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