They're Rewiring The Financial System Again While Nobody Is Looking.
The World Cup is a great time to engage in financial overhauls, isn't it?
Editor’s Note: In a previous version, I said that Yellen had discussed the leveraged basis trade with the Australian Financial Review. My apologies, it was an interview with CNN International. That interview is here.)
Dear Fellow Traveler:
Two nights ago, I went to the Cubs v. Orioles game.
My friend said, “I can’t wait to find out what the elite have done after the World Cup is over and we restart this war again.”
I said, “I already know. They’re creating a permanent bailout system.”
I had just read a piece by an author named Glenn Handley.
He writes a Substack called The Desk. Go read him…
He has 30 years in repo and liquidity… So, when I think of meeting him some day, I will play Andy Dufresne entering Shawshank prison… and he’ll be Morgan Freeman’s Red…
This week he tackled six things in the Treasury and repo markets in a single seven-day window.
Any one of them should have been the top story on a normal weekend.
He did the field reporting. What follows is what it adds up to.
Right now, the U.S. government is issuing debt so much faster than traditional dealer and bank balance sheets can comfortably intermediate that hedge funds running leveraged basis trades (the ones Janet Yellen mentioned to no follow up question from CNN International on the subject last year) have quietly become a critical marginal buyer and intermediary of the world’s most important bond market.
Regulators are terrified of that leverage, something I mentioned in my review of the Bank for International Settlements Annual Economic Report.
They’re equally terrified of what happens to Treasury-market liquidity if the leveraged demand disappears. So they’re rebuilding the plumbing underneath the trade AGAIN to make sure it never unwinds in public.
This whole rewiring, which looks suspiciously like a non-public bailout machine with a Deloitte logo on it, is being sold as modernization.
Nobody used that word in graduate school...
Do I Have This Right
The trade that regulators keep losing sleep over is called the Treasury basis trade.
We’ve covered it before. It exists because of a small price difference between a cash Treasury bond and the corresponding futures contract.
Hedge funds borrow heavily in the repo market to capture the spread.
Have you ever wondered, “what if I borrowed fifty dollars to make a nickel, and did it a hundred million times?” That’s the basis trade.
Again, the BIS told us in the June annual report that roughly 70% of bilateral dollar repo transactions with hedge funds occur at zero haircut.
That means, on the cash-repo leg, the fund can borrow $100 against $100 of collateral without posting a dollar of excess collateral. The fund still has to post futures margin on the other side.
But the repo leg, which is where the leverage breathes, can be financed without a dollar of extra cushion.
This is like buying a motel with no down payment, borrowing the furniture, renting the rooms to yourself and asking the Federal Reserve to keep the fire department nearby because the curtains smell warm.
Two plus two equals nine and we’re solid.
You Can’t Do This… Not One Bit…
You can’t do this at your local bank.
Go to Chase and ask the “personal relationship banker” whose nameplate says Kayla for the same arrangement Goldman offers Millennium. Kayla will tell you, with the patience of somebody who’s heard weirder requests before ten am, that this isn’t a service the branch can offer.
She has rules.
She also has a regional manager named Brendan who will write her up if she waives a $35 overdraft fee for a nurse.
Goldman’s team can lend a hedge fund billions against a trade held together by a futures spread… Goldman’s team also has to be at Delmonico’s by 12:30 pm to worry about something else.
Here Comes “Central Clearing”
Tomorrow’s “What Are We Missing” will be epic because of the new format, and the fact that it’s not going to be a nerd fest.
Tomorrow I’m going to stand in front of a camera and scream “central clearing” until someone at the SEC quietly closes their laptop.
It goes like this…
Rather than have these bilateral trades between two counterparties, who each carry the credit risk of the other, most eligible Treasury cash and repo transactions will now be marched into a giant clearinghouse…
They’ll alls be stripped, tagged, netted and photographed under fluorescent lighting.
When we see this, positions will net out, and banks will use less of their balance sheet.
In theory, regulators will see more of it.
And most of this is very defensible because that shadow trade is the one that is holding the viagra and popsicle stick market up right now.
The thing is, the risk doesn’t really go away.
It just migrates over, and concentrates inside the clearinghouse and the small number of sponsor banks providing access.
Just remember that if a regulator or central agency says that they’ve eliminated risk, the polite follow-up question is to ask where they hid it. This is why I remain incredibly frustrated by the Australian Financial Review’s interview with Yellen last year.
As Handley explained, the SEC ordered eligible Treasury cash transactions into central clearing by December 31, 2026, and eligible repo by June 30, 2027.
Separately, DTCC plans initial limited production trades of tokenized DTC-custodied securities in July 2026, with a broader launch targeted for October.
Separately again (because why not), the Bank of England has already built a contingent liquidity facility for eligible insurers, pension schemes and LDI funds during severe gilt-market dysfunction.
These are not one program.
Nobody made a document called Permanent_Bailout_FINAL_v7_REALLYFINAL.pdf.
That would create discoverable evidence.
Instead, the SEC builds the clearing mandate, and the DTCC builds the tokenized rail., and the Bank of England builds the non-bank liquidity facility, and 50 institutions join a working group.
Nobody has to conspire.
They simply attend the same panels, hire the same former regulators and discover, with astonishing consistency, that the public should absorb the tail risk.
I know you’re saying, “What?”
And “Huh?”
And… “Shit…”
ut the question is who wins.
Just look at who joined DTCC’s 50-plus-firm working group.
BlackRock. Goldman. JPMorgan. Circle. Citadel Securities.
Finally… I know… a small-business roundtable.
That’s what Handley laid out in terms of diagram and deadlines.
Isn’t the financial system wonderful?
You money.
They lever it. They clear it. They tokenize it. They build a facility to rescue the institution that financed the fund that bought the debt the government issued to pay interest on the debt.
Then CNBC brings on a man named Chip to explain that markets are functioning normally.
How am I going to not just lose it when I start talking about this on air again?
I’m Not Supposed to Say This Out Loud, But…
One of the things we have to continue to assess is the Federal Reserve’s Standing Repo Facility.
The Fed doesn’t lend to hedge funds directly.
The facility’s counterparties are primary dealers and eligible depository institutions.
The Fed doesn’t guarantee the hedge fund, and the dealer can still cut it off.
Of course, the hedge fund doesn’t stand inside the Fed’s house. It’s standing on the porch all day with an extension cord plugged into the dealer’s kitchen.
The Fed insists the hedge fund does not live there.
Fine.
Its phone charger is in the wall, and its shoes are by the door….
If any link in that chain bends, the surrounding institutions get reinforced without anybody ever mailing a hedge fund a novelty check.
The Bank of England has taken things a lot further.
It built a contingent facility that can lend cash directly to participating insurance companies, pension schemes and liability-driven investment funds against gilt collateral during severe market dysfunction.
It’s not an everyday funding window, and it’s not open to every hedge fund...
But it crosses an important institutional boundary. In severe conditions, the central bank can now provide liquidity directly to selected non-banks when bank intermediation isn’t enough.
For most of its operating history, the Fed’s routine lending architecture has centered on banks.
It later built standing operations around primary dealers.
Then it possessed emergency and tightly constrained authority to lend beyond them, including Sections 13(3) and 13(13).
But those authorities have either required unusual and exigent circumstances or sat largely dormant since the Great Depression.
Section 13(3), enacted in 1932, is how Bear Stearns, AIG and the pandemic facilities got backstopped.
Post-Dodd-Frank, 13(3) programs must be broad-based, used in unusual and exigent circumstances and approved by the Treasury Secretary.
It’s not routine peacetime infrastructure.
It’s the financial equivalent of the axe behind the glass.
You break it during the fire.
What they’re discussing now is removing the glass, handing the axe to BlackRock and calling it a kitchen utensil.
Researchers, central bankers and market architects are now openly considering a permanent, operationally ready access for buy-side non-banks such as pension funds, insurers and investment funds during market dysfunction.
The revolutionary part isn’t that the Fed has never possessed the legal power to touch a non-bank.
It has.
The revolutionary part is taking the emergency axe from behind the glass, mounting it on the wall next to the thermostat and telling everyone it’s “ordinary building maintenance.”
The U.S. hasn’t formally crossed that line.
But come on, we know it’s coming, right?
The coming lie will be that no bailout occurred, because no hedge fund will receive a check.
Public liquidity will enter through the dealer or the repo facility. The clearinghouse will keep positions netted, margined and operational long enough for the leveraged trade at the far end to survive and everyone involved to swear it rescued itself.
And who is positioned to monetize the new architecture whether the final rail is tokenized, centrally cleared or wrapped in another acronym?
BlackRock… which doesn’t need to control the clearinghouse, own the train, or the tracks or the station.
It needs to sell the scheduling software, manage the pension money riding inside the train and collect seventeen basis points for explaining why the collision improved long-term resilience.
No one needs to rob a bank… BlackRock just sells the bank its operating system, manages the vault, advises the regulator and owns a fund containing the company that manufactures the security cameras.
You don’t need a conspiracy anymore in finance.
You need 12 institutions responding to the same incentives and editing the same well-permissioned Google Sheet.
Meanwhile, in the actual country, 95% of Americans recently told a Harris Poll conducted for the Guardian that the country is experiencing an affordability crisis.
Roughly 50% said they’re struggling to afford groceries and gasoline.
Realtor.com reports that some measures of foreclosure activity are climbing back toward their pre-pandemic pace as relief programs unwind.
If you want to understand the political obscenity here, look at the difference in treatment. If you want to understand the “You’ll Own Nothing and Be Happy” movement that was part of the Davos Crowd, you’re looking at how we get there…
Asset markets get liquidity facilities, clearing mandates and emergency architecture designed by hundreds of specialists.
Households get higher insurance premiums, property taxes and an email from the bank congratulating them on qualifying for a payment plan.
The hedge fund gets a plumbing redesign.
The average person gets Brendan from collections.
Handley handed us the diagram.
The BIS handed us the leverage number.
Now, the SEC gave us a bunch of deadlines.
And in 70 years, an economist will win a Nobel Prize for discovering that a market permanently dependent on public liquidity, regulatory netting and emergency collateral facilities hasn’t been the spontaneous miracle of capitalism we were sold.
By then my daughter will be 78, and Larry Fink’s consciousness will be stored in a Delaware trust and licensed back to humanity for 17 basis points annually.
And then ask yourself again why the Socialists and Populists are gaining so much power at the extremes. The center can’t hold this status quo…
It’s not a left or right issue anymore…
For the love of god…
Look up at the helicopters dropping money into the banking centers…
Stay positive,
Garrett Baldwin
A little over my head but I do detect that we have some issues! I love your (sarcastic?) "stay positive" at the end of your piece! Easier said than done.
Something hinky is showing up in the bond market. So yeah, you're onto something.