The Silent Monetary Revolution

The most significant shift in global finance has been playing out behind the scenes: The power to price trillions of dollars in financial assets, once held by bankers, is almost in the hands of the Federal Reserve. Now, its powers are set to increase.

A lengthy attempt to eradicate risk from the global financial system, by both monetary authorities and major financial actors, is approaching its climax. What began as a panic reaction to the 2008 subprime crisis has transformed the way financial entities do business. The GFC (Great Financial Crisis) was a crucial turning point in how banks perceived risk. After decades of working on the flawed assumption that an ecosystem built on stark complexity had grown indestructible, they changed their perspective.

No longer believing in the fiction that lending between banks had become riskless, they saw a system fraught with peril. The major flaw of finance, where protection turns into the very thing that prompts a meltdown, had even threatened the most systemically important benchmark. In August 2007, as the subprime crisis began to unfold, the most critical interest rate globally had detached from its counterparts, the same number used to price well over $300 trillion in financial products: the London Interbank Offered Rate, known as LIBOR.

The rate that the world relied on to price everything, from business loans and securitizations to adjustable-rate mortgages and private student loans, had gone haywire. But this shouldn’t have come as a surprise. It’s just that everyone had dismissed LIBOR’s dubious origins.

It all began after the U.S. promoted globalization, post-WWII. In the 1950s, London grew into a global financial hub, since U.K. banks had the most freedom to finance prohibited dollar transactions. The Bank of England found out, but penalizing the bankers for mischief meant curbing global commerce.

Under the security pact America signed with almost every other nation, the financial behemoths quickly took advantage. The U.S. banks set up branches not just in the U.K. but worldwide, while non-U.S. banks set up branches in America. Hot money flowed into U.K. banks from other major powers. Among them were America’s main rivals (Russia, China, and many Arab states), who chose to keep their dollars outside America for political reasons, mostly out of fear that their funds could be frozen. As a result, financial alchemy flourished.

By the 1960s, we saw the rise of a fully-fledged, offshore dollar system: the Eurodollar. Not the FX pair, but the machine that enabled dollar banking outside America’s shores. Even before the Petrodollar was coined, the U.S. dollar’s global reserve status was assured.

As the Eurodollar trade started gaining momentum, a financier named Minos Zombanakis stumbled upon a similar opportunity. By avoiding U.S. financial regulation and writing cross-border loans, he could profit by lending huge amounts of money to entities needing U.S. dollars. After setting up a U.K. branch and quickly gaining a reputation as an international banker, he somehow became friendly with Iran’s central bank governor. The Shah of Iran was looking for an $80 million loan but needed various banks to diversify the risk of such a large sum.

Zombanakis delivered, securing funds from various banks worldwide. But he also created a unique structure for the terms of the loan. The Iranians were charged a rate calculated every few months using the average of these banks’ funding costs, plus a spread. He dubbed it: the London Interbank Offered Rate.

This exotic new financial structure, however, would not only set the scene for LIBOR to become a benchmark for interest rates, but for the birth of a myriad of elaborate financial instruments and markets, most of which became primary cogs in today’s financial machinery. Fast forward to the 1970s, and markets for these financial instruments, from forward rate agreements (FRA) to interest rate swaps (IRS), had skyrocketed in size and volume. Helping to price billions of dollars of these derivatives was — none other than — Zombanakis’s LIBOR.

By the 1990s, LIBOR had grown globally into the official standard for interest rates. A lobbying group called the BBA (British Bankers Association) had worked with the Bank of England to select a panel of banks that would report lending rates, which were then adjusted to prevent foul play.

As the subprime crisis hit our TV screens in the 21st century, LIBOR was helping to set interest rates worldwide on trillions worth of mortgages, loans, and derivatives. Yet, the financial crisis spelled the beginning of the end for LIBOR. Not only had the rate gone haywire (as aforementioned) but the panel banks began to understate their submissions, in order to appear more financially sound to their counterparties.

The shenanigans didn’t stop there. A few years later, another cheating scandal was unveiled. Despite prior warnings from insiders and whistleblowers, traders at the panel banks were allowed to manipulate LIBOR, generating huge profits. They could under-report or over-report the interest rates they submitted, earning millions of dollars from a mere 1-basis-point “error”.

After the scandal was revealed, monetary authorities finally took action: LIBOR had to be eliminated. But because of the perceived risk in a time of uncertainty, the major banks agreed. They even began working in tandem with regulators to reduce systemic risk. Banks now despised the idea of loaning money to each other on an unsecured basis, exactly what LIBOR was trying to estimate. They realized it was wiser to lend securely against safe assets, especially those backed by entities — say, the Fed — that would rescue them whenever turmoil emerged.

In 2017, after a few years of indecision, LIBOR’s successor was chosen. The ARRC (Alternative Reference Rate Committee), a coalition between market participants and the Federal Reserve, endorsed SOFR (the Secured Overnight Financing Rate) as LIBOR’s replacement. SOFR is a broad measure of the cost of borrowing cash overnight against U.S. Treasuries, an asset that market participants consider to be the most pristine collateral. This type of secured loan is also known as a repurchase agreement, or a “repo” for short.

SOFR is one of many rates that the Fed administers in money markets, which appears complex, but in reality, is just a series of acronyms representing different lending rates on cash.

Subsequently, for years now, we’ve seen finance gravitate more toward the “SOFR standard”. Authorities even caught on to this trend and took advantage. In 2014, they passed changes that discouraged investors from using prime MMFs (money market funds) filled with unsecured debt.

By enabling prime MMFs to impose “gates” on redemptions, and charge investors to redeem during panics, these rules increased the security and utility of government money market funds. In response, investors rushed into state-issued assets.

A few years later, during the COVID market meltdown, investors again pulled their capital from prime MMFs and parked it in government MMFs en masse, without hesitation.

During all this time, the U.S. government has also slowly been ramping up Treasury issuance to about $1-2 trillion per year. The world has been fed an ample supply of its preferred feast, and investors, lured by the security of Treasuries, will likely continue their meal.

What’s more, some Fed officials have recently suggested that QT (quantitative tightening) could last way longer than previously signaled. If so, the private sector will have to absorb even more government paper at a time when it’s already full.

Put differently, QT will transfer trillions of dollars in bonds from the Fed's coffers to private entities. The Treasury market during this process will NOT shrink, only the liquidity in the interbank system and the private sector (fewer bank reserves and fewer bank deposits)...

This will assist the transition to a secured lending standard, which is now almost complete. The UK is embracing its new secured rate known as SONIA. Canada will transition to CORRA, while the Aussies use AONIA. Other countries like Mexico and Singapore have their own rates too.

These (nearly) risk-free rates, known as RFRs, have transformed the trading and hedging behavior of market participants. Bond issuance based on LIBOR has almost evaporated, in favor of the new (nearly) risk-free benchmarks.

Meanwhile, a huge amount of derivatives are already tied to the RFRs. Judging by last year’s activity on the CME, the transition from LIBOR to SOFR has grown irreversible.

Like the epic rise of the options market and how it’s become a major influence on stock prices, the finance world’s appetite for derivatives keeps growing. Since the CME enabled SOFR options trading in May 2022, volumes have surpassed Eurodollar options — LIBOR’s cousin.

It’s no surprise then that SOFR now covers 25% of daily repo volumes, equalling around $1 trillion, while the number of repos traded daily worldwide totals around $4 trillion. The size of the Eurodollar system, meanwhile, has shrunk dramatically.

Still, a few “minor” issues remain unsolved with the secured lending standard. The major problem is it hides systemic risk. During the COVID crash, LIBOR skyrocketed above the Fed Funds rate, echoing stress in the unsecured debt markets. SOFR, meanwhile, failed to show the ensuing turmoil. If a similar scenario arises, monetary leaders must harness the power of other innovations, like Bloomberg’s BSBY index. This index almost perfectly tracked LIBOR during the COVID-19 market panic, allowing leaders to observe financial turmoil, unlike SOFR.

Moreover, $74 trillion of LIBOR loans are estimated to mature after June 30, 2023, when LIBOR is officially repealed. Fallbacks have been implemented but have yet to be stress-tested. Still, there’s no turning back now from the LIBOR transition. We’re stepping into the unknown.

As for the SOFR standard itself, it’s not free of hazards. The prominent risk lies deep in the weeds of the monetary system, with so-called collateral shortages. These are systemic failures of the daisy chains formed in repo markets, which tend to occur during panics.

Market makers, within the limits of regulation and risk appetite, use the same asset to fund multiple trades, known as “rehypothecation”. But this only works for so long. When disorder emerges, as we’ve seen in many recent blowups, these daisy chains begin to unwind. Like in 2008 and 2020, investors will prefer to hoard collateral, refusing to provide the necessary liquidity. Only after the Federal Reserve intervenes will sentiment rekindle.

Ultimately, the price for greater financial security is a stronger linkage between the instruments powering the global monetary system and the powers that oversee them. It’s a trend occurring in almost every area of finance, even in America's sovereign debt market.

Transforming the secondary Treasury market into an all-to-all model, however, is a huge task. Authorities are asking private entities to reveal any dodgy dealings or unfair market practices they could be engaging in. But for regulators, the risks are too large to watch on idly...

The GFC will be remembered as sparking one of the most influential shifts in monetary history. The major financial players went from feeling invincible to incredibly risk-averse, and it’s been the same ever since. Now, only large interventions reignite the global machine.

The age of banks taking excessive risk is over. The new risk takers are the shadow banks, like MMFs and securities dealers. These entities have absorbed most of the emerging hazards, but they are also now heavily supported by U.S Treasuries and other state-issued assets.

Thus, the duty to stabilize the monetary system remains at the sovereign (state) level, but that now comes with increased power and control. The reliance on U.S. government securities to back the majority of loans globally leads to one logical outcome: Since the Fed is becoming the sole entity capable of restoring confidence in a crisis, its powers are not about to diminish but grow. The U.S. central bank’s control over global finance is set to snowball out of control.