Treasury Debt and the Pricing of Short-Term Assets
Abstract: Since the 2008 financial crisis, the supply of short-term debt from the Treasury has been increasingly associated with changes in the yields of short-term money market assets. This puzzling pattern contrasts with the pre-crisis experience and raises questions about the ability of the Fed to fulfill its mandate. In this paper, I document and rationalize these developments in an intermediary asset pricing model with heterogeneous banks subject to a liquidity management problem and regulation. The combination of large amounts of excess reserves and a more stringent capital regulation prevents traditional banks from intermediating liquidity to shadow banks. As a consequence, the pricing of reserves disconnects from the pricing of other short-term assets. The liquidity premium of these assets is then free to react to variations in the supply of Treasury bills. The quantitative model accurately predicts post-crisis variations in Treasury bill and repo yields as well as in reverse repo volumes from the Fed.
Central Banking with Shadow Banks (co-authors: Adrien d'Avernas and Matthieu Darracq Pariès)
Abstract: This paper investigates how the presence of shadow banks affects the ability of central banks to offset a liquidity crisis. We propose an asset pricing model with heterogeneous banks subject to funding risk. While traditional banks have direct access to central bank operations, shadow banks rely on the intermediation of liquidity from traditional banks. In a crisis, this intermediation stops due to lack of collateral and shadow banks are left without lender-of-last-resort. Traditional instruments are not sufficient to fully mitigate the crisis. Opening liquidity facilities to shadow banks and purchasing illiquid assets is then necessary to further boost asset prices and tackle the crisis.
Intraday Liquidity and Money Market Dislocation (co-author: Adrien d'Avernas)
Abstract: This paper investigates the pricing of repurchase agreements (repos) within the new post-crisis regulatory framework. We find that new liquidity regulation prevents banks from using intraday credit provisions from the Fed. As a consequence, reserve-rich banks—rather than the Fed—are the marginal provider of liquidity to money markets. In this new regime, intraday liquidity can suddenly become scarce and constrain the supply of repo, leading to sharp increases in repo rates. These spikes in repo rates are more likely when the supply of Treasury debt financed by shadow banks is large and settlement volumes are high.
A Solution Method for Continuous-Time General Equilibrium Models (co-author: Adrien d’Avernas)
Abstract: We propose an algorithm capable of solving in a fast and standardized way a general class of continuous-time asset pricing models, including heterogeneous agent models. These models typically require to solve for a system composed of a Hamilton-Jacobi-Bellman equation for each agent, coupled with a system of algebraic equations. The resolution of such a system of PDEs is a tedious problem as approximation errors tend to amplify and create explosive dynamics. We rely on a Finite-Difference algorithm and show how using a Brocot-Tree decomposition as advocated by Bonnans, and al. (2004) allows for fast and stable convergence in settings with up to two endogenous and stochastic state variables.
Work in Progress
Are Stablecoins Stable? (co-authors: Adrien d'Avernas and Thomas Bourany)
Abstract:Stablecoins are cryptocurrencies designed to peg their value to an official currency. This paper proposes a framework to analyze their stability under the four most relevant pegging mechanisms. The analysis points out to potential fragility in existing stablecoin protocols and policy implications for regulators. Off-ledger currency-backed stablecoins face an increased risk of misappropriation when the demand for the stablecoin falls, leading the stablecoin price to drop below parity. Crypto-collateralized stablecoins are vulnerable to sharp declines in collateral asset value, even when a protective liquidation is triggered early. To admit a stable equilibrium, algorithmic stablecoins require that their demand grows at an exponential rate. Hence, stablecoin price may drop below parity—and potentially to zero—when demand falls. The decentralization of crypto-backed stablecoins improves stability by engineering better incentives for the risk management of individual vaults.
A Model of High Risk Premia Stagnation (co-authors: Adrien d'Avernas and Valentin Schubert)
Abstract: This paper investigates how productivity growth interacts with financial cycles. We show that movements in stochastic discount factor is a strong predictor of aggregate productivity growth. We rationalize these findings in a macro-finance model with heterogenous risk aversion and endogenous productivity growth where the financial sector is key in screening and absorbing innovation risk. Shocks to innovation levels and volatility generate financial cycles. During financial stresses, the financial sector becomes undercapitalized and reduces its exposure to innovation risk. As a consequence, willingness to take risk in the economy is reduced, and less innovation occurs. We show that the combination of undercapitalization and heightened uncertainty generate large time-varying risk premia, safe asset shortage, and hysteresis in productivity growth following financial crises that are quantitatively consistent with empirical observations. We derive macro-prudential policy implications of the arising trade-off between short-run growth and financial stability.