Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

Making the Treasury Market Resilient

Ensuring financial stability requires resilient institutions. That is why regulators around the world have strengthened capital and liquidity requirements for the largest financial intermediaries since financial crisis of 2007-09.

Making financial markets resilient is equally important. Repeated and sustained bouts of illiquidity and dysfunctionality in a key market can threaten the well-being of even the healthiest institutions.

In a global financial system that runs on dollars, the most important financial market is the one for U.S. Treasury securities. Yet, despite its importance and general reliability, the Treasury market occasionally suffers from serious disruptions. The strains in the Treasury market during the first half of March 2020 became an important motivation for the Federal Reserve’s unprecedented anti-COVID policy actions beginning that month (see here, here and here).

In the remainder of this post, we describe the COVID-induced troubles in the Treasury market and highlight Duffie’s compelling proposal to consider requiring central clearing of U.S. Treasuries. We endorse Duffie’s call to study such a mandate, and view this is as an important element of a broader effort to modernize and reinforce the financial infrastructure….

Fed's big stick lets it speak powerfully

The powerful stabilizing impact of the Federal Reserve’s COVID response is visible virtually across U.S. financial markets. What is most remarkable about this is how little the Fed has done to achieve these outcomes. To be sure, the central bank now holds $7 trillion in assets, an increase of $2.8 trillion since early March. Yet, virtually all the increase reflects large-scale purchases of government-guaranteed instruments. What we find astonishing is that the acquisition of risky nonfinancial debt remains tiny.

The point is clear: backed by massive fiscal support, the Fed’s mere announcement of its willingness to purchase corporate and municipal bonds, as well as asset-backed securities, has proven sufficient to stabilize markets despite the worst economic shock since WWII. Put differently, the Fed’s willingness to backstop markets has obviated the need to serve actively as a market maker of last resort.

In this post, we document these developments and then speculate about their implications. For one thing, in a future crisis where the U.S. fiscal and monetary authorities share key goals, people will now anticipate that the central bank will backstop financial markets. Because a central bank is almost certain to intervene when systemic risks rise, these stabilizing powers are welcome.

At the same time, the central bank’s backstop is a source of potentially serious moral hazard. We suspect that investors are now counting on Fed stimulus to support equity and bond prices (and possibly bank loans) even as household and business insolvencies rise. Yet, in a market economy, it is shareholders and creditors who ultimately must bear these losses. Indeed, were the U.S. equity market to plunge by 40 percent in the remainder of 2020, that by itself would pose little threat to the financial system, and ought not trigger large corporate bond (let alone equity) purchases by the central bank….

Central Bank to the World: Supplying Dollars in the COVID Crisis

In his comments at Jackson Hole last year, then-Bank of England Governor Mark Carney highlighted the continuing dominance of the U.S. dollar: it accounts for one-half of global trade invoicing; two thirds of emerging market external debt, official foreign exchange reserves, and global securities issuance; and nearly 90 percent of (one leg of) foreign exchange transactions.

It also is the basis for the Global Dollar system (see our earlier post). The BIS reports that short-term U.S. dollar liabilities of non-U.S. banks total $15 trillion. Foreign exchange forward contracts and swaps—with a gross notional value of more than $75 trillion—add substantially further to U.S. dollar exposures (see here). And, the U.S. Treasury reports that foreigners hold more than $7 trillion of U.S. Treasury securities. To put these numbers into perspective, total assets of U.S. depository institutions are currently $20 trillion. In other words, the U.S. dollar financial system outside of the United States is larger than the American banking system.

Like it or not, the Federal Reserve is the dollar lender of last resort not just for the United States, but for the entire world. The Fed’s role is not altruistic. Instead, it reflects the near-certainty that, in a world of massive cross-border capital flows, dollar funding shortages anywhere in the world will spill back into the United States through fire sales of dollar assets, a surge in the value of the dollar, increased domestic funding costs, or all three.

The Fed’s extraordinary efforts to counter the COVID-19 crisis include aggressive actions to counter dollar shortages outside the United States. In this post, we explore those actions, including the supply of dollar liquidity swaps to 14 central banks (“friends of the Fed”) and—to limit sales that might disrupt the Treasury market—the introduction of a repo facility to provide dollars to the others. We also note the challenges facing countries outside the small inner circle that do not have immediate access to the Fed’s swap lines….

FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

What Should the Fed Own?

The Federal Reserve began to consider just how far its balance sheet consolidation should go well before the tapering actually began nearly a year ago. Earlier staff analyses pointed to a gradual runoff of long-term debt that could take years to reduce Fed assets to a new long-run equilibrium. More recently, market observers have speculated about an early end to consolidation that would result in a higher steady-state level.

Yet, as a recent Wall Street Journal article highlights, policymakers and analysts have devoted less attention to the mix of assets that the Fed should select once the balance sheet shrinks to its long-run equilibrium and policymakers allow it to expand slowly—say, in line with the increase of demand for currency.

In this post, we argue that the Fed should aim in normal times—when the economy is expanding and absent any financial strains—for a portfolio that has minimal liquidity, maturity and credit risk. In practical terms, this means that their portfolio should be composed largely of Treasury bills and short-term notes, with an average maturity that is very short….

Regulating the Credit Rating Agencies? Less Would be More

Guest post by Prof. Lawrence J. White, Robert Kavesh Professor in Economics, NYU Stern School of Business

The major credit rating agencies (CRAs)—Moody’s, Standard & Poor’s (S&P), and Fitch—contributed significantly to the financial crisis of 2007-09. Their excessively high initial ratings of residential mortgage-backed securities (RMBS) helped fuel the bubble of mortgage finance that ultimately burst, with near catastrophic consequences for the U.S. financial sector.

These disastrous failings motivated the post-crisis urge to tighten regulation of the CRAs. It’s not hard to share the (metaphorical) desire—reflected in the Dodd-Frank Act of 2010—to grab them by the lapels and shout “Do a better job!”

There is, however, a better way, albeit one that is less intuitive and possibly less gratifying: namely, eliminate—or at least greatly reduce—the regulation of the CRAs. This would encourage entry into the credit rating business, stimulate innovation and, eventually, improve the efficiency of capital markets....

Banks and interest rates: be careful what you wish for

Many people seem to think that – as a new BIS working paper concludes – banks benefit when monetary policy tightens and interest rates rise (especially from a low level). Do they? In some instances, perhaps, but as a general principle, surely not.

A casual glance at recent U.S. stock market behavior seems to support the idea that higher interest rates would be good for banks now. When the Federal Open Market Committee decided not to hike interest rates on September 17, the S&P500 dropped by 1.85% over two days, while the KBW index of bank stocks fell by 4.85%. A week later, when Fed Chair Yellen speaking about inflation dynamics expressed her continued expectations for a rate hike this year, the S&P500 edged lower, but the bank index rose by nearly 2%...

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Money, Banking, and Financial Markets