From the iconic scene in the Movie, The Matrix, the choice of which pill to take offers very different outcomes. One, a life lived in harsh reality but where the individual can think and act independently; and the other, a computer simulation of a comfortable life, but bereft of the ability to think and act of one’s own volition.
The same choice is offered here. Would you like to see the financial system for what it really is, as opposed to what the financial media and textbooks tell you it is supposed to be?
This Collection focuses on presenting alternate ways of thinking about our modern financial system. Expect conventional thinking, wisdom, and theories to be challenged in areas where established viewpoints are deeply entrenched. How do people normally think about these issues? What is inaccurate about established viewpoints? More importantly, what happens when we change our paradigms and view these issues differently?
The articles in here aren’t for everybody. Some will be offended by having their viewpoints challenged, and others will end up more confused than they already were. But, for those willing and patient enough to question and reconfigure how they think, the clarity brought on by new insight and understanding will be like stepping into a whole new world.
READER WARNING: FOR THE OPEN MINDED ONLY!
While all Treasuries can be used as collateral, they are not all made equal.
At least from the perspective of what serves as the best, and most widely accepted forms of collateral.
Bearing in mind the preference repo counterparties have for liquidity, and the ability to recover some amount close to the loan value in the event of default, shorter maturity Treasuries, that is T Bills, are considered to be “better” forms of collateral.
“Better” in this case because, by being of shorter tenor, they have lower duration.
Duration is a measure of how sensitive a bond’s price is to changes in interest rates (mathematically, the first derivative of the curve). Longer tenor bonds are more sensitive to changes in rates (have higher duration) because the bulk of a bond’s cash flows come at the end, where the principal amount is repaid.
As such, this large lump sum payment is what affects the present value of the bond the most when interest rates change.
Since the primary purpose of collateral is to ensure that, in the event of default, lenders can recover as much of their loan values as possible, assets which trade with relatively higher levels of volatility are not that good forms of collateral.
Consequently, while UST 10 year notes and 30 year bonds offer similar liquidity and flexibility characteristics, their longer durations ultimately put them at a disadvantage to T Bills, which are considered to be the most pristine form of collateral in the financial system.
But how exactly do these collateralized repo transactions work?
Firstly, “repo” is short for repurchase agreement, which is a sale of securities (the collateral), with the simultaneous obligation to buy them back on a certain date.
Repos allow institutions which hold large stocks of financial securities to use them as a way to obtain quick funding without having to sell them.
Examples of such institutions include Wall Street trading desks, brokerage houses, hedge funds, asset managers, and even pension funds.
The repo rate is the interest rate paid by the borrower, and in general, the lower quality the collateral, based on the factors discussed in Part 1, the higher the repo rate, more colloquially (and affectionately) known as the “haircut”.
It is important to note that the party selling the securities (and buying them back later) is the one engaging in the repo.
The counterparty, that is, the one purchasing the securities (and selling them back later) is said to be engaging in a reverse repurchase agreement.
Reverse repos are used by parties that require the securities pledged as collateral for use in their own financial transactions. This could be a hedge fund lending cash to receive UST Bills, which they in turn use as collateral in another financial transaction.
This is possible because repo transactions can be rolled over.
That is, when the specified date is reached, instead of going through with the repurchase leg of the transaction (refer to the diagram above), both parties agree to extend the transaction to a future date, and re-negotiate terms as necessary.
This brings us to another important aspect of repo transactions, which is that collateral values are recalculated daily based on price fluctuations. This recalculation results in securities or money being delivered in one direction or the other, depending on how prices change.
As such, repos are considered to be “safe” transactions as levels of collateral are adjusted according to market moves on a daily basis.
The exception to this is of course systemic events, where everyone scrambles for collateral at the same time, resulting in mass liquidations across global markets.
To be continued…
What is money? This is not as simple a question as it may seem at first glance.
Consider the following example: You find yourself in possession of a piece of paper that has a number written on it.
You bring it to the supermarket and try to use it to pay for food, but the cashier thinks you’re insane and calls security to escort you out.
However, when you bring it to a certain, very specialized, type of merchant, the same piece of paper can be used to immediately obtain a cash loan (the paper is used as collateral). And, at an amount almost equal to the number written on it too!
So the piece of paper cannot be used to buy food, but it can very quickly get you access to cash with which to buy food.
Furthermore, you notice that the number written on the paper is slightly more than what you paid for it. Plus, you were told that if you returned it to the place you bought it from after 3 months, you would receive that amount back in cash.
It’s an almost magical piece of paper!
So, is your piece of magic paper money?
Obviously, it depends on whom you ask. The supermarket cashier does not, and will not, think it is, but the specialized merchant definitely does.
Why is that?
Simple – the merchant has use for the piece of paper, and the supermarket does not.
The magical piece of paper is actually a US Treasury 3 month Bill (T Bill), and the specialized merchant a repo trading desk at a big Wall Street bank.
Repo desks have multiple uses for T Bills, but almost all involve using them as collateral – where they are pledged as security against default when taking loans or trading financial securities.
It is important to note that all tenors of US Treasuries can, and are, used in the repo market as collateral, simply because USTs are considered to be the “risk free” asset.
Consequently, USTs are the bedrock on which repo desks and their counterparties from all over the world secure their transactions with each other.
Furthermore, the market for USTs (by virtue of their “risk free” status, or not) is also one of the most, if not the most, liquid market on the planet.
This means collateral can be immediately liquidated by traders with minimal adverse price movements. (In less liquid markets, assets sold quickly and in bulk will push prices lower, causing sellers to get less than they would otherwise have gotten)
Lastly, and arguably most importantly, USTs are denominated in USD. This means sellers do not have to (overly) worry about the value of their collateral fluctuating wildly due to currency movements.
Additionally, upon liquidation, the seller will, by virtue of the USD being the world’s reserve currency, be able to easily swap their holdings into other currencies or assets.
No other financial asset can provide this combination of flexibility, security, and liquidity, which makes US Treasuries the premiere form of collateral in the global financial system.
As such, their role as an interest bearing instrument takes a back seat to their low price volatility and their ability to be quickly converted into some other asset.
Store of value – check, and medium of exchange – check.
USTs are money.
To be continued…
Modern monetary policy is based largely around Central Banks expanding/contracting the amount of Reserves in the banking system.
This is done through smaller open market operations to influence overnight interest rates for borrowing/lending Reserves, and larger operations like QE.
But this doesn’t work!
The logical basis for these operations is that if the Central Bank increases/decreases the amount of Reserves held by banks, then banks will in turn loan more/less of these Reserves out into the economy. In doing so, the Central Bank influences economic growth and manages the level of inflation.
But, if Fractional Reserve Banking does not work because banks do not lend Reserves, doesn’t that mean Central Bank policy, i.e. QE, does not work as advertised?
Unfortunately for all of us, the answer to the above question is Yes.
Take a moment and consider the ramifications of this – that 1) Central Banks do not understand how money is created, or 2) they do understand it but are not tailoring their policies to reality.
If 1) is true, then what good are these QE loving Central Banks doing?
If they do not understand the very basics of how the system they are overseeing works, that means all their future monetary policies are dead on arrival, not to mention the decade(s) already gone.
If 2) is true, then it begs the question – Why?
A possible reason is that Central Banks feel the need to be actively doing something, which is after all a very normal emotional reaction all humans have in times of crisis. After the rubicon of implementing QE for the first time is crossed, each subsequent iteration then becomes easier to implement; it becomes a convenient solution of sorts.
Although, it must be asked, if QE works… then why are Central Banks doing it for a 2nd, 3rd, 4th… nth time?
The Fractional Reserve Banking (FRB) model is very deeply ingrained in today’s mainstream economic thinking.
This model is taught in introductory macroeconomic classes across the globe, and has been for years. Which means that every graduate, regardless of their degree, has at least heard about this if they took intro econ classes.
That’s a lot of graduates.
Now, you may be asking: Isn’t it good that many people are familiar with Fractional Reserve Banking? Isn’t it better for society if more people are familiar with how economic policy makers think?
Well the answer to the second question is yes.
The answer to the first question however, is a resounding no.
As it turns out, Fractional Reserve Banking is not what actually happens in the real economy, because banks do not lend Reserves.
This is very important and bears repeating; banks do not create new money through the process of Fractional Reserve Banking, at all.
This, of course, begs the question: How then is money created in the banking system and economy?
The answer is … ex nihilo. Which is Latin for “from nothing”. Here’s the accounting:
Like in Fractional Reserve Banking, lending is the mechanism through which money is created; unlike Fractional Reserve Banking, Reserves are not loaned out.
In fact Reserves are not present anywhere in the accounting for new loans. This is important because for Fractional Reserve Banking to work, banks must loan out Reserves, which means that Reserves should appear somewhere in the accounting.
But they do not.
Instead, when a new loan is made, the bank creates a new asset for the loan, since they will be earning interest on it. They balance this by increasing the deposit balance of the client who took out the loan.
From the client’s perspective, their deposits increase by the amount of the loan, and their liabilities increase by the same amount, since they now owe the bank the amount of the loan.
As can be seen, Reserves are not part of the process at all. Instead, when a new loan is originated by a bank, money is created through making the appropriate balance sheet entries – from nothing.
At this point, it would be completely understandable if you think that everything written above is incorrect, or some sort of misguided attempt at creating fake news. So don’t take our word for it; here’s the Bank of England explaining it in a research paper.
Of course, this new understanding of how money is actually created raises a lot of questions. What use do Reserves have since they aren’t lent out? Doesn’t this invalidate QE? What does this mean for modern monetary policy?
If you feel like your head is spinning, remember that not knowing is a good thing.
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