Post-LIBOR Short Term Debt Markets – Excessive Government Power

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Introduction

Government agencies regulating short-term credit markets have actively sought to create a market structure that meets their objective – government stabilization of risk in short-term credit markets. Every crisis seems to blow up these markets crumbled. And the taxpayer then pays the bill for the repairs.

But a private sector solution to the instability of the short-term credit market structure can be put in place, without periodic taxpayer-funded government bailouts. Creating a marketplace that enhances private sector market stability, this structure can also bring greater value to investors. And the burden of credit risk is shifted from taxpayers to private risk takers.

I recently described a way to provide retail investors with direct access to short-term Treasury markets. A second following article examined a similar way for retail investors to access subprime debt markets. These short-term debt portals offer two advantages over Prime Money Market Funds (MMF).

  • They are more suitable for retail investors.
  • They are less likely to crash when markets are under stress.

terms

LIBOR. A daily index of credit risk short-term rates, provided by a panel of 18 major commercial banks, is being withdrawn. The basis of the index was an estimated deposit rate (the interest rate on 3-month wholesale dollar deposits in London). LIBOR reflected the fact that short-term credit risk was real.

SOFR. The Government Micromanaged Guaranteed Overnight Funding Rate (SOFR). The Fed calculates SOFR daily from repo rates backed by Treasury bills other than special issues. The SOFR is the backbone of the government’s new short-term credit market structure. This structure replaces the direct acquisition of short-term debt by the government during the post-financial crisis quantitative easing program. SOFR reflects the new world of government transfer of credit risk from investors to taxpayers.

Quantitative easing. After the financial crisis, the Fed increased its initial economic stimulus, a zero policy rate, with the added stimulus of aggressive securities buying. Under this program, the Fed purchased hundreds of billions of dollars in assets, mostly US Treasury securities, federal agency debt and mortgage-backed securities.

First MMFs. A top-rated money market fund is a type of investment fund that invests in high-quality, short-term debt securities, cash, and cash equivalents. It is suitable for institutional investors.

AMLF. During the financial crisis, the Fed bailed out blue-chip money market funds with the liquidity facility of asset-backed commercial paper (AMLF) money market mutual funds. The AMLF was a loan facility that provided funds to US deposit-taking institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds under certain conditions.

chart

MMF volume over time (Investment Company Institute. SEC, Federal Reserve Board)

MMLF. The Money Market Mutual Fund (MMLF) Liquidity Facility. A loan facility to support the money market mutual fund industry was introduced by the Fed at the start of the COVID crisis. It made available to eligible financial institutions high-quality asset-backed loans purchased by the institutions from money market mutual funds.

The chart below measures MMF withdrawals during the Covid crisis, reflecting the market effect of MMLFs.

chart

Moment of COVID stress (Bloomberg)

Blue chip money market funds tend to fail when markets are under stress. In response to ongoing crises that rocked the Fed’s flimsy SOFR-based solution, the Fed pampered SOFR with government bailouts as crises unfolded and market interventions that were activated when the Fed’s short-term target rates deviated from the Fed’s objectives.

The status quo

The old structure of the short-term market relied on two main channels through which money flowed from investors to creditors: commercial bank deposits and major money market funds.

The first channel, wholesale deposits, has been reduced to a minimum by the end of LIBOR and regulatory disincentives for banks offering wholesale bank deposits. This means that the direct issuance of corporate debt, through investment funds, is now taking center stage. The graph below compares the assets of money market funds with those of other UCITS and deposits.

circular diagram

Who owns the MMFs (The Institute of Investment Companies)

Blue chip money market funds tend to fail when markets are under stress. In response to the ongoing crises that rocked the Fed’s flimsy SOFR-based solution, the Fed pampered SOFR with government security measures as the crises unfolded. These were market interventions that were activated when short-term credit funds threatened to collapse.

The federal short-term credit program

What is the appropriate financial market response to the adoption of LIBOR? Is it reasonable to access government balance sheets to bail out the entire short-term corporate debt market during recurring crises? Is a bailout of private debt by the taxpayer whenever threatened appropriate? The assurance of a corporate debt bailout in every crisis is tantamount to a taxpayer guarantee of all short-term corporate borrowing.

To date, no private sector effort has been made to replace these extreme federal measures. The article offers a long-term alternative to the government solution to the LIBOR replacement problem. Its advantages are that it is free from ad hoc government intervention in the market and depends on credit markets to correct itself.

The keystone of the regulators new version of the structure of the short-term debt market is the SOFR. The SOFR index created by the government fails in two ways.

  • SOFR is retrospective. Witness, for example, the March three-month SOFR futures contracts, which are still being traded. May 17and open interest was nearly $500 billion in a futures contract that forecast the past.
  • The SOFR does not include any credit risk dimension. The SOFR is constructed from the repo rates guaranteed by Treasury bonds. Thus, no discount is applied to these repos for credit risk.

The underlying intent of the Fed’s post-LIBOR responses to crises is to inspire confidence that high-quality commercial paper is less risky than before. Where once private sector borrowers signaled their risk forecasts with LIBOR, market regulators are signaling their intention to eliminate that risk at taxpayer expense with SOFR. SOFR is a credit risk-free rate adapted to the new government credit risk-free commercial paper market.

A market-based alternative to the federal bailout-based system

One of the main benefits of this market innovation is to reduce the need for now commonplace Fed bailouts in credit markets, creating a stable system for managing credit risk in the private sector.

A better version of LIBOR. In addition to government risk defenses in short-term credit markets, it would be desirable to add the kind of private sector credit risk indicator that LIBOR once provided. This index should avoid SOFR defaults by providing a forward-looking index of interest rates that includes the market’s estimate of the costs of expected credit risk.

Characteristics of LIBOR to be retained.

  • Homogeneity. LIBOR summarized the average cost of credit risk for the entire high-quality short-term private market at a three-month maturity.
  • Reliability. LIBOR was stable, providing its insights when the population of borrowers with market access dwindled.
  • Relevance. LIBOR was a forward-looking credit risk rate.
  • Liquidity. LIBOR’s main strength was its associated highly liquid Eurodollar futures market.

A feature of LIBOR to throw away.

  • Index based on opinions. The main flaw of LIBOR was that it was not derived from market transactions. However, deriving a daily index composed of market transactions in the short-term private debt market is not easy. The commercial paper market has no liquidity.

In summary, the market should manufacture a homogeneous, reliable and relevant index based on transactions in a liquid market for a single instrument based on commercial paper. Such an instrument does not exist.

How would a private sector LIBOR replacement work?

For a new credit risk index to be reliable, it must be provided by a stable and reliable credit risk instrument and market.

The instrument would necessarily be a commercial grade, paper-backed security. To be permanently priced in the market, the instrument must have the tradability property of an ETF.

In previous articles, quoted above, I have described closely related exchange-traded instruments. The main feature of their market structure is that liquidity is created by the separation of trading and settlement. A virtual version of the physical instrument is traded. Settlement of the traded instrument is a periodic (weekly) event. Once settled, the instrument becomes a paper-backed commercial debt.

This PowerPoint presentation explains how virtual commerce interacts with a settlement.

About Kristina McManus

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