Commercial paper

TradFi and DeFI: Same Problems, Different Solutions

In our recent primer on Crypto-assets and Decentralized Finance (DeFi), we explained that, so long as crypto-assets remain confined to their own world, they pose little if any threat to the traditional finance (TradFi) system. Yet, some crypto-assets are being used to facilitate transactions, as collateral for loans, as the denomination for mortgages, as a basis for risk-sharing, and as assets in retirement plans. Moreover, many financial and nonfinancial businesses are seeking ways to expand the uses of these new instruments. So, it is easy to imagine how the crypto/DeFi world could infect the traditional financial system, diminishing its ability to support real economic activity.

In this post, we highlight how the key problems facing TradFi (ranging from fraud and abuse to runs, panics, and operational failure) also plague the crypto/DeFi world. We also examine the different ways in which TradFi and crypto/DeFi address these common challenges.

To summarize our conclusions, while the solutions employed in TradFi are often inadequate and incomplete, features such as counterparty identification and centralized verification make them both more complete and more effective than those currently in place in the world of crypto/DeFi. Ironically, addressing the severe deficiencies in the current crypto/DeFi infrastructure may prove difficult without making highly unpopular changes that make it look more like TradFi—like requiring participants to verify their identity (see, for example, Makarov and Schoar and Crenshaw).

This is the second in our series of posts on crypto-assets and DeFi. In the next one, we will examine regulatory approaches to limit the risks posed by crypto/DeFi while supporting the benefits of financial innovation….

Read More

SEC Money Market Fund Reform Proposals Fall Far Short, Again

As the principal regulator of U.S. money market mutual funds (MMMFs), the SEC has a duty to end the market distortions and moral hazard that repeated public rescues create. There have been two MMMF bailouts, so far. The first came at the height of the Great Financial Crisis of 2008, while the second followed in the March 2020 COVID crisis. While the Treasury provided guarantees only once, the Federal Reserve offered emergency liquidity assistance both times.

These repeated government interventions encourage MMMF managers to behave in ways that make future liquidity crises more likely. Moreover, there is no credible way for the Fed to promise not to intervene should a systemic disruption again loom in short-term funding markets. The only realistic means to end the subsidies created by the implicit promise of future bailouts is to force MMMFs to be far more resilient than they are today.

Against this background, the SEC’s December 2021 MMMF reform proposals are seriously disappointing. In this post, we start with basic facts about the scale and mix of MMMFs today. We then describe the SEC’s proposals, before focusing on their key shortcomings. We hope that the public comments that the SEC receives will motivate it, at the very least, to conduct a serious quantitative assessment of introducing capital requirements for the most vulnerable MMMFs, to re-assess the scale of additional liquid assets needed for MMMF resilience in the absence of a Fed backstop, and to propose ways to enhance the effectiveness and utility of MMMF stress tests….

Read More

Fix Money Funds Now

On September 19, 2008, at the height of the financial crisis, the U.S. Treasury announced that it would guarantee the liabilities of money market mutual funds (MMMFs). And, the Federal Reserve created an emergency facility (“Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”) to finance commercial banks’ purchases of illiquid MMMF assets. These policy actions halted the panic.

That episode drove home what we all knew: MMMFs are vulnerable to runs. Everyone also knew that the Treasury and Fed bailout created enormous moral hazard. Yet, the subsequent regulatory efforts to make MMMFs more resilient and less bank-like have proven to be half-hearted and, in some cases, counterproductive. So, to halt another run in March 2020, the Fed revived its 2008 emergency liquidity facilities.

We hope the second time’s the charm, and that U.S. policymakers will now act decisively to prevent yet another panic that would force yet another MMMF bailout.

In this post, we briefly review key regulatory changes affecting MMMFs over the past decade and their impact during the March 2020 crisis. We then discuss the options for MMMF reform that the President’s Working Group on Financial Markets identifies in their recent report. Our conclusion is that only two or three of the report’s 10 options would materially add to MMMF resilience. The fact that everyone has known about these for years highlights the political challenge of enacting credible reforms.

Read More

The Fed Goes to War: Part 1

Over the past two weeks, the Federal Reserve has resurrected many of the policy tools that took many months to develop during the Great Financial Crisis of 2007-09 and several years to refine during the post-crisis recovery. The Fed was then learning through trial and error how to serve as an effective lender of last resort (see Tucker) and how to deploy the “new monetary policy tools” that are now part of central banks’ standard weaponry.

The good news is that the Fed’s crisis management muscles remain strong. The bad news is that the challenges of the Corona War are unprecedented. Success will require extraordinary creativity and flexibility from every part of the government. As in any war, the central bank needs to find additional ways to support the government’s efforts to steady the economy. A key challenge is to do so in a manner that allows for a smooth return to “peacetime” policy practices when the war is past.

In this post, we review the rationale for reintroducing the resurrected policy tools, distinguishing between those intended to restore market function or substitute for private intermediation, and those meant to alter financial conditions to support aggregate demand….

Read More

Eclipsing LIBOR

The manipulation of the London Interbank Offered Rate (LIBOR) began more than a decade ago. Employees of leading global firms submitted false reports to the British Banking Association (BBA), first to influence the value of LIBOR-linked derivatives, and later (during the financial crisis) to conceal the deterioration of their employers’ creditworthiness. U.S. and European regulators reported many of the details in 2012 when they fined Barclays, the first of a dozen financial firms that collectively paid fines exceeding $9 billion (see here). In addition to settling claims of aggrieved clients, these firms face enduring reputational damage: in some cases, management was forced out; in others, individuals received jail terms for their wrongdoing.

You might think that in light of this costly scandal, and the resulting challenges in maintaining LIBOR, market participants and regulators would have quickly replaced LIBOR with a sustainable short-term interest rate benchmark that had little risk of manipulation. You’d be wrong: the current administrator (ICE Benchmark Administration), which replaced the BBA in 2014, estimates that this guide (now called ICE LIBOR) continues to serve as the reference interest rate for “an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years [our emphasis].” In short, LIBOR is still the world’s leading benchmark for short-term interest rates.

Against this background, U.K. Financial Conduct Authority CEO Andrew Bailey, recently called for a transition away from LIBOR before 2022 (see here). In this post, we briefly explain LIBOR’s role, why it remains an undesirable and unsustainable interest rate benchmark, and why it will be so difficult to replace (even gradually over several years) without risking disruption.

Read More