Market-based credit during the pandemic
Primary dealers are leaning less since March
The securities dealing system was at the heart of the 2008 crisis of the market-based credit system: as everyone tried to exit positions in US mortgage at the same time, the dealing system was called upon to absorb the exit. It was unable to do so, and after the central bank tried and failed to get dealers working again, the Fed itself took on the dealing role and absorbed the exit.
The COVID-19 pandemic emerged not through financial markets but through the social effects of a contagious and deadly virus. But the pandemic's financial consequences, like those of the 2008 crisis, also flow through the dealing system. In this post, I make a first attempt at following the pandemic through dealers' financing activity.
Primary dealers are the securities dealers who maintain the privileges and obligations of close relationship with the Federal Reserve. They represent the majority of all US securities dealing. Primary dealers intermediate a large volume of funds, with securities in and securities out both around $5 trillion:
I have arranged these panels in the same way as I have done for central bank balance sheets here and here, with securities in above and securities out below. The main way that dealers accept securities is as collateral in reverse repo transactions, which are loans of money and so assets to the dealers. Likewise, securities out is mostly repo borrowing, and so liabilities to dealers.
Dealer net financing
But this way of thinking about it has limits: for example, if a dealer enters into a reverse repo transaction in order to obtain a specific security, is the dealer lending money or is it borrowing securities?
The dealer is doing both, because it is acting as an intermediary. One good way to understand this intermediation is to look at net financing: securities out less securities in. This shows the value of securities that dealers are on net adding to (if positive) or draining from (if negative) the pool of traded securities. Here is a graph of primary dealer total net financing:
The net financing figure is positive, more than $400 billion until March and a bit less than $300 billion since then. So on the whole, in their borrowing and lending activities, dealers are typically lenders of securities and borrowers of money vis-à-vis all other entities. We could think of it in a T account something like this:
Dealers have a matched-book function, in lines (1) and (2) of the T account, in which funding and securities pass through their books. To the extent that these flows do not net out, they have a second, speculative function, in line (3), which shows dealers as net borrowers of funds (and net lenders of securities).
Dealer net financing has contracted in 2021
The graph above shows that dealers' net financing contracted sharply mostly in March 2021, simultaneous with the TGA drawdown and the expansion of the ON RRP facility. There are a few approaches to make sense of this contraction. Start by breaking the net financing data out by tenor (maturity):
Dealers' positive net financing position turns out to have a specific term structure: a large net "securities out" position overnight is partially offset by a smaller net "securities in" position term (more than 30 days). Looking at it from the funding side, dealers are on net borrowing money overnight and lending much of it term—acting something like a bank.
Between January and March, both the overnight (net securities out) and the term (net securities in) positions contracted, leaving total dealer net financing volatile but level. But during March, the overnight position continued to contract, while the term position held steady, so that net financing overall contracted, settling in at a level a bit more than $100 billion below its 2020 level.
Tentative conclusion
We can think of primary dealer financing as having two tranches: a matched book tranche in which money flows net out, and a speculative tranche in which dealers take a money-for-securities position. That position, borrowing short and lending long, is a banking function. Dealers are doing less of that banking activity during the first part of 2021.
The next step is to connect this to money funds. More to come!