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The Fed As Derivatives Dealer of Last Resort?
Market-based finance changes the crisis fighting game
At the height of the concern in March that commodities financing markets were increasingly fragile and could hit a tripwire, the Wall Street Journal reported the following regarding the industrywide search for greater financing:
A vicious financial cycle is exacerbating the volatility and could worsen shortages in some parts of the world, traders say. Exchanges and the brokerage arms of banks are demanding big down payments, known as margin, from traders in futures contracts linked to commodities such as oil, wheat and natural gas. To avoid the expense of holding on to positions in markets, some companies are unwinding trades, fueling further price moves.
. . .
One concern for bankers is that commodity prices will slide back, leaving them with inadequate collateral with which to safeguard those new credit lines . . .
This is, of course, sensible, and the article suggests there was particular concern for new credit lines to smaller commodities players (again: sensible given less value in any recourse to their balance sheet than, say, to Glencore’s).
Quickly in March, the commodities industry was asking for central bank support. And the question of whether such intervention is or will become necessary has ebbed and flowed in its centrality, but has not left us since.
However, a central bank would face the same risk described above. In 2008, WTI oil fell from $145/barrel in July to $31 in December. In April 2020, oil went negative. This is not to say that our current situation is a 2008 or a 2020, but you get the point. Indeed, commodities are starting to dip severely. Metals are down 26% this month. And even energy has started tipping the last couple weeks. If a central bank had little recourse outside this collateral, it could’ve easily gotten its face ripped off doing this kind of intervention depending on its timing (even if overcollateralized). And/or, it could’ve further squeezed the borrower with its own margin calls.
After all, the liquidity squeeze on commodities balance sheets came from (reductively) two sources: higher commodities prices themselves effectively boosting inventory (shipping, insurance, float) demands on liquidity, and the higher margin needed on corresponding short hedges—only some of which was variable, i.e. returnable in the event of falling prices.
Commodities markets paint the most palpable example of this problem, but this is a much greater phenomenon in our increasingly markets-based financial world.
Central Banking: It’s the Future
Central banking and crisis-fighting have evolved as markets have evolved; as market-based finance has grown, so has the central banking arsenal developed. As a recent short note—“Market dysfunction and central bank tools”— out of a BIS working group headed by the FRBNY’s Lorie Logan and the BoE’s Andrew Hauser put it:
Episodes of severe financial market dysfunction eliciting large central bank responses have become more frequent and have occurred across a wider range of markets in recent decades.
. . .
The events of March 2020 – against a backdrop of ongoing changes in market structure over recent decades that have altered the nature of liquidity provision across markets and increased vulnerabilities to shocks . . .
. . .
At the same time, the Markets Committee at the Bank for International Settlements has been reviewing the tools available to central banks to address market dysfunction.
In 1991, following the 1987 market volatility, Congress removed the last restriction on permissible collateral for the Fed to accept under it Section 13(3) emergency interventions. Section 13(3) had until then prevented the Fed from providing lender of last resort services against “investment securities.” In the Senate Banking Committee report accompanying the legislation (the otherwise mostly unrelated FDIC Improvement Act), the committee said of the restriction removal [my emphasis]:
This clarifies that access to liquidity in special circumstances can be made available directly to a securities dealer to help preserve market liquidity and avoid market disruption.[. . .] With the increasing interdependence of our financial markets, it is essential that the Federal Reserve System have authority and flexibility to respond promptly and effectively in unusual and exigent circumstances that might disrupt the financial system and markets.
The evolution of central banking practice started in earnest during the Global Financial Crisis. The Fed intervened with force in repo, CP, and other funding markets. COVID-19 expanded this style of interventions dramatically; hell, the Fed bought junk bond ETFs. And we saw margin requirements across exchanges turn the screws on market participants.
The commodity example in the intro starts to point to some of the shortcomings of central banks ignoring/avoiding derivatives when engaging in markets-based lender of last resort activities, and the benefits to be had are further discussed below. It’s also first worth noting that the Fed already has both experience with and authority for intervening in derivatives markets!
The Fed’s Experience with Derivatives Books
The Fed has one historical instance of taking on derivatives directly: with its Maiden Lane vehicle it used to assist the rescue of Bear Stearns. As you’ll recall: to facilitate JP Morgan’s buyout of Bear Stearns in March 2008, the Fed set up Maiden Lane to buy $30 billion of assets off the combined institution’s balance sheet—JPM wouldn’t do the deal without being able to shed some of Bear it didn’t want. The Fed kept the senior $29 billion of risk and JPM put up the junior (equity) tranche of a little over $1 billion.
As part of that deal, Maiden Lane took on part of Bear Stearns’s derivatives portfolio. Here’s the Fed:
ML LLC purchased a pro-rata share of the macro, non-credit and credit hedges associated with the Mortgage Desk of Bear Stearns. Macro and non-credit hedges were largely in the form of interest rate swaps, futures, options on futures, U.S. Treasuries and agency mortgage TBAs. Credit hedges associated with the Bear Stearns Mortgage Desk’s outstanding positions on March 14, 2008, in the form of single-name credit default swaps (CDS) and to a lesser extent CMBX positions, were also purchased on a pro-rata basis.
In the event, the derivatives had a positive fair value of $3.7 billion on the date of the deal. It does not seem that they needed to have a positive fair value for the Fed to take them on, however — because of the genesis of the Fed’s authority to do so.
The Fed’s Authority to Take on Derivatives
The Fed’s Section 13(3) emergency liquidity authority has several constraints, the most often relevant being that the Fed is “secured to [its] satisfaction.” However, Section 13(3) also restricts the Fed’s liquidity assistance to “notes, drafts, and bills of exchange.” This does not restrict collateral. That is, this constraint is easily satisfied when the Fed is engaged in lending; the loan is the note/draft/bill of exchange, and the Fed is free to accept any collateral to back its loans.1 But it matters when the Fed is doing purchases, as is (likely) the case in the Maiden Lane transaction: the Fed took $30 billion onto its consolidated balance sheet.
But, the Fed did not take the derivatives directly under the 13(3) discounting authority. Rather, it said taking the derivatives — a pro-rata share of the derivatives from the asset book it was absorbing — was incidental to its 13(3) intervention. Here’s the Fed in a footnote from a then-confidential legal memo (available now at the Yale Program on Financial Stability resource library - here) discussing the authority for the Bear Stearns Rescue:
A small amount of assets of the LLC that are not notes, drafts, or bills of exchange (for example, cash and hedging instruments) may be discounted by the FRBNY under the incidental powers provision of the Federal Reserve Act. In addition to the express powers of the Federal Reserve Banks set forth in the Federal Reserve Act, the Act provides that each Federal Reserve Bank has the authority to exercise “such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this Act.”
This refers to Section 4(4) of the Federal Reserve Act - “General Corporate Powers.” This is a useful clause that essentially reminds the reader of the Federal Reserve Act that hey don’t forget! the Fed is, in fact, a bank. (The Fed also exercises its Section 4(4) authority when it sets up SPVs.)
As noted, the Fed’s authority/ability for taking derivatives is much simpler in the case of a loan program instead of a purchase program. The Fed has no statutory constraints on the types of collateral it can take, so long as it is “secured to [its] satisfaction” — which, while discretionary, cannot be any less than generally expecting to be repaid.
And certainly hedge derivatives would serve the aim of assuring repayment. (More on this below.) And other derivatives can be thought of as simply providing additional security; for instance, it’d be silly for the Fed to assess a deep in-the-money option as providing 0 security, and the Fed appears to have acknowledged this in the Bear Stearns rescue.
Improvements to Financial Crisis Fighting
Intervening in a broad-based way (as the law now requires in the U.S. — i.e., no Maiden Lanes for the benefit of just one borrower anymore) in derivatives markets is a serious undertaking both operationally and from a policy/incentives perspective. It’s likely a decision to be taken even less lightly than the Fed already takes emergency intervention decisions. But, as already alluded to above, there are cases where it would be particularly useful. And the case is even more clear in a situation like a 2008 — versus a 2020 crisis which was less financial in nature.
Just to highlight a few benefits to financial crisis fighting efforts:
The Fed would simply be more secured.
The Fed is not interested in maximizing profits when it engages emergency lending. It’s interested in its statutory economic goals and meeting all legal requirements when using its tools to achieve those goals. Any seemingly punitive terms would be for providing additional security or for moral hazard reasons, not for the P&L.
Taking a matched book reduces the chance of loss — thus fitting neatly into the Fed’s statutory standard of needing to expect repayment ex ante. Buying up a corporate bond portfolio with some CDS to match would by definition increase the chance of the Fed achieving repayment. It might reduce the Fed’s overall profit, but this is a secondary concern at best. Plus - it might increase the Fed’s profits if the Fed can do a higher volume thanks to the lower risk and less punitive other terms of assistance.
A more matched book could also expand the bounds of what’s possible intervention-wise both economically and legally…
Economically: The size of Fed interventions can be limited by the amount of equity support from Treasury (or elsewhere). The more recourse to hedges the Fed has, the farther it can stretch every outside dollar.
Legally: Sometimes the Fed looks for an equity investor not for economic reasons, but for solving some legal dissonance. There is some legal uncertainty at the Fed over whether the Fed can take wholly unsecured collateral. (I give this issue its due longer discussion here.) This is why, in 2008’s Commercial Paper Funding Facility, the Fed charged any unsecured issuers to program an extra fee to build up the equity layer and serve as some collateral (when Treasury balked at giving money).
ABCP issuers were exempt from this charge, as were an unsecured issuers who received an otherwise satisfying external endorsement of their credit. This was despite the Fed’s recognition that CP was often safer than ABCP due it having a corporate balance sheet behind it (instead of just being a financial vehicle). We talk about the Fed being “secured to [its] satisfaction,” but, zooming out, the law says “indorsed or otherwise secured.” A hedged book may help the Fed avoid needing Treasury money altogether.
Similarly, by taking a matched book, the Fed could reduce its reliance on the strength of a borrower’s balance sheet as there is less need for recourse (just basis risk and operational risks would remain)
Classic lender of last resort: the Fed backstops the liquidity risk
As the Dallas Fed put it regarding commodities matched books: “while the two positions net out in an economic sense, the cash flows aren’t offsetting.”
This is a distinction without a difference for the Fed (or a similarly situated central bank). The Fed faces no liquidity risk, and its concern is with the economic value of the collateral it takes.
Initial margins can grow whether prices are moving up or down, and even variation margin doesn’t flow back perfectly and instantaneously. Like the example in the opening paragraphs, say the Fed lent at peak commodities, and then they went into freefall:
Variation margin would move around the system, but not perfectly: there would be some costs and disruption due to the float
Initial/maintenance margins would have no reason to go down and might even go up.
Meanwhile, a central bank holding only long assets from the borrower is also making a margin call (if it has a recourse term), squeezing the borrower on the way down. (A matched book would reduce the margin call from the central bank, if so instituted.)
Macro counterparty risk falls
There’s an announcement effect to be had here, as is often the case with Fed interventions. The Fed acting as dealer of last resort in derivatives reduces the chance of an overnight derivatives liquidity pinch making a dealer insolvent, which thus encourages continued derivatives relationships.
This also means less funding market disruptions! Less perceived counterparty risk means less novation (assignment) requests, which means collateral chains need not go into reverse (and less strains on competitor balance sheets, size-wise). These requests contributed to the undoing of Bear and Lehman, and generally tightened liquidity across the Street.
A central bank intervening in market-based finance and only taking the outright long positions leaves the beneficiary with an open short that would need to be closed or borne.
Say the Fed is looking to ease balance sheet constraints in some market segment but only buys the longs. This does ease constraints by itself, but introduces new problems. It would likely lead to a closing of shorts. This might be “good” in the case of, say, bank debt - where it might help limit downward price pressure. But it might be “bad” in the case of commodities, where it could exacerbate any ongoing short squeeze. Plus, it might be costly at a time of already fragile balance sheets.
Additionally, the lower liquidity in the derivatives markets may prevent new economic activity altogether as hedging becomes more costly. We’ve already seen commodities firms in 2022 reduce their physical volumes for exactly that reason.
The case of Bear Stearns above is partially different because the firm had longs and shorts, so the “incidental authorities” was extra useful. But similarly, if JPM had simply liquidated even a perfectly matched derivatives book, the knock-on effects could’ve been disruptive, and collateral chains thrown into reverse…
One note on implementation
I’ve purposely avoided getting too much into the operationalizing bits, other than to note that this process would be manageable — and would almost certainly be done with the support of numerous third-party vendors, per usual for the Fed. But one front-and-center bit is the issue of Fed seniority: the Fed might not like where it sits in a counterparty’s capital stack when taking on derivatives. While the Fed likes to be senior-most, it has other risk management tools for when its not. Moreover, the Fed can operationalize the derivatives dealing in a way that keeps it senior in the stack.
For instance, it appears the way the Fed actually effected the discounting of derivatives in the Maiden Lane case largely wasn’t by taking the trades over itself (via Maiden Lane). Instead, it appears JPM stepped into the trades and the Fed simply wrote a total return swap (TRS) with JPM that mirrored the exposure. This type of arrangement can simplify both the risk management and the operationalization being derivatives dealer of last resort.
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See a short draft memo from the Fed Legal Division on the subject likewise now available in the YPFS library here. The draft further outlines the Fed’s broad collateral authorities when making a loan. In this specific instance, it’s assessing plans it ultimately abandoned to take equity warrants as part of the AIG rescue (it instead opted (p. 222) for convertible preferred securities).