Chartbook 401: The dollar system in an age of market-based finance - financial globalization beyond banks (The World Economy Now, July 2025)

This is the third in my on-going series that seeks to track broad developments in the World Economy Now.

Previous installments were

#1 May 2025: Putting Trump’s trade tantrum in its place

#2 June 2025: Whither China

In this installment I read the Annual Economic Report of the Bank of International Settlements (BIS) produced by the wonderful research team at the BIS headed by Hyun Song Shin. Their research allows us to chart how the global financial system and financial flows have changed since the 2008 financial crisis and what implications this has for the functioning of the dollar system.

According to the BIS team, the key starting point is to recognize a series of major trends that have rearranged global finance since 2008:

The Great Financial Crisis (GFC) (of 2008) was a watershed event that set in motion two related structural changes in the global financial system which define the state of the system today. First, the focus of financial intermediation has shifted from lending to private sector borrowers to claims on the government, especially in the form of sovereign bonds. Second, non-bank financial institutions (NBFIs) have assumed a greater role. While the GFC was primarily a banking crisis in which regulated banks were the main characters, portfolio managers investing in sovereign bonds have taken centre stage in the post-GFC financial system.

With the US in the lead, the private sector has “derisked” since 2008, whilst public debts have piled up as never before in peacetime.

Whilst bank balance sheets have continued to grow relatively modestly, Non Bank Financial Institutes - hedge funds, investment funds, pension funds, asset managers etc - have grown far more dramatically.

As the BIS remarks, investment funds, hedge funds and private credit markets have all expanded spectacularly. “Private credit funds’ assets under management have surged from $0.2 billion in the early 2000s to over $2.5 trillion in 2024.”

The shift from loans to bonds and from banks to non-bank financial institutions make up the trend that is often referred to as market-based finance. It intensifies trends already visible before 2008.

A third shift that we have seen since the 2008 crisis is the geographic reorientation of the build-up of financial claims. Whereas the build-up of net claims against the USA in the 2000s was between the US and the Emerging Markets, since the 2010s it is the “new creditors” - above all Advanced Economy lenders in Europe and Asia - that have been more important in buying up US assets. The BIS report contains a fabulous graph illustrating this point.

Net lending to the US in the form of bond purchases by European and other Advanced Economy increased between 2015 and 2023 by $ 1.2 trillion, which is three times more than the increase in claims by Asian Emerging Economies on the US over the same period. This is very much in line with the argument made in Chartbook 397 on the new pillars of the dollar system and the “dollar trap”. In that newsletter I was interested in the evolving geoeconomic logic of the dollar system. The BIS report allows us to think through the implications for the operation of the financial system.

The network of Advanced Economy non-bank financial institutions centered above all around the US Treasury market has new dynamics and new risks.

As the BIS describes it:

Before the GFC, international capital flows were mostly intermediated by banks. As a result, financial conditions were transmitted across borders mainly through the activities of internationally active banks. … After the GFC, the focus of international financial intermediation shifted from the activities of global banks engaged in cross-border lending to the activities of international portfolio investors in global bond markets.6 This “second phase of global liquidity” had several key drivers. On the borrowing side, it was largely driven by expansive fiscal policies in major jurisdictions and the surge in the supply of sovereign bonds.

Whereas the 2000s and early 2010s were an era in which official holders in the EM acquired net claims on the US, the world since the 2010s has been one in which:

foreign private sector lenders have grown in importance relative to foreign official holders. In the US Treasuries market, the largest bond market in the world, foreign private sector lenders (mainly NBFIs) have increased their holdings of Treasuries rapidly over the past decade. During that time, their accumulation of Treasuries has considerably outpaced that of foreign official holders (Graph 3.B). As a result, they currently account for more than half of all foreign holdings of Treasuries.

If you put these three developments together you have a new focus for attention in tracking global financial markets:

The center of attention are not worries about EM reserve managers i.e. the Chinese suddenly selling out dollar assets in a politically motivated “bear raid”.

Nor are folks very worried about mismatches in the balance sheets of big systemically important banks, the trigger for disaster in 2008. Global banks have not been left out of this phase of financial development. Bank lending to Non Bank Financial Institutions has increased. This increases risks. But even larger has been their market-making in FX swaps and other derivative mechanisms, that enable NBFI to raise dollar funding without heavily impacting bank balance sheets.

The focus of BIS concern is on the largest government bond markets i.e. the US and the Japanese bond markets (not so much the Eurozone right now). In those markets, the concern is that instability and a sudden tightening in financial conditions could be triggered by the highly complex plays of sophisticated Advanced Economy Non-Bank Financial Institutions i.e. mutual funds, exchange-traded funds (ETFs)), long-term institutional investors such as pension funds, insurance corporations and sovereign wealth funds, as well as hedge funds.

The historical precedent is not a “sudden stop” crisis where foreign creditors suddenly withdraw funding, as in Asia in the late 1990s, or a mega bank run, as in 2008, but something more like the panic in the US Treasury market at the start of COVID in March 2020, which forced the Fed into intervention on an unprecedented scale. For this incident see my book Shutdown on the economics of the COVID shock.

The BIS describes the new risk scenario as follows:

Aside from loan markets, the shifts in financial intermediation activity towards NBFIs has increased the likelihood that financial instability could originate or be amplified by liquidity stresses.

“Liquidity stresses” refers to a situation in which an asset like US Treasuries which are held largely for their liquidity - your ability to sell any quantity, whenever you like for a highly predictable price - might lose that property. Prices might fluctuate. Demand might not be there. The market might “gap”. That in turn risks an avalanche since it is precisely their assumed liquidity that creates demand for the Treasuries and that in turn enables a variety of high leveraged investment strategies to be piled on them. The liquidity of the US Treasury market is nothing less than the foundation of the entire global financial system. That could now be at risk. As the BIS puts it:

For instance, with broker-dealer balance sheets having smaller heft in the financial system post-GFC, liquidity in sovereign bond markets increasingly relies on open-ended mutual funds, hedge funds and other asset managers. These entities often face significant liquidity mismatches, rely on short-term funding backed by government securities as collateral or are either frequently highly leveraged or exhibit leverage-like behaviour. As a result, their liquidity provision is less stable and more likely to evaporate during periods of market stress. Hedge funds, in particular, have increasingly become a significant source of procyclical liquidity, especially in government bond markets. These investors actively pursue relative value trading strategies that seek to exploit small price differences between related financial instruments.23 To boost the returns on these small price differences they heavily leverage their positions. One method often used is to pledge government securities as collateral in the repo market to borrow more cash with which to purchase additional government securities. This practice has further evolved in recent years, with investors borrowing amounts equal to or higher than the market value of the collateral provided – that is, without any discount, or haircut, protecting the cash lender from market risk.24 In turn, that means that the borrower can obtain more leverage, leaving the overall market exposed to dislocations if haircuts are increased even slightly, leading to forced selling. The increased heft of hedge funds is reflected, for instance, in their growing US Treasury gross exposure – now exceeding 10% of the outstanding free float (Graph 13.A, red line) – and the expansion of the US repo market segment catering to leveraged investors (blue line).25

“Runs on repo” were a crucial dynamic in the 2008 financial crisis, with Lehman and other banks losing access to hundreds of billions of dollars in funding overnight. Today, the structure remains highly unstable.

Hedge funds’ relative value strategies are highly vulnerable to adverse shocks in funding, cash or derivative markets, as evidenced by some recent episodes. During the market turmoil of March 2020, for instance, margin calls in Treasury futures markets triggered fire sales, resulting in destabilising deleveraging spirals.26 More recently, a more orderly unwinding of relative value trades – this time tied to interest rate swap markets, where investors had bet on a narrowing in spreads due to potential deregulation – seems to have contributed to the heightened volatility observed in Treasury markets in early April 2025.

Non-Bank Financial Institutions also engage in cross border investments on a huge scale. Once again this involve them in highly leveraged and inherently precarious structures of funding. The numbers in this case are truly staggering in scale.

Many rely on short-term dollar funding and hedging markets through repos and foreign exchange (FX) swaps to finance positions and manage currency exposures. Notably, non-US pension funds and insurers hold substantial US assets hedged with short-maturity FX derivatives that are continuously rolled over. By end-2024, dollar borrowing through FX swaps, forwards and currency swaps accounted for 90% of the $111 trillion in these instruments globally outstanding (Graph 13.C). While these tools facilitate funding and hedging of large cross-border positions, they also expose NBFIs to significant short-term rollover risks and funding squeezes, as highlighted by the sharp volatility in early August 2024 (see Chapter II).

Before 2008 it was the North Atlantic system of interconnected banks in the US and Europe that were the powder keg that ultimately exploded. Now it is a broader range of non-bank financial institutions in the US, Europe and Advanced Economy Asia that matter. And as the BIS notes they are significantly more internationally exposed than the banks ever were.

Furthermore, they respond highly sensitively to movements in market sentiment, relative interest rates and exchange rates.

Movements of financial market conditions have become significantly more correlated in the last decade.

As recently as May 2025 amidst Trump induced turmoil, yields on long-dated bonds spiked simultaneously across Advanced Economy markets.

The dollar and the US markets remain at the center of this system. But in this new scenario, given the scale of foreign private engagement in US bond markets, the influences can run in many different directions. Increasingly, it is not just US conditions that affect the world, but “US financial conditions are increasingly affected by developments in other advanced economies (AEs).”

Though shocks transmitted from the US remain substantially more influential than those from any other market, the US too is becoming more susceptible to shocks from abroad. The most notable recent incident was the August 2024 unwinding of yen carry trades which triggered a small but noticeable tightening of US financial conditions.

It would be premature to say that we know how this system works when put under severe stress. So far the COVID shock of March 2020 is the only real test. That was certainly a moment when the massive stresses on the entire world economy reverberated through US markets with alarming effects.

The two things we learned are, first, that the US Treasury market did not prove robust and there is little to suggest that recent regulatory changes will really fix that.

Secondly, the only way to restore stability was by means of massive Fed intervention not in the banking system but in the US Treasury market. In the run up to 2020, relations between the first Trump administration and the US central bank were strained. But in extremis that did not prevent prompt action by Jerome Powell. Currently, there is no immediate crisis, but relations are even worse. What the BIS report helps us to gauge are the kinds of crisis mechanics to watch out for, should there be another bout of anxiety in global financial markets in the coming months.

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