When grounded in the framework of traditional banking, wholesale dynamics can be quite confusing to the point of being impenetrable. Nowhere is that more the case than the wholesale ideas of currency and what counts for establishing chains of traded liabilities. In the traditional banking/monetary framework, everything is reducible to money; all else are just derivative claims on it. The role of the central bank in that case is almost perfectly clear in terms of “currency elasticity.”

That obviously changed as hard money was slowly replaced over time by national currency in place of bank-drawn currency. The chains of liabilities to hard money were still present at first in even the later correspondent system that dominated in the first decades of the Federal Reserve System. However, they were increasingly obscured by new innovations including what would become the basis for transformation to wholesale and ledger money system – federal funds were introduced in 1920 first as an almost exploitation of the fault lines between banks within the reserve system and those remaining outside it.

That process or at least the ideas of exploring the edges of the “official” system were what got the eurodollar arena started. As is usually the case, over time, the “looser” strictures of the unregulated growth area pull the official system more and more in that direction (loosen regulation or banks threaten to leave). In terms of currency, with an almost purely ledger system there is little need for physical cash. That was one primary benefit of eurodollars over federal funds and traditional banking being far more efficient and, in theory (disproven beyond any doubt in 2008), less prone to the emotion of regular folks.

However, there are some very good features within a hard money system that do not survive the transplant to ledger money. The first is security. Hard money is collateral itself and thus needs no further security no matter how less derivative. In ledger money, it isn’t nearly as straightforward. The entire point of repo markets, and surely their gross development, was in that regard. It was the desire to combine funding efficiency but retaining at least the idea of hard money security.

What happens in that view is that, quite without direction or intent, collateral begins to take on the characteristics of currency itself. Demand and supply factors in monetary terms begin to influence the pricing of the collateral and can even alter its entire purpose. Ask yourself this question: why was subprime such a huge trend in the middle 2000’s; was it because there was an overwhelming eagerness to “reach for yield” or because Wall Street had figured out manufacturing collateral of any kind, paired, of course, with dark leverage, was akin to its own unfettered money printing?

That is sort of a trick question, as the answer is “yes” on both accounts; the real issue is in the balance of both “sides” and really how those two factors are self-reinforcing (more shortage in collateral, the lower the interest rates leading to demand for more collateral and thus monetary expansion and more of the shortage). There was undoubtedly “reach for yield” driving some demand but I don’t think that explains fully Greenspan’s “conundrum.” I would even go so far as to argue that the collateral consideration was far and away the driving force, especially as rehypothecation chains were as high as 8 to 1 by 2008.

Once you get to appreciate the nature of that transformation, the wholesale system starts to click into place. Back in July, I described Warren Buffet’s “takeover” of Salomon Brothers in these terms. At the time, very few could figure out why the rates desk was committing blatant and illegal activity over UST auctions. It was even described contemporarily by the LA Times as an “inept little scam” because there didn’t seem to be any great profit from it. But the investigation into Salomon’s Treasury adventures revealed something more systemic – that almost every dealer of every kind was cheating not on OTR UST but in trying for huge overallotments in GSE issues of MBS (to the point of maintaining two sets of order books). This was 1990-91.

It is easier today to see this with much greater clarity, as the wholesale banking system is now fully revealed (to those that want to make even slight inquiry), but the contemporary haze should not excuse lack of appreciation then. There is great significance of government and agency debt at auction and issuance, as it is on-the-run securities that control the repo environment. A bond, note or bill just auctioned is the most liquid because it contains the most direct and quantifiable characteristics; once a security is replaced by the next auction in the series, that security becomes highly liquid OTR and the previous fades into trading obscurity (off-the-run). In short, the frenzy over OTR is repo at a time when collateral wasn’t as widely available and the limited OTR’s were quite limited (a shortage the bubbles, greater sovereign issuance and securitizations would eventually but temporarily overcome).

Banking was still believed to be of the S&L model at that moment, but even they, or a good many of them as Resolution Trust and the FDIC would describe, had already transformed into the shadow visions that presaged everything that has come after. In other words, it was only being closed-minded about what was taking place in “money” that hid what Mozer and so many others were up to – collateral had become currency, maybe even at that early date the currency, and had thus attained “value” far beyond what was thought to be an “inept little scam.” Rehypothecation and leverage, and the legal and accounting structures surrounding and abiding them, made that so.

The growing quasi-currency of interbank operations was running up against an almost hard limit of supply. There was only so much at the time and not nearly enough to fill the growing desires for balance sheet expansion now almost totally freed from deposit influence. So Wall Street did what it really does best, it innovated and came up with a system, essentially, to manufacture collateral from illiquid loans just sitting in mortgage pools all throughout bank and institution balance sheets. Securitization was the means not just to start more trading commissions but rather to turn as much of a balance sheet as possible into, principally, currency.

The real point about money in finance as both self-correction and limiting scale is that it is self-extinguishing. I give you a quantity of gold and our transaction is at an end. Replacing that with a credit-based monetary system leaves a huge hole in that regard; there are now chains of liabilities without actual security. If you hadn’t noticed, almost every financial loan or credit product is collateralized in some fashion; the same has been true of credit-based reserve currencies. Where Wall Street under this central bank, central planning approach truly “shined” was in manufacturing collateral as if it were replicating the security function of hard money – repo.


In many ways, that was the real “genius” of the housing bubble, namely that subprime and vast mortgage expansion wasn’t just a means to great volume but really that it was its own “money printing” operation in parallel function. Banks were not just investing in formerly illiquid securities, they were inventing an entirely new form of currency and manufacturing it at will. The technocracy simply approved because it followed the course the technocrats set out for: some kind of rising GDP. Alan Greenspan thought he was controlling GDP via the federal funds rate when instead an enormous and almost unrelated currency system was doing it for him and almost completely without him.

There was and remains no way to calculate or even describe this “money supply” element; it doesn’t conform to any traditional conception let alone established and standardized metrics (including how dark leverage fits into this process). But realizing this collateral/currency dynamic gets you much closer to understanding especially the immense expansion in the 2000’s (once David Li’s Gaussian copula unleashed the full “marketable” potential of MBS) and where the serial asset bubbles truly came from; and then its downfall.

The repudiation of MBS collateral starting in 2007 was, under these currency terms, a severe contraction in this parallel money supply. The Fed really didn’t get it until September 2008 (even then it was, at best, fleeting and uphill), paying only marginal attention to collateral in some of its secondary schemes (such as TALF and TSLF). Just after Lehman, AIG, et al, the Fed engaged $50 billion in reverse repos which are, as has become more public the past few years, ostensibly “exit” strategies; what they are in this context is currency elasticity in collateral as a reverse repo is really “renting” out UST holdings in FRBNY’s SOMA portfolio.

That isn’t all, also on September 17, 2008, the Fed asked the Treasury for emergency assistance in the form of the Supplementary Financing Program. The SFP were bills issued by Treasury, almost like t-bills or Cash Management t-bills, where the proceeds would be a liability instead of the Fed. That was, basically in this context, the Treasury Department manufacturing collateral in an attempt to fill the interbank currency void left as all that prior MBS collateral imploded in rising haircuts and growing general revulsion. The mass of the currency run in 2008 was really collateral, billowed into further conflagration as balance sheet factors (dark leverage derivatives like CDS) became increasingly unavailable to maintain order and flow.

Against that tide the Fed was prepared for nothing; they were instead ready to implement plans designed in the 1960’s for the banking system of the 1930’s (I wish this was even slight hyperbole). The ad hoc and piecemeal nature of these belated responses shows all-too-well why there was this “impossible” panic. The Fed didn’t even notice that the market was forcing it into the proper, wholesale currency elasticity role quite against its will.  The entire wholesale block was on fire, but Bernanke parked his fire truck three streets over, observing only some smoke and wondered what all the alarm was.

To which the eurodollar/wholesale system has never solved that main problem. One primary reason it continues to falter was that its main engine of expansion, the manufacture of collateral from almost anything on the balance sheet, has been fatally compromised. Not only was there a decline in supply from MBS repudiation, but there was no way to fill the void after it was over – the only real alternative was sovereign debt, which European banks, in particular, were burned a second time in PIIGS. In that fact, you can appreciate why the 2011 crisis was, in many ways, the final nail in the eurodollar coffin.

QE’s didn’t help but rather accelerated the difficulties, especially QE2 which stripped so many t-bills from repo that Operation Twist was ordered to try to restore some balance between OTR bills and bonds/notes (it never did).

Without the ability to manufacture its own currency, the eurodollar system just can’t continue. These other central bank programs and ideas are just noise against that disintegration. This is not the only factor in the eurodollar decay, but it is one of the more top-level deficiencies on this downside of the inflection. Economists talk about “tight” money supply and the effects of that, they just don’t realize it is and has been taking place just in these other more relevant and wholesale forms of “money.” Anyone expecting central banks to be effective in this environment misses these exclusions; especially that, despite it all, central banks have chosen to interject still with 1960’s emphasis. Quantitative easing may be both those words in some respects, but it isn’t the quantity of collateral and therefore offers no easing to the eurodollar decay.