When it became apparent this week that LDI entities, such as insurers and pension funds, would need a large chunk of cash very quickly so as to not default on hedges… how do you think the story went down in money markets?
Because, yes, defaulting on counterparts is bad. But in a cleared system, the real issue facing markets this week wasn’t really a solvency one. All these entities seemingly had the assets on hand to be able to maintain their hedges. What they lacked were enough private counterparts in the system to monetise their assets in a way that wouldn’t create insane aberrations in gilt pricing. The thing there was a shortage of was temporary intraday liquidity.
One reason for that could have been a sudden breakdown in market confidence about the quality of gilts. Sure.
But another totally underreported reason could also have been a lack of spare intraday funding on a purely technical level to absorb this scale of liquidity operation in such a small amount of time.
The merry-go-round of counterparts and banks capable of acquiring such assets may, in other words, have encountered bottlenecks linked to the system not being able to square off those with positive liquidity balances against those with negative ones quickly enough. If the stars didn’t align in the world of intraday funding – no matter how solvent and capable of raising cash these entities were – they would not have been able to raise the money quickly enough.
That doesn’t mean the system was bust though as much as poorly designed.
A key reason for that may have been down to the very simple fact that the system still lacks any efficient price discovery mechanism for intraday funding.
Where’s Your Intraday Funding Signal?
As it stands, intraday funding prices have to be determined on a somewhat opaque bilateral interbank basis. Since there is no real-time price signal to respond to when imbalances strike, that means it doesn’t take too much of an unexpected imbalance to court fears of liquidity shortages passing through into the more stigmatised overnight emergency lending windows.
In such circumstances, there is often no other choice but for the Bank of England (or any other central bank) to intervene through conventional open market operations or through the provision of daylight overdrafts. This is an important point missed by the market this week. Before quantitative easing publicly equated open market operations with money printing, these sorts of technical operations focused on smoothing out short-term irregularities (while smaller scale) were often seen as routine and nothing to panic about.
In a recent Bloomberg opinion piece, I predicted that higher interest rates and quantitative tightening could lead to intraday funding issues.
I also predicted there was a high risk that the tapping of central bank daylight overdrafts when such imbalances appear could be misinterpreted as a system breakdown. (Though I failed to predict that the same stigma could impact open market operation efforts by central banks to ease temporary aberrations.)
The best way to deal with these stigmas, I argued, was for intraday funding markets to develop an Uber surge pricing mechanism to help them through periods of intraday funding market stress without having to resort to additional QE-generated liquidity buffers.
Without such a mechanism I am convinced that what happened this week will happen again. This is even more likely if we continue to combat inflation by raising interest rates and absorbing unnecessary spare liquidity from the system with quantitative tightening.
The Uber surge pricing analogy
What happened this week was the equivalent of a decentralised taxi market (in which the market is served by many independent providers) suddenly being faced with an unexpected stadium-scale event of user demand.
In the world of Uber taxis, that sort of sudden unexpected demand is usually dealt with by an immediate surge-pricing signal to the market. This incentivises spare capacity from all across the system to respond to the bottleneck.
In the world of central banking, however, there is no equivalent price signal. Even if the liquidity is out there, it has no incentive to come to the rescue. Instead, the equivalent of a last-minute deal has to be struck with a more centralised player – a hypothetical Black cab Union of last resort — with the means to rent out its otherwise idled capacity in a haphazard and clunky way.
That’s what happened this week.
The good news is, it might not have to happen again because fintech innovations are finally dealing with this issue are on hand. More on that in the next post.
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