The Plumbing of Monetary Policy

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David Beckworth: Our guest today is Josh Galper. Josh is the managing principal of Finadium, an independent consultancy in capital markets with the unique expertise in securities, finance, collateral, and derivatives. Josh joins us today to talk about money markets, overnight interest rates and some of the big issues in this area. Josh welcome to the show.

Josh Galper: Hi, David. Thanks for having me on.

David Beckworth: Well, it's good to have you on. We often talk about the big picture of monetary policy so it's great to get someone like you who can walk us through and explain the plumbing of monetary policy, which is what you'll be doing today. Before we do that though tell us how you got onto Wall Street and into consulting.

Josh Galper: Sure, sure. I've been a listener of your podcast for some while now.

David Beckworth: Oh, great.

Josh Galper: I'm actually a trained economist. I started out as an economist at the masters degree level. I then worked for The United Nations, primarily UNICEF with some secondments to The World Bank and The World Health Organization. Along the way I came to find that I really needed to do a PhD or an MBA and wound up at the MBA program at the MIT Sloan School, where my summer internship was with a unique organization called The World Federation of Exchanges. And that began what is now 20 years in capital markets for me. I'm coming right out of MIT, I was hired by Merrill Lynch, worked for another couple of firms, and in 2005 started Finadium.

David Beckworth: Very interesting. So you've been working in capital markets, you've been working with the overnight money market area. You know a lot about this and so I have to ask since this is the 10 year anniversary of the collapse at Lehman. We had Larry Ball on the show recently, there's been a lot of conversations about what could've been done differently, what was done right. What is your take on what happened with Lehman's collapse? Was it a pivotal catalyst or would we have had the great recession in any event?

Josh Galper: Great question. Part of how I describe my career arc is that I was the nerd who was doing this really boring stuff before anybody cared. Even 20 years ago the work I was doing centered on central securities depositories which is where securities are held and where substantial amount of collateral management activity happens.

David Beckworth: Okay.

Josh Galper: Even in 2008 I was already engaged in securities; lending and repo and collateral and liquidity. My view on the Lehman collapse is that it was a pivotal moment. I think that Lehman could have been saved. I think that some of the arguments made about Lehman's holdings and its collateral that held with the Fed, showed in retrospect that had the Fed taken a different view or had regulators as a group taken a different view, that Lehman did not have to fail. Now, what you saw on the repo markets was really a lack of confidence and a sharp drop off of confidence in Lehman who were pretty heavily leveraged and reliant on the wholesale funding markets. So without counterparty confidence the fact that the number of counterparties they were dealing with in repo dropped so precipitously in September 2008 could only lead to one outcome.

Josh Galper: I view it as unfortunate. There are a lot of underlying conditions as well. Of course, Lehman's engagement in various business activities and their use of the Repo 105 accounting treatment, played all a role. However, I don't think fundamentally that Lehman had to fail in order for the system to get cleaned out, if you will. I think there were other mechanisms that could've played a role and spared us all some real hardship.

David Beckworth: Yeah, it's very interesting. And the run on money markets that followed. That was very consequential right?

Josh Galper: That was extremely consequential.

David Beckworth: Okay.

Josh Galper: The breaking of the buck that occurred in the money fund space had never been seen before. Likewise that similar kinds of losses occurred in securities lending cash collateral pools. Most famously with AIG that required its own bailout.

David Beckworth: Yep. A very large bailout. Now, the hard thing here is for the policymakers to see this counterfactual world. I agree with you, again Larry Ball convinced me that it was a bad decision to forego it with the understanding, we don't wanna be in the habit of always bailing out these institutions but when you're in the thick of a crisis you've passed that point already. The horse is out of the barn, you have to make a decision and I know Hank Paulson was very worried about being the bailout guy but the alternative seems to have been far worse. Now again, we don't know what it would've looked like had they bailed out Lehman, but it's interesting to hear you reinforce the point that Larry made that, that run was consequential, it really was the catalyst that made things get really severe.

Josh Galper: Yes, and I've read Larry's report and actually did my own analysis on it for our client base, and I found him to be pretty spot on. Now, of course hindsight, we can all be armchair quarterbacks and say, "Oh, yes that was ...that was what regulators should've done."

David Beckworth: Fair, fair point.

Josh Galper: And in the heat of the moment it's of course extremely difficult to have seen all the aspects and known what was coming. I think it's tough to be overly critical or overly judgmental of what occurred in the heat of the moment for the people who had to make those decisions, but in retrospect I think we can say that Lehman's failure was indeed a pivotal moment.

David Beckworth: Okay. Fair enough. I have been guilty of armchair quarterbacking a lot on this show, so I'll take that charge.

David Beckworth: Okay, so let's move onto the area where you spent all your time, and that's with money markets. We've been talking about that with Lehman, but what's going on now? Oh, money markets, overnight interest rates and you've done a lot of interesting work on these topics. So why don't you walk our listeners through the basics first and what is an overnight interest rate? What is a repo rate? What is the interest on excess reserves? What are the key interest rates and what should we know about them?

Josh Galper: Sure. Interest rates are really a way for investors, corporations, the general public to be able to track levels of borrowing, the cost of borrowing. The two main ways that we think about interest rates are you've got unsecured rates and this is ... what would you lend money for if you're not receiving any collateral back? And that can be compared to secured rates which is, what would you lend money for if you're receiving collateral back? And there's a lot of debate about what the rates ought to be for different counterparties, and it's not one rate, it's multiple rates, it's a credit instrument. Let's leave that aside if we could for now.

David Beckworth: Okay.

Josh Galper: The real conversation that we're having is about LIBOR and in the US moving to the secured overnight financing rate, or SOFR. LIBOR is unsecured, and more than just unsecured. It's based on the best opinion of bank officers who are asked, "If you were to make an unsecured loan, what would you make it for?" I'm paraphrasing but that's the gist of it.

David Beckworth: Sure.

Josh Galper: SOFR on the other hand is based on secure repo transactions backed by U.S overnight treasury collateral. And there, there's no hypothetical. This is an actual transaction that occurred and there's a methodology for it, and I can walk you through that if that makes sense for the program. But the gist of SOFR is you're backed by a substantial amount of actual transactions.

David Beckworth: Okay. Well, why don't you go back a little bit and tell us more about LIBOR why is this transition taking place? What happened to LIBOR? You've already outlined the advantages in terms of there being actual assets, a secured loan. But walk me through this scandal that precipitated this discussion.

Josh Galper: Sure. The scandal of LIBOR is that LIBOR was supposed to be an independent person's best understanding of what they would lend for. What the allegations proved out in the LIBOR scandal, if you will, is that people were making up LIBOR numbers or submitting LIBOR numbers to benefit their own firms, or at some point in conjunction with others firms to benefit a group of firms.

David Beckworth: Okay.

Josh Galper: That of course is egregiously bad behavior.

David Beckworth: Right.

Josh Galper: Now, when you're in the business of trying to triangulate what your LIBOR submission number ought to be, there does become an interesting challenge to say, "Well, do I need to take talk to someone else to figure out what my LIBOR number ought to be." But there is definitely a line. It's a hard line between a person legitimately trying to figure out what the right number is versus colluding with a colleague at another firm or in another part of your bank to say, "Oh, we're gonna make LIBOR two [basis points] higher today because we benefit from that in some transactional form."

David Beckworth: So there is collusion and someone was making money off this collusion, which is very scandalous. But let's go back a step before that. So LIBOR, it's an overnight rate and these banks submit these bids as you mention or what they think it should be. Now, my dad always asked me this question, and Josh I want you to answer this question for my dad. I'll make sure he's listening to this episode. He always was frustrated. He goes, "Why should my loan be based on some bank from London." That was his take on LIBOR. He's like, "Why in the world am I being constrained by these decisions being made overseas?" How would you reply to him?

Josh Galper: Your father has a good point in that LIBOR is the submission of the London overnight rate. Some countries have developed their own localized rates. For example, TIBOR is the Tokyo interbank offered rate, for example.

David Beckworth: Okay.

Josh Galper: The US, there is a US LIBOR but fundamentally LIBOR, in my own opinion, is more of a generic rate. So does it make sense to be basing US mortgage rates off of what's happening out of London? Well, not exactly. On the other hand financial markets truly are globalized and I don't find inherent fault in the US using LIBOR even though technically it's called the London Rate. The greater concern is that what is LIBOR? And is it based on actual unsecured transactions? Or is it based on someone's best guess of what that transaction would be if it occurred? And increasingly LIBOR is based on the latter.

Josh Galper: Now, the people managing LIBOR today which is ICE Benchmark Administration have proposed a major reform to LIBOR that would incorporate quite a number of observed transactions, both unsecured and secured in a waterfall methodology. That doesn't help your father today if he's got a LIBOR based rate.

David Beckworth: No, but that makes it clear. I think your point is also well taken that there's only so much LIBOR could deviate from global pressures in a global market, right? LIBOR is ultimately participating in a global overnight market ... funding environment. It is representing probably close to what it should be. Let me ask this question then. There is a move away from LIBOR but how far is it? We've been talking about this new interest rate, SOFR, how far along because what I've read is that LIBOR still has lots and lots of reach. There's still trillions of dollars that have been priced off LIBOR. Are we talking serious progress? Or do we have a long ways to go before LIBOR becomes a distant memory?

Josh Galper: We have a long ways to go before LIBOR becomes a distant memory.

David Beckworth: Okay.

Josh Galper: That said, there is increasing momentum to move away from LIBOR as and where possible all over the world. For example, in the United Kingdom, they select a rate called SONIA which is the Sterling rate and it's unsecured but it is not LIBOR and it has its own volumes and transactional activity going on. The European Central Bank has selected a rate called ESTER which again, is an un-secured rate but much more observable than LIBOR. The real kicker here is that the United Kingdom's Financial Conductive Authority's chief executive Andrew Bailey said publicly last year that the FCA would no longer compel banks to submit to LIBOR after 2021. What Bailey did is he set a hard date for when LIBOR could become no longer usable.

David Beckworth: Okay.

Josh Galper: Now, the analysis on LIBOR is that 82 percent of derivatives contracts outstanding will mature before 2021. Or by the end of 2021 rather is more accurate.

David Beckworth: Okay.

Josh Galper: Leaving just 18 percent on longer-dated contracts. The trouble with that 18 percent is it amounts to some 36 trillion dollars in value. So after 2021 then you have this condition whereby I would expect that most US based derivatives contracts will be in SOFR, not LIBOR, but you're gonna have this 36 trillion that needs to be transitioned in some way or it's gonna run the risk of using either a stale LIBOR number or some kind of zombie LIBOR. It will not be an effective interest rate benchmark at that point. Unless ICE Benchmark Administration is able to resuscitate LIBOR, which they still could well do.

David Beckworth: Okay. But-

Josh Galper: So-

David Beckworth: Go ahead.

Josh Galper: Oh, ultimately we'll have competitive interest rates benchmarks, as we already do and it really does remain to be seen quite how LIBOR either transitions or is fully removed from financial markets.

David Beckworth: Okay, so LIBOR is on life support and the terminal date is around 2021 with a little bit lingering that 30 some trillion you mentioned and you mentioned by that date most of the derivatives would be based off of other interest rates like SOFR. What about other forms of finance like retail, going back to my dad again. He seems to be the center of our conversation. Will retail loans and mortgages, will they now be also priced off of something other than LIBOR by that point?

Josh Galper: Well, they will need to be if LIBOR is not functioning.

David Beckworth:     Okay.

Josh Galper: I would recommend to your readers that they visit a document by the Alternative Reference Rates Committee in the US which is hosted by the New York Fed. They recently put out what they call the second report on SOFR, on the SOFR transition really, where they presented a good amount of numbers on the amount of contracts outstanding, both derivatives and also non-derivatives, including mortgages, that use LIBOR as a benchmark.

David Beckworth: Okay, we will make sure to put a link up to that on the show so our readers have a chance to look at that. Okay, so that's this backstory of LIBOR. We know we are transitioning here and in other countries as well. This is kind of a global movement away from various forms of LIBOR. Now, I'm gonna come back to the secured overnight financing rate or SOFR in a minute. Before we do that though I want to once again go back and talk about the basic interest rates. So, let's go back and talk about the repo rate, the federal funds rate and now the interest on excess reserves and then we can tie in our SOFR is connected to all of those. But what are these rates and why do they matter?

David Beckworth: What are these rates and why do they matter?

Josh Galper: If I could back up for just one second and explain what a repo transaction is.

David Beckworth: Yep.

Josh Galper:  I often find in my professional work that there are market professionals who know repo and they grew up with repo. They know it in their blood. Then there's other folks who hear repo and it goes over their heads. Not that it's an impossible concept to understand, it's just not a daily point of interaction for many folks. A repo transaction is that I lend you money and you give me back collateral. So, it's a fully collateralized transaction with a bit of a haircut that there's a commitment for a certain amount of time that I'm gonna be able to use the money that you've lent me. Sorry, in the case that I give you back collateral, that you're gonna have these assets that you feel confident that even in the event of some market movement, if I were to go bankrupt tomorrow and still have your cash, that you would be able to sell my collateral and be able to recoup your cash.

Josh Galper: So, there's two aspects of the transaction then. What is the credit quality of the counterparty? That is, how much do you trust me in borrowing your cash. And second, what is the value of the collateral that I've given you? If I'm a top bank and I give you US Treasuries as collateral, then the rate that I'm paying to borrow your cash will be pretty low. In fact, it'll be pretty close to what the USTreasury benchmark is, the effective federal funds rate. On the other hand, if I'm a lower rated entity and I want to give you asset-backed securities or equities or private mortgages, the rate that I'm going to pay you to borrow your cash could be rather high. That's the basic concept of a repo. The full name is a repurchase transaction or a repurchase agreement.

Josh Galper: Now when you start thinking about that repo transaction in the context of an interest rate benchmark, what SOFR is, is a benchmark of only overnight US Treasury repo transactions. That is to say, I'm borrowing your cash. I'm giving you US Treasuries, and we've agreed that that transaction is going to last for only one day. I missed another part of the repo transaction, which is term. Instead of one day, I might arrange with you that I'm gonna borrow your cash for 30 days or 90 days or even a year, and you're gonna hold my US Treasuries or my collateral in return. That also will impact the rate. So, the fact that the US Treasury is focused only ... I'm sorry, the fact that SOFR is focused only on US Treasury collateral overnight means it's a very specific tight rate around one type of repo transaction.

David Beckworth: So, it's a very secured overnight investment, and therefore the rate is a risk-free rate? Is that fair?

Josh Galper: It's as close to a risk-free rate as you're reasonably gonna find.

David Beckworth: Now let me ask this question about repo, just to flesh this out, to maybe use an analogy. This is an analogy that Gary Gorton used in his work. Going back to our conversation on Lehman in fact, there was a run on repo. Is that fair at this time? Would you call that a run on repo?

Josh Galper: You can call it a run. You can call it a lack of confidence.

David Beckworth: Okay, lack of confidence. So, the way that he describes this, and I'd like to hear your thoughts on this. He compares repo to a checking account for us. Repo is the equivalent of a checking account for these institutional investors, these big money folks who have millions and billions of dollars to park. They need something like a checking account where they can park it overnight and pull the funds out the next day if they need to. Just like you and I have a checking account. We don't have collateral, but we do have FDIC effectively doing the same thing backing it up. So, we feel confident. We feel secure. None of us ever question whether we can pull our money out of the checking account. In his argument, that was the thinking. People felt secure. Investors would put money overnight into repo. They'd pull it out the next day. They could ... Every day they'd roll it over. But when the panic hit, when the lack of confidence was ushered in with the collapse of Lehman, suddenly investors weren't putting the money in, so those checking accounts for institutional investors began to disappear.

David Beckworth: Is that a good analogy or is it a misleading one?

Josh Galper: I think it's a little bit of a clunky analogy, but I get that for, I appreciate that for explaining the concept simply and quickly, it makes enough sense.

David Beckworth: Then if it's a clunky one, we'll say this. It's a clunky analogy. It's helpful to me then, in the sense that I understand the Great Depression bank run. It was a retail bank run. So, if I can take this clunky analogy and apply it to Wall Street and to shadow banking, these big institutional investors. There was something also like a bank run at that level. Is that also a ...

Josh Galper: That is correct. So what happened was that in a very short period of time, Lehman Brothers, which had been relying on wholesale funding in repo to meet its cash obligations saw a very quick turn in the confidence of its counterparties being willing to lend it cash.

David Beckworth: Alright, let's get back to SOFR or the secured overnight financing rate. As you mentioned earlier, it's a very secured, as the name implies, very secured interest rate, as close as possible to a risk-free rate. It's backed by treasuries. Now tell us who's actually providing this interest rate. Who's providing this service of compiling the data that will make it up?

Josh Galper: The data is being collected by The Federal Reserve and by the US Office of Financial Research. There's some important things to know also about SOFR and what's actually going into the measurement. SOFR is not just one rate. It's really three different rates coming from three different kinds of transactions. This is both a feature of SOFR and also something really to watch out for as the market evolves. The three parts of SOFR, all still overnight repo backed by US Treasuries, are first tri-party transactions. These are transactions that occur in the US at the Bank of New York Mellon, where two counterparties agree on a rate. They agree on collateral. Then they send the trade to Bank of New York Mellon, which operates as an outsourced collateral manager, valuation, and service provider. So, they're going, Bank of New York Mellon will tell both parties, "Yes. Your collateral or your cash is here. Here's the underlying collateral. Here's a report on it. Here's the valuation of it." Then it lets both parties know when the unwind has occurred. So, that's one rate.

Josh Galper: The second rate is a bilateral transaction where there is no tri-party engagement. The particular bilateral repo transactions that are contributed to SOFR are sent to the DTCC, which has a DVP, or delivery versus payment, program to help facilitate the transfer of funds between borrower and lender. The distinction here ... It might be a bit of a fine distinction for a casual listener, but there is some great importance to it when you dig in, because the amount of transactions going into tri-party versus the amount of transactions going to the bilateral DVP program make up SOFR in the end. The rates can be different, even though it's still the same counterparties transacting for the same term, the same amount of collateral, the same type of collateral.

David Beckworth: It's interesting you bring this up because I myself have been looking at repo rates for some research. I first came across the DTCC repo rate you'd mentioned, and it stands for the Depository Trust and Clearing Corporation. I looked at that rate. Now I was actually looking at these repo rates relative to the interest on excess reserve rate, and I noticed that rate tended to be closer to, and recently above, in interest on excess reserve. It hugs it but it tends to balance above. Then someone shared with me the Bank of New York Mellon, the BNY repo rate index, and that one was a little bit lower. I was like, "Well which one do I use?" Then there's the New York Fed SOFR repo index. So, they are different. I guess it speaks to the point there isn't one generic repo rate. Is that fair?

Josh Galper: That's right. In fact, the repo rate you were just referencing, to make matters slightly more confusing, is the popularly available GCF, or General Collateral Finance data, coming from DTCC. I mentioned at the onset that there are three different components of SOFR. There's tri-party, there's bilateral DVP, and then the third one is a central counterparty model operated also by the DTCC, and they're a fixed income clearing corporation unit, also called FICC, or F-I-C-C, where transactions are between different types of counterparties. They tend to be mostly dealer-to-dealer. So, you will often see transactions that start out in tri-party where a bank borrows money from let's say a money market fund and provides US Treasuries as collateral in return. Then the bank takes that same cash and lends it out on the GCF market to another dealer who doesn't have access to that money market fund directly.

Josh Galper: Still more complicated is that while GCF has historically been a dealer-to-dealer market, recently DTCC has been successful in promoting a sponsored repo, or cleared repo model, where buy side firms, including money funds, can go directly to the CCP via a dealer or a sponsoring clearing firm, and be able to transact with the backing of the Central Counterparty. When you say that there's different types of repo rates, that is really accurate. Just the other week, the tri-party rate on BNY Mellon for US Treasuries was 2.25 percent, but the average rate on the DTCC's GCF facility was 2.35 percent.

David Beckworth: That's quite a bit different.

Josh Galper: It is. And you can imagine that as market structure evolves and the fact that these rates are different for structural reasons and the types of counterparties that are transacting, that could have a future impact on SOFR.

David Beckworth: Let me try to wrap my mind around all of this because there's a lot there to digest.

Josh Galper: There is.

David Beckworth: I'm a policymaker. Let's say I work for the board of governors. Let's say I'm Jay Powell. I'll put on my Jay Powell cap here. Which one of those should I be paying attention to? Which one is the best summary indicator of overnight interest rate?

Josh Galper: Well-

David Beckworth: Or all of them? Maybe all of them.

Josh Galper: They're all of them. They're all of them because they are all accurate representations of the overnight interest rate for US Treasury collateral for one day. The reason why SOFR is a mix of them, a mix of those three rates, is that they're all accurate. Now the Fed itself, as you pointed out earlier, is also publishing now three rates. It's got its tri-party rate, its tri-party plus GCF, and then SOFR. Again, each rate has something slightly different to say. There's also the important factor of whether the Fed's own reverse repo facility is included in the data. When you look at tri-party data, that's also available on the New York Fed's website, the RRP, the reverse repo facility, run by the Fed, is in there. But the RRP numbers are not in the SOFR calculation. The argument there is that RRP is in effect an artificial rate set by the Fed. It's competitive to overnight private party transactions, but it's not quite the same as what the market would lend to each other.

David Beckworth: Yeah. The volume's come down quite a bit in that market, right?

Josh Galper: Volumes have fallen dramatically for a number of reasons that we can certainly discuss if there's time.

David Beckworth: That's a nice segue into a question I've had about the federal funds rate because it's also an overnight. Technically it's supposed to be an interbank lending rate, but it has largely changed. It's a shadow of what it used to be, if my understanding is correct. Before it truly was an interbank rate, but now my understanding is that it's the GSC, it's Fannie, it's Freddy, the Federal Home Loan Bank, and they're the ones only really lending on that market, and the takers on that market are mostly foreign banks because they're not penalized like domestic banks are by capital requirements from the FDIC. So, the Federal Funds market itself really is just a shadow, a hollowing out of what it used to be. Is that fair?

Josh Galper: It's tremendously hollowed out. There are a variety of instruments that have grown up to replace it that are a much better deal for market participants. One that I'd put out is interest bearing deposit accounts, which are transactions that are occurring largely between federal home loan banks and big US banks. The fact that the fed funds rate has such little volume actually makes it quite a poor benchmark. Then you've got the overnight benchmark funding rate. There's a whole variety of rates still out there that we could discuss, and which the alternative reference rate committee did evaluate as potential replacements for LIBOR.

David Beckworth: Let's put this back on the monetary policy then. The Fed still hangs onto the federal funds rate, at least using the term, which to me is largely symbolic. I mean, the interest in excess reserve is really the lever, the tool. It's the rate that manipulates for policy. I wonder why they still want to frame this though in terms of a federal funds rate, given what's happened to the market.

Josh Galper: Well, there's a lot of debate about that. I've heard some talk about whether the Fed would abandon fed funds, whether OBFR, or even SOFR could be a viable rate. Now there's a lot of monetary policy questions in there as well. In fact, what I just said to some folks is a tremendously loaded statement. As one idea, and getting to your work also on interest on excess reserves, is if you don't have a base rate or if your base rate is based on what's traded in the market, how do you set your controls? How do you more accurately influence monetary policy? The effective federal funds rate then is still a way for the Fed to at least set the lower bound, even if now the market is taking off and going in different directions, and the Fed doesn't have the same amount of control on the upper bound.

David Beckworth: Let me ask this question. The federal funds rate is very different. It's again a very different beast than it was prior to 2008. Interbank lending has dropped, has collapsed.

Josh Galper: Unsecured.

David Beckworth: Unsecured, okay. Unsecured interbank lending has declined. I've heard some observers say that's a shame because unsecured overnight bank lending was a useful signal. It provided information about counterparty risk. It told us something.

The market was revealing information. Can that information be found somewhere else or have we truly lost something valuable?

Josh Galper: The information can also be found in the repo market. I personally don't lament the loss of unsecured transactions. I find in my own thinking about it, my own work, unsecured transactions are less reliable. For example, if you go into a bank and you say you want a loan because you need to consolidate your credit card debt, the bank may well make you a loan based on your credit history, but if you have no collateral, they're going to charge you quite a bit.

Josh Galper: On the other hand, if you walk in and say, "Look, I have this house. I'd like to get a home equity line of credit so I can consolidate my debt, but this house is my collateral." If I'm the bank, I feel much more secure then about making you the loan, because I know that there is going to be something that I can get back if you default.

Josh Galper: Reality is the risk of default is very, very low in the overnight treasury repo markets. Lehman was a truly extreme event, and subsequent regulation in the form of Basel III and Dodd-Frank and others around the world have made banks much more robust and much more well capitalized to the point that today the idea of a major, a G-SIB, going bust overnight is truly ... It would really take an exceptionally fat tail event for that to occur.

David Beckworth: Well, that's comforting. That's good to know the world is a better place today, a safer place financially than it was pre-2008. Josh, any other thoughts on SOFR?

Josh Galper: There's one other thing I'd like to point out, which is I alluded to it earlier, but market structure in the repo market will have an impact on SOFR. In addition, regulation that impacts repo will have an impact on SOFR. I spoke earlier about the three different components that make up SOFR.

Josh Galper: You can track that pretty directly to regulatory changes or, for example, the DTCC is currently raising the amount of liquidity that it holds or that it requires its netting members to be able to attest to in the event of a future default. The US Treasury last year proposed that US treasuries, the instruments, should be removed from the denominator of the supplementary leverage ratio.

Josh Galper: Now, I'm getting into some technicalities here, but these kinds of market structure issues, I think, are very important to understand in the context of SOFR, that SOFR isn't just like LIBOR was. If I lend to you unsecured, what would it be, and that's it.

Josh Galper: As a traded product, overnight repo transactions, even just overnight repo based on US treasuries there's a lot of dynamics that go on behind the scenes that influence how much transactional volume occurs, what the rates are, how counterparties view one another, how counterparties view collateral.

Josh Galper: As SOFR becomes more popularly used, these underlying factors could well influence the rate going forward.

David Beckworth: Well, let's wrap our discussion on SOFR up by circling back to my dad. He's going to love this episode. Will my dad in the future be asking me, "What is SOFR? Why is SOFR constraining my decisions?" Will he have the same questions that he has today about LIBOR?

Josh Galper: I think everyone will have questions about SOFR. Repo transactions and securities finance generally speaking is not the sort of thing that most people get intuitively. Now, these aren't terribly complicated markets, but they're markets that are populated by people who have a native understanding of the terms of the markets, the credit impacts of the markets.

Josh Galper: It's not an equity market. We held a big conference on Monday, and one of the panelists said something funny like, "Younger programmers ask me why can't I automate my repo transactions like I can my futures transactions or my equities?" The answer is because there's a lot of components that go into determining what the right rate is.

Josh Galper: Some of those can be automated, and some of those are still very much human-driven. It's not a clean just like, "Yep. Here it is. That's the equity price. That's what IBM closed at today." You don't necessarily get that with repo and you definitely don't get it in today's market.

David Beckworth: Very interesting. We will be seeing more and more of the secured overnight financing rate, or SOFR, and maybe one day even the Fed might make it an important target rate for monetary possible.

Josh Galper: It could. There's one thing though that your dad is going to be very upset about.

David Beckworth: Uh-oh.

Josh Galper: Which is presuming your dad's got a longer term mortgage, there's going to be some point where if his mortgage currently is a floating rate and it's based on LIBOR, there could be a day when someone says, "You know what, it's not going to be LIBOR anymore. That rate is not going to move to SOFR plus or minus some points."

Josh Galper: This is going to be a very, very complicated time. How that transition for legacy LIBOR contracts, if LIBOR is no longer functioning, how those contracts get transitioned to SOFR could create a lot of trouble. Could be a lot of confusion, for sure.. There could be lawsuits. There could be complications, mechanical difficulties. There's some real potential mess there.

David Beckworth: We will be watching closely, and maybe coming back to you, Josh, for insight as this happens. The year will be 2021 when this transition happens, when the potential rough patches are hit.

Josh Galper: Well, really we're already in some rough patches, and they have to do with how much liquidity really is going into LIBOR versus how much is LIBOR a best guess. Now, the LIBOR figure has been continuously quoted, and so far it seems to me like it's fair enough. The end of 2021 is when the FCA has said that it will no longer compel banks to submit to LIBOR.

Josh Galper: A number of banks, I believe, would already have stopped submitting to LIBOR if they had been allowed to. They don't need the reputational risk. They don't need the exposure. There is a continuum of time between now and the end of 2021 where there are open questions about how LIBOR fares.

Josh Galper: The end of 2021, then, that's really the hard deadline to say, "Is there a version of LIBOR that the market can agree on, or is LIBOR completely no longer functional?"

David Beckworth: Very interesting. Let's switch gears just a little bit to a related but somewhat different topic. That is this new bank, The Narrow Bank, or TNB that's been chartered at a state level, and has applied to the New York Fed to get access to the balance sheets, so that it can tap into interest on excess reserves.

David Beckworth: Some of these other rates we've been talking about, repo rates, overnight rates, they've been offering a return that's lower than interest on excess reserves. At least they have been. Now, recently that has changed. They've gotten a lot closer. Up until recently, anyhow, there was a spread and many non-bank financial firms are not able to earn the interest on excess reserves rate.

David Beckworth: The idea for this, the business model was this Narrow Bank would tap in, get that higher interest on excess reserves rate, share it with these other financial firms, and they would benefit from that. I'm curious as to what your thoughts are on this development.

Josh Galper: This TNB Bank USA case, and they're based in Connecticut, I think this is a pretty brilliant lawsuit really. The fact that IOER is limited to a certain number of institutions or types of institutions creates an opportunity for those institutions to effectively arb the market. They could take in cash cheaper than IOER. They can deposit it. They earn basically a risk-free spread.

Josh Galper: What TNB Bank USA has said is that they want to be taking in customer deposits, depositing in IOER, earning the spread as well, but being quite transparent about what that spread is to their customers. They could offer, for example, IOER minus 10 BPS, and that would be the TNB spread.

Josh Galper: The difference that minus 10 BPS might be really a very, very good deal for depositors, and they know exactly where their money is being held. Conceptually this makes a lot of sense. I think TNB has got a reasonable point that the New York Fed has not given a clear reason or a strong justifiable reason, in my opinion, why they would reject TNB or other banks from having IOER accounts. It doesn't seem quite fair.

David Beckworth: I think you're right on the legal grounds. I had Michael Derby on this show, and we talked about it. He covered it for the Wall Street Journal. He's a Wall Street Journal reporter. The sense I got from talking to him and some of the other articles is the Fed's just a little uncertain, a little hesitant to go down that path.

David Beckworth: Because what it means is they're going to be opening up their balance sheet little by little. A little more creeping nationalization of financial and intermediation, I guess, is the fear or the concern. If we let in these other non-bank financial firms, who's next?

Josh Galper: Well, that's an old concern, and it's really a core question of who should have an account at the Fed. The logical extension or the far extension of that is current debates about central bank digital currency, where a central bank could issue its own crypto, or not cryptocurrency but digital currency, where banks would then be able to provide services on top of that. Ultimately an individual, you are I, we would have an account that could potentially sit at the Fed.

Josh Galper: TNB is another example of that discussion, in a smaller degree, but still part of the broader conceptual idea, as you were mentioning, about what is the role of private institutions and what is the role of the Fed. Personally, from the perspective of IOER paying an interest rate to banks for parking their cash, as an individual I'm a strong critic of that. I don't like that at all.

Josh Galper: I understand the policy objectives of why the Fed wanted to get that money. As far as I'm concerned, as quantitative easing furthers, I would like to see IOER go away.

David Beckworth: I share that. You probably know my views already if you're a listener to the show. I would like to see the Fed return to a corridor system where the IOER is kept below market rates, so the SOFR would be more consequential, and the IOER would be less consequential to policy decisions. This is an interesting discussion.

David Beckworth: I had Morgan Ricks on the show several times, and he's got these proposals for Federal Reserve accounts. He makes this interesting point that on one dimension you and I already do have access to the Federal Reserve's balance sheet. We have access to physical currency, which is a liability. We don't have access to the electronic form of account holding. This would provide symmetry. We do all those things.

David Beckworth: The advantage for consumers, well, not just consumers, but for big institutions as well would be a super-safe account. You would have no question about whether it was safe or not. The danger, and this is the libertarian streak in me coming out is this does imply further and further moving activity that was done in the private sector to the Federal Reserve.

David Beckworth: In the limit, I mean I don't want to go down a slippery-slope argument too far, but in the limit you get to the world of China and state-owned enterprises and banks and credit being allocated based on political decisions. That concerns me as well.

Josh Galper: Sure. Then I think also you have Europe's TARGET2-Securities or T2S as another example of what should be the role of the government versus what should be the role of private institutions.

David Beckworth: These are all very interesting questions the Fed has to wrestle with going forward. I think, again, going back to The Narrow Bank, part of the hesitation is the weight of these questions, and the worry about cracking open the balance sheet more and more to other firms and to the public in general.

Josh Galper: Mm-hmm (affirmative).

David Beckworth: Josh, we are getting near the end of our time here, and I just want to mention that Josh has this firm, Finadium. Maybe tell us a little bit more about it. I know I was invited by you to present at one of your conferences. Tell us what does your firm actually do?

Josh Galper: We're a research and consulting firm. At heart we are consultants, and like many others. What makes us a bit distinct is we run an independent research program. Our biggest practice is securities finance, collateral, and derivatives. That encompasses all the topics we've been talking about, including repo, securities lending, collateral, liquidity management.

Josh Galper: Functionally, you'll hear about prime brokerage or custody. Those are both businesses that we know a lot about, just as tangible examples. Over the years what's happened is that we've productized more and more of our consulting, so that we've got this research subscription now that we sell to quite a number of institutions.

Josh Galper: We have a magazine. It's called Securities Finance Monitor. This year we're going to run some 10 events and webinars around the world, all focused in the securities, finance, and collateral space. We have a second practice that we launched last year around fintech and capital markets. That's been very interesting.

Josh Galper: We've been able to delve into some topics that are enough outside the securities, finance, and collateral space, but we think are going to enter into that space within the next few years. One example is central bank digital currencies that I mentioned, stablecoins, which have some similarities, and the use of custody banks for custodying crypto assets.

David Beckworth: Very interesting, Josh. You definitely have your plate full there. It's important work because this is the plumbing of the financial system, and, again, from my perspective the plumbing of what monetary policy is attempting to do. It's great to be able to chat with folks like you. I appreciate you coming on today.

David Beckworth: Our guest today has been Josh Galper. Josh, thanks for coming on the show.

Josh Galper: David, thanks very much for having me.

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