4. Funding Risk
Key indicators point to low funding risks at domestic banks, but structural vulnerabilities persist at some types of money market funds, open-end mutual funds, and stablecoins
As of the second quarter of 2021, a measure of aggregate liabilities that are vulnerable to runs had increased 3.6 percent over the past year to $18.2 trillion; that level was equivalent to about 80 percent of nominal GDP (table 4 and figure 4-1).23 Banks relied only modestly on short-term wholesale funding and maintained large amounts of HQLA. Some types of money market funds as well as other cash-management vehicles remain vulnerable to runs, and bond mutual funds continued to grow rapidly and remained exposed to risks due to their large holdings of illiquid assets. Stablecoins can suffer from structural vulnerabilities, and their market capitalization has grown about fivefold over the past 12 months.
Table 4. Size of Selected Instruments and Institutions
(billions of dollars)
|Average annual growth,
|Total runnable money-like liabilities*||18,227||3.6||4.8|
|Domestic money market funds**||4,534||−2.2||5.9|
|Securities lending ***||747||15.0||7.7|
|Bond mutual funds||5,245||17.8||9.2|
Note: The data extend through 2021:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Total runnable money-like liabilities exceed the sum of listed components. Items not included in the table are variable-rate demand obligations, federal funds, funding-agreement-backed securities, private liquidity funds, offshore money market funds, short-term investment funds, and local government investment pools.
* Average annual growth is from 2003:Q4 to 2021:Q2.
** Average annual growth is from 2001:Q4 to 2021:Q2.
*** Average annual growth is from 2000:Q4 to 2021:Q2
Source: Securities and Exchange Commission, Private Funds Statistics; iMoneyNet, Inc., Offshore Money Fund Analyzer; Bloomberg Finance L.P.; Securities Industry and Financial Markets Association: U.S. Municipal Variable-Rate Demand Obligation Update; Risk Management Association, Securities Lending Report; DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation: commercial paper data; Federal Reserve Board (FRB) staff calculations based on Investment Company Institute data; FRB, Statistical Release H.6, "Money Stock Measures" (M3 monetary aggregate, 1997–2001); FRB, 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, Asset-Backed Commercial Paper Program Index.
Domestic banks continued to have high levels of liquid assets and stable funding
HQLA continued to increase for all domestic banks in the first half of 2021, reflecting an increase in Treasury securities, central bank reserve balances, and agency mortgage-backed securities (MBS) (figure 4-2). Reliance on short-term wholesale funding remained at low levels (figure 4-3). A measure of the exposure of banks to interest rate risk, calculated as the difference between the effective time to maturity or next contractual interest rate adjustment for bank assets and liabilities, increased to historically high levels for all banks. This increase was due to a rise in holdings of long-term Treasury securities and agency MBS at banks amid large deposit inflows. However, banks' strong capital positions, their high levels of liquid assets, and their stable funding are mitigating factors to the potential vulnerabilities from maturity transformation.
Foreign banking organizations play a major role in global dollar funding markets. They rely on short-term wholesale funding to a greater extent than domestic banks and can transmit stresses to the United States. Temporary dollar liquidity swap lines with foreign central banks, established at the onset of the pandemic as liquidity backstops to complement standing swap lines, were extended through the end of 2021 to help sustain improvements in global dollar funding markets and thus mitigate potential spillovers that could hamper the flow of credit to U.S. households and businesses.24
Structural vulnerabilities remain at some money market funds and other cash-management vehicles
Assets under management at prime and tax-exempt MMFs continued to decline in the first half of this year, while those at government MMFs remained near historical highs (figure 4-4). Vulnerabilities associated with liquidity transformation at prime and tax-exempt MMFs contribute to the susceptibility of these funds to runs and call for structural fixes. In October 2021, the Financial Stability Board (FSB) published a report analyzing options to mitigate MMF vulnerabilities globally, including several potentially promising options—such as swing pricing or similar mechanisms, a minimum balance at risk, and capital buffers—many of which were considered in a report by the President's Working Group on Financial Markets that focused on U.S. MMFs last year.25
Net assets in other cash-management vehicles, including dollar-denominated offshore funds and short-term investment funds, continued to increase in the first half of 2021. These vehicles also invest in money market instruments and are vulnerable to runs; moreover, they are less transparent and regulated than MMFs. Currently, between $400 billion and $1 trillion of these vehicles' assets are in portfolios similar to those of U.S. prime funds, and a wave of redemptions from them could destabilize short-term funding markets.
Some stablecoins are vulnerable, and the sector continues to grow
Stablecoins are digital assets that are issued and transferred using distributed ledger technologies and are purported to maintain a stable value relative to a national currency or other reference asset or assets. The value of stablecoins outstanding has grown about fivefold over the past 12 months and stood at around $130 billion as of October 2021, based on the report published on November 1 by the President's Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency.26 Certain stablecoins, including the largest ones, promise to be redeemable at any time at a stable value in U.S. dollars but are, in part, backed by assets that may lose value or become illiquid. If the assets backing a stablecoin fall in value, the issuer may not be able to meet redemptions at the promised stable value. Accordingly, these stablecoins have structural vulnerabilities similar to those discussed earlier for certain MMFs and are susceptible to runs. These vulnerabilities may be exacerbated by a lack of transparency and governance standards regarding the assets backing stablecoins. The potential use of stablecoins in payments and their capacity to grow can also pose risks to payment and financial systems.
Central banks continue to consider the costs and benefits of their own digital currencies
Many central banks around the world are weighing the pros and cons of issuing central bank digital currency, including the potential implications for financial stability. The Federal Reserve is committed to hearing a wide range of voices on this important issue, taking account of the broader risks and opportunities that such currencies may offer.
Bond and bank loan mutual funds experienced net inflows and remain exposed to risks due to large holdings of illiquid assets
Mutual funds that invest substantially in corporate and municipal bonds and bank loans may be particularly exposed to liquidity transformation risks, given that they offer daily redemptions while holding assets that can quickly become illiquid. U.S. corporate bonds held by U.S. mutual funds remained sizable and represented about one-seventh of outstanding U.S. corporate bonds in the first half of 2021 (figure 4-5). Total assets under management at bank loan and high-yield bond mutual funds remained high during the same period (figure 4-6). Since the record outflows in March 2020, bond and bank loan mutual funds have attracted net inflows (figure 4-7). Policymakers in the United States and abroad, as well as the FSB, are examining potential options to address vulnerabilities in mutual funds.
Central counterparties managed risks while adapting to persistent volatility and elevated activity in some markets
CCPs continued to operate as designed in the first half of 2021, managing the risks created by spikes in market volatility and high trading volumes. CCPs' total prefunded resources relative to expected market volatility remained higher at the end of March than before the bursts of retail-led trading volatility in January 2021.27 In addition, cash increased as a share of CCPs' total prefunded resources in the first half of 2021. However, there were some signs of higher liquidity stress in equities clearing. For a broader discussion of liquidity vulnerabilities, see the box "Liquidity Vulnerabilities from Noncash Collateral at Central Counterparties"
Liquidity risks at life insurers remained at post-2008 highs and have been increasing
Over the past decade, the gap between the liquidity of the assets and liabilities of life insurers has increased, potentially making it harder for life insurers to meet sudden withdrawals of their deposit-like liabilities. On the asset side, life insurers' share of liquid assets on their balance sheets has decreased, reaching historically low levels (figure 4-8). In addition, life insurers' exposure to risky and illiquid assets—including CLOs—has increased, in part in response to low long-term interest rates. On the liability side, life insurers have increased their reliance on nontraditional liabilities, such as funding-agreement-backed securities, Federal Home Loan Bank advances, securities lending and repurchase agreements, and cash reinvestments, through the first half of 2021 (figure 4-9). In general, these liabilities are more vulnerable to rapid withdrawals than most policyholder liabilities.
Liquidity Vulnerabilities from Noncash Collateral at Central Counterparties
CCPs serve a critical role in managing and reducing risk in many financial markets in the United States.1 A CCP interposes itself between counterparties to financial transactions, becoming the buyer to every seller and the seller to every buyer. The credit and liquidity risk associated with the transactions is thus managed by the CCP. As part of that risk management, clearing members—the counterparties that directly face the CCP—are required to meet certain financial and operational requirements.
The CCP is required to complete the daily payments associated with all cleared trades even if one of its clearing members subsequently defaults on its obligations to the CCP. CCPs must therefore ensure they have or can obtain sufficient cash in the correct currency to meet payment obligations to their participants in the event of a participant default. Participants post collateral to cover potential credit losses on their positions, but, to the extent this collateral is not posted in cash in the required currency, CCPs may need to monetize collateral, sometimes within only a few hours and under potentially extremely volatile market conditions.
At the onset of the COVID-19 pandemic in March 2020, the CCPs designated as systemically impor-tant in the United States endured a real-life stress test when volumes and price volatility of cleared products spiked, leading to significant increases in initial margin and variation margin collection. The designated CCPs performed as designed during that period, but their ability to manage the default of a large clearing member was not tested because no large clearing members defaulted.2
The turmoil in March 2020 also stressed the markets on which some CCPs might rely to monetize noncash collateral.3 These experiences raise questions about whether CCPs could successfully use these markets to monetize noncash collateral in the time required. If a CCP were unable to monetize its noncash collateral, clearing members relying on receiving those funds might fail to meet their own obligations, propagating stress through the financial system.
A CCP's payment obligations, and hence the need for liquidity if a clearing member defaults, are generally larger than the credit losses ultimately realized and are frequently more immediate.4 Each day, a CCP estimates the largest liquidity need it would have in the event of a default by a single clearing member and its affiliates under extreme but plausible market conditions. Each CCP is required to maintain liquid resources—including cash as well as highly reliable tools for monetizing noncash assets—sufficient to cover this need. Securities CCPs, shown in the top panel of figure A, generally have larger potential payment obligations than derivatives CCPs, shown in the bottom panel, because securities CCPs need to settle the full net notional value of securities trades, whereas derivatives CCPs generally need to cover only the net change in the value of a portfolio over a short period. Nevertheless, liquidity needs are material even at some derivatives CCPs.
A CCP's vulnerability to collateral illiquidity depends not only on the size of its potential payment obligations, but also on the amount of noncash collateral it would need to monetize to meet those obligations. To limit exposure to collateral illiquidity, some CCPs require that a certain percentage of initial margin be posted in cash or limit their acceptance of certain types of noncash collateral. Subject to these restrictions, clearing members are generally free to substitute one type of collateral for another.
The composition of collateral varies both across CCPs and over time (figure B). One important factor that drives members' choices of collateral to post to a CCP is the interest rate environment. At some CCPs, members are currently posting a greater portion of their collateral in cash because the opportunity cost of doing so is low given the current interest rate environment and the high level of bank reserves. Members' collateral preferences can change rapidly. Even if a CCP currently holds a significant amount of cash collateral, its need to rely on tools to monetize noncash collateral can increase quickly if clearing members substitute noncash collateral for cash.
The designated CCPs generally rely on three types of tools to monetize noncash collateral: (1) committed tools, such as committed lines of credit or committed foreign exchange swap facilities; (2) rules-based tools, for which the CCP rule book requires nondefaulting clearing members to provide liquidity support to the CCP; and (3) uncommitted or best-efforts tools, such as repurchase agreement (repo) transactions executed under an uncommitted master repo agreement or market transactions that may include sales of noncash collateral for same-day settlement.
While some types of tools may be expected to perform better than others, the reliability of all of these tools during extreme stress events is subject to some uncertainty. In the United States, the largest clearing members have overlapping participation at most of the designated CCPs. Severe stress at a large clearing member could cause that firm to default at many CCPs simultaneously. Multiple CCPs could then attempt to use their liquidity tools at the same time, potentially relying on the same market participants for liquidity. In such circumstances, using even ordinarily highly reliable tools to monetize noncash collateral may be challenging for CCPs. The current high level of bank reserves has mitigated this vulnerability to a certain extent, as designated CCPs' committed credit lines now total around 14 percent of large domestic banks' cash holdings, down by half since 2019.5
The reliability of uncommitted and best-efforts liquidity tools is less certain than that of committed or rules-based tools. As Treasury securities are commonly posted as collateral at CCPs, recent stresses in the Treasury markets illustrate some potential weaknesses of such tools. On September 17, 2019, Treasury repo rates rose dramatically in early-morning trading, and it is unclear whether, or at what rate, a CCP could have borrowed cash using best-efforts tools such as uncommitted master repo agreements in that environment. In the first few weeks of March 2020, liquidity in the cash market for Treasury securities deteriorated sharply, with wider bid-ask spreads, a higher price effect of trades, and diminished order-book depth. This deterioration was worse for off-the-run securities, which clearing members may be more likely to post as collateral, than for on-the-run securities.6 It is unclear whether, or at what price, a CCP relying on best-efforts market transactions would have been able to sell Treasury collateral at the peak of the March stress period for a regular one-business-day settlement, let alone for the unconventional same-day settlement that might be needed to meet immediate payment obligations.
These events occurred without the default of a large clearing member, such as a systemically important U.S. banking organization. The default of a large clearing member almost certainly would have exacerbated market stress, further reducing the likelihood that CCPs would be able to use uncommitted liquidity tools to monetize noncash collateral and meet their payment obligations. Although the official sector is examining ways to enhance the resilience of the Treasury market, the timing and effect of any such reforms cannot yet be determined.
CCPs are responsible for meeting payment obligations on time even when a participant defaults during market stress. A CCP's ability to meet its obligations depends on maintaining highly reliable liquidity tools that are sufficient to monetize any noncash collateral when needed, even under extreme market stress. A CCP that fails to adequately anticipate and prepare for liquidity needs may pose a vulnerability to financial stability rather than serving as a source of strength to the market.
1. The expansion of central clearing in the over-the-counter derivatives markets and simultaneous reforms to strengthen the standards applicable to CCPs were key pillars in the regulatory actions that improved the resilience of the U.S. financial system in response to the Global Financial Crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created a process for the designation of CCPs as systemically important by the Financial Stability Oversight Council; these designated CCPs are subject to enhanced supervision, including by the Federal Reserve, and have all been permitted to open Federal Reserve accounts to hold cash. Return to text
2. In March 2020, CME Clearing auctioned the portfolio of clearing member Ronin Capital, and the Fixed Income Clearing Corporation ceased to act for Ronin Capital. Ronin Capital was not a large clearing member at either CCP. Return to text
3. For more information on the March 2020 turmoil in the Treasury market and the roles of other market participants, including hedge funds, mortgage real estate investment trusts, principal trading firms, and dealers, see the box "A Retrospective on the March 2020 Turmoil in Treasury and Mortgage-Backed Securities Markets" in Board of Governors of the Federal Reserve System (2020), Financial Stability Report (Washington: Board of Governors, November), pp. 32–38, https://www.federalreserve.gov/publications/files/financial-stability-report-20201109.pdf. Return to text
4. For example, if a clearing member has posted collateral with a market value of $100 million and defaults before making a required variation margin payment of $100 million, the CCP may not realize any credit loss when the defaulter's portfolio is liquidated. However, the CCP still would need $100 million in cash in the correct currency, usually on the same day and potentially within a few hours after the default, to meet payment obligations to nondefaulting clearing members. Return to text
5. See the public quantitative disclosures of CCPs and Board of Governors of the Federal Reserve System (2021), Statistical Release H.8, "Assets and Liabilities of Commercial Banks in the United States," https://www.federalreserve.gov/releases/h8/current/default.htm. Return to text
6. On-the-run Treasury securities are the most recently issued Treasury bonds or notes of a particular maturity. Off-the-run securities are those issued less recently. Return to text
LIBOR Transition Update
The Federal Reserve and other regulators have issued supervisory guidance encouraging banks to end new use of USD LIBOR as soon as practicable and, in any event, by the end of this year. In general, institutions of all sizes have acknowledged year-end as the stop date for new LIBOR contracts. To reinforce the need to smoothly wind down new activity by year-end rather than to risk missing the deadline, Alternative Reference Rates Committee (ARRC) communications have urged market participants to materially reduce the use of LIBOR before December so that any remaining LIBOR use can be fully stopped before year-end.
With supervisory guidance encouraging supervised institutions to stop new use of USD LIBOR by the end of the year, the ARRC and the Commodity Futures Trading Commission's Market Risk Advisory Committee (MRAC) took several steps over the summer to encourage a swifter transition of derivatives markets to the Secured Overnight Financing Rate (SOFR). The success of these measures, dubbed "SOFR First," allowed the ARRC to recommend term SOFR rates produced by CME Group, which is expected to help speed the transition of certain key lending markets. Nonetheless, serious risks remain, particularly for business loans, where most new lending in the United States still references LIBOR.
Transition to SOFR
The ARRC had previously issued a recommendation that market conventions for quoting USD derivatives move to SOFR as of March 31, 2021, but dealers had been slow to move from LIBOR trading conventions. Recognizing the need for a more coordinated transition effort, the MRAC's subgroup on the LIBOR transition recommended that trading conventions in the interdealer market for interest rate swaps (the largest derivatives market referencing LIBOR) move from USD LIBOR to SOFR on July 26, 2021. This recommendation followed a similar "SONIA (Sterling Overnight Index Average) First" initiative in the United Kingdom and was the first phase of a broader plan envisioned by the MRAC to switch conventions in other segments of derivatives markets.
The application of SOFR First to interdealer swap trading was successful. Since July 26, trading in the interdealer market has moved from nearly all USD LIBOR to between 70 and 100 percent SOFR, and the volumes of LIBOR trading fell sharply (figure A). The switch in interdealer swap trading conventions spilled over into the dealer-to-customer market, leading to a significant increase in the total share of swap trading referencing SOFR from less than 5 percent to about 30 percent (figure B).
The success of the SOFR First initiative allowed the ARRC to formally recommend SOFR-based term rates, which are produced by CME Group based on transactions in SOFR derivatives markets. SOFR term rates are expected to be especially helpful for the business loans market, where transitioning from LIBOR has been slow. ARRC recommendations also recognized the use of SOFR term rates in end-user-facing derivatives or securitizations that are directly tied to business loans or legacy cash instruments referencing the SOFR term rates.
The ARRC has cautioned against widespread use of term SOFR in derivatives markets and other markets where overnight SOFR and SOFR averages, which are both considered to be more robust than term SOFR, have been successfully used, including floating-rate notes, consumer loans, and most securitizations. CME Group's licensing agreements restrict the use of CME term rates in derivatives markets, which will mitigate the risk that a large portion of the derivatives markets will reference term SOFR rather than overnight SOFR.
The success of the SOFR First initiative and development of SOFR term rates have shifted momentum toward the use of SOFR. Many banks have reported that they will offer several forms of SOFR (term rates, overnight SOFR, and SOFR averages) to business clients, in line with the ARRC's recommendations. However, some market participants have continued to pursue the use of other rates based on the same unsecured, wholesale bank funding markets underlying LIBOR. Supervisory guidance has noted that lenders will not be criticized for using rates other than SOFR in business loans. At the same time, leading officials from financial regulators, including the Federal Reserve, FSOC, the Office of the Comptroller of the Currency, and the SEC, as well as the International Organization of Securities Commissions, have emphasized the importance of robust underlying activity for reference rates used in derivative and capital markets and noted the importance of those markets moving to SOFR.1
Some legacy LIBOR contracts lack adequate fallback language and extend past June 2023, when the main tenors of USD LIBOR will cease to be published on a representative basis. In March 2021, the ARRC estimated outstanding legacy USD LIBOR exposures at roughly $223 trillion. Approximately $74 trillion of these legacy contracts are set to mature beyond the critical date of June 2023, and some of those contracts will lack adequate fallback language. Federal legislation that would address these contracts has been introduced in the Congress. Earlier in the year, the states of New York and Alabama enacted legislation that will allow legacy contracts governed by each state's law to transition to SOFR-based rates, but federal legislation would establish a clear and uniform solution on a nationwide basis.
1. See U.S. Department of the Treasury (2021), "Financial Stability Oversight Council," June 11, https://treas.yorkcast.com/webcast/Play/f5be3d221c084e9ea64adba4bd6c15aa1d; Michael J. Hsu (2021), "Statement by the Acting Comptroller of the Currency at the Financial Stability Oversight Council," speech delivered at the FSOC virtual meeting, June 11, https://www.occ.gov/news-issuances/speeches/2021/pub-speech-2021-65.pdf; and Gary Gensler (2021), "LIBOR Statement," prepared remarks by the Chair of the Securities and Exchange Commission before the Financial Stability Oversight Council, June 11, https://www.sec.gov/news/public-statement/gensler-fsoc-libor-2021-06-11. Return to text
23. Table 4 and figure 4-1 do not include data on stablecoins. Return to text
24. For the announcement, see Board of Governors of the Federal Reserve System (2021), "Federal Reserve Announces the Extension of Its Temporary U.S. Dollar Liquidity Swap Lines with Nine Central Banks through December 31, 2021," press release, June 16, https://www.federalreserve.gov/newsevents/pressreleases/monetary20210616c.htm. For more information on global dollar funding markets, see the box "Vulnerabilities in Global U.S. Dollar Funding Markets" in Board of Governors of the Federal Reserve System (2021), Financial Stability Report (Washington: Board of Governors, May), pp. 55–58, https://www.federalreserve.gov/publications/files/financial-stability-report-20210506.pdf. Return to text
25. See Financial Stability Board (2021), Policy Proposals to Enhance Money Market Fund Resilience (Basel: FSB, October), https://www.fsb.org/wp-content/uploads/P111021-2.pdf. Also, see President's Working Group on Financial Markets (2020), Report of the President's Working Group on Financial Markets: Overview of Recent Events and Potential Reform Options for Money Market Funds (Washington: PWG, December), https://home.treasury.gov/system/files/136/PWG-MMF-report-final-Dec-2020.pdf. Return to text
26. The report recommends a governmentwide approach to address the range of risks that could arise from stablecoins. See President's Working Group on Financial Markets, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency (2021), Report on Stablecoins (Washington: PWG, November), https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf. Return to text
27. Prefunded resources represent financial assets, including cash and securities, transferred by the clearing members to the CCP to cover that CCP's potential credit exposure in case of default by one or more clearing members. These prefunded resources are held as initial margin and prefunded mutualized resources. For more information on retail-led trading volatility, see the box "Retail Investors, Social Media, and Equity Trading." Return to text