Our debt markets can be stabilized without the regular Fed intervention we’ve seen since the financial crisis, read here. This market instability is the result of credit markets left unprotected by misguided monetary and regulatory policies. the fed is unlikely to reverse its recent policy and regulatory decisions, but the negative impact of these policies can be reversed by adapting private sector initiatives that have been successful in the stock and futures markets to create a stable haven for short-term debt investors .
This article provides a roadmap from two private sector successes – passive equity ETFs and Eurodollar futures – to a financial tool to calm the stressed market for market-traded short-term debt.
How the debt markets became so vulnerable
Debt markets have regularly been in crisis mode since the 2007-2008 financial crisis. Because of this constant barrage of disasters, the debt markets in both the UK (read here) and the US have been routinely put on life support by monetary authorities. What caused this weakness in the financial system?
The Fed’s management of debt market stability. The two regulatory sources of current instability in the debt market are:
- Hyper easy money. Central banks’ monetary policies were aimed at recovering from the crisis but were maintained long after the crisis ended.
- Regulations that divert commercial banks from their traditional risk management role in the debt market.
Hyper easy money. The Fed, struggling to find a version of easy money even more accommodative than zero interest rates, invented a dual-tool monetary policy – pumping interest-bearing reserves into the banking system in parallel with zero interest rates. This extreme version of easy money was quickly adopted by the central banks of other developed countries.
Whatever the benefit of super-easy money during a financial crisis, the policy has persisted for nearly 15 years – well after the crisis – and created a generation of private sector risk-takers who have never been constrained by the normal cost of capital (read here).
Taking the banks out of the debt markets. Then, despite market volatility threatened by extreme monetary policy, the Fed curbed the key market risk stabilizer, commercial banking sector risk-taking controls, in two steps.
- First, the Fed increased the regulatory capital that banks that issue wholesale deposits must hold. This reduced commercial banks’ willingness to trade in the deposit market – on spreads to the relatively docile stable wholesale deposit rates such as the London Interbank Offered Rate (LIBOR) and the yield on tradable wholesale domestic certificates of deposit (CDs). Wholesale deposits became a minor factor in risk management – ultimately ending the largest futures contract, Eurodollars, and any LIBOR-based hedging.
- Then the cost of capital for banks by holding inventories of tradable debt instruments, including short-term government bonds and bonds, was also increased by regulation. This reduced banks’ ability to create markets for commercial paper and other debt instruments, further reducing the liquidity of debt markets.
Central bank policies left the debt markets with only one liquid debt instrument, overnight repurchase agreements. Borrowers were left with relatively illiquid sources of cash-like assets such as commercial paper at market prices, and institutional investors were left with a single offering from investment houses – money market mutual funds (MMMFs).
Risk management became the domain of the ill-prepared shadow banking system.
Wholesale debt markets lack a stable haven
It makes sense to compare bond markets to supposedly riskier stock markets. Why didn’t the collapses in debt portfolio values and the resulting central bank bailouts coincide with similar collapses and bailouts in stock markets? Stock portfolios don’t collapse en masse like debt-backed wholesale debt does.
In the US, Prime Money Market Mutual Funds (Prime MMMFs) are the troublesome remaining daily source of liquidity for institutions seeking unsecured short-term private sector returns. Prime MMMFs, despite their post-crisis collapse, have become the leading large corporate debt-backed investment because they were not pushed out of risk management by regulators like banks were. But these prime MMMFs are vulnerable to mass redemptions and have twice forced Fed intervention, during the financial crisis and again during the COVID crisis.
The port of the stock markets. Equity markets are less vulnerable because private sector investment developers have created a haven that can withstand large withdrawals – passive equity funds and ETFs. Passive equity funds have one characteristic that is critical to their stability. There is no “breaking the buck” in the stock markets – no price of the underlying individual stocks that at the same time inhibits redemptions by investors in the passive stock funds.
What would a debt-based port look like?
Two markets are pointing a direction for mutual funds that want to be a haven for the short-dated bond market – LIBOR-based Eurodollar futures and passive common stock ETFs.
Forward-based liquidity. LIBOR dominated private sector short-term debt pricing long after the London deposit market dried up due to its importance as an index of short-term debt pricing, particularly in the derivatives and consumer bond markets. The important lesson of Eurodollar futures trading is that an index can be the successful basis for pricing if the related futures market is liquid, even if the spot market itself is illiquid.
Convenience-yield-based liquidity. Individual passive ETFs are successful because they offer an important convenience return. Rather than competing on price, these ETFs match the value and performance of the S&P 500 stock index at very low transaction costs. Passive ETFs have no incentive to use their assets to boost returns. ETF users seek stability and predictability from passive ETFs. Taking risks through leverage in this market is anathema to investors.
A short-term debt haven will not compete with prime MMMFs for customers. As with passive ETFs, the attractiveness of a debt haven would be its reliability as a price for short-term private sector debt that both accurately reflects market conditions and represents a safe haven investment.
Ultimately, the competition for returns in a debt-based fund encourages funds to take risks that result in dramatic losses for one fund or another. This is the main difference between passive index funds and other stock funds. Passive equity funds compete on costs, not returns. There is no incentive to leverage the returns of a passive ETF.
Debt investments that aim to replicate the characteristics of passive equity funds in the debt capital market would not compete for users by trying to earn a higher rate of return. Like passive ETFs, it would survive by offering a risk profile that cannot be matched through leverage.
The death of LIBOR and its rapid replacement by the flawed alternative, the Secured Overnight Funding Rate (SOFR), point to a potential haven that would provide security without losing the benefits of a private sector dated index – a standardized, highly diversified short-term corporate debt fund , which corresponds to the average returns and risks in the market for fixed-term securities.
A stable fund with a closing price that meets the three criteria below would be a source of stability in the commercial paper market that LIBOR once offered so imperfectly. The necessary properties include
- Values reflecting the average market returns and risk of diversified maturity commercial paper.
- Deliverable upon settlement of a futures contract. The instrument itself does not have to be liquid.
- A diversified debt portfolio without leverage. No competition to other funds on a yield basis.
Debt market breaks no longer need to be the constant concern they have been since the financial crisis. We just have to learn two lessons from the 21st century markets.
- Markets will accept a financial instrument that only offers an average return if it promises stability in times of crisis and serves as an important indicator of financial condition.
- Financial instruments themselves do not have to be liquid. They can be successful when dealing with a liquid futures market.
Regulators have left debt markets unprotected. To keep these markets safe, an exchange can offer debt investors a stable, diversified debt instrument that is unleveraged and diversified like a stock ETF. This instrument, in turn, can provide a liquid source of hedging by matching a liquid futures market to an index of market conditions, as Eurodollar futures did prior to the end of LIBOR.