4. Funding risk
Despite notable volatility in short-term funding markets...
Banks, securities dealers, money market mutual funds (also referred to as money market funds, or MMFs), and other financial market participants lend to and borrow from each other for short periods, typically ranging from overnight to two weeks, against high-quality collateral. These short-term secured loans are known as repurchase agreements (repos). The repo market allows securities dealers to finance their own inventories of Treasury securities or to finance purchases of Treasury securities by levered investors, such as hedge funds. Interest rates on these and other short-term loans among financial institutions spiked in mid-September, and some rates remained relatively elevated through early October.
The pressures in repo markets appeared to be driven by short-lived changes to demand and supply that occurred against a backdrop of increasing Treasury securities outstanding and declining reserves in the banking system. On the demand side, dealers and other investors had increased needs for financing securities following the settlement of Treasury auctions at mid-month. On the supply side, some institutional investors, such as government-only MMFs and banks, may have been less willing to step up repo lending because they experienced cash outflows over a few days as their clients were making corporate tax payments due in mid-September. Both the Treasury debt settlements and the tax payments reduced the amount of reserves in the financial system.
Repo rates started to increase on September 16 and spiked on the morning of September 17. Pressures in the repo market spilled over to other markets, including the federal funds market. The Federal Reserve took a number of steps beginning in mid-September to maintain the federal funds rate within its target range and to ensure an ample supply of reserves. Pressures in short-term funding markets subsequently abated.
. . . vulnerabilities stemming from liquidity and maturity mismatches in the financial sector remain low
The total amount of liabilities that are most vulnerable to runs, including those of nonbanks, increased about 9 percent over the past year to $15 trillion (table 4). Banks rely only modestly on short-term wholesale funding and maintain large amounts of high-quality liquid assets, in part because of liquidity regulations introduced after the financial crisis and the improved understanding by banks of their liquidity risks. MMFs remain less prone to runs than they were before the implementation of the money market reforms.
Table 4. Size of Selected Instruments and Institutions
|Item||Outstanding/total assets (billions of dollars)||Growth, 2018:Q2–2019:Q2 (percent)||Average, annual growth, 1997–2019:Q2 (percent)|
|Total runnable money-like liabilities*||14,733||9.3||4.0|
|Domestic money market funds**||3,192||12.9||2.4|
|Bond mutual funds||4,174||9.0||9.0|
Note: The data extend through 2019:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period.
* Average annual growth is from 2003:Q4 to 2019:Q2.
** Average annual growth is from 2001:Q4 to 2019:Q2.
*** Average annual growth is from 2000:Q4 to 2019:Q2.
Source: Securities and Exchange Commission, Private Funds Statistics; iMoneyNet, Inc., Offshore Money Fund Analyzer; Bloomberg Finance LP; Securities Industry and Financial Markets Association: U.S. Municipal VRDO Update; Risk Management Association, Securities Lending Report; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation: Commercial Paper data; Federal Reserve Board staff calculations based on Investment Company Institute data; Federal Reserve Board, Statistical Release H.6, "Money Stock and Debt Measures" (M3 monetary aggregate); Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States"; Federal Financial Institutions Examination Council, Consolidated Reports of Condition and Income (Call Report); Morningstar, Inc., Morningstar Direct; Moody's Analytics, Inc., CreditView, ABCP Program Index.
Banks maintain high levels of liquid assets and stable funding...
Banks have strong liquidity positions. Holdings of liquid assets at large banks decreased slightly in the second quarter of 2019 as those banks reduced their holdings of reserves, but liquid asset positions continue to exceed regulatory requirements at most large banks (figure 4-1). Meanwhile, short-term wholesale funding—which includes short-term deposits, federal funds purchased, and securities sold under agreements to repurchase—remains at historically low levels (figure 4-2). By contrast, core deposits—the most stable source of funding for banks—stand near historical highs.
. . . and run risk in short-term funding markets has stayed well below the pre-crisis levels...
Money-like liabilities that are prone to runs—an aggregate measure of private short-term debt that can be rapidly withdrawn in times of stress—stand at about 70 percent of GDP (figure 4-3). The growth in runnable liabilities over the past couple of quarters is largely attributable to a surge in repos backed by Treasury securities that in turn is a consequence of the high volume of Treasury issuance that has occurred over this period.
Reforms implemented by the Securities and Exchange Commission in 2016 reduced run risks associated with prime institutional MMFs.12 As the deadline for implementation approached, many investors shifted their holdings from prime MMFs to government MMFs, which hold assets backed by either the U.S. government or government-sponsored enterprises that are less prone to losing value in times of stress. As a result, assets under management at prime MMFs fell from their pre-reform levels of around $1.5 trillion in mid-2015 to $400 billion in the fourth quarter of 2016. However, these assets have been moving up recently, reaching $732 billion in September 2019 (figure 4-4).
. . . but holdings of corporate debt by mutual funds have grown notably in recent years...
U.S. corporate bonds held by mutual funds more than tripled over the past decade, reaching more than $1.5 trillion in the second quarter of 2019 (figure 4-5). Mutual funds are estimated to hold about one-sixth of outstanding corporate bonds and to purchase about one-fifth of newly originated leveraged loans. Total assets under management in high-yield corporate bond mutual funds, which hold primarily riskier corporate bonds, and in bank loan funds have more than doubled over the past decade to about $350 billion (figure 4-6).
The timing mismatch between the ability of investors in open-end bond and bank loan mutual funds to redeem their shares daily and the longer time often required to sell corporate bonds or loans creates conditions that can lead to runs on these funds in times of stress. While bank loan mutual funds continued to experience moderate outflows in 2019, mutual funds have been able to meet those redemptions without significant dislocations to market functioning (figure 4-7).
. . . while liquidity risks at life insurers have remained moderate
Nontraditional liabilities of life insurers—repos, funding-agreement-backed securities, and securities lending cash collateral, all of which suffered runs during the financial crisis, as well as Federal Home Loan Bank advances—have edged up over the past few years but have remained moderate by historical standards (figure 4-8).13
Global Stablecoins and Financial Stability
Stablecoins are a form of cryptocurrency whose value is supposed to be tied to an underlying asset or basket of assets.1 Innovations that foster faster, cheaper, and more inclusive payments could complement existing payment systems and improve consumer welfare if appropriately designed and regulated. However, the possibility for a stablecoin payment network to quickly achieve global scale introduces important challenges and risks related to financial stability, monetary policy, safeguards against money laundering and terrorist financing, and consumer and investor protection.
Stablecoins could become a new medium of exchange...
Price volatility is one of the key problems that has limited the use of early cryptocurrencies as a payment instrument. Extreme fluctuations in the value of bitcoin, for example, have made it a poor medium of exchange; the dollar value of bitcoin might double in a few hours. Stablecoins attempt to address this volatility by seeking to tie their value to an asset (for example, domestic currency) or a basket of assets (for example, a portfolio of sovereign currencies). Stablecoin initiatives that are built on existing large and cross-border customer networks, such as Facebook's Libra, have the potential to rapidly achieve widespread adoption. These initiatives are referred to as "global stablecoins."
. . . but, if poorly designed and unregulated, could negatively affect financial stability
A global stablecoin network, if poorly designed and unregulated, could pose risks to financial stability. The failure of a stablecoin to operate as expected could disrupt other parts of the financial system. For example, the inability to convert stablecoins into domestic currency on demand or to settle payments on time could create credit and liquidity dislocations in the economy. If a stablecoin's credit, liquidity, market, and operational risks are managed ineffectively, it could face a loss of confidence. This loss of confidence could lead to a run, where many holders attempt to liquidate their stablecoins at the same time. In an extreme scenario, holders may be unable to do so, with potentially severe consequences for domestic or international economic activity, asset prices, or financial stability.
Stablecoins must meet safeguards against money laundering and terrorist financing
The anonymity often found in stablecoins could be used to obscure financial transparency and facilitate money laundering, terrorist financing, and other financial crimes. Financial institutions are subject to customer due diligence and other anti-money-laundering regulations intended to help detect and disrupt illicit activity. Addressing such vulnerabilities is critical for any stablecoin. Regulators in many jurisdictions have made it clear that stablecoin issuers, operators, and intermediaries are responsible for preventing their systems from being used by criminals to obscure their identity, location, and transactional activity and for ensuring compliance with anti-money-laundering and counter-terrorist-financing laws and regulations in each jurisdiction in which they operate.
Consumer and investor protection will be crucial
With any financial product, it is key that consumers and investors understand how it works and are aware of the product's relevant costs and fees, terms and conditions, and risks. Stablecoin issuers, operators, and intermediaries should fully disclose the terms of their services. Disclosures should clearly detail consumer and investor rights and protections, including whether the holder of the stablecoin has any rights to the underlying asset. Issuers should be transparent on how the stablecoin is tied to the underlying asset. Holders must be protected against erroneous and fraudulent transactions and receive recourse in the event of any unauthorized use. In addition, holders' data privacy must be appropriately maintained.
The Federal Reserve is closely monitoring the risks of stablecoins
Given the array of risks and unaddressed issues to date, the Federal Reserve and other regulators are cooperating closely to ensure that any stablecoin system with global scale and scope must address a core set of legal and regulatory challenges before it can operate. As the Group of Seven has noted, "no global stablecoin project should begin operation until the legal, regulatory and oversight challenges and risks outlined [in this report] are adequately addressed, through appropriate designs and by adhering to regulation that is clear and proportionate to the risks."2
1. Noncollateralized stablecoins, such as those that are algorithmic, are outside the scope of this discussion. Return to text
2. See G7 Working Group on Stablecoins (2019), Investigating the Impact of Global Stablecoins (Basel, Switzerland: Group of Seven, International Monetary Fund, and Committee on Payments and Market Infrastructures of the Bank for International Settlements,October), p. iii, https://www.bis.org/cpmi/publ/d187.pdf. Return to textReturn to text
12. In July 2014, the Securities and Exchange Commission adopted amendments to the rules that govern MMFs to address risks of investor runs. The new rules, which became effective in October 2016, require institutional prime MMFs to value their portfolio securities using market-based factors and to sell and redeem shares based on a floating net asset value. The new rules also provided nongovernment MMF boards with tools—liquidity fees and redemption gates—to prevent runs. Return to text
13. The data on securities and repos of life insurers are not available for the pre-crisis period. However, the firm American International Group, Inc., or AIG, alone had $88.4 billion in securities lending outstanding at the peak in the third quarter of 2007; see AIG's U.S. Securities and Exchange Commission Form 10-Q for the quarter ended September 30, 2007, at https://www.sec.gov/Archives/edgar/data/5272/000095012307015058/y38903e10vq.htm. Return to text