The Mysteries of Dollar Creation and the Future of Money

Announcer  00:04

Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis, and insights in your car, at the gym, or wherever you decide to tune in.

Craig Jeffery  00:17

Welcome to the Treasury Update Podcast. This is Craig Jeffery, your host today for our discussion. Today’s episode, we’ll be talking about the future of money and payments. And this is at least a two part series. And I think everyone who’s paying attention to macro economic items, knows that many ideas have been shared about the future of money, how it’s changed, how will continue to change. And since this is part one of a two part series, we’re going to focus about dollar creation and just some ideas on how to think about that from a treasure whose strategic approach. My guest, Todd Yoder, and I have had chats not on the microphone about dollar creation, global economy, energy, embedded payments and beyond. But today’s discussion is on the microphone. So for this episode, we’ll focus on the concept of impact of dollar creation. And maybe we can think about what’s that? And I’m so glad that you asked what that is. Todd, welcome to the Treasure Update Podcast again.

Todd Yoder  01:18

Thank you, Craig. It’s great to be here. I appreciate the invitation. I’m starting to feel like a regular.

Craig Jeffery  01:22

You are definitely classified as a regular. You know, you introduced me to Kevin Coldiron a few years back and I’m not sure if you sent me his book or if he sent it to me. We had a recording maybe a month or so back. I don’t know if it was in October or November. It is it was the issue of carry is about his is his book. And, you know, as we as we think about this, I one of the items that we talked about was about pensions in the UK, the guilt issues that existed. I know you had some comments about that. Or maybe we could start there. What did you find interesting or worth expanding upon from from that, that discussion?

Todd Yoder  02:00

Kevin Coldiron. In his book, The Rise of Carry, I actually did a book review. Not too long after he wrote the book. One of the things I pointed out on his last podcast that you did with him, as he was describing what happened in the UK, with the UK pension funds, I think there is an easy way to kind of tie that in what occurred to corporate treasurers in an extended period of low interest rates, these pension funds due to how the accounting were when interest rates fall, their liabilities go up. And vice versa, when interest rates increase, the present value of their liabilities decreases. But on the asset side, if they are hedged, they have these derivatives swap contracts that become out of the money. And that’s exactly what happened in the UK with the gilt market, they do have hedges against those long term liabilities. So when we see interest rates increase, as the Fed has done, their long term liabilities decrease, but their hedges against those become way out of the money counterparties come to these pension funds and say, we need additional collateral. And where do these pension funds get their collateral their most liquid asset to cover these margin calls their guilts, they started selling their gilts into the market to cover the margin. And we know the inverse relationship between bond prices in yields. And so the prices began to collapse. As yields spiked up, basically what what we describe kind of the fire sale or everyone running for the door usually doesn’t end well. So we saw this huge spike in the gilt yields and falling bond prices. So the Bank of England had to step in and basically say, we will buy all the gilts that you need to sell. So that is a situation a paradigm where you have, you know, inflation concerns, but yet to bring stability to the market, that was definitely central central bank intervention, and what could be deemed by some to be adding gas to the inflation flame. And the way I would tie that to corporates, right is, you know, a lot of times we have forecasted cash flows. And if we just use currency as an example, that doesn’t get marked to market and put on our balance sheet, if we put hedges on against those long term cash flow forecast that does get recorded, and depending on how you were if you apply hedge accounting treatment, that may determine the geography of where that is recorded. And then depending on your hedging strategy, if you have a long longer term duration, hedges, you’ll have unrealized As gains or losses, if you’re doing a shorter term rolling strategy, you may even have cash settlements as you roll those hedges forward. And so that creates a cash liquidity event that, you know, has that impact. But, you know, you’re hedging what you’re hedging is long term. And it is not recorded through the balance sheet. There’s a lot of similarities to what we look at as corporate treasurers to manage asset liability, exposure and repricing risks.

Craig Jeffery  05:32

Yeah. So Todd, it seems like there’s a couple of things going on here. Let me see if I can restate it a different way. There’s a there’s an aspect of the the long term and short term aspect of this asset liability match and that the impact that inflation plays on it. And so there’s an economic element to this equation. And then there’s an accounting piece that has a feedback loop on the economic side of things, maybe maybe we just take that first part. So the while things might normally be fine with the, you know, the underlying exposure, and then the hedge to that exposure. Because there’s this this feedback loop on the hedge side, right, it’s out of the money, you have to mark the market, and there’s activities that have to take place. We’ve we’ve transitioned from economic side to economic to accounting, with a feedback loop to the economic side creating or accelerating the, the negative impact here, your asset, and the underlying exposure. Is that, uh, is that a fair way to say it? Or would you say that differently?

Todd Yoder  06:38

That’s definitely a fair way to say it. And not to get too off track. But it’s the same thing that banks, you know, have. So you have short term liquidity, but you do a lot of Long Term Lending. And I think I don’t want to get into the crypto area right now. But I think that’s a lot of the things that 99% of all my income don’t really serve the purpose that that the market really needs. But those that are trying to do it correctly, they still struggle with the same thing. So it’s, you know, short term deposits liquidity. And on the investment side, they want to keep those in extremely safe and short term assets, because they never know when they’ll get a, like we said earlier, run for the door, or a massive call of liquidity out of the business. Do you make a good point, the other thing to consider on on the example of the UK gilt market versus the corporate cash flow, hedging and exposure, another paradigm to that is, you know, are you are you hedging with a long term strategy, longer duration contracts? Or using a shorter rolling strategy? are you how are you set up? From a collateral standpoint? Do you have a credit support annex agreement in place where the bank is going to post collateral to you and you’re gonna post collateral to the bank, depending on how the positions go? Or are you uncollateralized, we could do a whole podcast on that very topic, where, you know, trying to monetize a mark to market how different bank look at that differently when they consider what’s the present value position that you’re on. But ya know, I think your assessment is very fair.

Craig Jeffery  08:12

You know, if an organization’s borrowing money from a bank, sometimes it can be like, you have to prove you don’t need the money for us to lend it to you. It’s kind of like this odd thing. And this is a situation of when you need to sell the most liquid assets. In the case of selling these guilts, for example, it’s like, if you start selling them, when you need to sell them, that has an impact on the market, it’s not this isolated event, it’s not like I can, I can sell my entire portfolio and not have an impact on the market. Because I do have an impact on the market. price moves a lot with a little bit of change. And so some of the ideas we have about liquidity and a margin from not from not from a trading standpoint, but a margin of comfort. Sometimes those things collapse when we don’t fully expect them. You know, because we just did the we did the mathematical formula, volume times face to race, collateral boat, not realizing that there’s an economic aspect of that, right, we sell it. And now each one gets a change as it moves the market, just like on the FX market. I think we should have a podcast on that at some point too. What are those? There’s unexpected events that happen when we do what seems to be rational like we make these assumptions. That might be another good one to think about this looking broadly looking around curves and I did like your your comments about the collateral it makes a difference how you, do you post these are they uncollateralized that changes the whole risk dynamic of these types of transactions. That was a great explanation on this longer term exposure and how you hedge which might have a shorter term rolling view or something that’s that’s more geared towards the long term organically. I’d love to hear you talk about the Money Creation in the Euro dollar system. So There’s a lot of US dollars held off shore. What’s going on here? I know we’re going to hear about triffids dilemma from this. But maybe you could talk about what’s the what’s the deal here? And how should a treasurer, be thinking about money creation and the potential impacts.

Todd Yoder  10:15

To be a strategic treasurer, I think macro economics is a really important piece of that. So a lot of the discussions that I’ve been having over the year, it’s been a busy year, a lot of great conversations. But in those conversations, I’m not hearing a whole lot about the macro economic part. And I think that’s a really important piece that strategic treasures need to, to spend some time with, you know, we’ve had economists and banks and others, not all, but a lot of them have been dollar bulls for quite some time, and especially during the pandemic, with a lot of US dollar cash put into the system, and some of that directly to US citizens. You know, everyone was even more dollar bullish, I think. And there were a lot of calls for the dollar to you know, even on the extreme, the dollar is going to depreciate rapidly. And I never believed that. And so what I wanted to just cover quickly, I think it might be interesting to your listeners is money creation. And then the other wildcard that no one seems to really be talking about is the Euro dollar system. And then the final thing is Triffins dilemma, which has has come to light, due to the situation we’re in with increasing interest rates here in the US and how that’s impacting the rest of the world.

Craig Jeffery  11:43

Maybe just do a quick definition of Triffin’s dilemma, at least to a view of how I have it as I’m not reading a definition, but it’s the mix of what a, let’s say, a central bank or a government does, based upon their short term, domestic betterment or goals versus their longer term, international position.

Todd Yoder  12:05

Yeah, so Triffin’s dilemma is definitely a big part of it. I think we just kind of run through the timeline or kind of a sequence of events that brings Triffin’s dilemma, back to the forefront of conversation in the macro environment. I mean, if we look at money creation, you know, there’s still a lot of people that believe the Federal Reserve comes out and says, we’re printing money, or we’re creating money. That’s not really what happens, the US Fed can can provide dollar liquidity to the primary dealer banks, at the end of the day, you know, money creation is driven by the private sector banks, right. So the commercial bank, the Fed can provide reserves to all the primary dealer banks and the amounts that it wants. Let’s just say as an example, you know, you and I were working together and you provided me with a billion dollars worth of liquidity. And you said, Hey, I’m printing a billion dollars, and I’m the primary dealer bank. Well, I that money only gets into the system, when I start to lend that money out.

Craig Jeffery  13:18

Just a quick interjection there. Todd. So, this is the money’s, you know, given to the these banks, they lend it out. The people they lend it to deposit some portion of it, or they they turn it into the economy and that’s re-lent out in different ways and so on until it it is expanded to a certain level, is that what you’re referring to?

Todd Yoder  13:36

Yeah, so the money provided by the Federal Reserve to the primary dealer banks that liquidity doesn’t really go anywhere, it doesn’t really do much for the economy doesn’t really do much for M2 and money creation until you have commercial banks that actually create the loans. And so to create the loans, they need to be comfortable. If the banks are concerned about a recession or a slowing in the economy, they may be less likely to to make those loans. That’s kind of the point there and it leads into the Euro dollar system. And this is an area one may think you’re referring to the Euro dollar exchange rate. But really your Euro dollars are any US dollars that are held outside of the Feds purview. So outside of the US a Euro dollar maybe US Dollars held in Japan at a Japanese bank that is outside of the Feds purview and not subject to regulation by the Fed.  The Euro dollar system. And I don’t want to get too much into history because we could talk for quite a while about it. But following the Bretton Woods agreement in the 40s prior to World War Two being completed, and the establishment of the US Dollar as the world reserve currency, what began to happen in the mid 50s. Running the trade balances was there was a lot of US dollar balances offshore in the late 60s where other countries wanted to convert their US dollars into gold. Of course, in August 15 1971. When Nixon ended, that then the US dollar became completely unbanked Fiat, at that point US dollar creation offshore, you can have, let’s just say you have a European bank, they make a US dollar loan in Europe that can happen, they can create US dollar loans. And they’re not subject to the reserve requirements. I mean, that the Fed ended that actually March 15 2020, suspended that for the US as well, back when I was in banking, and I was calculating reserve requirements was a 10%. Right reserve requirement that is no longer in place, but I’m sure it never was in place. There’s a lot of US dollar loans offshore. And kind of what we’re seeing is we’re seeing the Fed increase these rates, interest rates, and the ripple effect that’s having through the rest of the market rates go up, it leads to more defaults of of those that are having issues meeting, the interest requirements, my friend Kyle bass here, hedge fund guy from from Dallas, made the comment a rolling loan never fails, right. As these interest rates increase in the cost of US dollar liquidity offshore for these different markets increases, you have more default, we’re seeing kind of that getting clogged up. So the demand for US dollars has been extremely strong. And that’s why we’ve seen the US dollar actually appreciate when you and I know that that everyone says they’re very bullish on the dollar. And especially after the Fed started to print, the thing is those dollars are needed offshore. And we saw during the financial crisis 2008, the Fed open US dollar swap lines with other central banks because of the US dollar liquidity. And it really was this euro dollar system then as well. But now 2020, they opened US dollar swap lines again. And we recently saw Switzerland come to the market. There’s an auction every Wednesday with the New York Fed and Switzerland came and bought and then came back the next week and bought again, and they’re paying a pretty high premium for those dollars. So you don’t see that very often. And when you do doesn’t make the front page of the major news outlets, but it is a sign again as a strategic treasure when you’re looking at macro and what is causing that, that need for US dollars and the willingness and willingness to pay the premium for the US Dollars offshore. You know you have the Italian bond market and which is one of the more liquid bond markets, the spreads there, then you have rehypothecation you know, maybe we’ll save that for another day. But I was telling you, I think a few weeks ago, Manmohan Singh, who is at the IMF, he’s a senior economist. And I think it’s another place that could probably do a whole show on it, but treasurer should maybe take a look at the work he’s done on a rehypothecation. You know, here in the US, we have SEC Rule 15 C three dash c, which eliminates broker dealer rehypothecation of collateral to 140%.  Outside of the US, once you start moving into this euro dollar world, there is no reg T, a lot of the most pristine collateral is US dollar treasuries, that is re hypothecated and Manmohan Singh work measures on a quarterly basis. He’s one of the few people in the world because the Fed stopped publishing these metrics they used to publish on a weekly basis or bi weekly basis. And so he’s doing it on a quarterly basis. He’s got some some great papers, white papers that he’s written that I think are worth having a look at.

Craig Jeffery  19:06

Yeah, Todd, you shared a lot of good points and good information, we’re gonna have to draw this particular episode to a close.  This is part one of I think it’s gonna go more than two parts, Todd, but I’m looking forward to the other parts of the conversation here. So thank you so much for part one, and look forward to continuing continuing part one or what we’ll refer to as part two in the near term.

Todd Yoder  19:31

Yeah, now this is excellent. We’ll leave him hanging on on part two, we’ll draw them back in hopefully Thank you a lot, Craig, and I look forward to catching up soon.

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