Debt Markets Need A Safe Haven

Introduction

Our debt markets can be stabilized without the regular Fed intervention we have seen since the Financial Crisis, read here. This market instability is the result of credit markets being left unprotected by misguided monetary and regulatory policy. The Fed is not likely to reverse its recent policy and regulatory decisions, but the negative effects of these policies can be reversed by adapting private sector initiatives that were successful in the equity market and the futures markets to provide a stable haven for short-term debt investors.

This article provides a road map from two private sector successes – passive equity ETFs and Eurodollar futures – to a financial instrument to calm the fractious market for market-traded short-term debt.

How debt markets became so vulnerable

The debt markets have been in crisis mode regularly since the Financial Crisis of 2007-2008. Because of this steady diet of disasters, debt markets both in the UK (read here) and the US have been regularly placed on life support by monetary authorities. What caused this weakness in the financial system?

The Fed’s management of debt market stability. The two regulatory sources of current debt market instability are

• Hyper-easy-money. Central bank monetary policies aimed at recovering from the Crisis but were left in place long after the Crisis ended.
• Regulations driving commercial banks from their traditional role in debt market risk management.

Hyper-easy money. The Fed, scrambling to find a version of easy money even more expansive than a policy rate set at zero, invented a two-instrument monetary policy – pumping interest-earning reserves into the banking system in tandem with the zero policy rate. This extreme version of easy money was quickly adopted by the central banks of other developed countries.

Whatever the virtue of hyper-easy money during a Financial Crisis, the policy was left in place for almost 15 years – long after the Crisis – creating a generation of private sector risk-takers that were never reined in by normal costs of capital (read here).

Removing the banks from debt markets. Then despite the market volatility that extreme monetary policy threatened, the Fed inhibited the most important market risk stabilizer, the commercial banking sector’s management of private sector risk-taking, in two stages.

• First, the Fed increased the regulatory capital banks issuing wholesale bank deposits must hold. This reduced commercial banks’ willingness to trade in the deposit market – at spreads to the relatively docile stable wholesale deposit rates such as the London Interbank Offered Rate (LIBOR) and the yield on negotiable domestic wholesale certificates of deposit (CDs). Wholesale deposits became a non-factor in risk management – ultimately ending the largest futures contract, Eurodollars, and any hedging based on LIBOR.
• Then the capital costs to banks of holding inventories of negotiable debt instruments, including Treasury short-term debt and bonds, were also increased by regulation. This reduced the capacity of banks to make markets in commercial paper and other debt, further reducing debt market liquidity.

Central bank policies left debt markets with only one liquid debt instrument, overnight repurchase agreements. Borrowers were left with only relatively illiquid market-priced sources of money-like assets such as commercial paper, and institutional investors were left with a single offering of investment houses – Money Market Mutual Funds (MMMFs).

Risk management became the domain of the ill-prepared shadow banking system.

The wholesale debt markets lack a stable haven

It is useful to compare debt markets to supposedly riskier equity markets. Why have the collapses of debt portfolio values and resulting central bank rescues not been matched by similar collapses and rescues in the equity markets? Equity portfolios don’t collapse en masse as do debt-asset-backed wholesale liabilities.

In the US, the Prime Money Market Mutual Funds (Prime MMMFs) are the problematic remaining source of day-to-day liquidity for institutions seeking a private sector unsecured short-term yield. The Prime MMMFs have become the leading corporate debt-backed wholesale investment despite their post-Crisis collapses because they have not been squeezed out of risk management by regulators as have the banks. But these Prime MMMFs are vulnerable to mass redemptions and have twice forced the Fed’s intervention, during the Financial Crisis and again during the COVID crisis.

The equity market haven. Equity markets are less vulnerable because private sector investment designers have constructed a haven that is built to withstand large withdrawals – passive equity funds and ETFs. Passive equity funds have a property crucial to their stability. There is no “breaking the buck” in the equity markets – no price of the underlying individual equities that stampedes investor redemptions in the passive equity funds simultaneously.

What would a debt-based haven look like?

Two markets suggest a direction for investment funds that seek to be a haven for the short-term debt market – LIBOR-based Eurodollar futures and passive common stock ETFs.

Futures-based liquidity. LIBOR dominated the pricing of private sector short-term debt long after the London deposit market dried up because of its significance as an index for short-term debt pricing – especially in derivatives and consumer debt markets. The important lesson of Eurodollar futures trading is that an index can be the successful basis for pricing if its associated futures market is liquid even when the spot market itself is illiquid.

Convenience yield-based liquidity. Individual passive ETFs are successful because they provide an important convenience yield. These ETFs do not compete on price, but instead by matching the value and performance of the S&P 500 stock index at a very low transaction cost. Passive ETFs have no incentive to leverage their assets to magnify returns. Users of ETFs seek stability and predictability from passive ETFs. Risk-taking through leverage in this market is anathema to investors.

A short-term debt haven won’t compete for customers with the Prime MMMFs. Like passive ETFs, the appeal of a debt haven would be its reliability as a price for short-term private sector debt that is both an accurate reflection of market conditions and a safe investment haven.

Competition in yield in a debt-based fund ultimately encourages funds to take risks that create dramatic losses in one fund or another. That is the essential difference between passive index funds and other equity-based funds. Passive equity funds compete on cost, not on return. There is no incentive to leverage the returns of a passive ETF.

Debt investments designed to replicate the properties of passive equity funds in the debt market would not compete for users by seeking to provide a higher return. Like passive ETFs, it would survive by offering a risk profile that cannot be matched through leverage.

The death of LIBOR and its rapid replacement by the flawed alternative, the Secured Overnight Funding Rate (SOFR), point to a potential haven that would provide safety without losing the benefits of a term private sector index – a standardized highly diversified short-term corporate debt fund that matches average yields and risks in the term commercial paper market.

A stable fund with a closing price that meets the three criteria below would be a source of stability in the commercial paper market that LIBOR once provided so imperfectly. Necessary properties include

• Values that reflect average market yields and diversified term commercial paper risk.
• Deliverable in settlement of a futures contract. The instrument does not need to be liquid itself.
• A diversified zero-leverage debt portfolio. No competition with other funds on a yield basis.

Conclusion

Ructions in the debt market need not be the constant concern that they have been since the Financial Crisis. We only need to adapt two lessons of 21st-century markets.

• Markets will accept a financial instrument that provides only an average yield if it promises stability during crises and serves as an important indicator of financial conditions.
• Financial instruments need not be liquid themselves. They can be successful if they settle a liquid futures market.

Regulators have left the debt markets unprotected. To make these markets safe, an exchange can provide debt investors with a stable diversified debt instrument that is unleveraged and diversified like an equity ETF. This instrument can in turn provide a liquid source of hedging by settling a liquid futures market with an index of market conditions as did Eurodollar futures before the demise of LIBOR.