Open-end Funds vs. ETFs: Lessons from the COVID Stress Test

COVID-19 posed the most severe stress test for financial markets and institutions since the Great Financial Crisis (GFC) of 2007-09. By some measures, the COVID shock’s peak impact was larger than that of the GFC—both the VIX rose higher and intermediaries’ estimated capital shortfalls were bigger. As a result, the COVID experience provides a natural laboratory for testing the resilience of many parts of the post-GFC financial system.

For example, the March 2020 dysfunction in the corporate bond market highlights the extraordinary fragility of a market that accounts for nearly 60% of the debt and borrowings of the nonfinancial corporate sector. Yield spreads over equivalent Treasuries widened further than at any time since the GFC, with bond prices plunging even for instruments that have little risk of default. (See Liang for an excellent overview.)

In this post, we focus on how, because of the contractual agreement with their shareholders, an extraordinary wave of redemptions created selling pressure on corporate bond mutual funds that almost surely exacerbated the liquidity crisis in the corporate bond market. To foreshadow our conclusions, we urge policymakers to find ways to reduce the gap between the illiquidity of the assets held by corporate bond (and some other) mutual funds and the redemption-on-demand that these funds provide. To reduce systemic fragility, we also urge them—as we did several years ago—to consider encouraging conversion of mutual funds holding illiquid assets into ETFs, which suffered relatively less in the COVID crisis….

Monetary Policy Operations Redux

On September 17, the overnight Treasury repurchase agreement (repo) rate spiked to 6%—up from just 2.2% a week earlier and the highest level in more than 15 years (see DTCC GCF repo index). Oddly, this turmoil occurred at a time when the Fed had begun lowering its policy rate for the first time in more than a decade and market participants anticipated further policy easing ahead.

What led to this sudden disruption in short-term funding markets that been relatively calm in recent years? Had the Fed lost control? In our view, the explanation for the sudden rise in overnight interest rates is straightforward: the shrinkage of the Federal Reserve’s balance sheet that began in October 2017 reduced the aggregate supply of reserves gradually to where banks’ demand for reserves was insensitive to interest rates. Consequently, large temporary fluctuations in the supply of reserves that would have had virtually no impact even a few months ago, triggered sizable upward interest rate fluctuations.

Consistent with this view, the Federal Reserve recently took action to prevent a recurrence of the September disorder. At an unscheduled video conference meeting on October 11, the FOMC agreed to additional regular purchases of Treasury bills at least into the second quarter of 2020. The goal of this balance sheet expansion is to maintain reserve balances at least as high as their level in early-September before the turmoil began.

In the remainder of this post, we discuss the evolution of the supply and demand for reserves in recent years. We argue that, because no one—including the Fed—knew the precise level of reserves at which the demand curve would become inelastic, an episode like the one on September 17 was virtually inescapable as reserve supply declined. If our diagnosis of the cause is correct, then recent actions should help put the issue to rest. Yet, given the inevitability of the event―that the day would come when shrinking reserve supply hit the inelastic part of the reserve demand curve―the Fed could (and should) have been prepared. If so, it could have avoided even a temporary dent in its well-deserved reputation for operational prowess….

Commentary

Money, Banking, and Financial Markets