The horror scenario lurking in the plumbing of finance

We have the conflict between two gigantic, terrifying programs: ‘Basel reforms’ starring Godzilla, and ‘Fed asset purchases’ taking the place of Rodan, the flying monster

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When Hollywood was fully functional, horror movies were reliably released around Halloween or, sometimes, whenever there was a Friday the 13th. This year, however, the horror film will be shot in US Treasuries, the mother of all contemporary markets, during the summer and early fall.

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One of the strings that horror filmmakers pluck is the audience’s inability to warn the characters. “Don’t speak out to search the ruin in the dark forest!” “Don’t open that door – the man with the ax is on the other side!”

The equivalent fear that now hangs over the financial system is: “Don’t create an artificial shortage of good collateral! New! New!”

Just as the expendable teens always break up and then open the wrong doors, we can count on the US Federal Reserve and Congress to do the stupid things. In this case, that would be Congressional passivity regarding the artificial debt ceiling and the real (as opposed to rhetorical) budget. This nonsense limits the number of Treasury bills and short-term government bonds that can be issued.

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Federal Reserve Chairman Jerome Powell testifies before a hearing of the Senate Committee on Banking, Housing and Urban Affairs on July 15.
Federal Reserve Chairman Jerome Powell testifies before a hearing of the Senate Committee on Banking, Housing and Urban Affairs on July 15. Photo by Kevin Lamarque/Reuters Files

For its part, the Fed is locking up much of the short-term US government paper that may be available in accounts where it cannot be used to secure the myriad financial transactions that keep the global economy going. Kind of like the crazy teenage horror victim who loses the keys to the getaway car.

Most comments about central bank politics and the official provision of market liquidity revolve around bank reserves, and whether or not the Fed buys bonds to “add liquidity” in the form of cash to stimulate economic activity. This tends to ignore the key role of short-term Treasury bills, especially T-bills, as ‘good collateral’.

Short-term paper of the highest-rated government issuers, such as the US Treasury or the German government, can be lent and re-lent multiple times after purchase. This “collateral reuse” is a form of leverage that converts loans by trusted governments into liquidity for the global monetary system.

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Financial markets have always required collateral for many transactions, especially when buyers and sellers do not fully trust each other. But in the wake of the financial crisis, changes in banking regulations, known as Basel III, and new securities market rules have dramatically increased the demand for government securities as collateral.

As usual with disasters, it started with good intentions. For example, if a “Lehman Brothers” defaults on its obligations, its counterparties can claim collateral that keeps them solvent. And, perhaps as an afterthought, the regulator-driven demand for good collateral will make it easier for governments to fund themselves. Then they can send childcare checks, build highways, or send drones on revenge missions.

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Unfortunately, we now have the conflict between two gigantic and terrifying programs: “Basel Reforms” that stars Godzilla, and “Fed Asset Purchases” that take the place of Rodan, the Flying Monster.

The Basel reforms require the use of government securities to secure transactions. Purchases of Fed assets block that paper, not only in the form of longer-term assets, but also as the asset traded for cash through the now trillion dollar Reverse Repurchase Program.

Fed Chair Jay Powell seemed to finally acknowledge the problem during his recent testimony before the House Financial Services Committee. Towards the end of his appearance, he muttered like a scientist realizing that his experiment has gone very, very wrong, saying, “You could say there’s a shortage of safe short assets…so yeah, that’s why that happens, there is a shortage of T-bills, not many T-bills…”

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So government bond yields fall while many inflation measures go up. US money market funds can earn 0.05 percent using the RRP facility, but the securities that are collateral for their deposits cannot be re-lent. It would be better now if the big banks could expand their deposit base, buy notes and short-term bonds from the Treasury and the Fed and re-lend those securities for use in the collateral chain. The “Basel” rules need to be reconsidered.

Unless you believe in fairies and goodwill from all parties, there will be no solution to the debt ceiling and budget legislation before October or November, ie November.

At least until then, the shortage of collateral will continue to grow, which will slow down growth. And god help us if there is a global margin call – a demand for leveraged traders to place more collateral with counterparties – before then. The necessary paper is not there.

© 2021 The Financial Times Ltd

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