Sam Schulhofer-Wohl on Reforms in the Treasury Market and Developments with Central Bank Operating Systems

Sam Schulhofer-Wohl is a senior vice president and the senior advisor to President Lorie Logan of the Federal Reserve Bank of Dallas. Sam returns to the show to discuss recent macroeconomic conferences in the context of changes in the Treasury market and with central bank operating systems around the globe. 

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This episode was recorded on May 27th, 2025

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: Our guest today is Sam Schulhofer-Wohl. Sam is a senior vice president and the senior adviser to President Lorie Logan of the Federal Reserve Bank of Dallas. Sam is a longtime veteran of the Federal Reserve System, serving previously at the Minneapolis Fed and the Chicago Fed banks. Sam joins us today to discuss, first, the ongoing reforms in the Treasury market, and, second, developments in central bank operating systems. Sam, welcome back to the program.

Sam Schulhofer-Wohl: Thanks, David. Thanks for the opportunity to be on with you, and it’s great to be back on Macro Musings.

Monetary Policy Conferences

Beckworth: It’s great to have you back on. You are someone who knows these issues well. You’ve worked on them. You’ve been on commissions on them. I’m excited to have you back on. What’s interesting, Sam, is that we were recently together at a conference, the Atlanta Federal Reserve’s Financial Markets Conference. 

It’s been a busy month of May for conferences, for me at least. I’ll just run through a quick list of them I went through. I went to a John Taylor conference. They had a conference for him and his career work. We also had the Hoover Monetary Policy Conference. I was able to attend that as well. There was the Board of Governors Framework Review Conference in May, a big deal for the ongoing framework review. Then, finally, the Atlanta Federal Reserve Financial Markets Conference I just mentioned that you were there. Now, I understand you also attended another conference, the New York Fed, during this time, correct?

Schulhofer-Wohl: Yes. Really, May was an incredible month for conferences in addition to the ones you mentioned. Every year, the New York Fed and Columbia University have a joint conference on monetary policy implementation. It’s just a fantastic conference. There’s a small number of people in the world—at the Fed, at other central banks, and in the markets—who just care really deeply about the details and the plumbing of how monetary policy is implemented, meaning how a central bank causes interest rates to do what policymakers would like them to do. This is the annual festival for those folks to nerd out and get really into the details. That was last Thursday and was, as always, just a fantastic conversation. Hopefully, we’ll get a chance to touch on that during our conversation today.

Beckworth: I love your enthusiasm. You called it a festival to nerd out. How many people get to nerd out about operating systems and financial markets, Sam? We are one of a breed, I guess, and that’s why you’re at the Federal Reserve and I’m here at the podcast. I’m grateful to have people like you to come on this show because there are people listening who do appreciate these conversations, what we’re going to get into.

Role of Nonbank Institutions in the Treasury and Money Markets

Let’s talk about the Atlanta Federal Reserve Financial Markets Conference, and we’ll provide a link to it online. I encourage listeners to go check out all the panels, but I want to talk about two of them. The first one is a panel that was hosted by your boss, President Lorie Logan, and it was titled “The Increasing Role of Nonbank Institutions in the Treasury and Money Markets.” Great panel discussion, great lineup of guests.

There was Deirdre Dunn, who’s the head of global rates at Citigroup. Also, she’s the chair of TBAC, Treasury Borrowing Advisory Committee, a very important institution where the market gives its input to duration and other issues of the Treasury. Nate Wuerffel from the Bank of New York, Mellon, former New York Fed staffer. And Lou Crandall, famous money market newsletter individual, and chief economist at ICAP.

Great conversation. Lorie did a fantastic job moderating it, and, again, we’ll provide a link to that panel. That discussion centered on the Treasury market and the issues. This is something you’ve worked on, right? You’ve been a part of some commissions, some working groups. This has been part of the work you’ve done at the Fed, correct?

Schulhofer-Wohl: Yes, absolutely. There’s something called the Inter-Agency Working Group (IAWG) on Treasury Market Surveillance, which has existed for several decades now, and it brings together the Treasury Department, the New York Fed, the Federal Reserve Board of Governors, the CFTC, and the SEC, so the institutions that, in one way or another, regulate the Treasury market to try to share knowledge and operate in a coordinated way in making sure that the market really effectively serves its important public purposes.

Before I go any further, I should, of course, say that anything I say just reflects my own views, not necessarily those of my colleagues, or the Dallas Federal Reserve System, or certainly not those of anyone I’ve worked with in other agencies. I’ve had the honor of getting to help out IAWG with a lot of their analysis and report writing over the years and gotten to really see how that works and see how people are thinking about the issues.

That process really intensified after the market stresses in 2020 at the onset of the COVID-19 pandemic, where we saw really extreme volatility in the Treasury market, illiquidity, real market dysfunction that ultimately the Federal Reserve stepped in to address. People started thinking about what could we do to make this market more resilient, more robust, and hopefully reduce the likelihood of severe dysfunction in the future. You can’t prevent all disruption. The pandemic was obviously a very extreme case, but can we do things to make the market more resilient than it is? It’s been a real honor to get to work with people on that, and I think a lot of progress has been made.

Beckworth: I think it’s fair to say that even under the best-designed Treasury market system possible, there probably would have been some stress during the pandemic. That’s a once-in-a-lifetime ordeal. We should have some grace toward people who are working on this issue and to the Treasury market itself. You answered the next question I had, though. What is the history of these conversations? They really picked up, you said, after 2020. Was there conversations, though, after the flash crash in 2014 in that period?

Schulhofer-Wohl: Yes. The flash crash was also a really important moment for this work because then the agencies came together and wrote a report on why that happened and started holding annual conferences on the market. That moved things forward, and then, as I said, people really started pushing on this even more after the pandemic.

Beckworth: What are all the agencies working on, the Federal Reserve, and who else?

Schulhofer-Wohl: It’s the Federal Reserve Board, the New York Fed, the SEC, the CFTC, and, of course, the Treasury Department, which issues these securities and has a role in regulating the market.

Beckworth: I think it’s very timely, and I imagine the conversations you had as a part of this working group was to think about the future shocks that could hit the U.S. economy, that would strain the U.S. Treasury market. We’ve seen some shocks. We probably didn’t anticipate, some from the trade war. There were some challenges in April. I think just in general, going forward, there’s concern about the structural primary deficits we’ll be running, which will also put added strain on it. These are important questions.

I’ll just throw out my two cents’ worth. I think, fundamentally, we need to address the primary deficits going forward. That’s going to be a key issue, and that doesn’t seem to be an area we can solve easily. I think that’s something that also needs to be done, and that’s outside of what you’re going to discuss and what you’re doing. I think it’s fundamental to getting at the heart of some of these issues that we’re going to talk about today. Let’s go to the reforms that you do work on and have worked on at the Federal Reserve. Let’s go back to the one that I believe is very near and dear to your heart, Sam, and that’s central clearing. Give us the update on central clearing.

Central Clearing

Schulhofer-Wohl: Just to step back just a little, the IAWG has organized its work into five work streams. In addition to central clearing, which I’ll come back to, those include the resilience of market intermediation, so making sure that the intermediaries in this market and their ability to intermediate between buyers and sellers is resilient to stress. Then transparency, making sure that both the public and market participants, as well as the official sector have good visibility into what’s going on in the market.

Third, oversight of trading venues, and fourth, understanding the effects of leverage and liquidity risk management practices, so understanding what risks market participants are taking and what vulnerabilities those may or may not create. Then, finally, as you said, central clearing. Central clearing is something I’ve worked a lot on over the years. I got really deep into it when I was at the Chicago Fed. Chicago is a center in the United States for derivatives markets.

The institution of central clearing, in many ways, has grown up in derivatives markets. What central clearing does, or what institutions that do what we call central counterparties, what they do is they take both sides of a transaction to guarantee to the original participants in the transaction that it will actually be completed. Imagine that you buy a Treasury security from someone else. Those transactions today are not cash on the barrelhead, where if you bought the security from someone else, you would show up at the cash, they would show up at the security, and you would instantly exchange them at the moment you agreed to trade.

It’s actually pretty important that that doesn’t happen instantly because if you had to show up with the cash or with the security, it would be operationally very challenging, and you wouldn’t be able to trade nearly as flexibly. The way the market works is people agree on a trade and then have some time in the Treasury market typically overnight to actually get the cash and the security together to exchange them. That makes trading much more flexible, but now it creates a risk for both participants.

If I buy a Treasury security from you, so we agree I’m going to pay you a certain amount of money and you’re going to give me the security, I now face the risk that you may not show up tomorrow with the security. I know, David, you’re a really trustworthy guy, but still a risk.

Why should I care about that? Suppose the price of that security has gone up by tomorrow. I agreed to buy it from you for $100, and now tomorrow it’s worth $100.10. If you don’t show up, I’m going to have to go out and buy it from someone else and pay more than you and I agreed on, and that’s a loss to me. That’s a risk I should worry about. Similarly, you may worry that I may not show up with the cash. That’s a problem for you if the price of it has gone down in the meantime, because then you’d have to sell it to a different person who wouldn’t pay as much as you and I agreed.

A central counterparty steps into the middle of that. They become what we call buyer to every seller and seller to every buyer. They promise me that I really will get the security, and they promise you that you really will get the cash. Of course, in order to make that promise, they have to have a lot of rules about risk management to make sure that we really will do what we say and that they have the resources to cover it in the event that someone has some problem and doesn’t do what they say. They introduce a lot of strong risk management into a market in a very uniform way, and they reduce risk by doing that. That’s something I’ve been working on a long time, starting with thinking about the derivatives markets in Chicago, but then more recently in the Treasury market.

In Treasuries, historically, the share of transactions that have been centrally cleared has gone up and down over time. Far from all, Treasury transactions are currently centrally cleared. There are many transactions that participants just settle between themselves bilaterally or in the repo market, which is an overnight return funding market where people borrow against the Treasury security. It’s called the tri-party repo system where there’s a clearing bank that holds on to securities for people, like an escrow account, but it’s not actually providing a guarantee that transactions will be completed.

There are many transactions that are not centrally cleared, and I and others in research have really identified four reasons why more central clearing could make the market more resilient. One is, as I mentioned, that risk management is stronger and more uniform. If you and I are just doing that trade by ourselves, we’re going to have to agree on what protections we might use to try to reduce the risk that someone doesn’t show up or to do something about it if one of us doesn’t show up.

When you talk to market participants, they all say their risk management is really strong, but you also hear differences in how they do it. At a minimum, it’s not uniform, and some risk management is stronger than others. What a central counterparty does is they come in and they have a uniform and strong way of ensuring that there’s good risk management on all of those trades.

Uniformity helps because suppose that someone suddenly goes out of business or goes bankrupt and you may want to transfer all of their trades to some other market participant, that’s a lot easier if the risk management rules around that are going to be the same no matter who’s doing them than if there’s some kind of very customized risk management that would be hard to transfer. That’s one benefit, is strong and uniform risk management.

A second benefit is just directly reducing the risk that some trade doesn’t go through. One thing that a central counterparty can do is net out chains of transactions. Suppose that you are buying a security from me, and then you’re planning to turn around and sell it to your friend. Ultimately, cash is going to go from your friend to you, to me, and the security is going to go from me, to you, to your friend. There’s a chain here. If we’re handling all of those transactions bilaterally, if I break the chain at the beginning and don’t deliver the security, then you will also not be able to deliver to your friend, and there are two transactions that go bad.

A central counterparty can look at all this and say, “Well, you know what, David is just in the middle. Ultimately, the security is going from Sam to David’s friend, and the cash is going from David’s friend to Sam.” Now we can net down that chain and simplify it, and it reduces the number of failures that would happen if someone doesn’t do what they promised, because you simplify that chain and then the central counterparty is going to guarantee all the transactions anyway.

A third benefit is that you can get increased transparency. I mentioned that one of those work streams, IAWG has been trying to get more transparency into the market for both market participants and the official sector. If a central counterparty is handling all of the transactions in the market, you’re a team memo, then they’ve got the data on them. That means that the reports can be published, that provide transparency, and it means that regulators can understand what’s going on.

There’s less of a risk that vulnerabilities can build up in some corner that no one knows about, and it can be hard to understand. Particularly in moments of stress, it’s really valuable to have that thorough and accurate information. That’s another benefit that people have identified.

Then a fourth benefit that people have identified is that market participants can net out opposing transactions when they’re all centrally cleared. If you buy a security from me and then sell it to your friend, if those are both centrally cleared, then you have no net obligation to the central counterparty because as we talked about, dealing with that chain of transactions, they’re going to net the whole thing down. That means that, from your perspective, you don’t have to worry about the risk of those transactions at all. They’re handed over to the central counterparty, they’re netted down, and they’re gone. That’s an additional benefit of central clearing.

From an accounting perspective, market participants are often able to net down opposing transactions even if they’re not centrally cleared. I don’t want to overstate the benefit of netting, but that can be a factor in some circumstances. People have identified these four ways where central clearing can be beneficial in making the Treasury market more resilient. What the Securities and Exchange Commission did a few years ago is they introduced a mandate for broader central clearing of Treasury transactions. For most repo transactions in the market, most of these funding transactions, and then for a larger share of cash transactions where someone buys or sells a security outright, they require those to be centrally cleared.

They announced a fairly quick timeline to get that done. This past February, they extended the deadline by one year for market participants to complete that transaction. Market participants now have until the end of 2026 to meet the mandate for clearing cash transactions and until the middle of 2027 to complete the mandate for clearing repos. What I hear from participants in the market is that the industry is very committed to getting this done, that people are working hard to do it.

It’s, of course, hard work to start processing large numbers of very important, very crucial transactions in a different way, and so people are working hard at it. Of course, they are going to make good use of the additional time that the SEC has given. What I hear from market participants is they’re really on track to get this done, which based on the research and the analysis that has been done, should really be a step forward in enhancing the resilience of the market.

Beckworth: Sam, thank you for that update. It’s interesting. I didn’t realize that this had been extended a year to ’27, because last time we chatted, ’26 was the big time. ’27, we’ll look forward to that. That last benefit, the fourth benefit of netting, I guess that’s what I hear the most about, because it would open up balance sheet capacity, right? That’s the idea, so that intermediaries could handle more sudden movements in the Treasury market. Is that one of the key compelling arguments for increasing the robustness of the Treasury market?

Schulhofer-Wohl: As I said, that’s one effect that central clearing can have, but I don’t want to overstate it. There are different types of netting that can happen, right? If a market participant has two opposing transactions, and both of those are centrally cleared, from that market participant’s perspective, those transactions are essentially just gone because they just completely offset each other at the central counterparty, and that’s it.

Even if they’re not centrally cleared, though, there can be some ways of netting those transactions for some purposes. Some accounting rules allow for some purposes a market participant to recognize that, “Hey, I’ve got two transactions on my book that offset, and so I don’t have to consider them as each having separate risks. I can consider the total risk of the two transactions together.”

There’s some netting that market participants are already able to do without central clearing, and then central clearing can be additional netting on top of that. For those participants who have sets of positions that would net out where they’re not getting all of the netting that they might from the things they can do with the accounting rules, for example, that can free up some additional balance sheet, which they can use for whatever part of their business they choose. They might choose to use that additional balance sheet for Treasury intermediation. They might choose to use that additional balance sheet for other activities.

There’s the potential there that that makes the market more resilient, makes intermediation more resilient, or makes the financial system in general more resilient, depending on how they use that additional balance sheet. As I said, I don’t want to overemphasize that. In my mind, the clearest benefit of broader central clearing is this stronger and more uniform risk management that we have.

We have highly professional, well-run central counterparties saying, “Here are the risk management rules that everyone is going to follow on these transactions.” We’re sure that those are followed, and so the risks are really well managed, rather than leaving that to each market participant. They’ll have different preferences on risk management, and in considering risk management, they may consider primarily their own interests and not the effect on the broader market. That’s also something we can solve by having a central counterparty take charge of the risk management.

Beckworth: Big point here is it’s not a panacea for all the Treasury market problems. We need to manage our expectations, but still, it’s a great step forward. That provides a nice segue to a recent article that I know you’re aware of, where central clearing got some pushback. As awesome as it is, it got some pushback from YeshaYadav and JoshYounger, both previous guests on the podcast. They have a paper titled “Central Clearing in the US Treasury Market.”

They pushed back in two areas, I believe. One, they’re not so certain that central clearing is going to do all that much on the netting, which is what you just addressed. Maybe if you want to respond to them some more, that’s great. The other concern they addressed, I believe, is the centralizing of all risks into one node in the financial system. What do you think about observations like theirs and others that tell us to, again, step back, maybe manage our expectations about what it will deliver?

Schulhofer-Wohl: It’s a very thorough, very well-researched paper. I really enjoyed reading it. Josh is a co-author of mine on another paper, and I always love talking with Josh and learning from his insights, whether talking with him or his prolific writing. I think it’s entirely fair to say central clearing is, as you said, not a panacea. This is an extremely large, complicated market. There are a lot of different efforts in train to strengthen the market, of which central clearing is only one. We shouldn’t expect it to solve everything. It’s totally fair to point out the limitations on the potential benefits.

As I said, I don’t think we should overstate the potential benefits from netting. There could be more netting with central clearing, but there are other ways to achieve some netting. Of course, if a market participant doesn’t have a portfolio with offsetting transactions, then there’s no netting that can happen there anyway. It’s entirely fair to say we shouldn’t overstate the benefits of netting, though I do think that netting benefits can exist.

Then they made a few other points that I thought were meaningful points, but ones that don’t, for me, change the view that it is an important step forward in the resilience of the market to broader central clearing. One is, as you said, the concentration of risk.

It’s well understood in the regulatory and markets world that central clearing does two things about risk. One is it reduces a lot of risks by having stronger and more uniform risk management, by netting down opposing transactions so that you just eliminate some risks. But then it does concentrate the risks that remain because those risks are focused then at that central counterparty that is becoming buyer to every seller and seller to every buyer, or potentially a few central counterparties.

There’s currently one CCP in the Treasury market, but there are other firms that have said they intend to enter. You reduce a lot of risks, but you concentrate the risk that remains. It’s crucial that central counterparties are well run and well regulated. That is, I think, the general state of affairs in the United States, that central counterparties are well run and well regulated.

I don’t think anyone is proposing that we centrally clear our Treasuries at a badly run or badly regulated CCP. The proposal is to do it at a well-run and well-regulated CCP. That’s the plan. That’s what the SEC has required. I think we should expect that that will reduce risk. It’s a good reminder to everyone to keep our eyes on are CCPs well run? Are they well regulated? Because the risks that remain are concentrated at these very important firms.

The other issue that they raised in their paper was the potential that transactions could be structured in a way that would escape the clearing mandate. I took that again as an important reminder. Any regulation has to set boundaries somewhere, and so there’s always the potential that people will find a way to escape the boundaries of a regulation rather than complying with it. One important thing that regulatory agencies do in any field of regulation is to keep an eye on whether the boundary is becoming too porous and adjust if they need to.

It’s certainly important to keep an eye on that. I don’t take it as a reason to, in this market or in the other, to not regulate at all. It’s a reason to keep an eye on the effectiveness of what is done.

Beckworth: Fair enough. Now, something else that I learned from that paper, which was really interesting to me, is that they noted that FICC, which is the current central clearing firm, may not be the only one doing central clearing going forward. There’s two or three other entities that are applying or have applied for the ability to do it. The CME, Securities Clearing Incorporated, LCH Group, and then there’s a Eurex Repo, which should deal more with European activity.

This raises a question for me, Sam. When I think of a central clearing entity, I think of economies of scales, getting an average cost curve down to that lowest point. If we add all these extra—now, I say all these; there’s only three more I’ve seen listed—if we add these, do we lose some of those efficiencies, some of the multilateral netting effect if we have more than one central clearer?

Schulhofer-Wohl: The way I think about this is sort of analogous to issues that arise with various kinds of utilities: electric utilities, telecom, and so on. There are the economies of scale you mentioned in running the organization. There are also really big network effects, that if you and I are going to do a trade and it’s going to be centrally cleared, then if there’s more than one CCP, we will have to think about which CCP to clear that. That can fragment the market in certain ways.

On the other hand, we know that there are benefits to competition. If you have multiple CCPs, they may be more motivated to innovate. There may just be more fresh ideas that come out because you’ve got more people thinking about the problem. There can also be some additional resilience, that if one CCP makes a mistake of some sort, it’s not necessarily the case that the others will make the same mistake, and so the system can be more robust. There are tradeoffs there between the efficiencies of doing something that has economies of scale and network effects in only one place versus some of the innovation and competition and resilience that one might get from multiple CCPs.

Be that as it may, the way the law and the regulations work is that this is a market where more than one firm is allowed to seek to enter if they wish. The market participants will ultimately decide whether they like clearing their transactions at more than one CCP or whether, as they look at that landscape, they prefer to focus on just one. We’ve seen that in other markets as well. For example, interest rate swaps can be cleared at more than one CCP. A lot of those transactions happen at one particular one, but there are some that happen at another.

This is something where market participants will get to decide how they want to do it. The way I think about it is just that there are these tradeoffs between the efficiencies from network effects and economies of scale versus the benefits of competition that we know of from many markets.

Beckworth: As you mentioned, this is only one among many reforms at central clearing. Let me throw out a few others, and you may be limited in how much you can say about them, given your role. One that came up a lot in conversation during the month of May at all these conferences we listed was the supplemental leverage ratio. I’ll just throw out what I’ve heard from people at those conferences. One idea is that the SLR might just be lowered altogether, no tweaks to the components in it, but it’s going to be lower, the number.

By lowering the SLR, just to be clear, the idea here is to free up the funding of capital that has to be done, and therefore open up balance sheet space for financial intermediaries, primary dealers to absorb Treasuries. One proposal that I’ve heard is to lower the supplemental leverage ratio. Another is take out reserves and Treasuries altogether, then you get some pushback on that. If you take out Treasuries, there’s interest rate risk, and we saw what happened to Silicon Valley Bank in March 2023.

Then a third proposal, well, let’s only take out reserves. What I’m hearing, though, is something is happening. There’s something in the works. Now, maybe you can’t comment on that, but any observations you do want to share?

Schulhofer-Wohl: Yes. It’s really not my place to talk about potential regulatory changes, but I can maybe just help you understand what that conversation is really about. In bank capital regulation, we have essentially two different kinds of calculations that happen. One are risk-based calculations, where we say the amount of capital you have to hold against an exposure depends on how risky that exposure is. If you’re doing something very risky, you’ve got to hold more capital than if you’re doing something very safe.

The other types of calculations are nonrisk-based and just say the bigger your balance sheet is, the more capital you’ve got to hold, and it doesn’t matter how much risk you are taking. There’s a logic to both of those. The logic of the risk-based ones is sort of obvious. The more you stand to lose on a transaction, the more capital you better have to absorb that loss. The logic of the nonrisk-based ones is that risk is not necessarily measured perfectly, and mistake could be made. You could have firms trying to game it in some way, and so having a very simple calculation that’s not subject to modeling mistakes or to attempts at gaming can mitigate risk and make the system safer.

There’s a benefit to both risk-based and nonrisk-based calculations. Why people talk about that in the Treasury market, most kinds of intermediation in Treasury securities are in the spectrum of things that financial institutions do, low risk and low return. Treasuries are very safe. If you’re making an overnight loan collateralized by Treasury security, that’s an incredibly safe activity to do. Even buying and selling Treasury securities for a day, they’re not nearly as volatile as many other instruments that could be bought and sold. This is a very low-risk, low-return activity.

To the extent that an institution is bound by a nonrisk-based calculation, they’re going to say, “Why do I want to use up my limited capital on something that is low risk, low return? I would rather use that capital on something that is higher risk, higher return, because I can get higher returns, and the capital calculation that matters for me is this nonrisk-based one. Moving to a higher-risk activity won’t require any more capital under the rules that are currently binding me.”

Nonrisk-based capital calculations, depending on which ratios are binding for a given firm at a given time, can be a drag on doing low-risk, low-return activities. People bring that up as like, “Hey, this would be a way to get the Treasury market to have more intermediation if firms were not as bound by nonrisk-based capital calculations.” Now I think the tradeoffs that have to be considered are, number one, there has been a good reason why regulators have introduced nonrisk-based capital calculations in the first place.

Number two, if you free up capital for a firm, it’s not as mechanical as there’s less capital cost to doing Treasury intermediation, so therefore they’ll do more Treasury intermediation. Firms always take a look at what is profit maximizing, and so if capital is freed up in some way, they will think about what is the profit-maximizing way to use that capital. It’s entirely possible that they use it in a number of different ways. You can’t be guaranteed that any regulatory reform will have a mechanical consequence on what firms do with that capital. Those are things that people think through when they discuss this issue of how capital regulations affect the Treasury market.

Beckworth: In other words, the SLR reforms that are now being considered are also not a panacea. It may not be binding as a constraint in all settings. In fact, that came up in Lorie’s panel. Deirdre Dunn mentioned she didn’t think that the SLR is always a binding constraint for some of these big banks. That does remind me of another idea that’s been put out there, and this one doesn’t really get as much time, as far as I can tell, in terms of coverage, but if we had better liquidity regulations, it could actually affect the SLR in this way.

There’s been this recent push to count collateral at the discount window toward liquidity regulations. For example, let’s say you could count the collateral toward your liquidity coverage ratio or some kind of internal liquidity test. If you could do that, then these banks would have less demand to buy and hold Treasuries because they could count stuff at the discount window, and if they are having less Treasuries, then the SLR becomes less of a constraint. Better liquidity regulations leads to more efficient SLR use. Any thoughts on that idea?

Schulhofer-Wohl: It’s an interesting interaction you raise between the two sides of regulation. In bank regulation, there’s both capital regulation and liquidity regulation, and capital regulation is a regulation on the liability side of a bank’s balance sheet, how much of its liabilities need to come from capital, from equity, versus how much of those liabilities can be things like deposits that the bank has to make good on no matter what, and that potentially are more from equity.

Then, on the other hand, liquidity regulation is really a regulation on the asset side of the balance sheet. What are the assets that a bank holds to bank its liabilities, and then to what extent is it allowed to hold assets that are not liquid and are harder to sell? Think of, for example, commercial loans, versus to what extent does it need to hold assets that are more liquid and easier to move if suddenly it faces a withdrawal of deposits or has some other need?

The most liquid asset a bank can have is bank reserves, cash at the Fed, but also Treasury securities, for example, are considered high-quality liquid assets because that market is generally so deep and so liquid, both for selling the securities or for withholding them overnight to get funding. As you point out, there’s an interaction between these in the sense that a bank’s decisions about what assets it has to hold may affect how much risk it wants to take, what activities it wants to engage in, and that can feed back to the capital requirements it has.

I think that’s just an important reminder that we should not think of in any aspect of what a bank is doing or the regulations in this or any market in isolation, because these things work together. What’s going on the asset side of a bank’s balance sheet affects what’s going on the liability side and vice versa. The best results will be achieved when people think about those dimensions together rather than separately.

Beckworth: That’s why we teach general equilibrium in macro, right? We want to make sure we get the full picture. We don’t think partial equilibrium. Good stuff, Sam, as always. Let’s wrap this section up. Are there any other reforms that you want to mention? You alluded to the better reporting requirements. There was also a Treasury buyback program that Treasury introduced. Anything else you think is worth mentioning?

Schulhofer-Wohl: Yes. I would highlight the increases in transparency. FINRA has begun reporting at the end of each day on transactions and on-the-run Treasury securities. Those are the most recently issued of each tenor. The Office of Financial Research has begun collecting data on noncentrally cleared bilateral repo. There have been improvements in Form PF, which is a form that’s used to collect data on private investment funds and their holdings.

All of that gives the market and give regulators much more insight into what’s happening. That’s just really valuable for making good decisions, both for market participants and for the official sector. I’m really optimistic that now that we have those data, now that people are studying them, that will be a foundation for further strengthening the market.

Operating Systems in Central Banks

Beckworth: Okay. Well, let’s move to the second panel that I want to use to motivate our conversation in this second part of the podcast. That is the panel that I hosted at the conference, and this one was on the operating system in central banks. I had a great panel. I had Claudio Borio, formerly of the BIS. I had Imène Rahmouni-Rousseau. She’s the director of general market operations at the ECB. Not quite the same, but you can think roughly equivalent to the SOMA manager at the New York Fed. It’s a little different there, but that’s a rough approximation. And Patricia Zobel of Guggenheim, who used to be the SOMA manager pro tem and deputy manager as well.

We talked about demand-driven operating systems, and is there any application, if at all, for the Fed. I want to put a pin in that, though. I want to hold on to that. I want to talk about an article that you wrote on operating system, was really interesting. The title is “Monetary Policy Implementation and the Consolidated Government Balance Sheet.” Sam, I think one of the most important accounting identities in macroeconomics is the consolidated government balance sheet. That is so central to understanding so many things. I’m glad you brought this into central bank operating systems. Now, this paper is technical. A lot of T-accounts, which we can’t show on an audio podcast. 

Schulhofer-Wohl: I can try to draw with my hands here.

Beckworth: Yes, you could. Walk us through the arguments you’re making and why it’s important to think through them.

Schulhofer-Wohl: The central idea in the paper is that if a central bank creates more bank reserves, which are the main liability of many central banks, and backs those reserves by buying a government security from the finance ministry—I’m very careful in the paper to talk about the central bank and the finance ministry and not any particular central bank or any particular finance ministry. I’m trying to talk about the general issue here. If a central bank creates bank reserves and then buys a government security from the finance ministry, the central bank is really ultimately part of the government.

When you think about the consolidated assets and liabilities that the government is offering, that government security that the central bank buys from the finance ministry is simultaneously a liability of the finance ministry and an asset of the central bank. When you add up the government as a whole, those two things cancel out. This transaction where the central bank buys the government security and issues bank reserves, what that means is that the government will have more of its combined liabilities being bank reserves and less of its combined liabilities being government securities.

If you’re thinking about what is a good way to implement monetary policy, how many reserves to create, and what to back them with, one lens to take on it is, certainly not the only one—there are many lenses to bring to this—one is, does it matter what liabilities the government funds itself with? Does it matter how much of the government’s liabilities are bank reserves versus government securities?

A second point that falls out of that, historically, there are two major ways of central banks implementing monetary policy, right? Monetary policy implementation means policymakers decide on an interest rate target, and then the central bank has to do something to cause market interest rates to meet that target. Historically, one way to do this is what many large central banks are doing currently with ample reserves. You provide a lot of bank reserves. You pay interest on those reserves. It’s something close to the target. Because there are a lot of reserves, by arbitrage, money market rates stay close to the interest rate paid on reserves and close to the target.

A different way of doing it historically is what is often called scarce reserves, where the central bank doesn’t provide many reserves at all. As a result, banks are willing to hold those reserves, even if the interest on them is below money market rates. Then, by adjusting the scarcity of reserves, fine-tuning it, the central bank can make money market rates move around because as reserves get scarcer, money market rates will go up. Those are two different ways of doing it.

If you’re trying to decide between those, the scarce reserve system has a lot fewer bank reserves, and correspondingly, the government is more funded by government securities versus the ample reserve system that has more reserves, and the government is more funded by bank reserves and less by government securities. You can ask which of these is better.

That leads to a third point, which is really about taxation. Who holds bank reserves? Banks hold bank reserves. If banks are holding reserves that don’t pay interest at close to market rates, but they’ve got to hold those reserves for regulatory reasons or to manage their own liquidity risk, as we discussed earlier, then it’s like a tax on reserves for those banks because they need to hold those reserves to manage their risk or to meet regulations. This is an asset that doesn’t pay market rates. It pays less.

That might seem like a great thing for the government. They get to issue this liability of reserves for the consolidated government that pays less than market rates. Conceivably, you could imagine the government thinking it’s somehow saving some financing costs there. Of course, the flip side of that is the banks are not getting the interest they would get if they held assets that made a market rate. You can think of this as a tax on banks. What that means is that the government savings there is coming by taxing banks.

There’s a whole literature in public finance on optimal taxation, what kind of activities should you tax and not tax. The two big insights from that literature, number one, are that the government ought to tax activities that create negative externalities and subsidize activities that have positive externalities. That’s Pigouvian taxation. Then the other big insight is what are called Ramsey taxes, which is the government should tax things that are inelastically supplied because the amount of those things won’t respond. If the government taxes things that are very elastically supplied, the supply of them will respond, and that would distort the economy.

An example is property taxes are less distorting because the amount of land, in the extreme case, land taxes are less distorting because the amount of land is just fixed. Taxing property, built structures, is somewhat more distorting because although the current structures that exist are just there, we may distort the decision to build new structures. Taxing income can be more distorted than that because you change people’s incentives to work in general. The insight from Ramsey taxation is that the government should put higher taxes on things that are less elastically supplied or less elastically demanded so as to reduce distortion.

In the paper I talk about, well, if different policy implementation regimes end up looking like in some regimes there’s more of a tax on banks and other regimes there’s less of a tax on banks, what do those insights from public finance say about the tradeoffs between different regimes?

Beckworth: Now, this is closely tied to the argument you’ve made about the Friedman rule, too, isn’t it? You want banks to supply the optimal amount of money given the social cost and social benefit of that money.

Schulhofer-Wohl: Yes. Historically, the Friedman rule is thought of as saying that a central bank ought to run a deflation so that you don’t tax money holdings. The reason you have to run a deflation to not tax money holdings is that people assume that real interest rates are positive and that money is not going to pay interest because Friedman is imagining it’s paper currency, they can’t pay interest.

Once you can pay interest on reserves, the Friedman rule is different. If you don’t want to tax money holdings, then you just need to pay interest on reserves at market rates or close to market rates. Why is that a good thing? Banks use reserves for very important purposes. Reserves help banks manage their liquidity risk, they help banks make payments, meet their customers’ requests to make outgoing payments. They keep the whole financial system moving.

If you have a tax on reserve holdings, that’s going to double the works, and it’s going to mean that banks take more liquidity risk. Generally speaking, those are not going to be good things for the financial system. It’s preferable to not tax banks’ money holdings in that way for purposes of financial stability and the efficiency of the payment system. You can call that the Friedman rule with interest on reserves. It suggests, again, paying interest on reserves at close to market rates.

Beckworth: Listeners, check out Sam’s article online. We’ll have a link to it. Sam, I want to flesh out this point a little bit more. The point you’re making, that is, if you do have scarce reserves, it’s effectively a tax on the banks, there are efficiency reasons to question that approach. Now, this approach, the way you set it up, also has market rates equal to the interest on reserves in this ample reserve system, right? Again, this is very intuitive, very clear. When you read the article, there’s no question.

Here’s a question I have, though. Now, I know you mentioned this is no particular bank, and you assume away a lot of the, maybe, frictions. In practice, here in the U.S., interest on reserves has been above some of these overnight rates for quite a while. How would you reconcile that observation? Because that would strike me as maybe banks are actually, again, paid a little bit more than what a market rate would determine. They’re not getting quite equal.

Schulhofer-Wohl: Yes. I think many observers believe that currently there are more reserves in the system than the lowest amount that would be needed  to be on the flat or gently sloped portion of the demand curve where you would have money market where it’s close to interest on reserves. I worked through this in the paper also.

A central bank could supply a scarce amount of reserves, and money market rates would be above interest on reserves. They could try to get to a point where money market rates are near interest on reserves, or a central bank could supply even more reserves. If it did that, likely money market rates would be pushed below interest on reserves. Many central banks around the world, in response to the economic shocks, most recently the pandemic, but also the global financial crisis, greatly expanded their balance sheets and bought assets in order to support market functioning and to provide economic stimulus.

When a central bank buys a lot of assets and expands its balance sheet, that also creates more reserves and can push it into this situation where market rates are below interest on reserves. Essentially, the mirror image of the argument that says that it can be inefficient to have money market rates well above interest on reserves says it can also be inefficient for money market rates to be well below interest on reserves.

Now, when a central bank has a big policy reason, like it needs to provide economic stimulus, it needs to support market functioning, that could outweigh those inefficiencies. It suggests over time, a reason why many central banks have said that they intend to get back to more efficient balance sheet sizes is to not be in that situation of supplying more reserves than those central banks think is necessary and appropriate for their economies.

Beckworth: That’s a nice segue into the rest of your article, and I wanted you to touch on that point that that can be an issue. One last question, then I want to move on to the changing environment abroad for operating systems. Some observers have also raised questions about a ratcheting effect of ample reserve systems. I’m sure you’ve seen this work that once you create all these reserves, and again, it may be due to economic reasons, not necessarily an operating system per se, but there’s an economic crisis, so the balance sheets are expanded, it’s hard to bring it back down.

There’s several papers. One talks about banks create demand deposits, and other liquid liabilities are hard to retract. Another talks about bank supervisors coming to expect it. They both argued that this increased supply creates its own demand. It might be hard to get back to this optimal point where you describe in your paper. How would you respond to those observations?

Schulhofer-Wohl: The way I think about this is that there are potentially short-run and long-run demand curves. We’re used to that in many markets, that people or businesses have more opportunities to adjust their behavior in the long run than in the short run. If we asked, “What is your demand for natural gas to heat your house?” in the short run, it’s potentially very high because the amount of insulation your house has is what it is. The efficiency of the furnace is what it is. Even if the price of natural gas goes up a lot, you could put on a sweater, but ultimately, you’ve got to heat your house.

Now, on the other hand, if the price of natural gas goes up a lot and stays up, you might say, “I should get a more efficient furnace. I should put in more insulation. I should replace the windows.” Then you can bring your demand for natural gas down more. I think the same thing can go on with reserves, right? If we’re in an environment where there are a lot of reserves, where the interest rate on reserves is modestly above market rates, banks make decisions based on that. They start issuing deposits. They build customer relationships. Their balance sheets adjust.

If reserves dropped very precipitously to a much lower level, in the short run, banks would have limitations on what they could do about that. In the long run, there would be more adjustments they could make. I think if you ask, “How low can we get reserves today if we did it very rapidly before we saw money market pressures?” the answer is different than if you said, “How low could reserves get in the long run over time if they were running off very gradually, and banks knew that they were doing that and had time to adjust and do things differently? If supervisors had time to recognize we’re going to be in a different environment, this is what we should be looking for.” I just think that the short-run and long-run demand curves are different.

You’ve seen central banks try to bring down reserves gradually to allow that time for adjustment. I think one reason why that can help get to a lower level of reserves is because it lets you be on the long-run demand curve rather than the short-run demand curve.

Beckworth: All right. Great observation. In the few minutes we have left, I want to segue to the panel discussion I had. We don’t have a lot of time here, so I will encourage listeners to go to my Substack. Subscribe if you haven’t already. I provided in my remarks a link to the video. You can hear all the great comments made there. There are a number of central banks that are moving to some form of what they would call demand-driven operating systems. They all have different official titles.

Like the ECB says, we have a soft, floor-driven demand, which I’m not sure how to reconcile, but others are a little cleaner. The Bank of England has a demand-driven repo plus system. Reserve Bank of Australia has a demand-driven full allotment system. What are your thoughts and observations on these central banks, and what are they doing?

Schulhofer-Wohl: To me, the commonalities are much larger and more important than the differences. I think, historically, the discussion of operating systems was often described as floor versus corridor. The idea was if you had a lot of reserves, you would push rates down to a floor created by the interest rate on reserves, and you’d be on the flat part of the demand curve. Whereas if reserves were scarce, the lending facility and the rate at it would also matter a lot because banks would be having to borrow. Rates would be in a corridor between interest on reserves and the lending rate or those ceiling tools, the lending rate might matter a lot.

People talked about floor versus corridor, and they put a lot of importance on which was the most active tool. The interest rate on reserves or the lending facility. I don’t think that’s the most helpful way to look at it. To me, the really fundamental distinction is, are you supplying enough reserves that market rates are close to interest on reserves, and then there are all of these efficiency benefits to that, or instead, are you in an environment where reserves are scarce.

One thing we haven’t talked about at all is how these different systems influence the central bank’s ability to actually hit the interest rates harder, to control rates. There are differences there, too. Even just thinking about efficiency, I think that this difference of, are market rates close to interest on reserves or far is really a fundamental one. Different major central banks around the world are thinking about achieving that in different ways.

For some, the plan is to have a lending facility that banks are very willing to borrow from, other market participants are very willing to borrow from, and whose rate is not that far from interest on reserves. You’re going to see a lot of borrowing at that facility and rates are going to be close to interest on reserves. For other central banks, the plan is to supply the reserves outbreak by acquiring assets and pay interest on them. If you supply enough reserves, again, market rates will be close to interest on reserves.

I was at this New York Fed and Columbia University conference last week, and people brought this up a lot, that the similarities are bigger than the differences. It was under Chatham House rules, so I won’t name names. That was a running theme, and people pointed out that the different approaches really reflect differences in the financial system that a central bank operates.

Some central banks are in financial systems like the U.S., where there’s a very large number of banks that are very diverse in size and business model. There’s also a lot of nonbank finance. Other central banks are in much more concentrated financial systems, much less nonbank finance. Central banks also target different interest rates. Some target the repo rate. Some, like the Fed, target an unsecured overnight interbank rate. All of those nuances are going to affect which is the right tool to use to move rates around.

All of these central banks, what you see them doing is trying to get market interest rates close to the rate that’s paid on reserves. I would argue it’s because we know at this point that there are big efficiency benefits for doing that.

Beckworth: Well, with that, our time is up. Our guest today has been Sam Schulhofer-Wohl. Sam, thank you once again for coming on the program.

Schulhofer-Wohl: Thanks so much for having me. I really enjoyed the conversation.