Stability and inclusivity of stablecoins: A conversation with Circle CEO Jeremy Allaire
While cryptocurrency has been around for over a decade, it has only gained mainstream popularity recently. Crypto backers see the technology as the way of the future, but its instability leaves others skeptical. As a less volatile alternative to traditional cryptocurrencies, asset-backed stablecoins have joined the market. But as with all new technology, important questions must be resolved before stablecoins could become a more widely accepted part of our financial system.
In this fireside chat with Circle co-founder, chairman, and CEO Jeremy Allaire, we will discuss the rise of stablecoins, the state of regulation of stablecoins, and the potential for greater inclusion through new financial technology (fintech). The dialogue will cut through much of the hype of cryptocurrency – stablecoins in particular – and dive into the two important and distinct issues surrounding stablecoins: financial stability and inclusion.
This event will be part of the Brookings Center on Regulation and Markets’ Series on Financial Markets and Regulation, which looks at financial institutions and markets broadly and explores how regulatory policy affects consumers, businesses, investors, fintech, financial stability, and economic growth.
Viewers can submit questions for speakers by emailing events@brookings.edu or via Twitter using #Stablecoin.
The US needs urgently to raise its macropru game
Donald Kohn
Robert V. Roosa Chair in International Economics
Senior Fellow – Economic Studies
Implementing robust macroprudential policy—addressing threats to financial stability beyond those that were the focus of safety and soundness on an institution-by-institution basis or of investor protection market-by-market—was a constructive outcome of the legislative and policy response to the global financial crisis of 2008-09.
In the U.S., the Dodd-Frank Act of 2010 strengthened the hand of the Federal Reserve as it addressed the systemic risks in banks and bank holding companies, including those emanating from institutions that were “too big” or “too systemic” to fail. It also created two new institutions to look across the fragmented regulatory landscape to drive macroprudential policy addressing risks outside of banks: the Financial Stability Oversight Council (FSOC), which is chaired by the secretary of the Treasury and includes the heads of federal regulatory bodies, is charged with identifying and responding to risks to the financial stability of the United States, and the Office of Financial Research (OFR), which was created to support the work of FSOC through research and data gathering. FSOC’s powers are limited—it can designate systemically important institutions, and it can make recommendations to constituent regulators—but even those authorities have been infrequently used. The structures set up by Dodd-Frank have not led to consistent and effective macroprudential policies in the U.S.
The Biden administration, under the leadership of Janet Yellen at Treasury, intends to drive more active macropru policies, but at this still early stage of the administration, results are not yet evident. It is urgent they get on with the job. First, the “dash for cash” of March 2020 as the pandemic shutdown set in revealed a number of weaknesses in market-driven financial intermediation that required unprecedented and massive central bank intervention to prevent a total breakdown of the financial system that would have made an already dire economic situation much worse. We had hints of those weaknesses before the pandemic, but they became considerably more visible under stress. Moreover, the actions of the Federal Reserve and other central banks to counter their effects raise the possibility that private risk taking will be distorted by the expectation of future interventions in stress situations. The authorities need to move while memories are fresh and political support for corrective steps is at its highest.
The second reason for urgency is the current economic and financial situation. If the economic and financial situation evolves as seems to be expected in financial markets, credit will flow, and financial markets will continue to serve the needs of the economy. But the current situation is replete with fat tails—unusually large risks of the unexpected which, if they come to pass, could result in the financial system amplifying shocks, putting the economy at risk. At a recent FOMC meeting, the Board of Governors staff characterized financial vulnerabilities as “notable,” reflecting some asset valuations, leverage in corners of the financial system, and persistent structural issues.[1] Moreover, these vulnerabilities have arisen in the context of truly unprecedented circumstances, making it difficult, if not impossible, for policymakers or market participants to predict the future with confidence. There’s the virus, of course, and the public and private response to its evolution. In addition, fiscal policies are raising Federal debt-to-income to record peacetime levels and a new monetary policy framework has yet to play out in practice. Meanwhile, inflation has spiked to the highest levels in many years. Yet market participants appear to have priced in very low interest rates for a very long time even as the economy recovers and, judging from risk spreads and equity prices, are quite confident that higher debt levels can be serviced and sustained—even though a disproportionate increase in private debt has been among lower-rated business borrowers.[2]
Well-functioning U.S. financial markets are essential for well-functioning global finance. We saw all too clearly in 2008 how disruptions in U.S. markets can trigger a global financial meltdown and recession. Building resilience in the U.S. to risks that could readily materialize is essential to building confidence in a sustained global recovery from the pandemic. New legislation would be helpful in a number of dimensions—especially in reworking how FSOC and OFR function and making sure they are supported by a more prominent financial stability focus and analytical capability in constituent agencies. But U.S. agencies already have the tools to address many of the vulnerabilities that have lingered since the GFC and became so evident in March of 2020, and some new ones that have emerged more recently.[3]
Here’s a checklist of actions that do not require legislation. Notably, it is not a menu from which to pick a few “dishes” to make a macropru meal—all of these things should be addressed, and promptly.
Banking
The resilience of the banking sector was greatly strengthened after the Global Financial Crisis (GFC) by tightened and reformed capital requirements, stress tests of capital adequacy, liquidity requirements, and greater scrutiny of bank risk-management practices, with extra requirements in each area for systemically important banks whose failure would have significant knock-on effects. But more can be done to build resilience in banks and in securities markets where banks intersect with nonbank finance.
A very serious amplifier of stress in the March 2020 dash for cash was the counterintuitive and counterproductive behavior of Treasury securities prices, which fell, rather than rose, in the midst of a flight to liquidity and safety. Dysfunction in the Treasury market spills over in many ways to the broader financial markets and the economy since Treasuries are relied on for liquidity by market participants, for risk management, and as a pricing reference point. There were a number of contributors to this behavior, but one was the reluctance of private dealers, the largest of which are subsidiaries of systemically important bank holding companies, to flex their balance sheets to pick up the Treasury securities being offered in the market. The dealers were especially constrained by the risk-insensitive leverage ratio applied to systemically important bank holding companies, until the Federal Reserve temporarily exempted deposits at the Fed and Treasuries from its calculation. That exemption has lapsed, and with continuing Fed securities purchases, deposits at the Fed are a growing threat to making the leverage ratio salient again, which would constrain dealer market-making appetite. The Federal Reserve should permanently exempt deposits at the Fed from calculation of the leverage ratio.
This exemption, however, should not be allowed to reduce the capital required of banks, especially systemically important banks. There are a number of ways to keep this from happening, but one I favor is to raise risk-based requirements a bit on average through the cycle by activating the countercyclical capital buffer (CCyB). The Fed’s current practice is to leave this at zero unless it has identified the risk environment as already elevated. In this, it differs from many other authorities globally, who have targeted a positive CCyB in a normal risk environment, which enabled them to release that capital to back lending when the Covid-related shut down hit.
The argument for an active CCyB has been strengthened by experience in the pandemic. Evidence from both the U.S. and EU is that banks are reluctant to dip into their regulatory capital buffers to make loans under stress out of concern about market reactions and about supervisory constraints on earnings distributions. Studies have shown that banks with less headroom over buffers tended to lend less in the pandemic than banks with more headroom.[4] The beauty of the CCyB is that once released, it is not part of a regulatory capital buffer and is more available for use. Moreover, the recent changes to the Fed’s stress tests and capital requirements, including substituting a “stress capital buffer” derived from stress test results for elements of the capital stack, are likely to make capital requirements procyclical; adding an actively managed CCyB would counter this adverse macroprudential outcome.
The evident reluctance of banks to dip into regulatory buffers under stress suggests a reasonably sizable CCyB in “normal times” to release under stress would be a helpful countercyclical measure from a macroprudential perspective. The Financial Policy Committee at the Bank of England has established two percent as its target CCyB in a standard risk environment, twice what many other macropru authorities have set, in part by shifting capital from other elements of the stack.
The Federal Reserve should make the CCyB positive in normal risk environments and then manage it actively as risks build or materialize. As it implements a CCyB, the Fed should consider the appropriate level in the context of sterilizing a potential release of capital from adjusting the leverage ratio and the composition of the overall capital stack that would best support the resilience of the financial system and the economy.
Market-based finance
Credit has increasingly shifted to nonbank channels, especially to markets, responding to innovation and to regulatory arbitrage as bank regulation tightened. But elements in nonbank finance share the leverage and maturity and liquidity transformation characteristics of banks, making them also vulnerable to runs and fire sales that tighten credit and amplify business cycles. In many respects, however, vulnerabilities in market-based finance are harder to deal with than they are with banks. They are spread over many types of institutions and markets, subject to multiple regulators—and some parts are very lightly regulated, if at all. Market-based finance is global, facilitating arbitrage across borders and necessitating a globally agreed approach to regulation. And rapid technological change produces a constantly evolving set of instruments and players. Still, tools are available to address a number of vulnerabilities and the centrality of U.S. markets to global markets means that the U.S. should lead the effort.
As noted, well-functioning U.S. treasury markets are a critical element in keeping both bank and nonbank financing channels operating well. Leverage ratio reform is a necessary but not sufficient condition to bolstering Treasury market liquidity. In addition, the Treasury and the Fed should examine the costs and benefits of mandating central clearing for Treasuries and repos, which might free up dealer capital that would be available to be used for market making.[5] And the agencies need to gather and publish more complete data on market transactions to help both regulators and market participants better understand and anticipate market dynamics.[6]
Even with greater private-sector market making, circumstances could arise in which the Federal Reserve would need to step in to preserve well-functioning Treasury securities markets. To that end, backstop standing repo facilities for foreign official holders of Treasuries and for a wide variety of private market participants would put structures in place that could fill that role in a well-anticipated and transparent fashion. In that regard, the Federal Reserve’s recent announcement of two such facilities—one for foreign official institutions and another for dealers—was welcome.
But the repo facility for private parties is limited to the primary dealers and, over time, some depository institutions. To better guarantee Treasury market functioning, the Federal Reserve needs to design a repo facility that is available to a variety of large participants, like hedge funds and other leveraged investors that are playing an increasingly important role in the market. Such an extension would raise issues of counterparty risk and distortions to risk-taking incentives among lightly regulated entities; those can be dealt with through varying haircuts and by imposing a small ex ante fee on lightly regulated entities with access to the facility, but other approaches may also work.
Several types of open-end funds faced very large redemptions in March, including both money market funds and corporate bond and loan funds; to meet those demands, funds turned in part to selling the Treasuries they held for liquidity purposes, so these redemptions disrupted Treasury, corporate bond, and commercial paper markets. The scale of the redemptions is not surprising. Many mutual funds offer their investors much greater liquidity—an ability to redeem by tomorrow at tonight’s closing price—than the liquidity of the underlying securities they hold, which often trade in illiquid markets or simply don’t trade at all, like commercial paper. This mismatch creates a first mover advantage—an incentive to get out while the fund has Treasuries to sell—before redemptions by other investors force fire sales of less liquid assets, depressing prices. The SEC must change regulations to align the liquidity offered investors with the liquidity of the underlying assets in the fund. There are a variety of ways to do this—and the choice for money market funds might differ from the best choice for bond funds. Swing pricing forces early redeemers to pay the price of the liquidity they are getting; where that isn’t possible, as is argued for money market funds, alternatives may work to properly price liquidity under stress, like penalizing redemptions under some circumstances or holding back a portion of the investment.
Another source of elevated demand for liquidity in March 2020 arose from initial margining at central counterparties in derivative and securities markets. According to users, a lack of transparency and predictability about margining methodologies contributed to unexpected demands for cash during the “dash for cash.” But in addition, margin requirements rose substantially as markets became much more volatile. From the perspective of the clearinghouses, this made good sense, and in fact central counterparties remained functioning and viable during an extremely stressful market episode. But here is a case of the micro and macroprudential impulses in conflict as the interest of each clearinghouse added to overall market stress. The CFTC and the SEC should draw on the systemic perspectives of the Fed and Treasury to make margins in CCPs less procyclical with more through-the-cycle methodologies.
This is a formidable list—and I could have added more. Much of it is already under consideration in the U.S. and in global groups, like the FSB. Each element will draw opposition from private parties fearing added costs and counting on intervention from the fiscal and monetary authorities to contain the next market crisis. All of it will require a careful balancing of costs and benefits—but most explicitly and importantly taking account of the costs to society, beyond the costs to market participants, of repeated episodes of financial instability.
Other jurisdictions
The risk environment in the financial markets of many other advanced economies is quite similar to that facing the U.S. Asset prices are elevated and leverage in some sectors has ballooned as market participants count on low interest rates persisting for a very long time. But uncertainties abound as the global economy emerges from a global pandemic after application of unprecedented monetary and fiscal policies. And, until the U.S. raises its macropru game, they are vulnerable to disruptions emanating from U.S. markets.
Many authorities outside the U.S. have utilized a wider array of macropru tools than has the U.S. Given the risk environment, now is the time to make sure domestic institutions and markets would be resilient to severe shocks. Where requirements were adjusted or eased in response to the onset of the pandemic, they should be restored to former settings now that economies are recovering and credit is flowing readily. For example, CCyBs cut in March 2020 to encourage bank lending should be raised as quickly as is consistent with the commitments and forward guidance given when the reductions were announced. Where the “dash for cash” revealed new vulnerabilities that can be addressed in individual jurisdictions, actions should be taken to build resilience—for example, if the margining at CCPs and the behavior of highly leveraged investors in domestic sovereign bond markets amplified stress. Where effective remediation is not possible in global markets without the participation of the U.S., other authorities should work closely with U.S. authorities in international fora to build consensus around best practices that can be implemented globally, including in the United States.
[1] Darrell Duffie highlighted the potential for central clearing to economize on dealer capital. https://www.brookings.edu/research/still-the-worlds-safe-haven/
[2] Notably, the recommendations of the G-30 group on Treasury market functioning are broadly aligned with those of the Task Force. https://group30.org/publications/detail/4950
[3] https://www.federalreserve.gov/econres/feds/un-used-bank-capital-buffers-credit-supply-shocks-at-SMEs-during-the-pandemic.htm. And for similar findings away from the U.S.: https://www.bis.org/bcbs/publ/d521.pdf.
[4] https://www.federalreserve.gov/newsevents/pressreleases/monetary20210818a.htm
[5] https://www.ft.com/content/32a57864-d983-46b0-bbfa-85fd2d2361e5
[6] Much (though not all) of what follows is based on the recommendations of a Chicago Booth-Brookings Task Force on Financial Stability that I co-chaired. https://www.brookings.edu/research/report-of-the-task-force-on-financial-stability/. I have also drawn on my talk to the Kansas City Fed’s Jackson Hole symposium. https://www.brookings.edu/research/building-a-more-stable-financial-system-unfinished-business/
The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation.
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Regulating stablecoins isn’t just about avoiding systemic risk
It’s good news that financial regulators are focused on figuring out what to do about stablecoins because their growth is creating significant risks. But there’s a bigger picture here than how to bring these new instruments within the regulatory perimeter, or how to regulate crypto generally, even though these are important. The bigger issue is how do we modernize our payments system? This should be a Biden administration priority because it would help low-income people in particular.
Timothy G. Massad
Senior Fellow – The John F. Kennedy School of Government, Harvard University
Former Chairman – Commodity Futures Trading Commission
Former Assistant Secretary – Treasury for Financial Stability
The connection between stablecoins and helping low-income people might seem unlikely because stablecoins are primarily used today to speculate on cryptocurrencies. While their growth has led financial regulators to worry about potential systemic risks, that growth is partly because of deficiencies in our payments system, and those deficiencies are a major reason why the U.S. lags behind other developed nations in financial inclusion. Stablecoins have potentially much broader application. Properly regulated, they are one means—although clearly not the only means—of curing some of those payment system deficiencies. Thus, financial regulators should not only address the risks that stablecoins pose but keep their aim on that broader goal of modernizing our payments system and improving access to the financial system.
This paper discusses (1) why stablecoins are a problem; (2) how we should regulate stablecoins; and (3) the bigger picture about modernizing payments and improving financial access.
The risks of stablecoins
Stablecoins are digital tokens whose value is pegged to the dollar (or another currency or asset). They serve to grease the wheels of the crypto industry, enabling investors to easily transfer value between different crypto exchanges and cryptocurrencies without converting back and forth into dollars. Settlement is instant, thus avoiding delays of other means of payment. This function coupled with explosive growth in the crypto currency market explains why the market capitalization of stablecoins has increased from $20 billion twelve months ago to over $120 billion today1.
Figure 1: Market capitalization of stablecoins, January 2017 to August 2021
Stablecoins are currently not regulated in any meaningful way. While some issuers have state licenses, these impose minimal requirements. There are no standards requiring issuers to protect reserves or maintain liquidity. I have written about how a sudden spike in demand for repayment could cause a stablecoin to “break the buck” the same way the Reserve Primary Fund did in September of 2008, which triggered a run on money market mutual funds that was only stopped when the Treasury issued a guarantee of money market mutual fund liabilities.
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Although stablecoins are currently not used widely outside of the crypto industry, they have the potential for much broader application. Stablecoins first garnered wide attention in June 2019 when Facebook proposed creating “a simple global currency”2 or stablecoin called Libra that would be pegged to a basket of fiat currencies including the dollar and the euro. That proposal provoked harsh criticism, both because of its sponsor3 as well as its design. Central bankers feared it would undermine sovereign currencies and monetary policies4. The proposal has since been renamed Diem and redesigned as a set of stablecoins, each tied to an individual fiat currency. It is not operational, in part, because Facebook promised in Congressional hearings that it would not launch the idea unless regulators approved, and they have not done so. Other stablecoin issuers did not ask for permission, and their tokens have grown enormously, which has finally prompted regulators to consider acting.
How to regulate stablecoins
In July, Treasury Secretary Yellen convened the President’s Working Group on Financial Markets (PWG) to discuss stablecoins. The PWG does not have any power to actually do anything about stablecoins, however. Instead, Treasury staff will soon issue a report that will recommend a path forward, which could include a mix of recommendations for actions by different regulatory agencies and potentially Congress.
The best option is to have the Financial Stability Oversight Council (FSOC) commence a review. Under Title VIII of the Dodd Frank Wall Street Reform and Consumer Protection Act, the FSOC can require regulation of a “payment activity” that it determines “is, or is likely to become, systemically important.”5 The FSOC has broad powers to get information from institutions engaged in an activity that it has reasonable cause to believe meets the standard for such a designation. That type of inquiry is much needed given the lack of transparency about stablecoins.
The law sets forth criteria for making the systemically important designation, which include size as well as the effect that the failure or disruption of the activity would have on critical markets, financial institutions, or the broader financial system. Under Title VIII, the FSOC has designated two operators of business payment systems as systemically important financial market utilities, but it has never designated an activity generally nor an entity engaged primarily in retail payments. The “likely to become” phrase is not in Title I, under which FSOC designated four entities following the global financial crisis. It is clearly relevant to the concern that, unless regulated, stablecoins could continue to grow dramatically.
Having been a member of the FSOC for three years, I believe an FSOC review will be useful even if it decides against a systemically important designation. The FSOC can still be the forum for making a sound choice among the alternative paths, which involve different regulators who comprise the FSOC. There is a good argument that stablecoins could be regulated as bank deposits under existing law. Section 21 of Glass Steagall (which survived despite repeal of much of that law) prohibits anyone from receiving a bank deposit unless subject to regulatory oversight under specific exceptions.
There is also the option of regulating stablecoins as securities or as money market funds. Securities and Exchange Commission chair Gary Gensler has suggested he might move to do so and has referred to the PWG report as something that his staff is working on with Secretary Yellen. Although I have compared stablecoin risks to those of money market funds, I do not think that is the best way to regulate them. They are fundamentally payment devices and not investments. Classifying them as securities would also appear to pre-empt a systemic importance determination as part of the payment authority given by Dodd Frank since the definition of “payment, settlement and clearing activity” for purposes of FSOC’s jurisdiction excludes “any offer or sale of a security under the Securities Act.” The PWG report will presumably indicate which path of this fork the Biden administration will pursue.
Another option is to recommend to Congress that it enact new authority. Various bills have been introduced to address stablecoins, including one that would limit issuance to entities that are banks. But at a time when the Biden administration and Congress already have many weighty legislative priorities, rapid enactment of legislation seems doubtful.
If the FSOC does reach a determination of systemic importance, the Federal Reserve would be charged with developing “risk management standards” that “promote robust risk management; promote safety and soundness; reduce systemic risks; and support the stability of the broader financial system.”6
The path chosen may affect the comprehensiveness of the regulatory framework that can be created, though we should put in place what we can now and add to it later if necessary. Ideally, we need a framework that includes not just traditional prudential regulation standards, but also operational risk measures, consumer protection standards, and standards to achieve interoperability. Regulators should require that reserves are invested in bank deposits, Treasuries, or other safe, liquid assets, and that there are liquidity requirements. If the Federal Reserve were to broaden who is eligible for a master account, then stablecoin providers which are not banks could park reserves at the Fed, an option some would argue is even safer because it would avoid the operational risk of a particular bank. Regulators should require a capital buffer even if reserves are invested in cash or other safe assets. That is because capital can protect against other types of losses, such as operational ones. Regulators may also want to ban the payment of interest to discourage users from maintaining large deposits. That plus requiring reserves to be invested in cash or other safe assets would likely mean that stablecoins would be attractive only as payment instruments, not as investments. A prohibition on interest would put stablecoins at a disadvantage relative to bank deposits if interest rates rise, but regulators might desire that in these early days of the industry. Compliance with “know your customer,” anti-money laundering, and other laws combatting the financing of terrorism is crucial.
There should also be operational resilience standards. This is a huge area of risk often overlooked in commentary that focuses on stablecoin financial risks. Stablecoins run on decentralized blockchains and smart contracts. The software for the various layers of operation could have flaws or could be vulnerable to attack. The largest stablecoins run on multiple blockchains but are separate and distinct tokens on each such blockchain, as a recent post by Neha Narula of MIT explains. That means risks associated with the integrity and reliability of the blockchains and software are multiplied. In addition, a stablecoin could become too large in relation to the capacity of the blockchain itself. Federal Reserve staff are presumably becoming knowledgeable about these issues through their collaboration with MIT to design a hypothetical central bank digital currency platform.
The regulatory framework should also include requirements for adequate disclosure of information to customers, rights of recourse, and standards on protection of customer information, including on how a customer’s data can be used. The Consumer Financial Protection Bureau may have a role to play in this regard. Finally, we may want to create standards that ensure interoperability between different stablecoins to avoid a fragmented system.
One other advantage of an FSOC process is that the presence of representatives of state banking and securities regulators on the council may help figure out how state regulation of stablecoins—which exists, but is quite limited—should mesh with federal standards.
Both the PWG and the FSOC are well suited to examining risks generated by financial markets. The PWG was created in response to the 1987 stock market crash; the FSOC was created in response to the 2008 global financial crisis. But whatever path is chosen for going forward, the goal should be not just to regulate risks of this particular innovation but to address deficiencies in the payment system that are a principal reason for the growth of stablecoins.
How regulating stablecoins can advance financial inclusion
While stablecoin usage has largely been in the crypto industry, their impact has already been broader. As Federal Reserve chairman Powell said in discussing Facebook’s Libra proposal, the concept “lit a fire” under central bankers to consider central bank digital currencies (CBDCs). Both stablecoins and CBDCs are ways to remedy deficiencies of our payments system and potentially enhance financial inclusion. As financial regulators address the risks of stablecoins, they should articulate that larger goal of modernizing our payments system and increasing access to the financial system.
Banks handle the vast majority of U.S. dollar payments in a safe and well-tested manner. But the system is characterized by relatively high cost, weak competition, and insufficient innovation. Americans pay significantly more than Europeans for payment services, particularly because of high fees paid for credit cards. The system is also slow relative to real-time payments increasingly common in other countries.
Most Americans might say the system is fine. We don’t notice interchange fees paid by merchants because they are rolled into prices, and our credit cards give us free revolving credit, cash back, frequent flyer miles, or other rewards. Nor is anyone who has some savings likely to be inconvenienced if a check takes a couple days to clear.
But the flaws of the system weigh much more heavily on those in lower-income brackets. Those who live paycheck to paycheck are at risk of incurring significant overdraft fees when checks don’t clear quickly. The fact that approximately 70%7 of those who use check cashing services have bank accounts is clear evidence that something is wrong with the payments system. In addition, because people with lower incomes have fewer credit cards—they use more prepaid cards and debit cards, which don’t offer the same benefits—the credit card costs embedded in prices fall disproportionately on them.
It is shocking that with a financial system as sophisticated as ours, 25% of American households are unbanked or “underbanked,” according to the FDIC. The latter term means they have a bank account but use nonbank options like check cashing services or payday lenders, often to avoid even more expensive bank overdraft charges. Moreover, as Aaron Klein has written in an excellent new paper, the key issue is access to digital money, and low-income people are at a distinct disadvantage in that regard.
Stablecoins are one way to speed up payments, as are CBDCs. The original Libra proposal focused on its potential financial inclusion benefits. While some might regard that as window dressing by Facebook, the fact is that slow and expensive payments burden low income people in many ways. Remittances—a $700 billion market of sending money from one country to another—is a prime example, as the average cost exceeds 6%.
A retail CBDC could be a means of providing bank accounts as well.8 Of course, the banking industry is quick to cry out that this would disintermediate the banking system—because deposits would leave commercial banks and move to the Fed—and result in less lending and credit creation. But there are many design choices for CBDCs. One option is to create no frills, minimal retail accounts with deposit limits, which might help the unbanked and underbanked without draining away significant deposits. We could also mandate banks to provide such low or no-cost accounts.
These are not the only solutions, and some will argue that existing private and public sector initiatives are sufficient to modernize the system. The Federal Reserve’s new real-time payments system, FedNow, is due to be operational in 2023 and that will surely help. But it needs to be coupled with regulatory changes that will create more competition, or banks may only offer those services within their “walled gardens”.
The real issue is increasing competition—either from new private sector entrants or effectively from the government through a CBDC. Regulators can’t fix the system’s deficiencies as they move to regulate stablecoins, but they can frame the issue in that context. The big picture is that stablecoins have grown enormously because they offer distinct advantages in speed. Banks have not sufficiently modernized the system nor addressed financial inclusion. Changes in regulation may be needed to permit greater competition and facilitate innovation. The Biden administration should make this a national priority.
The risks of US-EU divergence on corporate sustainability disclosure
Sustainability disclosure is in vogue, with more than 80 percent of major global companies reporting on some aspects of their social and environmental impacts. This is partly driven by growing calls for transparency by civil society organizations and environmental, social, and governance (ESG) investors, who are demanding detailed and verified corporate sustainability information. ESG investments—assets that fulfill certain minimum social and environmental criteria—grew by more than 40 percent in 2020 in the U.S., and currently make up one-third of all assets under management. However, the process of classifying financial assets as ESG is unregulated in the U.S. Moreover, the data required to assess if ESG assets have achieved a positive social and environmental impact is often missing, incomplete, unreliable, or unstandardized.
The U.S. and the EU are pursuing different trajectories in regulating ESG investing and sustainability disclosures. The U.S. is following a laissez-faire approach with sustainable investing and disclosure being guided by voluntary, private-sector-led processes, protocols, and guidelines. Compliance is driven by peer pressure and the competitive drive to build an image as a sustainable, accountable business. In the absence of regulatory intervention, institutional investors that manage index funds—in particular BlackRock, Vanguard, and Mainstreet—have stepped in to take state-like roles by putting pressure on corporations to address systematic risks like climate change.
These voluntary mechanisms, however, have been criticized for being inadequate. Corporations are routinely accused of “greenwashing” their sustainability reports by overstating their positive environmental and social impact and downplaying negative ones. In the absence of detailed, verified information, asset managers can fall prey to greenwashing and classify securities of unsustainable companies as ESG assets. This leaves ESG investors with little assurance, legal or otherwise, that their money has been put to the intended use.
The EU priming for a green future
The EU, on the other hand, is following a systematic and centralized approach toward climate transition and sustainability disclosure. Its regulatory regime is underpinned by the European Climate Law that legally endorses the EU’s commitment to meet the Paris agreement. To achieve climate neutrality by 2050, the continental body has introduced a slew of regulatory measures that will accelerate capital allocation toward green investments.
One of these is the Corporate Sustainability Reporting Directive (CSRD) that was introduced in April 2021. It upgrades the 2014 nonfinancial reporting directive and seeks to improve the coverage and reliability of sustainability reporting. When the law comes into effect in 2023, the CSRD is expected to increase the number of European and Europe-based companies that disclose sustainability information by fourfold, to 49,000 in total.
The CSRD proposal applies the “double materiality” principle, requiring companies to disclose information that is material for the enterprise as well as for its societal stakeholders and/or the environment. For example, it requires companies to disclose the extent to which their activities are compatible with the goal of limiting global warming to 1.5 degrees Celsius. Importantly, the directive requires companies to seek “limited” assurance by third-party auditors.
The directive is also unique for requiring companies to report their sustainability performance using EU-wide disclosure standards. The European Financial Reporting Advisory Group (EFRAG), a private association with strong links with the European Commission, has been tasked with the difficult job of developing these disclosure standards. EFRAG intends to build on existing, third-party sustainability reporting standards and has initiated a collaboration with the Global Reporting Initiative (GRI), currently the most widely used reporting standard globally.
Alongside a similar sustainability disclosure law that regulates processes of ESG investing in financial institutions, the CSRD is expected to significantly improve transparency in European capital markets. These measures are also likely to increase the adoption of sustainability goals and targets among European corporations, further widening the existing disclosure gap between EU-based and U.S.-based corporations.
A change of heart at the SEC
Until recently, American regulators have been reluctant to mandate sustainability disclosure. At a recent Brookings webinar, Securities Exchanges Commission (SEC) Commissioner Hester Peirce offered the rationale why ESG rule-making is beyond the mandate of the SEC, reflecting the longstanding view among Republican commissioners at the SEC. Her long list of justifications includes some plausible ones, such as the broad and elastic nature of the ESG concept that would make it ill-suited as a domain of disclosure rule-making. Others were highly slanted, such as the contention that ESG disclosure could drive financial instability by leading to excessive allocation of capital to supposedly green technologies. This is ironic because the lack of ESG disclosure mandate is not slowing down the rapid growth of ESG investments; it is only making the process opaque and ineffective, making stock market volatilities more rather than less likely. In fact, the EU’s key justification for sustainability disclosure is preventing systemic risks that threaten financial stability.
The SEC, which now has a 3-2 Democratic majority and a Biden-appointed chairman, has of late shown keenness to play a more active regulatory role. In May 2020, its Investor Advisory Committee provided recommendations that urged the commission to set up mandatory reporting requirements on ESG issues. In December 2020, an ESG subcommittee issued a preliminary recommendation that called for the adoption of mandatory standards for disclosing material ESG risks. The recommendation, however, called for limited disclosure covering a narrow range of metrics tailored by industry, in a manner similar to the standards of the Sustainability Accounting Standards Board, while warning against the “highly prescriptive” standards that were purportedly adopted by the EU. In March 2021, the commission solicited public input on climate change disclosures, which revealed strong demand for mandatory sustainability disclosure.
Divergent disclosure laws
The SEC is thus set to adopt mandatory ESG disclosure rules, perhaps as early as October 2021. These rules, however, are likely to depart from the EU’s approach in a number of ways. First, an SEC regulation will target only publicly listed companies; the EU’s CSRD, on the other hand, covers large unlisted firms as well. Second, the SEC will mandate disclosure of a narrow range of outcomes related to climate risk and human capital, while the EU will mandate disclosure of a broader set of sustainability outcomes, including indirect outcomes through the value chain and relevant corporate strategies and processes. Third, given capacity constraints, the SEC will likely adopt less comprehensive, third-party disclosure standards as opposed to developing its own comprehensive standards as the EU intends to do. Facing pressure from Republican lawmakers and interest groups, the SEC’s measures are also likely to be timid, focusing only on protecting (ESG) investors through the narrow lens of financial materiality.
By comparison, the relatively wide coverage of the EU’s new disclosure law (CSRD) will lead to significant improvements in data availability. The use of uniform disclosure standards will also ensure that companies provide more detailed and comprehensive sustainability information. It is, however, less obvious how the directive will improve data quality and reliability. The requirement for limited assurance will reduce the most overt forms of greenwashing but is unlikely to eliminate disclosure of data with dubious quality. For example, such an assurance is unlikely to guarantee that a company used the most recent or robust method for assessing its carbon footprint.
The EU’s law is also unlikely to address the lack of standardization, which is to a degree inherent to ESG metrics. Sustainability disclosure will contain significant company-specific, qualitative data, including retrospective and forward-looking statements that are hard to quantify. The EU’s reporting standards will give managers significant discretion on what to disclose and how, and they impose different requirements for companies that differ by sector and size. More nuanced and detailed sustainability disclosure is more valuable to individual (ESG) investors though, at a macro level, this increases the cost of standardizing, comparing, and verifying the reported data. The search for the “holy grail” of the ideal ESG index will thus continue, hampered by the difficulty to converge on what categories of ESG are universally relevant, how to define their scope, which sets of metrics to use, and how to weigh and aggregate them.
A missed opportunity for coordination?
In both the EU and U.S., the move toward greater corporate transparency will help improve the existing power imbalance between shareholders and stakeholders. The lack of verified disclosure today discourages corporations from reporting unsavory business practices that have devastating societal and environmental impact. Greater transparency, stronger regulatory oversight, and more robust third-party ESG assessment can lead to better public understanding of the positive and negative externalities that corporations create, allowing the market to reward “good” ones and penalize “bad” ones. At the same time, given significant informational asymmetries and inevitable loopholes in principles-based disclosure standards, the tendency of corporations to understate their negative externalities is likely to persist, making greenwashing largely inescapable in the foreseeable future.
These challenges are further exacerbated by the lack of coordination to develop globally acceptable disclosure standards. Conflicting regulatory regimes between the U.S. and EU will harm trade and investment flows across the Atlantic and potentially globally. Frictions are already emerging in the context of the EU’s forthcoming carbon border adjustment mechanism, which will impose tariffs on imports from countries without carbon taxes. In the end, coordination at a global scale is needed to regulate corporate sustainability in a manner that does not sand the wheels of the global trading system.
Can fintech improve health?
Abstract
Access to electronic financial services, in particular digital money, has replaced the digital divide as an unintended yet significant barrier for low-income individuals to participate in new technologies, including those that lead to better health outcomes. This paper explores this problem in depth. It begins by describing and documenting the barriers, costs, and benefits to accessing and using digital money. Next, the paper turns to implications of the broader technological revolution on the nature of money and payment systems. This includes an examination into the structure of our banking and payment systems and their overlay into different demographic groups of Americans. The paper then explores the ramifications of disparity in access to digital money for physical health including an analysis of how the COVID-19 pandemic amplified existing problems. It concludes with a set of recommendations to ameliorate the problems identified.
The paper finds that access to digital money is an underappreciated vector by which technological innovation, both financial and non-financial, can be hindered in reaching certain populations. Accessing digital money is easy and free for those with money while for those without a lot of money, digital money is expensive. Digital money’s role as a barrier to accessing new technology, particularly in an app/mobile/online economy, will likely exacerbate existing inequalities and impede adoption of some new technology for lower-income people. To the extent that these new technologies offer health benefits and require digital money, existing public health inequalities will be exacerbated. Fully realizing the potential health and wealth benefits of new technology requires a better solution to the digital payment divide than currently exists.
Key Findings
America’s payment system is designed to segregate people by income and wealth. Access to digital payments is more expensive and difficult to obtain for lower-income households and racial minorities despite decades of continuing growth of usage of digital money. This results in barriers to adoption of new technology, which increasingly requires digital payments. The response to the COVID-19 pandemic exposed several consequences of this problem, resulting in reduced effectiveness of pandemic response and potentially greater health risks due to a lack of access to digital payments.
Linkages between income, wealth, and physical and mental health have been documented. However, prior research has not generally considered the role of payments and access to digital money as impacting either income or health. This paper argues that access to digital money has a direct impact on financial well-being and consequently should factor into determinants of health. In addition, the inability to access digital money easily and cheaply may factor into other elements that have been studied as part of the broader social determinants of health, specifically the ability to access new technologies that require digital payments.
A specific new finding in the paper is that the majority of Americans who use check cashers and the majority of checks cashed are from people with bank accounts. This challenges the notion that being “unbanked” drives use of certain “fringe financial services” such as check cashers. Issues around cost, including the value of immediate payment, drive decisions on how best to access money, whether through bank products or non-bank products.
Table 1: Use of check cashing services, by banking status
The main policy solutions discussed center on enhancing access to digital payments through expansions of the provision of low-cost financial services. The goal is universal access to digital payments at low/no-cost, which should reduce the inequality effects of new technology. A set of policy solutions are being discussed, but more analysis is needed to ensure that proposed solutions correctly identify and address the key challenges, which are primarily centered around cost and timeliness rather than physical locations, hours of operation, or the creation of new forms of digital currency. Inaction in solving these problems intensifies inequality, hampers responses to future pandemics, and reduces the efficacy of other solutions designed to improve public health. The status quo is not static. Technology continues to develop. Absent substantial reform of our nation’s banking and payment systems that lower the cost of accessing and transacting in digital money, millions of Americans will be unable to fully benefit from technological advancement, and that is likely to have health consequences.
Download the full report here.
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This report was funded by a grant from the Robert Wood Johnson Foundation. The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation.
Financial technology: A hidden path to a healthier outcome?
New financial technology (fintech) is transforming how people use money. Money, whether by its presence or absence, has an impact on health. What are, then, the health consequences flowing from fintech? The answer is even more important if access to fintech becomes a hidden gatekeeper in the ability to access new non-financial technology that can lead to better health outcomes. For example, many ride-hailing services, bike shares, and scooter shares do not take cash, so the new transportation app world won’t make it easier to get to doctor’s appointments or physical therapy for those who can’t pay through digital platforms.
On Friday, September 24, The Brookings Institution will release Klein’s new paper, “Can fintech improve health?” and he will present the paper’s key findings and recommendations. Following Klein’s presentation, there will be a conversation on the paper and the broader topic featuring Makada Henry-Nickie of Brookings, Brian Knight of the Mercatus Center, and Jennifer Tescher of the Financial Health Network.
Viewers can submit questions via email to events@brookings.edu or via Twitter using #FintechHealth
Building a more stable financial system: Unfinished business
Twice in this still-young century central banks have had to take steps, unprecedented in size and scope, to limit the economic fallout from financial instability. While we can’t expect a financial system to withstand an overnight shut down of the global economy like we experienced in March 2020 without support from central banks and fiscal authorities, the financial market turmoil at that time highlighted vulnerabilities that were visible well beforehand. The system is stronger than it was going into the Global Financial Crisis (GFC), but much remains to be done, especially in nonbank finance. I’m going to reflect on some of the actions that need to be taken, drawing on the recent recommendations of a Task Force on Financial Stability in the U.S. that I co-chaired, and on my experience as an external member of the Financial Policy Committee at the Bank of England.
My main points are:
Dealing with risks to financial stability is urgent. If the economic and financial situation evolves as seems to be expected in financial markets, credit should flow, and financial markets will continue to serve the needs of the economy. But the current situation is replete with fat tails—unusually large risks of the unexpected which, if they come to pass, could result in the financial system amplifying shocks, putting the economy at risk. Shoring up our defenses against financial instability can’t run on Federal Reserve or, even worse, FSOC time where near endless analysis and consensus building delay needed action for years.
Dodd-Frank and Basel reforms have greatly improved the resilience of the banking system. Still, I have two linked recommendations for banks. First, fix the Supplementary Leverage Ratio and perhaps some other post GFC regulations so they don’t impede market making in Treasury securities and related repo; second, improve risk-based capital regulation by utilizing a countercyclical capital buffer that builds bank capital in good times and releases it aftershocks.
There’s much more to do in nonbank or market finance. This was the focus of our Task Force and we ended up with a 135-page report with dozens of recommendations. I’m going to focus on the Treasury market, but many aspects of market finance need urgent attention.
Our regulatory processes and procedures need to adapt to provide more nimble, more transparent, more accountable responses to ever-evolving threats to financial stability. We must do a better job of spotting potential problems early and making concrete suggestions for dealing with them.
Read the full text here.
The Brookings Institution is financed through the support of a diverse array of foundations, corporations, governments, individuals, as well as an endowment. A list of donors can be found in our annual reports published online here. The findings, interpretations, and conclusions in this report are solely those of its author(s) and are not influenced by any donation.
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The future of money: The end of cash and the rise of digital currencies
Are we heading for a cashless future? Eswar Prasad, a senior fellow at Brookings and author of the forthcoming book, “The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance,” thinks so. Credit card and cell phone payments have disrupted the physical cash market already, but Prasad says the real driving force will be central banks—as new cryptocurrencies continue to emerge and their popularity expands, central banks will react by developing their own more stable forms.
On September 13, the Hutchins Center on Fiscal and Monetary Policy and the Global Economy and Development program at Brookings will host a virtual conversation between Prasad and Glenn Hutchins, co-chair of the Brookings Board of Trustees, on Prasad’s argument that the world is approaching a tipping point where cash phases out and digital currencies reign supreme. This will have far-reaching implications for individuals, businesses, banks, and governments: improved efficiency, increased flexibility, and improved market access, particularly for the unbanked. But the risks include market instability, minimal accountability, and decreased privacy.
Following the Prasad-Hutchins conversation, the Financial Times’ Gillian Tett will moderate an expert panel focused on the government’s role in managing and regulating digital currencies, maximizing benefits, and minimizing risk.
During the live event, the audience may submit questions at sli.do using the code #FutureofMoney, or join the conversation on Twitter using the hashtag #FutureofMoney.
Where are the Biden financial regulators?
Seven months into the Biden administration and despite rising attention to a host of diverse issues in financial regulation and monetary policy—notably concerns about inflation, central bank digital currencies, retail investing, stablecoins—the president has shown little appetite for filling pending vacancies in the financial regulatory agencies beyond the occasional (and often inconsistent) trial balloon.
This is an old problem: Joe Biden didn’t invent vacancies in new administrations, nor the preference to hobble along with people in acting positions while nominations await them.
The age of the problem is cold comfort, however. The Biden administration is exacerbating it and should change course, immediately.
Appointments in financial regulatory positions fill three vital functions. First, and most obviously, they permit the president to make policy. The issues pending before financial regulators in 2021 are staggering. The policy priorities of the president are clear—on racial diversity, inequality, climate change, full employment, even competition in banking—but announcing a bold policy agenda is just the beginning of accomplishing the work of policymaking. Without filling these key vacancies, the policy work of the administration will suffer from a lack of clarity on what should be accomplished, when, and by whom.
Second, policymakers appointed by the president to run financial regulation must govern. The poetry of bold policy agendas will always give way to the prose of practical governance. This is true in the Oval Office and is even truer for the corridors of the Federal Reserve System, the Federal Deposit Insurance Corp (FDIC), the Comptroller of the Currency—all of which have key vacancies—as well as other arenas of financial regulation.
Take the Federal Reserve System for example. The task of managing the Federal Reserve System is enormous and has only increased in its complexity. The Board members must be central bankers, voting on the course of monetary policy; they must be bank supervisors, working with banks and other financial institutions to manage financial risk throughout the system; they must be bank regulators, writing rules for that same system; they operate a financial system as participants in payment rails that allow money to flow through the global economy; and they must be managers, supervising the employment of the quasi-private Federal Reserve Banks and the 20,000 people who work within the Federal Reserve System.
Each vacancy—and, at this rate, we risk having at least three simultaneously, a low-water mark that was never crossed before the Obama administration and has become something of a new normal in Fed vacancies—adds to the work of governance and risks muddying the work of all those who depend on the Fed’s managerial competence in all of its many areas of responsibility.
Finally, and perhaps most importantly, these appointments are the principal—in some ways, the only—mechanism for democratic governance to organize, respond to, and participate in the technical affairs of financial regulation. The logic of representative democracy is that elections inspire political organization before they occur and have policy consequences long afterward. But few people make financial regulation the sole basis for their vote in a presidential election, even in the rare instances when politicians pay close attention to financial regulation on the stump. The ballot box just isn’t the time or place where the American public engages forcefully with essential questions about monetary policy, bank supervision, or whether (and if so, how) the Fed should create its own digital currency.
The better time is when a nomination is made and the U.S. Senate engages in providing its advice and consent on the appointment. In those moments, it is astonishing how high the quality of engagement becomes across the partisan divide in debating finer points about the causes of inflation, the consequences of the Fed’s management of the public-private partnerships that characterize our financial system, or the implications of banking merger policy.
At present, however, the administration has deprived the public of these focused conversations. Failing to nominate anyone for the first one-eighth of Biden’s elected term deprives the administration of its ability to make policy and society of the ability to engage in debate on these issues. Floating and then popping trial balloons is not enough to sustain this discussion: we need presidential nominations and hearings in the Senate.
President Biden can quickly change this unfortunate state of affairs. The benches of qualified candidates who can fill them are deep, from across the coalition of Democrats (and some Republicans) who support the president’s views on financial regulation and monetary policy. Some factions within the party may resent appointments made to representatives of other factions, but this must never become a barrier to making timely nominations of qualified candidates. That very intraparty debate is itself enormously beneficial for the nation as it seeks to understand what a candidate for, say, Comptroller of the Currency promoted by the left wing of the party believes about issues of importance to the party’s center.
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There is another risk to these vacancies beyond the top line of the administration. Most (but not all) of the vacancies pending are not the top officials—the Secretary of the Treasury or Chair of the Federal Reserve—but are deeper within the organizations, including the Vice Chair for the FDIC, the Comptroller of the Currency, members of the Fed’s Board of Governors, and others. They just don’t capture the same imagination as those top jobs, and so presidents of both parties may be unwilling to wage the partisan fights that nomination and appointment might invite.
This is folly. The consequence of this “only at the top” focus is to make those top appointments even higher stakes, creating strange hydraulic pressure on a single nomination to satisfy the accountability demands that should be satisfied through the other vacancies. So it is, for example, that Fed Chair Jay Powell’s presumed views on financial regulation threaten his reappointment as the nation’s chief monetary policymaker despite the fact that his record through the Obama and Trump administrations suggests that he will defer on regulatory matters to the administration. The debate about the Fed Chairmanship—a vacancy that the administration is sure not to let occur—has become a debate about financial regulation because the other nominations with arguably more influence on those policies are still pending. The result is an inferior public discourse about both financial regulation and monetary policy alike.
Let us end this abysmal record in financial regulation. Let the president fill the large and soon-to-be growing list of vacancies in the financial regulatory agencies. The policy, governance, and accountability of the system demand it.
What is swing pricing?
The problem
In March 2020, at the start of the COVID-19 pandemic in the U.S., investors pulled more than $100 billion out of corporate investment-grade and high-yield bond mutual funds, forcing funds to sell some of their holdings. The spread between corporate bond yields and U.S. Treasuries (a market that had its own dysfunction) widened, transaction costs rose, and issuance of new bonds came to a halt, disrupting the flow of credit to the nation’s corporations. This led the Federal Reserve to intervene by offering, for the first time, to buy corporate bonds and exchange traded corporate bond funds in what proved a successful effort to keep credit to corporations flowing. It was an extraordinary move that underscores the risks these funds pose to financial stability. (For details, see this Federal Reserve note.)
The growth of open-end fixed income funds magnifies the systemic significance of the tension between shareholders’ expectations of daily liquidity and the (often illiquid) holdings of the funds. The average corporate bond is traded about once a month. Shareholders in an open-end bond fund expect (and receive in many cases) to be able to sell their shares much more easily and quickly than if they held bonds directly. When he was governor of the Bank of England, Mark Carney said, “These funds are built on a lie, which is that you can have daily liquidity, and that for assets that fundamentally aren’t liquid.”
In normal times, redemptions are modest and can be met by an offsetting inflow of funds or by selling liquid securities in the portfolio like Treasuries.[1] But big outflows can force a fund to sell holdings of less liquid securities that may require a price concession to attract a buyer. Especially in times of stress, big sales force down bond prices because of the absence of a truly liquid market for the underlying bonds. This, in turn, raises the rates that all corporate borrowers have to pay on newly issued bonds—if they can sell them at all—thus harming the overall economy.
Shareholders in a fund who get out early can redeem at a better price than those who remain, because their redemptions are met before the fire sale forces the fund to mark down the value of its portfolio. This creates a “first-mover advantage,” which can induce a rush to the door that amplifies the price movements that would otherwise occur. (With equity funds, this is less of an issue. Most equities are traded in highly liquid markets where prices quickly reflect order flow. To be sure, there are small stocks that do not trade every day, but most trade every few days, and there is not enough volume in any single small stock to create a problem. The average corporate bond trades once a month; some commercial paper hardly ever trades. So any selling of such fixed-income securities can affect the price substantially.)
A possible solution
More widespread adoption of swing pricing. Swing pricing is widely used in Europe but not in the U.S., although its use was authorized by the SEC in 2018. Basically, it allows the manager of an open-end fund to adjust its net asset value up or down when inflows or outflows of securities exceed some threshold. In this way, a fund can pass along to first movers the cost associated with their trading activity, better protect existing shareholders from dilution, and reduce the threats to financial stability.
This brief draws from the report of the Task Force on Financial Stability, which recommended more widespread use of swing pricing, and a roundtable the Task Force convened with industry, academic, and public sector officials to consider the pros, cons, challenges and costs to doing so.
What is an NAV, and why is that important for open-end funds?
The net asset value (NAV) is the price at which shareholders can purchase or sell their shares in an open-end mutual fund. The Investment Company Act of 1940 requires mutual funds to offer and redeem shares at the next net asset value calculated by the fund after receipt of an order. The NAV is usually calculated by dividing the value of the fund’s assets by the number of its shares. With swing pricing, this calculation of the NAV is adjusted up or down to account for the price impact and transactions costs that will be incurred because of redemptions and new share purchases that will occur after the NAV is calculated. Most U.S. funds calculate their daily NAV using the closing market price of the securities at 4:00 pm Eastern time. Orders from investors that are submitted after 4:00 pm are executed at the next day’s NAV.
Open-end funds can issue an unlimited number of shares. In contrast, a closed-end fund has a set number of shares, the price of which is determined in the market and can diverge from the net asset value of the underlying assets. Exchange-traded funds (ETFs) combine characteristics of open-end and closed-end funds. The price of ETFs fluctuates throughout the day and is determined by the price in the market. The movement in ETF prices is indicative of the kind of swing in an NAV that might be needed in stress, because the ETF price adjusts to attract a willing buyer.
What is dilution and the first-mover advantage in open-end funds?
If shareholders redeem a large quantity of shares in an open-end mutual fund, the fund may be forced to sell not only the highly liquid U.S. Treasuries it holds, but other assets as well. If many funds are doing the same thing at the same time—as they were in March 2020—the price of their underlying assets can fall; this is known as a “fire sale.” The first redeemer or first mover gets out at the initial NAV, which does not reflect the price declines associated with the subsequent fire sale, leaving the remaining investors to bear the costs associated with the portfolio manager having to sell assets to satisfy the first movers. This decline in the value of the fund’s holdings, which are owned by the remaining investors, is known as “dilution.” In a stress situation, therefore, investors have strong incentives to be among the “first movers,” which itself can amplify redemptions and resulting fire sales.
Using data on daily fund flows, Falato, Goldstein, and Hortacsu find that between February and March 2020, the average bond fund experienced outflows of about 10% of net asset value, far larger than the 2.2% experienced during the peak of the 2013 taper tantrum. They find that fund illiquidity and vulnerability to fire-sale spillovers were the primary drivers of these outflows, and that the “more fragile funds benefitted relatively more from the announcement effect of the Fed facilities.”
How does swing pricing address this issue?
Swing pricing is a mechanism to apportion the costs of redemption and purchase requests on the shareholders whose orders caused the trades. It is designed so that remaining shareholders don’t bear all the costs (including dilution) caused by first movers. In effect, those attempting to take advantage of limited fund liquidity are charged for their redemptions by adjusting the price they receive to reflect the liquidity of the market for the fund’s assets. With swing pricing, the incentive to be a first mover is diminished, and with it the risk that existing shareholders will be diluted and the risk that large redemptions will drive prices down sharply with spillover effects on the market and the economy. To be fair both to those who sell and those who remain, a swing price must reflect a fair valuation and approximate the costs imposed by first movers; it cannot be set simply to impose an enormous penalty on redeeming shareholders.
Under full swing pricing, the NAV is adjusted daily for the likely costs of redemptions, regardless of the amount of shareholder activity. Under partial swing pricing, the adjustment is triggered only when net redemptions exceed some pre-determined threshold—a recognition that small transactions do not pose much of a problem.
How does swing pricing work in Europe?
Many global open-end mutual funds are based in Luxembourg (because it has a favorable regulatory climate), and many of those routinely use swing pricing.
Not all funds follow the same procedures, but here’s an illustrative example. All orders that will be redeemed at a given day’s NAV must be received by noon CET on the day of the trade. In that case, any orders received after noon will be processed at the next day’s NAV. The NAV itself is not set until 4 pm CET each day. This gives the fund four hours to assess its order imbalance and determine the gap between buy and sell orders. Most buy and sell orders can be “crossed,” so that rather than buying and selling new securities, the redeeming and purchasing customers can have ownership transferred without incurring any transactions costs or putting pressure on prices. If there is a net imbalance (say, many more requests to redeem than to purchase), then to meet the net demands, some securities will need to be sold. If there is a large imbalance, then the NAV is adjusted (or “swung”) to reflect the impact of the sales.
The swing threshold is the amount of net subscriptions or redemptions that trigger the adjustment to the NAV. The fund then estimates how much prices for the assets being sold are likely to move to meet the subscription or redemption requests it has received; other factors taken into account include transaction costs and the bid-ask spread. The fund then uses those estimates to adjust the NAV by some percentage, generally no more than 2% or 3%. The adjustment is known as the swing factor.
Swing thresholds and swing factors vary depending on the market for the fund’s underlying securities. Swing factors tend to be larger in funds that invest in more thinly traded securities.
Fund managers set the rules and size of the adjustment and disclose their procedures, but precise details are not always disclosed so as to avoid investors exploiting them unfairly. A bond fund prospectus might, for instance, set a maximum swing factor of 3%, but give the fund discretion up to that level.[2] (For an example, see paragraph 17.3 of the prospectus for BlackRock’s Luxembourg-based global funds. )
Here is a stylized example of partial swing pricing from Allianz. It shows the threshold (the volume of orders) that trigger swing pricing in normal markets and in times of distressed markets, and the size of the swing under various scenarios (0.5% or 1.0%).
A survey by the Bank of England and the Financial Conduct Authority of 272 U.K. mutual funds found that 83% (202 funds) have the option to use swing pricing in place. Most funds using partial swing pricing had a trigger of net flows of 2% or less of total NAV. During COVID, however, several funds used their discretion and reduced their swing threshold or moved to full swing pricing. Swing pricing is advantageous to investors not only because it mutes dilution, but because the fund needs to hold fewer lower-yielding highly liquid assets to meet redemptions.
Researchers at the Bank for International Settlements compared the track record of Luxembourg-based funds (which generally use swing pricing) to similar U.S.-based funds (which do not use swing pricing). They found that the Luxembourg-based funds hold less cash than their U.S. counterparts. They also found that during the 2013 taper tantrum, the Luxembourg funds had higher returns than their U.S. counterparts (in part because there was less dilution and in part because they hold less cash), though there was more daily volatility in the Luxembourg funds.
In addition to the Luxembourg-based funds, funds based in the U.K., Ireland, France, Netherlands, and recently Germany use swing pricing.
While investor fairness has been the primary driver of swing pricing in Europe, market participants say it can affect investor behavior in ways that may contribute to financial stability. If an investor has a very large order to place in a European-based fund, the investor may spread out the purchase or sale over several days or otherwise break up the order to avoid imposing costs on the mutual fund that will be passed along in an adjusted swing price.
What are the impediments to implementing swing pricing in the U.S.?
The institutional structure of the market and operational issues are the main impediments to embracing swing pricing in the U.S.
Although the NAV is usually set at 4:00 pm Eastern time every trading day, many U.S. funds don’t know the size of their net inflows and outflows until late in the day or even the next morning. Many funds receive order flows from intermediaries that stand between an investor and the fund, such as 401k plan administrators, broker-dealers, and financial advisers. Some intermediaries have agreements that allow them to receive requests until 4:00 pm Eastern but not convey the order to the fund until that evening or even the next morning, but then upon passing them on still have the order serviced at that 4:00 pm NAV. In other words, the fund managers determine the NAV before they know how large the flow of orders is. Such agreements would need to be renegotiated and the software systems used by the intermediaries would need to be overhauled if new redemption rules were to be put in place. The intermediaries would also need to rework their client agreements.
Industry participants noted the following additional considerations:
Setting a cutoff at 12:00 noon New York time for investors to place mutual fund orders at today’s NAV would be 9:00 am in California and 6:00 am in Hawaii. But global funds based in Luxembourg deal with even more time zones and have navigated this problem.
Retirement fund record keepers and insurance companies require actual NAVs to process trades, e.g. an investor who wants to sell $1 million worth of shares need to know an NAV to translate the $1 million into an actual number of shares. European funds often price such trades at yesterday’s NAV.
Smaller fund management companies may not have the resources to implement swing prices.
In any event, changing all this would be costly and would require a mandate from the Securities and Exchange Commission and coordination with other regulators, including the Department of Labor (which has oversight over retirement plans) and FINRA, among others. No single fund or group of funds will make this shift unless everyone else is doing so as well.
If a shift were mandated, the same rules would need to be applied to other types of savings vehicles that are economically similar to mutual funds, such as bank collective investment trusts.
When it authorized swing pricing in the U.S. in 2018, the SEC said, “We…appreciate the extent of operational changes that will be necessary for many funds to conduct swing pricing and that these changes may still be costly to implement, but we were not persuaded by commenters who argued that these changes are insurmountable, and indeed one stated that despite these challenges ‘the long-term benefits of enabling swing pricing for U.S. open-end mutual funds outweigh the one-time costs related to implementation for industry participants.’”
What are the alternatives to full-scale swing pricing?
One alternative would be for funds to consult and gather information from intermediaries and vendors a few hours before 4:00 pm, and then allow (or mandate) the fund managers to estimate a full-day’s flows and apply a swing factor if indicated. This would accomplish some, perhaps even much, of the benefits of swing pricing without the cost of reorganizing the whole network of vendors, intermediaries, and fund managers. It probably would require a safe harbor to protect intermediaries, vendors, and funds from liability if the estimates proved inaccurate.
The SEC anticipated such a possibility in its 2018 rule: “We acknowledge that full information about shareholder flows is not likely to be available to funds by the time such funds need to make the decision as to whether the swing threshold has been crossed, but we do not believe that complete information is necessary to make a reasonable high confidence estimate. Instead, a fund may determine its shareholder flows have crossed the swing threshold based on receipt of sufficient information about the fund shareholders’ daily purchase and redemption transaction activity to allow the fund to reasonably estimate, with high confidence, whether it has crossed the swing threshold.”
Other ways that have been discussed to mitigate the impact of transaction costs to a mutual fund’s portfolio generated by subscriptions and redemptions, as well as to reduce the risks to financial stability, are:
An anti-dilution levy or redemption fee—a surcharge on investors subscribing or redeeming shares to offset the effect of those orders.
Dual pricing, i.e. one price for buying shares and another for redeeming.
Notice periods of perhaps a few days before an order can be executed.
Redemption in kind, e.g. giving the shareholder bonds, not cash (not practical for funds with retail investors).
Restricted redemption rights so investors can redeem up to a certain dollar amount on any one day.
Redemption gates that allow a fund to limit withdrawals (although the experience with these for money market funds indicates that such gates tend to exacerbate the rush for the exits).
A regulatory mandate to align redemption policies (including a requirement of advance notice) with the liquidity of the underlying securities.
Does the rising popularity of Exchange Traded Funds change any of these considerations?
ETFs require that buyers and sellers agree on a price that reflects market conditions. So during periods of stress, ETF prices move considerably. In a sense, they have an element of swing pricing built into them. Some investors may prefer ETFs because they know that it will be possible to sell on short notice.
ETFs have their own issues regarding the infrastructure that is needed to support them. To make sure the fund price reflects the value of the securities that the fund is supposed to track, ETFs rely on firms that serve as “authorized participants” (APs) to step in to buy or sell the fund to keep the price of the ETF close to the underlying securities. The APs make profits by arbitraging differences in the prices in the underlying securities and the ETFs. If the APs step back from trading, say, because they are exposed to more risk than they are comfortable with, the ETF prices can become disconnected from the prices of the securities that they are supposed to mimic.
This risk can mean that the ETF prices can also fail to reflect only fundamental risks associated with the securities. Nonetheless, ETFs are not subject to the first mover advantage and seemed to handle March 2020 better than the open-end funds.
Can swing pricing help improve the stability of money market mutual funds?
Money market funds are a special kind of open-end fund that can hold only short-dated securities such as U.S. Treasury bills, commercial paper, and certificates of deposit. By limiting the securities to those deemed relatively safe and liquid, it is expected that the price of the fund will be stable as the securities have no price risk if held to maturity. Problems can—and do—still arise for money market funds if they sell the securities they hold before maturity; in that case, there is price risk. Prime money market mutual funds invest in short-term private-sector securities such as commercial paper and certificates of deposit. Default rates on these securities are low, but they trade infrequently so they are subject to the same kind of illiquidity problems as open-end bond and loan funds.
Prime money market mutual funds suffered a run in March 2020, leading commercial paper markets to freeze up and prompting the Federal Reserve to intervene to keep credit flowing to businesses.
Investors in prime money market funds generally are using these funds as substitutes for bank accounts. They expect to withdraw, possibly large amounts in some circumstances, and at multiple times during the day. As a result, these funds often set an NAV multiple times throughout the day. Some in the industry say that feature of these funds means the information demands of setting a swing would be daunting and incompatible with how investors use them. Still, in a June 2021 consultation report, the Financial Stability Board included swing pricing among several possible policy responses to the problems posed by money market mutual funds.
[1] Heavy selling of Treasuries during the opening months of the COVID-19 pandemic created problems in that market as well. See Chapter 3 of the report of the Task Force on Financial Stability and the Group of Thirty report, “U.S. Treasury Markets: Steps Toward Increased Liquidity.”
[2] When the SEC authorized swing pricing in the U.S. in 2018, it set a 2% ceiling on the swing factor.
Anil Kashyap is a member of the Financial Policy Committee of the Bank of England and a consultant to the Federal Reserve Bank of Chicago and the European Central Bank. He did not receive financial supportfrom any firm or person with a relevant financial or political interest in this piece.
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