The idea that liquidity demand follows real economic rhythms is not new.
Long before modern reserve forecasts, the Bank of England monitored maritime trade as an informal early-warning system for funding pressure. Clerks in the Discount Office watched the weather vane atop the Bank itself, its direction indicating whether ships were entering the Thames on a favorable wind.
A sudden forest of masts on the river meant imports were arriving, merchants would soon need credit to settle their bills, and customs revenues would soon flow into the Exchequer. Trade, liquidity demand, and fiscal receipts moved in sync, and the physical movement of goods provided a real-time signal of how much short-term money the system would require. The principle was simple: liquidity needs were continuous, variable, and closely tied to the pace of real economic activity in London, even if the instruments of the time could only respond imperfectly.
It was the Bank of England’s job to assess the business conditions of the day and dispense liquidity accordingly.
Today, markets possess the technological capacity to discover the price of liquidity continuously rather than in overnight intervals. This is a good thing, since trade and settlement increasingly occur in real time, meaning liquidity demands can fluctuate rapidly and unexpectedly by the minute, posing risks for banks without access to extremely short-term funding loans.
Yet, for unknown reasons — possibly an ongoing nostalgic attachment to the old way of doing things — the financial system is still structured around the pricing of unsecured interbank liquidity on overnight terms.
The Federal Funds rate has historically acted as the central reference point for price discovery in overnight dollar liquidity, anchoring conditions at the shortest end of the money market.
And yet, this rate has never been less useful than it is today. To understand why, one must look at the evolution of the funding market since 2008.
For most of the Federal Reserve’s history, the Fed Funds rate represented the closest thing to a true market-clearing price for unsecured money. This is because, before 2008, the Federal Reserve operated a scarce-reserve regime that required banks to meet key reserve requirements on a daily basis in order to be backstopped by the Fed. The Fed conducted monetary policy by influencing the price of those reserves — and via that the price of money — by adding or draining supply through open-market operations until the overnight rate aligned with its target. Scarcity made the mechanism work, and the federal funds market faithfully reflected real liquidity conditions in the banking system.
But those in the know know that the federal funds rate’s relevance as a market-clearing mechanism has been diminishing ever since the global financial crisis forced the Fed to flood the financial system with liquidity, thereby collapsing its ability to play any price-discovery role at all.
By flooding the banking system with liquidity, quantitative easing eliminated the structural shortage of reserves that had once driven unsecured interbank lending. Banks no longer needed to borrow reserves from one another in the same way, and when funding needs did arise they were increasingly met in secured markets, where borrowing against collateral was cheaper, safer, and more compatible with the new regulatory environment.
At the same time, regulators discouraged unsecured lending more broadly, having concluded that confidence-based funding markets had been a major channel of contagion during the crisis. Liquidity rules, leverage ratios, and capital requirements all reinforced the preference for high-quality liquid assets and collateralized borrowing.
But this transformation also created a new challenge for the Fed. With reserves abundant, the central bank could no longer rely on scarcity to control short-term interest rates.
Yet, without intervention, excess liquidity risked pushing money-market rates toward zero or below, especially in repo markets where collateral constraints and balance-sheet costs could drive funding rates sharply lower.
The Fed’s immediate solution was to pay interest on reserves, giving banks a risk-free alternative to lending cash at ever-lower yields. This new “administered” rather than market-based rate placed a floor under money-market rates and ensured that holding reserves at the Fed remained commercially viable.
By 2013, however, it became evident that secured rates — as reflected in repo rates — were not necessarily falling in line with such policy tools. On the contrary, repo rates had started somewhat embarrassingly to pierce through the zero bound.
The Fed realised it would have to engage directly in secured markets to prevent what had become a key price discovery arena for dollar liquidity from running ahead of policy and making a mockery of its rate target.
Its response came in the shape of two key facilities. First, the overnight Reverse Repo Facility, introduced in 2013, which sought to put a floor on repo rates by providing money market funds with somewhere to park their excess liquidity at a positive rate of return. Second, the Standing Repo Facility, made permanent in 2021, which sought to do the opposite: cap repo rates.
Both facilities, to this day, rely on administered rather than market-determined rates. Both are also primarily aimed at stabilizing overnight funding conditions rather than addressing intraday liquidity dynamics.
The liquidity is here, it’s just badly distributed
But dollar liquidity was also evolving in other, more challenging ways for financial institutions over this period.
In theory, the system boasted ample liquidity, yet oftentimes, it did not flow frictionlessly throughout the system. Instead, much of the excess liquidity created through quantitative easing appeared to accumulate on the balance sheets of the strongest institutions, such as JPMorgan, while weaker banks and nonbanks were forced to compete for collateral and funding capacity on a daily basis. As a result, the marginal cost of liquidity was increasingly being determined in secured markets such as repo and FX swaps.
At the same time, the nature of funding was also changing. Payments were settling faster, global dollar flows were moving continuously across time zones, and banks were increasingly managing liquidity in near real time rather than in discrete overnight intervals. Intraday funding — once a secondary operational concern — was slowly becoming a central feature of the system, because institutions increasingly had to source and deploy liquidity continuously to keep payments, securities settlement, and cross-currency flows moving.
Overall, while liquidity was increasingly being distributed on a secured basis, the market structure was becoming more disintermediated and more real-time, introducing new risks.
Taken together, these developments gave rise to a new range of liquidity-management challenges for banks, particularly regarding the timing of cash and collateral flows within the day.
Perhaps the clearest illustration of these pressures was the growing sensitivity of repo and sponsored repo markets to the size of the Federal Reserve’s balance sheet, a fact that revealed itself most acutely with the repo rate shock of 2019.
The Fed responded to the blowout by initiating large-scale repo operations to temper the chaos. These operations would eventually pave the way for the establishment of the Standing Repo Facility as a permanent backstop in 2021. The shift in focus to repo rates, however, would finally seal the fate of the Federal Funds market as a growing irrelevance. Rather than reflecting broad funding conditions, the market now primarily served as an arbitrage channel between institutions that can earn interest on reserves and those that cannot, such as government-sponsored enterprises.
That meant the rate had become less a market signal and more a by-product of the Fed’s new administered framework, also known as the “corridor system”.
The important point here is that this framework — wherein the lower bound is anchored by the rate paid on reserves and reinforced by the overnight reverse repo facility, while the upper bound is enforced through lending facilities such as the standing repo facility, and in periods of stress, the discount window — was now far more concerned with steering repo rates than Fed Funds.
Both the Fed and the market seemingly realised around the same time that the health of the financial system was now far more intimately tied to the stability of the repo market, than the cost of reserve balances sitting passively at the central bank.
That same year, 2019, JPMorgan would begin exploring intraday repo as a means for managing the growing divergence between intraday and overnight liquidity conditions (and the risks associated with those fluctuations).
There was, however, one major problem with the resulting corridor setup for the Fed. It required unrestricted access to U.S. Treasury bills and bonds, thereby making it even more difficult for the Fed to reduce the size of its balance sheet while simultaneously entangling monetary policy with fiscal policy to an ever greater extent.
The problem with fiscal dominance
Today, economists and academics rarely dispute that maintaining an indefinitely large Federal Reserve balance sheet can impose crippling long-term costs on U.S. taxpayers and become a fiscal constraint — especially in periods when economic conditions call for tight monetary policy.
This is the key reason why incoming Fed Chair Kevin Warsh is intent on reducing the Fed’s balance sheet as soon as possible. He considers an ample reserve regime a significant constraint on independent monetary policy. He also believes such a framework engenders an environment where the Fed increasingly must play second fiddle to the U.S. Treasury.
As Warsh noted in a speech last year: “The line between the central bank and the ostensible fiscal authority has grown harder to identify. The spirit of Treasury-Federal Reserve accord of 1951 is at odds with recent practice.”
But reducing the Fed’s balance sheet poses its own challenges. Economists Stephen Cecchetti and Kim Schoenholtz argued this week that, in practice, meaningful shrinkage is difficult to achieve because banks can replace lost reserves by borrowing through the standing repo facility. As they pointed out on FT Alphaville, “banks would simply borrow there to obtain the reserves they desire, frustrating any effort to constrain the balance sheet.”
Nor is eliminating the SRF a realistic option. Doing so, they argue, would “remove any cap on short-term rates — with potentially devastating consequences for the supply of credit and financial stability.”
Cecchetti and Schoenholtz do not deny that a large central-bank balance sheet carries costs. In their view, it “facilitates government financing in ways that risk fiscal dominance and distorts the functioning of financial markets.” Their argument is instead a comparative one: the alternative—“frequent, unpredictable spikes in money market rates that undermine banks’ willingness to extend credit and endanger financial stability”—would be even worse.
But this perspective lacks vision.
Today, most policy tools remain oriented around overnight conditions, even as the system is increasingly governed by real-time liquidity constraints. Once a viable market for intraday funds is established, price discovery can probably be relied on to restore equilibrium fluidly on a day-to-day basis.
Administered floors and ceilings anchor expectations, but they cannot fully reveal the intraday price of liquidity or impose a hard budget constraint on its provision, the way the Fed Funds market used to.
While it is true that the Fed has experimented with adjusting the timing of SRF operations, including offering morning windows in addition to the traditional afternoon auctions, to make the facility more responsive to funding pressures as they emerge, it still remains an administered rate geared primarily toward overnight liquidity.
Under such a structure, when imbalances arise, central-bank facilities tend to absorb them mechanically rather than allowing prices to adjust and ration liquidity in real time.
This may be tolerable if the Fed balance sheet remains small, but it becomes far more problematic when repeated interventions translate into a permanently expanded balance sheet, imposing lasting costs on taxpayers and constraining monetary independence.
Cecchetti and Schoenholtz do not appear troubled by such externalities. They prefer that the Fed prioritizes repo market stability at any cost, arguing that a prudent chair should be guided by the practical realities of how banks and financial markets operate.
However, there are other realities that should also be confronted. For example, soft budget constraints have a well-documented tendency to generate real economy shortages and, ultimately, inflation. History also shows that markets, left to their own devices, eventually identify and arbitrage away mispriced subsidies — often abruptly and at an even higher cost to taxpayers, if not systems outright.
Indeed, even academics, among them Rodney Garratt, agree that reasserting a market-based clearing price for money is essential to avoiding a broader economic breakdown. Moreover, if the Fed does not allow such a price to emerge, you can be sure the private sector — probably by way of new-fangled crypto markets — will eventually discover a way to do it regardless.
Hence, why recent commercial developments in crypto markets related to perpetual FX swaps are so interesting.
Quo vadis?
The central bank can still define a broad corridor for interest rates, but the intraday dynamics that discipline balance sheets and reveal stress would in such a system be governed more by markets, and pre-collateralized liquidity (such as stablecoins) than by administrative decree.
Today, stablecoins arguably represent a type of pre-collateralized liquidity that is particularly suitable for aiding intraday price discovery in FX swaps markets.
If it emerges, such a framework would represent a profound shift to the existing paradigm. The effective federal funds rate would no longer be a narrow benchmark derived from a thin unsecured market, but a broader, continuously discovered price emerging from collateralized transactions and real-time liquidity flows.
In practical terms, Treasury or stablecoin collateral, rather than central-bank overdrafts, would play a larger role in anchoring the system.
Whether this outcome would be preferable to the current regime remains an open question. Administered backstops provide stability and predictability, and they reduce the risk of sudden funding crises.
Yet they also obscure the true cost of liquidity and shift part of the burden of volatility onto the public sector. As global dollar funding needs grow larger, faster, and more erratic, the gap between the policy rate that dominates public discourse and the market prices that actually govern liquidity may continue to widen. The federal funds rate, once the definitive price of money, increasingly serves as a reference point—while the real price of dollars is discovered elsewhere, and increasingly, throughout the day rather than only overnight.
Related links:
Why ‘perps’ could be the next big thing after stablecoins — The Peg
Perpetual futures, explained — Bits about Money
The Fed’s quiet pivot to servicing intraday liquidity — and why it matters — The Blind Spot
LONG READ: The untold story of how crypto’s hottest derivative came to be — The Peg
IMPORTANT The Uber surge pricing model really is coming to liquidity markets — The Blind Spot
