Five things to know about commodity trading firms

May 3, 2014

The systemic importance of commodity trading firms (CTFs) deserves attention. Key points to understand are [i] CTFs’ core business is logistics, storage and processing, [ii] they are exposed to basis risk rather than outright price risk, [iii] their profitability depends on volumes and derivatives markets liquidity, [iv] they perform little traditional bank-style term transformation, but [v] they are financial intermediaries, by offering funding and structured product services.

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Understanding global liquidity

May 2, 2014

A new IMF policy paper defines global liquidity as the ease of funding in global financial markets. The concept is useful for understanding the commonality in global financial conditions, with four large financial centers dominating the world’s institutional funding. In the 2000s banks have been the main conduit of financial shock propagation, but asset managers may play a greater role in the 2010s (see also posts here, here and here).

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The vulnerability of modern dealer bank financing

March 28, 2014

Modern dealer bank financing relies largely on collateralized transactions. In order to achieve collateral efficiency institutions engage in rehypothecation, for example through matched-book transactions, internalizing trading activities, and re-pledging of margin collateral. A New York Fed article suggests that this funding structure faces risks from rollover, credit rating downgrades, and reputational considerations.

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How banks have adjusted to higher capital requirements

March 23, 2014

Capital regulation reform requires banks to hold a much higher ratio of core capital to risk-weighted assets, taking some toll on lending and economic activity. An empirical analysis by the BIS suggests that the process is well under way. Mathematically, most of the adjustment has been achieved through retained earnings. However, in developed countries also lending spreads have increased, credit growth growth has slowed, trading assets have declined, and the share of higher risk-weighted assets has fallen.

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How real money funds could destabilize bond markets

March 16, 2014

A paper by Feroli, Kashyap, Schoneholtz and Shin illustrates how unlevered funds can become a source of asset price momentum due to peer pressure and redemptions. Regulatory reforms that impair bank intermediation could compound negative escalatory dynamics. This raises the risk of dislocations in fixed income markets if and when extraordinary monetary accommodation is being withdrawn.

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Time-varying macroprudential policy

March 2, 2014

Persistent highly accommodative monetary policy in the U.S. raises fears of building systemic vulnerabilities. Federal Reserve board member Tarullo has discussed the use of time-varying macroprudential policy as a means to contain these risks and to allow monetary policy to keep rates low for longer. This policy has many limitations, however.

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Europe’s bank-sovereign nexus (revisited)

March 1, 2014

A Bank of Italy paper illustrates and explains the rise in European banks’ sovereign debt holding since the great financial crisis. It also reiterates structural causes for bank-sovereign feedback loops. One would conclude that this nexus remains an important factor for market dynamics and monetary policy.

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Shadow banking and the backstop problem

February 16, 2014

Modern shadow banking provides large-scale risk transformation services that are highly pro-cyclical (view post here). This is a systemic concern mainly for one reason: most shadow banking activities lack formal transparent backstops, i.e. external risk absorption mechanisms that prevent large negative shocks from escalating.

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Developed market bond yields and systemic EM risk

February 9, 2014

A new BIS paper argues that the expansion of EM local-currency bond markets and foreign-currency EM corporate issuance have strengthened the link between local EM financial conditions and global bond yields. The consequences would be (i) increased dependence of emerging financial systems on developed countries’ non-conventional monetary policies, (ii) decreased effectiveness of local monetary policies, and (iii) new systemic risks.

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The rise and risks of central counterparty clearing

February 8, 2014

A brief speech by ECB governing council member Benoît Cœuré summarizes problematic side effects of increased central counterparty clearing in derivatives markets. Systemic threats may arise from unprecedented risk concentrations in a few global central counterparties and participating banks, as well as from the mutualisation of losses and liquidity shortfalls across systemically important institutions.

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