2023 Financial Markets Conference - Old Challenges in New Clothes: Outfitting Finance, Technology, and Regulation for the Mid-2020s

Research Session Two: Nonbank Financial Intermediaries and Financial Stability

The heft of nonbank financial intermediaries (NBFIs) has grown significantly after the Great Financial Crisis. Presenter Sirio Aramonte, principal economist of the Federal Reserve Board of Governors, and discussant Valentina Bruno, professor of finance and Kogod Research Professor at American University, reviewed structural shifts in intermediation and how NBFIs have shaped the demand and supply of liquidity in financial markets. The conversation was moderated by Larry Wall, executive director of the Atlanta Fed's Center for Financial Innovation and Stability.


Larry Wall: If everybody could get seated, we can start here. This is the second of our two academic sessions, and we like to have them have a fit with the policy sessions. This is a very good complement to the policy session that we just had on nonbank financial firms. This one's going to be dealing with ... I'll do a much deeper dive into the liquidity aspects.

Before we get started, there were some references to some bailouts that have happened in nonbank firms. A ways back, I did a paper for our Policy Hub where I surveyed the FDIC, Fed, and Treasury interventions from 1970 to 2020, and came up with aid interventions for nonbank financial firms during that period. Sometimes this involved explicit financial support, but in some cases it was the Fed or Treasury officials talking with people in the industry, encouraging them to do the right things, and arguably in some cases providing some implicit support.

This goes back to 1980, with the Hunt brothers and the silver market. Then again, the Drysdale Securities failure in the 1980s; the housing finance in the 1980s, which was basically a GSE/Fannie Mae issue; ag finance, which needed a bailout in the 1980s; the 1987 stock market crash; long-term capital management; the global financial crisis; and the 2020 pandemic dash for cash. Concern about nonbanks and their implications for financial stability have been around for some time.

With that, we're going to have a paper now that's going to deal with the intersection of liquidity and leverage issues. Sirio Aramonte will be presenting it. The floor is yours. You can present from there, or you can present at the...

Sirio Aramonte: Sounds good. I'll just walk around a little. Thanks a lot, Larry, and thanks a lot to the organizers. It's an honor to be here today. This paper is a joint work with Andreas Schrimpf and Hyun Shin from the Bank for International Settlements.

I would like to bring your attention to the disclaimer that anything that I will say here today is just my own views and does not reflect the views of the Federal Reserve System, the Bank for International Settlements, or any other members of their staff.

With that aside, let me start with a chart, which is very useful to understand certain aspects of the evolution of the financial system over the past 50 years, which are relevant for the discussion today. Here you can see assets held by different types of US investors: banks, households, broker-dealers. You can see the data from the mid-1950s until present. I would like to highlight two things. One, in the late '70s you see that the assets of broker-dealers start to increase at a much faster pace than the assets of other investor types. In the late 2000s, after the GFC, you see a slight drop in the assets of broker-dealers, and then they flatten even though other intermediaries, other investors, see their assets keep growing.

These two turning points that you see in this chart actually are quite important turning points also for the evolution of the NBFI system. In the late '70s, the financial system started to become less bank-centric. It became more reliant on market-based intermediation where borrowers would issue securities, tradable securities, and broker-dealers would help make the market for these securities. Having a liquid secondary market was very important to make sure that the primary market for these securities would remain viable.

Fast forward to 2008. Here, what happened is that dealers started to retrench on a relative basis. What I'm going to say is, on a relative basis. It's not in terms of dealers reducing intermediation but compared to other intermediaries. At the same time, after 2008, the other intermediaries, I will touch upon a couple of them later in the presentation, started to become more important for liquidity provisions. The NBFI liquidity provision ecosystem has become a little more diffused, and some research highlights that it could have become a little more fragile to some extent.

Let me give you a specific example, focusing on corporate bonds, which have been the subject of a lot of policy work and research over the last 10-15 years. In the late '70s, what happens is that bank credit, bank loans, start to fall as a share of total corporate debt, and at the same time, corporate bonds gain ground. Again, broker-dealers were crucial to ensure the liquidity of these tradable securities. After 2008, I mentioned that broker-dealers, on a relative basis, retrenched a little, but something else happened, which is interesting from a financial stability perspective. Specifically, one type of investors in corporate bonds expanded their presence in the market. I'm talking about mutual funds. As we know, mutual funds can, in certain circumstances, generate spikes in liquidity demand, so we have a system where there has been a little increase in the spikiness of liquidity demand and there has been maybe a little increase in the fragility of the liquidity supply. Work has been focusing, and continues to focus, on whether essentially the risk of liquidity imbalances and disruptions has increased at this point.

I've talked about the time series aspects of the evolution of the financial system over time. At this point, let me talk about the cross-section. Standing as of today, what does the cross-section of intermediaries in the NBFI system look like? This is a simplified schematic, and I would like you to focus on both the blocks and the connections between the blocks. The ultimate goal is to have money from savers on the right-hand side find its way to borrowers on the left-hand side. On the right-most column, you have typical institutional investors that collect these funds, mutual funds, insurance companies, money market funds, and so on. In the two other columns, you have the intermediaries that work to make sure that these tradable securities that institutional investors buy have a liquid secondary market. In the middle column, we have highlighted intermediaries that have benefited from the regulatory push following the GFC to make sure that more activity would move from over-the-counter markets to cleared markets. You have exchanges, central counterparties, and CCPs are actually quite important for our discussion. On the left-most column you have broker-dealers, which continue to provide intermediation. At the same time, you have certain new intermediaries that, to some extent, look like market dealers, but in important respects they are quite different from market dealers. I will talk about them in a moment.

Let's focus on the question that we tried to get to in the paper. We want to understand how the rise of the NBFI system has changed liquidity supply and liquidity demand. Specifically, we want to look at how leverage affects liquidity, and we want to do so through the lens of margins. Actually, let me go back a moment to the schematics, because I forgot to talk about the connections. The lines that connect the different blocks here represent either transactions, buy and sell securities, or borrowing, which typically takes a collateralized form in the NBFI's realm, typically repos, not just collateralized, but a lot of it is collateralized. In many of these lines, you see a relationship but you also see either a margin or a haircut. Margins are how much money investors have to put down to open a position. Haircuts determine how much borrowing a borrower can get, given a set of collateral. In practice, margins can vary quite substantially, haircuts a little less so. The important thing is that both margins and haircuts determine the quantity, the amount of leverage, that can be obtained in the financial system.

Going back to this slide, our focus is on leverage, the link between leverage and liquidity through the lens of margins, because margins determine leverage. Leverage determines risk-taking capacity, balance sheet capacity, how many securities a certain intermediary can hold, and clearly, balance sheet capacity is tied to liquidity. There is also a macroprudential angle to this chain of connections, which I will develop when I briefly talk about the model that we have in the paper, but the macroprudential aspect is essentially that there is an amplification mechanism that links margins to liquidity risk. There is a set of externalities that, given the behavior of one investor, affect the behavior of other investors. Essentially, this is the definition of systemic risk, and this is why it's important to have a macroprudential perspective.

In the paper, we have a model that we use to formalize what I have mentioned so far. We use the model to distill certain highlights from the events in March 2020 in the Treasury market, and then we use these highlights to pose policy questions. In the paper we don't try to answer. We try to set the stage so we can ask policy questions that can help us understand how we can deal with liquidity risk in the NBFI system. I mentioned that we want to compare how liquidity demand and liquidity supply have evolved over time. When it comes to demand, we probably know a lot about these intermediaries. We know a lot of work has been done on money market funds and mutual funds, so let me glide over this slide and talk about something that reflects more recent developments. Let me talk about liquidity supply.

I mentioned that certain intermediaries have, over time, benefited from the push to move activity from over-the-counter to a cleared market, and CCPs are one of these intermediaries. CCPs are central to our story because CCPs set margins for activity that investors want to undertake, for trading that investors want to undertake. They do so because they need to defend themselves from credit risk. However, this behavior, through externalities, can have system-wide consequences in terms of amplification of liquidity fluctuations. Then we have hedge funds. Typically, hedge funds are not maybe the first item that comes to mind when it comes to liquidity provision, but it depends on the strategies that they employ. In particular, hedge funds that deal with relative value strategies do provide liquidity. Typically, they buy assets that embed a liquidity discount. They short sell assets that are comparable but that are less cheap, so relatively more expensive because they do not include a liquidity discount, and typically to enhance their returns they use leverage.

The last intermediary I would like to touch upon is PTFs, or principal trading firms. These are active especially in the Treasury market and have come to the fore, especially after the GFC. In a sense, they resemble, maybe don't take this literally, but they resemble dealers because they trade very often during the day, so they allow other investors to get in and out of positions, so they provide liquidity. At the same time, though, PTFs are known for having a very tight inventory management approach. They try to be neutral in terms of market risk at the end of the day. In a sense, PTFs help investors share risk during the day, but they do not warehouse risk overnight. Now, I mentioned that we have a model. I'm not going to show you any math. I'm just going to, in this slide, highlight key items, key characteristics, of the model and the key takeaways.

The model links changes in margins with debt capacity. At this point, you can think of it as a synonym for leverage, and it then links that capacity/leverage to liquidity. The model builds on a risk-neutral investor that maximizes expected returns, subject, and this is important, to a risk management constraint. This is what generates the amplification mechanism in the model.

Three takeaways: the first one is that leverage is recursive, that capacity is recursive. By this, I mean that there is a multiplier effect at play. Think about the fiscal multiplier. The more I spend, the more money circulates in the economy. In this set-up, the more leverage I take, the more other investors can take leverage. This works well on the way up, but also works on the way down.

The second point is that a significant spike in margins can also generate a substitution of high-risk, high-margin assets for low-risk, low-margin assets, which means that a spike in margins also pushes investors towards holding cash-like assets. This is important because, if you recall, in March 2020 there was a lot of talk about the dash for cash, and that was partly due to investors liquidating assets to pay for, essentially, margin calls. You will see something in a couple of slides. At the same time, part of what we saw, investors taking refuge to cash, was the flip side of the leveraging that we also observed.

The last point has to do with specifically hedge funds that provide liquidity through relative value trading. These activities depend, hinge essentially, on correlations between the long leg of the trade and the short leg of the trade being stable over time. When that does not happen, when correlations move about, and this happens often during episodes of market distress, correlations themselves contribute to amplification in balance sheet capacity, and eventually in liquidity.

I will now turn to the empirical side. Before I turn to March 2020, I mentioned that margins are important for our model and that they are central to the story, so let me highlight what drives margins. Margining models take different forms and inputs, but at the end of the day evidence is that margins are closely tied with expected market volatilities. Here, you see margins on Treasury futures against implied volatility, the VIX index. You can see that there is a lot of co-spikiness, let's say. This is unfortunate in a sense, because when margins increase investors need to raise cash to meet margin goals. This is exactly when it is more difficult to sell assets. To give you a sense of the prevalence of this phenomenon, here I'm showing data that highlights how during the depth of the turmoil in early 2020, even as markets were not functioning properly, investors sold significant amounts of assets, including Treasuries, to meet liquidity demands. Between 40-50 percent of liquidity demand was met by selling assets.

Now, let's move to March 2020. Before we look specifically at March 2020, I would like to spend one slide highlighting how we got there. The set-up to the events of March 2020. Here, what happened, basically, is that hedge funds had become, starting from 2017, an important element of the liquidity provision ecosystem for Treasuries, and they were doing so with one of the relative value strategies that I discussed early on. They were buying relatively cheap cash Treasuries, which included a liquidity discount. They were short selling futures, and they were pocketing the difference and leveraging up to enhance returns. They were using leverage acquired through a certain type of repo, which is known as sponsored repo. Essentially, it's a standard repo but it is cleared through a clearing platform so it is more capital efficient. It's something that became fairly popular after 2017. Here you can see a measure of the activity that hedge funds were undertaking in terms of relative value arbitrage. These are positioning in Treasury futures for a variety of intermediaries, and hedge funds are among those shown in the blue line.

You see that from roughly late 2017, early 2018, leveraged investors took increasingly short positions in Treasury futures. This is the short leg of the relative value trade that they put in place and that was providing liquidity to Treasuries. Come March 2020, what happens is that margins increase quite substantially for Treasury futures, but also more generally. Initial margin at CCPs increased between February and March of 2020 by roughly $300 billion. This meant that investors, including hedge funds, started to de-lever, because the level of attainable leverage in the system had gone down. Instead of buying Treasuries, they were closing positions, which means they were selling Treasuries, and they were subtracting from the liquidity in the Treasury market. Importantly, there was a de-leveraging spiral in place, and the de-leveraging spiral comes from the fact that de-leveraging by one investor imposes externalities onto other investors, pushing them to de-lever.

Here, this is the third-to-last slide, I want to show you how rapidly initial margins requested by CCPs increased in March of 2020. This is $300 billion, and this doesn't include variation margins by CCPs, and it doesn't include, obviously, margins from OTC markets. Here you can see some evidence of the de-leveraging that took place in March of 2020. The black line is sponsored repo, which was used not uniquely by hedge funds, but substantially so by hedge funds. You see that it starts to go up in 2017, just when Treasury futures, and the positions of leveraged investors in Treasury futures, start to widen. All of a sudden in early 2020, you see that there is a contraction in sponsored repo of roughly $150 billion in a very short time. This is very significant de-leveraging.

Now, this is the last slide of my presentation. I just want to quickly recap, and then raise a few policy questions. As I mentioned in the paper, we don't want to give answers, but we want to highlight what we think is the direction of discussion in the policy community. NBFIs, the NBFI system, can definitely function as a spare tire for financial markets, and it can increase efficiency and diversity of sourcing in financial markets. At the same time, we do know that NBFIs pose systemic risks. We spent a lot of time thinking about mutual funds over the last 15 years, and that is only one example of systemic risk. Systemic risk, by definition, calls for a macroprudential perspective. When it comes to the specific focus of this paper, again let me highlight that the mechanism we focused on is margins, de-leveraging, and a cascade onto liquidity in a variety of markets. When it comes to dealing with excessive fluctuations in leverage, one solution is to think about maybe limiting the variability of leverage, maybe limiting the variability of margins, putting a floor on margins.

This is one of several potential solutions that can be thought of. There is obviously space for a micro prudential angle, like increasing liquidity buffers at intermediaries that can generate spikes in liquidity demand. There is the macroprudential angle. I mentioned one example of possible actions. Eventually, we also need to work through what role central banks are going to have, and what it means for any possible regulations of the NBFI financial system. Once you put in place macroprudential precautions, once you have macroprudential tools in use, there is still the possibility that in some states central banks might need to come in as dealers of last resort, and what balance do we want to strike? It is definitely important to ensure that liquidity remains robust in the NBFI financial system, in good times and in bad times, for the simple reason that liquidity is needed for the NBFI system to work properly. At the same time, we need to make sure that the presence of backstops, implicit or explicit, doesn't lead to moral hazard, which in itself has been in the past a source of boom-and-bust cycles in financial markets. Thank you.

Wall: Thank you. Following Sirio's example, I should have done a little bit more of an introduction. The biographies are available online, but he is a principal economist at the Federal Reserve Board, and before that was at the Bank for International Settlements. The discussant will be Valentina Bruno, who is a Kogod Research Professor at American University.

Valentina Bruno: Thank you, Larry. Good morning. It's a great pleasure to be here. Thank you to the organizers for inviting me—thank you, Camelia—to discuss this great paper by Sirio, Andreas, and Hyun, "Nonbank Financial Intermediaries and Financial Stability." Banks are back in the headlines, but there was another time when banks were in the headlines. Let's take a trip down memory lane to the run-up of the global financial crisis.

This is the Sutyagin House in Arkhangelsk, Russia, which was considered to be the tallest wooden building in the world when it was finished. As you can see from its multi-layered structure, the builder added the new floors on the existing structure as construction progressed. Then there is the turret on top as the final flourish of the builder on top of an already precarious building. This is how you can think about leverage, and the analogy is that of a building and its foundation. In the case of banks, equity is the foundation and leverage is the height of the building. The taller the building, the higher the leverage and the greater the lending done by banks. The turret, you can think about was like one of those synthetic CDOs that the banks add in their balance sheets. This is what happens when financial conditions are loose, and this is what happens when financial conditions are tightened. This picture is from 2008, when the Sutyagin House was condemned to be a fire risk, so the top floors were dismantled. The analogy is that during the downturn, when banks started deleveraging and cutting down the credit supply, in other words it's like reducing the size of the building. The paper that Sirio presented, this is what it is about. It's about leverage in a systemic context. The eventual fate of the Sutyagin House, if you want, is a parable for excessive leverage. After the top floors were dismantled in 2008, eventually the building burned down in a fire in 2012.

The second message of the paper is about the dual role of prices. This is the Millennium Bridge in London. In June of 2000, Queen Elizabeth II inaugurated the bridge. Within moments, the bridge started wobbling and moving sideways, so that authorities had to close it almost immediately. You can still see the videos from the BBC on YouTube when they were interviewing the engineers and they couldn't understand at first what was going on. One engineer said, "Well, we don't understand. It's not that we divided by four instead of dividing by two." The Millennium Bridge has become a metaphor for systemic risk. At the gust of the wind, the bridge started moving sideways and wobbles. When this happened, the pedestrians adjusted their stance to regain balance. By doing so, the bridge moved even more. That was causing the pedestrians to adjust their balance yet again and causing the bridge to move yet again. You can think about a shock, an external shock, that gets then amplified within the system.

What does that have to do with financial markets? Think about pedestrians on the Millennium Bridge as traders reacting to price changes, and the movement of the bridge as price moves within the financial markets. Under the right conditions, price changes will elicit reactions from the traders, which will move prices, which will further elicit reactions from the traders, and so on. In other words, prices have a dual role. They are the reflections of fundamentals, but they are also an imperative to action. This is what I think is the leitmotiv in the paper by Sirio, Andreas, and Hyun, which can be summarized by the following quote:

"The received wisdom is that risk increases in recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions."

Essentially, the action-inducing nature of market prices are the most dramatic during the crisis episodes because they are in front of the cameras. They are the most damaging in boom times because it's when they are building up. Hyun and I have another model that looks at the fluctuation of leverage in the value-at-risk framework, which we call the financial channel of exchange rates. The financial channel of exchange rates works through shifts in the effective credit faced by banks that found themselves in the wholesale funding market and lend to local borrowers with a currency mismatch. Where local currency appreciates, local borrowers' balance sheets look stronger. Credit risk goes down, and this generates expanded lending capacity to the value-at-risk constraint, thus inducing more risk-taking buybacks.

As always in research, things get interesting during a downturn. When the wheel turns and the dollar gets stronger, then credit risk goes up and banks start de-leveraging and cutting credit supply. Broker-dealers are an example of how leverage, how debt, was used to finance the growth of assets. It is true that after the global financial crisis, as Sirio also explained, broker-dealers have a smaller half in the system, also due to regulatory constraints and changes in the business model. However, risk doesn't disappear. Risk is like a virus that mutates. It evolves and migrates somewhere, elsewhere. In the rest of my discussion, I will focus on three episodes. The first one will have the hedge funds at the center of it, as Sirio said, and it's about the dash for cash. I will look at the pension funds and the stress in the UK gilt markets of last year. Finally, I will look at the mutual funds and what's going on in local currency sovereign debt. Three very different episodes, three different contexts, but you will see there is one common risk. The ongoing risk is about market risk, where there are the ongoing vulnerabilities in financial markets.

This chart shows the leveraged positions in Treasury future markets, and as you can see, since 2018 some investors have increased their positions in some government funds to seek to arbitrage the difference in the basis trade. These leveraged positions reached a peak in September 2019, and after that we have seen the progressing de-leveraging. The business trade came undone in March of 2020 during the dash for cash, but you also see that small dip in September 2019 corresponding to the peak of the leveraged position. Something that the BIS bulletin defined as being a canary in the coal mine for the March 2020 turmoil.

Investors can achieve this high leverage because the collateral value of Treasury securities is normally high. Think about how you can borrow $99 by pledging $100 worth of Treasury, and you just need the $1 of your own funds to hold the Treasuries worth $100, essentially reaching a hundredfold for leverage. The problem is when the funds cannot meet their margins, and everything turns into a margin spiral, like when Russia defaulted, volatility picked up, and margins surged. LTCM was no longer able to meet the margin calls. If you think about it, this is exactly the wobble of the Millennium Bridge as the initial gust of wind got amplified by the reactions of the pedestrians. By the way, the CFTC on Friday released new data on these leveraged positions. Take a look. It's the same old story again. We are back to September 2019, where there has been a huge increase in the leveraged positions, if not worse than September '19.

Another example that the price is imperative to action is from last year, in the UK. As you know, pension funds bought derivatives as part of their liability-driven investment strategy. When UK gilt prices fell, they were unable to satisfy the margin calls, so they had to post more collateral. They sold more gilts, which draws prices further down and generates more margin calls. This chart is from a working paper from the Bank of England by Gabor Pinter. On the left-hand side, you see where the outflows were concentrated, and it's the gold line and the pink line. The outflows were concentrated into the longer maturities of nominal government bonds, above 10 years of maturity, not in the short-term maturities. If you want, this was an appetizer for what would happen a few months later with SVB. Now, very different episodes, different contexts, but the common theme is not about currency mismatches, it's not about maturity mismatches, it's about market risk, which might take the form of duration risk or interest rate risk. The right-hand side panel shows us that this time it's the pension funds that were the bad guys.

I will conclude by zooming into the mutual funds sector. This chart shows the outstanding market value of sovereign debt, denominated in local currency, in 16 major emerging markets' economies. These are holdings by US investors, divided in several categories: mutual funds, that's the gray color, pension funds in brown, the insurance sector, the very small orange line, and then in black you have all the others, like banks, hedge funds, broker-dealers, and all the other potential investors. The year 2012 was the high mark for the US holdings in local currency debt, and we have seen a progressive decrease since then. Here, the message comes from the gray color. It's the mutual funds that are the main actors at play in this specific market.

What happened in March 2020? This chart shows the net purchases, or sales, by US investors in these local currency bond markets. Specifically, countries are divided into two groups: countries where US investors hold mostly dollar-denominated debt, that's the green line, the green color, and countries where US investors hold mostly local currency-denominated debt, that's the pink and the red color. As you can see it is the latter group of countries that saw the largest outflows, the local currency debt, contrary to the wisdom that the dollar-denominated debt is the source of vulnerabilities for emerging countries. Within these countries, the outflows were concentrated into the longer maturities, and that's the dark red color. Essentially, US investors sold local currency debt, and they sold longer-maturity local currency debt. The message is the following, here: Countries can mitigate the rollover risk by issuing longer-maturity bonds, but the risk doesn't disappear into cyberspace. It's just passed, in this case, onto the investor side, that are now subject to greater duration risk.

Let me conclude. Yesterday in the keynote speech, Lord Mervyn King reminded us of the importance of the models, concurrently with looking outside the window and seeing the narrative, the ongoing narrative that is happening. The paper by Sirio, Andreas, and Hyun is telling us that there is a lot going on outside of the window, which we have to consider when applying the models. For instance, we teach our MBA students that we can increase leverage by reducing equity, but Sirio, Andreas, and Hyun have been telling us about the power of leverage and how leverage enables greater leverage. The attention has shifted from credit/default risk to price risk, which is also happening in the presence of safe assets. You don't need to have actual default in the mechanism. You can capture this with the motto, "you should never try to catch a falling knife." Risk has shifted from the banking sector to the nonbanking sector, and currently is coming back again to the banking sector, but it's a different type of risk. It's not about currency or maturity mismatches. It's about market and duration risk. The paper is about, really, this dual role of prices. As we saw, when central banks hit the brakes, someone flies out the window. I'm going to stop here. Thank you.

Wall: Okay. First, one quick observation, based on Valentina's presentation: the discussion of original sin reminded me that the way in which the relative roles of banks and nonbanks are affected isn't just ex ante regulation, but also ex post action. Post the LDC debt crisis, the banks learned that they could be leaned on if they were holding foreign debt, and so a lot of the activity shifted to bonds and people that couldn't be so easily leaned on. Similarly, post the global financial crisis, fines for some very bad mortgage practices were imposed on banks, whose only role was that they acquired one of the parties that was committing the problem. The banks said, "Okay, we're going to step back, and we'll leave it to the nonbanks to provide the service."

There have been several questions. I'm going to start with a couple of more technical ones related to the paper, and then we'll step back and deal with some bigger policy issues. One question from Adam is: Are you correcting for the post-GFC structural change of the large banks? Merrill Lynch, Morgan Stanley, and Goldman all either becoming part of a bank or getting bank holding company overlay on the regulatory side, and access to the window?

Aramonte: Let me think about that. I would say that access to the discount window is something that ... it doesn't seem to happen very often in practice, because of the stigma that is attached to the discount window. In that sense, it may have less of a pull on liquidity supply also, on the NBFI side, than theory would suggest.

Wall: A question per se, or really more of a comment, but we can turn this into a question. The variation margin flows were orders of magnitude bigger than the initial margin increases in March 2020. Their relative impacts were higher on the dash for cash, so making initial margin models less procyclical would not have helped, or would it?

Aramonte: Yes. When it comes to variation margin, I mentioned them in the discussion, the focus is on initial margins because initial margins are what gets liquidity into the NBFI system from outside of the NBFI system. When it comes to variation margins, they tend to be a reshuffling of liquidity positions within the NBFI system, because it's basically liquidity going from somebody who's already part of a trade to somebody who's already part of a trade. Now, it's not really neutral in the sense that it depends on how financially constrained the parties to a transaction are, but we decided to focus on the initial margin perspective because we wanted to focus on how the NBFI sector can absorb liquidity from outside of its confines.

Wall: Okay. Moving on to some bigger policy issues, there are two related questions. One is, what do you see as the most material risks to liquidity and repo markets, and what would be the impact on NBFIs and banks? Ten there's a more focused question on the implications of the US failing to raise the debt ceiling. This is coming from John: What would be the implications for posting collateral and borrowing capacity for NBFIs in the functioning of markets?

Aramonte: I can say that I wouldn't be surprised if the value of the collateral ... we know that government paper expiring in the window that is relevant for a potential debt ceiling issue, the value of the collateral is down, is lower than it would have been otherwise. That would be something that naturally feeds into the leverage capacity discussion.

Bruno: Larry, if I can add to Sirio.

Wall: Please.

Bruno: The latest data that the CFTC released on Friday seems to be quite worrying on that side, because the leveraged positions have increased dramatically, betting that the rates will fall. If not, then it's going to be again, history repeating of March 2020.

Wall: Thank you for that reassuring note. [laughter] A bigger philosophical-economic question arises when you're talking about the relative value trades that we saw, because those were intended to enforce a law of one price across different markets. Because they were not pure arbitrage, there was some risk being generated there. How should we feel about the importance of being able to enforce a law of one price, versus the risks that might be being created in the process of doing so?

Aramonte: That's a very interesting question. From my perspective, I would say that it's nice to have the law of one price hold, but it's good to have it hold all the time, instead of just in good times.

Wall: If NBFIs can improve market functioning, then they have to become more countercyclical. How do we set up the incentives for them to become more countercyclical, and how do these incentives feed into the risk premia then, for nonbank finance?

Aramonte: I would say that countercyclicality, to be able to happen, it's important that NBFIs are able to harvest the risk premium, which tends to decompress during volatile times. To be able to harvest the risk premium, they need to be able to have the balance sheet capacity. We always go back to the same issue that, unless there is leeway, unless there is balance sheet capacity, deviation from fair value is going to stay there. The question then is how do we ensure that they have balance sheet capacity at all times?

Wall: The answer is?

Aramonte: The answer is for policymakers to come together and decide.

Wall: Some sort of countercyclical requirements?

Aramonte: There are different ways in which that can happen, and at the end of the day, everything is about trade-offs. I wasn't being facetious when saying that policymakers have to come together to decide, because we need to decide on the objective. We need to understand what the options are for getting there, and then we need to decide, society at large needs to decide, what is the optimal way. There is a utility function behind how we get there, so it depends.

Wall: Following up with a question that's pointing at a particular issue: There are already anti-procyclicality expectations for CCP margins. How should we determine when they are sufficiently anti-procyclical? A quantitative question.

Aramonte: There are two elements to that question. One is, in terms of empirical analysis, to assess what is the extent of countercyclicality that those provisions can generate in margins? The second, going back to the societal utility function perspective, we need to figure out what is the point that we are comfortable with, in terms of countercyclicality. We might be willing to accept some procyclicality, if it means that we use means to get there that we are comfortable with. I'm not trying to evade the question, but it is a set of trade-offs, and the answer depends on what the weight is that we put on different elements.

Wall: You're going to duck the question of what sort of weights you would put? [laughter]

Aramonte: We'll see.

Wall: Okay. Question from Pete: Banks are not the liquidity providers they used to be, partially due to unintended consequences of regulation. How could the gap be filled? Change regulation again to bring banks back, other private sector actors, or the central bank, or...?

Aramonte: There was a bullet point in the first slide that I didn't go over because of time, but this is an important question. The answer, in my opinion, and actually there is quite a bit of literature explaining why banks retrenched, starting from the '70s. We are talking about secular forces that have shaped the banking system and opened the way for the NBFI system. Here, I am talking about technological innovation that made it possible for banks to focus on achieving economies of scale through, for instance, automated credit scoring systems, which puts a premium on borrowers that are easily scorable, basically. Then the question is, what happens to borrowers that are maybe smaller companies that don't really fit the mold? There we open another item for discussion, which is private markets, and private credit in particular.

The second point that is very relevant here is that back in the day, governments used to do a lot of consumption smoothing, pensions, education. Actually, we are at a place where a lot of retirement funding and education funding comes from private savings, which means that by market forces over time, basically, it became attractive for companies to issue corporate bonds that are bought by mutual funds instead of getting a bank loan, because the corporate bond is bought by mutual funds because I have to fund my retirement. There is an element for regulation, but we shouldn't just say that NBFIs are here because of bank regulation. There is a lot of change in the market structure of the banking sector that led us here, and these changes came from secular forces.

Wall: Okay. I'll conclude with one last question, from Timothy: The returns from Treasury bond arbitrage strategies come from both pure price arbitrage and an option premium arising from selling the cheapest-to-deliver option embedded in the futures. Do you have a view as to the relative size and policy implications of these two?

Aramonte: I agree that there is an element of that. I don't have an answer in terms of the relative weight, but definitely, I do think that that played a role, yes.

Wall: Okay. Any more comments that either of you would like to make?

Bruno: We have to remain vigilant. There are many tripwires here and there, and we have to remain vigilant because anything ... it's the complexity, as we discussed yesterday in the previous session. It's huge. A lot of tripwires here and there.

Wall: Well, with that, I'll say thank you, Sirio. Thank you, Valentina.

Aramonte: Thanks so much.

Bruno: You're welcome.

Wall: Lunch is next, and we reconvene at 1:30.