February 9, 2023 • 42 mins
The Federal Reserve raised interest rates at the fastest pace in decades in 2022. But despite the rapid shift in borrowing costs, not much in the financial system actually 'broke.' Stocks and other risk assets went down, but aside from a few issues like the gilt market drama in October, we didn't see a big systemic event. On this episode of Odd Lots, which was recorded live at the Credit Market Structure Alliance conference in New York, we speak with Fabio Natalucci about how he's thinking of financial risk right now. Fabio is the Deputy Director of the Monetary and Capital Markets Department at the International Monetary Fund and he writes the IMF's annual financial stability report. He walks us through the key risks he sees as still lurking in the system, as well as what's changed since 2008.
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Episode Transcript
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Speaker 1 (00:10):
Hello, and welcome to a special episode of the Odd
Thoughts podcast. I'm Tracy Alloway, I'm Joe Wisenthal. So this
is a live recording that we are doing at the
Credit Market Structure Alliance Conference. We are going to be
talking about one of the thorniest, most controversial topics in
financial markets. And it's not compensation, it's liquidity, right, and
(00:34):
so obviously, you know, it's kind of a wild year
for markets overall. In two I guess markets have been
a little bit more constructive calm so far to start,
but like I mean, I think it's still pretty clear
that people are like anxious about like what are what
are the various risks lurking out there, particularly like coming
off such a big pricing of interest rates and such
(00:57):
an uncertain macro environment, That's exactly. And we have had
instances where liquidity risk has reared its head recently, notably
with some real estate funds based in the UK that
had to suspend redemptions that prompted a well known question
of whether or not we should actually have these liquid
assets in a liquid wrapper. So we are going to
(01:17):
be delving into all of that with really the perfect guest.
We are going to be speaking with Fabio natal Lucci.
He is the Deputy Director of the Monetary and Capital
Markets Department at the International Monetary Fund. He's responsible for
the Global Financial Stability Report that the i m F
puts out every year. Previously at the Fed and the Treasury.
So really the perfect guest, Fabio, Thank you so much
(01:39):
for coming on. Thanks. Um. So, maybe a very simple question.
It seems like a simple question just to begin with,
but it never is. What is liquidity? So liquidity and
I think we're talking about market liquid here, not liquidly
on the balancial banks, but essentially is the ability to
uh liquid by in a position at market prices they know,
(02:03):
at a price that doesn't move or dual ow prices significantly,
so you can do it quickly, you can do without
much market impact, so you can essentially refi a position
without having a major impact on the overall market. So
you know, I mentioned that in the interio was kind
of a wild year for multiple asset classes, etcetera. Why
(02:23):
and large though not too much broke, right, I mean
I think like so you have the looking back, it
feels like it could have been worse. So this is
the big question, right, So if you work in financials
a bility now and you say, okay, if someone told
you a year ago that the Federals are would raise
interest rate four under fifty business points under business points, Uh,
(02:44):
do you think he would have worked smoothly or what
would have broke? And I think the answer you would
be looking for praising things that they were something didn't
work right now. There were some instances, I think so
the pension l D. I think in the okay, it
was a good example of liquidity problem interacting with leverage problem. Right,
(03:07):
so that's a combinational to vulnerabilities that amplify each other.
Of course, the trigger of the shock was very unique.
It was a physical policy shock that it's kind of
US incretic if you want. There was some other example
like a Korean as ber securities market, but generally speaking,
particularly focus in the US, I think things have gone
(03:27):
pretty smoothly, which if you work on the other side
you need to worry about risk. Then the question is
like did I miss something? All the system is really
more resilient, and I should feel comfortable, and it's always uncomfortable.
Feel comfortable. So well, this is something that I always
like to ask regulators, which is so much of so
much of the financial stability risk seems to be in
(03:48):
things that we don't see coming. So given that we've
been talking about liquidity risk for you know, probably eight
or ten years at this point, like should we be
looking at something else or do you think the problem
has largely been solved? So the way if I'm at
for a second thing, how we think about financial stability
of the fund right, so we don't try to forecast
what the next shock could be. So I think I
(04:09):
would admiss all of them. Right if you think about Cowvid,
that's not what probably wasn't my top lists the war,
So I don't want to be in that business. I
think what we can do and we try to do,
is to figure out what are the vulnerabilities. I think
of vulnerability is an amplifier that there's any shock that
hit whatever that is, and then there are fragilities in
the financial system and make the shock bigger. And so
we have some sort of like metrics where we look
(04:30):
at different sectors, so the sovereign debt for example, household corporations, banks,
and then when we call non bank financial institutions, and
then we look at different vulnerabilities. So liquidly it's one
of them, or lack of liquidity leverage. Financial leverage is
another one. Effects exposure or interconnections between the system and
then we try to fill the metrics based on the
(04:52):
data we have and we do this for the twenty
nine time important countries and we track them over time.
So liquidit it's one of them. Again, there were example
like the Dash for cash in was a good example
and involved the specific entity in the non bank financial
intermediation sector. There was the l d I in the UK.
It's a combination of liquidity and leverage. There was Archegos
(05:13):
is another example. I think more of financial leverage perhaps interconnectness.
So those are the things we're looking at. But again, um,
the thing to me the biggest puzzle now is financial leverage.
There's a lot of talks of leverage position being unwound
and resolates more higher volatilitarizes, but you don't really see
the system breaking. So again it's see that because it's
been the financial egolators have done a great job for
(05:35):
financial crisis, or maybe we're missing something they're like, think
of the l d I in the UK. Maybe this
is like a tramore that it's under the surface and
we don't see it, but something else may break. That's
the biggest concern at this point, that we're missing something
and we're not looking the right place. So I do
think that, like at the start of two, if you
had sent to someone, Okay, the FED is going to
hike for your fifty basis points, and by and large
(05:59):
things would be would like I think that would be
surprising for a number of reasons. Everyone had become used
to zero de facto zero interest rate. It was dramatic
hiking by any standards. Let's start like, how would you
like to what degree would you say that the smoothness
of markets last year can be attributed to post grade
(06:21):
financial crisis reforms? So I think that's certainly an aspect
of that. Right, So the financial post financial crisis regulation,
in my view, most certainly made the system the core
of the systems. So the banking sector more rezilient, right,
the more liquidity, the more capital, the resolution plans a
bunch of feature that made like, if you want the
(06:42):
fortress of the financial system safer, there is can move
away from there. And they moved towards we called the
nba FI or non bank Financial Institution. I think of
that as hedge funds, investment funds, solving wealth fund, pension
insurance um and part of it, I think it's okay
because they have different risk profile, the different investment aizing,
different investment funding structure, and so part of it is fine.
(07:04):
The question is one whether we have visibility into this
corner of the financial system, right, So do I can
I actually assess the same way I would assess a bank,
And I think the answer is no, because there is
a number of data gaps that have to do with
this institution. Whether this has to do with leverage for example,
perhaps that's the most difficult one, or even liquid it.
The other question is are they systemic enough? So suppose
(07:28):
something goes wrong and the shock gets absorbed by that
entity in the non bank financial sector, maybe it's okay
because it's not systemic. You can absorb it doesn't create
a financial stability even f X, Yeah, in some sense.
And then the other part is like, is there a
feedback though into the banking sector right that we have
no considered right? So Archegos. I think the example there
(07:50):
was yes that the entity per se perhaps was not systemic,
but there was so much feedback into the back door
of the banking sector to prom brokerage for example. Right,
so that that's kind of with think about it, um,
I think the reform there are some unfinished business in
the nonbank financial intermediation performed agenda. Some of it it's
holds and not being called by their form agenda somewhere
(08:12):
that to implementation. UM I don't want to just say
that it's all bad though, and their advantaging positive of
activity and risk moving to the non bank financial intermediation
right there again different risk profile, different lendings UH, funding structure,
different investment horizon UH. And they provide to growth to
the financial system, provide lending, provide financial services, so that
(08:33):
part is good. Other reason, and it's not just financial regulation.
Activities move away from the banks to the non bank
financial intermediation sector also because of technology, so some changing
market structure are conducive to being done outside of the
bank's balance is there too structure they're non nimble enough.
There are also conjunctual aspect right. So for example, when
you are at zero interest rate for all ten plus years,
(08:56):
it's normal and some of the risk cree shuffles around
their way from the banking sector and then the last one,
perhaps especially in advance a Gono, the center banks that
played an important role, people may say too large a
role in a number of markets, and so that's an
impact on pricing itself. So there's a number of factor
I think that contributed to this. Some are positive, some
(09:17):
are still I think open for assessment. You know, you
mentioned Archagos, and one thing I often wonder is in
the market, we talk a lot about excesses and stretched valuations,
and those seem like bad things, but they don't always
manifest in terms of financial stability risk except Archaicos was
actually a really good example of that. So could you
(09:38):
maybe talk a little bit about how you see, you know,
on a day when we're talking about financial conditions basically
going back to where they were before the FED started hiking,
talk to us about what excess in the market means
for financial stability. So there's two aspects of this, right,
So I want us to do that if you want
to call it like price misalignment or financial conditions are
too easy compared to the fundamental values. However you measure
(10:01):
fundamental values, that's one piece. I think that if there
are is no leverage employed, if there is no major
liquidly mismatch. No, it's not necessary systemic per set. Someone
will lose money, someone will make money, but let's not
part of my job. The concern is when that unwinding
of financial condition interact with vulnerabilities liquidity or in case
(10:22):
of our chegos, is financial leverage, right, because then that
vulnerability becomes a major amplifier. So it's not just that
risk as surprise risk risk as a reprise is that
the de leveraging in the case become an amplifier of
the reprise and I fire yourself. And all the de
leveraging that we saw during the financial crisis, there was
that component there. I think there was financial level employed
(10:43):
through the realtives, through prime brokerage, and the other weak
link there was that that was provided by banks, right,
and so there was an entry point into the banking sector.
That's where I think you need to be super careful
because for a lot of this financing structure or liquidity provision,
somehow it touches a balance of back in some formal
shape somewhere along the chain hits the Boden set of
(11:04):
the bank. So part of it it's a risk, but
it's it's an opportunity for the regulativity should be able
to see it once it touched the bond shield bank.
(11:25):
You know another thing that I think when I think
about the last year, maybe the last two years, is
uh sitting aside the market volatility. There was a lot
of growth, I mean, and maybe it's just nominal growth.
But of course with if you have a debt, like
the most important thing is you get it paid. How
much does just that maintaining a growing economy, unlike say
what we saw in the second half of two thou eight,
(11:48):
how important does that in terms of butchersing financial stability
is just they're not a lot of people defaulting because
people have good incomes, whether it's households, low unemployment rates
or low default rates for corporation. So usually um, the
one this is how we used to look at the FED. Growth.
To me, it's a precondition for financials to build it. Right.
You cannot have franchis debate without you need growth. So
(12:10):
growth it's really important. And so that growth that came
off the if you want the procession if you want
to called the way of the COVID was in part
because Center Bank stepped in majority. Right, So the FED
here at a major central bank and ended up back
stopping the full financial system. If you compare that with
two thousand and eight, back stopping was faster, more aggressive,
(12:31):
and wider. U. The other difference with two thousand and
seven two dosan A was fiscal policy. Right. So if
you remember the size of the ABAN administration physical plan
and think about the number of physical measures they've been
taking the US during COVID and the size of those, right,
the combination the two easy financial condition plus physical policy
as turbosh are essentially the economy now. Downside of that
(12:53):
is I think perhaps we as a community in general, policymaker,
maybe market so we have been slow to recognize is
the inflation problem? Right, So because growth was going fast
and because physical policy and be using that size for
a while, Um, that's where I think the concern is now,
and this is why we went into the Tilaning Morning,
Repolis and so on. So the flip side of that
(13:15):
fast growth has been inflation at levels that we haven't
seen since the plate seventy early eighties. Is inflation? How
does inflation manifest itself in financial stability risks? Yeah, So
that's that's the risk here, And I think That's why
priced ability is so important. Is that if you don't
tackle inflation now, So if you don't let prevent inflationary
pressure from becoming entrenched into the infression dynamics, so core
(13:38):
inflation wages and you'll let inflation expectation and more from
the target is going to be way more expensive to
bring inflation down. So in sometimes the personally I don't think.
I think there is in a symmetryn cost here, right,
So if you say, okay, what's the cost sire? If
I am tithening not enough for if tithing I'm not
tithening too much, that's when I think the cost society
(13:58):
if you're not aggressively approached this. Do you think of
the late sevent y earlieries in the US, It took
a lot of high any more other policy bring in
freshtion down, right, So being proactive and preventing the entrenchment
and increasing frention in pressing expectation, I think it's crucial
because you can control it, then you can bring invent
eventually you can bring race down to a rather I'm
(14:20):
supposed to go now. Of course, if you do this
space on which this is done, financial condition tied. If anything. Now,
the puzzle is why they haven't tied more than otherwise. Right,
any model that we you run, if you say, okay
that the frisk free rate moves by four and fifty
basis point, I think example, at least based on historical relationship,
will tell you the financial condition should be way tighter.
(14:42):
I mean, we had merged. It was just the FED,
you know, in addition to the massive stimulus and or
a couple other rounds of stimulus afterwards, and then the
Fed just you know, opening up one acronym after another
trying to backstop the market. And maybe you know, retrospect
that contributed to inflation. But was that a sort of
(15:03):
like you know, from your perspective, it is like this
is an example of we saw what happened in two
thousand and eight, two thousand nine when we go slow
and we let growth collapse, when we've let nominal income collapsed,
and sort of a successful lesson learned. I have no
doubt that was successful. I mean the alternative would have
been like fall into a creator of growth right in
the Great Procession story. Um. The issue is that that
(15:27):
response and the easing of financial condition and the build
up of some of the vulnerability highlighted. Some of the
reform agenda that you mentioned before has now been addressed. Right.
So the chapter that we pulled out in last October,
it was about open end investment fund and that's an example.
I think a sector where there are liquid in mismatch, right,
particularly those open and investment fund to have daily redemption
(15:51):
for a liquidous right think about high you know, corporate
bond for example, That's where I think there is case
and that's what we have seen. In March twenty the
outflows from those open ended funds was about five percent
of assets. That was larger than during the financial crisis.
Um and the camera faction of the FED not stepping
in very quickly and starting to backstop not just quei
(16:14):
or supporters by back stopping current market would have been
a much larger decline. A surprises, right. So what we
show in that chapter, it's one that there is a
link between the liquidity of the funds and what they hold, right.
So assets that are held by liquid funds tend to
drop in prices much more and that there are much
more volatility in return. So for example, once and the
(16:36):
deviation shock in the liquidity or some sort of what
you saw in March twenty increase volatility of return by
which is a large, significantly large number. And that's where
I think you need to think about doing what what
do we need to fit fit in terms of policy agenda,
is there a whole we need to think about the
regulatory emiter, what tools do we need? So, just on
(16:57):
the snow, there is that inherent tension between you know,
offering someone liquid assets and putting them in some sort
of liquid wrapper that allows them to go in and
out on a daily basis. What is the fund's view
on the best way to deal with that risk? And
also given what we saw in when the FED effectively
came in and back stopped not just credit markets but
(17:20):
the treasury market as well, which is supposed to be
the most liquid market in the world, Like, does that
mean was that the endgame problem solved? Central banks back
stop this and liquidity risk is no longer an issue? No,
So my personal view is that if you want to
live in a world where every X number of years
the center banks needs to step in and back stop
the financial system and every time push the line one more,
(17:43):
I think you need to rethink the regulatory perimier. Then, right,
if you want to be on the perceiving end of
the financial sector back stop, then the perimer need to
be different, right, So you need to be within the periment.
They're not outside the perimid obviously, but there's a different
way of thinking about financial stabilities because systemic risk at
that point it right. So the issue here is that
you're providing dare liquidly when there is underlying a liquid US. Now,
(18:06):
of course they all liquidly buffer and so on, so
that's a threshold for period of non stress. Perhaps the
system is fine, people can have different views. The problem
is during stress if you eat through the liquidly buffer. Therefore,
to sell us right, you face redemption. You sell, you
generally fire yourself. And because of the structure, there is
an incentive to run first because you're not bearing the
(18:27):
transaction cost when you get out the way this is designed,
and so I want to get out the first before
the market's price are going down essentially the enemy, so
that generate the run dynamics. That has important systemic implication
because you go into fire sale and that social cost
of the first mover is not addressed by the way
the design of this of these fissures are now so
(18:51):
what we look at. We look at a bunch of
possible solution there measure and we did some work across countries. Usually,
what the most common tools in terms of liquidly risk
management tools are either suspension obviously or redemption gates or
redemption fast. Those are pretty much widespread. What is much
less common is either what because swing prices so essentially
(19:12):
the ability to incorporates in the price you pay to
exit of the externality or if you want the transaction
cause the impose of those sustained the fund. Those are
not common or not the in in DUS for sure, and
even in Europe or in some sense they're voluntary. And
then this open debate of what do you do with
the liquid buffer? Do they work or not? So what
we find there is that the liquidity buffer that seems
(19:34):
to be some relationship between the liquid of the underlying
and liquid buffer. That is, if you hold more liquid usset,
you generally on average, tend to have higher liquid buffer.
The results that's more interesting though, is that one there
is very widespread use of this liquid buffers. Some when
you talk to people to in market, some tend to
actually use them actively. So I'm gonna sell the most
(19:56):
liquid stuff, use my ready lines and hope for the
best if you want. Others don't want to touch it
because they don't know what's coming nest and so they
start selling less liquid stuff. So there's a very different
use of this liquidity buffer. But on average at least,
what we find is that during stress, the average fund
if you want, tend to grow the relear butter. They
just don't want to use it. They don't know what
it's coming. So if that's the case, that is not
(20:19):
helpful for the example incentive to run right, it doesn't
prevent that. Swing prices are mostly used in Europe. Again,
swing prices the ability a century to correct the price
which you take money out based on this transaction costs
they impost on others. The problem is in principle they
are effective to reduce volatility. The problem is that the
buffer of the swing factor, if you want, how much
(20:41):
of this is used, is too small compared to what
would be used, and either because of competitive reason or
because of stigma, whatever the reason is, they're not calibrated
to the way that they should be calibrated during stress time.
At least, another option, which is more extreme if you
want is to more formally link your ability to exit
(21:01):
these vehicles from to the liquid of the underlying right.
So you mentioned the real estate one, they're the liquid.
It is not daily, right, you only a specific period
where you can withdraw. Um. If you go into landmark
in duance and you go back decades, there was no
daily liquidity. They used to be if I remember correctly,
intermitted funds or there were quarterly, monthly quickly. You need
(21:21):
to give advance and then when it comes time you withdraw.
That allows you to I think, manage liquidly better. I
think there's a lot of controversy and whether you should
restrict liquidity that can be given based on the underlying
but that that would be in principle the cleanest way
to fix the underlying mismatch between the liquidity and the
(21:43):
underlying assets. So just on that note, you know, one
thing with liquidity is I think a lot of times
when people talk about liquidity risk, often they're talking about
basically priced risk and the risk that you're going to
see a big drop when you try to sell. How
do you just aggregate those two things? And also there
there is an argument to be made that UM, if
you're holding a liquid assets and if you can get
(22:05):
away from marking them to market. UM. That often that
it can actually see you through a rough patch. Right. Again,
we see this with real estate nowadays, which is like
a lot of the big funds haven't had to mark
their assets to market and they're sort of holding on
waiting for a potential recovery and that helps in the interim,
so less I would deliquately one UM. I think they
(22:29):
take the treasury market here, the kid market in the UK, right, um.
And the issue was that in some cases it was
really hard to sell that you couldnot find a bit.
Right even if this are supposed to be the most liquid,
the most liquid fund, so you should not see those
in the most liquid markets. That's supposed to be the
risk for assets, right, you should be able to sell um.
(22:51):
The issue with liquidly, I think has to do with
the fact that often also interact withies. Right. I made
the example of leveage, right, that's what we called liquid
is spiral at least and in the in the in
the profession, that's where liquidity and leverage interact with each other.
My personal view is getting rid of market to market.
It's kind of like hiding a little bit um. I
(23:12):
want investor to be able to price risk and not
mark into market. And I can see the argument of saying, okay,
if I can only bridge to there, then the world
is going to be in a better place. My view
is that you need liquidity, you need to provide disclosure,
more disclosure. I'm only favor of disclosing trade for example,
because in the end, yes, you will take a loss,
(23:33):
but your price markets where they're supposed to be past
experience during the financial crisis, and when the pricing of
risk in the subprime market will postpone. I don't think
that's where we want to be. I think we want
to be in a place where your price market. Yes,
sometimes it's gonna overshoot. You know, both of you talked
about the l d I situation in the UK, and
of course in March we had that big dislocation in
(23:55):
the treasury market, but it was sold fairly quickly in
terms of the Central Brank step in and was a buyer,
and then the prices returned to normal and then subsequently
to March, and the FED is set up a standing
repo facility and so like, there's even more liquidity available
theoretically for treasury buyers. How powerful is that just looking
(24:17):
at the sort of risk free assets within any given
country to what degreetion more is, would you should more
central banks set up more robust facilities to create sort
of like both directional liquidity for holders of government debt.
So I don't think personally that the central bank should
in the business of managing data equally, right, so I
(24:38):
can see it all. What the central bank is the
blendard of last result of the proliquidity provider of last resort.
What the standing rip of facilities meant to do. It's
meant to cap in some tense rates, right, So they
don't want to see what you saw in September nineteen
where when they would normalizing the balance, it preparate. That's
what the facility is meant to be. That is not
meant to be a day to day a normal way
(25:00):
of providing liquid liquidly. It's in the market. There are
buyers and seller. That's how the systems should work. What's
changing the treasury market is that the underlying structure has changed. Right.
What the broker deer used to do now is done
by principal trading firms is done by firms. They are
not part of the trade shop banking system and they're
not within the traditional regulatory perimeter. That it's technology evolution.
(25:23):
I think the question is where the perimeter should be.
There are also a major discuss again have to do
with transparency of trades, so disclosing trades and whether you
should use central camera party to net some of this
position out then reduce some of the plosure, whether they
would free up balance it effectively to provide liquidly. I
don't think that daily to day job or a center
(25:45):
bank should be provide liquid in the markets. To me,
that's a lender of last resort function that I think
it's super important. Uh. That is a question though that
if you have access to the lender of last resort
function of a center bank, how to where the perimeter
of the regulations should be. You can't be just receiving
a check and then the central bank should be completely
out the business. Personally, I think that's a very uncomfortable
(26:08):
business for a center bank to run. Just on this
liquidity question, one of our all time favorite All Thoughts guests,
Chris White, said something on the podcast once which was
he asked a question, which is is liquidity something which
sort of happens naturally if you have a market that
(26:28):
is properly networked with people talking to each other, or
is it a service that you should have to pay
up for? And I'd be curious to hear a regulators
view on that topic. I think liquid it is a
financial service and like any other financial service, surprise. The problem,
(26:49):
I think after fifteen years of zero interest rate, zero volatility,
pre fat tightening, was that liquidly was no properly price.
That was a big problem. So you get used to
a place where liquid it is abundant, it's essentially free,
and you don't price the risk. Right, So that's a
think about price of li quickly break it down two pieces, right,
(27:11):
they expected liquidly and there is premium how much you
want to pay for insurance if you or if you're
providing it. I think that part that's where it was
miss priced. There was a quickly de premium was not paid.
You are not paying for that. They were not willing
to pay for. Situation where go away and I think
the normal interest rate normalizing, volatiality rising eventually. The hope
(27:32):
is that people will start to price liquidly. They should
be liquid is not free. Liquickly there's a financial service
that you should probably pay for and provision for. I
(27:54):
want to go back to some of these funds that
occasionally have issues with redemptions. There's the real estate one. Recently,
I think it was after the energy crash or sixteen
or that people started worrying about the high yield funds
or the high yield ETFs in the US and so forth.
But none of those turned out to be systemic per se.
(28:15):
I mean, people got anxious about the funds themselves, etcetera.
But even some of the recent stuff that didn't seem
like they're a huge spillovers. What is the scenario in
which something some stress that emanates from some fund or
some class of funds, because it becomes something that we
would regulators should be concerned as systemic risk. So it's
a question about mutual opening the fund or ETF or
(28:37):
both either one. Howeveryone, Well, let me start with the
first one that we do open in the funds. I
think there is because again what I was this described
before the pop You run for the door because I
want to come after you, and because they are incentive
to do that, and then by going out, you generate
the spiral where you get fire sale because they need
to weak me they to pay you, and the price
moves much more than it should have. I would argue,
(28:59):
if you take twenty when he as an example, that's
saying the system didn't break, it's a little bit too
generous as a view. The system didn't break because in
a month for reserve based of the entire francial system. Right,
So if I give a counter factual where instead of
them Monday with another month, my expectation is that the
system will have cracked in a different places um DTFS.
(29:22):
I think my views change over time. I think I
was trying and to look for place what could go
wrong there. I think they provide an important liquidity function.
Um you can get out, you just sell you share
with the FS, and in some sense they do sell
the price. Right. The concern that I have there is
more the opaque world of the other ICE participants. Right.
So the dealers that create and redeem shares, particularly in
(29:45):
fixed income where inequities, I think it's easier if you
have the SMP five. The bucket that you use is
more or less than index. With fix income, the basket
you used to create and reallym is way smaller than that,
and there is a lot of opacity exactly what's in
those baskets is provided to whom. If they don't provide
the function any breaks down, then the creation redemption can break. Now,
(30:06):
whether that's systemnic or not, I don't know, But to me,
that's where one question marks. Just on March specifically, it's like,
okay that that situation required enormous support from the FED
and other central banks. But I think with the point
that you know, we talked to Josh Younger, who's then
the JP Morgan out the New York FED, like, should
regulators be optimizing for the type of crisis that emerges
(30:31):
from a once in a century pandemic? Like I don't know,
Like is this is it worth like having the system
be robust or should we say, okay, once in the
century pandemic, it's not so bad if that requires the
FED to step in and start spraying money everywhere. The
first of all, it's two times in a century now
because it's from the GFC to to UH to COVID, right,
(30:52):
so it's kind of close to each other. Um, I agree,
I don't think you should calibrate too financial disaster every time,
but I think there is something in the middle between
caliber in like that and what is done now. I
think there are steps that can be taken to fix
some of these liquidity mismatch. Whether this is um swing
(31:12):
prices for example, and utilization of those So regulator can
for example, provide guidance of the implementation or some of
these liquidly tools. They can consider whether there some of
these liquid it would should be mandatory. The problem is
there's no alignment between the incentives of the individual manager
of the funds and the system financials to be objective, right,
If you align those then the system works better. So
(31:34):
whether this is again guidance, mandatory use of some liquid tools,
where this is stress testing, whether this is disclosure, I
think you can find a combination of this. It's gonna
be a functional country by country, depend on the institutional
set up, the legal setup can some things can work
better than others. And again or minimizing the gap between
the liquidity you provide and the deliquid of the end
of line. One last point, there is another aspect that
(31:58):
often it's not discussed in the US, but some of
these players are made of this open and the funds
are major players in emerging market and when you see
this in and out of those flows of those countries,
you can break those markets very easily. And so there
is any if you want the cross boarder systemic aspect
to list. And maybe it's not just us focus, but
at least from me working at the fund for some countries,
(32:19):
those are large, large molers. Yeah, I think that's a
good point. Um, you know you mentioned incentives there. Can
you talk a little bit more about the incentives at
play for you know, fund managers for instance, when it
comes to handling liquidity risk. And one thing you said
earlier was very interesting to me, this idea that you
know a lot of these funds will build up liquidity
or cash buffers, but will be reluctant to actually start
(32:41):
running them down in times of stress. So that was like,
there was a time I talked to a few people
in the loan market how they were marnaging liquidly right.
One was trying to understand what is your definitional ligue?
But fore wou do you use? Is the cash is
the lines of credit, is the most liquid leverage loans,
your whole treasury security? Is how big the buffer is?
(33:02):
I mean there's a trade off between Yeah, of course
you can alde a huge li quickly buffer, but it's
going to hit your return at some point, right, So
if I want to invest in the average loans, I
don't want you to hold twenty indiqudity. So that's one piece.
The other one was trying to understand the waterfall if
you went right, how do you manage this? And I
thought it was quite interesting. Then I got two very
different response right from I'm gonna start using and selling
(33:24):
the if I have some liquid liquid a like securities
after cash, then maybe use my lines of credit. Then
progressively moved to the rest LIEPID stuff, and then others
they would tell you I would never at touch it
now that even if you shoot me, I just because
I don't know what's next year. I need that as
my insurance. So I don't think the ARELA should tell
you exactly whether you should manage this personally. I think
(33:46):
they should provide some guidance. My sense now that it's
too much left to the individual manager that does not
internalize what the system in implication of the behaviors are.
So one of the things that happened on this podcast
of doing it for seven years is we've seen this
evolution in the type of things that we talked about,
and we used to have, you know, do a lot
of episodes on like the repo market and credit market, liquidity,
(34:11):
all these type of things. And then in the last
two years many of our episodes have become like very
like physical world commodity risks, one financial crossover with commodities.
We saw, like you know, there was the crisis at
some point last year in the nickel trading at the
London Medals Exchange. Can you talk a little bit about
how like as this and I don't know how long
like commodity markets or energy security is going to remain
(34:33):
so top of mind. But you know, we weren't really
talking much about that prior to COVID and some of
the commodity shocks. Can you talk a little bit about
how you're incorporating some of those stresses into your thinking
and the challenges of thinking about the markets from a
financial regulatory perspective. So if the maths sticks that were
describing before energy trading, we're not there obviously, right So
(34:55):
and those were not the entities were following clothesly for
we did. So there was one lesson I think learned
through in the February episode. I think it's important to
follow for a number of reason one because they are
they are important players in the financing of the physical assets, right,
so they provide colorized lending to shipments of various commodities.
(35:17):
So that's one important piece. So they're very much linked
to the physical asset too, because they are crucial players
in the dri of this market, the deriv markets used
by producer as a dge, and so they play a
crucial role in the middle. Obviously there are banks involved
and so so they play a function that is important
for the smooth operational the market commodities, a global market um.
(35:39):
The financial the risk from a financial stability perspective one
that we quickly scored that they were not data and
so if you want to say, I'm gonna have a chart,
and I don't know what chart to show. Some of
these entities have publicly ready bonds, So that's what we
were showing. That was for US proxy of investor concern
about these firms. But that was pretty much it, right,
not stability into their leverage position, who they were playing,
(36:03):
what market that was huge and sense of opacity in
terms of where there is where that was the big question.
I think the big flag, right flag came up. So
we're trying to do better job going forward. I mean
the big gap again, it's data data, and honestly they're
not these is one to to have conversation with. Glencore
(36:24):
doesn't want to talk to you. I can't imagine they
see the easier conversation without people. Um. You know you
mentioned cross borders village risks earlier. And one of the
things that I've thought about and I've written about at
various times is the role of benchmark index providers in
directing inflows and outflows. And I think the I m
(36:44):
F has done some work on this too. But how
much of a risk is that just this idea that
you create a benchmark, everyone tries to hug it as
closely as possible, and if you get a major change
in the index, for instance of China is added or
taken out, it triggers all the flows. Okay, So again
there's positive. It's like everything right, opportunities and risks right.
So I think opportunity of being added to the risk.
(37:06):
It means the country opens up to capital flows. So
capital flows are important for growth, for financial transaction. So
that's the positive of coming with it. The risk are
that the behavior of passive investor of benchmark investors very
different from SAM dedicated funds right am dedicated fund It's
really about going in and picking that I count re
picking the right credit, doing more the credit work if
(37:26):
you want, or solign work. Benchmarking is just following index.
And what we found is that the behavior of investors
that just benchmarks are much more linked to global financial conditions.
So when financial condition change and they tire and globally
di guid tends to leave. And so by being in
the index, yes you get more cavial, but you are
(37:47):
much more exposive before if you want to the risk
capiti change of the global investor. That's the downside of
of being in the index. So that's where I think
then it's important for the local Now there's another oportunity. Actually,
they often tend to deepen the liquidity of the local markets, right,
so their benefits. That's where though the local regulator I
(38:07):
think they need to play a role in terms of
like regulation that it's appropriate for those kind of flows
because those investors are not the typical em didy get
investors that sticks there. Those are investors that moves with
global financialries capitalize and we have seen that over the
last past few years. I want to go back to
something you said there at the beginning that I found
to be really interesting, the idea of growth being a
(38:28):
precondition for financial stability. And often when I think about
central bankers around the world of regulators, it feels like
to me that like the sort of macro part of
their job and the regulatory part of their job, or
like two separate things, and that there's enough managing the
banks making sure this and then also like making sure
they hit their inflation and unemployment goals, etcetera. Isn't that
(38:49):
the case of my misperception? Or do like should central
bankers should regulators recognize the interlinkages between maintaining robust growth
said financial stabuilding more than they currently do. I think
of like the banking sector, right, the best ingredient for
success of banks growth right because they have healthy balance,
the PLT cabital position, liquidity position. So to me, if
(39:13):
without growth the system is much more fragile. The way
we think about financial stability in terms of our framework,
we take if you use financial conditions, we use economic
condition then we try to forecast what the distribution of
growth will be, right, and so we think about financial
stability of the left tail. If you're on the downside risk,
that's for us. The link between financial conditions would not
(39:33):
abil is and growth. What do what policy meg are
trying to do when they think about financial stabilitia, trying
to minimize the downside the tail. That's to me, it
is the link between growth and financials ablity. That's the
framework we use in the financial Ability Report. I have
just one more question, and I'm sure this is the
one you get asked at every interview, but what are
you most worried about at the moment. I think what
(39:56):
I'm most concerned now is this sense of comfort that
nothing is broken um and as evidenced by this interview
and many of our questions. But it is because I
am reluctant to embrace this idea that we made the
system more residient and this is work out smoothly. Maybe
it's the case, and then we should celebrate. I'm just
(40:16):
concerned that I don't know. The energy trading firm was
an example that there are corners of the system that
I've not paid enough attention. The coronover time that they
became systemic, either because of size or because they use
leverage informed that they're not apparent or I don't have data,
or I don't understand the dynamic. Right. So the l
d I was a good example. People knew about LDI.
(40:38):
This is not a new thing that was learned, right,
It just happened. The combination of that business model with
a liquid in the guild market, with the policy shock
that perhaps no one it was difficult to forecast. But
the combination will this fact or create a situation where
what was going on in the UK had tremors across
the globe, You have reprising or create risk in the US,
(41:00):
you're reprising all asset execurities in as far as Australia
because people were selling across asset. That's the part that's
concerned me on missing something and becoming too comfort in this. Okay,
we got the right matrix with the right vulnerabilities, their
right legal model, because a lot of these are created
with the lens of the past, right on the lens
of the last crisis, that crisis tends to be different.
(41:21):
So I'm reluctant to be too comfortable that we managed
to to handle financials to be it's good not to
be complacent if you're a financial stability person, the regular
financial they should should be a healthy paranoia. I think
it's also true that no one had, you know, liability
driven strategies on their Bingo card for two financial stability risks.
(41:42):
So that's a really good example. Shall we leave it there? Show?
All right? This has been another episode of the All
Thoughts podcast. I'm Tracy Alloway. You can follow me on
Twitter at Tracy Alloway and I'm Joey Isn't that You
can follow me on Twitter at the store. The Year
(42:06):
E
Hello, and welcome to a special episode of the Odd
Thoughts podcast. I'm Tracy Alloway, I'm Joe Wisenthal. So this
is a live recording that we are doing at the
Credit Market Structure Alliance Conference. We are going to be
talking about one of the thorniest, most controversial topics in
financial markets. And it's not compensation, it's liquidity, right, and
(00:34):
so obviously, you know, it's kind of a wild year
for markets overall. In two I guess markets have been
a little bit more constructive calm so far to start,
but like I mean, I think it's still pretty clear
that people are like anxious about like what are what
are the various risks lurking out there, particularly like coming
off such a big pricing of interest rates and such
(00:57):
an uncertain macro environment, That's exactly. And we have had
instances where liquidity risk has reared its head recently, notably
with some real estate funds based in the UK that
had to suspend redemptions that prompted a well known question
of whether or not we should actually have these liquid
assets in a liquid wrapper. So we are going to
(01:17):
be delving into all of that with really the perfect guest.
We are going to be speaking with Fabio natal Lucci.
He is the Deputy Director of the Monetary and Capital
Markets Department at the International Monetary Fund. He's responsible for
the Global Financial Stability Report that the i m F
puts out every year. Previously at the Fed and the Treasury.
So really the perfect guest, Fabio, Thank you so much
(01:39):
for coming on. Thanks. Um. So, maybe a very simple question.
It seems like a simple question just to begin with,
but it never is. What is liquidity? So liquidity and
I think we're talking about market liquid here, not liquidly
on the balancial banks, but essentially is the ability to
uh liquid by in a position at market prices they know,
(02:03):
at a price that doesn't move or dual ow prices significantly,
so you can do it quickly, you can do without
much market impact, so you can essentially refi a position
without having a major impact on the overall market. So
you know, I mentioned that in the interio was kind
of a wild year for multiple asset classes, etcetera. Why
(02:23):
and large though not too much broke, right, I mean
I think like so you have the looking back, it
feels like it could have been worse. So this is
the big question, right, So if you work in financials
a bility now and you say, okay, if someone told
you a year ago that the Federals are would raise
interest rate four under fifty business points under business points, Uh,
(02:44):
do you think he would have worked smoothly or what
would have broke? And I think the answer you would
be looking for praising things that they were something didn't
work right now. There were some instances, I think so
the pension l D. I think in the okay, it
was a good example of liquidity problem interacting with leverage problem. Right,
(03:07):
so that's a combinational to vulnerabilities that amplify each other.
Of course, the trigger of the shock was very unique.
It was a physical policy shock that it's kind of
US incretic if you want. There was some other example
like a Korean as ber securities market, but generally speaking,
particularly focus in the US, I think things have gone
(03:27):
pretty smoothly, which if you work on the other side
you need to worry about risk. Then the question is
like did I miss something? All the system is really
more resilient, and I should feel comfortable, and it's always uncomfortable.
Feel comfortable. So well, this is something that I always
like to ask regulators, which is so much of so
much of the financial stability risk seems to be in
(03:48):
things that we don't see coming. So given that we've
been talking about liquidity risk for you know, probably eight
or ten years at this point, like should we be
looking at something else or do you think the problem
has largely been solved? So the way if I'm at
for a second thing, how we think about financial stability
of the fund right, so we don't try to forecast
what the next shock could be. So I think I
(04:09):
would admiss all of them. Right if you think about Cowvid,
that's not what probably wasn't my top lists the war,
So I don't want to be in that business. I
think what we can do and we try to do,
is to figure out what are the vulnerabilities. I think
of vulnerability is an amplifier that there's any shock that
hit whatever that is, and then there are fragilities in
the financial system and make the shock bigger. And so
we have some sort of like metrics where we look
(04:30):
at different sectors, so the sovereign debt for example, household corporations, banks,
and then when we call non bank financial institutions, and
then we look at different vulnerabilities. So liquidly it's one
of them, or lack of liquidity leverage. Financial leverage is
another one. Effects exposure or interconnections between the system and
then we try to fill the metrics based on the
(04:52):
data we have and we do this for the twenty
nine time important countries and we track them over time.
So liquidit it's one of them. Again, there were example
like the Dash for cash in was a good example
and involved the specific entity in the non bank financial
intermediation sector. There was the l d I in the UK.
It's a combination of liquidity and leverage. There was Archegos
(05:13):
is another example. I think more of financial leverage perhaps interconnectness.
So those are the things we're looking at. But again, um,
the thing to me the biggest puzzle now is financial leverage.
There's a lot of talks of leverage position being unwound
and resolates more higher volatilitarizes, but you don't really see
the system breaking. So again it's see that because it's
been the financial egolators have done a great job for
(05:35):
financial crisis, or maybe we're missing something they're like, think
of the l d I in the UK. Maybe this
is like a tramore that it's under the surface and
we don't see it, but something else may break. That's
the biggest concern at this point, that we're missing something
and we're not looking the right place. So I do
think that, like at the start of two, if you
had sent to someone, Okay, the FED is going to
hike for your fifty basis points, and by and large
(05:59):
things would be would like I think that would be
surprising for a number of reasons. Everyone had become used
to zero de facto zero interest rate. It was dramatic
hiking by any standards. Let's start like, how would you
like to what degree would you say that the smoothness
of markets last year can be attributed to post grade
(06:21):
financial crisis reforms? So I think that's certainly an aspect
of that. Right, So the financial post financial crisis regulation,
in my view, most certainly made the system the core
of the systems. So the banking sector more rezilient, right,
the more liquidity, the more capital, the resolution plans a
bunch of feature that made like, if you want the
(06:42):
fortress of the financial system safer, there is can move
away from there. And they moved towards we called the
nba FI or non bank Financial Institution. I think of
that as hedge funds, investment funds, solving wealth fund, pension
insurance um and part of it, I think it's okay
because they have different risk profile, the different investment aizing,
different investment funding structure, and so part of it is fine.
(07:04):
The question is one whether we have visibility into this
corner of the financial system, right, So do I can
I actually assess the same way I would assess a bank,
And I think the answer is no, because there is
a number of data gaps that have to do with
this institution. Whether this has to do with leverage for example,
perhaps that's the most difficult one, or even liquid it.
The other question is are they systemic enough? So suppose
(07:28):
something goes wrong and the shock gets absorbed by that
entity in the non bank financial sector, maybe it's okay
because it's not systemic. You can absorb it doesn't create
a financial stability even f X, Yeah, in some sense.
And then the other part is like, is there a
feedback though into the banking sector right that we have
no considered right? So Archegos. I think the example there
(07:50):
was yes that the entity per se perhaps was not systemic,
but there was so much feedback into the back door
of the banking sector to prom brokerage for example. Right,
so that that's kind of with think about it, um,
I think the reform there are some unfinished business in
the nonbank financial intermediation performed agenda. Some of it it's
holds and not being called by their form agenda somewhere
(08:12):
that to implementation. UM I don't want to just say
that it's all bad though, and their advantaging positive of
activity and risk moving to the non bank financial intermediation
right there again different risk profile, different lendings UH, funding structure,
different investment horizon UH. And they provide to growth to
the financial system, provide lending, provide financial services, so that
(08:33):
part is good. Other reason, and it's not just financial regulation.
Activities move away from the banks to the non bank
financial intermediation sector also because of technology, so some changing
market structure are conducive to being done outside of the
bank's balance is there too structure they're non nimble enough.
There are also conjunctual aspect right. So for example, when
you are at zero interest rate for all ten plus years,
(08:56):
it's normal and some of the risk cree shuffles around
their way from the banking sector and then the last one,
perhaps especially in advance a Gono, the center banks that
played an important role, people may say too large a
role in a number of markets, and so that's an
impact on pricing itself. So there's a number of factor
I think that contributed to this. Some are positive, some
(09:17):
are still I think open for assessment. You know, you
mentioned Archagos, and one thing I often wonder is in
the market, we talk a lot about excesses and stretched valuations,
and those seem like bad things, but they don't always
manifest in terms of financial stability risk except Archaicos was
actually a really good example of that. So could you
(09:38):
maybe talk a little bit about how you see, you know,
on a day when we're talking about financial conditions basically
going back to where they were before the FED started hiking,
talk to us about what excess in the market means
for financial stability. So there's two aspects of this, right,
So I want us to do that if you want
to call it like price misalignment or financial conditions are
too easy compared to the fundamental values. However you measure
(10:01):
fundamental values, that's one piece. I think that if there
are is no leverage employed, if there is no major
liquidly mismatch. No, it's not necessary systemic per set. Someone
will lose money, someone will make money, but let's not
part of my job. The concern is when that unwinding
of financial condition interact with vulnerabilities liquidity or in case
(10:22):
of our chegos, is financial leverage, right, because then that
vulnerability becomes a major amplifier. So it's not just that
risk as surprise risk risk as a reprise is that
the de leveraging in the case become an amplifier of
the reprise and I fire yourself. And all the de
leveraging that we saw during the financial crisis, there was
that component there. I think there was financial level employed
(10:43):
through the realtives, through prime brokerage, and the other weak
link there was that that was provided by banks, right,
and so there was an entry point into the banking sector.
That's where I think you need to be super careful
because for a lot of this financing structure or liquidity provision,
somehow it touches a balance of back in some formal
shape somewhere along the chain hits the Boden set of
(11:04):
the bank. So part of it it's a risk, but
it's it's an opportunity for the regulativity should be able
to see it once it touched the bond shield bank.
(11:25):
You know another thing that I think when I think
about the last year, maybe the last two years, is
uh sitting aside the market volatility. There was a lot
of growth, I mean, and maybe it's just nominal growth.
But of course with if you have a debt, like
the most important thing is you get it paid. How
much does just that maintaining a growing economy, unlike say
what we saw in the second half of two thou eight,
(11:48):
how important does that in terms of butchersing financial stability
is just they're not a lot of people defaulting because
people have good incomes, whether it's households, low unemployment rates
or low default rates for corporation. So usually um, the
one this is how we used to look at the FED. Growth.
To me, it's a precondition for financials to build it. Right.
You cannot have franchis debate without you need growth. So
(12:10):
growth it's really important. And so that growth that came
off the if you want the procession if you want
to called the way of the COVID was in part
because Center Bank stepped in majority. Right, So the FED
here at a major central bank and ended up back
stopping the full financial system. If you compare that with
two thousand and eight, back stopping was faster, more aggressive,
(12:31):
and wider. U. The other difference with two thousand and
seven two dosan A was fiscal policy. Right. So if
you remember the size of the ABAN administration physical plan
and think about the number of physical measures they've been
taking the US during COVID and the size of those, right,
the combination the two easy financial condition plus physical policy
as turbosh are essentially the economy now. Downside of that
(12:53):
is I think perhaps we as a community in general, policymaker,
maybe market so we have been slow to recognize is
the inflation problem? Right, So because growth was going fast
and because physical policy and be using that size for
a while, Um, that's where I think the concern is now,
and this is why we went into the Tilaning Morning,
Repolis and so on. So the flip side of that
(13:15):
fast growth has been inflation at levels that we haven't
seen since the plate seventy early eighties. Is inflation? How
does inflation manifest itself in financial stability risks? Yeah, So
that's that's the risk here, And I think That's why
priced ability is so important. Is that if you don't
tackle inflation now, So if you don't let prevent inflationary
pressure from becoming entrenched into the infression dynamics, so core
(13:38):
inflation wages and you'll let inflation expectation and more from
the target is going to be way more expensive to
bring inflation down. So in sometimes the personally I don't think.
I think there is in a symmetryn cost here, right,
So if you say, okay, what's the cost sire? If
I am tithening not enough for if tithing I'm not
tithening too much, that's when I think the cost society
(13:58):
if you're not aggressively approached this. Do you think of
the late sevent y earlieries in the US, It took
a lot of high any more other policy bring in
freshtion down, right, So being proactive and preventing the entrenchment
and increasing frention in pressing expectation, I think it's crucial
because you can control it, then you can bring invent
eventually you can bring race down to a rather I'm
(14:20):
supposed to go now. Of course, if you do this
space on which this is done, financial condition tied. If anything. Now,
the puzzle is why they haven't tied more than otherwise. Right,
any model that we you run, if you say, okay
that the frisk free rate moves by four and fifty
basis point, I think example, at least based on historical relationship,
will tell you the financial condition should be way tighter.
(14:42):
I mean, we had merged. It was just the FED,
you know, in addition to the massive stimulus and or
a couple other rounds of stimulus afterwards, and then the
Fed just you know, opening up one acronym after another
trying to backstop the market. And maybe you know, retrospect
that contributed to inflation. But was that a sort of
(15:03):
like you know, from your perspective, it is like this
is an example of we saw what happened in two
thousand and eight, two thousand nine when we go slow
and we let growth collapse, when we've let nominal income collapsed,
and sort of a successful lesson learned. I have no
doubt that was successful. I mean the alternative would have
been like fall into a creator of growth right in
the Great Procession story. Um. The issue is that that
(15:27):
response and the easing of financial condition and the build
up of some of the vulnerability highlighted. Some of the
reform agenda that you mentioned before has now been addressed. Right.
So the chapter that we pulled out in last October,
it was about open end investment fund and that's an example.
I think a sector where there are liquid in mismatch, right,
particularly those open and investment fund to have daily redemption
(15:51):
for a liquidous right think about high you know, corporate
bond for example, That's where I think there is case
and that's what we have seen. In March twenty the
outflows from those open ended funds was about five percent
of assets. That was larger than during the financial crisis.
Um and the camera faction of the FED not stepping
in very quickly and starting to backstop not just quei
(16:14):
or supporters by back stopping current market would have been
a much larger decline. A surprises, right. So what we
show in that chapter, it's one that there is a
link between the liquidity of the funds and what they hold, right.
So assets that are held by liquid funds tend to
drop in prices much more and that there are much
more volatility in return. So for example, once and the
(16:36):
deviation shock in the liquidity or some sort of what
you saw in March twenty increase volatility of return by
which is a large, significantly large number. And that's where
I think you need to think about doing what what
do we need to fit fit in terms of policy agenda,
is there a whole we need to think about the
regulatory emiter, what tools do we need? So, just on
(16:57):
the snow, there is that inherent tension between you know,
offering someone liquid assets and putting them in some sort
of liquid wrapper that allows them to go in and
out on a daily basis. What is the fund's view
on the best way to deal with that risk? And
also given what we saw in when the FED effectively
came in and back stopped not just credit markets but
(17:20):
the treasury market as well, which is supposed to be
the most liquid market in the world, Like, does that
mean was that the endgame problem solved? Central banks back
stop this and liquidity risk is no longer an issue? No,
So my personal view is that if you want to
live in a world where every X number of years
the center banks needs to step in and back stop
the financial system and every time push the line one more,
(17:43):
I think you need to rethink the regulatory perimier. Then, right,
if you want to be on the perceiving end of
the financial sector back stop, then the perimer need to
be different, right, So you need to be within the periment.
They're not outside the perimid obviously, but there's a different
way of thinking about financial stabilities because systemic risk at
that point it right. So the issue here is that
you're providing dare liquidly when there is underlying a liquid US. Now,
(18:06):
of course they all liquidly buffer and so on, so
that's a threshold for period of non stress. Perhaps the
system is fine, people can have different views. The problem
is during stress if you eat through the liquidly buffer. Therefore,
to sell us right, you face redemption. You sell, you
generally fire yourself. And because of the structure, there is
an incentive to run first because you're not bearing the
(18:27):
transaction cost when you get out the way this is designed,
and so I want to get out the first before
the market's price are going down essentially the enemy, so
that generate the run dynamics. That has important systemic implication
because you go into fire sale and that social cost
of the first mover is not addressed by the way
the design of this of these fissures are now so
(18:51):
what we look at. We look at a bunch of
possible solution there measure and we did some work across countries. Usually,
what the most common tools in terms of liquidly risk
management tools are either suspension obviously or redemption gates or
redemption fast. Those are pretty much widespread. What is much
less common is either what because swing prices so essentially
(19:12):
the ability to incorporates in the price you pay to
exit of the externality or if you want the transaction
cause the impose of those sustained the fund. Those are
not common or not the in in DUS for sure, and
even in Europe or in some sense they're voluntary. And
then this open debate of what do you do with
the liquid buffer? Do they work or not? So what
we find there is that the liquidity buffer that seems
(19:34):
to be some relationship between the liquid of the underlying
and liquid buffer. That is, if you hold more liquid usset,
you generally on average, tend to have higher liquid buffer.
The results that's more interesting though, is that one there
is very widespread use of this liquid buffers. Some when
you talk to people to in market, some tend to
actually use them actively. So I'm gonna sell the most
(19:56):
liquid stuff, use my ready lines and hope for the
best if you want. Others don't want to touch it
because they don't know what's coming nest and so they
start selling less liquid stuff. So there's a very different
use of this liquidity buffer. But on average at least,
what we find is that during stress, the average fund
if you want, tend to grow the relear butter. They
just don't want to use it. They don't know what
it's coming. So if that's the case, that is not
(20:19):
helpful for the example incentive to run right, it doesn't
prevent that. Swing prices are mostly used in Europe. Again,
swing prices the ability a century to correct the price
which you take money out based on this transaction costs
they impost on others. The problem is in principle they
are effective to reduce volatility. The problem is that the
buffer of the swing factor, if you want, how much
(20:41):
of this is used, is too small compared to what
would be used, and either because of competitive reason or
because of stigma, whatever the reason is, they're not calibrated
to the way that they should be calibrated during stress time.
At least, another option, which is more extreme if you
want is to more formally link your ability to exit
(21:01):
these vehicles from to the liquid of the underlying right.
So you mentioned the real estate one, they're the liquid.
It is not daily, right, you only a specific period
where you can withdraw. Um. If you go into landmark
in duance and you go back decades, there was no
daily liquidity. They used to be if I remember correctly,
intermitted funds or there were quarterly, monthly quickly. You need
(21:21):
to give advance and then when it comes time you withdraw.
That allows you to I think, manage liquidly better. I
think there's a lot of controversy and whether you should
restrict liquidity that can be given based on the underlying
but that that would be in principle the cleanest way
to fix the underlying mismatch between the liquidity and the
(21:43):
underlying assets. So just on that note, you know, one
thing with liquidity is I think a lot of times
when people talk about liquidity risk, often they're talking about
basically priced risk and the risk that you're going to
see a big drop when you try to sell. How
do you just aggregate those two things? And also there
there is an argument to be made that UM, if
you're holding a liquid assets and if you can get
(22:05):
away from marking them to market. UM. That often that
it can actually see you through a rough patch. Right. Again,
we see this with real estate nowadays, which is like
a lot of the big funds haven't had to mark
their assets to market and they're sort of holding on
waiting for a potential recovery and that helps in the interim,
so less I would deliquately one UM. I think they
(22:29):
take the treasury market here, the kid market in the UK, right, um.
And the issue was that in some cases it was
really hard to sell that you couldnot find a bit.
Right even if this are supposed to be the most liquid,
the most liquid fund, so you should not see those
in the most liquid markets. That's supposed to be the
risk for assets, right, you should be able to sell um.
(22:51):
The issue with liquidly, I think has to do with
the fact that often also interact withies. Right. I made
the example of leveage, right, that's what we called liquid
is spiral at least and in the in the in
the profession, that's where liquidity and leverage interact with each other.
My personal view is getting rid of market to market.
It's kind of like hiding a little bit um. I
(23:12):
want investor to be able to price risk and not
mark into market. And I can see the argument of saying, okay,
if I can only bridge to there, then the world
is going to be in a better place. My view
is that you need liquidity, you need to provide disclosure,
more disclosure. I'm only favor of disclosing trade for example,
because in the end, yes, you will take a loss,
(23:33):
but your price markets where they're supposed to be past
experience during the financial crisis, and when the pricing of
risk in the subprime market will postpone. I don't think
that's where we want to be. I think we want
to be in a place where your price market. Yes,
sometimes it's gonna overshoot. You know, both of you talked
about the l d I situation in the UK, and
of course in March we had that big dislocation in
(23:55):
the treasury market, but it was sold fairly quickly in
terms of the Central Brank step in and was a buyer,
and then the prices returned to normal and then subsequently
to March, and the FED is set up a standing
repo facility and so like, there's even more liquidity available
theoretically for treasury buyers. How powerful is that just looking
(24:17):
at the sort of risk free assets within any given
country to what degreetion more is, would you should more
central banks set up more robust facilities to create sort
of like both directional liquidity for holders of government debt.
So I don't think personally that the central bank should
in the business of managing data equally, right, so I
(24:38):
can see it all. What the central bank is the
blendard of last result of the proliquidity provider of last resort.
What the standing rip of facilities meant to do. It's
meant to cap in some tense rates, right, So they
don't want to see what you saw in September nineteen
where when they would normalizing the balance, it preparate. That's
what the facility is meant to be. That is not
meant to be a day to day a normal way
(25:00):
of providing liquid liquidly. It's in the market. There are
buyers and seller. That's how the systems should work. What's
changing the treasury market is that the underlying structure has changed. Right.
What the broker deer used to do now is done
by principal trading firms is done by firms. They are
not part of the trade shop banking system and they're
not within the traditional regulatory perimeter. That it's technology evolution.
(25:23):
I think the question is where the perimeter should be.
There are also a major discuss again have to do
with transparency of trades, so disclosing trades and whether you
should use central camera party to net some of this
position out then reduce some of the plosure, whether they
would free up balance it effectively to provide liquidly. I
don't think that daily to day job or a center
(25:45):
bank should be provide liquid in the markets. To me,
that's a lender of last resort function that I think
it's super important. Uh. That is a question though that
if you have access to the lender of last resort
function of a center bank, how to where the perimeter
of the regulations should be. You can't be just receiving
a check and then the central bank should be completely
out the business. Personally, I think that's a very uncomfortable
(26:08):
business for a center bank to run. Just on this
liquidity question, one of our all time favorite All Thoughts guests,
Chris White, said something on the podcast once which was
he asked a question, which is is liquidity something which
sort of happens naturally if you have a market that
(26:28):
is properly networked with people talking to each other, or
is it a service that you should have to pay
up for? And I'd be curious to hear a regulators
view on that topic. I think liquid it is a
financial service and like any other financial service, surprise. The problem,
(26:49):
I think after fifteen years of zero interest rate, zero volatility,
pre fat tightening, was that liquidly was no properly price.
That was a big problem. So you get used to
a place where liquid it is abundant, it's essentially free,
and you don't price the risk. Right, So that's a
think about price of li quickly break it down two pieces, right,
(27:11):
they expected liquidly and there is premium how much you
want to pay for insurance if you or if you're
providing it. I think that part that's where it was
miss priced. There was a quickly de premium was not paid.
You are not paying for that. They were not willing
to pay for. Situation where go away and I think
the normal interest rate normalizing, volatiality rising eventually. The hope
(27:32):
is that people will start to price liquidly. They should
be liquid is not free. Liquickly there's a financial service
that you should probably pay for and provision for. I
(27:54):
want to go back to some of these funds that
occasionally have issues with redemptions. There's the real estate one. Recently,
I think it was after the energy crash or sixteen
or that people started worrying about the high yield funds
or the high yield ETFs in the US and so forth.
But none of those turned out to be systemic per se.
(28:15):
I mean, people got anxious about the funds themselves, etcetera.
But even some of the recent stuff that didn't seem
like they're a huge spillovers. What is the scenario in
which something some stress that emanates from some fund or
some class of funds, because it becomes something that we
would regulators should be concerned as systemic risk. So it's
a question about mutual opening the fund or ETF or
(28:37):
both either one. Howeveryone, Well, let me start with the
first one that we do open in the funds. I
think there is because again what I was this described
before the pop You run for the door because I
want to come after you, and because they are incentive
to do that, and then by going out, you generate
the spiral where you get fire sale because they need
to weak me they to pay you, and the price
moves much more than it should have. I would argue,
(28:59):
if you take twenty when he as an example, that's
saying the system didn't break, it's a little bit too
generous as a view. The system didn't break because in
a month for reserve based of the entire francial system. Right,
So if I give a counter factual where instead of
them Monday with another month, my expectation is that the
system will have cracked in a different places um DTFS.
(29:22):
I think my views change over time. I think I
was trying and to look for place what could go
wrong there. I think they provide an important liquidity function.
Um you can get out, you just sell you share
with the FS, and in some sense they do sell
the price. Right. The concern that I have there is
more the opaque world of the other ICE participants. Right.
So the dealers that create and redeem shares, particularly in
(29:45):
fixed income where inequities, I think it's easier if you
have the SMP five. The bucket that you use is
more or less than index. With fix income, the basket
you used to create and reallym is way smaller than that,
and there is a lot of opacity exactly what's in
those baskets is provided to whom. If they don't provide
the function any breaks down, then the creation redemption can break. Now,
(30:06):
whether that's systemnic or not, I don't know, But to me,
that's where one question marks. Just on March specifically, it's like,
okay that that situation required enormous support from the FED
and other central banks. But I think with the point
that you know, we talked to Josh Younger, who's then
the JP Morgan out the New York FED, like, should
regulators be optimizing for the type of crisis that emerges
(30:31):
from a once in a century pandemic? Like I don't know,
Like is this is it worth like having the system
be robust or should we say, okay, once in the
century pandemic, it's not so bad if that requires the
FED to step in and start spraying money everywhere. The
first of all, it's two times in a century now
because it's from the GFC to to UH to COVID, right,
(30:52):
so it's kind of close to each other. Um, I agree,
I don't think you should calibrate too financial disaster every time,
but I think there is something in the middle between
caliber in like that and what is done now. I
think there are steps that can be taken to fix
some of these liquidity mismatch. Whether this is um swing
(31:12):
prices for example, and utilization of those So regulator can
for example, provide guidance of the implementation or some of
these liquidly tools. They can consider whether there some of
these liquid it would should be mandatory. The problem is
there's no alignment between the incentives of the individual manager
of the funds and the system financials to be objective, right,
If you align those then the system works better. So
(31:34):
whether this is again guidance, mandatory use of some liquid tools,
where this is stress testing, whether this is disclosure, I
think you can find a combination of this. It's gonna
be a functional country by country, depend on the institutional
set up, the legal setup can some things can work
better than others. And again or minimizing the gap between
the liquidity you provide and the deliquid of the end
of line. One last point, there is another aspect that
(31:58):
often it's not discussed in the US, but some of
these players are made of this open and the funds
are major players in emerging market and when you see
this in and out of those flows of those countries,
you can break those markets very easily. And so there
is any if you want the cross boarder systemic aspect
to list. And maybe it's not just us focus, but
at least from me working at the fund for some countries,
(32:19):
those are large, large molers. Yeah, I think that's a
good point. Um, you know you mentioned incentives there. Can
you talk a little bit more about the incentives at
play for you know, fund managers for instance, when it
comes to handling liquidity risk. And one thing you said
earlier was very interesting to me, this idea that you
know a lot of these funds will build up liquidity
or cash buffers, but will be reluctant to actually start
(32:41):
running them down in times of stress. So that was like,
there was a time I talked to a few people
in the loan market how they were marnaging liquidly right.
One was trying to understand what is your definitional ligue?
But fore wou do you use? Is the cash is
the lines of credit, is the most liquid leverage loans,
your whole treasury security? Is how big the buffer is?
(33:02):
I mean there's a trade off between Yeah, of course
you can alde a huge li quickly buffer, but it's
going to hit your return at some point, right, So
if I want to invest in the average loans, I
don't want you to hold twenty indiqudity. So that's one piece.
The other one was trying to understand the waterfall if
you went right, how do you manage this? And I
thought it was quite interesting. Then I got two very
different response right from I'm gonna start using and selling
(33:24):
the if I have some liquid liquid a like securities
after cash, then maybe use my lines of credit. Then
progressively moved to the rest LIEPID stuff, and then others
they would tell you I would never at touch it
now that even if you shoot me, I just because
I don't know what's next year. I need that as
my insurance. So I don't think the ARELA should tell
you exactly whether you should manage this personally. I think
(33:46):
they should provide some guidance. My sense now that it's
too much left to the individual manager that does not
internalize what the system in implication of the behaviors are.
So one of the things that happened on this podcast
of doing it for seven years is we've seen this
evolution in the type of things that we talked about,
and we used to have, you know, do a lot
of episodes on like the repo market and credit market, liquidity,
(34:11):
all these type of things. And then in the last
two years many of our episodes have become like very
like physical world commodity risks, one financial crossover with commodities.
We saw, like you know, there was the crisis at
some point last year in the nickel trading at the
London Medals Exchange. Can you talk a little bit about
how like as this and I don't know how long
like commodity markets or energy security is going to remain
(34:33):
so top of mind. But you know, we weren't really
talking much about that prior to COVID and some of
the commodity shocks. Can you talk a little bit about
how you're incorporating some of those stresses into your thinking
and the challenges of thinking about the markets from a
financial regulatory perspective. So if the maths sticks that were
describing before energy trading, we're not there obviously, right So
(34:55):
and those were not the entities were following clothesly for
we did. So there was one lesson I think learned
through in the February episode. I think it's important to
follow for a number of reason one because they are
they are important players in the financing of the physical assets, right,
so they provide colorized lending to shipments of various commodities.
(35:17):
So that's one important piece. So they're very much linked
to the physical asset too, because they are crucial players
in the dri of this market, the deriv markets used
by producer as a dge, and so they play a
crucial role in the middle. Obviously there are banks involved
and so so they play a function that is important
for the smooth operational the market commodities, a global market um.
(35:39):
The financial the risk from a financial stability perspective one
that we quickly scored that they were not data and
so if you want to say, I'm gonna have a chart,
and I don't know what chart to show. Some of
these entities have publicly ready bonds, So that's what we
were showing. That was for US proxy of investor concern
about these firms. But that was pretty much it, right,
not stability into their leverage position, who they were playing,
(36:03):
what market that was huge and sense of opacity in
terms of where there is where that was the big question.
I think the big flag, right flag came up. So
we're trying to do better job going forward. I mean
the big gap again, it's data data, and honestly they're
not these is one to to have conversation with. Glencore
(36:24):
doesn't want to talk to you. I can't imagine they
see the easier conversation without people. Um. You know you
mentioned cross borders village risks earlier. And one of the
things that I've thought about and I've written about at
various times is the role of benchmark index providers in
directing inflows and outflows. And I think the I m
(36:44):
F has done some work on this too. But how
much of a risk is that just this idea that
you create a benchmark, everyone tries to hug it as
closely as possible, and if you get a major change
in the index, for instance of China is added or
taken out, it triggers all the flows. Okay, So again
there's positive. It's like everything right, opportunities and risks right.
So I think opportunity of being added to the risk.
(37:06):
It means the country opens up to capital flows. So
capital flows are important for growth, for financial transaction. So
that's the positive of coming with it. The risk are
that the behavior of passive investor of benchmark investors very
different from SAM dedicated funds right am dedicated fund It's
really about going in and picking that I count re
picking the right credit, doing more the credit work if
(37:26):
you want, or solign work. Benchmarking is just following index.
And what we found is that the behavior of investors
that just benchmarks are much more linked to global financial conditions.
So when financial condition change and they tire and globally
di guid tends to leave. And so by being in
the index, yes you get more cavial, but you are
(37:47):
much more exposive before if you want to the risk
capiti change of the global investor. That's the downside of
of being in the index. So that's where I think
then it's important for the local Now there's another oportunity. Actually,
they often tend to deepen the liquidity of the local markets, right,
so their benefits. That's where though the local regulator I
(38:07):
think they need to play a role in terms of
like regulation that it's appropriate for those kind of flows
because those investors are not the typical em didy get
investors that sticks there. Those are investors that moves with
global financialries capitalize and we have seen that over the
last past few years. I want to go back to
something you said there at the beginning that I found
to be really interesting, the idea of growth being a
(38:28):
precondition for financial stability. And often when I think about
central bankers around the world of regulators, it feels like
to me that like the sort of macro part of
their job and the regulatory part of their job, or
like two separate things, and that there's enough managing the
banks making sure this and then also like making sure
they hit their inflation and unemployment goals, etcetera. Isn't that
(38:49):
the case of my misperception? Or do like should central
bankers should regulators recognize the interlinkages between maintaining robust growth
said financial stabuilding more than they currently do. I think
of like the banking sector, right, the best ingredient for
success of banks growth right because they have healthy balance,
the PLT cabital position, liquidity position. So to me, if
(39:13):
without growth the system is much more fragile. The way
we think about financial stability in terms of our framework,
we take if you use financial conditions, we use economic
condition then we try to forecast what the distribution of
growth will be, right, and so we think about financial
stability of the left tail. If you're on the downside risk,
that's for us. The link between financial conditions would not
(39:33):
abil is and growth. What do what policy meg are
trying to do when they think about financial stabilitia, trying
to minimize the downside the tail. That's to me, it
is the link between growth and financials ablity. That's the
framework we use in the financial Ability Report. I have
just one more question, and I'm sure this is the
one you get asked at every interview, but what are
you most worried about at the moment. I think what
(39:56):
I'm most concerned now is this sense of comfort that
nothing is broken um and as evidenced by this interview
and many of our questions. But it is because I
am reluctant to embrace this idea that we made the
system more residient and this is work out smoothly. Maybe
it's the case, and then we should celebrate. I'm just
(40:16):
concerned that I don't know. The energy trading firm was
an example that there are corners of the system that
I've not paid enough attention. The coronover time that they
became systemic, either because of size or because they use
leverage informed that they're not apparent or I don't have data,
or I don't understand the dynamic. Right. So the l
d I was a good example. People knew about LDI.
(40:38):
This is not a new thing that was learned, right,
It just happened. The combination of that business model with
a liquid in the guild market, with the policy shock
that perhaps no one it was difficult to forecast. But
the combination will this fact or create a situation where
what was going on in the UK had tremors across
the globe, You have reprising or create risk in the US,
(41:00):
you're reprising all asset execurities in as far as Australia
because people were selling across asset. That's the part that's
concerned me on missing something and becoming too comfort in this. Okay,
we got the right matrix with the right vulnerabilities, their
right legal model, because a lot of these are created
with the lens of the past, right on the lens
of the last crisis, that crisis tends to be different.
(41:21):
So I'm reluctant to be too comfortable that we managed
to to handle financials to be it's good not to
be complacent if you're a financial stability person, the regular
financial they should should be a healthy paranoia. I think
it's also true that no one had, you know, liability
driven strategies on their Bingo card for two financial stability risks.
(41:42):
So that's a really good example. Shall we leave it there? Show?
All right? This has been another episode of the All
Thoughts podcast. I'm Tracy Alloway. You can follow me on
Twitter at Tracy Alloway and I'm Joey Isn't that You
can follow me on Twitter at the store. The Year
(42:06):
E
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Joe Weisenthal
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