign business $100 in dollars in deposits from the loan.
Suppose the foreign business makes a $10 payment to its supplier,
who banks with CUSA, a U.S. bank. Then the small foreign bank
must settle a payment of $10 with CUSA. The small foreign bank
will ask BUSA to make a payment to CUSA on its behalf. BUSA
makes the payment by taking $10 in its central bank reserves and
paying it to the reserve account of CUSA. BUSA then deducts $10
from the $50 in deposits it owes the small foreign bank.

Foreign company (FCo) borrows $100 from Small European Bank (SEB) and buys $10
of supplies
Assets Liabilities
+ $100 Deposits at SEB +$100 Loan
- $10 to pay S
+$10 supplies from S

SEB sends $10 payment to S

Assets Liabilities
$50 Deposit at BUSA Equity
+ $100 Loan to FCo +$100 Deposit to FCo
-$10 Deposit at BUSA -$10 Deposit sent to S

Supplier (S) receives payment from FCo

Assets Liabilities
+ $10 Deposits at CUSA
- $10 Supplies sold

Supplier’s Bank (CUSA) receives payment from BUSA

Assets Liabilities
Loans Equity
+$10 Reserves from BUSA +$10 Deposit to S

Big U.S. Bank (BUSA) makes payment for SEB

Assets Liabilities
Loans Equity
-$10 Reserves to CUSA -$10 Deposit to SEB
This illustration shows a couple of important things. First, central
bank reserve ratios together with the quantity of central bank
reserves do not limit the size of the banking sector. The Eurodollar
system can use bank deposits as if they were central bank reserves,
and thus expand virtually without limit. Suppose there was $100
in reserves and a reserve ratio of 10, then that implies that total
domestic deposits cannot exceed $1000. But if a foreign bank held
$100 in those deposits, it could use them as reserves to also make
dollar loans and create dollar deposits. The foreign bank wouldn’t
be under Federal Reserve regulation, so they would be free to
decide their own reserve ratio, which could be higher or lower
depending on their risk tolerance. Remember, the lower reserves a
bank holds the more profitable it would be, but also the likely it
would experience trouble meeting withdrawals and possibly
collapse under a bank run.

The second point is that the growth of money is driven by bank

profitability. If there are many quality borrowers willing to borrow
at profitable rates, then a bank will make the loans. The
profitability of a bank’s loan is largely dependent on its net interest
margin, which is the difference between the interest it earns on the
loan and its funding costs. Ideally, it will have many retail deposits
at 0% interest, but if not, it will have to go to the money markets
and borrow funds at market rates. One way to estimate the general
profitability of the commercial banking is to look at the steepness
of the yield curve, specifically the spread between 3-month bills
and the 10-year Treasury. A wider spread suggests a more
profitable banking sector, which in turn is positive for economic
growth.
Not All Deposits Are the Same

The 2008 Financial Crisis was centered on the banking sector.

Banks (and shadow banks) held bad assets and thus could
potentially have been insolvent, so many depositors panicked and
withdrew their deposits. Banks sold assets to meet withdrawals,
which led asset prices to fall, fueling more panic. In response to
that episode, the global regulators devised a new set of regulations
called Basel III that were designed to make banks safer, but they
also changed the structure of dollar banking.

Basel III made banks safer by forcing banks to hold more high-
quality liquid assets like Treasury securities and also encouraged
them to have more reliable liabilities.30 The regulators classified
bank liabilities according to how “flighty” the liability would be in
a time of stress, with retail deposits being the stickiest and
unsecured deposits from banks or shadow banks the most
unreliable. Retail depositors benefit from FDIC insurance and
have little reason to panic, while banks and shadow banks often
have to withdraw their deposits in order to meet their own
investors’ withdrawals.

The change in regulatory treatment forced many banks to

fundamentally restructure their liabilities. Large domestic banks
were subject to the heaviest regulatory burden, so they pushed out
many of their shadow bank clients and attempted to increase their
footprint in retail banking. The shadow banks in turn began to
move their money to medium-sized U.S. banks or foreign banks,
both of whom were under less stringent versions of Basel III
regulation.
 This structural shift was further enhanced by reforms in the Dodd-
Frank Act that led to a change in the way FDIC insurance fees were
calculated.31 FDIC fees are assessed on U.S. banks to fund the
FDIC insurance that banks offer their depositors. Previously, the
FDIC assessed fees based on the amount of domestic deposits a
U.S. bank held. The new assessment regime significantly
broadened the assessment base to all assets minus tangible equity
and made risk-based adjustments. The effect of these changes was
to encourage U.S. banks to reduce their borrowings from
institutional investors in money markets, and instead rely on
stabler retail deposits. The U.S. banks followed that incentive and
reduced their borrowing in the money markets. The institutional
investors instead redeposited their money into foreign banks,
which are not FDIC insured and thus not subject to FDIC
assessment fees.

In effect, regulation shifted large amounts of institutional money

out of domestic banks and into foreign banks, sometimes into their
offshore offices.

Offshore U.S. Dollar Capital Markets

Borrowers can also obtain dollars by issuing dollar-denominated
bonds outside of the United States. In recent years, the outstanding
amount of offshore dollar bonds has grown at a faster rate than that
of offshore dollar bank loans. A wide range of borrowers issue dollar
securities offshore, including foreign governments, foreign
corporations, foreign banks, and even U.S. companies.
Borrowers who issue offshore dollar bonds usually have a choice of
either borrowing from a bank or issuing a bond, and decide to issue
bonds because it is cheaper. Interest rates on bonds are usually
benchmarked off U.S Treasury yields, which have remained
historically low since the 2008 Financial Crisis. The dynamics
behind the growth in offshore dollar bond issuance is similar to what
is seen onshore, where low interest rates have led to a flood of
corporate bond issuance.

Offshore dollar bonds can be issued from any jurisdiction but are
commonly issued in major financial centers like London. Major
financial centers are home to bankers with deep expertise in capital
markets and to large investment funds who may be interested in
purchasing the bonds. In practice, the offshore dollar bonds tend be
issued under English law or New York law, since those legal systems
are held in higher regard by the international community. In the
event of a dispute, investors could take the borrower to court in New
York or London, obtain a judgement, and then seek to enforce that
judgement. The enforcement aspect can be tricky, since the
borrower’s assets may be located in a jurisdiction that does not
acknowledge the judgement. Investors in defaulted Argentinian
government dollar-denominated bonds famously took a default
judgement by U.S. courts and used it to seize Argentinian ships
docked at foreign ports as payment.32

Investors in offshore dollar bonds include both U.S. resident

investors and offshore investors, but most offshore dollar bonds are
purchased by offshore residents.33 U.S.-based investors that venture
into offshore investments usually do so because they are attracted by
the relatively high yields offered by offshore dollar bonds, especially
those issued by borrowers in high-growth emerging markets.
Offshore dollar bonds give them exposure to that growth without
being subject to currency risk.

The offshore dollar capital markets are closely related to offshore

dollar banking because the dollars raised offshore through debt
issuance are usually deposited in an offshore bank. For the most
part, offshore bond issuers are borrowing dollar deposits held at
offshore banks and then depositing them at another offshore bank.
The onshore and offshore markets are linked, but most of the
offshore activity does not have a U.S.-resident borrower or lender.
Offshore banks create dollar deposits as they create dollar loans, and
those dollars circulate in the offshore system as payments and
investments are made. Some of those investments are in offshore
dollar bonds, and the circulation continues.

While most offshore debt issuance is purchased by offshore

investors, it’s important to note that offshore investors in dollar
assets hold most of their dollar investments in onshore securities.
Overall, offshore investors hold around $20 trillion in U.S.-based
securities.34 For example, foreign central banks hold around $7
trillion in dollars in their foreign reserves portfolio, which are largely
invested in safe U.S. dollar assets such as Treasuries or Agency MBS.
The foreign central banks obtained their dollars when their residents
exchanged dollars for their home currency or as a byproduct of
central bank operations like currency intervention. Institutional
investors in Japan and the Eurozone, both regions which have lower
interest rates than the U.S., have been increasing investments in
U.S.-based assets such as Treasuries, Agency MBS, and corporate
bonds. They usually obtained their dollars through FX-swap loans.
The Dollar as a WMD

The Eurodollar system is offshore, but ultimately, all dollar

banking transactions no matter the origin will have a link to the
U.S. banking system. After all, offshore dollars would not really be
dollars if they were not fungible with onshore dollars. The U.S.
government has authority over the U.S. banking system, and by
extension, over the offshore banking system. This implies that the
U.S. government has authority over virtually every dollar
transaction done through the banking system in the entire world.
Let’s walk through an example to see how this works.

Suppose a bank in Kazakhstan named KBank has a dollar loan

business. KBank makes a $1000 loan to its client and credits its
client’s account for $1000. The client then withdraws that $1000
to pay a U.S. supplier who banks with a U.S. bank, named UBank.
KBank is going to have to settle a payment of $1000 with UBank.
There are two ways it can do this: 1) if it has a reserve account at
the Fed, then it can send UBank a wire for $1000 in reserves or 2)
if it holds its dollars as a bank deposit at a U.S. commercial bank,
then it will have to ask that commercial bank to send UBank
$1000 in reserves. In the second case, KBank’s U.S. commercial
bank will send $1000 in reserves to UBank while reducing KBank’s
deposit balance on its books by $1000. In either example, the
transaction must go through the U.S. banking system.

This would be the same even if KBank kept its dollar deposits at a
non-U.S. commercial bank and the supplier banked with a non-
U.S. commercial bank. Suppose KBank held its dollars as bank
deposits at a commercial bank in London and the supplier banked
with a commercial bank in Paris. In that case then KBank would
ask its London bank to send the supplier’s bank in Paris $1000.
Assume that the London bank holds its dollars at a U.S.
commercial bank, who has a Fed account, and that the Paris bank
went through the trouble to open a Fed account, so it did not need
to hold its dollars at another commercial bank. Then the London
bank will ask its U.S. commercial bank to wire $1000 into the
French bank’s account, who would then credit the supplier’s
account. The U.S. commercial bank would send the Paris bank
$1000 in reserves. Even though both banks are foreign, the dollar
transaction ultimately has to go through the U.S. banking system.

The U.S. government, through its control of the U.S. banking

system, has the power to shut anyone out of the dollar banking
system. If the U.S. government decides that someone should be
sanctioned, then that person will not be able send or receive
dollars through commercial banks anywhere in the world. Banks
take these sanctions very seriously because if they are caught
violating them, then they may also be shut out of the U.S. banking
system. That would be a death sentence to any bank. In June of
2014, BNP Paribas admitted to helping Sudan, Iran, and Cuba
evade U.S. sanctions and move money through the U.S. banking
system. They were forced to pay a breathtaking fine of $9 billion.

In recent years, the U.S. government has shown greater

willingness to use its control over dollar payments to further its
policies. This is arguably the most powerful nonlethal weapon it
possesses as exclusion from the global dollar system would send
most into the Stone Age. Iran, who has been sanctioned by the U.S.
and the Eurozone, now must sell oil for payment in gold.
The World’s Central Bank
Former U.S. Treasury Secretary John Connally famously quipped
“the dollar is our currency, but your problem.” This remark was
made to an audience of shocked foreign officials in 1971 as the U.S.
took the dollar off the gold standard. Moving away from the gold
standard gave the U.S. greater freedom to run loose fiscal policy, but
it also led to significant devaluation of the U.S. dollar. This led to
chaos in the global markets, which U.S. officials were not
sympathetic to at that time.

U.S. policy makers over the decades have gradually become more
sensitive to the impact of the dollar on financial conditions abroad.
This may in part be due to the greater interconnectedness of the
global economy, where poor economic and financial conditions
abroad more easily impact the domestic economy. The existence of a
vast offshore dollar system has a couple of key implications: it
significantly strengthens the influence of U.S. monetary policy on
foreign economies and it significantly raises the risks of financial
instability.

The Fed has significant influence on dollar interest rates, and the
dollar is used globally, so monetary policy decisions by the Fed have
far reaching outcomes. For example, central banks in emerging
markets tend to set relatively high interest rates to combat inflation.
But if the Fed sets its interest rates at a relatively low level, then
emerging market companies will simply borrow in dollars. Dollars
are widely accepted and even preferred to some home currencies. In
effect, the Fed is wresting some control of monetary policy away
from these other central banks.
A large offshore dollar market can potentially be destabilizing
because the offshore market participants do not necessarily have the
Fed as a lender of last resort as U.S. banks do. If a bank in the U.S.
suddenly experiences withdrawals or payments that it can’t meet, but
is otherwise financially sound, then the bank can borrow from the
Fed’s discount window. This safety net helps prevent bank runs.

Banks in the Eurodollar system do not necessarily have the same

safety net. Foreign banks that have branches in the U.S. will have
access to the Fed’s discount window, but many foreign banks don’t
have branches in the U.S. In practice, all large foreign banks have
U.S. branches, but smaller ones do not. Applying for and
maintaining an account at the Fed is an expensive process that is
usually not worth it for a small foreign bank, who will instead hold its
dollars as deposits at a large commercial bank. When there is a run
on these smaller foreign banks, they go into the wholesale funding
markets and start bidding up dollars. This demand for dollars drives
up short-term dollar interest rates and destabilizes financial markets.

In times of crisis, the Fed has shown a willingness to lend to foreign

banks and support the offshore dollar market. During both the 2008
Financial Crisis and the 2020 COVID-19 panic, the Fed became
lender of last resort to foreign banks via the FX-swap lines, where the
Fed lends dollars to a foreign central bank, who in turn lends to the
foreign banks within their jurisdiction.35 The Fed feels comfortable
doing this because it is lending to a foreign central bank, who is
presumably a good credit risk and offering foreign exchange as
collateral. The Fed has in effect become the world’s central bank and
ultimate backer of the dollar banking system.
Section II Markets
Chapter 5 – Interest Rates

Interest rates are the building blocks of all asset prices, financial or
real. For example, a home buyer takes the mortgage rate into account
when deciding how much they are willing to pay for a home, a
corporate raider makes a hostile bid for another company based in
part on how much their junk bond financing will cost, and an
investor takes a stream of cash flows and discounts them with a risk-
adjusted interest rate to price a stock. Assets cost money, and
interest rates determine how much money costs.

The foundational interest rates for all U.S. dollar assets are Treasury
yields, which are the return an investor earns when investing in
Treasuries. These returns are considered risk-free, so they form a
basis on which all risky investments can be judged. Investors will
take a look at how much they can earn by buying Treasuries and then
compare that return to what a potential investment is offering.
Investors will expect to earn a bit more in a risky investment, with
the additional premium increasing with the level of risk. The level of
Treasury yields thus has a significant impact on the expected returns
from all assets. For example, the level of Treasury yields will in part
determine the level of yield that mortgage and junk bond investors
can expect and the discount rates used to arrive at a stock’s
valuation.
The Treasury issues debt in tenors that range from 1 month to 30
years, and the yields on those securities form the Treasury yield
curve. The yield curve tends to be upwards sloping, which means
longer-dated yields tend to be higher than shorter-dated yields. The
Fed controls short-term interest rates, but long-term interest rates
are largely determined by market forces. The level of Treasury yields
can have a powerful effect on asset prices, because lower yields imply
higher asset price valuations. Analyzing the level of yields and shape
of the yield curve can tell us what the market views as the Fed’s next
action as well as the market’s expectation for economic growth and
inflation.

Short-term Interest Rates

The Fed controls short-term interest rates through its control over
overnight interest rates. In theory, this is through its control of the
federal funds rate, which is the rate commercial banks pay to take
out an overnight loan for reserves on an unsecured basis. By setting a
target range for the federal funds rate, the Fed is able to exert
influence throughout the short-term interest curve as market
participants use the overnight rate as a reference for what the rate for
slightly longer tenors, such as 3 or 6 months, should be. For example,
if the Fed set the federal funds rate at around 1% for the foreseeable
future, then the interest rate of any 3-month loan is going to have to
be at least 1%, otherwise the lender would just lend at 1% overnight
every day instead of locking their money into a 3-month investment.

Historically, the Fed controlled the funds rates by controlling the

quantity of bank reserves in the banking system. Commercial banks
are required by law to hold a certain level of bank reserves against
their deposits, and the Fed is the only entity that can create reserves.
Each day, the Fed’s trading desk would estimate the demand curve
for reserves and then adjust the amount of reserves in the banking
system needed to maintain the federal funds rate within its target
range. However, this method of controlling the federal funds rate
became obsolete when the Fed started conducting quantitative
easing. Quantitative easing increased the level of bank reserves in the
banking system from around $20 billion to a few trillion. It became
no longer possible to control the funds rate by adjusting the quantity
of reserves.

In the current world with very high levels of reserves, the Fed
controls the federal funds rate by adjusting the interest rate it offers
on the Reverse Repo Facility (RRP) and the interest it pays on
reserves that banks hold in their Fed account. The RRP offers a wide
range of market participants the option of lending to the Fed at the
RRP offering rate. These market participants include money market
funds, primary dealers, commercial banks, and a few government-
sponsored enterprises. The option to lend risk-free to the Fed at the
RRP offering rate puts a floor on the returns they are willing to
accept from the private sector. For example, if an investor can lend
risk-free overnight to the Fed at 1%, then it would never be willing to
lend at a rate below 1%. The RRP offering rate effectively sets the
minimum overnight interest rate in the market. The rate is usually
set at the bottom of the Fed’s target range to prevent the funds rate
from dropping below the range.

The Fed makes sure the federal funds rate does not move above its
target range by adjusting the interest it pays on reserves. Prior to the
crisis the Fed did not pay interest on reserves. The ability to earn
interest risk-free from the Fed gives commercial banks a bargaining
position when they think about lending or borrowing in the federal
funds market. If interest on reserves were 1%, then a bank would
only lend reserves if the rates they received were greater than 1%.
Otherwise, the bank would just let its reserves sit at the Fed earning
that 1%. Some commercial banks are willing to borrow in the funds
market, but only at rates below interest on reserves.36 This is because
they can deposit the funds in their Fed account and earn the
difference between the funds rate and interest on reserves. The Fed
can thus shift the federal funds rate to stay within its target rate by
adjusting the interest it pays on reserves. In recent years, the Fed has
consistently been able to lower the federal funds rate by lowering the
interest it pays on bank reserves.

The Fed views its control of the federal funds rate as an essential part
of its tool kit and has been willing to go to great lengths to maintain
that control. In recent years, the Fed has only lost control of the
federal funds rate in one instance: September 17, 2019. On that day
there was tremendous volatility in the overnight repo markets, where
rates exploded off the charts by doubling to over 5%. Lenders in the
federal funds market saw the high rates in the overnight repo market
and used that as bargaining power to drive the federal funds rate
higher and out of the Fed’s target range. In response to this, the Fed
restarted quantitative easing and began lending hundreds of billions
of dollars in the repo market, which they had not done since the
2008 Financial Crisis. This brought overnight repo rates under
control and the federal funds rate back into the target range.

In practice, the RRP offering rate is probably a much more

influential rate than the federal funds rate. The RRP rate is available
to a wide range of market participants, while the federal funds rate is
available only to commercial banks. This means that changes in the
RRP rate affect the opportunity costs of a much larger group of
market participants. In addition, activity in the funds market has
declined significantly since the 2008 Financial Crisis as regulations
discouraged commercial banks from borrowing in the funds market,
making changes in the funds rate even less impactful on interest
rates in the broader market.

The Fed’s firm control over overnight rates allows it to exert control
along the Treasury yield curve, though its influence declines rapidly
as tenors increase. Market participants will use the overnight rate set
by the Fed as a reference to value what the 1-week, 1-month, 2-
month, etc. Treasury yield should be.37 Assuming the Fed is not
expected to adjust its target range, market participants will expect
these short-term risk-free rates to be slightly higher than the
overnight risk-free rate; otherwise, the lenders would just lend
overnight consecutively while preserving the option of pulling their
money back any day they want instead of locking it into a term asset.
However, the farther out on the yield curve, the less the current
overnight rate matters. This is because the Fed is expected to adjust
its overnight rate in the future in line with changes in its economic
outlook, so expectations on economic conditions become
increasingly important for tenors beyond a few months into the
future. Rates beyond the short term are largely determined by the
views of market participants.

Longer-Term Interest Rates

While the Fed determines short-term rates, the market determines
longer-term interest rates. When an investor is thinking about
lending longer term, they take into account a number of things such
as how the Fed will set short-term interest rates in the future,
estimates for future inflation, how volatile those estimates are, and
future supply and demand dynamics of Treasury debt issuance. Since
the expected path of the policy rate is just one piece of the puzzle, the
Fed has weaker influence on longer-term rates.

A common framework for thinking about longer-term yields is to

decompose them into two components: the expectations for the path
of short-term interest rates and a term premium. For example, you
would expect the returns you could earn on a 10-year Treasury to be
equivalent to lending risk-free overnight to the Fed for 10 years plus
a premium for keeping your money locked up for 10 years. The first
component depends on how the market perceives the Fed to act in
the future, which in turn depends on how the market perceives
future inflation. Fortunately, there is an easy way to see what the
market thinks the future path of policy will be.

The short-term interest-rate futures market offers a glimpse of what

the market thinks short-term interest rates will be in the future. The
most popular short-term interest-rate future is the market for
Eurodollar futures. The Eurodollar futures market is the deepest and
most liquid derivatives market in the world. Eurodollar futures are
essentially the market’s best guess of what future 3-month LIBOR
rates will be. Since 3-month rates are firmly within the Fed’s
control,38 this is largely a bet as to what the Fed will do in the future,
which in turn is a bet based on how economic conditions will unfold.

Of all the financial instruments, Eurodollar futures are the most

reflective of economic fundamentals. Eurodollar traders know the
Fed will react according to how the economy performs, so they focus
on hard economic data even as other asset classes are stuck in
moments of euphoria or fear. Often times, they will even disagree
with the Fed.
For example, in September 2018, the Fed announced via their “dot
plot” projections that they anticipated raising interest rates by 75
basis points in 2019. The Eurodollar futures market saw this and
priced in the rate hikes. The Fed slightly lowered their projected rate
hikes in 2019 to 50 basis points at their December meeting. This
time however, the Eurodollar market instead predicted that the Fed
would be cutting rates in 2019. Eurodollar traders may have thought
that the large declines in the stock market in December would
compel the Fed to change its mind. As is often the case, the market
was correct, and the Fed ended up cutting rates rate three times in
2019.

There are four major Eurodollar futures contracts in each calendar

year that take the name of their month of expiry: March, June,
September, and December. Each of these contracts is a bet that
estimates what the 3-month LIBOR will be at on the contract expiry
date of that month. Eurodollars contracts are available for many
years into the future, so a market participant can easily see what the
market thinks short-term interest rates will be far into the future.
For example, the implied rates from the March 2027 Eurodollar
contract would be the market’s best guess of what the 3-month
LIBOR rate will be in March 2027.

Market participants can look at the rates implied by Eurodollar

futures to see what the market’s best guess is for the path of short-
term interest rates.39 They can then use that as a baseline, compare it
to where Treasury yields are currently trading, and derive a term
premium.40 Admittedly, the “term premium” is really just what
cannot be explained by the estimated path of short-term interest
rates. However, it’s not unreasonable to assume that investors would
require a term premium to invest in longer-dated Treasuries.

In recent years, the estimated term premium using the Adrian-

Crump-Moench model has been historically low, potentially due to
lower volatility of inflation in recent years as well as the hedging
benefit investors receive from holding Treasuries.41 In the 1970s and
1980s, inflation was very high and volatile, while inflation during the
past 10 years has been very muted. A lower volatility for inflation can
make forecasts more precise, thus reducing the level of term
premium an investor requires. In addition, the negative correlation
between equities and Treasuries has grown stronger in recent years.
This makes holding Treasuries valuable as a hedge against stock
market declines. Investors may thus be willing to hold Treasuries
even at low term premiums.
The discussion above offers a theoretical framework to think about
how longer-term interest rates are determined, but basic supply and
demand dynamics play an important role as well. Like any other
product, increased supply leads to lower prices. When the U.S.
Treasury issues more Treasury securities than the market expects,
then yields offered by those Treasury securities must increase to
attract additional investors. Unfortunately, both supply and demand
for Treasuries are difficult to predict.

The supply of Treasuries is determined by the federal government’s

deficit. When the federal government announces large budget
deficits, the Treasury market will usually interpret the news as an
increase in Treasury supply, and yields accordingly move slightly
higher. The Treasury releases deficit estimates quarterly to help
guide investors, but in practice, they are not very useful because
deficit levels are ultimately a political decision. Future politicians
may adjust spending or taxes in ways that make the forecasts useless.
In addition, the Treasury has some flexibility in the tenor of the debt
it chooses to issue. Concentrating issuance in the short-dated
Treasuries will have limited impact on longer-tenor yields, while
issuing in longer tenors will have a direct impact on longer-tenor
yields. From time to time, the Treasury will also offer new debt
products to fund the federal deficit, most recently, the 20-year
Treasury in Q2 2020. All these variables are difficult to predict.

Future demand for Treasuries is just as difficult to estimate as the

future supply of Treasuries. This is because Treasuries are purchased
by investors throughout the world, with foreign demand in part
determined by foreign monetary policies and foreign trade policies.
In recent years, negative rates in Japan and the Eurozone have
increased demand for U.S. Treasuries, which continue to offer
positive returns. The U.S.’ chronic trade deficit has led many foreign
countries to accumulate a large stock of dollars that they in turn
reinvest into Treasuries. China and Japan, two nations with large
and persist trade surpluses with the U.S., each hold around $1
trillion in U.S. Treasuries.42 Changes in trade policy or monetary
policy of foreign countries have a meaningful impact on the
international demand for Treasuries but are difficult to predict.

Domestically, the Federal Reserve is the largest purchaser of

Treasuries. The Fed’s actions are very difficult to predict because
they depend on financial conditions and the judgement of the policy
makers at the time. In 2019, many market participants were
expecting Treasury yields to rise due to the federal government’s
growing deficit. When the 2020 COVID-19 panic struck, the Fed
decided to purchase over $1 trillion in Treasuries over a span of
weeks and committed to purchase large amounts going forward. This
essentially solved the demand issue and kept Treasury yields at
record lows. The COVID-19 panic, and the Fed’s strong reaction,
could not have been predicted beforehand. As the Fed becomes
increasingly aggressive in its willingness to purchase Treasuries,
other factors that affect longer-term yields appear to become less
important.

Other than the Fed, major domestic investors include pension funds,
insurance companies, commercial banks and mutual funds. These
investors are incentivized by regulations to hold low-risk assets such
as Treasury securities. For example, Basel III mandates large
commercial banks to hold sizable amounts of high-quality liquid
assets such as Treasuries. Demand for Treasuries from these
domestic investors appears stable but could also change with any
modifications to the regulatory framework. For example, regulatory
tweaks that allow more risk-taking would dampen demand for
Treasuries, which are safe but very low yielding. A looming pension
crisis where pensions cannot afford their obligations could
conceivably lead to such regulatory tweaks.

Shape of the Curve

In addition to the level of yields, the shape of the yield curve is also
an important watch point for investors. The yield curve can be used
to infer the market’s perception of the state of the economy. Market
participants often focus on an inverted yield curve—one where
longer-term yields (usually the 10-year Treasury) are lower than
short-term yields (usually the 2-year Treasury or 3-month Bill)—as a
sign that the economy will soon be in recession.

Recall, longer-term rates are driven in part by the market’s

expectation of the future path of short-term interest rates. When
longer-term interest rates are lower than short-term interest, then
the market is expecting the Fed to lower short-term rates soon. That
imminent rate cut is already being reflected in the pricing of longer-
dated Treasuries. The market thinks the Fed will cut rates soon
because it perceives economic weakness that will prompt the Fed to
take action. Participants in the bond market are very sophisticated
and extremely sensitive to economic conditions, so their judgements
are not to be taken lightly. In practice, the market will often, but not
always, sniff out economic weakness before the Fed figures out what
is happening.

The shape of the yield curve is also in part determined by Fed action.
The Fed purchases longer-dated securities through quantitative
easing, which effectively lowers longer-term yields and thus flattens
the yield curve by putting downward pressure on longer-dated yields.
In the past, the Fed has also engaged in operations which flattened
the yield curve by selling short-term Treasuries and buying longer-
term ones.43 This flattens the yield curve by raising short-term
interest rates in addition to putting downward pressure on longer-
term rates. The size and composition Fed’s portfolio can thus impact
the shape of the Treasury curve.

Some commentators note that Fed involvement may cause Treasury

yields to be less reflective of economic fundamentals. The Fed’s share
of outstanding Treasury securities is around 20 percent in mid-2020,
which is relatively low among major central banks but is gradually
increasing. It seems likely that with the great majority of Treasuries
outstanding being freely traded, Treasury yields are still sensitive to
economic conditions. Even if affected by Fed action, interest rates
are still regarded as the best market signal for the state of the
underlying economy.
Chapter 6 – Money Markets

Money markets are markets for short-term loans with maturities that
range from overnight to around a year. Money markets are the
plumbing of the financial system; they keep the financial system
working but are out of sight. The shadow banks and commercial
banks are often structured to have longer-tenor illiquid assets funded
by short-term liquid liabilities borrowed from the money markets.
Without well-functioning money markets, the banks would not be
able to operate. When money markets break down, those entities
cannot roll over their short-term debt and are forced to sell their
assets to repay loans. Historically, breakdowns in money markets
have led to fire sales that precipitate into financial crisis.

There are secured and unsecured money markets. In secured money

markets, a borrower puts up a financial asset as collateral for a short-
term loan. In unsecured money markets, a borrower does not put up
collateral and borrows on the basis of their creditworthiness. In the
post–2008 Financial Crisis world, new regulations intended to
strengthen the financial system led to structural changes that have
been unfavorable to unsecured money markets. Basel III discouraged
commercial banks from borrowing in unsecured money markets, and
Money Market Reform significantly reduced the amount of lending
in unsecured money markets. While still sizable, unsecured money
markets have correspondingly become less important. Secured
money markets appear to increasingly be the money market of choice
for borrowers and regulators, with the Fed now publishing secured
overnight reference rates and controlling secured overnight rates
through ongoing repo operations.

Secured Money Markets

Secured money markets are markets for short-term loans that are
secured with financial assets as collateral. Should the borrower
default on the loan, then the lender is free to seize the collateral to
satisfy the loan. The two largest segments of secured money markets
are the repo market and the FX-swap market. Repo loans are secured
by securities such as Treasuries, corporate bonds, MBS, or equities.
FX-swap loans are loans in one currency secured by another
currency, such as a loan for 1000 euros secured by collateral of 1000
U.S. dollars.

In a repo transaction, which is short for repurchase transaction, a

borrower “sells” a security to a lender while at the same time
entering into an agreement to buy back the same security at a future
date at a slightly higher price. The prices for these transactions will
be lower than the market value of the security to provide the lender
with an extra margin of safety. Economically, this is equivalent to
borrowing money using the security as collateral. The slightly higher
price paid to repurchase the security is equivalent to the interest on
the loan. This transaction structure is advantageous from a
bankruptcy law standpoint; even if the borrower files for bankruptcy,
the lender will be allowed to seize the collateral because it has
technically been sold to them. If the transaction were structured as a
secured loan, then the lender would have to go through bankruptcy
court before seizing the collateral. In practice, most repo transactions
are overnight loans collateralized by safe assets including U.S.
Treasuries and Agency MBS.

The repo market is enormous and essential to the modern financial

system. The size of the U.S. dollar repo market is not fully known
because of data collection limitations, but is estimated to be around
$3.4 trillion.44 The largest segment, overnight loans made against
Treasury security collateral, is around $1 trillion each day.45 U.S.
dollar repo transactions are done across the world in all major
financial centers. The repo market is used both as a deep source of
liquidity and a market for cheap leverage.

The repo market is the essential link that allows Treasury securities
to be “money.” The Treasury market is already the world’s deepest
and most liquid market, but a $1 trillion overnight repo market goes
one step further and allows Treasuries owned outright to be
converted to bank deposits any time for virtually no cost, and then
returns the same Treasury security the next day. Of course,
borrowers can easily roll over their overnight repo loans for as long
as they want or choose a longer-tenor repo loan. This makes
Treasuries fungible with bank deposits, thus turning Treasuries into
money and giving the U.S. Treasury the power of the printing press.

The repo market is also a market for cheap leverage. Investors can
speculate on securities by putting down a little of their money as
equity and borrowing the rest in the repo market. This is because an
investor can purchase a security, simultaneously enter into a repo
agreement to borrow against that security, and then pay for the
initial purchase of the security using proceeds from the repo loan.
For example, a hedge fund who wants to invest $100 in Treasuries
can put down $1 of its own money and end up borrowing the
remaining $99 in a repo transaction. Here is how that would work:

Step 1: Hedge fund A goes and buys $100 in Treasuries from Hedge
fund B.

Step 2: At the same time, Hedge fund A enters into a repo

transaction with a dealer where Hedge fund A sells the $100 in
Treasuries for $99 dollars and agrees to buy the Treasuries back at
$99.01 tomorrow (the $0.01 is the interest for the overnight loan).
Hedge fund A cannot sell the Treasuries for the full $100 because the
dealer will ask for a small haircut to protect itself from any changes
in the collateral value. In this case, the dealer sees Treasuries as very
high-quality collateral and is only looking for a 1% haircut.

Step 3: Hedge fund A takes the $99 it received from the dealer, plus
$1 of its own money, and pays Hedge fund B $100. Hedge fund A is
thus able to buy $100 of Treasuries with just $1 of its own money.
Step 4: The next day Hedge fund A is obligated to purchase the $100
in Treasuries back from the dealer for $99.01, where $0.01 is the
interest charged on the overnight loan. Hedge fund A can either
renew the loan or get out of the trade by selling the Treasury on the
market for $100 and paying the dealer $99.01 with the proceeds.

In practice, a borrower looking for leverage through repo loans could

be engaged in a few common strategies: they could be hoping that
the security purchased would appreciate, they could be earning
interest on the security purchased that is in excess of the interest
costs of the repo loan, or they could use the security as a hedge to
another part of their portfolio or as part of an arbitrage strategy. In
any case, the repo market allows a borrower to take large positions
with just a little bit of their own money.

The cash borrowers in the repo market are primarily dealers and the
investment funds who borrow from the dealers. Usually a money
market fund would lend to a dealer who in turn uses the money to
finance their own inventory of securities or acts as an intermediary
and re-lends the money to a hedge fund client.
The primary cash lenders in the repo market are money market
funds, who lend around $1 trillion dollars each day. Money market
funds gravitate towards the repo market because they value liquidity
and security. The short maturities of repo loans allow money funds
to easily meet investor redemptions, while the high-quality collateral
allows them to lend without worrying about default. Money market
funds can thus park their money virtually risk-free, earn interest, and
have the money back in case there are any investor withdrawals.

In recent years, the Fed has become an active borrower and lender in
the repo market through its Repo and Reverse Repo Facilities. The
two facilities are used by the Fed to control repo rates. The Fed’s
Reverse Repo Facility offers money market funds a place to park
their money at a set interest rate. This helps the Fed maintain a floor
for repo rates because it provides money funds with strong
bargaining power against dealers. The Fed’s Repo Facility has a
similar purpose: it acts to prevent repo rates from rising too much.
The Repo Facility provides virtually unlimited repo loans to primary
dealers at a set rate, which then acts as a soft ceiling for repo rates. If
a money market fund demands rates higher than the Fed’s Repo
Facility rate, the dealer can just borrow from the Fed instead. The
spread between the Reverse Repo Facility rate and Repo Facility rate
is usually only a small fraction of a percent.

Deep Dive into the Repo Market

The repo market is the largest and most important market that
most people have never heard of. It’s about $3.4 trillion in size and
comprised of three major segments: Tri-party, uncleared bilateral,
and cleared FICC.46

The tri-party repo market refers to trades conducted on the repo

platform of a clearing bank, who performs the operational back
office work of the transaction such as collateral valuation,
securities custody, and payment settlement. Cash lenders in tri-
party repo are not specific in the collateral they accept; for
example, a lender against Treasury collateral would be open to any
tenor Treasury collateral (this is called “General Collateral”). In the
U.S., the only tri-party platform is operated by Bank of New York
Mellon. Tri-party repo is basically a user-friendly way to conduct
repo. As a result, cash lenders like money market funds or
corporate treasurers transact the bulk of their repo on a tri-party
platform. The cash borrowers in tri-party tend to be dealers who
are either financing their inventory securities or borrowing cash to
lend to their hedge fund clients. Data from the New York Fed
shows that the tri-party repo market is around $2.2 trillion in
size.47
 Cleared FICC repo refers to repo transactions that are centrally
cleared through the Fixed Income Clearing Corporation, a clearing
house. The FICC repo market is an interdealer market, so all
transactions are between dealers. Dealers in FICC can request
specific collateral for their loans; for example, a dealer lending
cash can specify that it only wants recently issued Treasury
securities. Centrally cleared means that when two dealers agree on
a repo trade, they submit the trade to FICC who then takes the
other side of the trade to each dealer. If Dealer A agrees to borrow
$100 from Dealer B using Treasury securities as collateral, then,
through a process called novation, FICC becomes the counterparty
facing each dealer. At the end of the trade, Dealer A will be
borrowing $100 from FICC, and Dealer B will be lending to FICC.
This reduces counterparty risk because FICC is regarded as a high-
quality counterparty. It also allows borrowing and lending in FICC
repo to be netted since all FICC repo is ultimately with FICC as the
counterparty. This helps a dealer’s regulatory metrics by reducing
its balance sheet size. The FICC repo market is estimated to be a
bit over $1 trillion.

Uncleared bilateral refers to repo trades done without the

assistance of the tri-party platform and are not novated to FICC.
These trades are generally between dealers and either cash lenders
that are too small for the tri-party platform or so large that they
are able to demand terms more flexible than those possible on the
tri-party platform. There is no official data on this segment of the
market.

The other major secured money market is the FX-swap market,

which is a market for foreign currency loans. FX-swap transactions
are like repo transactions, but instead of securities the collateral used
is foreign currency. For example, a 3-month Euro-USD FX swap
would be borrowing euros using U.S. dollars as collateral. The party
that ends up with dollars will pay a USD interest rate like the 3-
month LIBOR and receive a euro interest rate like the 3-month
Euribor from the party that ends up with euros.48 The FX swap
allows investors to obtain foreign currency and hedge out exchange
risk, which can easily wipe out any investment gains.

The FX-swap market is an enormous market, with estimates of daily

volumes around $3.2 trillion.49 Most of these transactions have the
U.S. dollar as one part of the leg. This reflects the preeminent role of
the U.S. dollar in the world, where both foreign corporations and
foreign investors have strong dollar needs. Foreign companies need
dollars to conduct international trade, and foreign investors need
dollars to invest in U.S. assets. Lenders of U.S. dollars in the FX-
swap market tend to be domestic commercial banks, U.S. investors
who seek to invest in foreign assets, or foreign central banks seeking
to earn a return on their dollar reserves.

In recent years, U.S. interest rates have been higher than the rest of
the developing world. As Japan and the Eurozone moved their policy
rates negative, U.S. rates remained positive. Negative rates have
made investing difficult for Japan and Eurozone investors and
pushed many of them to search for yield outside of their respective
countries. However, any foreign investment can only make sense if
the currency risk is hedged. For example, suppose U.S. Treasuries
yielded 2% more than Japanese government bonds. While 2% is a
hefty difference when it comes to interest rates, a 2% move in the
yen/dollar currency cross is a relatively frequent occurrence. Thus,
while a Japanese investor could earn a higher return in Treasuries,
they could easily lose all that and more if the yen suddenly
appreciated. An FX swap allows the Japanese investor to hedge out
currency risk but at a price that may not always make sense. In
addition to paying a USD interest rate, the foreign investor usually
also has to pay a “basis.”

FX-swap markets are subject to supply and demand dynamics like

any other market, and this dynamic is expressed in the “basis” of a
FX swap. Following the example above, if there is stronger demand
in the market for dollars than yen, then the yen lender will have to
offer more than just 3-month USD LIBOR to entice dollar lenders.
This extra interest, called the “basis,” is determined by the market
and is a good barometer of global demand for dollars. Foreign
investors looking to invest in U.S. dollar assets will usually look at
the returns after accounting for FX hedging costs, which may be
sizable enough to make higher-yielding U.S. dollar investments
unattractive. Note that the yen lender would pay USD interest on
their dollar loan and receive yen interest on the yen lent. In negative
interest countries like Japan, the yen lender would be receiving
negative interest on the yen lent, which is to say they would be
paying interest both on the dollar loan and on the yen lent.
Generally, the FX-swap basis for dollars with major currency pairs is
a fraction of a percent. But in times of stress it can be much higher.
During the 2020 COVID-19 panic, demand for dollars pushed the
basis to around 1.5%, where borrowers of dollars had to pay 3-month
USD LIBOR plus 1.5%.
During the 2008 Financial Crisis and the 2020 COVID-19 panic, the
FX-swap basis for major dollar crosses exploded from a fraction of a
percent to several times that in a matter of weeks.50 This implies
significant stress in the U.S. dollar funding markets because
borrowers are unable to borrow dollars unless they offer exceptional
interest rates. This could happen as U.S. dollar holders pull back
their FX-swap lending to conserve dollars and reduce risk amidst
market turmoil. When the dollar lenders pull back, foreign investors
who borrowed dollars in the FX-swap market on a short-term basis
to purchase longer-term U.S. dollar assets may be forced to sell those
assets at fire sale prices. Foreign banks with a U.S. dollar loan
business and who manage their currency risk through the FX-swap
market may be forced to rollover their FX-swap loans at very high
rates, leading to significant capital losses that cause them to retrench
from lending activity. All this causes significant stress in the financial
markets.

In both crises, the FX-swaps market was calmed only when the Fed
stepped in and offered to enter into FX-swap transactions with other
major central banks. The Fed would lend dollars to a foreign central
bank secured by foreign central bank reserves, and the foreign
central bank would then lend those dollars to banks within its
jurisdiction. These actions were effective in calming the FX-swaps
market during both crises, but it took several hundred billion dollars
of emergency swap loans.

Money Markets are Global

Sophisticated investors often view money markets as a global

market where they can freely move around the world in search of
the highest return. They will look at the interest rates offered by
money market products throughout the world, taking account of
FX hedging costs. For example, even when Eurozone sovereigns
issue short-term debt at below zero percent, a U.S.-based investor
can still find it more attractive than positive-yielding short-term
Treasury securities after taking FX hedging costs into
consideration.

Market Pricing in December 2019

3M U.S. Treasury Bill 1.5%
3M French Bill -0.6%
3M EUR LIBOR -0.4%
3M USD LIBOR 1.9%
3M EUR/USD FX-swap basis 0.2%

In late 2019, 3-month French bills yielded -0.6% while 3-month

Treasury bills yielded 1.5%. On its face, a U.S. investor could earn
much more investing in the 3-month Treasury bill than a 3-month
French bill (1.5% vs -0.6%). But that was not the case on a FX
hedged basis. If the investor swapped their dollars into euros and
then invested into the 3-month French bill, then they would have
earned 3M USD LIBOR by lending dollars, paid negative 3M EUR
LIBOR for euros (which means receiving positive interest),
received the FX-swap basis, but lost 0.6% in negative yielding
French bills. Overall, they would be earning 1.9% (1.9% + 0.4% +
0.2% - 0.6% = 1.9%), which is 0.4% more than Treasury bills over
the same period.

Focusing solely on domestic interest rates can be misleading

because money markets are global. Changes in interest rates in one
country automatically affect those in other countries via arbitrage.
Not all investors can participate in the arbitrage due to varying
levels of sophistication and risk tolerance, so the opportunities
persist.
Unsecured Money Markets
Unsecured money markets are markets for short-term loans where
the promise to repay is backed by nothing other than confidence in
the borrower. These loans tend to offer higher interest rates than
secured loans because of the higher risk involved. While a secured
lender would lend largely on the quality of the collateral backing the
loan, unsecured lenders rely heavily on ratings agencies to determine
the creditworthiness of a borrower. Common unsecured money
market instruments include certificates of deposit, commercial
paper, and federal funds. In the post-2008-crisis world, unsecured
money markets have become less important as regulations
discouraged banks from borrowing in them.

Before the 2008 Financial Crisis, commercial banks were major

participants in the unsecured money markets. The well-known
benchmark rate, 3-month LIBOR, is in fact a benchmark rate for the
interest rate a commercial bank would have to pay to borrow dollars
on an unsecured basis for 3 months. Borrowing in unsecured money
markets was an easy way for a commercial bank to expand its loan
portfolio without worrying about deposit outflow. When a
commercial bank aggressively expands its loan portfolio, it will often
experience net deposit outflows as the newly created deposits are
spent by borrowers and end up deposited at other commercial banks.
In this case, a commercial bank could go to the market even when
they don’t have collateral and borrow in the unsecured money
markets to replace the lost deposits.

The largest segment of unsecured money markets are certificates of

deposit (CDs), which are essentially deposits that cannot be
withdrawn until they reach a preset maturity date. While data on
CDs is not publicly available, Federal Reserve data show that
commercial bank time deposits were around $1.6 trillion in 2020.
Time deposits are a slightly broader category of bank liabilities that
include CDs. These deposits offer banks a way to manage outflows,
and depositors a way to earn competitive interest rates. The largest
issuers of CDs tend to be foreign banks, as they lack the stable retail
deposit base that domestic commercials banks have. Retail deposits
can be withdrawn any time, but in practice tend to just sit in the
bank. Domestic banks have an easier time managing their deposit
outflows because most of their deposits are stable retail deposits.
Foreign banks don’t have retail businesses, so they have to instead
rely on CDs where the depositor is contractually obligated to keep
the deposit at the issuing bank until the CD matures.

Investors in CDs tend be very rate sensitive. These investors will

quickly move money from one bank to another even for a fraction of
a percent. The largest investors in CDs are prime money market
funds, who usually invest in CDs issued by a number of commercial
banks as a way to diversify credit risk. Because CDs are unsecured,
many investors are reluctant to put large sums of money into a single
bank’s CDs. Instead, investors would invest in prime money market
funds and benefit from the fund’s diversification.

Another common unsecured money market instrument is

commercial paper (CP). Whereas CDs are legally deposits and can
only be issued by commercial banks, CPs are short-term unsecured
debt that are not deposits, so they can be issued by any entity. When
a financial institution issues CP, it is called financial CP. Insurance
companies, bank holding companies, dealers, and specialty finance
companies are all common issuers of financial CP. Many non-
financial corporations also actively issue CP to manage their working
capital, such as vendor payments, payroll, inventory management,
etc. Non-financial CP is a relatively small portion of unsecured
money markets. This helps non-financial CP issuers borrow at
slightly lower rates than financial CP issuers, even controlling for
credit rating. Investors in non-financial CP are willing to accept
slightly lower returns to diversify their portfolios away from financial
issues. Prime money market funds are the dominant investors in CP,
as they are in CD.

Money Market Reform 2016

An earthquake shook the money market world on October 14,

2016, when a few long-awaited money market reforms came into
effect. First announced by the SEC in 2014, the reforms were
designed to make money funds safer in light of the failure of a few
prime money market funds during the financial crisis. One the
major changes was to give prime money market funds the option
to freeze redemptions in times of market stress. This was designed
to prevent a run on prime money market funds, where massive
investor flight would force the fund to liquidate assets at fire sale
prices and result in investor losses.

Prime fund investors were terrified of the possibility of having

their money frozen in a prime fund when they would need it most.
Many investors in prime funds were institutional investors who in
turn were managing someone else’s money. If these institutional
investors could not redeem their prime fund investments, then
they might not have the cash on hand to meet their own
redemptions. That possibility was too terrifying for many
institutional investors, and they decided to move their money en
masse out of prime funds and into government funds, which did
not have the redemption gate feature. As the October 14, 2016
effective date approached, prime funds lost a record $1 trillion
dollars in assets over the span of a few weeks.
Prime funds were the dominant investors in the unsecured money
markets, as government money market funds cannot invest in
unsecured private sector liabilities. This meant that in the span of
a few weeks, borrowers that had relied upon unsecured money
markets would lose close to a trillion dollars in funding. The
largest borrowers in unsecured money markets were foreign
banks. Heading into October, the 3-month LIBOR rocketed to
multiyear highs as foreign banks competed for the remaining
prime fund investments. On the flipside, government money
market funds were flooded with money and were forced to place
hundreds of billions into the Fed’s RRP facility because they had
nowhere else to invest.

Money market reform led to dislocations in the unsecured money

markets, but the market quickly sorted things out. Over the next
few months, the banking sector was able to adapt to the seismic
shift in funding sources by adjusting the way that it borrowed.
 Foreign banks who were accustomed to issuing CDs to prime funds
would now instead borrow from government funds through the
repo market. Government funds were able to lend in the repo
market if the loan was secured by Treasury or Agency MBS
collateral. The banking sector essentially rewired itself from large-
scale unsecured borrowing to large-scale secured borrowing using
Treasuries or Agency MBS as collateral.

The most well-known unsecured money market is the federal funds

market, which is where the Fed sets its policy rate. The federal funds
market is an interbank market where commercial banks borrow
reserves from each other on an overnight unsecured basis.
Historically, commercial banks borrowed in the funds market to
have enough reserves to meet reserve requirements at the end of the
day or to meet daily payment needs. In a sense, it was the marginal
cost of funding for a commercial bank. The Fed hoped to influence
longer-term interest rates and bank lending activity by raising or
lowering the federal funds rate.

The Fed was able to control the funds market because it had
complete control over the supply of reserves in the banking system,
and a very good sense of the demand for reserves. The demand for
reserves came from the regulatory framework that commercial banks
operated under, which forced them to hold certain levels of reserves
depending on their size and the types of liabilities they had. The Fed
knew exactly how much reserves the commercial banking system as a
whole needed and adjusted the supply of reserves so that the funds
rate stayed within the target range. As is discussed in Chapter 5, the
Fed now controls the funds rate with a new framework.
While unsecured markets remain sizable, they are much smaller than
they were prior to the financial crisis. The financial crisis was
fundamentally a banking sector crisis, and that experience left many
market participants, including banks, wary of unsecured exposure to
banks. Regulators have also put forth rules that make it unattractive
for a bank to borrow in the unsecured money markets. As a result,
the interbank unsecured money markets have virtually disappeared.
What remains of the unsecured money markets is primarily a
nonbank to bank market, and that has also shrunk significantly due
to Money Market Reform.

The Death of the Federal Funds Market

Even though the federal funds market continues to be where the

Fed sets its policy rate, the funds market died many years ago.
Before the 2008 Financial Crisis, the funds market was deep and
dynamic, with hundreds of billions of dollars exchanged each day.
Commercial banks borrowed and lent funds in it throughout the
day as they adjusted their liquidity positions. The funds rate was
relatively volatile as it reflected dynamic market conditions. Note
that this is in part because the funds rate was a weighted average
prior to March 2016, but a median afterwards.

In the post-financial-crisis world, the federal funds rates is

basically unchanged each day, like an EKG meter that has
flatlined. This is due to two reasons: quantitative easing and Basel
III. Quantitative easing significantly increased the level of central
bank reserves in the banking system from about $20 billion to a
few trillion. Commercial banks have much less of a reason to
borrow in the funds market when they already have so many
reserves. In addition, Basel III made interbank borrowing less
attractive. When a crisis hits, those loans are usually the first to
disappear and leave a bank scrambling for cash, so Basel III seeks
to make commercial banks safer by encouraging them to reduce
their overnight unsecured borrowing.

The funds market today exists largely due to a quirk in regulations.

Federal Home Loan Banks (FHLBs) have reserve accounts at the
Fed, but they are not eligible for interest on reserves. To earn at
least a little bit of interest on their reserves, FHLBs lend into the
funds market. Some foreign banks, who are more lightly regulated
than domestic banks, are willing to borrow from FHLBs and then
deposit the funds into their Fed account to earn the interest on
reserves rate. They thus earn the small spread between the rate
they borrowed at and the Fed’s interest on reserves rate.

As the funds market has largely lost its significance as a signal for
funding conditions, the Fed is likely to move its target rate to other
reference rates. This could be one of the Fed’s new references rates
such as Secured Overnight Funding Rate (SOFR), which is a
reference rate based on overnight repo transactions secured by
Treasury collateral. SOFR captures a market that is around $1
trillion in size with a wide range of market participants, so it is
much more representative of real funding market conditions. In
addition, the Fed already has good control over the overnight repo
market through its Reverse Repo and Repo facilities.
Chapter 7 – Capital Markets

Capital markets are where borrowers go to borrow from investors

rather than from commercial banks. The borrowings are usually at
tenors of several years, which put the borrowings outside of money
markets. Capital markets financing is different from a commercial
bank loan in that it does not increase the amount of bank deposits in
the system, but allows holders of bank deposits to lend them to other
nonbanks.51 In a sense, it allows a more efficient use of existing
money by allocating it to the borrowers who value it the most.
Capital markets are broadly divided into equity and debt markets.
Equity markets are where a company offers an ownership interest in
itself in exchange for bank deposits. Debt markets are where a
borrower offers an “IOU” in exchange for bank deposits to be repaid
with interest at an agreed upon date.

Equity Markets
Equity markets are the most followed financial market by the public.
Major equity indices like the Dow Jones are talked about on the news
and often viewed as a barometer for the health of the overall
economy. However, equity markets are actually the most emotional
market and least reflective of economic conditions. An easy way to
see this is to see how often equity markets go into manias where they
swing higher, only to crash over a short period of time even as the
underlying economic data has not materially changed.
Market participants generally try to value equities on either a
fundamental or relative level. Fundamental analysts will take a
discounted cash flow approach and view a stock price as a series of
future earnings discounted by a risk-adjusted discount rate. After
forecasting future earnings and then determining a discount rate, the
fundamental analyst will arrive at a valuation. An analyst valuing a
stock on a relative basis would compare it to similar stocks. For
example, a shoe company’s stock could be considered expensive if its
price to earnings ratio or some other valuation metric were higher
than another comparable shoe company’s ratio. Relative valuation
can also be conducted across asset classes, such as comparing the
returns of Treasury securities to the expected future returns of a
stock.

The difficulty with using valuation to predict the future price of a

stock is that there are many ways of valuing a stock and it is not clear
that one method is consistently better than others. Prior research has
suggested that stocks that are “cheap” on a price to book ratio tend to
outperform, but more recent research suggests that may no longer be
true.52

The Rise of Passive Investment

The structure of the equity market has changed significantly over

the past couple decades due to the rise of passive investment.53
More and more Americans are investing in the stock market
through employer-sponsored retirement plans such as target date
funds that don’t invest according to valuations the way an active
investor would. While an active investor would buy stocks
according to some sort of valuation metric, a passive investor does
not care about the price. For example, retirements funds will
invest the money allocated to them each paycheck period, no
matter how expensive stock valuations are. Over the past two
decades flows from passive investors have grown to become the
marginal investors in the equity market. This has a few extremely
important implications:

• The stock market trends higher. Every week there is a constant

flow of new money entering the stock market, even if
valuations are considered to be sky high. This creates an
upward bias in the market as a whole.
• Stocks with large market capitalizations continue to get even
bigger at an accelerating rate. Retirement accounts are usually
set to track a certain stock index, like the S&P 500. Companies
with larger market capitalizations in an index are allocated a
greater share of money by index tracking funds, which in turn
 pushes the price of the stock higher. This is because a stock’s
order book depth, which represents the amount and size of the
outstanding buy and sell orders, does not scale perfectly with
the market cap of the stock, so the increased investment flows
into large cap stocks push their prices upwards at an
accelerating rate. As the price of a stock rises, it becomes a
bigger part of an index and so more money needs to be
allocated to it, reinforcing the upward momentum. In a market
dominated by passive investment, companies with large market
caps become even bigger. This is exactly what is seen in the
incredible outperformance of large cap tech companies like
Microsoft or Apple. Not coincidentally, the two companies
happen to be members of all three major equity indexes: the
Dow Jones, S&P 500, and Nasdaq.
• Value investing no longer works. Value investing relies on the
idea that “cheap” companies tend to appreciate over time and
outperform the market. This was famously documented by the
Fama-French study that used price to book value as a measure
of value. However, that study was done in a world before
passive investment flows dominated the market. Cheap
companies, which tend to be smaller companies, are largely
absent from the major stock indices that receive passive
investor flows. These value companies thus continue to
underperform. The active investors that look for value cannot
compete with the constant torrent of retirement money that
drives major stock indices higher.

Many market participants believe in the existence of a “central bank

put” where significant declines in major equity market indices will
compel central banks to do something to push market prices higher.
No central bank official will ever acknowledge such a policy, but that
is exactly how major central banks around the world have acted in
the past decade. In November 2010, Chair Bernanke, in defense of a
new round of quantitative easing, noted that higher stock prices
created a wealth effect that could improve consumer sentiment and
thus consumer spending.54 The Fed believed that higher stock prices
could help them achieve their policy goals. The stock market had
appeared to become a policy tool.

In 2014, the Bank of Japan became the first major central bank to
begin purchasing equities. Japanese stock market indices were
euphoric and surged higher in the months following the
announcement, but then drifted around in the following years. Of
course, many aspects other than central bank actions affect equity
prices, and many notable events transpired in the following years,
but Japanese stock market indices appeared to be less and less
excited by subsequent announcements of additional BOJ equity
purchases. The Nikkei essentially traded sideways from 2015 to 2020
even as the BOJ steadily increased its ownership of Japanese equities
to around 6% of the market capitalization of the Tokyo Stock
Exchange.

The Fed does not have the legal right to purchase equities. However,
the Fed has been creative in finding ways to support the financial
markets in times of crisis. Recent history shows a clear pattern of the
Fed taking on riskier assets onto its balance sheet, so it is not
inconceivable that one day the Fed could purchase equities.
The equity market is more than just the stocks listed on an exchange.
There also exists a separate market for non–publicly traded private
equity. To be able to sell equity shares to the public, a company goes
through a regulatory process and then finally launches an initial
public offering (IPO). It is then subject to ongoing regulatory
disclosures and must respond to the interests of its new
shareholders, who may have a wide range of conflicting visions for
the company. While an IPO gives a company the opportunity to raise
money from a large pool of investors, some companies decide that it
isn’t worth the trouble, preferring instead to look to the private
markets to raise money.

Companies can raise money through private markets by offering

equity for sale to accredited investors, who are investors that meet a
certain regulatory standard of wealth or sophistication. These
investors are assumed to not need the regulatory protections that an
IPO offers because they are sophisticated enough to conduct their
own due diligence. Companies who choose to not list their equity
publicly are generally smaller and less sophisticated than their public
counterparts. For example, a medium-sized family-owned business
may seek to raise money by selling shares in the company to
institutional investors. The institutional investor buys an ownership
interest in the business and sometimes offers some managerial
expertise to further improve the business.

There are some benefits for a company to remain private, even if it

can IPO. Often, remaining private allows the company to be more
long term in its thinking because its shareholders also have a longer
time horizon. Public companies are under a quarterly reporting cycle
and may be forced to behave in ways that maximize short-term gain
at the expense of longer-term profitability. Owners of public
companies also run the risk of losing control in a hostile takeover, as
anyone can go out and purchase enough shares of the company to
gain control.

Private equity investments can potentially yield high returns, but on

average appear to have returns comparable to the broader stock
market.55 Private equity investors further suffer a serious liquidity
problem. Investors in public equity can easily sell their shares on an
exchange, but there is no exchange for private equity. Investors
looking to sell their private equity shares must look for other
sophisticated investors, provide confidential financial information on
the company to help the buyer evaluate the investment, and then
agree on a price. On the bright side, the lack of a liquid market allows
private equity investors to avoid marking down their holdings even if
public equity markets crash.

The illiquidity problem frequently leads private companies on the

path to becoming public companies. An IPO offers an easy way for
the private equity holders to cash out. Founders and investors in
private companies may have enormous wealth based on model
valuations of their private equity holdings, but all their wealth is only
hypothetical unless they can actually sell the shares. Once the shares
are publicly traded, they can easily monetize their holdings by
logging onto an online brokerage and selling at the price that is
flashing on the screen.

Market Makers: An Invisible Hand

Equity prices usually exhibit a pattern of a slow grinding move

upwards, punctuated by sudden large drops. There is always a
shifting array of explanations for these drops, but one is the
structure of the equity markets. Institutional investors tend to buy
puts to hedge their downside and sell calls to generate additional
income. Options dealers usually take the other side of these trades.
As a result, options dealers are forced to hedge their options book
in a way that slows down upward moves in equity prices but
accelerates downward moves.

An options dealer makes money from transaction fees it earns

from selling and buying options. It does not take a directional view
as to whether stocks will go up or down; it is only interested in
earning a transaction fee. For example, when an investor wants to
sell a call option on a stock, the dealer will take the other side of
the bet and end up owning a call option. If the stock price goes up,
then the value of the call will increase. As the dealer’s business
model is based on transaction fees instead of directional bets, the
dealer will hedge its exposure to the call option by shorting the
stock. This way, when the stock price goes up, the dealer’s gain on
the call option is offset by its short (this is called being “delta
hedged”). If the stock price declines, then the value of the call will
also decline. To remain delta hedged, the dealer will reduce its
short stock position by buying some of the stock. As dealers are
structurally long call options, the higher the stock goes the more
shares the dealer shorts, and the lower the stock goes, the more the
dealer buys. This moderates the rate in which stock prices rise and
decline.

However, dealers also tend to be structurally short puts. This is

because investment funds buy puts to insure their portfolios.
When a dealer is short a put a different dynamic occurs. To hedge
a short put position, the dealer sells stocks. This way, when stock
prices decline the dealer is losing money on its short put position
but earning money on its short stock position. The lower stock
prices go, the more shares the dealer has to sell to remain hedged.
If stock prices increase, then the value of the short put also
increases. This leads a dealer to reduce its short stock position by
buying shares, which reinforces the upward movement in stock
prices. This dynamic enables a volatile self-reinforcing cycle of
stock prices that can lead to sudden stock market crashes and
sudden upward surges in stock prices.

When a dealer is short an option, whether it is a put or call, the

dealer is “short gamma.” That means that its losses on the put
(call) it sold will increase in a nonlinear fashion as the price of the
underlying stock declines (rises). This forces the dealer to sell
(buy) ever increasing amounts of the underlying stock to hedge its
position as the price of the stock is decreasing (increasing). On the
other hand, when a dealer is long an option, the dealer is “long
gamma.” They hedge their position in the opposite direction of the
 price move, so they sell (buy) shares of the underlying stock when
the price is increasing (decreasing). Hedging a short gamma
position reinforces the price trend, while hedging a long gamma
position moderates the price trend.

The amount of hedging the dealer community does is estimated to

be in the billions for even small moves in the S&P 500.56 Dealers
are usually long gamma, but sudden drops in the equity market
occur can push their out-of-the-money puts into the money and
require additional hedging. This means sudden declines in the
level of equity indices can push dealers into short gamma and
force them to sell large amounts of stocks to remain hedged,
further exacerbating downward price moves. That pattern is
exactly what we see in real life.

Debt Capital Markets

Debt capital markets are less glamorous than equity markets, but
larger and arguably more important. These are where companies or
governments borrow money by issuing bonds. A bond is just a
promise to repay issued by a borrower in exchange for an investor’s
bank deposits. When a commercial bank originates a loan, it creates
bank deposits that are credited to the borrower’s bank account, but
when a nonbank borrower issues a bond to a nonbank investor, then
the nonbank investor sends bank deposits to the nonbank borrower’s
account. Rather than create more bank deposit money, the debt
capital markets allow a more efficient use of existing bank deposit
money.57
The bond markets are a lot more complicated than the equity
markets because bonds are highly customizable along many
dimensions. For example, they come with all sorts of tenors, interest
rates, seniority, optionality, and covenants. Any big company will
likely have just one kind of stock publicly listed on the stock
exchange, but it will certainly have several issues of debt
outstanding. Some of it could be long term, some short term; some
could be floating rate, some fixed rate; some could be senior
unsecured, some secured; some could be callable, etc. Even Treasury
securities come in a wide range of tenors and coupons. This makes
understanding the bond market a very complicated undertaking.

The bond market is also opaquer than the stock market. While stocks
are identified by a ticker symbol that is usually four or fewer
alphabetic characters, bond issues are identified with a CUSIP58
number that is a nine-character alphanumeric identifier. For
example, “91282CAE1” is the CUSIP for the 10-year Treasury
maturing August 2030. Anyone can search on the internet to find the
price a stock is trading at, but searching for the price of a specific
CUSIP often requires access to professional platforms. Furthermore,
most bonds don’t trade frequently, so you may not have any data on
its price unless you call a dealer.

Market participants usually evaluate bonds in terms of their yields as

a spread to Treasury yields of the same tenor. For example, a 5-year
bond issued by Microsoft would be evaluated by how much
additional yield it offers over 5-year Treasuries. Treasuries are
assumed to be risk-free and highly liquid. The additional yield
offered by the Microsoft bond is meant to compensate an investor for
the credit and liquidity risk the investor is taking.
Credit risk takes into account how likely the company will default,
and if it does, what percentage of the money lent could be recovered.
Credit ratings are the single most important determinant of a bond’s
perceived credit risk. Large investors do not realistically have the
time to carefully go through the financials of every company they
invest in, so they place a lot of reliance on ratings agencies to do the
work. In many cases, reliance on ratings is literally written in their
mandate, where they can only invest in bonds that are above a
certain rating. The higher a company is rated, the lower the interest
rate they can borrow at. Once a company’s rating falls below
investment grade, the interest rates it can borrow at shoot up
significantly because many investment funds are not allowed to
purchase so-called junk bonds.

Liquidity risk takes into account how difficult it would be to sell the
bond in case the investor needed money before it matured. While
Treasury securities trade throughout the world and around the clock,
most other bonds trade infrequently. Depending on market
conditions, an investor may not be able to sell their bond without a
significant discount. A bond’s spread over Treasury securities is
wider when the bond is more illiquid.

The bond market is generally thought of as the “smarter” market

because it is more sensitive to economic fundamentals. A bond
investor only cares about being able receive their investment back
plus interest, while an equity investor can dream of the unlimited
upside offered by a company’s next product. Bond investors don’t
have any upside beyond principal and interest payments, but they
can lose money if a company is unable to repay its debts.
Deteriorations in a company’s fundamentals will quickly be reflected
in the company’s bond prices, but not necessarily in its equity prices.
The general public is aware and actively engaged in the stock market,
but much less aware of the intricates of the bond market. For
example, after Hertz filed for bankruptcy in June 2020, its bonds
quickly traded down to pennies on the dollar, reflecting the low
likelihood of any recovery. In bankruptcy, all debt holders are paid in
full before equity holders receive anything, so a bankruptcy filing
almost always implies that the company’s equity is worthless.
However, Hertz’s stock surged after bankruptcy as an army of retail
investors piled in. These investors were likely unaware of the
implications of a bankruptcy filing, which was quickly understood by
the bond holders.

The bond market is segmented into different subclasses, the largest

of which are Treasury securities, mortgage-backed securities, and
corporate debt. Other notable segments are municipal bonds and
asset-backed securities. The sections below will offer a broad
overview of the three largest segments of the bond market.
Corporate Bonds
Corporate bonds are held by a wide range of investors, the largest of
which are insurance companies, pension funds, and mutual funds. A
small but increasingly important investor class are ETF funds.
Broadly speaking, the market is divided into an investment-grade
universe (bonds rated BBB-59 and above) and a high-yield universe
(bonds rated below BBB-, also known as junk bonds). According to
S&P, around 85% of corporate bonds are investment grade and the
rest are high yield. Insurance companies and pensions funds tend to
be more conservative in their investments, so their corporate bond
holdings are largely investment grade, while mutual funds ETFs vary
significantly according to their investment strategies. Mutual funds
and ETFs that offer high yields will have a higher composition of
high-yield bonds.
While a relatively small holder of corporate bonds, ETFs have grown
in prominence as a source of liquidity and price discovery for the
corporate bond universe. Corporate bond ETFs hold a diversified
portfolio of corporate bonds but issue shares that are traded actively
throughout the day like a stock. The shares are much more liquid
than any of the underlying corporate bonds, so how the shares trade
give a real time glimpse as to how the fund’s portfolio of bonds is
being valued. The relationship between share value and the
underlying corporate bond assets of the ETF is policed through
arbitrage. Institutional investors are also able to sell baskets of their
corporate bonds to the ETF in exchange for shares of the ETF or
redeem ETF shares for baskets of corporate bonds.

Borrowers in the investment-grade corporate bond market tend to be

larger corporations with solid credit ratings. In recent years, the
investment-grade corporate bond market has grown tremendously as
interest rates and corporate bond spreads reached record lows. The
highest rated corporate issuers can borrow billions at yields that are
only slightly above inflation and much lower than what any
commercial bank can offer. This is because a bank would price a loan
not just on credit risk, but would also take into account the effect the
loan has on its regulatory ratios and return on equity. Corporate
bond investors do not have these concerns but focus on the relative
returns of comparable products such as Treasuries or Agency MBS.
As central bank policy has reduced the yields on comparable
products, corporate bond investors have been forced to accept lower
and lower yields on their bond investments.

Borrowers in the high-yield market tend to be corporations with high

debt levels relative to their cash flow, thus explaining their lower
credit ratings. They are generally former investment-grade
companies that had been downgraded or younger companies that
lack the operational history required for an investment-grade rating.
In the high-yield space, commercial banks can offer a comparable
product called leveraged loans, which are essentially high-interest
loans. Being a loan, leveraged loans are not as easily tradable as
high-yield bonds and may also come with more restrictions on how
the money can be used. These restrictions, called covenants, would
be enforced through ongoing monitoring by the bank. In practice,
banks often originate and then sell the leveraged loans into a
Collateralized Loan Obligation (CLO) investment vehicle, which then
securitizes the loans. The bank will retain only the highest rated
senior bonds of the CLO and the rest will go to investors with higher
risk appetites.60

Just as many market participants are convinced of the existence of

central bank “put” on the equity market, some market participants
are also becoming increasing confident of a central bank “put” on the
debt markets. This is because central banks are becoming
increasingly active buyers in the corporate debt market.

The BOJ was the first major central bank to begin buying corporate
bonds in 2013, followed by the ECB in 2016 and finally the Fed in
2020. These purchases were justified based on improving the
transmission of monetary policy by lowering the borrowing costs of
corporate borrowers, thus stimulating the economy. Instead of
relying on low rates to be transmitted to borrowers through the
banking system, the central bank can now directly lower the
borrowing costs of corporations by buying corporate bonds and thus
pushing yields lower. Corporate bond purchases by central banks do
appear to lower corporate borrowing costs, but also appear to make
corporate bonds less sensitive to economic fundamentals. Many
market participants now are less concerned with their risk exposure
to corporate debt as they believe the central banks will just keep
bond prices high even when fundamentals deteriorate.
In practice, the amount of corporate bonds purchased by central
banks has been relatively small. The Fed’s purchases have been a
particularly small 0.1% of the U.S. corporate bond universe. Like
many other central bank policies, it appears that the perception that
the central bank is in the market is sufficient to boost investor
confidence. Market participants may simply expect the Fed to
massively increase its purchases in the event of financial distress.

How QE Lifts Stocks: Corporate Leveraging

A corporation can finance itself using equity or debt. Equity

holders are the owners of the corporation, so they share in the risk
of the enterprise. If the company is very profitable, then the equity
becomes more valuable, and if the company goes bankrupt, then
the equity holders receive nothing. In contrast, the debt holders
get paid their principal and interest and nothing more. If the
company goes bankrupt, then its assets are sold off and the
proceeds go to the debt holders.

One of the ways in which a corporation can boost its equity prices
is by issuing debt to buy back equity. Suppose that equity holders,
because they are subject to more risk, demand a 10% return on
their equity. At the same time, because interest rates are low, the
same company can issue debt at 5%. Then, by issuing debt to buy
back stock, the corporation reduces its cost of capital. The
company is effectively borrowing at 5% to repay 10% obligations.
At the same time, there will be fewer shares of stock outstanding
so each shareholder would receive more of the earnings. This leads
to higher stock prices purely through financial engineering.
Over the past few years, quantitative easing has helped push
longer-term interest rates to record lows. Corporations have taken
advantage of the record low interest rates and issued record
amounts of debt that they used to buy back stock. A notable
example of this is Apple, which bought back around 20% of its
shares between 2015 and 2019.61 Even though the company’s net
income in 2019 was around the same level as in 2015, its earnings
per share had materially risen due to the smaller number of shares
outstanding. This financial engineering helped Apple’s share
prices double over that 4-year period.
 However, there are also clear risks to an increase in corporate
leverage. While there are fewer shareholders to share the profits
with, there are also fewer shareholders to share the losses with. In
the event of an economic downturn, shareholders will experience
higher losses per share, which may result in large declines in share
prices. A more highly leveraged capital structure suggests greater
volatility in stock prices on both the upside and downside.

Agency MBS
Agency MBS are mortgage-backed securities guaranteed by the
government. Mortgage-backed securities are bonds that receive the
cash flow generated by a pool of mortgage loans. The government
can either guarantee the mortgage-backed securities or the mortgage
loans underlying those securities. Agency MBS are the second largest
market for bonds in the U.S., with over $8.5 trillion outstanding. The
vast majority of Agency MBS are backed by single family home
mortgages, with around a $1 trillion backed by commercial real
estate mortgages that are predominately multifamily homes. Agency
MBS have minimal credit risk,62 are very liquid, and have returns
that are slightly higher than Treasuries, so they are very popular with
conservative investors like insurance companies and foreign central
banks worldwide. Around $1 trillion in Agency MBS are held by
foreigners, with over 60% of that held by Asian investors.63

Fannie Mae and Freddie Mac

Fannie and Freddie are the two giants of the mortgage bond
market. Their job is to support the U.S. housing market by
providing liquidity in the secondary mortgage market. They do this
by buying mortgage loans and packaging them into securities that
can be sold to investors. The loans underlying the securities are
guaranteed by Fannie and Freddie, so investors don’t have to
worry about any homeowner defaulting.

Historically, mortgages were originated by commercial banks who

held on to the mortgage loans for interest income. Fannie and
Freddie offer commercial banks the additional option of selling the
mortgage loan, provided the loan meets certain minimal credit
standards. This additional flexibility was designed to encourage
commercial banks to make more mortgage loans since they always
had the option of selling them to Fannie or Freddie in case they
needed to raise money. This created a robust secondary market for
mortgage loans and also made possible an “originate to distribute”
business model where mortgage loans were primarily originated to
be sold rather than held as investments.
Today, most mortgage loans are originated by nonbank mortgage
lenders who specialize in the “originate to distribute” business
model.64 These mortgage lenders take out a loan from a
commercial bank, lend the money to a home buyer, sell the
mortgage to Fannie or Freddie, and then repeat the process by
taking the proceeds from the sale and lending to another mortgage
borrower. Nonbank mortgage lenders make money off the
origination fees, not the interest from the loan. In the early 2000s,
this volume-driven business model led to a lowering of lending
standards as lenders tried to maximize the volume of loans
originated, but post-crisis regulations have significantly clamped
down on that kind of behavior.

Fannie and Freddie take the mortgage loans, add a guarantee onto
them, package them into securities, and return them to the
mortgage seller to be sold to investors. A guarantee from Fannie
and Freddie make the mortgage securities virtually risk-free.
Should a mortgage loan default, Fannie or Freddie will buy it back
so the investors would not face any losses. These securities, called
Agency MBS, are in significant demand worldwide because they
offer slightly higher yields than comparable Treasuries with
minimal credit risk. This demand for Agency MBS creates more
demand for mortgage loans, which in turn encourages more
mortgage origination, which makes more mortgage loans more
widely available to the public.

Prior to the 2008 Financial Crisis, Fannie and Freddie were very
profitable businesses since they collected guarantee fees while
house prices marched upward relentlessly. When house prices
crashed in 2008, Fannie and Freddie had guaranteed around half
of all the mortgage loans in the U.S. The mass foreclosures
 following the crash quickly made Fannie and Freddie insolvent
and compelled a government rescue. Since then Fannie and
Freddie have remained in government conservatorship.

Agency MBS bonds are a bit tricky to evaluate because mortgage

borrowers have the option of prepaying their mortgage. Treasuries
cannot be prepaid, and corporate borrowers issuing bonds with
prepayment options usually don’t exercise them. Prepayments
means an investor doesn’t know for sure when they will be paid back.
An investor who purchased a 30-year Agency MBS might get their
money back in 25 years if interest rates fell and large numbers of
mortgage borrowers decided to refinance their mortgages. When a
mortgage is refinanced, a new mortgage loan is taken out to repay
the old mortgage loan, so the mortgage investor gets paid back
sooner. On the other hand, if an investor purchased a 30-year
Agency MBS on the assumption that prepayments would remain
steady, but in fact, interest rates rose and prepayments declined as
fewer borrowers refinanced, then the investor will get paid back later
than they expect. Prepayment uncertainty means that any valuation
of an Agency MBS is model dependent. Investors will try to estimate
future prepayments and then discount the cashflows to produce a
valuation.

The Fed has been an active buyer in the Agency MBS market since
the 2008 Financial Crisis with the stated objective of supporting the
housing market and placing downwards pressure on interest rates.
The Fed’s holdings as of September 2020 were a sizable $1.9 trillion,
around 20% of all Agency MBS outstanding. By purchasing large
quantities of Agency MBS, the Fed encourages mortgage lending by
increasing the resale value of mortgage loans. Mortgage lenders
usually sell the mortgage loans they originate to investors, who hold
them through Agency MBS. When prices for Agency MBS are high,
mortgage lenders are incentivized to increase lending, even at lower
interest rates, because they can resell the loans at higher prices to
Agency MBS investors.

That One Time When the Private Sector Created Risk-free Assets

When the U.S. Treasury issues Treasury debt, it’s as good as any
form of money. It’s risk-free and can easily be sold or put up as
collateral for cash in the repo market. There was also a time when
the private sector could do something like that, back in the early
2000s.

In the early 2000s, there was a booming market for securitized

private-label mortgage-backed securities. A private-label MBS is a
bond that is backed by mortgages that are not guaranteed by a
government-sponsored enterprise like Fannie Mae. Instead, they
could be loans made to borrowers who have very low credit scores
or no documentable income. Financial engineers would take these
mortgages and create reportedly risk-free securities through credit
enhancement techniques like subordination and
overcollateralization.

For example, suppose $1000 worth of low-quality mortgages are

backing $900 worth of securities. Further, suppose that the $900
worth of securities were divided into three tranches: a $100 A
tranche, a $300 B tranche, and a $500 C tranche. Using
subordination, any cashflow from the mortgages would first be
directed to pay off the $100 A tranche, then the $300 B tranche,
then the $500 C tranche. The subordination of the B and C tranche
to the A tranche lowers the risk of default for the A tranche. With
overcollateralization, $1000 of collateral is used to back $900 of
bonds, which means that $100 of mortgages can default before any
of the bonds take losses. Taken together, the A tranche would only
take losses if $900 of collateral defaulted. This is unlikely and
makes the A tranche very safe.

Ratings agencies also took the view that such large defaults were
unlikely and often rated these senior tranches as AAA, which made
them as safe as U.S. Treasuries but with higher yields. Investors
snapped them up, and a large and liquid market for them
developed. They became money.

However, when housing prices began declining in 2006, investors

began to feel less confident in the quality of the mortgages backing
their securities. Many of the subordinate private-label MBS
tranches began to trade at discounts. In early 2007, Bear Stearns, a
 major investment bank, failed because too many of its investments
in private-label MBS soured. Investors began to suspect that even
the AAA-rated tranches were not safe and began dumping them.
Many investors and banks took enormous losses, which eventually
precipitated the 2008 Financial Crisis.

In retrospect, almost all of those AAA-rated tranches were paid

off.65 Investors who bought them in 2008 during the financial
crisis easily doubled their money in a few years. However, the
damage had been done, and the private-label MBS market never
recovered. Furthermore, regulators decided that safe assets must
be created by the public sector and even AAA-rated private sector
assets could not be considered safe. Today, when regulated entities
are required to hold high-quality liquid assets, that exclusively
means government assets.

Treasury Securities
Treasury securities are the deepest and most liquid market in the
world and the bedrock of the global financial system. Almost all U.S.
dollar assets are priced off of Treasury yields, which are considered
the risk-free benchmark. While retail investors hold bank deposits as
money, institutional investors throughout the world hold Treasuries
as money. They pledge Treasuries as collateral to purchase other
financial assets, borrow against them in the repo market for
immediate cash, or sell them outright for cash. Treasuries are issued
by the U.S. government in regular auctions in a range of tenors,
broadly divided into bills and coupons. Treasury bills are short-term
debt that matures within 1 year and is issued on a discount basis,66
while coupons are issued in tenors that range from 2 years to 30
years and pay interest semi-annually.

The stated debt management strategy of the U.S. Treasury is to issue

at regular and predictable times at the lowest long-term cost to the
taxpayer.67 In practice, this means that the Treasury will issue
coupons in predictable sizes and make up funding shortfalls with bill
issuance. For example, if the Treasury announced $100 billion in
coupon issuance for the quarter but then realized it needed $20
billion more, then it would just issue $20 billion more in bills.
Coupons are auctioned monthly in sizes that are announced at the
beginning of each quarter, while bills are auctioned twice weekly in
flexible sizes. If Treasury needed to further customize its cash flow
needs, it could issue Cash Management Bills, which are essentially
bills that are issued in a nonstandard tenor.

The Treasury bill market is very deep and can easily absorb
significant fluctuations in issuance. Investors have little concern
holding these as short-term debt, as it is essentially money that pays
interest. In contrast, the market values of longer-dated Treasuries
can fluctuate with expectations of inflation and interest rates and can
become less liquid over time. The most recent issue of coupons is
called “on the run,” while coupons issued from previous auctions are
called “off the run.” On-the-run coupons are very liquid, but become
progressively less liquid as time goes on. An owner of a deep off-the-
run coupon can still instantly borrow cash against the coupon in the
repo market, but would have more trouble selling it outright. This
makes investors of coupons a bit more cautious, so while bills can be
elastically sold, coupon supply sticks to a schedule.
Treasury debt is auctioned by the New York Fed to primary dealers,
who then resell the debt to their clients. Technically, investors can
place bids through the primary dealers (indirect bid), or investors
can go through the process of becoming eligible to bid directly
themselves (direct bid). Notwithstanding that, primary dealers play a
key role in the auction process because they are obligated to bid on
every auction. This means an auction can never fail due to lack of
demand because it is backstopped by the primary dealers.

The success of an auction can be judged by the auction award rate

and degree of participation. A very successful auction would be one
where the yield awarded is lower than the yield anticipated by the
market and the amount of bids submitted far exceeds the amount of
Treasuries being auctioned (high bid to cover). A relatively low share
of purchases by primary dealers also suggests strong investor
demand. Auction results help the market gauge the demand for
Treasuries and can thus move prices. Results that are very strong or
very weak often lead to discrete moves in Treasury yields as investors
reevaluate their view of pricing in light of the new information.
Auction results are released publicly on the Treasury’s website right
after each auction.
Treasuries have a global investor base, with around $7 trillion held
by foreigners. This is in part due to the dollar’s role as the world’s
reserve currency. Central banks around the world must hold dollar
reserves to facilitate currency exchange or defend their currency
against significant depreciation. They tend to hold their dollar
reserves in the form of Treasuries. For example, China is estimated
to hold around $3 trillion foreign reserves with a sizable share of it in
Treasuries. This is not out of the goodness of their heart, but out of
self-interest. China runs a large, persistent trade surplus with the
U.S., so over time, it accumulates large amounts of dollars. It needs
to keep those dollars to participate in global trade, such as
purchasing industrial commodities like oil. A large institutional
investor like the People’s Bank of China (PBOC) simply doesn’t have
any investment options for dollars other than Treasuries. Private
sector assets have credit risk and are not deep enough to hold all that
money. If the PBOC had sizable holdings of corporate debt or
equities, they would only be able to sell their holdings slowly unless
they accepted deep discounts. Treasuries, and to some extent Agency
MBS, are their best options.

Notwithstanding significant foreign holdings, most Treasuries

continue to be held by domestic investors. Money market funds are
major investors in bills, while mutual funds, insurance companies,
and pension funds are major investors in coupon Treasuries.

The Fed has been the single largest buyer of Treasuries since the
beginning of quantitative easing in 2008. The stated purpose of the
purchases was to stimulate the economy by lowering medium- and
longer-dated Treasury yields, which the Fed otherwise did not have
much control over. Since all assets are in part priced off of Treasury
yields, lowering these yields leads to lower mortgage rates, auto
rates, commercial loan rates, etc. As of September 2020, the Fed has
increased its share of the Treasury market to 20%. This clearly exerts
downward pressure on Treasury yields, but likely still leaves room
for price discovery.
Section III Fed Watching
Chapter 8 – Crisis Monetary Policy

Conventional monetary policy relies on the central bank to be the

lender of last resort to commercial banks and to use short-term
interest rates to influence economic activity. When a financially
sound bank suddenly has outflows that it has trouble meeting, the
central bank would step in and lend in order to prevent a panic.
When the economy is in recession, the central bank would lower
interest rates to encourage consumption and investment, and when
the economy overheats, it would raise interest rates to tamp down on
economic activity.

But what happens when there is a panic in the shadow banking

system, and how can a central bank influence economic activity when
interest rates are already at 0%? These were the challenges faced by
the Fed during the 2008 Financial Crisis and 2020 COVID-19 panic.
In response, the Fed devised a new series of tools.

Democratizing the Fed

The Fed was established in an era where commercial banks were the
dominant players in the financial system, so its attention was
naturally focused on the commercial banking sector. The Fed
regulates domestic commercial banks to ensure they are prudently
run and offers them emergency loans through the discount window
to meet unexpected liquidity needs. However, the growth of shadow
banks and offshore banking meant that a significant amount of
financial activity now takes place outside of the Fed’s purview. In
2008, panics emerged in the shadow banking and offshore banking
world. To save the financial system, the Fed was forced to use its
emergency Section 13(3) lending powers, which essentially allow the
Fed to lend to anyone.

In 2008, the shadow banking world was falling apart. There was a
run on the primary dealers, there was a run on the money market
funds, there was a run on the securitization vehicles, and there was a
run on the hedge funds. The commercial banks were not safe either,
because they were deeply intertwined with the shadow banks. They
had guaranteed many obligations of the shadow banks and had also
lent them a lot of money. The stock market indices sensed the
trouble and were imploding. A collapse of the entire financial system
was on the horizon.

The Fed met the crisis by vastly expanding its lending counterparties
to include key shadow banking sectors. It set up lending facilities for
the primary dealers (Primary Dealer Credit Facility), for money
market funds (Money Market Investor Liquidity Facility), and
securitization vehicles (Asset-Backed Commercial Paper and Term
Auction Securitization Facility) and even special loans for too-big-to-
fail banks. The Fed effectively became the lender of last resort not
just to the commercial banks, but also to the shadow banks.

A similar crisis was playing out outside the U.S. in the offshore dollar
banking system. Just as U.S. commercial banks and shadow banks
were imploding from the losses on subprime mortgage-related
investments, foreign commercial banks were also in crisis for the
same investments. The European banks had notably made huge
investments in U.S. mortgage-related assets and were potentially
insolvent from the losses. However, foreign banks were even further
removed from the Fed’s purview as they were not even in the U.S. It
would be poor optics for the Fed to bail out foreign banks. Yet their
impact on U.S. markets was undeniable as their desperate bid for
cash pushed dollar short-term interest rates to dizzying heights.

Market participants usually measure stress in short-term interest-

rate markets with the spread between the benchmark market rate of
3-Month LIBOR and the 3-Month Overnight Index Swap, which is
roughly the expected average federal funds rate for the next 3
months. When the spread is wide, that means that market rates are
much higher than the Fed’s policy rate, which suggests financial
distress. In benign times, the spread is a bit higher than zero, but in
the depths of the financial crisis, it reached all-time highs of around
4%. Investors were afraid to lend to foreign banks, forcing the
foreign banks to offer extremely high interest rates for even 3-month
loans.
The Fed ultimately decided to lend to foreign banks by establishing
central bank swap lines with a roster of friendly foreign central
banks. The Fed would lend dollars to a foreign central bank, who in
turn would lend to the banks within their jurisdiction. The swap lines
solved the global dollar bank run, but they also essentially made the
Fed the backer of the global dollar system, both within and outside of
the U.S.

How to Monitor Fed Special Lending Facilities

The Fed discloses its balance sheet on a weekly basis via the H.4.1
release on its website. The values are weekly averages and
Wednesday snapshots. Below is a snapshot of the H.4.1 on July 2,
2020.

From the release, you can see the size of all the major Fed lending
programs implemented during the COVID-19 panic. The data
show that the emergency credit facilities were little used, with the
largest utilizations at $75 billion in repo loans and $66.7 billion via
the Paycheck Protection Program Liquidity Facility. In some
situations, the mere existence of a Fed credit facility can calm the
markets and thus restore market functioning. Market participants
know that the Fed is backstopping the market, so there is less tail
risk. The lack of usage itself doesn’t necessarily mean that the
emergency facilities were not needed or had no effect.

One notable exception is the FX-swap lines. The Fed’s FX-swap

lines were heavily drawn upon, with $226 billion outstanding on
that date. A more detailed breakdown of Fed swap-line usage can
be found on the New York Fed’s website, which reveals the Bank of
Japan to be the major user of FX swaps. This is not unexpected, as
Japanese investors have very large holdings of USD assets that
they fund through the FX-swap market. They are thus most likely
to need emergency funding in the event of a disruption in USD
money markets.
The end result of these actions was stabilization of the financial
system and the establishment of a precedent where the Fed would be
the lender of last resort for commercial banks, shadow banks, and
even foreign banks. During the 2020 COVID-19 panic, this precedent
was even more firmly established as the Fed promptly rolled out
virtually all the 2008 crisis-era 13(3) facilities. They even went one
step further and took upon themselves the responsibility of being the
lender of last resort to private businesses.

In March and April of 2020, the Fed announced new facilities that
were targeted at lending to small businesses through commercial
banks and larger businesses through the capital markets.68 The
Primary and Secondary Corporate Facilities would buy corporate
bonds in the primary and secondary market, while the Main Street
Lending Facility offered to buy eligible loans that commercial banks
had made to small businesses. The Fed had firmly stepped beyond its
traditional role of offering liquidity to commercial banks, to offering
liquidity to virtually all of America’s businesses. They had
democratized access to their balance sheet to virtually everyone but
individuals.

One common critique to the Fed’s expansion of lending powers is

moral hazard, which is when someone acts recklessly because they
know they are insulated from the consequences. During the 2008
crisis, many commentators suggested that bailing out investors who
made poor decisions would encourage more poor decision-making,
because now investors would think that the Fed would be there to
bail them out. This thinking contributed to the decision to allow
investment bank Lehman Brothers to fail. The failure of Lehman
Brothers precipitated declines in financial assets that were so
terrifying that even those afraid of moral hazard no longer stood in
the way.

The Fed chose to address moral hazard in another way: regulation.

In the aftermath of the crisis, the Fed and regulators across the world
enacted much more stringent regulation on banks such that they
would be unable to undertake the levels of risk they had before.
Therefore, the banks would unlikely ever need another Fed bailout.
These reforms appear to have been successful, as domestic
commercial banks sailed through the COVID-19 panic with little
issue.

New regulations were also used to reform major shadow banks like
the primary dealers and money market funds. These sectors also
sailed through the COVID-19 panic with ease, with only the prime
money market funds experiencing some trouble. However, other
shadow banks like mREITs, ETFs, and private investment funds
were not subject to enhanced regulation. Many of these entities
suffered large losses during the COVID-19 panic and were only saved
by Fed actions.

Reaching Across the Curve

In 2008, the Fed reached the zero lower bound, where the overnight
interest rate is 0%, which on its face seemed like a point where
monetary policy would become powerless as the Fed could no longer
lower interest rates. But the Fed was able to surprise everyone with
the introduction of two new tools: forward guidance and quantitative
easing.
Forward guidance is a way for the Fed to extend its control of
interest rates from short-term rates to medium-term rates as well.
The Fed would verbally commit to keep its policy rate low for an
extended period of time. As long as the market believed in the Fed’s
commitment, then even medium-term interest rates should move
lower as the market would price out any rate hikes from the present
to medium term. The interest-rate curve during a recession is usually
upwards sloping with 2-year Treasuries at higher yields than the
overnight policy rate. This is because the market expects that the
economy will gradually rebound and prompt the Fed to raise its
policy rates, so overnight rates in the future will be higher than they
are today. Under forward guidance, the curve becomes much flatter
because the Fed is committing to keeping its policy rate low even if
the economy recovers.

In June 2019, the Treasury curve was inverted, suggesting a near-

term recession in which the Fed would soon cut overnight rates,
leading to a steeper curve. A year later, the recession arrived and the
curve both steepened and flattened. Chair Powell said in his June
2020 press conference, “we’re not even thinking about thinking
about raising rates.”69 The market priced out any rate hikes for the
next few years.
There are different ways that the Fed can implement forward
guidance. It can do so by committing to keeping rates low until
specific economic performance targets are met or for specific lengths
of time. For example, the Fed can commit to keeping interest rates at
zero until inflation rises sustainably above 2%, until the
unemployment rate drops below 4%, or for a minimum of 2 years,
etc. In the aftermath of the 2008 crisis, the Fed has used both types
of guidance, initially relying on lengths of time and then relying more
on economic targets. Forward guidance appeared to be well
understood by the market, but it also appeared to lead to more
volatility around important data releases as market participants
directly linked movement towards economic targets with Fed action.

Quantitative easing is a way for the Fed to control longer-term

interest rates by purchasing longer-dated Treasury bonds and thus
driving the yields of those bonds lower. When it was first announced,
quantitative easing understandably generated an enormous amount
of controversy. Many feared imminent hyperinflation, and the price
of gold skyrocketed. Obviously, hyperinflation did not occur.
Purchasing Treasury securities by printing central bank reserves was
like printing a $100 bill and using it to buy another $100 bill. The
amount of money in the system didn’t change, just the composition
of it. There were now fewer Treasury securities and more central
bank reserves.

Research conducted by the Fed suggests that quantitative easing was

effective in lowering longer-term interest rates, which helped
stimulate economic activity.70 Even without research, basic supply
and demand dynamics suggests that buying trillions in Treasury
securities would exert upward pressure on their price (downward
pressure on yields). However, quantitative easing also did not appear
to have significant side effects. After over a decade of use, the Fed
has become comfortable with quantitative easing and deployed it in
size during the COVID-19 panic.

Both forward guidance and quantitative easing have moved from

unconventional to conventional parts of the Fed’s toolkit after over a
decade of use. They have both proven effective in influencing the
level of interest rates. In 2020, the Fed has also begun preliminary
discussions of yield curve control (YCC), which would potentially
allow even more precise control of interest rates. YCC is when a
central bank announces specific numeric targets for its interest rates.
Note that YCC was actually first used during World War II when the
Fed sought to support the war by keeping interest rates low. Interest-
rate control under YCC is likely to require fewer central bank bond
purchases as market participants know the central bank is willing
and able to enforce its expressed interest-rate target with unlimited
purchases.
Yield curve control is one of the new monetary policy tools gaining
traction in the central banking community. The Bank of Japan was
the first major central bank to implement YCC when it announced in
2016 that it would anchor the yield of the 10-year Japanese
Government Bond (JGB) to around 0%. Interestingly, the BOJ
announced YCC not to keep interest rates low but to raise them.
Before YCC, the 10-year JGB was trading around -0.5%. The BOJ
hoped that by raising the 10-year yield, the JGB interest-rate curve
would steepen and encourage the commercial banks to lend. The
BOJ has been successful in implementing YCC, with JGB yields
staying within a narrow band around 0% since the announcement.

In early 2020, the Reserve Bank of Australia (RBA) became the

second major central bank to implement YCC. The RBA announced
that it would peg the yields of the 3-year Australian government
bond to 0.25%. The announcement alone was sufficient to move the
3-year interest rates to 0.25%. The intention of the policy was to
stimulate the economy through lower rates, as many of Australia’s
mortgages and corporate debt are around the 3-year tenor. The RBA
was able to implement this target with little more than an
announcement.

Does Lowering Interest Rates Really Work?

Modern central banking dogma dictates that lower interest rates

can spur economic growth, which is why central banks are so eager
to lower rates during a recession. However, the evidence suggests
that interest rates and economic growth are not negatively
correlated but positively correlated, so interest rates tend to
increase along with economic growth.71 This may in part explain
why low (and even negative) interest rates in many advanced
economies for the past decade failed to produce meaningful
economic growth.

Suppose there were no central bank. When the economy is

booming and optimism abounds, then there is a strong demand for
loans. People feel confident about the future and they want to
borrow money, even if interest rates are high. This increased
demand for money leads to higher interest rates. On the other
hand, when economic storms are brewing and people don’t feel
confident about the future, then they don’t borrow. They try to pay
down their loans in anticipation of harder times. As demand for
money declines, so do interest rates. Even without the Fed,
interest rates would still follow the business cycle.

The Fed controls short-term interest rates, and it influences

longer-term interest rates. Borrowers usually save a little money
on their business loans or mortgage loans when the Fed lowers
rates. A business or consumer may take out a loan at a 4% interest
rate that they would not have taken out at 6%. But would they have
taken out a loan at 2% that they would not have taken out at 3%?
Even if lowering rates stimulates the economy, it likely has
diminishing effects.

Taking low interest rates to the next level, Japan and the Eurozone
faithfully followed their economic models and took their interest
rates to negative territory. Economists at the ECB believe that
negative rates encourage growth by forcing companies to invest
rather than see their money disappear via negative interest rates.72
In a sense, negative rates are like a tax on cash that is designed to
force spending. Notwithstanding the research out of the ECB, the
Eurozone economy has had poor growth for many years.

Negative interest rates appear to have a negative impact on bank

profitability. Negative interest rates are implemented on central
bank reserves, so in aggregate, it reduces the income of the
banking sector. It also shifts the entire interest-rate curve lower, so
loans earn less interest. Notably, European banks have been
suffering declining stock prices for over ten years, while U.S. banks
have been able to exceed their 2008 highs. The negative impact on
the banking sector is one of the reasons U.S. policy makers are
hesitant to implement negative rates. A healthy banking sector is
needed to create loans that fund economic growth.

However, low or negative short-term interest rates can have

tremendous impact on financial assets. This is because many
speculators buy financial assets using very short-term loans. When
the Fed lowers overnight rates by 1%, that fully flows through to
overnight repo rates and stock market margin interest rates.
Suppose an investor had bought $1 million in bonds yielding 3%
interest using a repo loan at 2%. Then a decline of short-term rates
of 1% would cut their interest expenses by 50% and significantly
widen their interest margin. They would now even be willing to
purchase bonds at lower yields (thus higher bond prices) since
their interest expenses have been lowered.

Judging from a decade of experience, lower interest rates appear

to boost financial assets, but not necessarily real economic growth.
Chapter 9 — How to Fed Watch

The huge impact Fed decisions have on the markets has led to the
growth of a cottage industry of “Fed Watchers.” These people, often
holding the title of Strategist or Economist, tend to be people who
worked for a few years at the Fed and then decided to double their
income by joining an investment bank. They spend their time
analyzing Fed actions and then share their analysis with wealthy
clients or large institutional investors. They will also go on CNBC or
Bloomberg and speculate on future Fed actions. Sometimes they
have good insights, but most of the work they do can be done by
anyone with the right information and training. This chapter will
teach you the basics of Fed Watching.

Prior to the 2008 Financial Crisis, Fed actions were very opaque. In
fact, sometimes the market would be surprised by the Fed’s interest-
rate decisions. This rarely happens anymore; the market now
anticipates Fed actions accurately. This is due to the Fed’s effort to
improve transparency by sharing its thinking with the market. The
basics of being a Fed Watcher are keeping on top of what the Fed is
currently thinking, and then predicting how the Fed will behave in
the future. The sections below will review the channels the Fed uses
to communicate with the market.

Fed Communication and Importance

FOMC Statement High
 FOMC Press Conference High
FOMC Minutes High
FOMC “Dot Plot” High
Fed Official Speeches Moderate
Fed Interviews Moderate
Desk Operating Statements Moderate
Fed Balance Sheet Moderate
Fed Research Low
Fed Surveys Low

FOMC Statement

The Federal Open Market Committee (FOMC) releases a statement

at the conclusion of each its meeting. The statement briefly
summarizes the FOMC’s view on the state of the economy and the
actions the FOMC is taking to achieve its duel mandate. While no
more than a page in length, the FOMC statement is very, very
carefully worded to convey a precise message. Market commentators
will compare current and previous statements to gauge changes in
the committee’s view from slight changes in wording. Declassified
FOMC materials illustrate just how much thought goes into the brief
statement.

The table on the following page comes from the Tealbook B prepared
for the January 2014 FOMC meeting. Tealbook B, officially titled
“Monetary Policy: Strategies and Alternatives” is a briefing prepared
for each meeting that presents the committee with sets of policy
options. The briefing is highly classified but is declassified to the
public several years after publication. From the declassified briefing,
you can see that the FOMC was presented with different options
varying in their degree of dovishness, like a choose your own
adventure script. The options show a high degree of nuance in how
the Fed can proceed. With respect to language, the different choices
express different degrees of optimism in the economy. With respect
to balance sheet policies, the options show different degrees of
accommodation by adjusting the pace of Fed QE. With respect to the
funds rate, the options express very subtle differences in how soon
the Fed may raise rates.

At each meeting, the FOMC will review the current briefing, discuss
their view of the economy, and then vote on which courses of action
to undertake.
FOMC Press Conference
Each FOMC meeting ends with a one-hour press conference starting
at 2:30 p.m. EST where the Fed Chair takes questions from the press.
These press conferences are one of the most important points of Fed
communication. Here, the Fed Chair is asked about a wide range of
topics and the market receives their most up-to-date thinking on
them. More importantly, this is on-the-fly speech that is not heavily
edited and reviewed like other FOMC communications. The market
watches the Chair’s reactions and parses their words to guess future
Fed actions. The Fed Chair also knows this is an opportunity to guide
the markets, so may purposefully choose their words.

As discussed in the previous chapter, Chair Powell noted in his June

2020 FOMC press conference that he was not just not going to raise
rates, but that he was “not even thinking about thinking about
raising rates.” With the prospect of a deep recession looming, the
Chair used the opportunity to signal to the market that rates would
be at zero for a very long time. Recall, the Fed controls short-term
interest rates but only influences longer-term interest rates. The
Chair was conducting money policy by attempting to push longer-
term interest rates lower by telling the market that short-term
interest rates would remain low for a long time. He wanted the
market to not price in any rate hikes for a long time.

FOMC Minutes

The minutes for each FOMC meeting are released three weeks after
the meeting takes place. The minutes offer a glimpse of what
information was presented to the FOMC and what they discussed
during the meeting. While FOMC statements are succinct, the
minutes are usually around ten pages. Like the statement, the
minutes are very carefully crafted to convey a specific message and
the market’s reaction to them is carefully monitored.

The first part of the minutes reviews the economic and financial
conditions of the intermeeting period, then there is a forecast of
economic conditions, and finally, there is a segment where FOMC
participants discuss their views. The first two segments are put
together by the Desk and Federal Reserve Board staff. The review of
intermeeting period developments will largely be factual, but the
Board’s economic outlook is useful in informing future Fed actions. A
downbeat assessment suggests a more accommodative policy.

Despite receiving a briefing on economic conditions at the meeting,

each FOMC participant also has their own staff of economists and
may have a different viewpoint based on the data they see in their
respective district. The minutes will reveal some of the discussions
that took place during the meeting but in an anonymized fashion.
This will give the reader a sense as to the overall viewpoints held by
FOMC participants by quantifying support for each viewpoint with
words such as “majority” or “a number” or “a couple.” Remember,
every word in the minutes is carefully drafted and goes through
many levels of review so that the intended message is communicated.

For example, the July 2020 FOMC minutes noted:

“A majority of participants commented on yield caps and targets—

approaches that cap or target interest rates along the yield curve—as
a monetary policy tool. Of those participants who discussed this
option, most judged that yield caps and targets would likely provide
only modest benefits in the current environment, as the Committee’s
forward guidance regarding the path of the federal funds rate already
appeared highly credible and longer-term interest rates were already
low. Many of these participants also pointed to potential costs
associated with yield caps and targets.”73

This segment was crafted to offer the reader a sense of how strongly
yield curve control was supported within the FOMC. Yield curve
control had been frequently discussed by FOMC members in the
earlier months, but the minutes revealed that FOMC support was not
strong. Treasury yields rose after the minutes were announced,
suggesting that some market participants adjusted their bets after
this new information.

The minutes often foreshadow policy moves in coming months. For

example, in January 2018, the FOMC Minutes showed discussion of
a “technical adjustment” on the interest paid on bank reserves to
control the federal funds market. That technical adjustment was not
discussed at the press conference at the time but was later
implemented. The minutes for the April 2020 FOMC meeting
contained a discussion on raising the interest rate on Fed repo loans.
That was also not discussed at the press conference at the time but
was later implemented. Fed Watchers had noticed these clues in the
minutes and were expecting the actions before they took place.

FOMC “Dot Plot”

Starting in late 2007, the Fed began releasing a set of economic

projections (“Summary of Economic Projections”) every quarter at
the March, June, September, and December FOMC meetings. The
summary included projections on real economic growth, inflation,
and the unemployment rate. Later in 2012, the Fed added
projections for where the federal funds rate would be. Each FOMC
participant’s projection appears in the form of a dot of where the
participant believes the appropriate policy target range would be at
year-end of the specified year. The graph of the projections ends up
looking like a plot of dots.

The “dot plot” is a market-moving data release because it gives a

glimpse of what the trajectory of future policy rates could be and how
dispersed the views are of FOMC participants. This is more concrete
than the economic forecasts because it translates the forecasts into
interest-rate adjustments. The more consensus there is in the dot
plot, the more strongly the market will price in upcoming Fed action.
But the dot plot is not always a good forecast of what will happen.

In December of 2018, the Fed’s dot plot showed that a plurality of

FOMC member were penciling in three 0.25% rate hikes in 2019. The
target range for year-end 2018 was 2.25% to 2.5%, and the dot plot
showed a plurality of FOMC participants expected the target range at
year-end 2019 to be 3% to 3.25%. Furthermore, there appeared to be
widespread consensus on the FOMC that at least two hikes were
needed. After digesting the news, the stock market panicked and
dropped to multiyear lows in the following weeks. Thereafter, the
FOMC promptly did a complete roundabout in January and
announced that they would be cutting rates in 2019. The stock
market then strongly rebounded in the following months. When
financial conditions change, the Fed can also quickly change its
mind.
Federal Reserve Speeches

Federal Reserve Bank Presidents and Federal Reserve Board

Governors routinely give speeches on how they are thinking about
monetary policy.74 They don’t always agree, and some of them are
much more important than others.

The voting body of the FOMC is composed of the Board Governors,

the President of the New York Fed, and a set of four Presidents from
the regional Federal Reserve Banks that rotates annually. Within the
FOMC, the most influential people are the Chair, the Vice Chair, and
the President of the New York Fed (who is also a Vice Chair). These
three are called the “troika” and have the most power on the FOMC,
so their thoughts must be given the most weight. In 2019, New York
Fed President John Williams gave a speech suggesting that when
interest rates are low, the Fed has less ammunition to combat
recessions, so it should cut rates more aggressively.75 In 2020, when
the COVID-19 recession arrived, the Fed did exactly that and quickly
cut rates to 0%. That move had been anticipated days before by
short-term interest-rate futures traders, who were no doubt attuned
the William’s thinking.

In November 2019, Fed Governor Lael Brainard gave a speech

speculating on the usefulness of yield curve control.76 Chair Powell
has also acknowledged some discussion of yield curve control at Fed
meetings. This led many Fed Watchers to assign a high probability of
the Fed implementing yield curve control in the near term. The Fed
is very cautious institution, so if a policy change is mentioned in a
speech, then it is already being seriously discussed internally. But
then, economic conditions changed as the COVID-19 panic occurred,
and Treasury yields plummeted. FOMC meeting minutes then
suggested that yield curve control had been placed on the backburner
but could be revived later.

FOMC members are generally labeled as either “doves” or “hawks”

based on the views that they reveal. Doves prefer more
accommodative monetary policy, while hawks prefer less
accommodative monetary policy. Some Fed Presidents are well-
known for always advocating lower rates and more quantitative
easing, and some are known for the opposite. Fed Watchers can
review the speeches given by each Fed president to see where they
stand, then look to see who will rotate to a voting position next year
to guess how the FOMC may vote.
Fed Watchers take particular note when a dove turns hawkish or
when a hawk turns dovish. These shifts can foreshadow a shift in the
FOMC’s actions. For example, when even a Fed president known for
being dovish is pushing back on further easing, then further easing is
very unlikely.

Fed Interviews and Congressional Testimonies

Fed officials generally have a preset schedule as to when they will

communicate with the market. There are prescheduled FOMC
meetings, industry group conferences, or other events. But they
always have the option of just calling up the press and giving an
unscheduled interview. Sometimes this occurs when the Fed thinks
the market has misunderstood them and they want to correct the
misunderstanding before it gets out of hand. If the Fed Chair or Vice
Chair ever suddenly gives an unscheduled interview, then it should
be taken seriously.

Ahead of the March of 2017 FOMC meeting, short-term interest-rate

markets were not pricing in any Fed action despite recent positive
economic data. Fed officials then came out with a series of interviews
that strongly hinted at a rate hike at the March FOMC meeting.77
Short-term interest-rate traders took heed and began pricing it in.
The FOMC delivered that hike shortly after. Remember, the modern
era Fed doesn’t want to surprise the market too much because it does
not like volatility in financial asset prices.

The Fed Chair appears before Congress twice a year at the

Humphrey-Hawkins hearings (also known as Monetary Policy
Report). During the hearings, the Chair offers testimony on financial
and economic developments as well as Fed actions. The Chair will
also take questions from members of Congress. While these hearings
generate significant publicity, they usually don’t reveal anything new.
The Chair will largely repeat things they have said during prior
FOMC press briefings, and members of Congress will largely take the
opportunity to grandstand.

Desk Operating Statements

The Fed buys and sells securities through the Open Markets Desk,
known as the Desk. The Desk releases its operating policies and
operating calendar on the Federal Reserve Bank of New York’s
website. This information can tell you a bit about how the Fed is
thinking about the financial markets.

During the 2020 COVID-19 panic, the Desk issued a statement on

March 23rd noting they would be buying an eye-popping $75 billion
in Treasuries each day.78 Over time, they tapered that amount to
around $80 billion a month, which is still substantial. From this
information, Fed Watchers could extrapolate the amount of liquidity
the Fed was pumping into the financial system and then suggest
implications that may have on interest rates and stock prices. Many
market commentators saw this and believed the stock market would
explode higher, which it did.

In June 2020, the Desk announced it would raise the minimum

offering rate of their repo lending facility from 0.1% to 0.15%. This
caused Treasury bill yields to also increase slightly as market
participants speculated the move would place slight upward pressure
on all short-term rates. Primary dealers’ bargaining position with
cash lenders would weaken as rates on borrowing from the Fed, their
alternative funding source, moved up from 0.1% to 0.15%. Private
sector lenders would have a bit more bargaining power to demand
returns greater than 0.1%.

The Desk also posts the results of their daily operations immediately
after they have concluded. Throughout the day they will post the
results of their repo and reverse repo operations, MBS purchases,
Treasury purchases, and securities lending. Fed Watchers notice
changes in these operations and infer from them changes in the
markets. For example, when participation in the Desk’s reverse repo
operation gradually increases, that implies that money market fund
investors are having trouble finding higher-yielding private sector
investments and are thus forced to park their money at the Fed. That
usually means that there is an abundance of liquidity in the financial
system and suggests that money market rates will remain low for the
near future.

Fed Balance Sheet

Fed Watchers have become increasingly interested in the Fed’s

balance sheet as that has become a bigger part of the Fed’s tool kit.
They want to know whether it is growing, and if so, what assets are
driving the growth. They use this information to predict what may
happen to the financial markets. Generally, they assume that if the
Fed is expanding its balance sheet, then interest rates will move
lower and the stock market will move higher. Higher participation in
some credit facilities may also be an indicator of stress in some
segments of the market.
The Fed publicly discloses its balance sheet weekly in the H.4,
published online every Thursday afternoon. Highlights in the H.4
include the amount of bank reserves held by commercial banks, the
amount of Treasury and Agency MBS securities the Fed holds, and
the size of special Fed credit facilities, as well as the amount
securities held on behalf of foreign official accounts.

Reserves and Securities Holdings. Reserves and securities holdings

are the flip side of each other, as reserves are created to pay for the
securities that the Fed purchases.

Fed Credit Facilities. In times of significant market stress, the Fed

offers special credit facilities to support certain segments of the
market. In the 2020 COVID-19 panic, the Fed announced the return
of several 2008 Financial Crisis–era facilities and added a few new
ones. The outstanding loan balances under these facilities are
disclosed weekly. The degree to which these facilities are utilized
helps market participants gauge the severity of market strains. For
example, the outstanding balance of FX-swap trades with foreign
central banks rose to almost half a trillion dollars in April. In the
same period, private market FX-swap basis exploded higher and the
dollar strengthened considerably. However, the FX swaps
outstanding at the Fed gradually declined after April as markers of
offshore dollar funding stress also receded. Taken together, this
suggests that there was tremendous amount of stress in the offshore
dollar funding markets during COVID-19 panic, and those stresses
were solved by half a trillion dollars in Fed liquidity.

FIMA Accounts. The Fed provides banking services to the foreign

official sector clients, such as foreign central banks, foreign
governments, or international organizations. The Fed provides them
with two main services: a collateralized “checking account” and
custodial services for their securities. The collateralized “checking
account” is structured as a repo transaction, where the foreign
official sector clients lend money to the Fed in the form of a repo
loan. In practice, it is basically a checking account collateralized by
Treasury securities. Many foreign official sector clients also hold
their dollar reserve in the form of Treasury securities to earn a higher
return. The Fed can act as the custodian for these securities.

Many foreign official sector clients prefer to hold their dollar reserves
with the Fed because it is a risk-free counterparty. However, some
also hold at least a portion of their dollar reserves with commercial
banks. This could be because the commercial banks provide a more
comprehensive product suite and offer higher interest rates, or for
diversification reasons should geopolitical risks emerge. Market
participants note when those Treasury holdings decline, because that
suggests that foreign central banks are selling their Treasuries and
using the dollars to intervene in the currency market.

Desk Surveys

The Desk regularly surveys market participants to try to figure out

what the market is thinking. The surveys go out to the primary
dealers, as well as a select group of market participants that include
many of the world’s largest investment funds.79 Survey questions
usually contain a standard set of questions on expectations of the
policy rate, growth, inflation, and unemployment, and then some
questions that are topical. For example, when the Fed was
normalizing its balance sheet, the survey contained questions on the
estimated future levels of reserve balances.
The surveys are used to try to figure out what is priced into the
market so the FOMC can properly calibrate their actions. While some
form of market expectations is readily observable in market pricing,
the distribution of the outcomes is not. For example, amidst the
Covid-19 panic in early March of 2020, the Fed funds futures market
implied that the FOMC would cut rates another 0.5% at the
scheduled March 17th meeting right after it had cut rates by 0.5% to
1% at an unscheduled emergency meeting on March 3rd. The March
2020 survey revealed that there was an unusually high degree of
dispersion in expectations, where most respondents expected a 0.5%
cut at the upcoming meeting but over a quarter of respondents
expected a full 1% cut to 0%. Market pricing thus reflected the
median participant but hid a large left tail expectation. This
information is useful because the FOMC tries not to surprise the
market too much, which could result in significant volatility. In the
end, the FOMC cut by 1%, delivering a dovish but not totally
unexpected surprise to the market.

In another example, the January 2014 Desk surveys revealed that

market participants largely expected a slight cut of $10 billion in the
monthly rate of asset purchases at the upcoming meeting. With that
as the baseline expectation, the FOMC determined that a policy of no
cuts in the rate of purchases would be perceived as dovish, while cuts
of greater than $10 billion would be perceived as hawkish. The
FOMC ultimately decided to meet the market’s expectations. But if it
wanted to slightly surprise the market in either direction, it knew
from the surveys how to do that.

The Desk survey questionnaires are publicly available on the New

York Fed’s website around two weeks before an upcoming FOMC
meeting, and the results of the survey are publicly available about 3
weeks after the FOMC meeting. The questions can help a Fed
Watcher understand what the Fed is currently interested in, and the
results can help in understanding Fed policy actions.

Federal Reserve Research

Each Federal Reserve Bank has a large staff of PhD economists who
regularly publish economic research either in the form of research
papers or blog posts. The research published does not necessarily
reflect the views of Fed officials but is rather an outlet for staff
economists to share their personal views and findings. The Fed is a
very large and bureaucratic organization, so it should not be
surprising to see a wide range of views that sometimes conflict. Fed
economists have access to significant amounts of confidential data,
so their research findings offer an opportunity to learn about the
latest developments in markets. It may not add much insight as to
what the FOMC will do next, but following staff research is a good
way to continually educate yourself. A couple noteworthy Fed outlets
are the New York Fed’s Liberty Street Economics blog and the Board
of Governor’s FEDS Notes section. In addition, the Board of
Governors’ semiannual Financial Stability Report is an excellent and
accessible publication that provides a good overview of the state of
the financial system based on the data the Fed has collected.

Federal Reserve Surveys

The Federal Reserve Banks and the Board of Governors conduct

surveys to gather qualitative information on economic conditions. A
couple of the more notable surveys are the Beige Book and the Senior
Loan Officer Survey. These surveys are not market moving but help
in understanding how the Fed is viewing the economy.

The Beige Book, published eight times a year, is a compilation of

anecdotes from business leaders in each Federal Reserve district.
Federal Reserve staff conduct outreach to business contacts in their
district and record their findings, particularly regarding information
that pertains to employment and price changes. The Beige Book
complements the Fed’s trove of hard data by offering narrative
context as to what is happening across regions and industries.

The Senior Loan Officer Survey, published quarterly, goes out to

executives at commercial banks and is aimed at helping the Fed
understand changes in credit conditions. The Fed wants to know if
lending standards are tightening or loosening, since the availability
of credit is a key economic indicator. When banks tighten up their
lending then there is less money flowing through the system, which
could be a headwind for economic growth.

What Do You Think the Fed Will Do?

A Fed Watcher will have to keep on top of all the communications

discussed in this chapter and then formulate a view as to what the
Fed is thinking and what the Fed will do.

Carefully reviewing all Fed communication will make you an average

Fed Watcher that will be fairly accurate in benign economic
conditions but inaccurate in crisis times. When something serious
happens, then even the Fed is in disarray. To figure out what they
will do, you would also have to be aware of how the financial system
works, where the system may be breaking, and what tools the Fed
has available to fix them. If you understand the concepts presented
throughout this book and keep on top of Fed communications, you
will be well on your way to being an expert Fed Watcher.

The New Framework

On August 27, 2020, Chair Powell announced the Fed’s new
monetary policy framework at the annual Jackson Hole Economic
Policy Symposium.80 The framework made two significant changes
to how the Fed conducts monetary policy: average inflation targeting
and asymmetry in maximum employment.

Asymmetry in Maximum Employment

Maximum employment is one of the Fed’s duel mandates. To that

end, the Fed’s strategy statement previously noted that its policy is
informed by “deviations from [employment’s] maximum level.” That
meant that the policy rate could be raised when employment
exceeded its maximum level and could be lowered when employment
was below its maximum level. In its new strategy statement, the Fed
now notes its policy would be informed by “assessments of the
shortfalls of employment from its maximum level.” This means that
employment higher than the Fed’s estimated maximum level would
not encourage the Fed the raise its policy rate.

Chair Powell noted in his speech that this change is in part due to the
difficulty in calculating the maximum level of employment, and the
flattening of the Phillips curve. The Phillips curve is a concept in
economics that links the unemployment rate with inflation, where a
lower unemployment rate would generate higher inflation.
Specifically, inflation would rise when the economy exceeded its
maximum employment. However, in recent years, the link between
unemployment and inflation seems to have significantly weakened.
Unemployment in 2019 fell to multi-decade lows of around 3.5%, yet
inflation continued to be below 2%.

This puzzle suggests either that the maximum level of employment is

higher than the Fed estimates or that the link between employment
and inflation has changed. In either case, the Fed cannot operate on
the same framework it has previously used when looking at
employment data. Hence, the Fed is now saying that a low
unemployment rate (high levels of employment) will no longer factor
into its decision in tightening monetary policy.

Average Inflation Targeting

The Fed’s second mandate is to maintain stable prices, which has

been interpreted as an inflation target of 2% on the Personal
Consumption Expenditures (PCE) index. For most of the past
decade, the PCE was comfortably below the Fed’s target. This
persistent underperformance has led the Fed to change the way it
implements its mandate.

The Fed has officially adopted an average inflation targeting

framework where past undershoots of its inflation target would be
met with future overshoots, such that the average inflation over a
period of time would be around 2%. This opens the door to the Fed
allowing persistent prints of inflation over 2%, which would not have
been allowed under the prior framework.

Critics note that the Fed has not been able to meet its 2% inflation
target for the past several years, so it is unlikely to move inflation to
an even higher level to compensate for prior shortfalls. Yet, PCE
inflation did occasionally exceed 2% even as the Fed hiked rates
several times. If the Fed had not hiked rates at all, inflation may have
persisted at levels exceeding 2%. The verdict on the effectiveness of
the Fed’s new framework won’t become clear for another few years,
but the bond market seemed to offer some degree of confidence in
the Fed. After the new framework announced, the Treasury yield
curve steepened, suggesting that at least some market participants
anticipate higher inflation in the future.

Inflation is largely a political choice. Any government can create

inflation with massive fiscal spending, and any government can
create deflation by massively raising taxes. The Fed has made the
choice of keeping interest rates low for a long time; should the
Federal government decide to continue massive deficit spending,
then the chances of higher inflation in the future are very good.
Modern Monetary Theory

Modern Monetary Theory (“MMT”) is an ascendent school of

economic thought that is laying the theoretical framework for a
revolution in fiscal policy.81 MMT postulates that a government
issuer of fiat currency is not constrained by taxation or debt, but
only by inflation. Taxation and debt issuance are merely tools
through which the government manages inflation. This is in stark
contrast to economic orthodoxy, which tends to negatively view
deficit spending and high government debt levels.

Conventional economic thinking views a country like a household,

where living beyond one’s means and going into debt means leaner
times ahead. A country with a high debt load would have to
increase taxes on future generations to repay the debt. Too much
debt may also lead investors to demand higher interest rates,
further dampening economic growth. Adherents to this school of
thought caution against government deficits and strive for a
balanced budget.

Proponents of MMT note that the government can simply print

more money to fund its spending. The government does not need
to borrow or to tax, but it should use those tools to combat
inflation. When the government engages in deficit spending it is
actually boosting economic growth by creating money and
spending it on goods and services. Deficit spending and high debt
loads are not a source of concern and can be good for the economy,
provided inflation is under control.

Consciously or coincidentally, the MMT revolution appears to have

quietly taken over the world. Governments across the world are
becoming more and more aggressive in fiscal spending and less
concerned of sovereign debt loads. The U.S. deficit has gone
parabolic and is running at over $3 trillion in 2020. Central banks
have made this revolution possible by keeping interest rates low
and funding government spending by purchasing large quantities
of government debt. The economy has responded positively to the
massive fiscal stimulus. More importantly, there appears to be no
consequence to this behavior, as inflation remains subdued,
interest rates remain historically low and currency markets remain
stable. The bond vigilantes that fiscal hawks feared appear to be
fairy tales.

MMT is largely correct in describing how the monetary system

works, but they may have misunderstood the purpose of the bond
vigilante fairy tale. A government budget is a constraint on
government power, like the Bill of Rights, the separation of
powers, and the Constitution. To remove that constraint grants the
government unlimited spending powers, which may or may not be
wisely used.
History shows over and over again that government officials are
neither wiser nor less self-interested than any other person. A
monetary system is only as strong as the confidence placed in it,
and removing long held safeguards built into the monetary system
opens up the potential for great disaster.
1The vast majority of reserves are held by commercial banks, but a select group of other
institutions are also eligible to have reserve accounts at the Fed. These include government-
sponsored enterprises (GSEs) like Fannie Mae, clearing houses like CME, credit unions, and
the U.S. Treasury.
2 A commercial bank can convert its central bank reserves to fiat currency, which would
reduce central bank reserves and increase currency outstanding. But in practice, this is not a
meaningful level of activity since the bulk of transactions today are electronic and do not
involve fiat currency.
3 Repo loans, or repurchase agreements, are described in Chapter 6.
4For more details, see McLeay, Michael, Amar Radia, and Ryland Thomas. “Money
Creation in the Modern Economy.” Quarterly Bulletin. Bank of England, Q1 2014.
5Judson, Ruth. “The Death of Cash? Not So Fast: Demand for U.S. Currency at Home and
Abroad, 1990-2016.” In International Cash Conference 2017 – War on Cash: Is There a
Future for Cash? Deutsche Bundesbank, 2017.
https://econpapers.repec.org/paper/zbwiccp17/162910.htm.
6 It is also in part determined by central bank actions, where increases in reserves also
increase bank deposits.
7Powell, Jerome. “Monetary Policy in a Changing Economy.” Speech, August 24, 2018.
https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm.
8 Engen, Eric, Thomas Laubach, and Dave Reifschneider. “The Macroeconomic Effects of
the Federal Reserve’s Unconventional Monetary Policies.” Finance and Economics
Discussion Series 2015-005. Washington: Board of Governors of the Federal Reserve
System, 2015. http://dx.doi.org/10.17016/FEDS.2015.005.
9Anstey, Chris, and Hidenori Yamanaka. “Not a Single Japanese 10-Year Bond Traded
Tuesday.” Bloomberg, March 13, 2018. https://www.bloomberg.com/news/articles/2018-
03-14/not-a-single-japanese-10-year-bond-traded-tuesday-death-by-boj.
10In emergency circumstances, the Fed has also used large asset managers such as PIMCO
and Blackrock to manage temporary programs such as the Commercial Paper Funding
Facility.
11All Treasury trading with the Fed is done through the Fed’s proprietary trading software,
FedTrade. The Fed puts out an operational schedule telling the primary dealers when they
will be operating, and then the primary dealer participates.
12For a current list of primary dealers, see
https://www.newyorkfed.org/markets/primarydealers.html.
13“Federal Reserve Announces Two Initiatives Designed to Bolster Market Liquidity and
Promote Orderly Market Functioning.” Press Release. Board of Governors of the Federal
Reserve System, March 16, 2008.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20080316a.htm.
14Baba, Naohiko, Robert McCauley, and Srichander Ramaswamy. “US Dollar Money
Market Funds and Non-US Banks.” BIS Quarterly Review, March 2009, 65–81.
https://www.bis.org/publ/qtrpdf/r_qt0903g.pdf.
15“Reserve Primary Fund Drops below $1 a Share amid Lehman Fall.” Reuters, September
16, 2008. https://www.reuters.com/article/us-reservefund-buck-
idUSN1669401520080916.
16 Schrimpf, Andreas, Hyun Song Shin, and Vladyslav Sushko. “Leverage and Margin Spirals
in Fixed Income Markets during the Covid-19 Crisis.” BIS Bulletin No 2. BIS, April 2, 2020.
https://www.bis.org/publ/bisbull02.htm.
17Basak, Sonali, Liz McCormick, Donal Griffin, and Hema Parmar. “Before Fed Acted,
Leverage Burned Hedge Funds in Treasury Market.” Bloomberg, March 19, 2020.
https://www.bloomberg.com/news/articles/2020-03-19/before-fed-acted-leverage-
burned-hedge-funds-in-treasury-trade.
18For more on the topic, see Covitz, Daniel M., J. Nellie Liang, and Gustavo A. Suarez. “The
Anatomy of a Financial Crisis: The Evolution of Panic-Driven Runs in the Asset-Backed
Commercial Paper Market.” Proceedings, Federal Reserve Bank of San Francisco, January
2009, 1–36.
19Gissler, Stefan, and Borghan Narajabad. “The Increased Role of the Federal Home Loan
Bank System in Funding Markets.” FEDS Notes. Board of Governors of the Federal Reserve
System, October 18, 2017. https://doi.org/10.17016/2380-7172.2070.
20Murau, Steffen, Joe Rini, and Armin Haas. “The Evolution of the Offshore US-Dollar
System: Past, Present and Four Possible Futures.” Journal of Institutional Economics,
2020, 1–17. https://doi.org/10.1017/S1744137420000168. See also He, Dong, and Robert
N. McCauley. “Eurodollar Banking and Currency Internationalisation.” BIS Quarterly
Review, June 2012, 33–46. https://www.bis.org/publ/qtrpdf/r_qt1206f.htm.
21BIS Working Group. “US Dollar Funding: An International Perspective.” CGFS Papers
No. 65. BIS Committee on the Global Financial System, June 2020.
https://www.bis.org/publ/cgfs65.htm.
22
McCauley, Robert N., and Hiro Ito. “A Key Currency View of Global Imbalances.” BIS
Working Papers No. 762. BIS, December 2018. https://www.bis.org/publ/work762.htm.
23McCauley, Robert N., Patrick McGuire, and Vladyslav Sushko. “Global Dollar Credit:
Links to US Monetary Policy and Leverage.” BIS Working Papers No. 483. BIS, January
2015. https://www.bis.org/publ/work483.htm.
24He, Dong, and Robert N. McCauley. “Offshore Markets for the Domestic Currency:
Monetary and Financial Stability Issues.” BIS Working Papers No. 320. BIS, September
2010. https://www.bis.org/publ/work320.htm.
25Aldasoro, Iñaki, and Torsten Ehlers. “The Geography of Dollar Funding of Non-US
Banks.” BIS Quarterly Review, December 2018, 15–26.
https://www.bis.org/publ/qtrpdf/r_qt1812b.htm.
26 Onshore deposit taking institutions have around $20 trillion in dollar liabilities, based on
the Federal Reserve’s H8 and the NCUA’s quarterly reports on credit unions. Foreign bank
dollar liabilities booked outside of the U.S. are around $10 trillion, based on BIS data. FDIC
reports show domestic banks have a $1.4 trillion in deposits in their offshore branches, but
its not clear how much of the deposits are denominated in dollars.
27He, Dong, and Robert N. McCauley. “Eurodollar Banking and Currency
Internationalisation.” BIS Quarterly Review, June 2012, 33–46.
https://www.bis.org/publ/qtrpdf/r_qt1206f.htm.
28 Ibid.
29Friedman, Milton. “The Euro-Dollar Market: Some First Principles.” Federal Reserve
Bank of St. Louis Review 53 (July 1971): 6–24. https://doi.org/10.20955/r.53.16-24.xqk.
30 This regulation is called the Liquidity Coverage Ratio.
31Kreicher, Lawrence L., Robert N. McCauley, and Patrick McGuire. “The 2011 FDIC
Assessment on Banks Managed Liabilities: Interest Rate and Balance-Sheet Responses.” BIS
Working Papers No. 413. BIS, May 2013. https://www.bis.org/publ/work413.htm.
32Jones, Sam, and Jude Webber. “Argentine Navy Ship Seized in Asset Fight.” Financial
Times, October 3, 2012. https://www.ft.com/content/edb12a4e-0d92-11e2-97a1-
00144feabdc0.
33He, Dong, and Robert N. McCauley. “Offshore Markets for the Domestic Currency:
Monetary and Financial Stability Issues.” BIS Working Papers No. 320. BIS, September
2010. https://www.bis.org/publ/work320.htm.
34“Foreign Portfolio Holdings of U.S. Securities as of 6/28/2019.” U.S. Treasury, April
2020. https://ticdata.treasury.gov/Publish/shl2019r.pdf.
35Aldasoro, Iñaki, Torsten Ehlers, Patrick McGuire, and Goetz von Peter. “Global Banks’
Dollar Funding Needs and Central Bank Swap Lines.” BIS Bulletin No. 27. BIS, July 16,
2020. https://www.bis.org/publ/bisbull27.htm.
36Some entities have reserve accounts at the Fed but do not earn interest on reserves. These
include Fannie, Freddie, and the Federal Home Loan Banks. Since these entities don’t earn
any interest on their reserves, they are willing to lend out their reserves at rates below
interest on reserves.
37 In practice, there are slightly more steps in extending the overnight risk-free rate (RRP
rate) to term risk-free rates. The overnight RRP rate influences the overnight Treasury repo
rate, which in turn influences term Treasury repo rates, which then affects the pricing of
Treasury bills. The RRP is an overnight reverse repo facility with a risk-free counterparty
(the Fed), so it directly affects the overnight reverse repo market.
38 In practice, LIBOR also contains a credit component. In times of severe market stress,
LIBOR can increase even if the Fed does not change its stance of policy. This is because the
risks of defaults rise.
39 In practice, there is still a spread between 3-month LIBOR and the Federal funds rate
that fluctuates over time. To more clearly tease out the expected path of short-term interest
rates would require a sophisticated model to account for that spread.
40Term premium calculations are complicated and very model dependent. Each model may
use different inputs, have different assumptions, and arrive at different values.
41Clarida, Richard. “Monetary Policy, Price Stability, and Equilibrium Bond Yields: Success
and Consequences.” Speech, November 12, 2019.
https://www.federalreserve.gov/newsevents/speech/clarida20191112a.htm.
42 U.S. Treasury. “Major Foreign Holders of Treasury Securities,”
https://ticdata.treasury.gov/Publish/mfh.txt.
43 This is the Maturity Extension Program, announced September 21, 2011.
44 Baklanova, Viktoria, Adam Copeland, and Rebecca McCaughrin. “Reference Guide to U.S.
Repo and Securities Lending Markets.” Staff Report No. 740. Federal Reserve Bank of New
York, December 2015.
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr740.pdf.
45See Federal Reserve Bank of New York. “Secured Overnight Financing Rate,”
https://apps.newyorkfed.org/markets/autorates/SOFR.
46 A fourth segment, the general collateral financing (GCF) market, has shrunk significantly
in recent years and is only around $100 billion. GCF is an interdealer market that is settled
in tri-party.
47For the latest data, see Federal Reserve Bank of New York. “Tri-Party/GCF Repo,”
https://www.newyorkfed.org/data-and-statistics/data-visualization/tri-party-repo.
48 Technically, a borrower enters in a spot FX transaction to buy foreign currency and
simultaneously enters into a forward transaction to sell that foreign currency. The forward
rate takes into account the interest rate differential and the basis. In a closely related
instrument, the FX basis swap, the two parties would exchange currency amounts, make
ongoing interest payments to each other that include the basis (if any), and then return the
same currency amounts at the end of the transaction. FX-swaps and FX basis swaps are
economically equivalent. For more information, see Baba, Naohiko, Frank Packer, and
Teppei Nagono. “The Basic Mechanics of FX Swaps and Cross-Currency Basis Swaps.” BIS
Quarterly Review, March 2008, 82. https://www.bis.org/publ/qtrpdf/r_qt0803z.htm.
49“Triennial Central Bank Survey of Foreign Exchange and Over-the-Counter (OTC)
Derivatives Markets in 2019.” BIS, 2019. https://www.bis.org/statistics/rpfx19.htm.
50 Coffey, Niall, Warren B Hrung, Hoai-Luu Nguyen, and Asani Sarkar. “The Global
Financial Crisis and Offshore Dollar Markets.” Federal Reserve Bank of New York Current
Issues in Economics and Finance 15, no. 6 (2009).
https://www.newyorkfed.org/research/current_issues/ci15-6.html.
51Commercial banks are also able to participate in capital markets but are not major
players. When a commercial bank lends in capital markets it takes an asset onto its balance
sheet and credits the bank account of the borrower with bank deposits. This is the same as a
bank-originated loan. Commercial banks occasionally issue equity and debt securities on
behalf of themselves that essentially reduce the aggregate level of bank deposits by
transforming some of the bank deposits into equity or debt. Commercial bank borrowing in
the capital markets thus reduces the amount of money in the banking system.
52 For a discussion on value premium see Fama, Eugene F., and Kenneth R. French.
“Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial
Economics 33, no. 1 (1993): 3–56. https://doi.org/10.1016/0304-405X(93)90023-5. For a
discussion on how changes in market structure have affected the value premium, see Green,
Mike, and Wayne Himelsein. “Talking Your Book About Value (Part 1).” Logica Capital, May
14, 2020. https://www.logicafunds.com/talking-your-book-about-value-1.
53 For more information, see the work of Mike Green at Logica Capital.
54Bernanke, Ben. “Aiding the Economy: What the Fed Did and Why.” Op-ed. Board of
Governors of the Federal Reserve System, November 5, 2010.
https://www.federalreserve.gov/newsevents/other/o_bernanke20101105a.htm
55Barber, Felix, and Michael Goold. “The Strategic Secret of Private Equity.” Harvard
Business Review, September 2007. https://hbr.org/2007/09/the-strategic-secret-of-
private-equity.
56 See www.squeezemetrics.com for daily estimates of dealer gamma positioning.
57Commercial banks can still be involved in the debt capital markets by borrowing or
lending. In the former case it essentially transforms bank deposit liabilities into longer-term
debt, which helps it manage its outflows. In the latter, it is functionally the same as making a
bank loan. When a commercial bank purchases a bond, it credits the sellers account with
freshly created bank deposits. The main difference between a bond and a loan is that bonds
are readily tradable, so they are much more liquid.
58CUSIP is an acronym for the “Committee on Uniform Securities Identification
Procedures,” the group that manages these numbers.
59These are under S&P ratings, which rates credit from highest to lowest as AAA, AA, A,
BBB, BB, B, and CCC, with an added plus or minus as in-between ratings. The two other
credit ratings agencies, Moody’s and Fitch, have comparable ratings systems. In practice, all
three major agencies usually give an issuer equivalent ratings.
60DeMarco, Laurie, Emily Liu, and Tim Schmidt-Eisenlohr. “Who Owns U.S. CLO
Securities? An Update by Tranche.” FED Notes. Board of Governors of the Federal Reserve
System, June 25, 2020. https://www.federalreserve.gov/econres/notes/feds-notes/who-
owns-us-clo-securities-an-update-by-tranche-20200625.htm.
61Santoli, Michael. “Apple’s Stock Gains the Last 4 Years Prove ‘Financial Engineering’ via
Buybacks Works.” CNBC, July 31, 2019. https://www.cnbc.com/2019/07/31/santoli-apples-
gains-are-largely-the-product-of-buyback-financial-engineering.html.
62 Agency MBS guaranteed by Ginnie Mae have no credit risk because Ginnie Mae is a part
of the federal government. Agency MBS issued by Fannie and Freddie benefit from an
implicit government guarantee. While they are not part of the federal government, it is
assumed that they are backed by the federal government. This assumption was tested during
the 2008 Financial Crisis and proved true when the federal government provided its full
support to Fannie and Freddie as they became insolvent.
63 Kaul, Karan, and Laurie Goodman. “Foreign Ownership of Agency MBS.” Ginnie Mae,
July 2019.
https://www.ginniemae.gov/newsroom/publications/Documents/foreign_ownership_mbs.
pdf.
64Shoemaker, Kayla. “Trends in Mortgage Origination and Servicing: Nonbanks in the Post-
Crisis Period.” FDIC Quarterly 13, no. 4 (2019): 51–69.
65Ospina, Juan, and Harald Uhlig. “Mortgage-Backed Securities and the Financial Crisis of
2008: A Post Mortem.” BFI Working Paper 2018-24. Becker Friedman Institute, April 2018.
http://dx.doi.org/10.2139/ssrn.3159552.
66 Discount basis means that it is sold for less than face value. For example, if a 1-month bill
is sold at 99 cents then that means the buyer will receive $1 upon repayment in a month. In
effect, they will earn 1 cent in a month, which annualizes to an annual interest rate of about
12%.
67For more information see “Overview of Treasury’s Office of Debt Management.”
https://home.treasury.gov/system/files/276/Debt-Management-Overview.pdf.
68 “Federal Reserve Announces Extensive New Measures to Support the Economy.” Press
Release. Board of Governors of the Federal Reserve System, March 23, 2020.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm;
“Federal Reserve Takes Additional Actions to Provide up to $2.3 Trillion in Loans to
Support the Economy.” Press Release. Board of Governors of the Federal Reserve System,
April 9, 2020.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.htm.
69 Powell, Jerome. “Transcript of Chair Powell’s Press Conference.” Press Conference. Board
of Governors of the Federal Reserve System, June 10, 2020.
https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20200610.pdf.
70 Kim, Kyungmin, Thomas Laubach, and Min Wei. “Macroeconomic Effects of Large-Scale
Asset Purchases: New Evidence.” Finance and Economics Discussion Series 2020-047.
Washington: Board of Governors of the Federal Reserve System, March 2020.
https://doi.org/10.17016/FEDS.2020.047.
71Lee, Kang-Soek, and Richard A. Werner. “Reconsidering Monetary Policy: An Empirical
Examination of the Relationship Between Interest Rates and Nominal GDP Growth in the
U.S., U.K., Germany and Japan.” Ecological Economics 146 (April 2018): 26–34.
https://doi.org/10.1016/j.ecolecon.2017.08.013.
72Altavilla, Carlo, Lorenzo Burlon, Mariassunta Giannetti, and Sarah Holton. “Is There a
Zero Lower Bound? The Effects of Negative Policy Rates on Banks and Firms.” Working
Paper No. 2289. European Central Bank, June 2019.
https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2289~1a3c04db25.en.pdf.
73 “Minutes of the Federal Open Market Committee, July 28-29, 2020.” Board of Governors
of the Federal Reserve System, August 19, 2020.
https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20200729.pdf.
(Emphasis added.)
74The St. Louis Fed has a webpage that can help you keep abreast of all the latest Fed
Speak.
75Williams, John C. “Living Life Near the ZLB.” Speech, July 18, 2019.
https://www.newyorkfed.org/newsevents/speeches/2019/wil190718.
76Brainard, Lael. “Federal Reserve Review of Monetary Policy Strategy, Tools, and
Communications: Some Preliminary Views.” Speech, November 26, 2019.
https://www.federalreserve.gov/newsevents/speech/brainard20191126a.htm.
77Condon, Christopher, and Rich Miller. “Fed Officials Signal More Willingness to Consider
March Hike.” Bloomberg, February 28, 2017.
https://www.bloomberg.com/news/articles/2017-02-28/fed-officials-signal-greater-
willingness-to-consider-march-hike.
78“Statement Regarding Treasury Securities and Agency Mortgage-Backed Securities
Operations.” Operating Policy. Federal Reserve Bank of New York, March 23, 2020.
https://www.newyorkfed.org/markets/opolicy/operating_policy_200323.
79The list of survey respondents is available on the Federal Reserve Bank of New York’s
website. A sample of firms include PIMCO, Citadel, Vanguard, D.E. Shaw, BlackRock, The
Carlyle Group, etc.
80 “Federal Open Market Committee Announces Approval of Updates to Its Statement on
Longer-Run Goals and Monetary Policy Strategy.” Press Release. Board of Governors of the
Federal Reserve System, August 27, 2020.
https://www.federalreserve.gov/newsevents/pressreleases/monetary20200827a.htm.
81For more information, see Kelton, Stephanie. The Deficit Myth: Modern Monetary
Theory and the Birth of the People’s Economy. (2020)