July 30, 2020

Episode 109: Understanding the Fed’s Money Printer, and Lessons from the Crisis

July 30, 2020

Quantitative easing is a monetary policy whereby a central bank buys government bonds or other financial assets in order to inject money into the economy to expand economic activity. But what exactly does that mean? In today’s episode, Benjamin and Cameron are going to address this topic, avoiding highly politicized aspects, like whether or not central banks should be involved in the economy in the first place, and focusing purely on the operational perspective of quantitative easing – what is it, how it works, and what the intended transmission mechanisms are. Benjamin explains what he has learned through his extensive research, from what money printing and the stock market have to do with one another, where the money for loans comes from, how central banks can influence lending rates, and the difference between regular open market operations and quantitative easing. We also cover how quantitative easing works, the relationship between bank reserves and money in the economy, and what causes inflation, as well as the effect of quantitative easing has on stock prices (if any). We also catch up on recent news stories, and Cameron takes us through five key personal finance lessons we can learn from this crisis. If you’re looking to understand quantitative easing, this episode will hopefully become a useful resource! Tune in today.

Key Points From This Episode:

This week’s book of the week is Mindf*ck: Cambridge Analytica and the Plot to Break America by Canadian, Christopher Wylie [0:04:38]
A chart showing the ratio of the Nasdaq 100 index divided by the Russell 2000 [0:08:22]
University endowment sued for active investing by 94-year-old Clarence Herbst. [0:10:02]
This was not the first time Clarence Herbst had an issue with his alma mater. [0:13:05]
Multimillion dollar mismanagement of public pension funds in Maryland, 2014. [0:13:22]
Benjamin introduces the main topic, quantitative easing (QE), a central bank action. [0:14:42]
What do money printing and the stock market have to do with one another? [0:17:37]
You can summarize money as a social construct that facilitates economic activity. [0:20:06]
As long as there are credit-worthy borrowers, banks will print money out of thin air. [0:22:28]
The distinction between central banks and private banks, which interact with customers and have to monitor their net flow of money. [0:25:27]
Open market operations allow a central bank to influence overnight lending rates. [0:28:30]
The difference between regular open market operations and QE. [0:33:14]
A couple of theories about how QE might work, like the portfolio balance theory. [0:37:42]
There is no relationship between reserves and money in the economy. [0:41:11]
What causes inflation? It’s not reserves! Demand for loans drives demand for loans. [0:43:07]
What about the effect of QE on stock prices? We would expect a positive impact. [0:45:14]
Money is this medium that facilitates economic activity and that's all it does. [0:47:40]
Five key personal finance lessons we can learn from this crisis: Stocks are volatile [0:50:35]
Debt is dangerous and emergency funds have a very important purpose. [0:50:35]
Don’t stop spending, always prepare for the worst – disability insurance is crucial! [0:54:51]
Cameron still wants to understand how fee-free trading platforms make money – nothing is for free! [0:50:35]

Read the Transcript:

Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We're hosted by me, Benjamin Felix and Cameron Passmore.

Cameron Passmore: This weekend we'll get our great producer, Matt Passi, and maybe let the music play a little bit longer here. I think the comments on the various places, be it YouTube, or on The Rational Reminder website dotca, of course we'll put comments in there, there's a lot of comments about the music, and some people really don't like it. Some people love it. Some people have changed their minds and they do like it. We like it. We had to change. The reality is we had to change it because it was causing problems on YouTube.

Ben Felix: Yeah, because of the copyright or something like that. It's also such a small sample of, there are thousands-ish of people that listen to the podcast, and we've had, in aggregate, probably 10 comments about the music. So we're drawing these insights from a tiny, tiny sample size.

Cameron Passmore: And assuming those 10 that represent other people, and maybe it's just the people that are passionate about the music, but some people are really passionate about the music. Someone said it sounded so typical, or the new music sounded so typical, the other one was so original. The irony is that the other one was just picked out of some music box, digital music box somewhere. I don't know what we paid for it, but We did pay for it. It was all legitimate, but the new one was custom written just for us.

Ben Felix:That was a funny one.

Cameron Passmore: It cannot be more custom. Anyways, I thought that was funny. I also, I don't know about you, but every week you wonder like where's the content going to come from, and then quickly through the week it becomes like, oh my gosh, where did we get all this content? How are we going to fit it all in? They wind up cutting stuff out. There's endless content for us to talk about, and we've got some great guest recommendations. Mind you, we're pretty much booked up for the rest of this year. Next week, Craig Alexander, the chief economist from Deloitte will be here, incredible interview. Then two weeks after that is Michael Kitces so advisors out there, of course know Michael. He's an excellent financial planner, researcher, consultant speaker, expert on our industry. Great guy, great interview coming up. Also, wanted to give a shout out to those who might be interested in watching us on YouTube.

We're getting more and more viewership over there and lots of great engagement in the comments. The last thing which will make Lisa's daughter's laugh, because I think it's pretty funny, we find it hilarious that we're considering having a merchandise shop, a swag shop. We've had people asking for the sweatshirt I've got on and the water bottle that I used when we recorded this. So, we're looking into getting us some sort of swag shop going, hopefully in the next month or so. If you have interest in that, again, drop us a note in the comments if it's of interest. Might go well, it might be complete flop. I don't know. It'll be a neat experiment to try anyways. Going to it'd be a fun project for my daughter to run. She wants to run her merchant shipping out of her basement.

Ben Felix: All four items.

Cameron Passmore: Well, maybe not even that much. We'll see. Anything else dad? I kind of dominated the intro here after your lovely intro?

Ben Felix: Oh no, no, that's fine. I always think it's good to reiterate the rationalreminder.ca website is the best place to discuss what we talk about on the episode. So, if you want to talk about this episode, it's rationalreminder.ca/podcast/109. Also, just the general discussion on The Rational Reminder site, every time I check it blows my mind. I'll check maybe once every couple of days. It's like, there's 10 new discussion threads that have been started and people are talking with each other over there, which is unreal. In terms of the actual data on the website traffic, it's becoming heavily concentrated. It's increasing overall, but becoming increasingly concentrated in the discussion page. It seems like there are a few people that are active and posting and answering other people's questions, but it seems like there are a lot of other people that are going to visit that discussion page, and presumably, getting some good insight and information from the conversations that are going on.

I think that's great. The outcome from when we added that comment section, that comment tool, the outcome has been as good as I would have hoped. So, keep it up, and like I said, if you want to discuss this episode, which I'm guessing there's going to be some commentary around the quantitative easing discussion or some questions or whatever, it'd be awesome if we could have most of that on rationalreminder.ca/podcast/109.

Cameron Passmore: I agree. Anything else?

Ben Felix: No. Let's go.

Cameron Passmore: Okay. Let's go. We'll let Matt take us over to the episode with the snappy new music.

Ben Felix: Welcome to episode 109 of The Rational Reminder Podcast.

Cameron Passmore: The book of the week. Wow, what a book, another great book. I've been lucking out lately with my book choices, but it's called, I don't want to use the profane name, but it's Mindf: Cambridge Analytica and the Plot to Break America by Canadian Christopher Wylie. What an incredible story. You know the story behind Cambridge Analytica?

Ben Felix: Somewhat. Yeah.

Cameron Passmore: Anyways. Christopher Wiley is the whistleblower behind Cambridge Analytica, and he came out after the whole debacle with the, not a debacle in Trump's mind, of course, but he came out to talk about how this confluence of all these events from data to technology, to social media, to Russia, Trump. So, Cambridge Analytica is this British political consulting firm that pulls together all kinds of information and data mining that they actually got from Facebook, if you can believe it. He worked with researchers at the university of Cambridge to get this information from Facebook, and it's unbelievable the information they were able to get from Facebook in an effort to help Facebook deliver better service to its users.

It was unbelievable access to some very private information, and not only would they get your information, they would get all the info of your friends. The average Facebook user has 162 friends, I believe. There's actually a Netflix documentary on this, which I started watching a couple of nights ago called the Great Hack, so it's the exact same story. They talk about in the movie that they had upwards of 5,000 data points per person. It's absolutely wild. They were able to take this data and learn about people, learn about their tendencies, and then figure out what sorts of information they can shove down this pipe into social media. Now we all know that the name of the game for companies like Facebook is eyeballs, right? Is to get your engagement, and the way to get your engagement is to send you stories that you like, that you believe in.

We're all busy, we're all looking for self-affirming information. We've talked about this many times. So they shoved down these fake stories. People like them, people share them, and there are certain personality traits that did more liking and sharing so they can put that information that would be appealing to who would vote for Trump's. This was discovered and brought to politics by Steve Bannon. You remember the episode we had where we interviewed Greg Zuckerman, who wrote the book on Renaissance Technologies, right? Well, one of the big names behind them is the one that funded this whole thing. So Robert Mercer was one of the early founders of Renaissance Technologies, a multi-billionaire. He funded this, Steve Bannon drove it, and Christopher Wiley was part of the data analytics behind this, and it is absolutely wild how this influenced the election. It was like the perfect storm.

You've got an audience that fed off this information, you have a platform that needed eyeballs, and you had people that figured out how to manipulate this at a time when you could get access to this information about people, and it worked. It worked like crazy. Just shows you how susceptible we all are to our own wirings, our own psychological wirings to want to read stuff we agree with. It's easier, it's more interesting, and we want to share it, or we get validation when someone else shares it. So, it was like this perfect confluence and it was great book. Great, great book. Guys from Victoria, I think he's actually a similar age to you, so who knows? You may have crossed paths [crosstalk 00:08:15].

Ben Felix: I don't know. Crazy story.

Cameron Passmore: Crazy story, and the documentary is excellent, so I highly recommend it, recommend them both. I shared a chart on our notes for this week. Just a simple chart from Bloomberg that I caught on the Twitter feed this week, to show, in a simple ratio, of the NASDAQ 100 Index level divided by the Russell 2000, which is the small cap, US small cap index. So, just a simple ratio. It's amazing. You can see it right now. It is almost as high the ratio. The NASDAQ 100, largely tech stocks divided by the small cap stocks. The ratio right now, price ratio is over seven times higher. NASDAQ to Russell 2000. It has not been this high since the early 2000s. Not predicting anything.

Ben Felix: Yeah. It looks a lot like the spread between value and growth chart that we talked about a few weeks ago, or even a couple months ago.

Cameron Passmore: I actually thought that's what it was until I looked into it more.

Ben Felix: Same idea really.

Cameron Passmore: [crosstalk 00:09:14]. Same idea, right?

Ben Felix: Same idea. But the point is that this run of large cap growth has been, I mean, something. I don't know how else to describe it. It's been something.

Cameron Passmore: It's causing a lot of people, again, as we've mentioned many times, to really question the value premium.

Ben Felix: Yeah, question the value premium. I think there's a lot of FOMO going on where people want to be getting in on the price increases of these large cap, mostly tech stocks.

Cameron Passmore: We were talking about Tesla last time. It was just you and I, and I flipped back, and I remember we talked about the market cap movements of Tesla. During the recording, it went up one General Motors, then it went down two General Motors while we were recording.

Ben Felix: Yeah. Crazy.

Cameron Passmore: Over $60 billion fall in that hour. Last news item. This one was recommended to us by a listener. I think it was on the Rational Reminder Website. This is an article from Institutional Investor of July 20th. Crazy story. Interesting story though. It's a 94-year-old donor who is taking on the $2 billion University of Colorado Foundation overactive investing. The quote is, "He's suing the Foundation over some investment strategy in so-called abysmal returns." The individual is Clarence Herbst, who in the past had donated $5 million as alma mater, and actually used to chair the Investment Committee in the early '90s. What he's proposing is that, they should replace the diversified equity portfolio with the Vanguard S&P 500.

Now, he's long been known to be an index advocate, but he says that the foundation has underperformed the S&P fund by almost 5.5% from 2010 to 2019. He said that the performance could have insignificantly improved by simply investing in broad index over the actively managed investments and alternative investments. He believes that this has cost the foundation $1 billion over the past decade. That's what the plaintiff argues. Quote is, "The foundation insisted on irresponsibly and blindly paying Perella Weinberg Partners," who's their manager now, "and dozens of other active managers and hedge fund managers, tens of millions of dollars per year in advising fees to underperform relative to the market." Said the complaint.

Ben Felix: Honestly, I honestly think it's a bit of a flimsy complaint because you can compare a lot of things to the S&P 500 and say, well, it was irresponsible not to invest in that over the last 10 years.

Cameron Passmore: Absolutely. Was there a value bias, small debt bias than portfolio? Who knows what's the makeup of the portfolio, but the story is more interesting. I did some poking around. It used to be only an index funds up until 2003. Then after that became more active. But the chief investment officer who made that change in 2003 left in 2009, then joined Perella Weinberg Partners, which then became the funds [inaudible 00:12:04] to manage the investments. The lawsuit accuses, and here's the quote, "Following the initial contract with Perella Weinberg, the Foundation did not negotiate the percentage fees and costs it would pay to Perella Weinberg and other active manager firms engaged by Perella Weinberg to manage the Foundation's assets, and has not done so in the last 10 years. The foundation did an insider," I'm quoting here, "insider transaction with Mr. Bittman, who was a former CIO and PWP."

The Foundation of course, responds, "They believe the case is without merit, and we've been looking at these issues in conversation with the plaintiff for years. We believe, and our board believes, that fall, the plaintiff's demands would be a breach of our fiduciary duty and it would not be consistent with the best practices of colleges and university endowments across the country. When you compare their performance to NACUBO, they actually outperform the majority of their peers."

Ben Felix: Who all underperformed a 60-40 index.

Cameron Passmore: Hey, I'm just reading you the story.

Ben Felix: As we talked about in our last episode about this.

Cameron Passmore: Anyways, another story I've found is that this is not the first time that the plaintiffs had an issue with his alma mater. He also took the school out of his will after he was upset with how much funding was going to athletics at the university.

Ben Felix: Interesting. This isn't the first time. I've seen something somewhat similar to this. There was a report in 2014 from the Maryland Institute of Public Policy, I think was the name, where they did a whole research case on public pension plans in the State of Maryland. It wasn't a lawsuit, but they were looking at similar issues. Basically just saying, how much better off all of the pension beneficiaries would be if they had just invested in index funds, as opposed to paying all of these billions of dollars in fees to active managers?

Cameron Passmore: It's a ton. Anyways, this story, and please, listeners, if you have other stories you'd like us to consider, send them through, add on YouTube comments.

Ben Felix: Ties right into the conversation we had a couple of weeks ago about ... well, actually for the last couple of weeks where we talked about the different institutional pension models and how most of them underperform index funds, and then it also ties into our conversation about private equity and how there may have been opportunity there in the past, but now valuations for private equity are just as high as public equity so there's no expected premium. It all ties together.

Cameron Passmore: Under the big topic for today, I'm super jazzed about this one. I want you to set it up. Tell us where you got this idea to dig into this, and what's the genesis of it?

Ben Felix: I don't have a very good answer, to be honest with you.

Cameron Passmore: Well, it's been bugging you for months.

Ben Felix: Well, yeah. How did I land on the topic though? I don't think I have a good answer, but yes, I've mentioned in the podcast a bunch of times over the last couple of months that I've been trying to figure this topic out, which is the quantitative easing topic. So, it's something I have been spending a lot of time researching. I think one of the hard parts about it is that it's far enough outside the sphere of what I know well that it wasn't as easy as going and finding a couple of good academic papers and getting the main issues, because I pick up the academic papers on this topic, and it's like, okay, there's 50 things I need to understand before I can even read this paper.

Cameron Passmore: Oh, you didn't have the same foundation that you have...

Ben Felix: Not even close. Not even close.

Cameron Passmore: You must have even worried about getting it right. Like you had this reviewed, right?

Ben Felix: Yeah. That was a whole issue. Anyway, I think I got it to a point where I was comfortable, at least talking about it.

Cameron Passmore: Okay. Let's go through this carefully. I'm going to stop you a lot. I've read your notes very carefully. I want to make sure people understand because of this is really important, and there's a lot of conventional wisdom that you will show us that doesn't necessarily hold water.

Ben Felix: Yeah, and some of it came up in episode 106 with Jim Stanford, and some of the came up in an episode that we have coming out next week, 110, with another economist. So, you'll hear these issues a couple of times in the next couple of weeks. Well, between episode 106, this episode, 109, and episode 110, we touched on these issues a few times. Okay. The first thing to set the stage for the discussion is that this is about quantitative easing, which is a central bank action. Any central bank action is political inherently. This is not about that aspect of it. This is not about whether or not central banks should be involved or trying to be involved in the economy. This is just about, from an operational perspective, what is quantitative easing, how does it work, and what are the intended transmission mechanisms?

Cameron Passmore: Right. You're not passing any policy judgements here at all.

Ben Felix: Not saying whether or not QE is a good idea. I'm not saying whether or not central banks are a good idea. Those are all very politicized issues that I'm not taking a position on at all. I think the thing that people have been hearing, and this is ... you know what? Actually, to answer your question, this is why I wanted to cover this topic, is so many people respond to what the stock market is doing by saying, well, it's being propped up by the fed printing money.

Cameron Passmore: The money from helicopters.

Ben Felix: Yeah, helicopter money is a very specific term in monetary economics, but I don't even know if you will think that far. It's like, oh, the stock market's going back up because the fed is printing an unlimited amount of money. That seems sensible sort of if you don't dig into the issues. It seems like an easy way to explain away what's happening, at least. Anyway, so I kept seeing that in YouTube comments so that made me want to figure it out. Like, is there actually a relationship there? I didn't know how to answer the question, what does the money printing even mean? Anyway, to understand that, to understand what the money printing means, and then to understand how that might be related to the stock market, I got to take a big step back and think about what money is in the modern economy and what purpose it actually serves.

Cameron Passmore: This was your first breakthrough, right? I remember, when this kind of hit you, the realization of what money is and how it's created.

Ben Felix: Well, yeah, I mean, what money is, is part of it, and I think it's an important part of the foundation of understanding, how ... Well, understanding some of the conclusions that we'll get to in a few minutes. How money is created is an important one. That was one of the trickiest parts to figure out, anyway. At the most basic level, and this part, I think people are familiar with. Money facilitates the exchange of goods and services pretty easy. It serves as a unit of account. These are the required characteristics of money. Serves as a unit of account. So, it provides a standardized way to measure income wealth, asset prices and profits. Pretty standard. And it acts as a store of value, which allows people and businesses to store wealth in a convenient form in the short-term.

All of the money or most of the money in today's capitalist, modern capitalist economy is Fiat money. It's not gold. It's not backed by anything. Fiat means, let it be, in Latin.

Cameron Passmore: I did not know that until you wrote that.

Ben Felix: Yeah. All Fiat means that the money has no intrinsic value, but it's used in an economy based on government pronouncement. One of the interesting things that I came across while I was researching, this is, how do governments ... Well, one of the ways that governments can give money value is by making their citizens pay taxes in that currency. Thought that was interesting. It doesn't give it intrinsic value, but one of the ways the governments can enforce the use of money in their economy, of a specific money in their economy is by having their citizens pay taxes in that currency.

Cameron Passmore: In that currency.

Ben Felix: Correct.

Cameron Passmore: That's the key. Interesting.

Ben Felix: Yeah. I thought that was interesting too. Now, the stability of money, so paying taxes is, I guess, part of that, but the stability of Fiat money comes from the productive capacity of the economy. So, like Canada or Japan, those are truly fundamentally productive economies. That's one of the places that money value comes from. The supply of money, which is one of the things that comes up in this whole quantitative easing discussion, and the state's endorsement and protection of its use, which ties back to the idea of requiring taxes to be paid in that currency. Now, if you tie all that together, I think you can summarize money as a social construct that facilitates economic activity.

Cameron Passmore: That is such a great line because that's exactly what it is. It is a social construct. It's not backed on by anything.

Ben Felix: Which is okay.

Cameron Passmore: The belief. The belief the system will keep working.

Ben Felix: Ultimately, yeah. And the belief that the economy still has productive capacity, and that the government will continue to enforce the use of that currency to facilitate economic activity.

Cameron Passmore: Exactly.

Ben Felix: Now, the government, in trouble because of its involvement, does not create most of the money in the economy. Governments are usually the entity that makes physical currency. So, bills, plastic bills, I guess not paper bills, but bills and coins. Government's usually responsible for that, but that's a tiny fraction of money that exists in the economy.

Cameron Passmore: And shrinking, I'm sure.

Ben Felix: That's probably true too. Most of the money in the economy comes from private banks, making loans to individuals and businesses. The vast majority.

Cameron Passmore: Wow.

Ben Felix: Now, every time that a new loan is issued by a bank, and this is pretty obvious, I think, but it creates a loan, which is an asset to the bank and a liability to the customer, and it creates a deposit, which is a liability to the bank and an asset to the customer.

Cameron Passmore: When they're making a loan, they're not using the money in the bank to make the loan necessarily.

Ben Felix: There is no, and I have this written somewhere in my notes, but there is no reserve requirement. There's no requirement to have money to lend out.

Cameron Passmore: So, this is fundamental. Because you said, making a loan creates new money. I can hear listeners saying, yeah, but they have deposits. You're just lending out those deposits. Not necessarily.

Ben Felix: Not at all. You go and open up a bank, okay? Before you've taken in any deposits, you can make loans.

Cameron Passmore: Hence creating money.

Ben Felix: Lending is the process that creates money, and it does not require deposits to happen.

Cameron Passmore: That is key to understanding where you're going.

Ben Felix: Yes. Yes, it is. Now, just that concept, that private banks create money out of thin air every single day, when they make loans, and banks will always make a loan if they have a credit worthy borrower who's willing to take the loan.

Cameron Passmore: And enough demand for those loans.

Ben Felix: That's the credit worthy borrowers. There have to be credit worthy borrowers who are willing to come and borrow from the bank. That is exactly the demand for loans, and that's where money comes from. As long as they're credit worthy borrowers looking to borrow money, banks will print new money out of thin air and stick it in the economy. Now, the banks are competing with each other to create loans, to create money so that competitive force is always there. The constraint that banks have is not deposits, it's not reserves, it's not having enough cash to lend out, or whatever. All that's flawed thinking, and we'll get more into that in a second, but their only constraint is their own ability to remain profitable.

They can't go and make a bunch of loans that are too risky, where the borrowers are never going to be able to pay the loans back. Otherwise, they risk going out of business. But as long as they have credit worthy borrowers, they'll make long, regardless of any ... I can't hammer it home enough. Literally, this isn't an operational thing. This is a rules thing. Central banks in Canada and the US, The Bank of Canada and the Federal Reserve do not have reserve requirements. So there is no requirement in either of those central banking systems to hold any amount of money on reserve with a central bank in order to make loans. It's like the example I gave earlier. You could open up a bank, take in no deposits and make loans.

Cameron Passmore: Right. Now, if those loans default, you're going to go out of business as a bank.

Ben Felix: So you've got to be careful with who you're making loans to, which is why the money creation is coming from demand for loans from credit worthy borrowers.

Cameron Passmore: Got it.

Ben Felix: Banks aren't just creating money because I feel like it. They're creating money if they think that they're going to make a profit on the lending arrangement, which depends mostly on the customer. What stems from that is that fractional reserve banking, I just blew that out of the water a second ago, by saying that there are no reserve requirements in Canada or the US. Fractional reserve banking, and then the money multiplier effect, the idea that banks take in deposits and then lend out a multiple that, those are fundamentally incorrect. That's not how banking or money work in a modern monetary system. I said modern monetary system. That might make people think of MMT, which is not what I'm talking about.

This is just like operationally. This is how it is happening and how it works. Yeah, so the way that all of that can be summarized is that borrowing, and I think Jim Stanford talked about this in episode 106 too, borrowing is the money creating process that allows for saving, and not the other way around. It's not people well saving money that allows banks to lend out more money to other people that creates savings. It is banks creating money out of thin air, allowing people to make presumably profitable investments, which allows for saving.

Cameron Passmore: Creates employment, creates income, which leads to saving.

Ben Felix: But the money creation is coming from initially borrowing. It's not people coming with their hard earned saving to the bank and the bank lending those hard earned savings out to other people.

Cameron Passmore: Exactly.

Ben Felix: It's the bank creating money out of thin air, giving it to people who they think will be able to pay it back plus interest, and that's it. Now, all of the banks ... actually, maybe it's important to make a quick distinction. Within this system, there are central banks, so the Bank of Canada in Canada, the Federal Reserve in the US, and whatever other banks around the world, and then there are private banks. The private banks are the ones interacting with the customers, and then the private banks interact with each other and with the central bank. The central bank does not interact directly with individuals and businesses in most cases. The private banks, the thing that they need to keep an eye on is not their reserves, because there are no reserve requirements. It's their settlement balances, it's their net flows of money.

If a bank goes out and makes a loan to a customer, and that customer goes and takes their money out of their bank account and goes and buys some equipment from their supplier, who banks with a different bank, and that piece is key, the money has now left bank one and gone into bank two, which means bank one has a negative settlement balance for the day. They have a negative flow. Now, all of the banks in the private banking system have settle their balances at the end of each day through a central clearing house. This is where the central bank is able to influence lending to an extent, because they're the ones that dictate, or at least try to dictate, the rate that will lend to each other in the overnight lending market.

If I'm a bank and I have a negative settlement balance at the end of the day, I'm required to settle that up with, either one of the other private banks by borrowing from them in the overnight lending market, or if I can't do that, the central bank will charge me interest. Likewise, if I have a net positive balance at the end of the day, the central bank will pay me interest.

Cameron Passmore: But all the banks in totality will be net flat.

Ben Felix: Yes.

Cameron Passmore: Because all the debits and credits will even out. So does that mean they're charging each entity interest between them normally? Is that what normally happens?

Ben Felix: The bank of Canada, the way that they transmit their target interest rate is by having a 50 basis point operating band around the interest rate that they want to target. What that ends up meaning is that banks have an incentive to settle their transactions with each other at the end of the day. If they can't, they'll have to settle with the central bank, but they would have been slightly better off by settling with the private banks. The bank of Canada talks on their website about how their incentive system ends up working really well, where banks can usually clear everything with each other. In times of stress, like what we're going through now, the central bank is the ultimate backstop.

That liquidity, that interbank lending, when that locks up is when the banking system can collapse, and that's happened in the past, and that's why, and again, I'm not trying to get political here, but that's why central banks were created, initially, was because the private banking system, left to its own devices, had a tendency of locking up, where banks would not settle transactions with each other at the end of the day.

Cameron Passmore: So, those that may be net positive didn't want to lend back to someone, another bank who was net negative, perhaps on the day.

Ben Felix: That's the idea. So the central bank will clear everything. That role that the central bank plays lets them affect the overnight lending rate. One of the ways that they do that is through these things called open market operations. As much as there are no reserve requirements, bank reserves are sort of the currency that banks use to settle these overnight payments. So you're not required to hold money in reserve relative to deposits, but banks are still using bank reserves. They have reserve accounts that they use to close their settlement balances. The central bank can come in and add or remove liquidity in the, I guess, market for reserves. If the central bank wants to affect the overnight lending rate, if they want to increase the overnight lending rate, they can go and buy up bank reserves. If they want to decrease it, they can go and buy assets in exchange for reserves.

Cameron Passmore: Which gives them more cash.

Ben Felix: Yeah, or short-term government debt or whatever. By affecting the supply of bank reserves, they can affect the overnight lending rate.

Cameron Passmore: Do you have any sense of how much clearing goes on every night? Do you have any sense of the magnitude of the dollars?

Ben Felix: No, I'm sure it's huge. I know, in Canada, they go through the large value transfer system. I don't know what the magnitude is. I'm definitely not an expert in this topic. I'm just sharing the research that I've done so far. I think that the information we've collected so far gives me a lot of comfort in not worrying about asset bubbles caused by central banks and not worrying about runaway inflation based on the mechanisms this operates through, but I'm still definitely not an expert. Anyway, open market operations, which is the central bank transacting with the private banks to effect the overnight lending rate. This is a normal thing, happens all the time, every day, always, in normal times and abnormal times, whatever. Open market operations.

Now, why would a central bank do this? Why would they engage in open market operations? Why would they set a target interest rate? Again, this gets into the sort of political side of, should central banks play a role at all? But that's not what this is about. Why would they do this to affect the overnight lending rate, which ultimately affects the rate that banks will make loans to their customers at. A lower rate in the overnight lending market means a lower rate that banks will charge their end customers on loans, which theoretically, should stimulate the economy. If people are more willing to borrow to invest in profitable stuff, that should kick start everything.

Cameron Passmore: Monetary policy.

Ben Felix: That's just classic monetary policy, right, where the central bank will decrease the overnight rate to stimulate things, and they'll increase it if they want to cool things off. One of the really important things about open market operations is that when that's happening, when the bank is buying up short-term government securities, that the central bank is buying short-term government securities from the private banks, they're doing that with bank reserves, and they'll create those bank reserves out of thin air in order to purchase these short-term government securities from the private banks. Now, we have two different layers of money printing, I guess. Private banks make loans to customers, and when they do that, they print money. When the central bank engages in open market operations, which is a totally normal part of their role in the banking system, they'll create bank reserves out of thin air.

Bank reserves aren't money though. They're money-ish, but they're not the kind of money that you can go and take to the grocery store. Bank reserves are only used between private banks and the central bank, but the net effect, whenever the central bank engages in open market operations, the net effect on the private banking systems assets is neutral because they go and create bank reserves out of thin air, and they use those to purchase short-term government securities from the private banking system. The private banking system loses short-term government securities, which ended up on the federal reserve, or whatever central bank's balance sheet, but the private banking system gains bank reserves. The magnitude of assets does not change.

Cameron Passmore: Okay. I can hear many listeners right now saying, okay, is this what happened lately when the central bank bought up a bunch of ETFs in the US?

Ben Felix: So, sort of. That is an open market operation, and that's related to quantitative easing, or it is a part of quantitative easing. I'd want to drive home the idea that normal open market operations, which are part of the transmission of regular monetary policy set in the overnight lending rate, that's daily, normal stuff. Quantitative easing is just a special case of open market operations. The thing that you talked about, Cameron, where the central banks are buying up ETFs, that is part of quantitative easing.

Cameron Passmore: What's the difference between quantitative easing and just normal course action monetary policy?

Ben Felix: The big differences are the magnitude. So, in QE, they're purchasing larger amounts of private sector assets and the type of assets that they're purchasing. In normal open market operations, where they're just trying to affect the overnight lending rate, they're just transacting in short-term government debt. So they're using bank reserves to buy short-term government debt. With quantitative easing, they're buying larger amounts of longer term government debt, corporate debt, asset backed securities, and in this case, maybe some fixed income ETFs, and the goal is different. The goal of regular open market operations is to effect the overnight lending rate, short-term interest rates, which won't necessarily affect long-term interest rates.

Now, the central bank's goal is to promote, I think it's like stable prices and low inflation and full employment, or something like that. That's their goal. If the economy is not doing well, they'll reduce interest rates, which is what we've seen. The overnight lending rate, the target overnight rate. They'll do that by, or one of the ways they'll do that is by engaging in open market operations. Now, recently, when we had this little coronavirus incident, interest rates were already really low, everywhere.

Cameron Passmore: Exactly.

Ben Felix: Short-term rates. When that happens, when the central bank wants to do something that should stimulate the economy, but short-term rates are already at zero, or effectively at zero, quantitative easing is one of the other things that they'll use, and its intended effect is to have an impact on longer term interest rates, which is why they're purchasing longer term securities, longer term government debt, corporate debt, asset backed securities. But it's the same mechanism, where the central bank is creating bank reserves out of thin air, and they're using those bank reserves to purchase securities from the private sector. The net effect on the magnitude of the assets that exist in the private sector is zero.

It's an asset swap. They're trading bank reserves for other types of securities. The amount of assets is not effected. What is the fact that is the composition of assets, and that's the key. That's the key, by reducing the amount of longer term government debt and other types of debt assets in the market, the prices of those assets should increase reducing their yields, making it cheaper for companies to borrow, as opposed to for overnight lending, where that might affect shorter-term rates. This should be affecting longer-term rates, or if a company wants to do a bond issuance or something like that, or the government wants to borrow more money, this should help more with that, is the idea. Whether it works or not, and actually stimulates the economy, that's a bigger question.

I think the key so far is that, when people talk about money printing and quantitative easing being the feds money printer propping up the stock market, all that's happening is that the fed is creating bank reserves out of thin air, which is normal. That's not some crazy thing that they're doing. It happens all the time. They're just doing it at a larger scale. They're taking those bank reserves and they're purchasing assets from the private sector. The private sector is ending up with bank reserves. Actually, there's a point that I haven't mentioned to you that's really important. In both Canada and the US, when banks have excess positive settlement balances, when they have lots of extra reserves sitting on their books, the central bank is paying interest on those excess reserves.

If you have way more reserves than you need to settle up your settlement balance at the end of the day, you're getting interest on those reserves. In quantitative easing, when they're buying huge amounts of assets, then all of the banks are ending up with excess reserves, but those excess reserves are paying interest. It's really just an asset swap. It's truly an asset swap, where the central bank has changing the composition of the private sector's assets without affecting the magnitude of the assets. They're not injecting money into the economy, they're injecting bank reserves, and they're not creating anything new, they're just swapping bank reserves for other debt assets that already existed in the private sector.

So, balance sheet of the private sector is not affected. The composition of the private sectors assets are affected. This thing is really just an asset swap, where the central bank is trading bank reserves, that they created a thinner, which is why this is referred to as money printing, for private sector assets.

Cameron Passmore: Which you can see how someone could take a little bit of this information and create a narrative different than what reality is.

Ben Felix: Yeah. There are a couple theories, proper academically studied theories about how quantitative easing might work. I think the evidence on QE is fairly up in the air in most aspects of its transmission effects, and effective as in general, but the way that it theoretically should work, one of them is portfolio balance theory, which I kind of alluded to before. That's the idea that taking huge amounts of certain types of assets off of the market should affect their prices, which should affect longer term interest rates. Another one is signaling theory where when the bank is doing this, they're committing to accommodative monetary policy. When they're engaging these large scale asset purchases, that signals that they're probably going to continue with accommodated monetary policy for a while. It's crazy how much psychology plays into this, where it's like, just by showing that they're going to continue to keep rates low, that's one of the ways that they can theoretically stimulate economic activity.

I think one of the challenges though, is that if people aren't willing to borrow, lowering rates isn't necessarily going to help. That's been the experience in Japan, where they've engaged in massive asset purchases like this, and it has not been great for their economy. Their economy is still struggling, I guess, anyway. Now, so that's QE should not lead to inflation because it's taking bank reserves, swapping them for other assets. Bank serves are not money. Banks aren't taking their bank reserves and buying groceries, so it shouldn't really affect the prices of goods, and it's not really increasing the supply of money. It's increasing the bank reserves that banks hold, but banks don't make loans based on the amount of bank reserves that they have, which is one of the first things we talked about.

Banks create money regardless of the reserve that they're holding. The idea that all of these bank reserves sitting on the banks balance sheets are going to turn into new money, that's just completely flawed. I'm going to come back to the effect on stock prices, but I want to talk a little bit more about the inflation piece. There's a guy named Cullen Roche. He wrote a book called Pragmatic Capitalism, and he's got a paper, I can't remember what the paper is called, but it's a paper about the modern monetary system. When the federal, the QE, initially in 2008, he was one of, I don't know how many other people there were, but he was one of the people, of the few people, small handful of people who were saying that QE is not going to be inflationary for the reasons that I just described, but there were a lot of people, even a big group of economists that published an open letter to Ben Bernanke at the time talking about how QE was going to be inflationary.

But Cullen Roche was one of the few people that said like, no, this is not dumping new money literally into the system. It's an asset swap and whatever, all the stuff that I just talked about. And that's what happened. Was he right or was it some coincidence? Who knows, but it seems like, based on the outcome, that there was not inflation after the QE that happened, in the US same as Japan, so it seems like the description that I just gave, which largely came from Cullen Roche, but also from Jim Stanford's book, it seems like that's accurate, where QE does not cause inflation, at least not directly, or at least not immediately, I guess. That concept of reserves not equaling new money in the economy, that's not a simple, oh yeah, that's obvious.

Ben Felix: It's something that a lot of people have written a lot about. Again, it's a relatively small group of people who get it, or at least get this interpretation of it. But there's one paper in 2010 from the Federal Reserves Finance and Economics Discussion Series. This paper was titled, Money Reserves and the Transmission of Monetary Policy. Does the money multiply or exist. This is tying back to that idea of, is there a relationship between reserves and money in the economy? In this paper, they said, "Changes in reserves are unrelated to changes in lending and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected. Specifically, our results indicate that bank loan supply does not respond to changes in monetary policy through a bank lending channel, no matter how we group the banks."

That right there flies in the face of what most people understand to be the way that banking works. Then there's another one from the bank of England who's also been pretty vocal, and I think Jim Stanford mentioned this in our conversation with him too, with this paper. In 2014, they had a bulletin titled, Money Creation in the Modern Economy. Here's a quote from them. They said, "Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot lend them out to consumers in the economy who do not hold reserves accounts. When banks make additional loans, they are matched by extra deposits. The amount of reserves does not change." Again, no relationship between reserves and actual money, the money that can be used to buy stuff entering the economy.

Cameron Passmore: So, what drives inflation then? Additional demand for borrowing, which means a stronger economy?

Ben Felix: Yeah. Well, what drives inflation? A good question. I don't know if I'm qualified to answer that.

Cameron Passmore: No, just from a money supply standpoint. So, money is created by banks making loans based on the demand for those loans, demand for the money. I'm assuming, economy starts picking up, businesses may need more money to develop their companies and expand, right? It's not big as the banks have lots of money to give up, that that's driving inflation or driving demand for the loans. It's companies in the economy that's pulling more from the system will cause inflation.

Ben Felix: Correct. Yes. There was another paper from an economist with Standard & Poor's that he wrote, I don't know, around the 2010 mark, I think, but his paper was titled, Banks Cannot and Do Not Lend Out Reserves. The basis of his paper, I guess similar to the ones I just mentioned, but the basis of his paper was specifically, with quantitative easing, all these bank reserves are going to lead to excessive lending. His conclusion is basically what you just said is that demand for loans comes from demand for loans.

Cameron Passmore: Not supply of money.

Ben Felix: It doesn't come from supply of money. Even if it did, bank reserves don't have any relationship to that. The other piece is really important, is that when central banks are using this tool, when they're using quantitative easing, it is likely a time when conventional monetary policy, so just affecting the overnight lending rate, is not working. It's not stimulating the economy enough. So they feel the need to engage in quantitative easing to reduce longer term rates. In that type of situation, I think deflation is going to be a bigger concern than inflation. I think, in our next episode with another economist, Craig Alexander, he had a great quote that was like, yeah, you learn in first year economics, you learn that it's the supply of money that dictates inflation.

Ben Felix: But then, in second year economics, they teach you that's not actually totally true. It has more to do with the velocity of money. Anyway, so that's the same kind of idea here. It's like, when QE is happening, deflation is likely a bigger concern, and the central bank always has the ability to unwind their balance sheet, to sell assets back to the private sector, to increase the overnight lending rate or longer term interest rates. Now, in terms of the effect on stock prices, we would expect, based on the intended outcome of QE, we would expect a positive impact on asset prices across the board, stocks and bonds, because you think about the two things that the theories that I mentioned, portfolio balance theory and signaling theory, both of those should be making a more favorable business environment. A more favorable business environment should have reduce risk premium and should increase asset prices.

Cameron Passmore: Yeah, reducing anxiety of that business owner to go and borrow money for their business.

Ben Felix: Correct. That's the simplest way I can explain it, is that you would expect a positive impact on stock prices. There is some quite a bit of empirical work. There was one paper in particular from 2014 that I found titled, The valuating Asset Market Effect of Unconventional Monetary Policy Across Country Comparison. They used an event study analysis, and they showed that, within the sample they were looking at, quantitative easing, a 25 basis point surprise reduction in the 10 year US Treasury yield resulting from quantitative easing, results in a 0.7% increase in stock prices. So there is a positive relationship, and I've seen papers similar to this on the Japanese stock market as well.

But one of the interesting points about that is that conventional monetary policy tools are much more impactful than unconventional policy tools. So, effecting the idea of reducing the overnight lending rate has a much bigger impact on stock prices than quantitative easing. The impact of monetary policy on stock prices is reduced when the overnight rate is already low. I think the same paper looked at the UK, where I think there was even no impact on stock prices when interest rates, when the target overnight rate was already at zero, but when it wasn't at zero, reducing that rate had an impact on stock prices. I've read some other stuff about how markets get used to and start to anticipate quantitative easing, and that can have impacts on asset prices.

Ben Felix: But I think that the idea that QE is propping up the stock market, or irrationally, somehow creating a bubble where prices are high, just because of central bank actions and only that, I think that's incorrect. I think there are a lot of different transmission channels that central bank actions go through, and they can lead to higher asset prices. But I don't think we can say quantitative easing is the reason that asset prices have recovered from the coronavirus downturn that we had. Yeah. That's kind of it, but then to sort of sum it up, money is this medium that facilitates economic activity, and that's all it does. It facilitates economic activity. In the short term, it can be a store of wealth, long-term, not so great at that, but at the most basic level, it's this thing that facilitates economic activity.

Most of the money that exists in the economy comes from private banks making loans to individuals and businesses, and the demand for those loans from credit worthy borrowers is what dictates the amount of money that exists in the economy. That's key. It's not quantitative easing, it's not excess supply of bank reserves. It is demand for loans. Central banks try to influence demand for loans, up or down, by effecting the overnight lending rate. When that rate's already at zero, or effectively at zero, they'll unconventional monetary policy, which is quantitative easing to try and affect longer term interest rates, to try and have the same overall effect to stimulate economic activity. From that, we would expect some positive impact on stock prices, but probably not enough, definitely not enough to prop up the stock market single-handedly. Inflation, you wouldn't reasonably expect inflation solely from quantitative easing because all it is, is an asset swap.

Central banks pay interest on reserves. They're just another form of short-term government debt. Central bank is swapping short-term government debt for longer term government debt and corporate debt in order to affect the prices of those assets. Now, all of that is fascinating, and I hope that was interesting to people because that was like literally months of me feeling I was beating my face against a wall.

Cameron Passmore: I think it's going to become a very good reference discussion for a lot of people.

Ben Felix: I hope so. Now, after I'd finished, all right, I'd started to feel okay about my understanding of all this. Then I remembered there was a paper I read from Famo a while ago, that at the time when I read it, I didn't really get it. But now that I felt I had a better handle on all this stuff, I thought I'd go and read it again. Famo has got this 2013 paper, and in his paper, he basically shows that the fed does not control short-term interest rates, that the fed follows the market rate that the market dictates and the fed kind of does policy actions following that. Then he also cast a lot of uncertainty around whether or not ... so pretty much definitely they don't affect short term rates, and he casts a lot of uncertainty around whether or not they affect long-term rates.

Famo is basically saying that the market dictates rates and the fed just kind of follows along. Then it's like, okay, I just feel like I got a grasp of how the central bank interacts with the economy and the stock market. Then Famo is like, no, no, no, they don't affect anything. Okay. That's it.

Cameron Passmore: Awesome. That was great. That was great. So you're good to go onto our planning topic?

Ben Felix: Yup. Let's go.

Cameron Passmore: This is an article that, and shout out to a financial planner, Jason Heath, he wrote an article in The Financial Post this week, entitled Five Key Personal Finance Lessons We Should Be Learning From This Crisis. I thought it was nice, clean, good topical items. Perhaps we can go through them quickly, and maybe add in our two cents. Number one of the things that we should learn is stocks can be volatile. We all know this. We've all said this many times, volatility always has a story that goes with it, and you went through painstakingly all the crises back to 1900, back in, I guess it was early April on the podcast, but there's always these stories that make the volatility feel worse. That was certainly the case this time. Obviously selling at the bottom of the downturn, you would have turned what, in hindsight, was a temporary loss into a permanent one if you didn't stay invested.

Ben Felix: Yeah. The psychological risk of selling at the wrong time is big with volatility. I think one of the other big things with volatility is that it can happen any time and therefore putting money that you need in the short-term and stocks is generally not a good idea. I did a thing for The Globe and Mail a couple of weeks ago for their Stress Test Podcast. They had this like sort of case study where they interviewed a person, and I had to answer questions about what I thought about what this person was doing. This person had their money that they were going to use for a down payment on their house invested in individual stocks. That money obviously decreased in value when the coronavirus stuff happened, and they were wondering about what they should do.

In the interview originally, I said something along the lines of like, they need to recognize that they made a mistake and that they never should have own stocks to begin with. I think the producer actually asked me to rerecord that piece because I was too harsh, but it's true. If you have money that you need in the short-term, it probably shouldn't be in stocks. If stocks lose their value over ... because it happens quickly, that's the nature of volatility. Anyway.

Cameron Passmore: Yeah. Ken French talked about that, right? In the return, you've got the expected return and the unexpected return. The unexpected may be positive or negative. Stuff happens in the near term. Number two thing we should learn, debt is dangerous, even though rates are likely to remain low for the foreseeable future, going back to your prior conversation. The Bank and County governor TIFF Macklem was a very clear with Canadians, and I quote here, "If you've got a mortgage or if you're considering making a major purchase or you're a business and you're considering making an investment, you can be confident that interest rates will be low for a long time.

Ben Felix: There it is. That's signaling. Signaling right there.

Cameron Passmore: That is signaling going on right there. Each seem to think about borrowing costs being low. Now with work from home, you wonder what the impact that will have on [Saruman 00:53:25] housing prices. I know where I am. just outside of Ottawa, housing prices are surging. Is it the low interest rates? Is it the demand? Is it lack of supply? I don't know, but it will be interesting to look back.

Ben Felix: I agree. It will be fascinating.

Cameron Passmore: On debt, you remember the conversation we had with Andrew Hallam back in episode 99, and he linked, and he talked about the happiness research that goes on. He said there's definitely a linkage found in studies between debt and people's level of misery. Something to keep in mind. Number three, emergency funds have a purpose. Boy, do emergency funds have a lot of respect now, which I think prior to that, I think over the past couple of decades, just in my experience, more and more people have thought of their lines of credit for emergency funds, as opposed to actually having cash in the bank three to six months of expenses on hand. Well, I think now a lot of people, a lot more respect for a cash buffer.

Ben Felix: Yeah. I haven't heard about it actually happening, but Ben Rabidoux, who was on the podcast a while ago, he was talking a lot about when all of this stuff was starting, about how he wouldn't be surprised if banks start making people pay back their HELOC, turning it into a regular debt repayment, mortgage type thing, or reducing balances of HELOCs. I don't know if that's actually happened, but he was saying, this is a thing that could happen, and it'll happen at the worst time, which is why it's not the best place to draw for an emergency fund.

Cameron Passmore: The next item that Jason highlighted is don't lose sight of spending. I think I've heard so many people I know talking about this, like all of a sudden you get this shock to the system where you stop spending. I think I may have said this on a prior podcast, but for a couple of months after the work from home, I had credit card balances that I haven't seen since I was in university. It was that dramatic,.

Ben Felix: Like low balances.

Cameron Passmore: Low balances. Exactly. You're not spending. We're living this at work as well, where we're not spending nearly as much on travel and all kinds of different items. So, spending is going down. Savings rate are at 20-year high right now in Canada, up to 6.1% in the Q1 of 2020.

Ben Felix: Which speaks to the QE stuff, like the demand for loans from qualified borrowers is low. When savings are high, that guy, Ben Rabidoux talked about that too. It's got a name. I can't remember what it is, saving for a session or something like that.

Cameron Passmore: Yeah. Then as things come back, I think it's worth keeping in mind, it's probably a good time to revisit your long-term financial planning goals and say, okay, how much do I need to save to reach those, and be mindful as your spending comes back to normal and perhaps put yourself on some sort of dollar cost averaging automatic savings plan to make sure you keep up the savings that you need. The last item he had, which I totally agree with is prepare for the worst. Jason says, "This crisis is a good reminder that we should all plan for the risk of disability or death." He's quite unequivocal about it. Any working age Canadian who is not financially independent should have disability insurance, or place their income if they cannot work. It may sound obvious, but a lot of people do not have disability insurance.

Anybody with financial dependence, who is not financially independent, should have life insurance. So, if you have people depending on you for what you earn while you work and you're not financially independent, you absolutely have to have life insurance. Lastly, get your wills and powers of attorney done. All very sensible, arguably common sense, but I think it's worth reviewing.

Ben Felix: The disability one is huge. I was speaking with someone today and they mentioned that they were reading a book on personal finance. One of the things that they found interesting was that the author was saying that the most important planning thing that anybody who's working can do is get disability insurance. It's true. It's not talked about enough. Everyone gets their heads into, should I hold my bonds and my TFSA or my RRSP. Then people think about life insurance, I think that's an easier one to grasp, but statistically, you're much more likely to become disabled than you are to die prematurely.

Cameron Passmore: Do you know what gets me on disability insurance? And those on YouTube can see me grabbing my head, what gets me disability insurance that you often hear is, "Oh, it's so expensive. Can't afford it." Think about that for a second. If you can't afford it, how can you afford not to have it? By definition.

Ben Felix: That's a good point. When I started with a proper job, I got a policy with the, I remember what it's called, the ability to increase the amount ...

Cameron Passmore: FIO, Future Increase Option? Income Option.

Ben Felix: Yeah, and I've been jerking that up as much as I can ever since.

Cameron Passmore: Onto the last topic, not necessarily bad advice of the week, but it's a story about the industry that I thought was interesting, and it's something that I really want you and I have to dig into more to understand. We started it a couple of weeks ago with the pay for order flow discussion. I still want to understand how platforms make money, because I think it needs some digging into because it's not as transparent as I've been able to solve, but we're kind of picking away at it to understand how these fee free trading platforms actually make money because everyone knows that businesses are in the business of making money.

This one is an article that came from an industry publication called Advisor Hub publish on June 22nd of this year. The title was Wells Fargo raises some revenue sharing fees for asset managers. Basically comes down to this. I did some research with some ... I looked into some research done by a friend and upcoming guest actually, Michael Kitces, who talks about how mutual funds in this paper that he wrote, and I'll get back to the Wells Fargo article in a second, but I want to set it up. So he pointed out the mutual funds have been trading for free. These are mutual funds, not ETFs, trading for free on no transaction or fee platforms for long time, going on 30 years. This was enabled because, in the US, they've got what's called 12b-1 shareholder service fees that were charged instead of charging transaction fees.

The problem is that ETFs don't have these kinds of fees. They need another model in order to be able to keep everyone happy to raise fees so that platforms could trade for free. What came out of this is platforms, so the big brokers platforms negotiating with the providers for shelf space fees, and they can either be flat fees or basis point fee. This is the area I want to do some more research into and understand more about this, but I just want to raise the topic this week. But get this, Vanguard has never paid shelf space fees, but many of these platforms allowed Vanguard onto their platform to get their credibility.

Ben Felix: Wow.

Cameron Passmore: The Vanguard Mutual Funds. Let's go back to the article now. Wells Fargo, the point of this article is that Wells Fargo has raised the upper limit of these fees that third party asset managers, so pick a mutual fund manager, pays Wells Fargo to get access to brokers who sell the mutual funds and ETFs. Sometimes these are called data agreements. We get this a minimum at Wells Fargo remains, the minimum remains at $450,000 US to get access, but the upper band has moved from 650K from 550K. Is that a lot of money? I don't know. I don't know what it is in terms of basis points overall, but the point of the article is that there's a pretty good chunk of change being paid just for access, but apparently, it's lowered other recordkeeping fees and other admin fees a few basis points.

Anyway, the point of the article is that these fees are pretty important source of revenue for large brokers firms, but it made the argument that it's a big barrier for smaller asset managers because they may not have the asset base to advertise those fees over. Article also mentions that Morgan Stanley charges as much as $600,000 a year for allowing fund salespeople to market to advisors at branch offices and conferences. Unlike Wells Fargo, Morgan Stanley charges a platform fee of between one and 10 basis points of assets per year. [inaudible 01:01:42] way to say, however, if you're in a fee based account, some of that's reimbursed. Again, we have to understand more. The point is there's a pay to play game going on here that had to change when fees, the 12b-1 fees were charged in mutual funds and shared with the platforms.

They're not part of the ETF world. Found another article. Let's see here, Morgan Stanley, a couple of years ago, received a negative press when it stopped selling Vanguard Mutual Funds because Vanguard refused to pay for shelf space.

Ben Felix: Crazy.

Cameron Passmore: But you can't keep people from trading in ETFs. I guess you could still buy a Vanguard ETF through Morgan Stanley, but there's no pay to play fee in there. You can't close that access to ETFs, which you can do to mutual funds. How does the money get around to afford these platforms? I don't know the answer. That's what we have to learn more about. It was the reason that Morgan Stanley gave for stopping to sell Vanguard Mutual Funds is that it's cutting a shelf space by 25%. Vanguard attributed the drop to the fact that they maintain low cost by not paying shelf space fees. Morgan Stanley said they were being dropped due to under performance. So you can see kind of both sides of the debate going on here. Bottom line, we have to learn more about this, but there is some level of conflict of interest going on here, and bottom line is that nothing is for free. Anything else to add?

Ben Felix: No.

Cameron Passmore: All right. Well, thanks for joining us.