Thread by @concodanomics

The most significant shift in global finance is almost complete. By moving onto a secured standard, monetary leaders have tried to destroy systemic risk. But risk has only been transferred, not eliminated. The Fed's Volatility Suppressor™ is about to be unleashed... 1/

After the subprime bubble burst in 2008, a paradigm shift in banking unfolded. While banks no longer wanted to lend to each other or take excessive risk, the global regulatory complex set out to prevent a repeat of the crisis. The death of the unsecured standard had commenced...

https://twitter.com/not_concoda/status/1698335092433645944

Central bankers flooded the system with enough reserves to kill the Fed Funds market, the market for unsecured interbank loans. Meanwhile, the regulatory establishment had begun to devise a new banking standard to discourage unsecured lending. The Basel III Accords had arrived...

Known collectively as "the agencies," the Federal Reserve Board, FDIC (Federal Deposit Insurance Corporation), and OCC (The Office of the Comptroller of the Currency) not only adopted the BIS's (Bank of International Settlements) Basel III standard. They went a step further...

https://twitter.com/not_concoda/status/1698225163391701128

By April 2014, each agency had fully enforced an additional set of constraints, obliterating the concept of banks taking on excessive risk forever. From then on, the Wall Street behemoths had to raise enormous amounts of capital to execute even the simplest of trades...

Any dealing deemed mildly speculative by monetary officials had been outlawed. By doing so, America’s leaders had not only forced banks out of risky trades but also forced the largest market makers to pull back from providing liquidity in key areas of the financial system...

With the “shadow banks” (non-bank financial institutions not subject to the same stringent regulations) filling in the gaps, the regulatory war against banks’ risk-taking abilities reached escape velocity. The Global Regulatory Complex™ had achieved its most desired objective...

Slowly but surely, over the past decade, the banking arm of every global financial goliath has been transformed into nothing more than a boring utility, ridding itself of its most speculative risk-taking capabilities...

Even so, following the Silicon Valley Bank collapse and subsequent regional banking panic, regulators have once again decided to reignite their tenacity. In the face of a puzzled finance industry, authorities are about to punish banks further...

By implementing harsher capital requirements, banks must raise an even greater amount of liquid capital held against their assets. Some estimates suggest the largest Wall Street banks will have to raise their capital buffers by a whopping 24%...

Swiftly, it’s become clear that the regulator’s war on bank risk-taking is far from over. But what’s also evident is the effects this ongoing battle will have on global finance. The impending rules, no matter how extreme, will push more activity into the shadow banking layer...

A subsequent increase in the opaqueness of the financial system will ensue, prompting an even greater reliance on the Fed’s volatility suppressor to come to the rescue when choppy seas emerge. The U.S. central bank’s primary bailout mechanism is set to increase in power...

The unique, contemporary effort by regulators to rid the global monetary system of systemic risk has been defined by a move away from “bank-based” finance and toward “market-based” alternatives...

While “bank-based” finance refers to bank-based operations, “market-based” finance refers mainly to shadow banks (such as money market funds and securities dealers) and the markets (such as debt and equity) in which they operate...

Under the secured standard, banks now stick to their more traditional functions. Shadow banks, meanwhile, absorb any excess demand that the Global Regulatory Complex™ has denied prominent players from fulfilling...

The most glaring sign of this evolution has been large dealers’ declining appetite for making markets even in the most pristine collateral: U.S. Treasuries. A decade ago, the Fed’s primary dealers were once able to absorb up to 80% of every 10-year Treasury auction...

https://twitter.com/not_concoda/status/1698083161022841059

Now, however, exposed to the Fed’s SLR (supplementary leverage ratio and tougher restrictions imposed on systemically important entities, primary dealers absorb, on average, a mere ~17% of bond issuance at auction...

When you’re constrained under Basel III, avoiding activities that yield little profit, such as making markets in Treasuries, has grown necessary. Superseding the primary dealers are the traders and asset managers, who now directly bid for U.S. government securities themselves...

https://twitter.com/not_concoda/status/1698271692915626125

The most pertinent change emanating from the move to market-based finance, however, was the rapid growth of the repo market, the market for secured cash loans...

https://twitter.com/concodanomics/status/1667603294825615362

Other debt and equity markets, such as corporate debt, ballooned in volume. Still, since repos were loans primarily secured by high-quality sovereign debt like U.S. Treasuries, the repo market has prospered...

https://twitter.com/not_concoda/status/1698315963790160087

What’s more, the abundant liquidity of the dollar funding markets meant that if entities ever fell short of U.S. Treasuries, they could simply tap the securities lending markets temporarily swapping lower-quality debt securities for Treasuries to participate...

In their models, America’s monetary leaders plus the rest of the Global Regulatory Complex assumed U.S. Treasuries, the collateral powering the secured standard, could weather any storm. But they were swiftly proven wrong: the COVID-19 market turmoil had arrived...

The 2008 credit crunch was defined by a dash for safe assets, but the Covid-19 market turmoil was defined by a dash for cash in the form of cold, hard dollars. Being the closest alternative to cash, U.S. Treasuries were liquidated en masse. Bond market illiquidity arose...

By committing to purchase virtually unlimited amounts of U.S. Treasuries, the Fed’s “volatility suppressor” was born. U.S. sovereign debt was shown to only be truly risk-free when paired with added monetary alchemy and intervention from the Federal Reserve...

Extensive central bank intervention was the only solution to stabilizing the value of “safe assets” backing trillions of dollars in funding transactions. The idea that securing more loans against sovereign debt delivered complete financial stability had been crushed...

Only with the Fed’s “volatility suppressor” could confidence in the financial system be resurrected, and next time, it will be no different. When another inevitable black swan surfaces, the Fed’s playbook remains unchanged...

During future crises, the forthcoming stricter regulations — the so-called Basel III Endgame — will only put more pressure on the Fed to fire up its volatility suppressor to restore stability in opaque markets where shadow banks operate...

Whether or not monetary leaders have to abandon their unofficial “stealth easing” stance for official easing (QE and rate cuts) is now the more fundamental question.

Thanks for reading! If you enjoyed this, feel free to retweet the top tweet of this thread and follow @concodanomics for more.

You can also subscribe below to receive more in-depth articles about finance, markets, and geopolitics in your inbox...

👉 👈concoda.substack.com/subscribe