Money Markets after the Global Financial Crisis: Functioning and Regulation

Money markets are a cornerstone of the financial system that comprises 'money-like instruments' - debt securities with less than one year to maturity. These markets were at the epicenter of the financial crisis with dysfunctional money markets being one of the reasons for Lehman Brother's default. Consequently, money markets became the focus of financial regulators and went through major post-crisis reforms. In this research project, we focus on three roles of money markets in the post-crisis environment. First, money market rates act as proxies for the risk-free interest rate. Virtually every textbook in financial economics uses the 'risk-free rate' to characterize the return on safe assets and for discounting of future cashflows. In theory, the risk-free rate characterizes the simplest possible investment opportunity. In practice, however, deciding which interest rate should be the "the risk-free rate" is a difficult question that became even more difficult after the financial crisis. Klingler and Sundaresan (2020) examine Treasury bill yields as candidate and find that Treasury yields are substantially more volatile than other benchmarks. Moreover, Klingler and Syrstad (2022) examine the alternative benchmark rates suggested by regulators. Excess liquidity, in the form of Quantitative easening (QE) by central banks, has compressed the level of different interest rates towards the level of the risk free rate (e.g., the central bank interest rate). This has particularly been the case in Switzerland, Euro-zone and Japan, but less so in the USA. Rime, Schrimpf and Syrstad (2022) study how this compression in one money market spill-over to the other money market (US) via the FX swap market. Syrstad og Viswanath-Natraj (2022) study in depth the contribution of quantitative easening and swap-lines between central banks contributed to FX swap pricing. Georgievska, Klingler, Rime og Syrstad (2023) follows Rime, Schrimpf and Syrstad and study in depth how banks with different characteristica trade in order to satisfy their short term funding. Second, the role of short-term financing as a lubricant for the financial system. Security dealers play an important role in intermediating the demand and supply of securities that trade off centralized exchanges (the so-called over-the-counter securities). To provide this intermediation, dealers need to stock up their security inventories, which are mainly financed through short-term funding. Hence, a stable short-term financing market directly supports market liquidity - the ease of trading financial assets. Dick-Nielsen, Poulsen, and Rehman (2022) investigate the impact of post-crisis regulatory reforms on an important segment of over-the-counter market, the corporate bond market. In addition, Klingler, Syrstad, and Vuillemey (2021) examine firms usage of short-term financing. Rehman (2022) compare how the money market fund industry operate in EU and US in response to different regulations, and how this influences the customer's propensity to run on the funds. Third, the role of money markets in implementing monetary policy. Akram, Nyborg, Rehman, Rime and Syrstad (2023) use Norwegian data on liquidity auctions - transactions in which banks pledge collateral with the central bank to obtain cash - and examine how Norges bank?s collateral policy (i.e. which collateral is accepted) affects money market rates. Natvik and Syrstad (2021) examine how central bank communication about the future impacts money markets.

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Money markets are the cornerstone of a well-functioning financial system. These markets ensure the smooth flow of capital to its most productive use, acting as a lubricant of the financial system. Before the Global Financial Crisis (GFC) of 2007-2009, the functioning of money markets was essentially taken for granted. However, as highlighted by the GCF, disruptions of money markets can occur with potentially disastrous consequences (for example, the default of Lehman Brothers can be attributed to disruptions in its access to money markets). As a consequence of the GCF, financial supervisory authorities around the world have tightened the regulation of money markets. These new regulations, combined with unconventional monetary policy (also known as quantitative easing), had a significant impact on the functioning of these markets. Following the GFC outcomes in money markets around the world has differed significantly from the pre-GFC period. We plan to address these changes. Examples of projects are listed below. A collateralized loan (which is safer than an uncollateralized loan) should have a lower interest rate than a comparable uncollateralized loan does. However, this does not hold anymore. This pattern raises an important question: which rate should we use as proxy for the risk-free interest rate? We will follow up on this question and describe a drastic shift in the level of different proxies for the risk-free rate in the post-GCF regime. Because financial institution, corporations, and investors all use the risk-free interest rate – either directly or indirectly – in their investment decisions, understanding the benefits and limitations of different risk-free rate proxies is of paramount importance. More broadly, the principal of no-arbitrage – arguably the most important concept in financial economics – is frequently violated in the post-GCF environment. We plan to trace violations of this concept back to distortions in money markets.