Course Textbook


Today, our financial system is broken. It works, but the fractures within make it prone to ruptures. It almost collapsed in 2008 and again in 2020. The Federal Reserve has done its job as lender of last resort in each circumstance and kept the financial system alive, but everybody now understands the Fed is the world's only true source of liquidity, and without its support the system couldn't stand on its own. From a layered-money perspective, there aren't a lot of places in the dollar pyramid that don't have an explicit or implicit guarantee of liquidity backstop from the Federal Reserve today. The dollar pyramid has fractured itself in so many places since 2007, that the Federal Reserve has had no choice but to place bandages across its entire facade. This chapter tells the account of how the Federal Reserve became the world's lender of only resort.

A Bookkeeper's Pen

Without gold, U.S. Treasuries stood alone atop the dollar pyramid as the only first-layer money. Treasuries them- selves are a form of credit, and their creditworthiness comes from the assets of the United States government and the power to collect taxes from its citizens. These government bonds became the highest-quality way to store dollars and still are today. In gold's absence, the Fed's balance sheet used U.S. Treasuries as its dominant asset, and the private sector used them as the omnipotent form of monetary collateral. For banks, ownership of these government bonds wielded the power to create yet another type of dollar called Treasury Repo dollars.

During the second World War, the United States Treasury suspended the Federal Reserve's independence with regard to monetary policy and effectively forced the Fed to finance the war effort. The Fed purchased enormous quantities of U.S. Treasuries at fixed interest rates as a result, and the United States government's quest for geopolitical dominance supplanted the Fed's politically independent monetary policy. A few years after the war ended, the Treasury-Fed Accord restored independence to the Fed, but more importantly, transitioned a vast portfolio of Treasuries into the hands of dealer banks, responsible for the healthy functioning of the Treasury market and dealing of Treasuries. These dealer banks had the power to extract liquidity from their Treasury holdings using a market for collateralized borrowing called the Treasury Repurchase (Repo) market. In a Treasury Repo transaction, a bank that owns a Treasury bond can pledge it as collateral and borrow money against it, just like in a pawn shop. Treasury Repo dollar creation occurred via the same balance sheet mechanism used for Eurodollar creation: the bookkeeper's pen. Banks could use the money they borrowed in the Treasury Repo market in interbank dollar settlement, and thus their Treasury holdings were a brand-new source of money. By 1979, the Federal Reserve concluded in a study that the explosion in Treasury Repo transactions was in fact causing an overall increase in the measurable supply of dollars and admitted not being able to make that measurement with exact precision. By 1982, the Federal Reserve fully gave up on managing the supply of dollars because they had veritably lost the ability to keep track of it; between the explosion in Eurodollars and Treasury Repo dollars, the dollar money supply had unquestionably lost all measurability. Instead, the Fed shifted to a monetary policy regime focused on managing short-term interest rates.

The Dollar's Suite of Reference Rates

Reference rates are pivotal in understanding how the dollar system broke in 2007. A reference rate is the interest rate of a credit instrument considered risk-free within financial academic theory. Financial theory uses the concept of a "risk- free rate" as the reference point for quantifying the risk of an investment. But credit instruments, by definition, have counterparty risk; no such thing can truly be wholly risk-free. Any borrower, no matter how mighty, can theoretically default. In reality, however, an entity like the United States Treasury has never defaulted on its debt obligations and has its own central bank to implicitly back any and all of its issuance. The Fed is the largest holder of Treasuries in the world; it is likely to purchase them ad infinitum because the purchase of Treasuries is how the Fed creates second layer reserves into the system.12 Also remember that in the past, the Fed was legislated into purchasing U.S. Treasuries in order to assist with war finance.

Treasuries are considered the risk-free asset in academia because financial models and valuation formulas require a baseline interest rate to reference. The entire spectrum of financial lending, from corporate debt, to residential mortgage loans, to consumer credit cards uses reference rates to set a baseline. After all, no lender would charge a family a lower interest rate to borrow than it would charge the United States government. From a layered-money perspective, instruments will always look one or two layers higher for their reference rate. Recurrently, this lands on Treasuries as the most creditworthy asset within the dollar spectrum. And in fact, it is. No other corporate, sovereign, or private entity has the track record and the implicit backing of a powerful central bank like the United States government has, landing the risk-free crown atop Treasuries. However, U.S. Treasury interest rates aren't the only reference rates in the dollar universe.

First, let's look at the differentiation between Treasuries themselves. Newly issued Treasury securities range from one month to thirty years in maturity, leading to a range of risk between Treasuries. While short-maturity Treasury Bills (T-Bills) have minimal price variability during their life, long-term Treasury Bonds have a much higher price sensitivity to changes in interest rates. This sensitivity, formally called duration, gives long-dated U.S. Treasuries a unique and markedly different risk profile relative to their monetary cousins, T-Bills. T-Bills don't have any considerable duration and are considered the highest quality, most liquid monetary instrument one can own within the dollar denomination. The interest rate on T-Bills is therefore one of the most cited reference rates in the money market.

The Federal Reserve targets a short-term interest rate as a part of its monetary policy called the Federal Funds Rate (Fed Funds), an interbank lending rate for second-layer reserve deposits held at the Fed. Fed Funds is an essential reference rate because it's the Fed's desired price for short- term lending within the U.S domestic banking system.

In 1986, interest rates on Eurodollar deposits in London were formalized in a rate called LIBOR, which would express the average rate at which banks in London lent Eurodollars to each other. These dollars didn't have any connection to the Fed's second-layer reserves or third-layer dollar deposits insured by the FDIC. Nevertheless, LIBOR mirrored Fed Funds; the investing world didn't prescribe any substantial quantitative difference to the price of interbank money whether in New York or in London.

In 1998, the Fixed Income Clearing Corporation introduced an interest rate called General Collateral Financing to reflect the average collateralized lending interest rates of Treasury Repo. The concept of General Collateral (GC) started because hundreds of different Treasury securities can exist at any time, and therefore measuring the interest rate of Treasury Repo should be done by averaging interbank Treasury Repo transactions.

Interest rates for T-Bills, Fed Funds, LIBOR, and GC all mirrored each other, implying the financial system viewed these four money-types as more or less identical. The four reference rates all harmoniously trudged along in congress until August 9th, 2007, when harmony turned to discord. Before we recount that fateful day, we must start with an overview of Money Market Funds.

Money Market Funds

Most people are instinctually risk-averse. They tend to avoid conflict, or in monetary terms, they crave higher-order monies that won't default. In small amounts, FDIC insured third- layer bank deposits suffice. In large amounts, it gets more complicated. Let's bring back the example of the VOC, its shares, and the creation of the Bank of Amsterdam to illustrate the state of money today, relative to investment. In Amsterdam, shares of the VOC were speculative but rewarding to its earliest investors. When investors wanted to cash out, they required a cash-type superior to gold and silver coins stuff ed into a suitcase. The Bank of Amsterdam provided that cash- type in the form of BoA deposits, which with mandated usage became a remarkably convenient way to swap between investments and cash. It was at this point that cash transitioned into a word used to describe the alternative to investments with risk. Cash now refers to a higher order of money relative to stocks and bonds, not exclusively to paper currency. In reality, no large investor can actually use paper currency with any utility: that type of cash is useless when dealing in large amounts of money. Cash today means monetary instruments that are safe relative to basically all other investments that have risk. That brings us to Money Market Funds.

Let's say you win a billion-dollar lottery. Unfortunately for you, your government exerts a 99.99% lottery tax on all winnings, leaving you with a tax bill of over $999 million dollars. The tax collector won't accept your money for a month. How do you keep the money in cash? The safest way is to purchase a T-Bill that matures on your tax due date. Th at way, your money is tied up in the safest possible asset until your tax bill is due. Second-layer money simply isn't an option for you: no bank has access to or the capability to store that much paper currency, and you as an individual don't have access to Fed reserves. You can keep it on deposit at your bank, but that third-layer money far exceeds the FDIC insured amount, so it carries the risk of default by the bank. If the bank is healthy, this shouldn't be a problem, but are you willing to put all your eggs in one basket and trust one single bank with a billion dollars? There is an option, however, that combines Treasuries, bank deposits, and other monetary instruments into shares of a Money Market Fund (MMF shares): a tidy cash instrument that services the world's unrelenting demand for safe money in a world of risky investments. Your best option to store your lottery winnings is by investing it in a Money Market Fund.

Money Market Funds became popular during the 1970s alongside the boom in Treasury Repo supply. MMF shares were a phenomenally desired investment product: a method to diversify away from concentrated bank risk exposure while simultaneously holding a cash-like monetary instrument. These funds had the most powerful trait possible of money; their shares held a par value relative to other high quality second- and third-layer money-types. This means that a dollar invested in MMF shares could always be redeemed for a dollar. MMFs invested in T-Bills, other U.S. Treasuries, Treasury Repo lending, commercial paper, and an array of bank liabilities.

Money Market Fund shares, depending on the exact composition of monetary instruments, became second- and third-layer money-types in their own right. Demand for MMF shares raged on as they allowed an uncomplicated way of owning a mix of monetary instruments in one security. Excess cash held by investment managers from across the world swept funds every afternoon into MMFs that in turn would purchase monetary instruments. This transformed the world's cash pool into a liquidity lifeline for multinational corporations that began to heavily rely on commercial paper funding of their operations. If, for some reason, cash holders decided to sell MMF shares for higher-layer monetary instruments, banks and corporations relying on the constant demand for their short-term obligations would face a crisis in liquidity. Therefore, the success of Money Market Funds also brought a great fragility to the financial system. Figure 13 shows what the dollar pyramid looked like as we headed for the twenty-first century and how MMF shares became the dominant form of retail money. There are two pyramids, one to represent the U.S. dollar system and another to represent the off shore U.S. dollar system.

Figure 13

When Interbank Trust Failed

Long Term Capital Management (LTCM) was a hedge fund launched in 1994 with tremendous fanfare. Its partners painted a picture of perfection with their track record. They hailed from the mighty Salomon Brothers investment bank, the Federal Reserve, and included a pair of Nobel Prize winning economists. Their art was arbitrage, much like the first bill discounters of sixteenth century Antwerp upon which the money markets were built. LTCM's competitive advantage combined interest rate arbitrage, enormous amount of leverage, and carte blanche from the world's leading investment banks. However, it all ended in ruin after the fund spectacularly failed after only four years in existence. American financial journalist Robert Lowenstein titled his book about LTCM's ultimate collapse in 1998 When Genius Failed in perfect summation. That a hedge fund took oversized risk and went insolvent wasn't anything new, rather a typical cycle of boom, hype, and bust. The riveting revelation from LTCM's collapse was also the smoking gun that indicated the events of 2007 and beyond were inevitable. Shortly after the Federal Reserve bailed out LTCM's investment bank counterparties and the unwind of the infamous hedge fund itself, Federal Reserve chairman Alan Greenspan characterized the bailout as of necessity due to the prospect of a systemic collapse of the entire financial system in a testimony to U.S. Congress:

The issue was, in all of our judgments, that the probability [of systemic collapse] was sufficiently large to make us very uncomfortable about doing nothing . . . My own guess is that the probability was significantly below 50 percent, but still large enough to be worrisome.

Only with the passage of time and subsequent Federal Reserve emergency actions does the gravity of Greenspan's admission begin to sink in. He confessed that the system might have collapsed had it not been for a measly $3.6 billion bailout. Why?

The answer lies in derivatives. Derivatives are financial contracts not considered securities. (Securities describe stocks and bonds for example, and derivatives describe stock options, futures contracts, and interest rate swaps). Derivatives blossomed in the 1990s as a way to synthetically expose a portfolio to an array of outcomes, most commonly the fluctuation of interest rates. They were bank liabilities in a new form, one that was difficult for financial regulators or even the banking system as a whole to fully comprehend. Most illustratively though, derivatives existed as a tangled web of financial obligations within the banking system, concentrating risk in the relationships between a handful of banks in the United States and Europe. An enormous margin call from the investment bank and major LTCM counterparty Bear Stearns in September 1998 triggered a collective realization that derivatives held by the hedge fund had the power to bring down the entire house of flimsy interbank risk.

At the time of the LTCM bailout, the total market value of all the world's derivatives including interest rate swaps, credit default swaps, and foreign exchange currency swaps was $3 trillion. To compare, the total supply of U.S. Treasuries was also about $3 trillion. By 2007, the total supply of U.S. Treasuries increased to $4 trillion but the market value of derivatives outstanding increased to $11 trillion. While the $4 trillion in Treasuries stood upon a bicentennial tradition of creditworthiness, conversely, the $11 trillion unsustainably teetered on the thin and fraying wires of interbank trust.

Falling into Disrepair

Despite cracks in the dollar pyramid's foundation that surfaced after the LTCM bailout, money market interest rates portrayed a sturdier facade. U.S. Treasury Bills, Fed Funds, Eurodollar LIBOR, and Treasury Repo GC rates all closely tracked each other for years. Small divergences would occur but were always characterized as the result of seasonal or idiosyncratic factors. That would all change starting on August 9, 2007. On that day, LIBOR rose by what might seem like a paltry 0.12% relative to the rest of the family of money market rates, but it was the start of something dramatic. The night before, French bank BNP Paribas was unwilling to value certain derivatives and froze all cash withdrawals for funds holding financial instruments related to risky American home borrowers. A sudden jolt of distrust electrocuted the interbank funding market in the weeks to follow. Banks were afraid to lend money to each other in any capacity because they weren't sure which banks might not open back up the next day. The era of unlimited, almost care-free interbank exposure had ended, replaced by extreme caution and nervousness. The ascent up the dollar pyramid had begun.

On December 12, 2007, the Federal Reserve was finally forced to address the gargantuan elephant in the room, which was that European interbank trust and the "bookkeeper's pen" Eurodollar funding mechanisms had broken down. A con- traction in European interbank trust, expressed by a rising LIBOR, was causing the whole dollar pyramid to rattle like an earthquake. The Fed instituted foreign exchange swap lines to the European Central Bank and Swiss National Bank in order to provide liquidity to the off shore banking system, having to turn a blind eye to the practice of creating dollar liabilities outside the Fed's purview. The Fed's role as lender of last resort had expanded beyond its borders because of the complicated evolution of the international monetary system, not because its mandate all of a sudden switched from domestic to global monetary policy. This conundrum was neither escapable nor up for discussion considering that the international monetary system was unabashedly dependent upon the Federal Reserve as the lender of only resort.

These foreign exchange swaps created yet another type of second-layer money made available by the Federal Reserve exclusively to other select central banks.

Amidst a wave of American mortgage defaults in 2008, the intricate web of failing mortgage derivatives started causing lower layers of the dollar pyramid to crumble with dramatic and permanent consequences. When the prestigious investment bank Lehman Brothers failed on September 15, 2008, a money market fund called Reserve Primary Fund famousl "broke the buck" when it posted a share price of $0.97 because it owned a fair amount of newly defaulted Lehman Brothers commercial paper. This drop of a mere three cents from par triggered an all-out financial panic that elicited unprecedented emergency actions from central banks and governments around the world. The reason for the panic wasn't necessarily the three-cent drop, but the fear that if Lehman Brothers commercial paper could fail, and Reserve Primary Fund's shares weren't worth a whole dollar, nothing could be trusted. All forms of bank liabilities lost liquidity, and the financial system froze. Time stood still, as nobody knew if banks would open the following day.

The Fed fulfilled its role as lender of only resort by launching a slew of consecutive rescues to stave off systemic collapse. The insurance giant American International Group (AIG) received a Fed lifeline on September 16th because it had underwritten insurance on risky mortgage securities that were suddenly defaulting. The entire Money Market Fund complex received a guarantee from the Fed on September 19th that its share prices would be supported to prevent withdrawal panic. Goldman Sachs and Morgan Stanley received their lifeline on September 22nd after being allowed to convert from investment banks into bank holding companies which gave them direct access to Fed lending. Concurrently, the Fed was increasing liquidity capacity for major central banks across the world on a daily basis. It was an all-out capitulation from the Fed to avoid systemic collapse.

Despite the Fed backstopping each and every form of cash it could, the ongoing liquidation of inferior assets and ascent up the dollar pyramid persisted. The original intent of the Federal Reserve System was to provide a second layer of money elastic enough to withstand shocks to the system exactly like this one. On November 25th, the Federal Reserve had no other choice than to flood the system with reserves by purchasing U.S. Treasuries, many of which had been newly issued in order to finance enormous deficits resulting from economic recession, tax shortfalls, and corporate bailouts. Large-scale expansion of second-layer money by the Fed was a response to contraction elsewhere in the system; it had to meet the collapse in interbank trust and liquidity with its own reliable liquidity. The Fed called it Quantitative Easing (QE), but we can refer to it as second-layer money creation.

Interbank trust only decayed in the years after the financial crisis of 2007–2009. Banks started dialing back their exposure to each other during the fourth quarter of each year to prepare for year-end regulatory snapshots. Divergences in key money market interest rate spreads - like when LIBOR split from Fed Funds and others in August 2007 - occurred more often, especially around calendar events such as the end of each quarter and United States tax deadlines. Complete dis- locations would occur, indicating that money needed at certain times during the year wasn't necessarily available to those who needed it most. Liquidity was haphazard, to say the least. The Fed had slashed the price of money and targeted interest rates of 0%, backstopped the unknown quality Eurodollar market, and created trillions of dollars of reserves to bolster the American banking system, but for what? When the Fed eventually tried to unwind its emergency actions years later, it was unable to raise interest rates above 2% without financial panic briefly rearing its ugly head again. The Fed quickly reversed course upon becoming reacquainted with the dollar system's fragility. A return to peaceful money markets was unattainable, as the Fed had removed price discovery from the system by disallowing so many third-layer money-types from realizing their ultimate fate.

Lender of Only Resort

Much like several of the money market dislocations of the 2010s, the initial blame for the Treasury Repo crisis in September 2019 was ascribed to the United States corporate tax deadline. The financial media's narrative was: MMF shares were sold by corporations so they could pay their tax obligations which in turn depleted the Treasury Repo lending base, but that Treasury Repo liquidity would return quickly much like in the days after other calendar events. On September 16th, the spread of General Collateral to Fed Funds increased by 0.10%, but nobody blinked an eye. Moves of this size had  become quite standard in the years since the notorious day in August 2007 when LIBOR became disjointed from the rest of the money market.

The next day, however, would live in Treasury Repo infamy. By late morning, the Treasury Repo GC rate registered at an alarming 8% higher than Fed Funds, indicating that at least one bank holding U.S. Treasuries could not find a counterparty to lend money against its Treasury collateral. The Federal Reserve responded with an emergency Treasury Repo funding operation later that day, effectively backstopping the entire market for Treasury-collateralized lending. The measures were supposed to be temporary as seasonal factors were surely to blame, but it didn't play out as such. The Fed increased its commitment to a smoothly functioning Treasury Repo market by cementing its willingness to lend freely against Treasury collateral so that what happened on September 17, 2019 would never happen again. After saving the Eurodollar in December 2007, the Fed had liberated yet another dollar-type in Treasury Repo and made a trend out of institutionalizing dollar-types gone astray. The Fed continued to find new ways to create wholesale second- layer money in order to counter instability.

During the pandemic-induced global financial panic of March 2020, the Federal Reserve announced several additional lending facilities to further backstop the Treasury Repo market, Money Market Funds, and fifteen additional foreign central banks. To protect the system against foreign liquidation of U.S. Treasuries, the Fed instituted a facility to lend money in the Treasury Repo market to approved foreign entities so that these governments and central banks didn't disrupt the Treasury market if they ever needed cash: they could post their Treasuries as collateral directly at the Fed's pawn shop. Even though Treasury prices soared in the first few days of pandemic panic as unlimited demand emerged for the world's safest asset amidst collapsing prices of stocks and corporate bonds, they didn't remain impervious. U.S. Treasuries with longer maturities (ten to thirty years) suddenly lost a bid despite their typical safe-haven status because of all the chaos in the markets. Members of the Fed panicked: a malfunctioning Treasury market was a recipe for disaster. What followed was a wave of U.S. Treasury purchases and reserve creation by the Fed that made the 2008– 2010 Quantitative Easing programs look like a practice run. The Fed convened over the weekend and announced a new, unlimited QE program of Treasury purchases without any defined maximum in order to mollify all concerns that the Fed might let the world's most important security market experience any sustained disturbance.

Money-types around the world were losing their ability to survive independent of the Federal Reserve. While it never lost its position atop the dollar money pyramid, the Fed has with some degree of success managed to claw back power over sections previously outside of its purview, mostly due to the fact that as each money-type almost failed, the Fed stepped in to save the day. The whole system has become entirely beholden to its support. Yet despite the dollar system's fragility that has been exposed over the past dozen years, the dollar is more deeply entrenched as the international monetary system's fulcrum than ever. The world is seemingly trapped inside a dollar denomination and is hankering for a monetary renaissance. Each crisis seems to be unraveling more quickly than the previous one as the system becomes dramatically more fragile.

Taking a step back, we have to understand why the Fed is creating all this second-layer money in the form of reserves, Treasury Repo lending, foreign exchange swap lending, and other bailout mechanisms. It does this because the Fed is a wholesale money safety net. Unless it flies a fleet of helicopters over American cities and unloads crates of second- layer retail money (Fed notes or cash), it does not have a way to provide money in a retail setting to individuals. The only way the Fed can provide monetary stimulus is to provide wholesale money where it is needed most within the financial system. The Federal Reserve is meant to provide reserves, and currently it possesses no political authority to issue retail monetary stimulus.

Tales of the dollar's demise are premature. While their arguments have mathematical merit given just how much money the Fed has created, they lack cohesiveness when considering the alternatives. The dollar is still the undisputed world reserve currency. Half of all international invoices are denominated in USD even though the American economy comprises only 15% of the global economy. Despite all the worthy criticisms about the Federal Reserve's seemingly infinite dollar creation, the dollar's stature as an accounting denomination, preferred method of payment for inter- national commerce, and capital market funding currency is nothing short of dominant. Its dominance is unlikely to fade away over the next several years. U.S. Treasuries remain the only asset that has the proven market liquidity and depth required to don the title of risk-free asset. The dollar has become so ephemeral in nature that the only way to truly store dollars over time is to own a portfolio of U.S Treasuries. That is why dollars travel around on the second and third layer of money, but only U.S. Treasuries can call themselves first- layer money in the dollar pyramid. The depth and liquidity of the U.S. Treasury market doesn't preempt the decision to store capital in the dollar denomination, it's actually the only thing holding it together because of the uncertainty that stems from owning bank-issued third-layer money.