Jun 15, 2020

Darrell Duffie on Treasury Markets and the Post-COVID Path to Financial Stability

The US treasury market would benefit greatly from implementing an expanded centralized clearing mechanism.
David Beckworth Senior Research Fellow , Darrell Duffie

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Darrell Duffie is a professor of finance at Stanford University, and he joins Macro Musings to discuss the treasury market problems that emerged in March 2020 and what can be done to avoid them in the future. Specifically, Darrell and David lay out the current state of financial markets, the ability of treasury markets, as currently designed, to handle demand shocks, and how central banking reforms can better ensure financial stability in the future.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Darrell, welcome to the show.

Darrell Duffie: David, it's a pleasure to be here.

Beckworth: Well, it's a real pleasure for me to have you on. I've read your work extensively. You've had a number of papers I had to wrestle with. I recently did a paper, not recently, few years ago did a paper on the Fed's new floor system and I cited your paper about monetary policy pass-through with Arvind Krishnamurthy. They helped me understand the issues. I mean, you've written a lot of stuff. “The Failure of the Dealer Banks,” your Journal of Economic Perspectives paper. I remember reading that. Your work on Libor, central clearing which we'll kind of weave into what we talk about today about the treasury market, but you have a vast array of papers. All things financial system, financial stability. So it's a real honor for me to get to chat with you. I know people have actually requested you as well. So you're checking off several marks in my book at least getting you on the show here. Before we get into it though and your paper on the treasury market and what happened in March, I’d love to hear how did you get into economics? How did you pick this career path and end up thinking about financial stability and economics?

Duffie: Well, I've been around the block quite a few times, but going way back when I was a PhD student, my PhD is in a field called engineering economic systems, which is basically math and economics. It was in the course of get holed up in math and economics that I got really excited about research on financial markets. So my PhD was some mathematics related to financial markets. Of course, I didn't know anything about the real world at that point, but over the years through teaching, research, and policy work, I've become more and more passionate about understanding the financial system and contributing to research in that area.

Beckworth: You've had two very rich environments. The Great Recession of 2008 and then this one we're in today. So as they say in my line of work, you strike while the iron is hot. It's unfortunate for humanity, but it's great for people like you and me to think about these issues. So it's great to have you on, and again, you have this great paper. The title of it is “Still the World's Safe Haven? Redesigning the US Treasury Market After COVID-19 Crisis.” So we'll get into that, but one more personal question before I move on. I saw that you're Canadian and as listeners of the show will know I'm a big fan of the Canadian financial system because it's so stable, especially compared to the United States system. So just a few points that I have brought up on the show before, but during the Great Depression, no bank shut down during that in Canada.

Beckworth: Now there were some mergers I understand. There was some movement, some activity, but unlike the US like 9,000 I believe banks shut down. It was relatively quiet up north. Canada did relatively well in 2008 I understand as well. Also I'm a big fan, and on this podcast I have sung the praises of the Bank of Canada's corridor system that they have, and that they seem to be able to do it. It's like an off-on switch during normal times. Then you get the periods like today or 2008, they go to a floor system. So they do it in my mind by the textbook. They're really great. They've got a lean balance sheet in normal times. They expand in hard times like now. So they do things amazingly easy compared to all the struggles we go through here in the US and I wonder if you, as a Canadian sit back and marvel at how successful your country is with financial stability.

Duffie: Well, Canadians are supposed to be famous for humility. So I need to start off by saying, I don't think Canada should take as much credit maybe as you want to give it. In part, because it's a bit easier when you have a small country.

Beckworth: Fair point.

Duffie: Canada has quite an oligopolistic banking system. So if you're willing to have a small number of banks that are very profitable, then it's easier to maintain financial stability. That said, you might not be aware. Canada does not even have a national financial, did not have it on until the last year of financial stability a regulatory body. It's just been introduced thanks to a successful suit by the Canadian government in front of the Supreme Court of Canada. The, the interesting fact is that the constitution of Canada gave all things about financial markets to the provinces of Canada to oversee and not the Federal government, as opposed to the United States. So it took a lawsuit by the federal government against one or two provinces to actually get the authority to regulate financial stability in Canada. I was actually an expert for the Canadian government in that Supreme Court case. It was a fascinating set of issues. You can read my report in my webpage if you're ever interested.

Beckworth: That's interesting. So they unified the regulation at the national level as opposed to the province level?

Duffie: Well, that was the original idea, but the provinces objected. I think correctly, if you read the constitution carefully enough. That they had authority over financial markets. So the provinces to this day still have authority over all financial market regulation. So the provinces get together to regulate most things similarly. Ontario being the leading player in that, but rightfully so, the Canadian Federal government said, you know what? There are national concerns related to financial stability that we saw in the 2008 crisis. We really want the ability to have some overriding powers in the area of national financial emergencies. So they obtained those powers in that court case, the Supreme Court of Canada.

Beckworth: Very interesting. The more you know. Canadians, rich history. So listeners of the show, if you haven't heard already, we have a number of podcasts on Canada. So we encourage you to go back and listen to those as well. Okay. Let's talk about the treasury market. Supposed to be the safest market in the world, the biggest market, the deepest market, the anchor market of the world, and yet in March it almost crashed or imploded, came close to not functioning at least. You have a great paper that you presented at Brookings on this. Again, the title is “Still the World Safe Haven? Redesigning the US Treasury Market After the COVID-19 Crisis.” So why don't you start by walking us through what actually happened in March? What were the signals, the signs, the developments that really alarm people like you, Fed officials, and market observers?

Still the World's Safe Haven?

Duffie: Well, thanks David. By the way that paper I got contacted about writing that paper just a couple months ago by Brookings’s David Wessel, Don Cohn, the former vice chair of the Fed and Elion who was the head of the Fed's office of financial stability. They just basically said, we want you to write a paper that explained what happened in the treasury market, what went wrong, and what did the Fed do? Is there anything that should be done about it? So the deeper I got into it, the more intrigued I got, because it was an extremely unusual situation where you're entering into a period of extreme financial stress. The stock market was gyrating, all of this related to very adverse news about the COVID crisis and how severe the US economy would be hit. When those sorts of things happen that is extreme stress and financial markets, you normally see a flight to quality by which the prices of treasury securities rise relative to other securities, and that didn't happen.

Duffie: The treasury market gyrated on some days, the prices of benchmark treasuries dropped quite precipitously, and people were kind of confused about whether the treasury market would be in fact a safe place to go. Looking into it the problems in treasury market price volatility were not related in my view to uncertainty about the ability of the United States government to pay off those treasury securities or even news about inflation or monetary policy. They were actually related to the fact that so many large investors were trying to liquidate their treasuries, that the dealers who intermediate that market were unable to handle the flood of trade requests. We see lots of evidence of that. For example, the bid offer spreads that the dealers offered to investors went up by more than a factor of 10 from normal.

So many large investors were trying to liquidate their treasuries, that the dealers who intermediate that market were unable to handle the flood of trade requests.

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Beckworth: Wow.

Duffie: That's from a speech of Laurie Logan who's the head of the markets, the trading desk at the New York Fed. In the inter-dealer market where the dealers trade with each other, the market depth, the amount of treasuries that you could buy at the best bids and offers dropped by more than a factor of 10. So basically market depth disappeared, market liquidity disappeared. The prices of treasuries that were very close in maturity were not close anymore. The yield curve became disjointed, and it was clear that the market was not functioning properly. It wasn't a question of the treasury securities, but rather the need to trade them which is not being met. The Fed, thank heavens, stepped in quickly, and in the most aggressive market operation ever undertaken by any central bank purchased a trillion dollars of treasuries in just three weeks and then continued to purchase. It's now approaching $2 trillion not to support the prices of the treasuries, although that might've been a byproduct, but more to just take the treasuries away from the market so that the market wouldn't have to deal with such large volumes. The Fed took several other actions. We could discuss that if you like, and eventually calmed down the market. [The] conclusion that I drew is that the current design of the US treasury market is not adequate for handling surges in trade demands on stress periods like this. We're likely to see this again in the future.

[The] conclusion that I drew is that the current design of the US treasury market is not adequate for handling surges in trade demands on stress periods like this. We're likely to see this again in the future.

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Beckworth: So you make the case also in your paper that this is closely tied to the surging budget deficit. So the main way of getting these treasuries transacted are through these dealers. You mentioned, there's two main markets on the treasury market, but these broker dealers they're important for keeping this market functioning and their balance sheet capacity could not keep up with the growing amount of public debt that was being issued. Is that a nice way of summarizing it? Is that accurate?

Duffie: Yes, that's exactly right David. In my previous paper I document the fact that the treasury market has been growing by leaps and bounds, even in the past decade nearing a trillion dollars a year of additional deficits that all have to be funded with additional treasury securities. And meanwhile, the balance sheets of the largest dealers have not been growing in fact very good new financial regulations after the last financial crisis limited the growth of the dealer balance sheets. They no longer have the kind of appetite that had before the financial crisis to grow their balance sheets, to take opportunities, to offer intermediation, to market participants since 2010, basically no increase in dealer balance sheet size. Meanwhile, the treasury market is doubled and it looks like it's going to double again pretty quickly especially because of the COVID crisis, the government is spending an extra two point some trillion dollars this year. So the deficit is going to create such a large treasury market that the ability of the dealers to offer liquidity to the market with their limited balance sheets is just diminishing. And we need to, I think, rethink the current market structure going forward so that it doesn't rely so intensively on access to the balance sheets of the large dealers.

Beckworth: Yes. So your solution suggests that looking at the regulations as a cause of this crisis is probably not the right angle. You said that the new regulations that were introduced were good, they served a useful purpose, they increased capital requirements and all that good stuff. So maybe the right way to think about this is that they helped us uncover a problem in the existing structure as opposed to being the cause of the problem. When the system got stressed, we're able to peel back and see another potential weak spot in the system. Because it could be easy to point the finger at the regulations and say, "Hey, they're supposed to make the system safer and instead they caused the strain." But a more optimistic take would be they helped us see an additional weakness in the system, is that fair?

Duffie: Yes, although I wouldn't say that it was a good thing that they helped us understand that. Some in fact, not surprisingly coming from banking circles have suggested that regulations being the reason that banks don't want to intermediate as much as they have is a suggestion we should back off on regulation, not so much capital requirements, not so much liquidity requirements. But I don't have that view of course, we want our banking system to be stable. In fact in March, the strength of the banking system was evident in their lending ability and the fact that they didn't come under such severe stress that people were worried that they were going to fail. So that was a success story. Rather than be rolling back regulation what we need to do is to, as I said, reduce the requirement that almost every trade from an investor has to go onto a dealer's balance sheet before it can move on to another buyer.

Beckworth: So walk us through the steps of the proposal, how would that look? What would change and maybe in the process walk us through the two parts of the treasury market you outlined in the paper.

Treasury Market Basics

Duffie: Sure. Well, the treasury market is basically a two tiered secondary market in which if you're an investor like an insurance company or a pension fund or a hedge fund or a foreign central bank, then it's virtually certain that you're going to be conducting all of your trades with one of the large dealers. These are large bank affiliated dealers most of them. On the other hand the dealers themselves have an inner tier market in which they trade with each other called the inter-dealer broker market, which is populated by the inter-dealer brokers themselves, which are middlemen for the dealers. The primary dealers are the largest participants, but in the last decade or so, the transactions' volume is beginning to be dominated by high frequency trading firms called PTF or principle trading firms. And that inner tier market is partially centrally cleared, which means that when two dealers trade with each other, rather than waiting until the next day for settlement, they will move their trade commitment into a clearing house, which becomes the buyer to every seller and then becomes the seller to every buyer. So that primary dealers are not relying on each other they're relying on the clearing house. And that's the focal point of my suggestion, which is that the government should do a study, a careful quantitative study of the benefit of expanding that central clearing function to the entire marketplace.

Duffie: So that if you're an insurance company, a pension fund, a hedge fund, a primary dealer, an inter-dealer broker, whoever you are, if you're active in the market your trades should also centrally cleared. And that has a range of great benefits that I can walk through if you like. But most importantly, for the purposes of my overall concern in this project, it would relieve the need to rely so heavily on dealer balance sheets because of two main benefits. Number one, you as a dealer don't need to wait for the purchases that you made to clear and wait for the sales that you made to clear with your bilateral counterparties. You can net them together at the central counterparty so that if I bought 100 billion today and I sold 80 billion today, I wouldn't have to wait for 180 billion of trades to clear tomorrow. I could net them down to a 20, 100 minus 80. So my commitment on my balance sheet is only for 20 billion, which is a dramatic reduction in the commitment of balance sheet space. Now we don't know yet how much reduction we would get until we do a quantitative study. But my suspicion is that there would be a dramatic economization of dealer balance sheet space if we were to introduce a very broad central clearing requirement in the market. Just like was done in the swaps market after the last financial crisis in the Dodd-Frank Act, which required that all standard interest rate swaps and other standard swaps become centrally cleared.

Beckworth: Let me ask this question. Is there any relation to what happened late last fall with repo and treasury markets with what happened in March?

Common Threads in Repo Market Activity

Duffie: There is a relationship. In fact, I'm doing some research on that right now with my PhD student David Yang and with an economist at the New York Fed Adam Copeland. And we are diagnosing that September event and other spikes in the repo market as being mainly related to the demand for reserves. That's the deposits of banks at the central bank the Fed, the demand for reserves got so great relative to the supply of reserves that on certain days, like those days in September last year, it looked like the dealers were starting to hoard their reserves rather than let them go into the repo market at low interest rates and repo rates spiked. Now there's also a proposal, there has been a proposal to do central clearing in the repo market, which would alleviate some of that demand for reserves again, because of netting. And the natural thing to do would be to centrally clear in the same clearinghouse, both the repo trades and the trades of treasury securities together, that would even more economize on dealer balance sheet space.

Duffie: And it's been proposed actually by others in congressional testimony and in industry reports as a possible solution. I think in the past, people have been talking mainly about this as a solution for lowering the risk of failure into settle in this market. That is, there is such a large volume of trade that's not centrally cleared that there could be an accident someday by which somebody that promised to pay doesn't actually pay. And if that were to happen, there could be a daisy chain kind of reaction causes financial instability in the treasury market. And it of course raises costs because you never know for sure if you're actually going to get what you were promised. So others in the past have proposed a central clearing requirement, at least in the repo market and in some cases in the treasury securities market, and I am proposing the same thing, but as you can see, my main impetus in this case is not only reducing the settlement risk of failure, but economizing on dealer balance sheet space so that the dealers could continue to intermediate this market as it grows larger and larger without committing more and more balance sheet space to the intermediation.

Beckworth: So are you saying your proposal would be a substitute for the David Andolfatto proposal for a standing repo facility, Jane Ihrig as well?

Duffie: Yes, I read the paper by Andolfatto and Ihrig and I thought that was a great proposal in terms of how monetary policy transmission could be improved by having a standing repo facility. I don't think they were thinking as much about settlement risk or intermediation liquidity in the treasury's market, but what they proposed is a good idea.

Beckworth: I guess would it be enough though, in terms of what you see as the problem, would it go far enough in dealing with the issue?

Duffie: No, I don't think it would because the proposal for a standing repo facility would be very effective at putting a corridor on interest rates in the repo market. So monetary policy transmission would be and be more reliable. But there would still be a need to intermediate, a very large treasury market with a much smaller available space on dealer balance sheets that we have today. And we would still have episodic bouts of dysfunction like we saw in March of this year. By the way David, this is not the first time this has ever happened that the market became dysfunctional. I read a book that's coming out from Ken Garbade who's probably the world's expert on the history of treasury markets in relationship to the Fed. And he points out in his book that there are three other incidences of this in the last century.

Duffie: One was on the opening of the Second World War one, of course, the catastrophic economic implications of the Second World War caused the treasury market to become dysfunctional and the Fed stepped in and returned the market to liquidity just like it did this year. And next time was 1958 when security concerns in the Mideast caused president Eisenhower to deploy Marines to Lebanon. The entire Mideast looked like it might blow up. And again, those concerns hit the treasury market caused it to become dysfunctional and the Fed rescued it. And then the final episode in the last century was in 1970 when president Nixon announced the incursion of US troops from Vietnam into Cambodia followed immediately by the tragic protests at Kent State University, which led to the treasury market becoming dysfunctional again. And the Fed did it again and it rescued the market.

Duffie: So these things happen I'm not suggesting from the COVID crisis, that this is the first time the market has ever become dysfunctional. I'm certainly not suggesting that the Fed should stand back from rescuing it, but what I am suggesting is that we can look forward to this happening more frequently now that the treasury market is becoming so large relative to US GDP, and also relative to the ability of the dealers to intermediate the market themselves. And so rather than just sitting back and waiting for it to happen more frequently, we should think about how to redesign the market so that it's better able to handle surges of demand for trade and demand for liquidity on stress periods. And that's the genesis of my suggestion.

Beckworth: Now I like your proposal because it's an attempt to keep the market itself healthy and engaged, and not over rely on the Fed to do all the action. We don't want to completely undermine the treasury market by having the Fed, do all the heavy lifting all the time. That's probably the concern of some, with setting something up like a standing repo facility. I guess my question going back earlier about connecting the two events. You mentioned in your paper that, I mean, what was going on, some of these hedge funds, some of these foreign official sectors were trying to get actual dollars. They were trying to sell treasuries, right? To get actual dollars.

Beckworth: And you can tell a similar story back in the fall that the treasury general account was sucking reserves out of the system. There were dollar shorts due to regulations, banks also wanted dollars. I guess the common thread I see is there's a shortage of reserves in the system, and maybe this is tied up in some way to the fact it's a floor system. But I think it has to do with the regs, the balance sheet space you're talking about. And there seems to be some overlap there. And I just find that fascinating. And if I'm missing something, let me know there. But is that common thread, the demand for reserves, whether it's supply or demand driven shock.

Duffie: Well I would say that the common thread is that in the case of the spikes in the repo market that we saw in September, 2019, it was the case that dealer balance sheet space for reserves was limited. Well, let me put it another way. The dealers at the largest banks were required to demonstrate that they had plenty of reserves at all times. And that was done both through liquidity coverage ratio, which is analogous to a capital ratio. And also through testing and supervision. And because of those heightened regulations, the banks really didn't want to lend out all of their reserves. They wanted to keep back a lot so they could demonstrate to regulators that they were complying. And that left on days where there was a surge of demand for borrowing reserves, it led the market to become relatively dysfunctional. It led to the dealers to limit the amount of intermediation that they wanted to do in that market. I think there is a common thread, but the functionality of the treasury market that I'm speaking about with you today is more related to the capital requirements of dealers and the limited space that they have on their balance sheets to hold treasuries, because of their desire to meet those capital requirements without issuing new shares of equity to the market. Which their shareholders really don't like.

Because of those heightened regulations, the banks really didn't want to lend out all of their reserves. They wanted to keep back a lot so they could demonstrate to regulators that they were complying.

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Beckworth: Right. So if I can summarize your proposal, you want more of the treasury market, if not all of it, to clear on some central clearing mechanisms. You mentioned, for example, some of them now use the Fixed Income Clearing Corporation. So expand the role for that organization. Would that be one approach?

Duffie: One of the options would be to take the existing Fixed Income Clearing Corporation, which offers central clearing to the dealers, and expand it to the broader marketplace. And now I don't think, since it hasn't happened on its own, I don't think this is going to happen without some sort of regulation that mandates a requirement just as was done in the swaps market. That all large active market participants centrally clear. The other option would be if the Fixed Income Clearing Corporation doesn't want to do it, to set up a new clearinghouse. And the new one could either be a private sector one, or it could be operated by the government, either the Fed or the Treasury. So I'm pretty open. And I think it's not a mere professor at Stanford that's going to be able to make these choices. It's got to be done based on a careful study by the government. I imagine government agencies involved in the treasury market, of which there are a number, would want to first of all, see if it's worth it by doing a quantitative study. And then seeing how it would be done, how would we implement it, whether through an expansion of the FICC or through a new clearinghouse.

Beckworth: All right. Do you foresee any objections to going down this path?

Duffie: Well, if you were to introduce a broad central clearing mandate to the market, that would make it easier for exchange operators to step in and say, hey, now that we have central clearing, we can offer a straight through processing of all to all trade among any market participants. And while many in the market might appreciate that opportunity. If I were at one of the largest dealer banks, I would say, well, wait a minute. Right now I'm handling all of the investment, the demand for liquidity from investors around the world. And if we were to have central clearing, and from that eventually to get all to all exchange trading, then I would lose some of my market share. So if I were one of the large dealer banks, I would say, well, let's think about this really, really carefully and make sure that it's absolutely necessary because I don't think it's in my interest.

Beckworth: That makes sense. They're going to lose some opportunities there if this does happen. I was thinking another critique or pushback might be, and you addressed it in your paper. Is the concern that you would concentrate risk in one institution, the clearing centers. That's an objection I think to the swaps we've heard that as well, right? Yes, it creates more transparency, better data, we know what's going on. But all that risk is concentrated in one setting. So how do you respond to that?

Duffie: Yeah. Well first of all, it's absolutely right that if you do this, you're taking the CCP and making it into a systemically important financial institution that simply you can't afford to have it fail. I mean, after all, the treasury market is a national priority. It's a matter of national economic security that it continues to operate. It's how the government funds itself, after all. So you couldn't afford to have that fail. So now that you've made something that's too big to fail, you've raised the ante on supervision, regulation, proper capital commitments, proper liquidity commitments. And so the creation of this big new node in the financial system is something to think about. Do you really want to do this? I would argue, yes, for the following reason. All that risk that would be placed into this new clearinghouse, it's already there. It's already out into all of the transactions that are being made in the market today, where one investor faces another, or one investor faces a dealer. All of that, almost all of it I used treasury market practice group data to indicate that 77% of trade now is not centrally cleared. All of that settlement risk is there. And it's dispersed. If you were to bring it into the clearinghouse, first of all, it would become a lot smaller because all the buys would get subtracted from the sells. And so the net amount of settlement risk would go way down.

77% of trade now is not centrally cleared. All of that settlement risk is there. And it's dispersed. If you were to bring it into the clearinghouse, first of all, it would become a lot smaller because all the buys would get subtracted from the sells. And so the net amount of settlement risk would go way down.

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Beckworth: That's a great point.

Duffie: And not only would it become smaller, but it would become more transparent to regulators. They would be able to see all of the trades that are being settled, how much there is, whether there's proper margin and capital requirements. They would be able to step into one place in the financial system to fix it if it became more intractable. And you would remove a lot of uncertainty among market participants about whether they really need to fear a breakdown in settlements in the market. By the way, we do have a lot of settlement failures in the treasury market. And my guess, as I explained in my paper, is that those failures to settle would be reduced if we had a broad central clearing mandate of the type I suggested.

Beckworth: Very interesting. Well I hope this idea gets more discussion. And so all the officials out there listening to the podcast, if you haven't read it already, read the paper. And give Darrell a call so he can chat with you about it. Darrell, I want to step back a little bit from this proposal, but still stick to this question about what happened in March. As we mentioned earlier, kind of underlying that demand for treasures was a demand for cash, for actual dollars. And so one way to look at this is that there was this huge rush for dollar funding during this time. And the Fed responding to this was part of its greater response in terms of providing liquidity facilities across a number of different outlets. So yeah, it helped out in the repo market. It also set up the primary dealer credit facility, the money market facility, dollar swap lines, commercial paper. Many of the same facilities that were set up in 2008. And in my mind, the way I think about this, is that these facilities are a way to provide lender of last resort to the shadow banking system in the same manner like discount window lending does to traditional banking. It's the Fed is trying to meet its mandate, and it's having to invoke 13-3 to set up these facilities to go into the places it normally can't go.

Beckworth: And so I've had this conversation, question with others on their show, and I'm delighted to get to ask you this. What can the Fed really do about this going forward? Because it's very ad hoc. In other words, there are dollars out there in the world that are outside the normal traditional banking system, right? And some of them are overseas. In fact, the BIS has about 13 trillion overseas. And so the Fed has to step in, in a crisis, otherwise there might be some effect back here in the US. How do we think about handling this? I've had some people on who say we need to somehow make all firms that issue money liabilities be regulated or taken out of the shadows inside the traditional banking system. I've heard others say more capital funding. But this seems like a complex problem, right? There are firms overseas doing this. I'm not sure how it would get those ones into our legal structure of regulation. So how do you foresee wrestling with the shadow dollar creation overseas around the world and how it relates to the Fed's job as the lender of last resort?

Global Dollar Demand and the Fed

Duffie: Oh, that's a-

Beckworth: That's a big question.

Duffie: $64 trillion question. Okay, let's remember the mandate of the Federal Reserve. It was set up to provide financial stability, and eventually grew into its job of conducting monetary policy on a day to day basis. But the origins of most central banks are to act as a lender of last resort in financial stress. And then as I said, over time their mandate for controlling inflation and maximizing employment, and so on, kind of settled in. They haven't lost their financial stability mandate, it's still there. And we need the Fed to meet its responsibilities when there's a financial stress by robust provision of liquidity to banks. That's the first line of defense. And banks include foreign central banks.

Duffie: And so the Fed, even within its normal mandate, can provide dollar funding to a foreign central bank that the foreign central bank can then on lend to its local commercial banks. And so as to alleviate a cash crunch in dollars around the world, that's good for the United States. That's good for the Fed's mandate because it helps preserve financial stability for the US dollar. When problems appear outside of the normal banking system, the Fed is kind of in a corner because its mandate doesn't give it the right to start lending left and right to anyone in the economy taking risks. It once had that ability under what you noted to be the section 13-3 of the Federal Reserve Act. But in 2008, the ability of the Fed was significantly curtailed. And now if the Fed wants to lend outside of the banking sphere, it needs to get permission from the treasury department.

Duffie: And so in this particular COVID crisis, the programs by which the Fed is lending to corporations around the country is first of all with the permission of the Treasury and with the Treasury guaranteeing that the Fed won't take a loss and affect those losses. So the Fed is providing effectively liquidity to corporate borrowers, but it's not itself taking the risk of loss. And that distinction is quite important. The reason it's important is that the Fed needs to maintain its independence in setting monetary policy and providing liquidity. If it were to start to take risks on its own balance sheet when lending to corporations, then the public and Congress could say, "Well, you're exceeding your normal mandate. As long as you're doing it why don't you do this and that." Because in my state we have a factory that employs a lot of people and the company is running into difficulty how about lending money to that one? And some Senator or the President could say, we have problems also with this industry and why don't you lend to it as well?

Duffie: And pretty soon the Fed loses its independence and setting monetary policy becomes another arm of the government. And it was set up in the first place to have a separate mandate that's at least in the short run independent of fiscal policies that would be set by the government. And so that's why there's a division between the monetary and financial stability mandate of the Fed and the fiscal responsibilities of the rest of the government. And I think it's a good idea as long as you can get it. Of course the government always has the right to take away that independence, the Fed is a creation of the government and that mandate could change.

Duffie: But for the time being I think it's very good to have an independent central bank and therefore for the Fed not to overreach by lending into the economy. In this particular crisis, for the first time in history as far as I know, the Fed has been purchasing corporate bonds directly in the market, which is a first. Now again it's indemnified for its losses by the treasury in effect. But it's felt a need to become quite active in the market in order to keep liquidity flowing to US corporations at this very unusual time. And I think it's appropriate that the Fed have that ability whenever the treasury signs off on it and covers those losses.

Beckworth: So I agree largely with what you've just said, I'm just wondering if there's some fix. I know there's no easy answers in a complicated world like ours, but is there a facility or facilities where you could take in a lot of counterparties? A permanent standing facility where you could get more counterparties to the Fed, maybe apply haircuts as needed, but something more systematic, predictable, so that in a crisis you would have the same facility as you would a normal time. So distressed primary dealers run into the same facility as do the commercial paper dealers, as do the regular banks. Kind of an expanded standing repo facility for all. And maybe you would have, a couple of them for just maybe long-term version, short term version. But do you see something like that as providing a useful framework moving forward or some other solution along those lines?

Duffie: Well, we do have a precedent now of standing up facilities during a financial crisis. So you already mentioned the primary dealer credit facility, which was established in 2008 after Lehman failed or actually just before Lehman failed. And served a very useful purpose for the Fed to provide liquidity to a wider set of players than just banks. During the last financial crisis. And then it stood it up again in this COVID crisis, which was not induced by the financial sector but causes stress in the financial sector that the Fed could alleviate by establishing again the PDCF Primary Dealer Credit Facility. So given that precedent that serves somewhat the purpose that you just described. It is done on a case by case basis because these are not banks, they're dealers. And it is outside the normal mandate of the Fed.

Duffie: It does require a sign off and guarantees from the treasury department. If you were to expand that to all comers and not just the primary dealers, then the Fed would have to check their credit quality. Is the Fed going to take a loss if it lends to company XYZ that wants to borrow money? And you would then have the Fed either taking on an enormous role in the economy or taking some risks by lending anyway. And then as I said earlier risking the loss of its independence. So I think the Fed has had to hue a very careful narrow line between expanding its liquidity provision during stress periods, but not expanding them so far that it risks entering into making fiscal decisions that could erode its independence. And I think the Fed has done an excellent job of that.

Beckworth: All right. Well along that line, but switching gears just a little bit, I mean what are the implications of facility like that as the fed's balance sheet could get pretty large very quickly everyone ran to the Fed and tapped it. And you've written on something that could also expand the fed's balance sheet, at least in theory and that is central bank digital currency. And I'm just wondering where you see this going. We have a few minutes left, but where do you see central bank digital currency going? Is it inevitable that central banks will one day be issuing central bank digital currency?

Future Prospects for Central Bank Digital Currency

Duffie: This is a great topic. And one I've been looking into for the last several years, because ever since Libra it's been every dinner conversation among central bankers includes a discussion of central bank digital currency. And should we introduce it? And under what conditions? The Fed as you probably know is considering the introduction of a fast payment system by which you wouldn't have to wait a couple of days if you're a merchandiser and you're selling stuff by credit cards or bank through the banking system, you wouldn't have to wait a couple of days to get paid, that's very expensive. And you wouldn't have to give up more than 2% of your credit card revenues to interchange fees that are very expensive. With the Fed now system you could pay instant 24/7/365. The payment system would be open all the time, be cheap for everyone.

Duffie: And fed now is an attempt to make that a reality scheduled for release in 2024. It's a big technology lift and I think the Fed is more likely to pursue that solution than introducing a broad market central bank digital currency. Other countries are seriously considering the central bank digital currency approach. China is already testing its form of central bank digital currency. But when a central bank does that, it takes on a lot of extra responsibility it now becomes at least in the most straight forward forum of CBDC, the central bank becomes responsible for monitoring all the transactions to make sure that money laundering or financing terrorism or other illegal transactions are not being done. Currently the AML and CFT checks are being done by banks. I would say the Fed in fact in a speech governor Lael Brainard at the Fed spoke about the heavy responsibility that the Fed would face if the Fed had to do all of that. So that's one concern. Another concern would be protecting the privacy of all of those transactions' data security. Probably most central banks will not at least in large developed market. Central banks will not go that route.

Other countries are seriously considering the central bank digital currency approach. China is already testing its form of central bank digital currency. But when a central bank does that, it takes on a lot of extra responsibility.

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Duffie: Probably they will do either fast payment systems or some sort of a hybrid of a central bank digital currency, by which they would authorize banks and tech firms to use the backing of the central bank for their own private digital currencies that would then circulate in the economy. Everybody would know that they're backed by the Fed or the central bank of whatever country it is. And they would allow digital payments that are more efficient than we have today. The key sticking point being interoperability, meaning if you had a mobile phone app that was loaded with money that you got from JP Morgan chase and someone wanted to send you money from a new startup FinTech payment firm that had access to the same backing from the central bank, would you be able to load up your mobile apps from those two providers with fungible digital currencies?

Duffie: Or would you have to keep track of all of those separately? And that would be a nightmare of course, it would be a bad user experience and would also be very expensive. Because you'd have to have pre-funded dollars in each of the different private versions of it. And that's why the central bank does everything solution is cleaner, but it raises those other costs that I discussed earlier. So I think most central banks are probably going to offer fast payment systems and maybe some will opt for these hybrid systems under some strong standardization to get interoperability.

Beckworth: So would an example of that latter option be like the narrow bank that was tried in New York? Remember they're trying to get that squeeze between interest and excess reserves and I forget what the other spread was. But they're trying to effectively do that very thing, right?

Duffie: Not exactly.

Beckworth: Okay.

Duffie: I have had some experience with that. I'm actually on the board of that startup narrow bank, it's called TNB.

Beckworth: TNB. Thank you, yes.

Duffie: But it wasn't proposing to do anything in the payment space. It was going to offer deposits to institutional depositors and just hold their money and pay an interest rate which TNB thought would be much more competitive than what banks are currently offering today, which is actually a pittance. But you couldn't use TNB accounts to do payments because by construction the only way that you can get money back out of the account is to get it back into the account from which it came. So you cannot make a payment using TNB.

Duffie: But other narrow banks could be used for payments and they could just set up. It would be equivalent to what I described as a hybrid central bank digital currency, where a bank it backs the deposits it takes for payments with central bank deposits. And then it allows depositors to make payments with those deposits using apps, using application program interfaces that you could pay for coffee, you could pay for your refrigerator when you have it delivered, you could pay your friend for the a hundred dollars you borrowed last week, all with a simple switch of an app. If you get these standardization interoperability problem cured. Right now you can do that with a credit card payment which has real problems or things like Venmo, which is a very limited scope.

Beckworth: Okay. Well with that our time is up. Our guest today has been Darrell Duffie. Darrell thank you so much for coming on the show.

Duffie: David it’s been such a pleasure. We covered a lot of territory and I really appreciate it.

Photo by Mandel Ngan via Getty Images

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