Carolyn Sissoko on the Collateral Supply Effect and Other Concerns in the Money Market

The collateral supply channel has become very important part of the monetary policy transmission mechanism, and it deserves much heavier analysis.

Carolyn Sissoko is an associate professor of economics at the University of the West of England, and she has written widely on shadow banking, money markets, and the plumbing of the financial system. Carolyn joins Macro Musings to talk about the evolution of money markets over the past few decades, and its implication for both monetary and fiscal policy. Specifically, David and Carolyn discuss the collateral supply effect, the consequences of moving from LIBOR to SOFR, and solutions to other money market concerns.

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 [email protected]

David Beckworth:  Carolyn, welcome to the show.

Carolyn Sissoko:  Thank you very much for having me, David. I'm really pleased that you've invited me here today.

Beckworth:  Well, I'm glad to have you on. You are another great example of someone who I've had the privilege to get to know over Twitter. Twitter has been incredibly useful for me. I've met interesting people like you. I see their ideas. In fact, this paper we're going to discuss today was promoted by other people on Twitter. I knew you already, and it seems like we've had conversations in the past dealing with the plumbing of the monetary system. You always had thoughtful things to say on Twitter.

Beckworth:  I'm just grateful that we've gotten to meet each other. Now that you can come on the show, we can talk a little bit more in depth about your work. You have a great paper that we're going to use to motivate our conversation today. The paper's title is *The Collateral Supply Effect on Central Bank Policy.* We'll provide a link to it for all the listeners to find it on the show notes. It's really a great paper, and we'll get into it in a few minutes. Before we do that, though, tell us how did you get into this area? Why did you get a passion for money market, shadow banking and financial regulation?

Sissoko:  Well, let's see. When I was in graduate school, the basic thing is I was studying money and macroeconomics at UCLA, a very traditional, classic approach to macroeconomics. To be honest, I wasn't convinced by what they had to say about money, so I really started to think about, "Well, what's the role of banks in the monetary system?" In fact, that was basically the title of my dissertation, the monetary role of banks. I was really looking...

Sissoko:  I had one paper that looked historically at what was the evolution of central banking, so I start out in 13th century Venice, and wander on to 1800 Bank of England. Of course, you start talking about crises and worrying about that. I was worried about crises, but I also had a theory paper on trying to motivate the idea that bank lending can play a role in economic growth. That's where I was coming from when I finished my dissertation in around 2003. It was 2003.

Sissoko:  Then with the financial crisis, in 2008, I'm like, "Wow, this is exactly what I'm interested in." I have to admit I actually took some time off teaching at that point, and spend time just actually hanging out on blogs and on Twitter. An incredible number of people are actually in finance, who are telling you all kinds of things on the internet. I got the picture of the plumbing simply from paying attention on a day to day basis of what was going on in late 2007, 2008.

Sissoko:  As I started to look at this, and I wrote up a 2010 paper essentially attributing a lot of the problems to changes in the legal system, and essentially the way we completely change the way the law governing financial... I wrote a paper in 2010 on that, and I realized I was writing a paper about the law. That sent me off to law school actually, because I was like-

Sissoko:  I'm not actually going to understand any of this unless I actually learn what the lawyers were thinking when they were making all these [inaudible] for financial laws. Since then, I just been deep in studying the guts of the financial system, both from a legal perspective and also because you do really get to listen to people in the financial industry. If you know the internet well, and you follow the blogs and you follow the right people on Twitter, there are incredible conversations you can participate in or be privy to that I think really do give you a sense of how the internal dynamics of finance work.

Sissoko:  I basically have through the internet focused on the guts of the financial system. I'm paying attention to legal issues, but of course, I came out of an economics training background. Also, essentially when I was working with a theoretic framework, I was working with a search model of money, so my basic mental framework of money is completely different, because for me, the search model of money is the framework I tend to use to organize things. In particular, I have my own version of it. That is what's working in my head as I'm analyzing all of these things. I'm coming at this from a very different perspective, but bringing together all those threads, both the legal thread... I love the technical details of how the financial system works, and then the economics.

Beckworth:  Well, that's fascinating. I didn't realize you went back to law school after having your PhD, so you were a glutton for punishment, but hey, more power to you. You understand things better. It's true. A lot of the interesting people on Twitter that I've gotten to know, I mean, from Morgan Ricks, who has a novel idea for Fed accounts to other people, I could go through and list. A lot of them do have training in law on the background, and yet they also understand economics and the plumbing of the monetary system.

Beckworth:  It's a cross-discipline approach to really understand what's going on. It's great that you've done that. That's pretty bold and ambitious. I'm also excited to hear you're a fan of search models and money because I am, too. I mean, I've worked a little bit with that. I have a co-author, Josh Hendrickson, and we've done some monetary search models ourselves, so big fans of that, because in our view, it takes money seriously as opposed to some of the models just assumes money's important.

Beckworth:  We'll put that to the side for now, but I can see why you have taken the approach you have with that background. That's really neat to hear. Well, let's move to your paper because it's a great paper. Again, the title is *The Collateral Supply Effect on Central Bank Policy.* It was really fun reading this paper because it got at something that's been nagging at me and, I think, probably a lot of people who've been following closely what happened in the repo market in September last year.

Beckworth:  We had the repo market spike in yields, and then in March when supposedly the deepest, safest market of all, the treasury market had a hard time. It too also had some plumbing problems. We've had Darrell Duffie on the show to talk about that. We've had George Selgin to talk about what happened in September, and other guests. I've had a number of guests actually. I can't go through all them right now. They all have great answers and perspectives on this, everything from how was the Treasury's general account handled.

Beckworth:  It could have been done better to the operating system, to other answers like that that are part of the story. What you really, in my mind, at least uncovered in this paper is the changing nature of the money market itself. All those other explanations are important, but there's still something missing. I think, for me, at least, you've uncovered it's the changing structure of the money market itself, and it's been pretty significant. I actually touched on this with Daniela Gabor. A few months ago, she was on the podcast.

Beckworth:  We're talking about the history of the repo market and how it's changed, but we really didn't go down as deep as you do in this paper. It's great to get you on here and to highlight this for us. Maybe you could just maybe summarize the key points of your paper upfront, and we'll dive down deep and work our way through it. What's the bird's eye view summary of the paper?

*The Collateral Supply Effect on Central Bank Policy*: A Bird’s Eye View

Sissoko:  The bird's eye view summary is really that we need to start from this understanding, just like you just said, that there's been a transition in our money markets. The historical money market, especially the 1980s, you would be talking about an uncollateralized core interbank money market, federal funds market in the U.S., London interbank markets internationally. These are uncollateralized markets where essentially they really depend on the trust essentially that you have, so these four financial institutions aren't going to go bankrupt because you're just the general creditor if they do.

Sissoko:  You don't have any special status. Since 2008, those markets are basically moribund. I mean, they still exist. There's still a little bit of trade going on, but they're just not anywhere near as important as they were. The core interbank markets now is the repo market basically. It's the market for collateralized debt, where for the most part, it's high quality. Sovereign debt is being used as collateral to borrow, and the banks borrowing from each other are relying also on this collateral.

Sissoko:  Essentially, the core money market now is not on collateralized money market. I started from that. My real concern is I'm not sure even the central banks have a good understanding of how this has transformed the operations of the money market and what it means for monetary policy. I started out just looking at monetary policy in this paper, and essentially looking at two major consequences. One is when the Federal Reserve... or sorry, when the Treasury issues debt, we don't just have a problem.

My real concern is I'm not sure even the central banks have a good understanding of how this has transformed the operations of the money market and what it means for monetary policy.

Sissoko:  It doesn't just affect the money market by the question of how do you settle payments on the debt? In other words, when the Treasury issues debt, it's going to withdraw cash from the economy. Until it spends that money, there's going to be a change in the money supply if it's a big debt issue. This settlement issues are a core central bank issue that they've been worried about from day one, and central banks are completely on top of it, so we stabilize Treasury debt issues really easily.

Sissoko:  But now, there's a second factor. Before, when the Treasury issued a 30-year bond, it wasn't going into the repo market, and being funded on the repo market and creating another demand for a second loan. The treasury bond is one loan. When you borrow against the treasury bond, that's a second loan. That's a second loan on the market. 1980s, it wasn't a big deal. Some treasuries were funded on repo, but it's a small fraction of them. Now, it's something closer to 70% or thereabouts.

Sissoko:  Now when you issue those treasuries, there's actually a demand on the money market for funding the Treasury. Suddenly, we have actually a second effect on the money markets created by a debt issue, which is the demand for funding on the money market. That's one thing that essentially needs to be part of the calculations. When you start thinking about my... Well, when you start thinking about what's going on in the money markets, and then the other big issue that happens is that when you're talking about using long-term treasuries as collateral on the repurchase agreement market, if interest rates rise...

Sissoko:  Remember, when we think about normalizing monetary policy, we're basically thinking about having interest rates rise. Well, you don't just have the effect of increasing the cost of long-term debt, but actually, the whole supply of collateral actually shrinks automatically when interest rates rise. This is something that everybody in finance is like, "Well yeah," but it's not something I think economists have really internalized into their thought processes all the time, and certainly not as clearly as they could into their models.

Sissoko:  There's this dynamic where if you get for... If you have a 30-year treasury, and you get a 50-basis point or half a percentage point increase in interest rates, that 30-year treasury will fall in value by something like 12%. Anybody who's funding their activities on a leveraged basis using that treasury suddenly finds they have 12... that the collateral has fallen to 88% of what it was the day before, well, what it was before the shift in interest rates. This is actually a factor, I believe, in what's going on with monetary policies. When you think about a taper tantrum, the Federal Reserve is trying to raise interest rates, but as soon as it starts to do this, you get this freak out on money markets, right?

Sissoko:  I think one of the things that can explain this is the collateral supply effect. Basically, when they raise these interest rates, what they're doing is they're shrinking the collateral that everybody in the industry, both the banks, which are probably more prepared for it because they have a good understanding of what these dynamics are, but every single hedge fund out there that's posted a long-term treasury as collateral is going to watch the collateral they have shrink.

Sissoko:  When this happens, I mean, the idea that there are going to be some players who end up facing margin calls going bankrupt, getting shut down, well, it seems like it's highly likely, because every single one of these entities that's posted, even a 10-year note will have a 5% effect, but everybody who's posted a 30-year bond is going to have over a 10% effect on the value of their collateral. It's hardly surprising that as traders see their collateral value fall, a bunch of them get into trouble, face margin calls, and then are either selling their collateral to meet the margin call or perhaps having the collateral foreclosed on and having it sold out from under them by the banks.

Sissoko:  This collateral supply effect is something that I think is affecting monetary policy all the time. Then we look at what happened in March 2020. I think you have to ask the question whether actually there isn't a fundamentally destabilizing dynamic at the heart of the system. That is that not only do you have this problem that when you implement monetary policy, you're going to have a tightening from a quantitative as well or from the supply side as well as from the increase in the interest rates.

This collateral supply effect is something that I think is affecting monetary policy all the time.

Sissoko:  It's also possible that actually the system doesn't really work. We don't actually have a way of dealing with our collateral supply situation without generating destabilizing dynamics. I guess I think one of the important things also is to compare 2008 to 2020. In 2008, they said, "Okay, we had all these problems with the repo market, but it was because they were mortgage-backed securities." It's causing all these private securities that everybody should have known were risky, and they shouldn't have been borrowing against them like that, and so the regulators have been very effective at re-jiggering the system so that we aren't using risky private debt anymore as repo collateral.

It's also possible that actually the system doesn't really work. We don't actually have a way of dealing with our collateral supply situation without generating destabilizing dynamics.

Sissoko:  We're mostly relying on safe sovereign bonds as repo collateral, but what March 2020 told us was, "Well, wait a minute, that was not a solution." We are getting the same dynamics in 2020 that we had in 2008. The difference is in 2008, it was with mortgage backed securities and private sector collateral. We got these same dynamics in March 2020 of this situation where you get a liquidity spiral, and there are a few hedge funds that have this problem where their collateral supply has been reduced, and they have to sell the collateral. You get these sales. As you have these sales, you reduce the collateral value further. You watch the yields go up, so you've set off this liquidity spiral dynamic. That's essentially the Brunnermeir and Pedersen dynamic.

Beckworth:  There's a lot more moving parts now because we have seen the money market move to repo-centric design. We want to unpack a lot of what you've just shared, but one of the implications of what you've just shared, if I understand correctly, is this new channel or maybe it's always been there, but it's much stronger, this collateral supply channel is an important part of the monetary policy transmission mechanism. I know when I used to teach, I would make my own charts, and others would make these charts.

Beckworth:  You'd have, "Here's the Fed, and draw these little arrows out showing all the different channels, exchange rate channel, credit channel, all these different channels," but this is an important new arrow to add to that chart, right, this collateral supply channel. I think one big point of your paper is we just don't understand it well enough. I mean, scholars are wrestling with... In fact, you said in your paper, you want this paper to motivate others to look at this closer and see what it means.

Beckworth:  The Fed in particular and other central banks too, they really need to wrestle with what this means. One way to maybe help us think about that is if you have an increase in interest rates, as you said, so that the price of the bonds fall, the collateral disappears. It's not just a finance question. It becomes a money supply question because as that collateral falls, that means there's less funding available, less collateral support funding, which means a decline in institutional money supply, the money that these institutional investors use, so it's actual decline in the money supply.

Beckworth:  It's a complicated channel, but it's an important one. I think we should go back, maybe talk about what is money here. Because if we can paint a proper thorough measure of money, we'll see that this channel is very important, and therefore any Fed watcher, any Fed official should be thinking about it. You have a great discussion in your paper about what is money. You note money is more than the standard M1, M2 definitions.

Beckworth:  I like the fact you did bring up money Divisia measures, which is I've worked with those. Kudos to you for bringing those up. You point out that even these aren't enough, right? You talk about contingent bank liability. Walk us through what is the contingent bank liabilities, and why is it important understand them in thinking about this collateral channel?

Contingent Bank Liabilities and the Collateral Channel

Sissoko:  Yes. When I think about money, I think of off balance sheet bank liabilities as being just as important as on balance sheet bank liabilities. The standard thing is the on balance sheet bank liabilities, the deposits are... That's what you're measuring in the money supply. In fact, however, our modern banks have a lot of off balance sheet or contingent liabilities. It's not clear that there is a theoretical reason for drawing a distinction between them. This is actually... People have been discussing this since 1900. Keynes actually talks about this issue.

Sissoko:  Basically, it's this idea that if you have an overdraft checking account where you have a limit, you can overdraw your account by $1,000. If your balance is zero in that account, you have just as much access to liquidity as the person who has an account with no overdraft and a positive balance of $1,000 in their account. Essentially, as a practical purpose as a user of money or as a user of bank services, there's no difference between having the overdraft ability and a zero balance, and having a $1,000 balance and no overdraft capacity.

Sissoko:  Granting that overdraft is an off balance sheet liability that the bank does doesn't need to realize effectively until you use it. Those kinds of things, I argue, are actually as much money as deposits. We need to start being a little more flexible in terms of how we think about what money is. I actually want to take that even a step further, and say that when you have a commercial bank that has a market making commitment... This is rare, because we actually don't think of our commercial banks as being in a principal role as market makers.

We need to start being a little more flexible in terms of how we think about what money is.

Sissoko:  But in the repo market, actually, our commercial banks are actually acting as market makers. That's why this matters. This is another kind of off balance sheet commitment. That's not contractual like an overdraft. If you have signed up for an overdraft account with your bank, they have a contractual obligation for the most part to meet that. A market making commitment is more of an understanding that you will stand ready to buy something like a U.S. Treasury at some price, and the market maker doesn't need to commit to a particular price.

Sissoko:  The market maker has the right to set the prices, but then you'll stand ready to buy that asset basically in normal circumstances. Somebody can rely on the fact that you are there to buy that asset. I want to actually argue that when you have a commercial bank that's willing to stand ready to buy an asset like a treasury, and has got a strong policy that's reliable on this, we can also think of that market making commitment as a form of monetization.

Sissoko:  We certainly see historically when central banks have these kind of standing facilities, and we think of them as creating money even now, but if the central bank is scanning facility, everybody says, "Well, that's a way of providing money to the system." I'm going to stretch it and say, "Well, you know what, if you have a commercial bank that has a very reliable facility like this, then we would also call that a form of money." It's another way of monetizing things. That's my framework when I'm thinking about money. I have a much broader idea of what we should put in the category of what is money.

That's my framework when I'm thinking about money. I have a much broader idea of what we should put in the category of what is money.

Sissoko:  In particular, I think that over the course of the 1990s, the repo market had the effect of monetizing the assets that were repo collateral. It did so in particular because of some of what... One particular bank, JPMorgan, which is in the same sense that Drexel created the junk bond market, I think you can think of JPMorgan is creating the modern repo market. It's really the role that JPMorgan played in the development of the repo market over the course of the 1990s that, I think, led us to the repo market that we have today.

Beckworth:  Just to recap, money should include not just the explicit contractual things on the balance sheet that's very clear, which it's easy to observe, but also these off balance sheet obligations that effectively are very liquid, they’re promises, and they act as money. It's hugely consequential as we saw in 2000. If there's a run on them, and they disappear, that affects economic activity. I mean, the reason money matters is because it's the medium of exchange. It facilitates trade and economic activity.

Beckworth:  If something happens to it, it's destroyed, it's gone, then we're in trouble and runs on money. It's hugely consequential. If we want to think carefully about runs and financial stress, when you think about these broader measures of money, which leads us into repo... Let's transition then into your history of the evolution. You've touched on it earlier, but let's just unpack it. You mentioned in the 1990s, some big changes happened. In fact, I mentioned this with... I discussed this with Daniel Gabor.

Beckworth:  There was a repo market before the Great Depression in the U.S., but the Great Depression killed it off, more or less. The bank regulations that follow kill it off. It wasn't until this period you begin to cover in your paper that really gets new wind beneath its wings begins to take new life. You mentioned a couple of things. You touched on one already, but first, you mentioned the tri party repo market. It grew as a means of providing intraday funding. This was consequential for another event I wasn't aware of, and that is in 1994, the Fed started charging banks to get intraday credit from it.

Beckworth:  Whereas before 1994, banks could get intraday credit from the Fed at no charge, if I interpret this correctly. Banks if they had some payments to make, and they didn't have enough reserves of their own, they could go to the Fed during the daytime. You mentioned at nighttime, they could go to the securities lenders. It seems to me that's a pretty big decision there, a pretty consequential decision. I mean, the Fed suddenly starts charging banks for intraday credit. Well, why not go to the repo market if it's cheaper, if it's attractive? I mean, what was the Fed's reason for doing this? Why did the Fed play an important role maybe unintentionally of pushing the market towards repo financing by charging banks for intraday credit?

The Fed’s Role and Reason in Repo Financing

Sissoko:  All right, so I think that policy happened because... Well, of course, they hadn't charged banks for intraday credit for decades. The traditional thing was not to charge banks for intraday credit, but what they found around 1990 or thereabout of the late 1980s is that the banks were essentially financing the broker dealers’ securities portfolios on an intraday basis. People have to pay for overnight money, but you don't need to pay for intraday money. The intraday portfolios were being financed by the commercial banks effectively for free because they could get the money from the Fed for free.

Beckworth:  I see.

Sissoko:  The Fed was looking at this and saying, "Wait a minute. Wait, why are we financing the broker dealers' portfolios? I don't think that's what we want to do," so then the Fed stepped in, and they put on the charges essentially to discourage that…

Beckworth:  They meant well. It was a good reason, but then it created the incentive to rely more on repo market as a byproduct. Is that right?

Sissoko:  Yeah. This is one of the things everybody noticed suddenly in 2008. It's like, "Wait a minute, you've got these massive tri-party clearing banks, and they're the ones providing a vast amount of free intraday credit." Why do we have these huge private banks doing this, and do we want this? That was actually one of the things that was addressed after 2008. Yes.

Beckworth:  Repos there, again, it was killed off in the Great Depression. It's still lingering. It's there. It's growing, but a catalyst, a big push forward was the Fed starting to charge for intraday credit. Then the other big thing you mentioned is just J.P. Morgan. I want to read a paragraph here you have in your paper from page eight.

Beckworth: So, 1994 is a pivotal moment, and then you have this... You mentioned in your paper, so that's going on in the background, there's this transition taking place already, because of the Fed's decision in '94, but later in that decade, you say, "Then in 1997, notably the year in which the Asian financial crisis took place, J.P. Morgan moved its repo market, making into the bank, and then in 2000, became one of the core tri-party clearing banks via merged with Chase Manhattan Corporation."

Beckworth:  "The end result of this bank intermediation of the repo market was to super-charge with implicit government guarantees, and convert JPMorgan Chase into a de facto central bank." Boom. It's this really rich story here. We have this transformation taking place. It's small steps but important steps that culminates, really, I guess in 2000 with this merger, and really JPMorgan Chase becoming a branch of the government, I mean, because of the implicit backstop it has from the government. You know you work with JPMorgan if worst case scenario unfolds, the feds will be there to bail them out.

Beckworth:  It's really doing the work that the Fed was doing, as you mentioned earlier, but now the Fed's pushed it off balance sheet, and JPMorgan's doing its work for it. This is a fascinating, I guess, evolution, and this is where the money market takes us into the 2000s leading up to the 2008 crisis. Here's a question I have. Was this inevitable? Was it inevitable that we would have a transition to repo market financing, and then you could say more generally to market based financing, right?  I mean, is this in equilibrium we were just destined to get to because of globalization, global capital flows? The forces are such that we would have ended up here no matter what. Maybe this is one path we went down, or was there another way?

Was the Transition to Market Based Financing an Inevitability?

Sissoko:  Well, that's actually the paper I'm working on right now.

Beckworth:  Oh wow. Okay.

Sissoko:  That's the question of why did this happen? Like I said, I actually went to law school so I would start to understand what's been going with the financial regulation for these years. I would actually attribute the growth of this margin-based financing to essentially three dynamics that have been taking place since the collapse of Bretton Woods. I would say the first one is the U.S... Well, the Federal Reserve's too big to fail guarantees, which I consider is starting essentially right with the collapse of Bretton Woods 1974 with Franklin National.

Sissoko:  That's step one, where you're like, "Okay, the international money markets are so important." A U.S. bank, even if everybody knew it was in trouble, was badly managed, and in fact, its directors end up going to prison for fraud, the Federal Reserve will stand behind that bank. That's a pretty big decision, right? That basically carries on from then forward. Essentially, in my view, it weakens the U.S. banking system. One dynamic is this deep-seated instability at the heart of the banking system that we are encouraging bad banks to grow.

Sissoko:  I mean, this is classic Badgett. The one bank you can't finance is the fraudulent bank, because if the government gets behind the fraudulent bank, it's going to be badly managed banks that develop. Once you know the government will stand behind the badly managed banks, you're going to get the growth of badly managed banks, and nobody else can compete against them because these are government-supported badly managed banks. I would actually say that we've been facing this problem, essentially, since the mid-1970s.

Sissoko:  You just go from crisis to crisis, whether it's the LDC debt crisis or the commercial real estate crisis. Then you go to... LTCM is in a different category, but it's another issue of the big banks being involved in financing something that was going to create a lot of trouble for them. Then we get to the mortgage-backed security crisis, but we've just been doing this ever since we put in the too big to fail guarantees. That's one aspect.

Sissoko:  The other aspect is that in part because of the growth of U.S. banking internationally, because of these too big to fail guarantees, the UK started looking at the system and saying, "Wow, man, we're getting shut out of financial markets, and we're supposed to be the world's financial center." You actually get deregulatory competition between the UK and the U.S. The UK has the big bang in 1986. The U.S. responds by a regulatory repeal of Glass-Steagall.

Sissoko:  There's this back and forth in the regulatory aspects of the banking system that essentially plays in with too big to fail. Too big to fail is part of the whole story and part of why we get away from Glass-Steagall. One of the offshoots of having these commercial banks that are starting to be big players in capital markets is, guess what, your broker dealers who are traditionally partnerships in the U.S., they’re traditionally, partnerships in the UK are suddenly like, "Well as a partnership, we can't play in this field with these big commercial banks coming in to our territory."

Sissoko:  It turns out that by the 1990s, essentially, the partnerships are more or less gone. I think Goldman Sachs holds out to 2000, but the partnerships of the dealer banks are gone. This is actually part of this taking apart of Glass-Steagall in the traditional banking structure. These are huge regulatory changes that are taking place. I think one factor in the growth of secured lending is that we really have weakened our core banking system dramatically through the changes we have made both in terms of too big to fail and in terms of rolling back the regulations that really helped support financial markets and stabilized them.

I think one factor in the growth of secured lending is that we really have weakened our core banking system dramatically through the changes we have made both in terms of too big to fail and in terms of rolling back the regulations that really helped support financial markets and stabilized them.

Sissoko:  I actually like Glass-Steagall. In fact, this is completely on the side, but you kept on saying repo markets existed before the depression. There's a key thing there. They had a different name. They weren't repurchase agreement markets. They were securities loan markets or collateralized securities loans. They had very similar properties. They were outlawed by the Glass-Steagall Act in one clause of the Glass-Steagall Act. One of the reasons we have repurchase agreement markets, or in other words, they're not collateralized loans, they're sales and resales, is to get around the law around, is to get around the 1933 Act.

Sissoko:  Actually, they didn't have repo markets. They had something that was very similar, but the names matter when you start with … anyhow. Then I think the third factor that I wanted to add in going back to our main story is actually the change in the regulation of financial markets. On the one hand, in 1984, repurchase agreements are given privileges under the bankruptcy law that essentially makes it very easy to foreclose on your collateral and keep it. That was at a time when repurchase agreements were mostly treasuries and no other very safe assets.

Sissoko:  In 1990, swaps contracts are given similar privileges in bankruptcy, so we're giving special privileges to these contracts that have these margin call characteristics. Those are fairly... That's a very new change in the law, and there was one other big aspect of changing how these contracts are governed. That's actually related to derivatives contracts. I think one of the things that I don't always talk about that one needs to keep in mind when he talks about the repurchase agreement market is that it is also really a market for derivatives collateral, that the way we've set things up these days, the collateral flows fairly smoothly from backing derivatives to a repurchase agreement type loan.

Sissoko:  It's really the same kind of market. The other huge change was rolling back the traditional rules governing derivatives markets that meant that you were in a real danger of finding that your derivative was unenforceable in a court of law, because it could be characterized as gambling. That's actually a traditional regulation of derivatives markets. The gambling law was there and understood in the late 19th and early 20th century as a means of regulating derivatives markets. You can actually trace that back to the British 1845 Gaming Act, where they literally looked at it. I mean, it's derivatives regulation.

Sissoko:  We rolled that back, well, both in 1990 and then in 2000. We have these huge changes in our regulation of financial contracts that are essentially almost pushing firms to use this secured contract. Because we've given them privileges in bankruptcy, we've taken away the restrictions that would have made them dangerous to use, which was that they might not be enforceable in a court of law if they were interpreted as wagers.

Sissoko:  Instead, we've said, "Hey, these are the best kind of contracts to have, because you get super priority in bankruptcy if you use this kind of contract." Essentially since 2000, which is the Commodity Futures Modernization Act, there's been a really heavy finger on the scale in favor of these kinds of contracts. That's one of the reasons they grew. Then actually, the Bankruptcy Act of 2005 was, I mean, for people who were financial legal professionals, it was a work of art.

Sissoko:  They managed to make it so this collateral can flow very smoothly across the whole financial sphere, and they crafted this really smooth legal structure that provides extraordinary support for repurchase agreement markets and derivatives collateral. I think the evidence is always a little bit hard to check into because we didn't keep a good data on what was collateralized, how many repos we had in this kind of thing, but it does seem like that set off a good significant growth in the collateralizing markets. Basically, we've actually changed the law to promote these contracts, so there's nothing natural about it at all.

Beckworth:  It wasn't inevitable.

Sissoko:  No.

Beckworth:  Well, it sounds like though it would be tough to... it would be a long journey to undo these many steps to get back. We'll come back to your proposed solution, but it is interesting to think. I mean, we have this history you just outlined, and here we are today, where the money markets, particularly the dollar money markets across the world are so consequential to the financial system that the Fed has to step in and bail out the global financial system when there's a crisis like we had. I think the Fed had to do it.

Beckworth:  I mean, but it's worth recognizing this shouldn't be the way it is. I mean, the Fed had offered dollar swap lines. It had to step in and have facilities for commercial paper for the broker dealers. All these liquidity facilities were important to keep the financial system running, but it should give us pause that we're at this point. I've had people on to talk about this before like, "How do you approach, deal with the shadow banking system? It's global in nature now. We've created this beast that's out there."

Beckworth:  We'll come back to your suggestions in a bit, but before we do that, I just want to go over again and recap the consequences of this. I mean, we've been touching on them, we outlined them at the beginning, but you have several issues you outlined what this move in the money market again from unsecuritized overnight lending federal funds market to the repo market. What has does this transition done? I'll just throw this in there for extra effect. You note the Fed has sanctioned the SOFR as an overnight rate, a move from LIBOR to SOFR, and that's secured overnight funding rate.

Beckworth:  The Fed has put its blessing on this move maybe unintentionally, but it's saying, "Look, we like the secured overnight rate, not the unsecured LIBOR rate." There's all these pressures that say, "Hey, we're there. We're moving there. It's hard to move back, and there are some consequences." Walk us through, I believe you have three, three consequences you outlined and you mentioned earlier this move has created for monetary policy.

The Consequences of Moving from LIBOR to SOFR

Sissoko:  I think one of the things is that essentially when you raise interest rates, obviously, the Fed more or less controls the short-term interest rate. The goal also, however, is frequently to affect long-term interest rates. When the Fed gets traction on long-term interest rates and manages to get them to go up, you have this situation where you don't just have an interest rate effect.

Sissoko:  You also have an effect on the quantity of collateral that's available, so you're both affecting the money supply by raising its price, and at the same time pushing down the quantity of the money supply. There's this... It's essentially a supercharged effect of monetary policy in this world that you don't really have when you're operating through the federal funds market. That's something that I think is not fully understood, and should be studied a lot more carefully.

Beckworth:  It's interesting. What you're saying is it's supercharged because it has a double punch effect, right? There's the short-term rate effect, and there's also the quantity, the collateral effect, which affects the supply. This goes back to, again, what we're talking about what happened in September, why interest rate spreads were so important back then. It makes me also wonder if it's another reason why it's so hard to raise interest rates.

Beckworth:  I'm a big fan of safe asset shortage literature. I think there are demographic and structural reasons for why rates are low, but the fact is what you're outlining, if the Fed raises rates, it's not just a little tightening. It's a double whammy coming in through destroying collateral on the long end of the yield curve. It may be much harder even in the absence of demographics and other structural reasons to raise interest rates because of this.

Sissoko:  Yeah. I mean, I actually think that if we want to think about why we have this low for long problem with interest rates, I would say the first thing you should be looking at is the shift to collateralized finance.

I actually think that if we want to think about why we have this low for long problem with interest rates, I would say the first thing you should be looking at is the shift to collateralized finance.

Beckworth:  That's interesting.

Sissoko:  I mean, I think that's one of the huge dynamics that is driving interest rates down that essentially, we can't afford to have the collateral supply shrink the way it would if long-term interest rates rose as they did, I think, the last really traditional tightening cycle was the mid-1990s. That was just one of these classic cycles where the Fed raises short-term rates, and all the long-term rates inch up alongside it. But essentially, since then, the Fed can't get traction on long-term rates.

Sissoko:  I would actually argue that it's related to the issue of collateral supply. I have to admit, I wonder, because we do have... JPMorgan was acting as a dealer in this kind of thing, and there are strategic issues in this that maybe it makes more sense to take the collateral on your balance sheet and essentially be the one that holds it for a while to stabilize the rates instead of allowing the collateral supply to shrink, and that some of these strategic issues for the big dealer banks we're dealing in repo may actually play a role in why the rates are increasing. I mean, I don't think... I mean, I think it's mostly they're thinking about their bottom line.

Beckworth:  Let me ask this. Is this an argument for the government, the treasury department issuing more short-term debt than long-term debt then? I mean, would it-

Sissoko:  Well, you see, I mean, I think the collateralized money market creates really big issues, mainly because, I think, if we're going to think long term, and think about what's best for the United States as a polity, well, you go back to the financial revolution in Britain in the 18th century, and that was a great invention. They were issuing 3% debt, and they could keep consistent 3% debt. Even if they had to issue debt at 4%, as soon as whatever war was going on was over, they could take it right back down to 3%.

Sissoko:  Well, that was actually consoles. That was indefinite debt length. There was no payment date on that. That actually is one of the things that gave Britain its great financial power. The idea that, "Oh, well, let's just do short-term debt instead," I guess as a historian, it makes me say I think the side effects of that are not going to be a good idea.

Beckworth:  I mean, there's other things that would happen, but by itself, I guess it would argue for the treasury issued more short-term debt. I bring this up because I've had a number of interesting conversation with folks in the context of should Treasury go lock in these longer rates right now, invest in infrastructure, whatever it may be. There's arguments for and against it. I mean, there's been some work that shows even though you get really nice low rates now on long-term bonds, over the business cycle, it's still cheaper to finance more on the short end of the yield curve.

Beckworth:  There are arguments for doing long term. I mean, you mentioned one there, the history of the UK, but also, there's tax smoothing purposes to having long-term debt that if you're the generation who fights the war, why should you be the one to pay all the taxes for... Why not spread it out over a longer period? There's political economy considerations beyond pure financial ones that play into this. This is just another issue to think about when you think about the debt structure of the U.S. government, but it definitely is an important one.

Sissoko:  I do think though that even the U.S. needs to think about the fact that you can end up being in the hands of financiers and their demands if you issue only short-term debt. In other words, when things go wrong, you have fewer options if you're issuing short-term debt. I don't think of the U.S. as being able to completely ignore those factors. I mean, you can say right now, it's not an issue, but if this is your policy over the long run, the day will come when it is an issue.

I do think though that even the U.S. needs to think about the fact that you can end up being in the hands of financiers and their demands if you issue only short-term debt. In other words, when things go wrong, you have fewer options if you're issuing short-term debt.

Beckworth:  Absolutely. All right, so what were the other concerns that have emerged because of this development in the money market? Do you want to summarize those?

Money Market Concerns

Sissoko:  I think one of the core things is that especially when you look at what went on in March 2020, we need to ask the question whether this collateralized money market is just fundamentally unstable. It's essentially prone to liquidity spirals, where effectively, the only thing that can solve the problem is absolutely massive central bank intervention. One of the things I point out in my paper is that in the last two and a half weeks of March, the Federal Reserve purchased 5% of all marketable treasuries outstanding as of February. I took that February 28th data. It was 5% of all treasuries outstanding as of February 28, 2020. You're talking about a size of purchases in order to stabilize the market. That is just mind boggling, right?

Sissoko:  When you hear these claims that, "Oh, well, if you would just make some tweaks to regulations to improve dealer balance sheet capacity," and I also think that in a lot of ways, Darrell Duffie's central counterparties for treasuries, that's also about how can we improve the balance sheet capacity? That's the underlying idea, and you sit there and you say, "Did you see how big that action had to be to stabilize the market?" Do we really think we can ever tweak dealer balance sheet capacity such that they can purchase 5% of all marketable treasuries within a period of two weeks? It's just like the numbers don't work out here.

Sissoko:  I think one of the stories of March 2020 is that the only thing that stabilizes the system is the dealer of last resort, essentially, the central bank coming in there and saying, "Okay, I'm going to provide liquidity on long-term debt markets, because that's where the liquidity is needed." It marks a necessity of working with the dealer of last resort, but it also set off a whole other problem, which is at least in the current structure of the US's financial monetary policy implementation process, the Federal Reserve works through dealer banks, and it increased reserves so much through these transactions in treasuries, that actually, the process of doing this was causing them to breach their supplementary liquidity ratio requirements.

Sissoko:  The Fed actually had to essentially give them regulatory relief, so the Fed lifted the requirements to count treasuries and reserves in the supplementary leverage ratio, because its dealer of last resort action was essentially causing the dealer banks it was trading with to breach the requirements. That already tells us, "Wait a minute, so a dealer of last resort is a good idea,” then we need to think about how the Fed is implementing dealer of last resort, because the way we've got things structured right now, it doesn't seem to work correctly. I think it raises other issues as well about the plumbing of the financial system.

Beckworth:  Well, let's move to your solution then, or solutions. I mean, some of them, you've mentioned in the paper you go over they've been proposed, but you don't think will work in entirety. You mentioned Darrell Duffie's proposal that more central clearing of treasuries might give us some breathing room, but it's not a full fix to the problem. Standing repo facility, David Andolfatto and Jane Ihrig's proposal, what about that one? What does that do? Does that get its part of the way there or not far at all?

Solutions for the Money Market

Sissoko:  Well, I think actually, one of the things that we saw in March 2020 is that the first thing the Fed tried to do was essentially expand the repo facility. Can we address this problem by providing effectively unlimited liquidity in a repo facility? It wasn't a standing repo facility, but that's extended repo facility.

Beckworth:  In the spirit of it.

Sissoko:  In fact, there wasn't take up of what they were on. It was not solving the problem if there wasn't take up, and the Fed had to step in to buy the treasuries, which is what it did. In fact, it started out by buying 40 billion in treasuries a day, and that was too little. When it went up to 70, $75 billion of treasuries a day, it did that because a smaller amount didn't work. It was literally forced to buy that huge quantity of treasuries, which is why, again, I don't think dealer balance sheets would ever handle this.

Beckworth:  A standing repo facility is not going to cut it either. What about this simple idea? How about just expanding the number of primary dealers making the feds counterparties a much larger list of institutions? Might that be some of the pressure, or does that still not get at the core of the problem?

Sissoko:  It's a good question. I have to admit I think part of the problem is the speed.

Beckworth:  The speed, okay.

Sissoko:  When you think about your QE2 or QE3, that was a vast change in the quantity of the Fed's balance sheet, but it was kind of steady and took place slowly over time, and so it didn't seem to have any adverse effect on the dealer balance sheets.

Beckworth:  I see.

Sissoko:  In this case, you need to have this sudden shift, because the Fed had to jump in there and act in two weeks. It's that sudden change that doesn't allow for other things to shift.

Beckworth:  Good point.

Sissoko:  My guess is that even if you had a whole bunch of dealers like finding the capacity for a really rapid change, it's still going to be a problem.

Beckworth:  What do you recommend we do? What's the direction that you would put us on?

Sissoko:  I actually would go for trying to roll back the use of long-term sovereign debt in repurchase agreement markets. Basically as collateral, I think it would be better if the central banks were to have a policy of steadily imposing increasing haircuts. Like, minimum haircuts should be increasing over time until such time as basically nobody's relying on 20-year, 30-year debt as collateral, mainly because it's not actually a safe asset. If you look at what happens to its prices when interest rates change-

I actually would go for trying to roll back the use of long-term sovereign debt in repurchase agreement markets. Basically as collateral, I think it would be better if the central banks were to have a policy of steadily imposing increasing haircuts.

Beckworth:  Good point.

Sissoko:  ... there's a lot of volatility that's built into the nature of the asset. Another one of my favorite little factoids is that if you look at the first draft of the... Well, they weren't the Basel capital agreements. There was a U.S.-UK capital agreement that was made to push the Basel group into actually deciding to do a capital accord. The first draft actually distinguishes between short-term and long-term sovereign debt, and says that long-term sovereign debt should have a capital requirement of 25%.

Sissoko:  This is something that actually everybody knew the long-term debt had different properties than short-term debt. It's just interesting that for whatever reason, the way our regulatory system help with this is as if long term debt is comparable toward short-term debt. I think we'd be better off with a regulatory system that just acknowledges, "Hey, these are different animals. One is more risky than the other, and we should discourage the use of long-term debt as collateral just because it's here."

Beckworth:  Make it increasingly expensive to do that liquidity transformation in the repo market and long-term security, so really pull apart... The repo market has brought long-term and short-term really close together and try to morph them into one entity. You're saying, "Let's pull them apart, and let them be two different entities altogether." Let me ask this final question here before our time runs out.

Beckworth:  Let's say the U.S. does that. We get Congress to pass them along, and they make that possible. Would it be enough to do it just in the U.S., or would we want to see it done in Europe, in Japan and other places where we have market-based finance?

Sissoko:  I think because of the global reach of your typical big bank, if it was only in the U.S., they would simply fund abroad using the long-term debt. At least it would be a risk. I mean, you basically need to look at the whole picture. Is there a way to design a U.S. law that would manage to keep the banks from-

Beckworth:  Sneaking overseas.

Sissoko:  ... [inaudible] on foreign markets? There might be. Some lawyers are really creative. If you put a really good lawyer on that, they might be able to figure it out, but it's definitely an issue you need to think about. I mean, I do think it's an issue at the level of the FSB or the Bank of International Settlements. You want people coordinating on how you deal with these issues, ideally, because it's really difficult for one country to act alone.  I mean, that's essential what we found for the last 34 years.

Beckworth:  I think that's the core challenge for shadow banking in general is you need international coordination to deal with the challenge as well. With that, our time is up. Our guest today has been Carolyn Sissoko. Thank you, Carolyn, for coming on the show.

Sissoko:  Thank you very much for having me.

Photo by Angela Weiss via Getty Images

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.