4. Funding Risks
Funding risks at domestic banks are low, but structural vulnerabilities persist in other sectors that engage in liquidity transformation
Over the past year, the total dollar amount of aggregate financial system liabilities that are vulnerable to runs increased 2.9 percent to $19.1 trillion, equivalent to about 77 percent of nominal GDP (table 4.1 and figure 4.1).13 The large banks that are subject to the liquidity coverage ratio (LCR) continued to maintain levels of high-quality liquid assets (HQLA) that suggest that their liquid resources would be sufficient to meet redemptions during periods of stress, and their reliance on short-term wholesale funding remains low.
Table 4.1. Size of Selected Instruments and Institutions
(billions of dollars)
|Average annual growth,
|Total runnable money-like liabilities*||19,080||2.9||4.9|
|Domestic money market funds**||4,522||-.3||5.5|
|Bond mutual funds||4,565||-12.9||9.0|
Note: The data extend through 2022:Q2. Outstanding amounts are in nominal terms. 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, local government investment pools, and stablecoins.
* Average annual growth is from 2003:Q1 to 2022:Q2.
** Average annual growth is from 2001:Q1 to 2022:Q2.
*** Data through 2022:Q1. Average annual growth is from 2000:Q1 to 2022:Q1.
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 staff calculations based on Investment Company Institute data; Federal Reserve Board, Statistical Release H.6, "Money Stock Measures" (M3 monetary aggregate, 1997–2001); 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, Asset-Backed Commercial Paper Program Index.
Prime and tax-exempt MMFs as well as other cash-investment vehicles remain vulnerable to runs, and some of these vehicles maintain stable net asset values (NAVs) that make them particularly susceptible to sharp increases in interest rates. Some open-end bond mutual funds continued to be susceptible to large redemptions because they hold assets that can become illiquid amid stress while promising shareholders the right to redeem their shares every day. The market capitalization of the stablecoin sector continued to decline after falling sharply earlier in the year, and the sector remains vulnerable to liquidity risks similar to those of cash-like vehicles. As market volatility persists, CCPs have maintained prefunded resources at high levels. Although CCPs' variation margin requirements have remained elevated, particularly for interest rate swaps, to date participants have continued to meet their margin calls.
Banks maintained high levels of liquid assets and stable funding
The amount of HQLA held by banks has declined, and its composition has shifted away from central bank reserves (figure 4.2). However, banks' LCRs—the requirement whereby large banks must hold an amount of HQLA to fund cash outflows for 30 days—continue to suggest that banks have the liquidity resources to meet potential redemptions during periods of stress. These LCRs have been stable despite the declines in HQLA, in part because larger banks have seen a slight decline in institutional deposits, which are part of the denominator of the ratio and may be more sensitive to the significant widening in the spread between deposit rates and short-term market rates in recent months. Banks' reliance on short-term wholesale funding, another factor in the LCR denominator, also has remained low (figure 4.3).
Structural vulnerabilities remained at some money market funds and other cash-management vehicles
Prime and tax-exempt MMFs remain a prominent systemic vulnerability because of their susceptibility to runs and the significant role they continue to play in short-term funding markets. Since the May report, prime MMF assets under management (AUM) have grown 23 percent to approximately $510 billion, with growth concentrated in retail prime funds, which offer investors a stable NAV (figure 4.4). Growth in prime MMFs likely reflects faster increases in their yields relative to the yields of other MMFs and deposit rates, as short-term interest rates have risen. However, the AUM in this category remained well below its pre-pandemic level. Government MMFs' AUM were little changed over the period.
Other cash-management vehicles, including dollar-denominated offshore funds and short-term investment funds, also invest in money market instruments and are vulnerable to runs. Since the May report, the aggregate AUM of these cash-management vehicles has held steady at about $1.3 trillion. Currently, between $500 billion and $1.3 trillion of these vehicles' AUM are in portfolios similar to those of U.S. prime MMFs, and large redemptions from these vehicles also have the potential to destabilize short-term funding markets.
In addition, many cash-management vehicles—including retail and government MMFs, offshore MMFs, and short-term investment funds—seek to maintain stable NAVs that are typically rounded to $1.00. When short-term interest rates rise sharply or portfolio assets lose value for other reasons, the market values of these funds may fall below their rounded share prices, which can put the funds under strain, particularly if they also have large redemptions.
Stablecoins remained vulnerable to runs
The market capitalization of stablecoins—digital assets that are designed to maintain a stable value relative to a national currency or other reference assets—has fallen 7 percent to $143 billion since the previous Financial Stability Report, after exhibiting a much larger decline earlier in the year following the collapse of TerraUSD, which led to investor outflows and declines in coin value (see the box "Digital Assets and Financial Stability").
Although the market capitalization of stablecoins is still relatively small and stablecoins are currently not widely used as a cash-management vehicle by institutional or retail investors, they are an important vehicle for digital assets investors. Some stablecoins have structural vulnerabilities that mirror those of cash-like vehicles that engage in liquidity transformation and hold risky assets, like certain MMFs. Specifically, stablecoins are susceptible to runs if there are widespread redemption demands by coin holders, and are vulnerable to risks from liquidity and maturity transformation due to holdings of reserve assets that may become illiquid or lose value amid stress or increases in interest rates. Stablecoins' holdings of riskier reserve assets, such as commercial paper and other short-term instruments, have reportedly diminished. Notably, however, the lack of transparency regarding their asset holdings could exacerbate the effects of their vulnerabilities on financial stability through spillovers to other cash-management vehicles that participate in these markets.
Box 4.1. Digital Assets and Financial Stability
Activities in the digital assets ecosystem can pose challenges to financial stability.1 Digital assets may offer a host of useful innovations and products. The events of the past few months, however, suggest that the ecosystem faces similar vulnerabilities and risks to those that can occur in traditional finance, including runs, excessive leverage, operational risk, opacity, and fraud. Acting now to promote an appropriate regulatory environment for the digital assets ecosystem will help support responsible innovation while preserving financial stability.
Speculation and risk appetite appear to be the primary driving forces of crypto-asset prices, which have recorded big swings in recent years. Figure A shows the market capitalization of selected crypto-assets (excluding stablecoins), which is currently about 69 percent below its November 2021 peak.
Stablecoins have also experienced significant volatility over the past year, including, in certain cases, runs. TerraUSD was a stablecoin with market capitalization of about $18 billion before its collapse in May 2022. TerraUSD largely lacked assets to back its value, and, as with many other stablecoins, its demand was mainly driven by the return that investors could earn. Amid a reduction in lending rates earned by TerraUSD holders in the months before May and temporary liquidity shortages, concerns about the stability of TerraUSD precipitated a run and a complete collapse within days. Both the market capitalization of TerraUSD and of the whole Terra blockchain, including its governance token Luna, were wiped out.2 The collapse of the Terra blockchain was followed by strains throughout the digital assets ecosystem, highlighting vulnerabilities and interconnections in the space. Several entities that had direct exposures to TerraUSD or were engaged in speculative bets on other crypto-assets found themselves in financial distress, sometimes leading to bankruptcy. The events surrounding TerraUSD may have also triggered a temporary loss of confidence in another stablecoin, Tether, which briefly traded significantly below its peg. The market capitalization of stablecoins has declined about 22 percent since its peak in April 2022, with almost half of the decline corresponding to the collapse of TerraUSD.
The aftermath of the turmoil that started in May has also severely curtailed the activity in decentralized finance (DeFi) protocols.3 As shown in figure B, the total value locked in various DeFi protocols has substantially declined, having dropped about 72 percent from its November 2021 peak.4
The turmoil in the digital assets ecosystem did not have notable effects on the traditional financial system because the digital assets ecosystem does not provide significant financial services and its interconnections with the broader financial system are limited. The digital assets ecosystem, however, could grow rapidly and increase its connections to the traditional financial system. Spillovers from runs on stablecoins represent the most salient financial stability risk, particularly for those stablecoins backed by traditional money market instruments. Enforcing existing regulation, expanding the regulatory perimeter, and addressing regulatory gaps are essential. The FSOC's Report on Digital Asset Financial Stability Risks and Regulation, published in October 2022, has several recommendations along these lines.5
1. Digital assets, such as crypto-assets and stablecoins, are an electronic representation of value and operate as part of a complex and interconnected digital ecosystem. Crypto-assets are digital assets that use cryptographic techniques to prove ownership. The crypto-assets with the largest market capitalization, like Bitcoin or Ether, are not designed to maintain a stable value. Stablecoins are digital assets that also aim to maintain a stable value relative to a reference asset—typically the U.S. dollar. For a thorough review, see Pablo D. Azar, Garth Baughman, Francesca Carapella, Jacob Gerszten, Arazi Lubis, JP Perez-Sangimino, David E. Rappoport, Chiara Scotti, Nathan Swem, Alexandros Vardoulakis, and Aurite Werman (2022), "The Financial Stability Implications of Digital Assets," Finance and Economics Discussion Series 2022-058 (Washington: Board of Governors of the Federal Reserve System, August), https://doi.org/10.17016/FEDS.2022.058. Return to text
2. A governance token acts as a decentralized governance body to vote on the direction of a blockchain project or for resetting specific parameters. Return to text
3. DeFi protocols generally refers to open-source code running on open-access blockchains that aim to provide financial products without traditional financial intermediaries. Return to text
4. Total value locked is the overall value of assets committed to a DeFi protocol. This metric includes governance tokens staked in the protocol, staked tokens where one of the coins in the pair is the governance token, and borrowed coins in lending protocols. Certain tokens are double counted across protocols. Return to text
5. See Financial Stability Oversight Council (2022), Report on Digital Asset Financial Stability Risks and Regulation (Washington: FSOC, October), https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf. Return to text
Bond mutual funds experienced outflows and remained exposed to liquidity and interest rate risks
Mutual funds that invest substantially in corporate bonds, municipal bonds, and bank loans may be particularly exposed to liquidity transformation risks, given the relative illiquidity of their assets and the requirement that these funds offer redemptions daily. Total outstanding amounts of U.S. corporate bonds held by mutual funds fell to its lowest level since 2013 on an inflation-adjusted basis, primarily driven by a drop in valuations (figure 4.5). The fraction of mutual fund holdings of corporate bonds was approximately 13 percent of all U.S. corporate bonds outstanding. Total AUM at high-yield and bank-loan mutual funds, which primarily hold riskier and less liquid assets, also has decreased sharply in real terms so far in 2022 (figure 4.6).
In general, fixed-income mutual funds typically sustain losses when interest rates rise, and they have experienced negative returns and sizable outflows most of this year (figure 4.7). These funds remain susceptible to sharp increases in rates because their interest rate risk, as measured by the duration of their bond holdings, has reached its highest level since at least 2005.
Central counterparties' prefunded resources remained elevated amid high market volatility
CCPs continue to effectively manage increased risks and have maintained prefunded resources at elevated levels after increasing their resource requirements in the first quarter of 2022, following the general increase in market volatility.14 Variation margin calls on clearing members have remained high amid persistent broad market volatility, but the driver of the largest liquidity needs has shifted toward rate-related exposures and away from commodity-related ones. Clearing members have been able to meet their margin calls; however, looking ahead, some clients—particularly clients with directional exposure to rates—may need to increase their access to liquidity resources to avoid having to unwind positions. In addition, concerns remain around the concentration of clients at the largest clearing members even as some clients reduce their hedging activity because of increased funding costs.
Liquidity risks at life insurers continued to increase
Over the past decade, the liquidity of life insurers' assets declined, and the liquidity of their liabilities increased, potentially making it more difficult for life insurers to meet a sudden rise in withdrawals and other claims. Life insurers increased the share of illiquid assets—including CRE loans, less liquid corporate debt, and alternative investments—on their balance sheets (figure 4.8). In addition, they continued to rely on nontraditional liabilities, such as funding-agreement-backed securities, Federal Home Loan Bank advances, and cash received through repurchase agreements and securities lending transactions (figure 4.9).
13. Table 4.1 and figure 4.1 do not include stablecoins. Return to text
14. 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. Return to text