Risks related to central counterparties in derivatives markets

January 11, 2013

The large volumes of notionals and market values in OTC (rates and credit) derivatives markets have spurred a regulatory enhancement of risk buffers at banks. However, an IMF working paper by Li Lin and Jay Surti points out that no commensurate prescriptions apply to the two monopolistic central counter parties (CCPs) that clear a large share of the OTC derivatives market. This bears the risks that CCPs could become a medium of regulatory arbitrage of even systemic pressure.

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BIS on safe asset shortage and need for low real interest rates

January 6, 2013

A recent BIS working paper reminds us that the securitized credit and euro area sovereign credit crises have structurally diminished the world’s reserves of perceived safe assets. As safe assets are essential for institutional finance (pensions, insurances) and transactions (collateralization) their continued shrinkage would propagate a financial sector meltdown. This is why persistent negative real interest rates on sovereign and central bank liabilities are a critical stabilizer: they increase safe asset supply, reduce demand, and stabilize the finances of sovereign borrowers. Central banks play the lead role in sustaining this real rate compression, as they have often done in history.

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The tipping point in the Japanese government bond market

December 19, 2012

Low government bond yields (0.76% for 10-year maturity at present) allow Japan to preserve debt sustainability despite a gross debt-to-GDP ratio of over 220%. However, a working paper published (a while ago) by Takeo Hoshi and Takatoshi Ito argues that a tipping point may be ahead. Thus far yields have been kept low thanks to large domestic savings with a strong home bias and low returns in other assets. Under current trends, however, the nominal public debt stock will have reached the overall level of private sector financial assets by 2016. Meanwhile, attempts to reflate assets and stimulate the economy will raise the opportunity costs of holding government debt.

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Solvency issues of European insurances

December 18, 2012

The latest ECB’s financial stability report has a short but insightful section on the position of the EU insurance sector. While financial positions according to current (Solvency I) standards seem satisfactory, the ECB fears that “a persistent low-yield environment could become a major solvency risk in the medium term”. The planned introduction of the EU’s Solvency II directive in 2014 and the related prospective marking to market of liabilities in a majority of countries could make this issue more obvious.

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U.S. Fed: Why replacement of “operation twist” with outright bond purchases makes a difference

December 17, 2012

JP Morgan’s Nikolaos Panigirtzoglou presented a nice reasoning, why the December 12 2012 U.S. Fed decision to replace its maturity extension program with outright bond purchases of the same size will put in place an important additional influence on long-term treasury yields. This influence is an intensified “liquidity affect” over and above the previous “demand effect” on government bonds.

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Why is volatility so low while uncertainty is still so high?

December 15, 2012

This note from Claudio Irigoyen and others supports the notion that implied volatilities naturally return to long-term trend even if economic uncertainty does not. While implied volatility is very sensitive to deteriorating conditions, actual and implied volatility under poor but stable conditions may be compressed by investor adaptation (defensive repositioning, risk management changes, easing risk aversion, etc.) and policymakers’ direct market intervention (liquidity supply, policy puts, etc.). Technically speaking, the first derivative of economic uncertainty indicators may condition the mean reversion of implied volatility.

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BIS re-interpretation of TARGET2 (im-)balances

December 10, 2012

In an easily readable working paper Stephen Cecchetti and colleagues explain the connection between euro area break-up concerns, Target2 balances, and financial conditions. This research would support the idea that commitment to 100% euro zone stability, via OMT and other measures, is the most effective form of monetary easing in the euro area.

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On collateral chains

December 8, 2012

A new IMF paper investigates the role of shadow banks in securitization and collateral intermediation. One important forward-looking concern is the potential vulnerability of collateral chains, i.e. the use of a single security for multiple secured loan transactions.

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Functions and risks of shadow banking

December 1, 2012

Shadow banking encompasses credit intermediation outside the regulated banking system, mostly through investment funds, money market funds, structured finance vehicles, broker-dealers, and finance companies. In parallel to the classical deposit-based funding of bank intermediation, the shadow banking system establishes secured transactions-based wholesale funding of non-bank intermediation. Thereby, the role of asset managers and off-balance vehicles of banks in intermediation has greatly increased, as has the importance of asset managers as source for “collateral mining. Regulators fear that shadow banking has been conducive to excessive leverage in the economy and contributed to systemic pressure through sudden stops and asset fire sales.

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A review of euro area bank deleveraging

October 27, 2012

Since 2008, Bank delevering has been on of the key drivers of the euro areas poor economic performance and its vulnerability to recurrent financial crises. Barclays Cross Asset Research nicely summarized and discussed its main drivers, whose impact is widely seen as most intense in 2012 and maybe 2013. ECB and IMF research suggests that the deleveraging is ongoing and could eventually reach an equivalent of 10-30% of euro area GDP.

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