Ad Hoc Commentary – shadow banking will help development banking move from billions to trillions

Today, yours truly plan to share specifics on how to move from billions to trillions to finance the Sustainable Development Goals (SDGs) based on our two basic insights:

1. the Federal Reserve’s reverse repo facility (RRP) as a template for financing the SDGs:
https://tradehaven.net/ad-hoc-commentary-the-feds-rrp-as-a-template-for-financing-the-sdgs/

2. “…we should first create a central marketplace and use the new transparency to crowd-in the private sector….”
https://tradehaven.net/ad-hoc-commentary-financing-the-sustainable-development-goals/

We first need to go back to the Bank of England’s definition of money:
“Money in the modern economy is an IOU that everyone trusts.”
https://tradehaven.net/ad-hoc-commentary-the-bank-of-england-explains-away-two-misconceptions-about-money-creation/

Who you trust depends on who you are. For the banking system in America, money are liabilities of the central bank. Money for the traditional banking system (i.e. banks) are reserves at the Fed. Money for the shadow banking system (i.e. broker-dealer and money funds) are RRPs with the Fed. These are the same RRPs that we are talking about when we said that the hike is supposed to bailout underfunded pensions:
“…Yellen probably really wanted to bailout the pension and insurance funds…”
“…It is a noble goal, but one that will probably suffer from severe unintended consequences…”
https://tradehaven.net/ad-hoc-commentary-yellen-and-the-hike-that-is-not-supposed-to-be-a-hike/

To understand the unintended consequences better, and why development banks, as opposed to the central bank can do a better job, we need to understand what is happening in the shadow banking arena before Yellen came along with her expanded RRP.

Before Yellen expanded her RRP:
1. cash pools (the famous wall of money) were lending trillions to broker-dealers, secured by collaterals.
2. leveraged investment funds (the famous search for yield) were, in turn, borrowing the same trillions from broker-dealers, secured by collaterals.

In summary, cash pools were providing working capital to leveraged funds, intermediated by broker-dealers.

Who are the cash pools? These are FX reserves of sovereigns, corporate cash stockpiles of corporations, and so on. Who are the leveraged funds? These are funds that pensions were investing into, in a usually vain hope to close the gap between lofty pension promises and the reality of low interest rates.

When Yellen came along with her expanded RRP, she probably wanted to ease the problem of “the search for yield”. It is a noble goal, and probably would have worked well if the world was less interconnected and if there was little leverage in the system. But the world is interconnected and market participants  were, directly and indirectly, leveraged. Only time will tell if Yellen’s RRP ultimately suffered the very people she wanted to help with the double whammy of higher borrowing costs, and magnified losses on existing leveraged bond holdings. That is why yours truly concluded that:
“…The uncertainty is so great that Yellen’s advisors are probably suffering from severe analysis paralysis…”
https://tradehaven.net/ad-hoc-commentary-yellen-and-the-hike-that-is-not-supposed-to-be-a-hike/

So, where does the supranational central-counterparty comes in? Well, the supranational can act as the broker-dealer of last resort. By doing both borrowing from cash pools and lending it out to funds that are aligned with the sustainable development goals, it will be a more complete solution than Yellen’s one-sided RRP. Effectively, the supranational is building a relatively safe demand deposit account for institutional cash collateralized by sustainable development bonds. The supranational should also build a public liquidity backstop. However, the supranational should keep the credit backstop private. Since private assets are credit-risky, there should be credit transformation in the form of haircuts (and tranching) to provide credit enhancements.

We can call the new facility the Supranational Window (Supra Window). The Supra Window will provide funding for capital markets lending that meet development goals. It can hopefully solve both developmental problems, and the asset-liability mismatch of pensions and insurance funds. There are many details to be considered. Chief among this is the question of how big. Perhaps a 10% reserve requirements is a good start. In other words, 2.5 billion of official development assistance can be used to mobilize 25 billion dollars of private money.

Technically, the shadow banking arena is not a bad place to start as the Supra Window satisfies the following requirements that we set out previously:
“…In short, to gain wide market acceptance, we need debt instruments that are:
1. Short-term (as opposed to long-term)
2. Credit enhanced by long-term collaterals (as opposed to credit insurance)
3. Public-sector [backstops] (as opposed to private-sector [backstops])..”
https://tradehaven.net/ad-hoc-commentary-the-feds-rrp-as-a-template-for-financing-the-sdgs/

Politically, one would need to find out if the existing market participants would welcome a Supra Window.

Good luck in the markets.