Naoto Takemoto, Simon Jurkatis and Nicholas Vause
In less than two decades, the system of market-based finance (MBF) – which involves mainly non-bank financial institutions (NBFIs) providing credit to the economy through bonds rather than loans – has both mitigated and amplified the economic effects of financial crises. It mitigated effects after the global financial crisis (GFC), when it substituted for banks in providing credit. But it amplified effects at the outbreak of the Covid pandemic, when NBFIs propagated a dash for cash (DFC), and more recently when pension fund gilt sales exacerbated increases in yields. This post outlines five different aspects of MBF that contribute to such amplification and summarises some policy proposals – suggested and debated internationally by regulators, academics and market participants – to make MBF more resilient.
1: Money market funds
When companies needed cash during the Covid pandemic, one of their main actions was to redeem their money market fund (MMF) shares. To help meet the resulting outflows, funds drew on their liquid asset buffers. However, the managers of any funds whose liquid-asset ratio fell below a certain threshold were required to consider imposing liquidation fees or redemption gates, which could have disadvantaged remaining investors. Thus, there was a risk that a first-mover advantage could increase redemptions and MMF suspensions. As redemptions cumulated, central banks provided exceptional support to MMFs for the second time in a dozen years.
The Financial Stability Board has already developed policy proposals in four areas. First, it suggests reducing the liquidity transformation that makes MMFs vulnerable to first-mover advantage, for example by requiring them to hold a higher share of liquid assets. Second, it recommends that the cost of meeting redemptions should fall on the redeeming investors, with swing pricing being one mechanism. Third, to eliminate the cliff effect of liquid-asset thresholds, it suggests removing the requirement for MMF managers to consider liquidation fees or redemption gates when such thresholds are breached. Finally, to help absorb losses, it recommends policies such as a minimum balance at risk or capital buffers.
2: Open-ended funds
The experience of open-ended funds (OEFs) during the DFC period was similar to that of MMFs. Bond funds, in particular, experienced large redemptions and in a ‘reverse flight to liquidity’ prioritised selling their more-liquid assets, adding to selling pressure in fixed-income markets.
Similar policy measures have been proposed for OEFs as for MMFs. These include limiting maturity transformation, for example, by grouping assets into liquidity buckets and requiring a certain distribution of assets across those buckets, or by requiring notice periods or less-frequent dealing for funds that hold illiquid assets. They also include swing pricing, liquidity stress tests and countercyclical liquid-asset requirements.
One other suggestion is to convert OEFs into exchange-traded funds (ETFs). These funds mitigate the first-mover advantage as investors can only exit them by selling their shares at the current market price and not a price previously quoted by the fund, which may be relatively attractive. During the DFC period, US corporate bond ETFs had smaller outflows than a matched sample of OEFs.
3: Margin calls
Sharp changes in asset prices and volatilities during the DFC period triggered large variation margin (VM) and initial margin (IM) calls. This increased the liquidity needs of derivatives users, in some cases taking them by surprise and requiring them to urgently seek additional liquidity via borrowing or asset sales. Increases in haircuts on sale and repurchase agreements (repos) during the GFC had previously created similar liquidity strains for cash borrowers. And, during this year, sharp increases in commodities prices and interest rates generated large margin calls for market participants, including pension funds’ liability-driven investment (LDI) strategies.
One strand of policy proposals could aid the preparedness of derivative users for margin calls. At present, only a minority of central counterparties (CCPs) show how their IM requirements would change in hypothetical scenarios, such as ones with sharp volatility increases. In addition, derivatives users would like to better understand how CCPs determine IM add-ons and what triggers intraday VM calls.
Another strand suggests dampening the reactivity of CCPs’ IM models. The most widely used mechanism puts a floor on IM requirements. However, that does not reduce spikes in IM requirements due to market conditions changing from normal to stressed, which may start above the floor. Thus, a combination of mechanisms may be needed, or regulators should instead adopt an outcomes-based approach, determining upper limits for the reactivity of margin models and leaving CCPs to find an approach consistent with those limits.
A final suggestion is to broaden the range of eligible collateral.
4: Leveraged investors
The use of leverage amplifies investors’ exposure to a given move in asset prices. For example, before the DFC, hedge funds took highly leveraged positions in US Treasury cash-futures basis trades – betting that the spread between US Treasury yields and associated futures would narrow. Anecdotal evidence suggests that leverage rates of 40–60 were common, but were even higher in some cases.
During the DFC period, however, this spread widened and hedge funds unwound an estimated 20% of these positions, resulting in the sale of US$200 billion of US Treasury securities. This occurred amid large margin calls on futures and difficulties in rolling over repo funding, and exacerbated the dysfunction in the US Treasury market.
Even in the short time since the DFC episode, leveraged investors have again been a source of instability. For example, Archegos Capital Management generated significant losses for some large banks at the core of the financial system when it could not meet margin calls from its prime brokers and its positions had to be liquidated. One problem was that Archegos used several different prime brokers, which hid its overall leverage from them. And more recently, the net asset values of leveraged LDI funds used by UK pension funds collapsed when long-term gilt yields rose sharply. This threatened a wave of gilt liquidations in excess of the market’s capacity, prompting the Bank of England to establish a special gilt market operation.
Policy proposals for leveraged investors focus on enhancing transparency, mitigating risks to the banking system, and introducing safeguards in the markets where leverage is created. One proposal is to require any non-regulated financial institutions greater than a certain size to make public their leverage. That would not reveal proprietary positions, but could prompt greater scrutiny from investors and counterparties where high leverage was reported. The same institutions could also be required to disclose – to regulators at least – what actions they would take if they needed to deleverage, as common strategies across institutions might highlight systemic risks.
Another approach is to ensure that the banking system is appropriately managing risk exposures to leveraged clients, to protect the core of the financial system.
Finally, to help control leverage, countercyclical derivative margins and repo haircuts have been suggested by some.
5: Dealer-intermediated markets
Several dealer-intermediated markets became dysfunctional during the DFC period, with even the US Treasury market requiring interventions to support market function. Contributing factors included the scale of bond sales by mutual funds, hedge funds and official institutions; dealers starting the period with already high bond inventories and a spike in volatility that increased the riskiness of these inventories. In addition, principal trading firms (PTFs) – which had accounted for around 60% of volumes in the interdealer segment of the US Treasury market – stepped back, reducing the scope for dealers to manage inventory risk by trading with these institutions. Moreover, the fact that bond markets have been growing faster than dealer balance sheets, and are projected to continue to do so, suggests that such dysfunction could recur in the future.
A first strand of proposals focuses on improving market infrastructure. This includes enhancing transactions data so that investors can be more confident about trading at fair prices. This could be achieved by establishing a consolidated tape in Europe, similar to TRACE in the US, which could report data with shorter lags. Such actions may also help dealers and PTFs to keep their algorithmic market-making programmes running through periods of stress. This strand also includes proposals to expand platform trading and central clearing of bonds and related repo transactions.
A second strand focus on regulations which may have constrained dealers during the DFC period. This includes proposals to relax the Basel III leverage ratio, for example by permanently exempting central bank reserves and possibly other assets seen as very safe. Similar changes could be made to calculations that determine G-SIB capital requirements.
A final strand relates to central bank facilities. This includes potentially expanding the availability of central bank facilities to NBFIs or refining how central banks stand ready to backstop core markets. Restricting access to central bank facilities to banks alone is unlikely to prove sufficient to stabilise core markets, given the increasing importance of non-bank participants. However, careful consideration would need to be given to who should have access to these tools, either directly or indirectly, and on what terms. One suggestion is that NBFIs should have access to central bank discount windows if their liabilities are treated as safe, but only on the condition that they hold enough assets to cover the value of these liabilities after the haircuts that a central bank would apply.
Market-based finance can support economic growth, but if it is to do so sustainably its risk-amplification mechanisms must be addressed. The goal is to find a package of measures from among those being debated – as summarised above – that will do just that.
Naoto Takemoto, Simon Jurkatis and Nicholas Vause work in the Bank’s Capital Markets Division.
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