Glimpses of the regulatory process are starting to hit the news. Gary Gensler, Chairman of the Commodity Futures Trading Commission offered some insight into the process as he spoke of the evolving discussions surrounding the swaps market.
It is estimated that the swap market has over $600 trillion in contracts outstanding. (The Gross Domestic Product of the United States, in current dollars, is a little less than $15 trillion.) There are now 16 regulated futures exchanges that could handle swap transactions. Gensler expects that there may be 20 to 30 more organizations that will register as Swap-execution facilities (SEFs), organizations that would match buyers and sellers and provide more transparent pricing and information to the world.
One of the known unknowns about the swaps market is the volume of trades that will take place. Currently, swaps are created privately and are traded privately. The trading volume is not very substantial given the dollar-volume of the swaps market.
The chief executive of the International Swaps and Derivatives Association (ISDA) states that fewer than 2,000 standardized swaps, on average, are traded daily. The most active, the 10-year dollar swaps, only trade about 200 times a day.
One might expect that as this market develops and more transparency and openness come to the market that volumes will increase. This is the experience of other derivative markets as they have moved to more formal and standardized formats.
Gensler guesses that maybe up to 200 organizations may want to become “swap dealers.” These organizations would have to “register” under the new setup and meet regulatory qualifications for being classified as such.
Of interest is the fact that of these 200 or so organizations that might move in this direction about 75 banks could be considered to be swap dealers. This total, Gensler stated, consists of 25 global banks, 25 non-US banks that do some trading in the United States, and a further 25 US banks that are not global in scope.
“The rules could require these 75 banks to set up separate entities, with their own capital, that would be registered to trade derivatives including commodity, equity, and some credit default swaps.” (See http://www.ft.com/cms/s/0/44491a9a-c1e3-11df-9d90-00144feab49a.html.)
The new rules and regulations are supposed to be in place by July 2011. Gensler told CNBC that he has enough staff to develop the rules. The problem is that he will need at least 400 more employees to enforce them. (See http://professional.wsj.com/article/SB10001424052748704394704575495723231513104.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.)
It is very, very difficult to write new rules and regulations for financial markets that were previously just “over-the-counter” markets. Even going back historically to the “standardization” of relatively simple instruments, like interest rate futures and so forth, shows how difficult it is to capture all the nuances and quirks that relate to a specific type.
The new standardized, formal markets will be forthcoming. They will be heavily used and trading volume will increase substantially as information becomes more public.
Perhaps the ultimate, bottom line conclusion to the developments described above is that the swap market will grow and prosper, including the sector relating to credit default swaps. The hysteria connected with the financial crisis has subsided and financial innovation continues on. The populist outcry against the greedy bastards that developed the derivatives industry is fading into the shadows.
So, financial innovation is alive and well. It is impossible to know what form it will take next.
Showing posts with label central bank liquidity swaps. Show all posts
Showing posts with label central bank liquidity swaps. Show all posts
Friday, September 17, 2010
Sunday, February 7, 2010
Everything is in Place: Federal Reserve Exit Watch Part 7
Looking at the Federal Reserve figures for Wednesday, February 3, 2010, one could argue that just about everything seems to be in place for the Fed to execute its exit plan. The Fed will still purchase some more Mortgage-backed securities and there are some other residuals left from the world financial crisis that still remain, but these are now relatively minor parts of the picture.
On Wednesday, February 3, 2010, the Total Factors Supplying Reserves to the banking system totaled $2,231.3 billion or a little more than $2.2 trillion. The Securities held outright by the Federal Reserve amounted to $1,911.6 billion or approximately 85.7% of the total factors supplying reserves.
To put these numbers in perspective, on Wednesday, December 5, 2007, Total Factors Supplying Reserves to the banking system equaled $920.4 billion and Securities held outright amounted to $779.7 billion or 84.7%. The Fed did have outstanding $46.5 billion in repurchase agreements which, if included, made about 89.8% of their balance sheet related to securities.
On February 3, 2010,the Federal Reserve had no repurchase agreements outstanding.
I go back to December 2007 because one has to go back that far to get to a Fed balance sheet that does not include “special” line items that were constructed to combat the financial crisis. In December 2007, the Term Auction Facility (TAF) was initiated. During the time the TAF existed total funds supplied through this facility reached several hundred billion dollars. On Wednesday February 3, 2010, funds supplied to the banking industry through the TAF were only $39 billion, down $37.4 billion over the past four weeks and down by $101 billion in the last 13-week period.
In preparing to remove excessive amounts of reserves from the banking system the Federal Reserve has been allowing the “special” facilities that have supplied reserves to banks to “run off” while the Fed has replaced these funds with open market purchases.
Another area in which this has taken place has been in central bank liquidity swaps. This facility was also started in December 2007. At one time central bank liquidity swaps were in the hundreds of billions of dollars. On Wednesday, February 3, swaps totaled $100 million.
In the last four weeks and the last 13-weeks, the other items on the Federal Reserve statement did not change dramatically. To me what I have presented in the last three paragraphs pretty well sums up what the Fed has been doing to get itself ready to begin removing excess reserves from the banking system…when it decides it is time to do so.
Over the past 13-week period, reserves have been removed from the banking system by a reduction in funds available through the TAF ($101 billion) and through a decline in central bank liquidity swaps ($32 billion) or a total of $133 billion.
During this time, the Federal Reserve has purchased open-market securities of $214 billion. Thus, total factors supplying reserves during this time rose by $81 billion from these factors.
Over the past 4-week period, the TAF has been reduced by $38 billion and central bank liquidity swaps declined by $10 billion or a total of $48 billion.
Federal Reserve purchases of open market securities totaled $66 billion. Total factors supplying reserves from these factors rose by roughly $18 billion.
I have not discussed the factors that have been absorbing bank reserves over the past 4-week and 13-week periods because they have been impacted by some wide swings in the deposits of the federal government, much of which are technical in nature. And, these factors should not play any important role in how the Fed removes reserves from the banking system.
The bottom line in this discussion is that it seems to me that the Fed has basically eliminated or reduced most of the facilities that it created over the past two years that can have a major impact on the creation or destruction of bank reserves. The two major facilities are, of course, the TAF and central bank liquidity swaps.
The Federal Reserve now has one thing to work with in withdrawing reserves from the banking system: its portfolio of open-market securities. The Fed’s balance sheet is composed of roughly 85% open-market securities held outright. (A shown above, as a percentage of the balance sheet this is not too far off what the composition of the balance sheet was in early December 2007.)
The Fed has already had some recent test runs using “Reverse Repurchase Agreements” (reverse repos), or, selling securities to securities dealers under an agreement to repurchase. The idea here is to test the market’s reception to the withdrawal of funds from the banking system. Since the reverse repos are only temporary, the funds withdrawn will be put right back into the system avoiding any disruption that might be caused by the sale of the securities.
In this way, the Fed can “feel” its way toward withdrawing the excess reserves from the banking system. On one side is the question about is how the Fed will react to a pickup in bank lending and a rapid rise in the growth rates of the money stock. On the other side, the Fed wants to avoid a catastrophe like the 1937-1938 period in which reserve requirements were raised at a time when banks seemed to have had a lot of “excess reserves” on their hands, but really wanted to keep excess reserves on their balance sheets.
Bernanke, a historian of the Great Depression knows this lesson all too well. That is why a suggestion like that of Andy Kessler, a former hedge fund manager, which appeared in the Wall Street Journal last Thursday morning, “Bernanke’s Exit Strategy: Tighten Reserve Requirements” (http://online.wsj.com/article/SB20001424052748703699204575017462822204340.html#mod=todays_us_opinion) seems a bit absurd.
My belief is that Mr. Bernanke and the Fed are going to, at least initially, take things slow. When they begin to exit they are going to engage in some reverse repos and see how the banking system reacts. Then they will do some more…and then some more. The strategy: basically stepping out into the river to see how deep the water is. And, then stepping out a little further…and then a little further. The hope is to avoid falling in over their head, causing a further contraction in the banking system that would lead to another financial crisis.
In doing this the Fed keeps the reserves in the banking system if the economy remains slow or if the banking system wants to hold onto the funds. However, in this plan they start to remove the reserves, testing the market all along the way, so as not to pull the reserves out too quickly.
The problem is on the “up-side”. If bank lending does start to accelerate then the banks will want those “excess reserves” for loans. And, the funds are already on their balance sheets. In such a case the questions will be “How fast will the Fed sell the securities on its balance sheet?” and “How high will the Fed drive up interest rates in order to avoid a credit inflation from breaking out in the United States?”
As we have seen in other periods of time, we can simultaneously be in a period of economic stagnation and still experience a credit inflation. Bernanke has not earned his “star” yet! He still has $1.1 trillion of EXCESS RESERVES in the banking system that must be removed.
On Wednesday, February 3, 2010, the Total Factors Supplying Reserves to the banking system totaled $2,231.3 billion or a little more than $2.2 trillion. The Securities held outright by the Federal Reserve amounted to $1,911.6 billion or approximately 85.7% of the total factors supplying reserves.
To put these numbers in perspective, on Wednesday, December 5, 2007, Total Factors Supplying Reserves to the banking system equaled $920.4 billion and Securities held outright amounted to $779.7 billion or 84.7%. The Fed did have outstanding $46.5 billion in repurchase agreements which, if included, made about 89.8% of their balance sheet related to securities.
On February 3, 2010,the Federal Reserve had no repurchase agreements outstanding.
I go back to December 2007 because one has to go back that far to get to a Fed balance sheet that does not include “special” line items that were constructed to combat the financial crisis. In December 2007, the Term Auction Facility (TAF) was initiated. During the time the TAF existed total funds supplied through this facility reached several hundred billion dollars. On Wednesday February 3, 2010, funds supplied to the banking industry through the TAF were only $39 billion, down $37.4 billion over the past four weeks and down by $101 billion in the last 13-week period.
In preparing to remove excessive amounts of reserves from the banking system the Federal Reserve has been allowing the “special” facilities that have supplied reserves to banks to “run off” while the Fed has replaced these funds with open market purchases.
Another area in which this has taken place has been in central bank liquidity swaps. This facility was also started in December 2007. At one time central bank liquidity swaps were in the hundreds of billions of dollars. On Wednesday, February 3, swaps totaled $100 million.
In the last four weeks and the last 13-weeks, the other items on the Federal Reserve statement did not change dramatically. To me what I have presented in the last three paragraphs pretty well sums up what the Fed has been doing to get itself ready to begin removing excess reserves from the banking system…when it decides it is time to do so.
Over the past 13-week period, reserves have been removed from the banking system by a reduction in funds available through the TAF ($101 billion) and through a decline in central bank liquidity swaps ($32 billion) or a total of $133 billion.
During this time, the Federal Reserve has purchased open-market securities of $214 billion. Thus, total factors supplying reserves during this time rose by $81 billion from these factors.
Over the past 4-week period, the TAF has been reduced by $38 billion and central bank liquidity swaps declined by $10 billion or a total of $48 billion.
Federal Reserve purchases of open market securities totaled $66 billion. Total factors supplying reserves from these factors rose by roughly $18 billion.
I have not discussed the factors that have been absorbing bank reserves over the past 4-week and 13-week periods because they have been impacted by some wide swings in the deposits of the federal government, much of which are technical in nature. And, these factors should not play any important role in how the Fed removes reserves from the banking system.
The bottom line in this discussion is that it seems to me that the Fed has basically eliminated or reduced most of the facilities that it created over the past two years that can have a major impact on the creation or destruction of bank reserves. The two major facilities are, of course, the TAF and central bank liquidity swaps.
The Federal Reserve now has one thing to work with in withdrawing reserves from the banking system: its portfolio of open-market securities. The Fed’s balance sheet is composed of roughly 85% open-market securities held outright. (A shown above, as a percentage of the balance sheet this is not too far off what the composition of the balance sheet was in early December 2007.)
The Fed has already had some recent test runs using “Reverse Repurchase Agreements” (reverse repos), or, selling securities to securities dealers under an agreement to repurchase. The idea here is to test the market’s reception to the withdrawal of funds from the banking system. Since the reverse repos are only temporary, the funds withdrawn will be put right back into the system avoiding any disruption that might be caused by the sale of the securities.
In this way, the Fed can “feel” its way toward withdrawing the excess reserves from the banking system. On one side is the question about is how the Fed will react to a pickup in bank lending and a rapid rise in the growth rates of the money stock. On the other side, the Fed wants to avoid a catastrophe like the 1937-1938 period in which reserve requirements were raised at a time when banks seemed to have had a lot of “excess reserves” on their hands, but really wanted to keep excess reserves on their balance sheets.
Bernanke, a historian of the Great Depression knows this lesson all too well. That is why a suggestion like that of Andy Kessler, a former hedge fund manager, which appeared in the Wall Street Journal last Thursday morning, “Bernanke’s Exit Strategy: Tighten Reserve Requirements” (http://online.wsj.com/article/SB20001424052748703699204575017462822204340.html#mod=todays_us_opinion) seems a bit absurd.
My belief is that Mr. Bernanke and the Fed are going to, at least initially, take things slow. When they begin to exit they are going to engage in some reverse repos and see how the banking system reacts. Then they will do some more…and then some more. The strategy: basically stepping out into the river to see how deep the water is. And, then stepping out a little further…and then a little further. The hope is to avoid falling in over their head, causing a further contraction in the banking system that would lead to another financial crisis.
In doing this the Fed keeps the reserves in the banking system if the economy remains slow or if the banking system wants to hold onto the funds. However, in this plan they start to remove the reserves, testing the market all along the way, so as not to pull the reserves out too quickly.
The problem is on the “up-side”. If bank lending does start to accelerate then the banks will want those “excess reserves” for loans. And, the funds are already on their balance sheets. In such a case the questions will be “How fast will the Fed sell the securities on its balance sheet?” and “How high will the Fed drive up interest rates in order to avoid a credit inflation from breaking out in the United States?”
As we have seen in other periods of time, we can simultaneously be in a period of economic stagnation and still experience a credit inflation. Bernanke has not earned his “star” yet! He still has $1.1 trillion of EXCESS RESERVES in the banking system that must be removed.
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