The Case for Deflation: Part 4 Liquidity and REPO - E214

In this episode I walk through an understanding of Liquidity and how the actions of the Federal Reserve can’t increase liquidity and flow in the economy. I also give a quick definition of the REPO market and interpret it as a money substitute factory – a place that creates and destroys money substitutes. This is the consensus layer of the global financial system and how we need to define what money is. It’s money substitutes that flow through the REPO and money markets.

​Mises on money​ substitutes

https://wiki.mises.org/wiki/Money_substitutes

Jeff Snider

https://www.youtube.com/watch?v=OM_J-4fJYEk

​Excellent REPO market resource

​https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/icma-ercc-publications/frequently-asked-questions-on-repo/4-how-big-is-the-repo-market/

​Highlighted Fed paper on Discount Window Stigma and how they try to address it

https://hyp.is/go?url=https%3A%2F%2Fwww.federalreserve.gov%2Feconres%2Fnotes%2Ffeds-notes%2Fstigma-and-the-discount-window-20171219.htm&group=__world__

Transcript by provided by Bradly Stone

All right, Bitcoiners, welcome back to the show. This is going to be Part 4 of my Case for Deflation.

I’m going to be going over liquidity and REPO. During this episode, I want to tie these things back into the case for deflation. You probably know what liquidity and the REPO are, but I will add my interpretation. Hopefully, I’ll give you a clearer image of what’s happening. We’re going beyond the “Brrrrr” meme on this show and diving into some of the fundamentals.

Don’t forget, this is a listener-supported podcast — go to https://patreon.com/bitcoinandmarkets and you can keep this content coming; keep the contrarian takes rolling.

What is liquidity?

The textbook definition is the ability to sell an asset quickly and at a stable price. So if you have 100 chickens and you want to sell all those chickens, hopefully you can get a stable price for them because the demand, the aggregate demand, or the overall demand in the market is much higher. Therefore the quantity of chickens you’re selling isn’t going to affect the overall price. Now, if that’s not the case, and say there’s only 50 chickens demanded in the market, then you wouldn’t be able to sell your chickens quickly or at a stable price. So this would be asset liquidity, which is the ability to quickly sell that asset at a stable price. There’s also other types of liquidity here.

You have what I’m calling liquidity, or you could call it portfolio liquidity, and that is the amount of cash in a portfolio or how quickly you can liquidate your holdings in your portfolio. Cash, of course, would be the most liquid good. Other goods will have a certain amount of liquidity relative to cash. This could be banks, it could be businesses, it could be individuals and their portfolio liquidity. So if you have a portfolio of all cash, it is the most liquid portfolio possible. If you have a portfolio full of real estate, then it might not be as liquid most of the time, but sometimes it’s going to be way worse and you can’t sell it for almost any price. 

The third type of liquidity I want to talk about here, and I think this is where we need to concentrate, is market liquidity. It’s an overall broad statement, and what it means is “the flow of money through the economy.” So, if the economy is functioning well or flowing with very little friction, that would be a liquid market. If the market has lots of friction, or there’s impediments to the movement of cash due to people hoarding cash or something, then the liquidity of the market goes down.

This is a measure of flow. You could also say “velocity”. Velocity of money measures the flow of money through the economy.

Remember, liquidity in this respect is two-way. Pretty much no matter which type of liquidity we’re talking about, you have three things that are necessary: One party needs cash, the other party to the trade needs something to trade for the cash. And then the third thing is, the person with the cash needs to have demand for the other good. Technically, we would say that the product or service side of this exchange would also need demand for cash, but since cash is the most liquid good, it’s also the most demanded and most salable good in the economy. 

Assume that there’s demand for cash, but the cash side of the equation doesn’t necessarily have demand for what they’re selling. And so you need all three of these things, you can have problems in any one of these three areas. You could have a lack of cash or there’s something that’s not demanded to trade.

Let’s take a look at what’s going on here with the Fed in regards to this idea of liquidity, because we hear that the Fed is “injecting liquidity” into the marketplace by injecting cash.

Let’s just assume for the time being that this is actual cash injections (which I kind of disagree with here, but let’s just for argument’s sake say that they’re injecting cash into the market). Well, that isn’t necessarily increasing flow, right? That’s increasing portfolio liquidity, but it’s not increasing the market flow. And so they are not really addressing the problem. This is actually counterproductive in some ways, but we will get to that. So when the Fed injects “cash”, they are trying to make a synthetic flow or simulate flow in the economy.

They’re interpreting the lack of flow and a lack of velocity as a dollar shortage (and maybe they’re not, more later). That’s a little piece that we can talk about at the end. The only thing you can do to get more flow is confidence. The Fed has our back, right? Don’t fight the Fed. Though these are just slogans to instill confidence in this church of the Fed — everybody is in the church of the Fed — and the church of the Federal government as well.

Especially, this whole virus situation, which really highlighted the amount that people are willing to sacrifice for their beliefs in this thing called government. 

There are very few anarchists out there that are willing to say “Think for yourself and be responsible for yourself.” Most people believe in the institution called government and they will do what they’re told, because it’s a religious organization. Same with the Fed. It’s a religious organization. And it depends on our confidence, our belief in the myth that the Fed has our back and the Fed can control these things. But in reality, they rely on manipulation of the emotions of the market. Intervention, Fed intervention actually makes things worse. And even if they have pure belief in the system here, they still can make things worse. 

How the Fed makes it worse

The way that this is happening, the way they’re actually impairing liquidity more by stepping in and injecting “cash” is that they do so anonymously. So in a normal, robust market that isn’t fragile, you will have one bank or one hedge fund or somebody that’s short on cash and they’re going to go insolvent. They really need that cash badly, but they can’t access it because they’re being discriminated against in the money markets. No one wants to lend money, because they’re a bad credit risk, and that company goes bust. Now, maybe their portfolio, let’s say, is 100 billion dollars, and only 1 billion is impaired. It’s bad, but they have to go to the Fed to get a bailout of that 1 billion, the buyer of last resort being the Fed. The problem there is that if that’s reported to the wider market, that they had to go to the Fed, no one else would lend to them, then it would be a self-fulfilling type of thing. No one would lend to them at all, not just for that collateral, but for anything that they’re trying to sell. So what the Fed has done is make it anonymous. 

You can go to the REPO desk that the Fed has set up, which we’ll talk about here in a second, but these distressed businesses can go to the Fed and get this money. But since it’s anonymous, they think, “We’re going to help the stigma attached to this.” What really happens is that stigma is expanded to the entire market, because people know somebody’s distressed out there, somebody is in trouble, but they can’t point a finger at it. So they have to treat everybody like that. So these actions of the Fed are actually making the flow worse. They’re damned if they do, and they’re damned if they don’t, because if they don’t, and that business fails, and anybody that’s connected to them falls like dominoes. But if they try to make it anonymous, it stops the flow in the whole economy. It’s a tangled web. 

When you intervene in the market, you have unintended consequences. And the unintended consequence here is this tangled web of a no-win situation, you cannot win this situation by intervening. So the only way to win this is to let people fail. And it’s going to be dramatic, it’s going to be painful. Everybody is going to be affected. But that’s what has to happen to get the natural flow of the market back up.

Time can heal all wounds in a way, but we will never return to previous growth rates. And that’s what I’ve said in past episodes, maybe in past interviews, that a typical global growth rate might be 5 – 10% per year. But after the financial crisis, it was 4 or 5%. China was slowing down, emerging markets were slowing down. And now after this, it’s gonna be 1%. Maybe we just barely struggled to make any growth. And that’s what happens, and it will continue on, we’ll stagnate until eventually, it continues to press towards zero and below zero on growth. And when GDP globally is contracting, people won’t stand for it, they will have revolutions, uprisings and things like that, because people will be suffering. When that happens, we’re going to have to transition to a new system.

The only way to cure this is to get rid of the system. Let people fail, bring on the pain, and short-term pain may be very dramatic for a year or two in the world economy. And then we’ll be over it with a new system. Whether that’s Bitcoin or gold, we’ll have to wait and see. I’m hoping it’s Bitcoin.

Dollar shortage

I want to circle back real quick to this dollar shortage thing because we don’t have a dollar shortage. There’s plenty of reserves in the system. There’s plenty of cash in the system. But it’s not being lent out. The Fed is the only person that will lend their money. Calling it a dollar shortage, either because they’re wrongly interpreting this as a dollar shortage, or they don’t know exactly what’s going on. They say it’s a dollar shortage.

When they do inject cash, people are fooled. People will think that the Fed has their back, but how does the Fed have your back? They’re injecting cash because there’s a dollar shortage of course. So we’re solving the dollar shortage; that’s the problem. It’s a Hegelian dialectic. They say this is a dollar shortage so that they can pump in cash, and people believe it.

But slowly, we’re starting to lose confidence in the Fed. We’re starting to lose confidence in our institutions. It has diminishing returns, right? How do we know it’s not a dollar shortage? Because there’s plenty of dollars out there.

REPO Market

Let’s go into the REPO market. You guys probably have learned quite a bit about this over the last six months or so, but a lot of people’s attention went on to the repo market around September. It’s a crazy world out there. 

So what is the repo market? It is a global market for short-term secured loans. How short? Well, most of the volume is under a month in term. So this would be overnight to one-week or two-week terms. But most of the outstanding, or open interest, is longer than a month. So probably between one and three months. It’s three months or shorter, most of the volume is overnight or one week, something like that. So these are short-term loans, and the secured piece means that there is collateral involved.

You have to post collateral to get your cash. This compares to the eurodollar money market in that the eurodollar system would be unsecured. Just regular loans out there. So that’s kind of the difference.

The REPO market is not geographically located. There’s concentration of this activity in London and New York, probably Tokyo, maybe Singapore, Hong Kong, but it’s not geographically located – it can happen over a phone line between banker A and banker B. They need to do a REPO so they can do that. There are “laws” that regulate this in different jurisdictions – each jurisdiction is slightly different – and if there is a problem, you could go to court or there would be an arbitration involved. But it’s not geographically located.

You might have heard the Fed set up this REPO facility where they do all these overnight loan operations. Well, they’re not taking over the market. It’s not like they took over the New York Stock Exchange or the REPO exchange, there is no such thing. They are out there with a desk so bankers can call them, banker A can call the Fed instead of banker B. The Fed has said that they will offer up to a trillion dollars in overnight loans, but that’s still not a huge percentage of the overall REPO market. 

We don’t know the total size, but it’s at least 5 trillion every night and volume probably upwards of 10. At the peak, it might have been 15. But it’s come down over the last 10 years, the amount of these REPO operations going on globally. So the Fed is roughly 10% and they’re not even doing a trillion. They’re offering a trillion, but I think the average is 50 to 100 billion a night, so it’s not that much. 

Remember, this is the stigma that they’re expanding to the entire market. Just the fact that they’re having to do some REPOs means that something is wrong, somebody is in trouble out there. And so everyone else is a little bit skittish. And it’s just waiting, most likely, at the end of the quarters, the balance sheet stuff usually comes to a head at the end of quarters. And so I think around the end of the quarters is when we’re going to see some major moves, major things snapping and breaking in the market. 

The money substitute standard

One interesting thing I think about these REPO markets, goes back to a point I brought up previously, about what money is. What is functioning as money? Because it’s not the balance sheet of the Fed, right? The Fed can create money, but so can commercial banks when they make loans, so the money supply is not the Fed’s balance sheet. We can even expand that globally. Banks around the world create dollar-denominated loans. So what is the money supply? We don’t know. All these things are treated as money substitutes in my mind. We don’t have money, we have money substitutes, or substitutes of substitutes. So this REPO market can turn Treasuries or high quality corporate bonds, something of that nature, into money. So those things serve as a money substitute in a way, it’s almost like a claim on the money itself, which is a substitute.

It’s confusing, but we don’t know what money is, it’s very hard to pin down what the supply is. It’s like when we were talking about inflation versus deflation, which again is expansion or contraction of the money supply. If all of these things are treated as money substitutes, and then there’s some illiquid event, like what happened back in September, when the REPO market basically froze. Then all of that stuff like the collateral that was treated as money now isn’t, the money disappears from the market. 

This is a deflationary shock. Overnight, boom, deflation, probably 50% deflation overnight. That’s what I’m talking about. When we talk about why this deflation is going to happen, it’s because the system is set up to drastically reduce the money supply, to contract the money supply.

Conclusion

What else do I have on this? I would just concentrate on some of these definitions. We’re talking about liquidity, flow, and how the Fed injecting cash cannot increase flow. The overall market is slowing down, deflation is what we’re worried about here, and spreading of the Fed stigma to bring full confidence back. We can bring some confidence back through time healing all wounds, but you can’t get it back to 100%. Every time you’re going to shrink a little bit until we get rid of this system, which hopefully is coming up soon. 

The last thing I’ll say here on this is this is where I think Bitcoin has a very big role to play in the coming years. I hope we will see some major moves towards Bitcoin becoming collateral, Bitcoin moving into this market and making waves. It just can’t yet, it’s too small. You need collateral worth, say a billion dollars, and you just can’t do that with a $100 billion-dollar market cap. If it’s a trillion or $10 trillion market cap, sure, you can have these $500 million or billion-dollar pieces of collateral amounts of Bitcoin that can stand in. Once Bitcoin grows, it will act more and more like collateral, and I hope we can start seeing some growth in this vector here. 

Anyway, that’s it for this episode. This is Episode 214, you can find it on the website bitcoinandmarkets.com/e214. For the show notes, I did link a bunch of stuff: More reading about the repo market, some really great website I found that is mostly European-centric, but explains a lot of different things about what’s going on in the repo market, and how it works, like how baskets of collateral work, how different the legalese is that goes on there. So it’s a very good place. And I did also link a paper about the Fed stigma or the stigma attached to the discount window, and why they have gone more anonymous. So that’s a good read as well, check that out in the show notes. 

I hope you guys learned a little bit about liquidity and why this market is tending towards deflation. You learned a little bit about the repo market, and how that whole thing works. If you have questions, hit me up on Twitter and Discord, I will try to get to those in a future episode. I want to get back to addressing the news in Bitcoin specifically on future episodes, but thanks for going on this four-part series with me. We’ll see you guys next time.

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