WWW.HENRYLIANG.COM

HENRY LIANG’SFRM GUIDE II

HENRY L IANG, CQF

Algo trader / quant

Golden Future Education: senior CFA/FRM lecturer

CATTI Certified Interpreter – Level II

Member of the Translators Association of China

Practitioner of Kyokushin Karate

FRM: LESS IS MORE

i

Last update: 6 May, 2017

Photographer: Josef Koudelka – Invasion Prague

BASEL ACCORD

5

6

A. Basel I

Reasons for bank regulation• Ensure that a bank keeps enough

capital for the risks it takes.• Make the probability of default for any

given bank very small.• Create a stable economic environment

where private individuals and businesses have confidence in the banking system.

• Dual safety: deposit insurance provided by governments + bank regulation concerned with capital requirements.

Systemic risk

• A failure by a large bank will lead to failures by other large banks and a collapse of the financial system.

• When a large bank gets into financial difficulties ⇒ too big to fail (the government will bail them out).

Bank regulation pre-1988• Definitions of capital and the ratios

varied from country to country.• A Bank operating in a country where

capital regulations were slack had a competitive edge.

• The types of transactions entered into by banks were becoming more complicated: such as over-the-counter derivatives.

• The value of total assets was no longer a good indicator of the total risks being

HISTORY OF THE BASEL ACCORD

SECTION 1

7

BASEL I1996

AMENDMENT

BASEL II BASEL 2.5 BASEL III

Begin in 1988 1996 20072011

implementation

2010

Covering Credit risk: SA Market risk: SA, IMA

Credit risk: SA, IRB

Stressed VaR, IRC, CRM

CCB, CB, Leverage ratio

Cooke ratio Add Tier 3 Op risk: BIA, SA, AMA Liquidity risk

Three pillars Counterparty credit risk

taken: for example, the PFE (potential future exposure) on derivatives was not reflected in the bank’s reported assets.

B. Basel II

Basel II’s application• The Basel II capital requirements

applied to “internationally active” banks.

• In the US: Basel II would not apply to small regional banks.

• In Europe: all banks, large or small, were regulated under Basel II. Furthermore, the European Union required the Basel II rules to be applied to securities companies.

Three Pillars (since Basel II)

Pillar 1. Minimum Capital RequirementsTotal Capital = 0.08 × (credit risk RWA + market risk RWA + operational risk RWA)

Pillar 2. Supervisory Review• It covers both quantitative and

qualitative aspects of the ways risk is managed within a bank.

• Banks are expected to keep more than the minimum regulatory capital.

• Early intervention: to prevent capital from falling below the minimum levels.

• Supervisors encourage banks to develop better risk management techniques.

• Banks should evaluate risks that are not covered by Pillar 1.

Pillar 3. Market Discipline• Banks should disclose more

information.

C. Basel II.5

Changes to Basel II.5• Some commentators have blamed Basel

II for the crisis: when calculating regulatory capital, banks had the freedom to use their own estimates of model inputs such as PD, LGD, and EAD.

• Basel 2.5 added:- The calculation of a stressed VaR;- A new incremental risk charge;- A comprehensive risk measure for

instruments dependent on credit correlation.

D. Basel III

Newly-added parts1. Capital definition and requirements2. Capital Conservation Buffer3. Countercyclical Buffer4. Leverage ratio5. Liquidity risk

8

6. Counterparty credit risk

Leverage Ratio

Leverage ratio = total Tier 1 capital / exposure >=3%• The exposure measure is the sum of

- On-balance-sheet exposures;- Derivatives exposures;- Securities financing transaction

exposures;- Off-balance-sheet items.

Why introduce the leverage ratio?Regulators require banks to satisfy:• The ratios of capital to risk-weighted

assets;• The ratio of capital to

non-risk-weighted exposure.

Proponents and opponents of the leverage ratio• Proponents: the rules for

determining risk-weighted assets have become too complicated.

• Opponents: the leverage ratio encourages banks to hold risky assets ⇒ banks become more likely to fail.

Liquidity RiskReasons to consider liquidity risk• Liquidity risks arise because there is a

tendency for banks to finance long-term needs with short-term funding, such as commercial paper.

• As soon as the bank experiences financial difficulties, it becomes impossible for the bank to roll over its commercial paper.

Liquidity Coverage Ratio (LCR)

LCR = High-Quality Liquid Assets / Net Cash Outflows in a 30-Day Period > 100%• The LCR focuses on a bank’s ability to

survive a 30-day period of liquidity disruptions.

• HQLA:- High credit;- Certain valuation;- Low correlation with risky assets;- Listed on recognised exchanges;- Not carrying claims against them.

• Level 1 assets (highly liquid):- Cash;- Central bank reserves;- Marketable securities.

• Net cash outflows = outflows over the next 30 days – min(inflow, 75% of outflows)

Net Stable Funding Ratio (NSFR)

NSFR = Amount of Stable Funding / Required Amount of Stable Funding > 100%• The NSFR focuses on liquidity

management over a period of one year.

9

Counterparty Credit Risk• Credit Value Adjustment (CVA):

the expected loss due to the possibility of a default by the counterparty.

• Reported profit is reduced by the total of the CVAs for all counterparties.

• The CVA for a counterparty can change. • Basel III requires the CVA risk arising

from changing credit spreads to be a component of market risk capital.

G-SIBs, SIFIs, And D-SIBs• SIFI (systemically important financial

institutions) should keep sufficient capital to avoid a repeat of the government bailouts.

• A popular view of SIFIs: too big to fail.• The systemic importance of a bank or

other financial institution depends on the effect that its failure could have on the global financial system.

• In 2013, the Basel Committee called for more Tier 1 equity capital for G-SIBs: an extra equity capital from 1% to 3.5% of risk-weighted assets.

• G-SIBs’ total equity capital = 4.5% Tier 1 equity capital + 2.5% capital conservation buffer + the above-mentioned additional amount.

• These calculations do not include extra capital requirements required by national supervisors, such as the countercyclical buffer.

Contingent Convertible Bonds (CoCos)• CoCos automatically get converted into

equity when certain conditions are satisfied (when the company is experiencing financial difficulties).

• CoCos are attractive to banks:- In normal times the bonds are debt

and allow the bank to report a relatively high return on equity;

- When the bank experiences financial difficulties and incurs losses, the bonds are converted into equity and the bank is able to continue to maintain an equity cushion.

• CoCos are attractive to regulators because they avoid the need for a bailout. The conversion of CoCos is sometimes referred to as a “bail-in.”

• Popular triggers: the ratio of Tier 1 equity capital to risk-weighted assets; or the ratio of the market value of equity to book value of assets.

• CoCos (prior to conversion) qualify as additional Tier 1 capital if the trigger (the ratio of Tier 1 equity capital to risk-weighted assets) >= 5.125%. Otherwise they qualify as Tier 2 capital.

10

A. Basel I

RWA (Risk-weighted Assets)

RISK WEIGHTS FOR ON-BALANCE-SHEET ITEMS

RISK WEIGHTS FOR ON-BALANCE-SHEET ITEMS

RISK WEIGHT ASSET CATEGORY

0% Cash, gold, OECD governments debt

20% OECD banks debt

50% Uninsured residential mortgage loans

100%Corporate bonds, less-

developed country debt, non-OECD banks debt

Credit risk exposures can be divided into1. Those arising from on-balance sheet

assets (excluding derivatives).2. Those arising for off-balance sheet

items (excluding derivatives).3. Those arising from over-the-counter

derivatives.

Risk-weighted assets for N on-balance-sheet items

N

∑i=1

wiLi

Li: the principal amount of the ith item;wi: its risk weight.

For an over-the-counter derivative, the credit equivalent amount

max(V,0) + aL• V: the current value of the derivative to

the bank;• a: an add-on factor;• L: the principal amount;• max(V,0) is the current exposure;• The add-on amount, aL, is an allowance

for the possibility of the exposure increasing in the future.

The total RWA for a bank with N on-balance-sheet items and M off-balance-sheet items

N

∑i=1

wiLi +M

∑j=1

w*j Cj

• Li: the principal of the ith on-balance-sheet asset;

• wi: the risk weight for the asset;• Cj: the credit equivalent amount for the

jth derivative;• w*j : the risk weight of the counterparty

for this jth item.

CREDIT RISK CHARGE

SECTION 2

11

NettingNetting: a clause in the master agreement, which states that in the event of a default all transactions are considered as a single transaction. Netting reduces credit risk.

Without netting, exposure isN

∑i=1

max(Vi,0)

With netting, exposure is

max (N

∑i=1

Vi,0)At the beginning, the 1988 Basel Accord did not take netting into account, the credit equivalent amount for a portfolio of derivatives is

N

∑i=1

[max(Vi,0) + aiLi]

Later on, the 1988 Accord was modified to allow banks to reduce their credit equivalent totals when enforceable bilateral netting agreements were in place.• Step 1: Calculate the NRR (net

replacement ratio)

NRR =max (∑N

i=1 Vi,0)∑n

i=1 max(Vi,0)

• Step 2: The credit equivalent amount is

max (N

∑i=1

Vi,0) + (0.4 + 0.6 × NRR)N

∑i=1

aiLi

B. Basel II

Weakness of the 1988 Basel I• All loans by a bank to a corporation

have a risk weight of 100% regardless of their differences.

• In Basel I there was no model of default correlation.

1. The Standardised Approach• The SA is used by banks that are not

sufficiently sophisticated.• Similar to Basel I except for the

calculation of risk weights.- Various risk weights are assigned to

exposures with different rating, category, and maturity.

- OECD status of a bank or a country is no longer considered important under Basel II.

• Treats banks and corporations much more equitably.

• It may be better to have no credit rating than a very poor credit rating.

• Special treatments:- For retail lending: risk weight =

75%;- For claims secured by a residential

mortgage: risk weight = 35%;

12

- For claims secured by commercial real estate: risk weight = 100%.

Adjust risk weights for collateral

1) Simple approach• RWA = risk weight of collateral ×

collateral + counterparty risk weight × exposure not covered by collateral

• The risk weight of the counterparty is replaced by the risk weight of the collateral for the part of the exposure covered by the collateral.

• For any exposure not covered by the collateral, the risk weight of the counterparty is used.

• The minimum level for the risk weight applied to the collateral is 20%.

2) Comprehensive approach• Banks adjust the size of their exposure

upward to allow for possible increases in the exposure and adjust the value of the collateral downward to allow for possible decreases in the value of the collateral.

• A new exposure = the adjusted exposure – the adjusted value of the collateral.

• The counterparty’s risk weight is applied to this new exposure.

2. The Foundation Internal Ratings Based (IRB) Approach

1) Reasoning• Use bank’s own internal estimates of

credit to determine the risk weights.• Worst-case loss (VaR): calculated using

a one-year time horizon and a 99.9% confidence level.

• EL (expected losses) are usually covered by the way a financial institution prices its products.

0 0.2 0.4 0.6 0.8 1 1.2

One-year loss

EL One-year99.9%WCL

UL,Capital

2) The capital required

The capital required = the 99.9% WCL – the EL

WCL99.9%, 1−year = ∑i

(EADi × LGDi × WCDRi)

EL = ∑i

(EADi × LGDi × PDi)

The capital required (or credit VaR, UL):

∑i

[EADi × LGDi × (WCDRi − PDi) × MA]

13

• PD: the probability that the counterparty will default within one year (%).

• EAD: the exposure at default ($).• LGD: the loss given default (%).• MA: maturity adjustment.

3) WCDR (worst-case default rate)

WCDRi = NN−1(PDi) + ρN−1(0.999)

1 − ρ

• WCDR: the “worst-case default rate” defined so that the bank is 99.9% certain it will not be exceeded next year for the ith counterparty.

• ρ: copula correlation between each pair of obligors.

• WCDR depends on PD and ρ in the Gaussian copula model.

• When ρ=0, WCDR = PD. There is no default correlation and the percentage of loans defaulting can be expected to be the same in all years.

• As ρ increases, WCDR increases.

4) MA (maturity adjustment)

MA = 1 + (M − 2.5) × b1 − 1.5 × b

b = [0.11852 − 0.05478 × ln(PD)]2

• M: maturity of the exposure• When M = 1, MA is 1.0 and has no

effect.

RWA for credit risk = 12.5 × [EAD × LGD × (WCDR − PD) × MA]

5) Capital for corporate, sovereign, and bank exposures

The calculation of rho:

ρ = 0.12 [ 1 − exp(−50 × PD)1 − exp(−50) ] + 0.24 [1 − 1 − exp(−50 × PD)

1 − exp(−50) ]or ρ = 0.12(1 + e−50×PD)

• As PD increases, ρ decreases.• As a company becomes less

creditworthy, its PD increases and its PD becomes more idiosyncratic and less affected by overall market conditions.

• WCDR is an increasing function of PD.

6) Capital for retail exposures• All banks using the Advanced IRB

approach provide their own estimates of PD, EAD, and LGD.

• RWA = 12.5 × EAD × LGD × (WCDR − PD) × 1

- There is no maturity adjustment, MA=1.

The calculation of rho:

ρ = 0.03 [ 1 − exp(−35 × PD)1 − exp(−35) ] + 0.16 [1 − 1 − exp(−35 × PD)

1 − exp(−35) ]or ρ = 0.03 + 0.13e−35×PD

• Correlations are much lower for retail exposures than for corporate exposures.

• For residential mortgages: ρ = 0.15.

14

• For qualifying revolving exposures: ρ = 0.04.

7) Guarantees and credit derivatives• The credit rating of the guarantor is

substituted for the credit rating of the borrower.

• This overstates the credit risk because, for the lender to lose money, both the guarantor and the borrower must default (with the guarantor defaulting before the borrower)—double defaults.

• The capital requirement can be calculated as the capital that would be required without the guarantee multiplied by 0.15 + 160 × PDg, where PDg is the one-year probability of default of the guarantor.

8) Parameters in the Foundation IRB• Banks supply PD.

- PD >= 0.03% for bank and corporate exposures.

• LGD, EAD, and M are supervisory values set by the Basel Committee.

- LGD = 45% for senior claims.- LGD = 75% for subordinated

claims.- When there is collateral: LGD is

reduced.- M = 2.5.

3. The Advanced IRB Approach• Banks supply their own estimates of the

PD, LGD, EAD, M for corporate, sovereign, and bank exposures.

• The PD (>=0.03%) can be reduced by credit mitigants.

• The two main factors influencing the LGD: the seniority of the debt and the collateral.

• Banks use their own models to calculate EAD.

• In the case of derivatives, the model is likely to involve a Monte Carlo simulation to determine the expected exposure.

• If switch from SA to IRB:- Capital > 90% of previous year’s

capital.- Capital > 80% of the capitals two

years ago.

15

A. 1996 Amendment

TRADING BOOK

BANKING BOOK

Purpose Held for trading

Held to maturity

Valuation

Mark to market (fair

value accounting)

Valued at historical cost

Types

Derivatives, equities, foreign

currencies, commodities

Loans, debt securities

Risks faced Market risk Credit risk

1. Standardised Approach• The SA assigned capital separately to

each of debt securities, equity securities, foreign exchange risk, commodities risk, and options. No account was taken of correlations between different types of instruments.

2. Internal Model-based Approach

MRC = max(VaRt−1, mc × VaRavg) + SRC

• VaR is calculated with a 10-trading day time horizon and a 99% confidence level.

• 10-day 99% VaR = 10 × the one-day 99% VaR.

• Method for calculating VaR is historical simulation.

• mc: a multiplicative factor, mc>=3.• VaRt−1: the previous day’s VaR.• VaRavg: the average VaR over the past

60 days.• max(VaRt−1, mc × VaRavg) covers risks

relating to movements in broad market variables such as interest rates, exchange rates, stock indices, and commodity prices.

• It is the loss that has a 1% chance of being exceeded over a 10-day period.

• IMA better reflects the benefits of diversification and leads to lower capital requirements.

SRC (Specific Risk Charge)• SRC covers risks related to specific

companies such as those concerned with movements in a company’s stock price or changes in a company’s credit spread.

• For a corporate bond, there are two components to its risk: interest rate risk

MARKET RISK CHARGE

SECTION 3

16

and credit risk of the corporation issuing the bond.

• The interest rate risk is captured by max(VaRt−1, mc × VaRavg).

• The credit risk is captured by the SRC.• To calculate the SRC:

- 10-day 99% VaR;- A multiplicative factor (>=4).

• The IMA capital >= 50% of the capital given by the standardised approach.

Total Capital = 0.08 × (credit risk RWA + market risk RWA)

Tier 3 capital• For market risk only.• Short-term subordinated debt with an

original maturity of at least two years.

Back-Testing• Require the one-day 99% VaR that a

bank calculates to be back-tested over the previous 250 days.

• If the actual loss that occurred on a day > the VaR level calculated for the day, an “exception” is recorded.

• Reason for the exceptions:- Due to changes in the bank’s

positions during the day: the higher multiplier should be considered, but does not have to be used.

- Due to bad luck: no guidance is provided.

DURING THE PREVIOUS 250 DAYSDURING THE PREVIOUS 250 DAYS

NUMBER OF EXCEPTIONS M_C

<5 3

5-9 3-4

>10 4

B. Besel II.5

1. Stressed VaRBlames for the traditional HS VaR• Most banks use historical simulation to

calculate VaR.• Assumption: the percentage changes in

market variables during the following day would be a random sample from their percentage daily changes observed during the previous one to four years.

• The market risk VaRs calculated during benign period for regulatory capital purposes were low.

• The VaRs continued to be too low for a period of time after the onset of the crisis, because much of the data used to calculate them continued to come from a low-volatility period!

Stressed VaR• Stressed VaR measure assumes that the

percentage changes in market variables during the next day are a random sample from their percentage daily changes observed during the 250-day period of stressed market conditions.

17

• The one-year period chosen should reflect a bank’s portfolio. A bank is now required to search for a one-year period that would be particularly stressful for its current portfolio.

MRC = max(VaRt−1, mc × VaRavg)+ max(sVaRt−1, ms × sVaRavg)

• The first VaR is the usual VaR based on the previous one to four years of market movements. The second is stressed VaR calculated from a stressed period of 250 days.

• VaRt−1 and sVaRt−1: the VaR and stressed VaR (with a 10-day time horizon and a 99% confidence level) calculated on the previous day.

• VaRavg and sVaRavg: the average of VaR and stressed VaR (again with a 10-day time horizon and a 99% confidence level) calculated over the previous 60 days.

• ms and mc: multiplicative factors, >=3.

2. Incremental Risk ChargeBasel Committee’s concern• Exposures in the trading book were

attracting less capital than similar exposures in the banking book.

• A bond: if held in the trading book, the capital would be calculated by applying a multiplier to the 10-day 99% VaR; If held in the banking book, capital would be calculated using VaR with a one-year

time horizon and a 99.9% confidence level.

• The trading-book calculation usually gave rise to a much lower capital charge than the banking-book calculation.

Incremental Risk Charge (IRC)• Calculate a one-year 99.9% VaR for

losses from credit sensitive products in the trading book taking both credit rating changes and defaults into account.

• The aim: to set capital equal to the maximum of that obtained using trading book calculations and that obtained using banking book calculations.

• Banks are required to estimate a liquidity horizon for each instrument subject to the IRC. The liquidity horizon represents the time required to sell the position in a stressed market.

3. Comprehensive Risk Measure

• CRM is designed to take account of the correlation risks in ABS, CDO. They are sensitive to the correlation between the default risks of different assets.

• The CRM replaces the IRC and the SRC for instruments dependent on credit correlation.

• Basel II.5 allows banks, with supervisory approval, to use their internal models to calculate the CRM.

18

A. Basel II

1. Basic Indicator Approach

Operational Risk Capital = the bank’s average annual gross income over the last three years × 0.15• Gross income = net interest income +

non-interest income.• Net interest income = income earned

on loans – interest paid on deposits and other instruments that are used to fund the loans.

• Years where gross income is negative are not included in the calculations.

2. Standardised ApproachA different factor (0.12 ~ 0.18) is applied to the gross income from different business lines.

3. Advanced Measurement Approach• The bank uses its own internal models

to calculate the operational risk loss that it is 99.9% certain will not be exceeded in one year (worst case loss).

• Operational Risk Capital = WCL – expected loss.

• Advantage of the AMA: it allows banks to recognise the risk mitigating impact of insurance contracts subject to certain conditions.

OPERATIONAL RISK CHARGE

SECTION 4

19

A. Basel I

Capital Adequacy Ratio (CAR) = total capital / Risk Weighted Asset (RWA) >= 8%

Tier 1 Capital: >= 4%• Common equity: >= 2%.• Noncumulative perpetual preferred

stock. (Goodwill is subtracted from equity).

Tier 2 Capital, T1+T2 >= 8%• Cumulative perpetual preferred stock.• Certain types of 99-year debenture

issues.• Subordinated debt with an original life

of more than five years.• T2 <= T1.

B. Basel III

CapitalTier 1 Capital: >= 6%• Tier 1 equity capital (core Tier 1 capital)

- >= 4.5 of RWA- Common equity, retained earnings,

but does not include goodwill or deferred tax assets.

• Additional Tier 1 capital- Non-cumulative preferred stock.

Tier 2 Capital, T1+T2 >= 8%• Debt that is subordinated to depositors

with an original maturity of five years.There is no Tier 3 capital.

Capital Conservation Buffer• CCB in normal times consisting of a

further amount of core Tier 1 equity capital equal to 2.5% of risk-weighted assets.

• To ensure that banks build up capital during normal times so that it can be run down when losses are incurred during periods of financial difficulties.

• In circumstances where the capital conservation buffer has been wholly or partially used up, banks are required to constrain their dividends until the capital has been replenished.

After the CCB is considered• Tier 1 equity capital >= 4.5+2.5 = 7%.• Tier 1 Capital >= 6+2.5 = 8.5%.• T1+T2 >= 8+2.5 = 10.5%.• These numbers can decline to 4.5%,

6%, and 8% in stressed market conditions (because of losses), but

CAPITAL REQUIREMENT

SECTION 5

20

banks are then under pressure to bring capital back up to the required levels.

Countercyclical Buffer• Countercyclical buffer is similar to the

capital conservation buffer, but the extent to which it is implemented in a particular country is left to the discretion of national authorities.

• To provide protection for the cyclicality of bank earnings.

• Countercyclical buffer = 0% ~ 2.5% of total RWA and must be met with Tier 1 equity capital.

21

The Fundamental Review of the Trading Book (FRTB) will lead to

a totally new approach to determining capital for market risk

A. New Market Risk Measures

Old ways of VaR calculation• The Basel I calculations of market risk

capital were based on a VaR calculated for a 10-day horizon with a 99% confidence level.

• The VaR was based on the behaviour of market variables during recent one to four years.

• Basel II.5 required banks to calculate an additional stressed VaR based on the behaviour of market variables during a 250-day period of stressed market conditions.

• To determine the stressed period, banks were required to go back through time searching for a 250-day period that would be particularly difficult for the bank’s current portfolio.

FRTB’s innovative treatment• Instead of VaR with a 99% confidence

level, expected shortfall (ES) with a 97.5% confidence level is proposed.

ES = μ + σexp(−Y 2 /2)

2π(1 − X )- X: the confidence level- Y: the point on a standard normal

distribution that has a probability of 1-X of being exceeded.

• For normal distributions, the two measures are almost exactly equivalent.

• For a distribution with a heavier tail than a normal distribution, the 97.5% expected shortfall can be considerably greater than the 99% VaR.

• Capital is based solely on the calculation of the expected shortfall using a 12-month stressed period.

• Banks are required to search back through time and choose a period that would be particularly difficult for the bank’s current portfolio.

Liquidity horizons

FUNDAMENTAL REVIEW OF THE TRADING BOOK

SECTION 6

22

• The FRTB further proposes that the old 10-day time horizon should be changed to reflect the fact that the market variables underlying transactions vary according to their liquidity.

• FRTB requires the changes to market variables to be the changes that would take place in stressed market conditions over periods of time that reflect the differing liquidities of market variables.

• The periods of time are referred to as liquidity horizons: 10 days, 20 days, 60 days, 120 days, and 250 days.

ES = ES21 + Σ5

j=2 ESjLHj − LHj−1

10

2

LHj: the liquidity horizon for category j.

Other details in the FRTB

• Banks sometimes find it difficult to search for past stressed periods because of a shortage of historical data.

• The market variables are divided into a number of risk categories: interest rate risk, equity risk, foreign exchange risk, commodity risk, and credit risk. A bank is required to calculate expected shortfalls for each risk category.

• The capital charge is based on a weighted average of (a) the expected shortfall for the whole portfolio and (b) the sum of the partial expected shortfalls.

• FRTB proposes back-testing be done using a VaR measure calculated over a one-day horizon and the most recent 12 months of data. (It is difficult to back-test a 10-day expected shortfall directly).

B. Trading Book VS. Banking Book

• The FRTB attempts to make the distinction between the trading book and the banking book clearer and less subjective.

• The FRTB provides more objective rules for determining whether the trading book or the banking book should be used.

• There are strict rules preventing instruments being subsequently moved between the two books. Transfers from

23

Category 1 Variables: Variables with a time horizon of 10 days

Category 2 Variables: Variables with a time horizon of 20 days

Category 3 Variables: Variables with a time horizon of 60 days

Category 4 Variables: Variables with a time horizon of 120 days

Category 5 Variables: Variables with a time horizon of 250 days

one book to another can happen only in extraordinary circumstances.

• Any capital benefit as a result of moving items between the books will be disallowed.

C. Credit Trades

• The FRTB recognises that for instruments dependent on the credit risk of a particular company, two types of risk can be identified.

1. Credit spread risk: the company’s credit spread will change.- Can be handled similarly to other

market risks.2. Jump-to-default risk: there will

be a default by the company.- Handled separately and is subject

to an incremental default risk (IDR) charge based on a 1-year, 99.9% VaR calculation.

- The IDR charge will apply to all instruments that are subject to default risk.

• The FRTB also looked at the credit value adjustment (CVA) risk.

24

A. Solvency II

European Union’s standards for the regulation of insurance

companies

Three pillars• Pillar 1: the calculation of capital

requirements and the types of capital that are eligible.

• Pillar 2: the supervisory review process. • Pillar 3: the disclosure of risk

management information to the market.

Pillar 1Solvency Capital Requirement (SCR)• If its capital < the SCR level, an

insurance company should deliver to the supervisor a plan to restore capital to above the SCR level.

• The SCR involves a capital charge for investment risk (subdivided into market risk and credit risk); underwriting risk (subdivided into risk arising from life insurance, non-life

insurance, and health insurance); and operational risk.

• Two ways to calculate the SCR: the standardised approach; the internal models approach (involves a one-year, 99.5% VaR calculation).

• The internal models are required to satisfy three tests: statistical quality test, calibration test, and use test.

Minimum Capital Requirement (MCR)• The MCR is regarded as an absolute

minimum level of capital. • If capital < the MCR level, supervisors

may prevent the insurance company from taking new business. It might force the insurance company into liquidation.

• The MCR will typically be between 25% and 45% of the SCR.

Capital in Solvency II• Tier 1 capital: equity, retained

earnings, etc.• Tier 2 capital: liabilities that are

subordinated to policyholders and satisfy certain criteria.

SOLVENCY II & OTHER REGULATIONS

SECTION 7

25

• Tier 3 capital: liabilities that are subordinated to policyholders and do not satisfy these criteria.

B. Dodd–Frank Act

The Dodd–Frank Act in the United States aims to prevent

future bailouts of financial institutions and protect the

consumer

1. Two new bodies were created to monitor systemic risk and research the state of the economy.

2. The amount of deposits insured by the FDIC was increased permanently to $250,000.

3. Require large hedge funds to register with the SEC and report on their activities.

4. A Federal Insurance Office was created to monitor all aspects of the insurance industry.

5. Volcker rule: proprietary trading activities of deposit-taking institutions were curtailed.

6. Some high-risk trading operations were required to be spun off.

7. Standardised over-the-counter derivatives must be traded on electronic platforms, making

prices in the OTC market more transparent. Standardised over-the-counter derivatives between financial institutions must be cleared by central clearing parties.

8. The Federal Reserve was required to set risk management standards for systemically important financial utilities.

9. Protection for investors was increased.

10. Rating agencies were required to make the assumptions and methodologies behind their ratings more transparent.

11. The use of external credit ratings in the regulation of financial institutions was discontinued.

12. Ensure that consumers get clear and accurate information when they shop for financial products.

13. Issuers of securitised products were required to keep 5% of each product created.

14. Issue regulations that discourage the use of compensation arrangements that might lead to excessive risk taking.

15. Mortgage lenders were required to make a reasonable good faith determination based on verified and documented information that the borrower has the ability to repay a

26

loan. Failure to do this might lead to a foreclosure being disallowed.

16. Large financial firms were required to have board committees where at least one expert has risk management experience.

17. The FDIC was allowed to take over a large financial institution when it was failing.

18. All SIFIs prepare “living wills”: mapping out how they could raise funds in a crisis and how their operations would be wound up in the event of failure.

The controversial aspect of Dodd-Frank• The Volcker rule prohibits banks from

proprietary trading and restricts investment in hedge funds and private equity companies by banks and their affiliates.

• The rationale: banks should not be allowed to speculate with depositors’ funds, because those funds are insured by the FDIC.

• The rule may be difficult to enforce, though as it can be difficult to tell whether a particular new trade is entered into for hedging or speculative purposes.

• When financial institutions received funds during the crisis under the Troubled Asset Relief Program (TARP), compensation was restricted. But, as soon as the funds were paid back, banks

had much more freedom in their compensation arrangements.

An objective of legislators post-crisis• To increase transparency of derivatives

markets.• One method: creating a trade

repository of all derivatives transactions.

• A central repository for all derivatives transactions should mean that regulators are never taken by surprise.

• Regulators in most countries consider living wills to be important for SIFIs and are applying pressure on SIFIs to develop them.

• Many banks moved to bonuses that are deferred by being spread out over three to five years, rather than all being paid in one year (claw back).

27

Last update: 26 Mar, 2017

Photographer: Henri Cartier-Bresson

CURRENT ISSUES IN FINANCIAL MARKETS

6

28

Bitcoin• An online communication protocol that

facilitates the use of a virtual currency.• Built on a transaction log that is

distributed across a network of participating computers.

• A virtual currency with potential to disrupt existing payment systems.

• To reward honest participation.• Bootstrap acceptance by early adopters.• Guard against concentrations of power.• More flexible.• More private.• Less amenable to regulatory oversight.

A. Bitcoin Design Principles

• Scarcity: where money is held in electronic forms, scarcity is preserved by legal rules ensuring the correctness of bookkeeping records.

• Decentralisation: Bitcoin lacks a centralised authority to distribute coins or to track who holds which coins.

• Issuance: Bitcoin issues new currency to private parties at a controlled pace in order to provide an incentive for those parties to maintain its bookkeeping system.

B. Enabling Technologies and Processes

Transactions And The Block ChainBookkeeping• Bitcoins are recorded as transactions.• Each individual bitcoin can be traced

back through all transactions in which it was used, and thus to the start of its circulation.

• All Bitcoin transactions are readable by everyone.

Two cryptography technologies1. Public-private key cryptography to

store and spend money.2. Cryptographic validation of

transactions.3. In Bitcoin, to authenticate the

transfer of money to other participants, such an instruction is encrypted using the sender’s private key, confirming for everyone that the instruction in fact came from the sender.

Transaction processes1. Identification

BITCOIN: ECONOMICS, TECHNOLOGY, AND GOVERNANCE

SECTION 1

29

If B wants to send bitcoins to C, B publishes a message, encrypted with his private key, indicating that he got his bitcoins from A and what he wants to send to whom. The Bitcoin network identifies A, B, and C only by their public keys.

2. BlockchainEvery new transaction that is published to the Bitcoin network is periodically grouped together in a “block” of recent transactions. The block itself is compared to the most recently published block—yielding a “block chain.” A new block is added to the chain roughly every ten minutes. Any Bitcoin user can verify that a prior transaction did in fact occur.

3. RewardsTo encourage users to assist keeping the transaction record operational and updated, the Bitcoin system periodically awards newly minted bitcoins to the user who solves a mathematical puzzle that is based on the pre-existing contents of the block and which can only be solved by computationally intensive methods that include a random component. Thus, faster computing is more likely to solve a given problem.

4. MiningUpon solving the puzzle, the user publishes a “block” which contains a proof-of-work that a solution was carried

out along with all observed transactions that have taken place since the last puzzle solution was announced and a reference to the previous complete block. After other users verify the solution, they start working on a new block containing new outstanding transactions.

5. ValidationA Bitcoin transaction is not final until it has been added to the consensus block chain. By continually presenting their solutions to the puzzles, with the associated new tail of the block chain, miners are in effect “voting” on the correct record of Bitcoin transactions. A Bitcoin transaction is considered as final only after six confirmations. While this provides greater assurance, it creates a delay of approximately one hour before a Bitcoin transaction is finally validated.

Computing and electricity requirementsThe computerised proof-of-work calculations are quite power-intensive. These computational costs have grown sharply because Bitcoin automatically adjusts puzzle difficulty so that the time interval between two blocks remains roughly ten minutes. Spikes in the exchange rate have been followed by increases in computational difficulty.

Built-in Incentives

30

1. The miners who verify the block chain are rewarded with bitcoins. The reward ultimately falls to zero and no further bitcoins will be created. Hence, the protocol design for Bitcoin sets a controlled pace for the expansion of the currency and an ultimate limit to the number of bitcoins issued.

2. When listing a transaction, the buyer and seller can pay an optional “transaction fee”, which is a bonus payment to whatever miner solves the puzzle that verifies the transaction.

Avoid fraud• Bitcoin could validate transactions

using a simple consensus by majority vote. But an attacker could game the system by creating numerous fake identities.

• But voting on the authenticity of a transaction requires first working to solve a mathematical puzzle that is computationally hard to solve. Through

this design, the proof-of-work mechanism simultaneously discourages creating numerous fake identities.

What Bitcoin Doesn’t Have• Bitcoin lacks a governance structure.• Bitcoin imposes no obligation to verify

a user’s identity.• Bitcoin imposes no prohibition on sales

of particular items.• Bitcoin payments are irreversible.

C. Centralisation and Decentralisation in the Bitcoin Ecosystem

Decentralisation• Avoid concentrations of power that

could let a single person or organisation take control.

• Avoid a central point of failure.• Offer at least the appearance of greater

privacy for users.

CentralisationBut significant economic forces push towards centralisation and concentration among a small number of intermediaries.

Four Key Intermediaries That Have Shaped Bitcoin’s Evolution

31

Early in Bitcoin’s operation, updating the block chain yielded bitcoins more often. This design benefited those who ran the Bitcoin platform at the outset.

As the mathematical puzzles become harder, the automatic reward for solving the puzzle may drop below the cost of doing so. At that point, those who wanted a Bitcoin transaction could bid up the optional fees.

1. Currency ExchangesCurrency exchanges allow users to trade bitcoins for traditional currencies. But Bitcoin today resembles more a payment platform than a currency.• Many trades in bitcoin need more than

one conversions from or to conventional currencies.

• Price quotes in bitcoin are computed in real time by reference to a fixed amount of conventional currency.

• Significant regulatory requirements.• The number of Bitcoin exchanges has

remained modest, and the number of Bitcoin exchanges with significant volume has been even smaller.

2. Digital Wallet ServicesBitcoin wallets are data files that include Bitcoin accounts, recorded transactions, and private keys necessary to spend or transfer the stored value.• Bitcoin wallet software can be difficult

to install, and can impose onerous technical requirements.

• A crash or attack on the computer holding the digital wallet could cause the loss of a user’s bitcoins.

Safety of digital wallet service• Some services let the user maintain

control over private keys: a user who loses the key or allows it to be compromised is at high risk.

• Other services require users to let the service store their private keys: increase risk if the digital wallet service is compromised.

3. MixersTo preserve privacy against this tactic, mixers let users pool sets of transactions in unpredictable combinations, thus preventing tracking across transactions.

Limitations• Mixers must ensure that timing does

not yield clues about money flows. It is rare for different users to seek to transmit the exact same amount.

• Leave payers with little recourse if a mixer absconds with their funds.

• Mixing protocols are usually not public, so their effectiveness cannot be proven.

• Correlations in timing might still reveal transaction counterparts, particularly at little-used mixers.

• Mixers increase costs for those who choose to use them.

4. Mining Pools• Mining pools: miners work

independently, but upon winning a miner shares earnings with others in the pool.

• Oversized mining pools threaten the decentralisation that underpins Bitcoin’s trustworthiness.

32

• An attacker who holds a majority of Bitcoin’s computational resources can alter some of the system’s records.

D. Uses of Bitcoin

Early Uses• Online sale of narcotics.• Gambling sites.• Evade international capital controls.• Arbitrage opportunities.

Supports• Reputation systems ensured

trustworthiness of the transaction parties.

• Escrow services mitigated counterparty risk.

• Hedges protected customers against currency volatility.

Current Uses• Bitcoin could offer an alternative that

might pressure card networks to lower their prices to merchants.

• Users seem largely satisfied with Bitcoin payment.

• Merchants appear particularly pleased because Bitcoin payment processing is strikingly low-cost.

For credit card users• A consumer who pays by Bitcoin loses

such rebates or bonuses.

• If competing Bitcoin exchanges bid the fee for converting from currency to bitcoin downwards, there could be room to make both consumers and merchants better off than through payments by credit card.

The block chain poses a further barrier to using Bitcoin• Every Bitcoin transaction must be

copied into all future versions of the block chain—the storage burden would need to be addressed.

• Updating the block chain entails an undesirable delay.

• Other users appear to be buying bitcoins not to use them but to hold them in appreciation.

Possible And Future• General-purpose payment: need to

convert to or from bitcoin, which adds to transaction costs.

• International remittances: transfer from bitcoin to local currency is likely to be difficult and merchants are unlikely to accept payment by Bitcoin.

• To date, there has been only limited use of the Bitcoin platform to provide services other than payment.

E. Risks in Bitcoin

33

1. Market risk: fluctuation in the exchange rate between bitcoin and other currencies.

2. Shallow markets problem: a person seeking to trade a large amount of bitcoin typically cannot do so quickly without affecting the market price.

3. Counterparty risk: as users convert currency to bitcoin but then leave the bitcoin in the exchange.

4. Transaction risk• Irreversibility of Bitcoin payments.• When receiving payments, transaction

batches may not be added into the block chain.

• Malevolent participants could double-spend bitcoins before the block chain is updated.

5. Bitcoins blacklist• Transfer losses to those who had

unknowingly accepted bitcoin that later turned out to be ill-gotten.

• Add significant complexity and create a risk of abuse by those who manage the blacklists.

• Widespread use of blacklists could undermine the fungibility of bitcoins.

6. Operational risk• Any action that undermines Bitcoin’s

technical infrastructure and security assumptions.

• 51 percent attack: if some group can reliably control more than half the computational power, they can seize control of the system.

• Denial-of-service attacks: entail swamping a target firm with messages and requests in such volume that it becomes unusable or very slow.

- An attack on a mining pool can prevent a pool’s participants from solving the current puzzle.

- News of an attack can undermine trust in an exchange—allowing an attacker to buy bitcoin at lower prices.

- Attackers can demand ransom from service providers.

7. Privacy risks: Bitcoin transactions are not truly anonymous. Transactions made using Bitcoin often reveal real names.

8. Legal and regulatory risks

9. Uncertain tax treatment of Bitcoin gains and losses

F. Regulating Virtual Currencies

Fighting CrimeBitcoin receives regulatory scrutiny for three classes of criminal concerns

34

1. Bitcoin-specific crimes are attacks on the currency and its infrastructure like bitcoin theft, attacks on mining pools, and denial-of-service attacks on exchanges to manipulate exchange rates.

2. Bitcoin money laundering could evolve to become more difficult to trace, particularly when funds are routed through mixers.

3. Bitcoin-facilitated crime entails payment for unlawful services delivered offline.

Consumer Protection• The risk of collapse calls for disclosures

to help consumers understand the products they are buying.

• Broader consumer protection concerns result from irreversibility of Bitcoin transfers.

• Protect consumers against unauthorised transfers.

Regulatory Options• Regulators are naturally drawn to key

intermediaries. But intermediaries raise predictable defences.

• Some users will anticipate regulators targeting intermediaries and will act to avoid such scrutiny.

• Transfers through currency exchanges are also within regulators’ grasp.

• Bitcoin’s electronic implementation in some ways makes it easier to regulate

than offline equivalents: such as Bitcoin blacklists.

• Tax treatment of Bitcoin remains unsettled.

• If one country places too large a burden on Bitcoin services based there, services are likely to develop elsewhere.

G. Bitcoin as a Social Science Laboratory

Bitcoin has the potential to be a fertile area for social science research• A clear set of rules.• Publicly available record of

transactions.• General availability of data even beyond

the block chain.

Bitcoin As A Financial AssetMost users treat their bitcoin investments as speculative assets rather than as means of payment.

Incentive-compatibility In Bitcoin Protocols• Pool hopping: Miners opted out of

the pool in long rounds, in which the potential block reward has to be shared with a larger group.

• Larger blocks are less likely to win a block race than smaller ones: a miner

35

reduces the chance of collecting a reward when including new transactions into blocks.

Privacy And AnonymityA set of heuristics can help to link Bitcoin accounts with real-world identities as long as some additional information is available for a related transaction.

Monetary Policy• Bitcoin’s protocol calls for an end of the

minting phase at which point k = 0.• k (money generation speed) may even

be negative in the future, because bitcoins can be irreversibly destroyed when users forget their private keys.

• The fixed slow growth rate of Bitcoin creates the possibility of deflation if Bitcoin was to be used widely.

• It remains unclear whether decentralised cryptographic currencies can be designed with monetary policies.

H. Looking Ahead

Solved• Mixers: close the most obvious privacy

shortcomings.• Pools: help reduce risk for miners.• Wallets: address some of consumers’

usability and security concerns.

Unsolved

• Call for a focus on simplicity and lower prices.

• No clear way for Bitcoin to substitute a different approach to record-keeping while retaining installed Bitcoin software.

• Instantaneous transaction confirmations seem to require equally fundamental changes.

• Numerous competing virtual currencies would first need to achieve confidence in their value and adoption.

36

Two distinct types of liquidity• Market liquidity: cost of buying or

selling an asset for cash.• Funding liquidity: the ability of a

financial entity to raise cash by borrowing.

They can be closely related• Funding liquidity declines ⇒

intermediaries become less willing to provide market liquidity ⇒ further impair funding liquidity.

• Capital and liquidity requirements play a role in preventing such a self-reinforcing negative dynamic.

A. Market Liquidity

The evidence that market liquidity has diminished is mixed• For the U.S. Treasury market, quoted

bid-ask spreads in the inter-dealer market have remained stable since 2010.

• Order book depth does not appear low by historical standards.

• For the corporate bond market, some evidence even suggests improving market liquidity.

However• Significant data gaps make it difficult to

comprehensively measure market liquidity.

• U.S. Treasury market: we have poor visibility into dealer-to-customer transactions as business is conducted bilaterally on an OTC basis.

• Corporate bond market: TRACE data show what trades have taken place, not what trades have potentially been foregone ⇒ TRACE transaction data tells an incomplete story.

Indirect evidence suggests a decline in market liquidity• Large blocks of securities are now

harder to buy and sell without generating significant movements in prices.

• Average trade sizes have decreased.• Growing bifurcation in the

corporate bond market: greater activity and liquidity in those bonds that were issued more recently, larger in size or brought to market by larger issuers.

Capital and liquidity requirements might have adversely impacted market liquidity

MARKET AND FUNDING LIQUIDITY

SECTION 2

37

• Affect the profitability of dealer intermediation activities and consequently the provision of market liquidity.

• Supplementary leverage ratio (SLR): limits the leverage of dealer balance sheets. The SLR is much tougher on low-risk assets. This makes the economics of repo-financing much less attractive.

• An increase in the Basel risk-weighted capital ratio, the Comprehensive Capital and Analysis Review (CCAR) stress tests.

• The Volcker Rule prohibits proprietary trading for a number of asset classes.

Other non-regulatory factors are also important• The demand for liquidity is evolving

with the growth of high-frequency trading firms.

• In the U.S. Treasury market, HFT firms have seized a large proportion of the inter-dealer market.

• In the credit market, a rapidly rising share of corporate bonds outstanding is now held by mutual funds. Because mutual funds are not natural providers of intraday liquidity, their rapid growth

may have contributed to the decline in secondary market trading activity.

• Fixed-income market liquidity may also be declining for cyclical reasons.

• The effects of unconventional monetary policy on rate expectations and corporate bond issuance may also be affecting market liquidity.

Concluding that tougher regulatory requirements are the most important factor that market liquidity has diminished would be premature• The decline needs to be weighed against

the benefits of a more resilient and robust financial system.

• A somewhat higher cost for the provision of market liquidity during the more benign stages of a financial cycle is worthwhile in exchange for less volatility and stress.

If the cost of providing liquidity services has increased, this creates strong incentives for innovators to find better ways to match buyers and sellers• Execution algorithms have been

developed to divide large trades into smaller sizes, thus reducing the costs of moving large blocks of securities.

B. Funding Liquidity

38

We do not observe marked declines in dealer holdings of Treasuries, even as overall dealer assets have stagnated.

Deterioration in funding liquidity also increased the degree of systemic stress as firms were forced to sell assets, which depressed their prices.

A vicious cycle• Firms cannot obtain funding liquidity ⇒ less transactions volume, thinner markets, less overall market liquidity ⇒ less pricing efficiency ⇒ wider and more persistent disparities in the prices of similar assets.

• Without access to funding, leveraged players ⇒ difficult to react to transient dislocations in market prices by engaging in arbitrage ⇒ market functioning become impaired ⇒ further disrupt funding and market liquidity.

Relationship between the volume of dealer-funded repo versus the size of Treasury bid-ask spreadsDuring times of financial, crisis sharp deleveraging of dealers’ repo books coincides with an increase in Treasury bid-ask spreads. However, during non-crisis periods, this correlation is quite low.

The drop in the availability of repo financing also leads to less efficient arbitrage between closely related asset pairseg. Difference between the fixed-rate paid on a 10-year interest rate swap and the secondary market yield on a 10-year

Treasury note has been negative: the higher capital requirements have made it unattractive for dealers to arbitrage away this dislocation.

Funding liquidity risk can be addressed1. Capital requirements can be

bolstered to reduce the risk that a firm will become insolvent.

2. Improved reporting and transparency can reduce the degree of uncertainty about whether a firm is solvent.

3. Liquidity requirements can be increased to reduce the risk that the firm will have to engage in a fire sale of assets.

4. A liquidity buffer gives the firm’s management time to respond to bad events.

5. A lender-of-last-resort can provide a liquidity backstop that makes funding liquidity more resilient.

6. Replenishing the firm’s capital.7. Selling assets.8. Selling all or part of the securities

firm’s operations.

Some significant gaps• The Federal Reserve has a very limited

ability to provide funding to a securities firm.

• The appropriate role for the home- versus host-country supervisor: who will be the lender-of-last-resort?

39

A. Introduction

Market liquidity: the ability to rapidly execute sizeable securities transactions at a low cost and with a limited price impact.• A lower level of market liquidity

reduces the efficiency with which funds are intermediated from savers to borrowers, and can potentially inhibit economic growth.

• Liquidity drops sharply ⇒ prices become less informative and less aligned with fundamentals ⇒ increased volatility.

Market liquidity is high if• Market infrastructures are efficient and

transparent.• Market participants have easy access to

funding.• Risk appetite is abundant.• A diverse investor base.

Conflicting effects on market liquidity• As banks have been shrinking their

inventories, market-making services become concentrated in fewer clients.

• Regulations requiring banks to increase capital buffers and restrictions on proprietary trading ⇒ retrench from trading and market-making activities.

• Electronic trading ⇒ make market liquidity becomes less predictable.

• The rise of larger but more homogeneous buy-side institutions ⇒ more sensitive to redemption pressures, more prone to herd behaviour, less likely to absorb order flow imbalances.

• The inclination of pension funds and insurance companies to act counter-cyclically may have declined.

Unconventional monetary policies have affected market liquidity• The policies have probably enhanced

market liquidity by positioning the central bank as a predictably large buyer.

• The asset purchases have drastically reduced the net supply of certain securities available to investors.

• Easy monetary policies have induced a search for yield, prompting funds to invest in bonds with low market liquidity.

MARKET LIQUIDITY – RESILIENT OR FLEETING?

SECTION 3

40

- Bond prices strongly affect consumption and investment.

- Bond prices also affect financial stability through their pivotal role in the repo market.

- The bond market is the medium through which monetary policy affects the market liquidity of other asset classes.

The main findings of this paper1. Only some markets show obvious

signs of worsening market liquidity.2. Benign cyclical conditions are

masking liquidity risks.3. Regulatory changes are likely to have

had mixed effects on market liquidity.

4. Changes in the investor base have likely increased liquidity risk.

5. Monetary policy has had a positive impact on market liquidity in recent years but may have increased liquidity risk ⇒ relax funding constraints for financial intermediaries.

Policy recommendations1. Policymakers should adopt

preemptive strategies to deal with sudden shifts in market liquidity.

2. Asset managers and other traders should have access to electronic trading platforms on equal terms.

3. Trade transparency in capital markets and instrument

standardisation should be promoted to improve market liquidity.

4. Restrictions on derivatives trading should be reevaluated.

5. Central banks should be mindful of the side effects on market liquidity arising from their policies.

6. Ways to reduce both liquidity mismatches and the first-mover advantage at mutual funds should be considered.

7. As the Federal Reserve begins to normalise its monetary policy, a smooth implementation will be critical to avoid disruptions of market liquidity.

B. Market Liquidity—Concepts and Drivers

Concept And MeasurementTwo aspects of market liquidity• Low levels of liquidity may foretell low

resistance to shocks. But measures of the level in normal times may be insufficient to assess the risk.

• Higher market liquidity reduces volatility and speeds up information aggregation. But high market liquidity could favour trading frenzies and amplify asset price bubbles.

41

General Drivers Of Market Liquidity Levels And ResilienceThree broad categories1. The risk appetite, funding

constraints, and market risks faced by financial intermediaries.

2. Search costs, which influence the speed with which buyers and sellers can find each other.

3. Investor characteristics and behaviour reflecting different mandates, constraints, and access to information.

General drivers• Tighter funding constraints for trading ⇒ lower dealers’ risk-taking capacity or willingness to make markets.

• New regulations in major jurisdictions have also affected search costs.

• The growth of electronic trading platforms ⇒ reduce search costs.

• Central banks’ large-scale purchases of securities under unconventional monetary policy are likely to have affected market liquidity both positively and negatively.

The risk that liquidity might suddenly disappear• The growing role in bond markets of

mutual funds that offer daily redemptions to retail investors has made market liquidity more vulnerable to rapid changes in sentiment.

• This buildup of liquidity risk in the asset management industry was likely encouraged by accommodative monetary policy and the ensuing search for yield.

• The growth of index investors and the more widespread use of benchmarks are likely to have increased commonality in liquidity and thereby systemic liquidity risk.

• Hedge funds become more similar to mutual funds in their behaviour.

C. Market Liquidity—Trends

• Only the U.S. Treasury market appears at first glance to have recently suffered a deterioration of liquidity.

• But that market remains highly liquid compared with most other large markets, and estimated bid-ask spreads are close to their 2004 levels.

• In the bond markets of the United States, Europe, and emerging market economies, imputed round-trip costs are generally below their 2007 levels.

• The level and resilience of market liquidity for higher grade corporate bonds appears to be increasingly stronger than that for lower grades.

42

D. Changes in Drivers of Market Liquidity—Empirical Evidence on Their Impact

Event Studies Of Market-Making And Funding ConstraintsEvidence of reduced market making• Dealer banks in advanced economies:

be less active market makers in fixed-income securities.

• In several advanced economies: bank holdings of corporate debt have declined.

• The evidence on sovereign bonds is more mixed.

Impact of reduced market makingBanks now may face tighter balance sheet constraints for market making compared with the pre-crisis period.

Monetary policy and market makingTo improve the market liquidity of some assets, the central bank includes the instruments in the list of eligible collateral for repurchase operations ⇒ the liquidity of these securities improves.

Event Studies Of Search Costs

Impact of trade transparency• Greater trade transparency should

improve market liquidity because it increases competition.

• Increased transparency may erode the willingness of market makers to carry large inventories because it hampers their ability to unwind large positions.

• For corporate bonds traded in the United States, enhanced transparency has had a positive impact on liquidity.

• When the data for large transactions of bonds of lower credit quality were released, market liquidity improved significantly.

• The improvement in price discovery caused by transparency outweighed the potential costs for market makers.

Impact of the EU ban on uncovered credit default swaps• The EU’s ban on indirect short selling

of sovereign debt via uncovered sovereign credit default swaps (SCDS) reduced the liquidity of those assets.

• The EU’s ban also reduced liquidity in the European sovereign bond market.

Monetary policy and scarcity effectsQuantitative easing in the United States at first improved liquidity in the market for mortgage-backed securities (MBS), but then degraded it.

Investor base

43

The decline in the heterogeneity of the investor base may have contributed to a deterioration in liquidity.

In SumBoost market liquidity• Decline in market making.• Enhanced transparency regulations.• Monetary policy.

Decline market liquidity• Restrictions on CDS in the EU.• The proliferation of small issuances.

Econometric Evidence For Risk Appetite And Other Cyclical Drivers• The combined contribution of the TED

spread, the VIX, and unconventional monetary policy account for most of the liquidity behaviour of investment-grade bonds and of high-yield bonds.

• For investment-grade bonds, the cyclical factors explain almost 80 percent of the total variation of aggregate market liquidity, whereas for high-yield bonds the model explains slightly more than 40 percent.

E. Liquidity Resilience, Liquidity Freezes, and Spillovers

Liquidity Regimes And ResilienceStructural factors• A lower presence of market makers, a

broader range of smaller and more risky bonds, large mutual fund holdings, and concentrated holdings by institutional investors ⇒ higher vulnerability of liquidity to external shocks.

• Higher leverage at financial firms and their greater use of short-term funding ⇒ higher liquidity risk.

Cyclical factors• Market liquidity tends to abruptly

switch between different states: a regime-switching model is used.

• Liquidity resilience in the corporate bond market can be predicted by cyclical factors: business conditions, financial volatility, and risk appetite; the price of credit risk; monetary policy measures.

• High-yield bonds seem to be especially sensitive to business conditions and credit market developments, whereas unconventional monetary policy only affects the liquidity of investment-grade bonds.

• When inventories at dealers are low or when dealers’ ability to make markets is impaired, aggregate liquidity is more likely to drop sharply.

• In the markets for foreign exchange and European sovereign bonds, business

44

conditions in key advanced economies seem to be the main drivers of liquidity regimes. The resilience of liquidity of foreign exchange markets in emerging market economies and smaller advanced economies seems to be driven by external conditions.

• Unconventional monetary policy measures by advanced economy central banks have had a positive impact on the liquidity resilience of foreign currency markets.

• The fact that investors require higher returns on illiquid assets only during periods of stress indicates that they pay little attention to the possibility that liquidity can suddenly vanish during normal times.

Spillovers• Market illiquidity and the associated

financial stress can spill over to other asset classes.

- When highly leveraged- When assets are correlated

• Liquidity spillovers are larger during stress periods, and spillovers have become more prevalent in recent years.

• Shocks often propagate from the investment-grade bond market to other markets, not vice versa.

Summary Of Findings

• Having high liquidity today reduces the probability of being in a low-liquidity regime tomorrow.

• Dealers’ inventories and their overall balance sheet capacity are negatively associated with illiquidity spells.

• Unconventional monetary policy can reduce the likelihood that markets will be in a low-liquidity regime.

• Liquidity risk seems to be priced only in periods of financial stress.

• Spillovers are particularly pronounced during periods of financial stress.

• Liquidity spillovers: shocks often originate in investment-grade bonds traded in the United States.

F. Policy Discussion

• Monitor market liquidity conditions using transactions-based measures, especially in the investment-grade bond market.

• Regulatory changes aimed at curbing risk taking by banks can impair their capacity to make markets, and constraints on dealers’ balance sheets may impair market liquidity.

• Traditional market makers may have reduced their presence in the marketplace, but the emergence of new players and trading platforms may help fill the void.

45

• Smooth normalisation of monetary policy avoid disruptive effects on market liquidity.

On market microstructure design• Reforming the design of markets

should be encouraged.• Open access to electronic platforms

should become the norm.• Restrictions on the use of financial

derivatives should be reevaluated.

On the role of central banks• Central banks should take into account

the effects on market liquidity when making policy.

• Central banks and financial supervisors should routinely monitor market liquidity in real time across several asset classes, but especially in the investment-grade bond market.

• In periods of financial market stress, central banks could use various instruments to enhance market liquidity such as by accepting a wide range of assets as collateral for repo transactions.

On the regulation and supervision of financial intermediaries• Liquidity stress testing for banks and

investment funds should be conducted taking into account the systemic effects of market illiquidity.

• Liquidity mismatches in the asset management industry should be mitigated.

46

SUMMARY OF FINDINGS AND POLICY IMPLICATIONSSUMMARY OF FINDINGS AND POLICY IMPLICATIONSSUMMARY OF FINDINGS AND POLICY IMPLICATIONSSUMMARY OF FINDINGS AND POLICY IMPLICATIONS

Characteristics Markets Findings Tentative Policy Implications

Improving the Level of LiquidityImproving the Level of LiquidityImproving the Level of LiquidityImproving the Level of Liquidity

Transparency U.S. Corporate Bond

Post-trade transparency is

beneficial to market liquidity

Promote post-trade transparency

Cost of Holding Inventory

U.S. Corporate Bond

Increase in dealers’ inventory costs or

reduced balance sheet space decreases their

ability to provide market liquidity

Encourage entry of new market makers

by promoting standardisation and

equal access to trading venues

Central Bank Purchases

U.S. MBS

Central bank purchases degrade market liquidity for the underlying asset

Take into account market liquidity when

implementing monetary policy

Short-Sell Ban CDSShort-sell bans

decrease market liquidity

Consider revoking the ban

Improving the Resilience of LiquidityImproving the Resilience of LiquidityImproving the Resilience of LiquidityImproving the Resilience of Liquidity

Ownership by Mutual Funds and

Concentration of Ownership

U.S. Corporate Bond

Ownership by mutual funds and

concentration makes market liquidity evaporate more

quickly during severe market downturns

Contain liquidity risks associated with

mutual fund ownership and

redemption pressures

Collateral EligibilityEuropean Sovereign

Bond

Including an asset as eligible for collateral

temporarily increases market liquidity

During crisis, support market liquidity of certain markets by

including the assets in collateral pools

Cyclical Factors, including Monetary

Policy

U.S. Corporate Bond; U.S. and EU

Sovereign Debt; FX

Explains most of the behaviour of the level

of liquidity and an important part of the resilience of liquidity

Reversal of current monetary stance

should pay special attention to the

possibility of a rapid deterioration of market liquidity

Liquidity RegimesU.S. Corporate Bond;

U.S. and EU Sovereign Debt; FX

Market liquidity evaporates during

crises

Have a preemptive strategy to deal with

liquidity dry-ups.

47

AbbreviationsHigh-frequency trading: HFTHigh-speed trading: HSTAlgorithmic (or algo) trading

Our concerns• Unexpected events linked to

algorithmic and high-frequency trading have caused significant volatility and market disruption.

• The complexity of market interactions among HFT firms increases the potential for systemic risk to propagate across venues and asset classes over very short periods of time.

• Key supervisory concerns centre on whether the risks associated with algorithmic trading have outpaced control improvements.

A. Introduction and Market Evolution

HFT’s evolution• HFT activity benefited from technology

that reduced delay to the markets.• By co-locating their servers with market

servers at an exchange or dark pool data centre, algorithmic traders

increased the speed at which they could access the markets.

• The decimalisation of pricing.• Alternative trading systems (ATS) and

dark pools began to attract volume and grow market share.

Benefits• Firms engaging in algorithmic trading

activity have benefited from a fragmented market structure by arbitraging prices between different trading venues.

• Traders now use trading strategies based on algorithms to arbitrage price differences across related products and trading venues.

B. Key Risks

Systemic Risk May Be Amplified• An error at a relatively small

algorithmic trading firm may cascade throughout the market ⇒ sizeable impact on the financial markets.

• Clearinghouses and central counterparties (CCPs) may also be affected by erroneous trades.

ALGORITHMIC TRADING BRIEFING NOTE

SECTION 4

48

Algorithmic Trading Desks May Face A Significant Amount Of Risk Intraday• Intraday risk controls may not be

robust, reporting may not be complete or timely, or limit breaches may not be transparent to senior risk officers.

• An unintended accumulation of a large position during the trading day may result in a firm taking on significant exposure before end-of-day risk processes take effect.

Internal Controls May Not Have Kept Pace With Speed And Market Complexity

Without Adequate Controls, Losses Can Accumulate And Spread Rapidly• 2010 Flash Crash• 2012 Facebook IPO

C. Key Control Principles and Sound Practices

1. Controls must keep pace with technological complexity and trading speeds.• A multilayered “defence-in-depth”

strategy, which increases control

redundancy and diversity, can reduce the risk that an erroneous or destabilising order will reach financial markets.

2. Governance and management oversight can limit exposure to losses and improve transparency.• Establish firm-wide governance for

algorithmic trading controls being aligned with the firm’s stated risk appetite framework.

3. Testing needs to be conducted during all phases of a trading product’s lifecycle.- Initial testing: firms wishing to

deploy a new or updated strategy or algorithm must first conduct simulations.

- Controlled rollout: the algorithms should be rolled out in a controlled and cautious fashion.

- Ongoing testing: to ensure that they can withstand significant or elevated market volumes and external events.

4. When assessing control depth and suitability, management should ensure sufficient involvement of control functions as well as business-unit management.

D. Questions for Firms and Supervisors

49

Business-Unit/Desk-Management Level• Management should consider the risks

of allowing traders to develop their own algorithms; of allowing developers to test their own code; and of allowing developers to deploy their own code into production: all run counter to separation-of-duties principles.

• Independent risk management functions should review and approve any changes and should inform senior management and the board of these exceptions.

• The business unit should establish compensating controls to mitigate both firm-specific and systemic risk.

• Trading desk management should develop appropriate reports for independent risk management and senior management and the board.

Control-Function And Senior-Management Level• Independent risk management should

review risk reports and ensure that senior management is aware of the level of intraday risk taken across the firm.

• Independent risk functions should be robust enough to develop their own key risk indicator reports and provide them to a chief risk officer.

• Independent risk management and senior management also should challenge business units as needed to

ensure that intraday risk exposure remains within acceptable limits.

• Robust involvement in the control-setting process by control functions can foster productive discussion about the optimal balance of control strength and innovation pace.

• By reporting near-misses through firm-wide incident management systems, firms gain the opportunity to mitigate control weaknesses before those weaknesses cause harm to the firm or to financial markets.

• Firms should effectively communicate any lessons learned to the entire organisation.

• To manage exceptional circumstances and assess and manage risk rapidly and effectively, senior management must understand in advance how exceptional circumstances are handled at each trading venue and the impact on the firm’s risk position.

• Markets, market participants, and clearing entities should regularly review their risk management and operational risk policies and procedures to ensure that they reflect the latest best practices.

• Appropriate, comprehensive, timely, and coordinated incident reporting and response procedures are required.

Board And Executive Level

50

• Senior management should leverage information provided by desk-level management and independent risk management to communicate to executive risk committees and to the board.

• Boards should request risk information from senior management, and senior management should be able to collect the information across desks and present it to the board from a risk perspective.

• Senior management should inform the board about near-misses and low-impact incidents that highlight critical control weaknesses.

51

Electronic and automated trading have become an increasingly important part of fixed income markets in recent years.

ETP: electronic trading platform.

Electrification• Aim to overcome some of the liquidity

challenges inherent in asset classes where trading is infrequent.

• Facilitated automated trading (AT), particularly high-frequency trading (HFT) strategies in fixed income futures and wholesale markets for major benchmark bonds.

• New market participants have emerged as liquidity providers and seekers.

• Innovative trading venues and protocols have proliferated.

A. How is the Market Structure Evolving?

• Traditionally, trading in fixed income: centre on dealers, trade bilaterally, OTC, without centralised marketplace.

• Dealer-to-dealer market: dealers trade exclusively with one another.

• Within the dealer-to-dealer market, specialised voice brokers helped

facilitate and anonymise the matching process by exchanging information on dealers’ buy and sell interest.

• Dealer-to-customer market: dealers trade with customers.

• Market participants negotiated terms of a trade via telephone or electronic chatting systems: significant search costs.

Electronic trading in the dealer-to-customer segment emerged1. Single-dealer platforms (SDPs):

proprietary trading systems offered by a single dealer to its clients, like an electronic version of the bilateral dealer-client OTC market.

2. Multi-dealer platforms (MDPs): allow end investors to request quotes from a number of dealers simultaneously, effectively putting dealers in competition for the transaction as in a multilateral auction ⇒ tend to lower the costs of finding a counterparty.

Main driver of electrification: to reduce the cost of trading and improve market liquidity.

HANGING UP THE PHONE

SECTION 5

52

Key advantage: automat the processing and settlement of trades, reduces the need for human processing, lower both the cost of trading and operational risks.

Central limit order book (CLOB): a trading protocol where market participants submit limit orders that are stored in a queue based on predefined rules.

AT• Order and trade execution decisions are

generated autonomously by computer algorithms.

• AT becomes prevalent in some fixed income segments.

• AT is a high-frequency trading (HFT).• Principal trading firms (PTFs)

place their servers in the vicinity of the matching engine of the exchange or electronic platform.

AT’s influences• Over 50% of trading volumes in

benchmark US Treasury securities on formerly exclusively dealer-to-dealer venues can be accounted for by PTFs.

• The most advanced HFT strategies thrive in highly liquid markets with CLOBs.

• Firms pursuing HFT strategies tend to generate a large number of orders, hold open positions for short periods and

cancel a large share of orders that they generate.

RFQ platform• Dealer-to-customer platforms are

usually based on the request for quote (RFQ) trading protocol, a multilateral electronic version of OTC trading.

• RFQ platforms do not present algorithms with a continuous market.

• Non-benchmark sovereign or corporate bonds are mostly trade via RFQ platforms. They do not see much HFT.

Corporate credit markets• Innovative trading protocols:

allow investors to negotiate with players outside the traditional dealer-intermediated market.

• New trading protocols are largely based on variants of RFQ.

• Platform providers are also considering protocols that would allow members to negotiate with each other, such as dark platforms.

• Objective: to pool liquidity outside the dealer community and enable multilateral communication of trading intentions.

Overall• Today’s market features greater

connectivity among the different players, more transparency and a greater variety of trading protocols.

53

• The share of electronic trading in many fixed income segments remains below that observed for other asset classes.

• Reason: the greater heterogeneity of the traded instruments and the resulting difficulty in finding matches in supply and demand.

B. What is Driving the Electronification of Fixed Income Markets?

1. Technological advancesRise in computing speed and capacity ⇒ lower the marginal and average costs of each trade, reduce search costs, the entry barriers for new platform providers have declined ⇒ the number of ETPs offering trading in fixed income instruments has further increased ⇒ increasing competition among ETPs can reduce the price charged to market participants ⇒ push towards electrification.

2. Changes in the demand for liquidity services• Potential size of secondary bond

markets ⇒ greater opportunity for economies of scale to be realised by ETPs.

• An increasing demand for price transparency ⇒ ETPs provide an efficient means of monitoring markets and comparing prices.

• The persistent decline in the level of yields ⇒ induce many fixed income investors to monitor their cost of trading more closely ⇒ incentivise greater use of electronic trading.

3. Regulatory reforms to contain systemic risks in the financial system• Mandatory clearing of standardised

OTC derivatives and supplementary trade reporting requirements.

• Ensure compliance with enhanced pre- and post-trade transparency requirements.

• ETPs enable banks to provide liquidity at lower cost.

• Offer the opportunity for other market participants to provide liquidity.

C. A Survey of Electronic Trading Platforms

How Have Electronic Trading Volumes Evolved?• Dealer-to-dealer platforms account for

the largest share of trading.• Fixed income electronification has been

growing steadily over the past five years.

• AT has become more prevalent. • Average daily turnover on electronic

platforms has been trending up.• Average daily trading volume rose.

54

• The number of transactions rose.• The evolution of average trade sizes has

differed across market segments.• A pickup in corporate bond trading:

record issuance of corporate securities; the growing popularity of this asset class among asset managers; electronic trading via platforms helping overcome some of the liquidity challenges.

• Trading of sovereign and quasi-government securities grew at a slower rate.

• Trading volumes for derivatives products have actually fallen.

How Are Electronic Trades Executed?• Electronic trading volumes grew most

in the dealer-to-customer segment (relies predominantly on RFQ), where end users can put multiple dealers in competition for a trade.

• Platforms relying on RFQ: the largest rise in volumes over the past five years.

• Dealer-to-dealer platforms: a smaller increase.

• All-to-all platforms: contributed little to the rise in aggregate volumes.

• Dealer-to-dealer platforms: 90% of the trades were executed via a CLOB.

• Survey data also point to an increase in AT.

Who Trades Electronically?

• Dealers’ dominance has diminished.• PTFs have assumed a key role as

liquidity providers on some formerly exclusively dealer-to-dealer venues.

- They employ emulated market-making strategies to profit from the bid-ask spread, while ensuring tight risk control over inventory positions.

• Non-bank financial institutions also play a key role as market participants on dealer-to-customer platforms.

D. Implications for Market Quality

Benefits of electrification• Support market quality by enhancing

both price efficiency and market liquidity.

• Enable market participants to detect and exploit arbitrage opportunities more quickly.

• Reduce trading costs by enabling greater transparency

• Increase competition among market participants.

• Enable market participants to optimise the implementation of their trading strategies, with large orders being split into multiple ones.

How electronification affects the ability of markets to cope with stress

55

• Market conditions hinge on the capacity and willingness of intermediaries to stand ready as suppliers of immediacy.

• Dealers remain the key liquidity providers.

• PTFs employing market-making strategies have become supplementary suppliers of immediacy.

• Liquidity conditions in many fixed income segments remain largely dependent on dealers’ capacity and willingness to make markets.

• Currently, dealers have raised their capital buffers and have reduced their trading book exposures.

• Dealers have responded by adjusting the way they provide liquidity services:

- Automation of market-making and hedging (save costs).

- Shift their immediacy services from a principal- to an agency-based model.

- This has reduced dealers’ warehousing of assets.

Behaviour of market liquidity during strained conditions• Abrupt but short-lived price swings

(flash crashes) may become more frequent in highly automated fixed income markets.

• Increasing complexity of trading algorithms represent a source of risk that can act as an amplifier in stress episodes.

After effects• Electronic trading may have changed

the dynamics of market responses to imbalances in demand and supply.

• However, the basic underlying economic mechanism of how illiquidity risks unfold have remained largely unchanged.

• Market conditions remain susceptible to a sudden evaporation of liquidity.

• Traditional gauges of liquidity conditions may be less suitable in the new market environment: HFT strategies enable the submission of highly competitive prices even in highly volatile conditions.

- This may lead to conflicting signs of liquidity conditions.

- The lifetime of orders in turn shortens.

- Both make it difficult to assess whether the market is actually liquid.

E. Is Electronification Harming Market Robustness?

1. Difficult to assess empirically how these changes have affected market robustness (market’s ability to absorb shocks)

56

• A lack of detailed data on trading activity prior to the advent of electronic trading.

• Many factors can affect liquidity conditions, making it difficult to single out the impact of any individual one.

Tentative observations:• Transitory jumps in liquidity conditions

occur in both markets.• Liquidity conditions on the US

Treasury market appear to be characterised by less volatile bid-ask spreads.

2. Difficult to judge which of the two market structures ensures more robustness.• CLOBs with significant HFT presence

may support trading at tight spreads throughout strained market conditions.

• Quote-driven markets benefit from the capacity of dealers to warehouse assets over an extended period of time, which may help absorb temporary order imbalances.

• Dealers, however, will seek to mitigate risks to their balance sheets by widening spreads in situations of elevated market uncertainty.

57

A. Context for Negative Policy Rates

Danmarks Nationalbank (DN), the European Central Bank (ECB), Sveriges Riksbank, the Swiss National Bank (SNB) and the Bank of Japan (BoJ) all introduced negative interest rates in mid- 2014 and early 2015.

Declared objectives 1. Counter a

subdued inflation outlook.

2. Focus on currency appreciation pressures.

3. Underpin the firm anchoring of medium to long-term inflation expectations.

4. Safeguard the role of the inflation target as a nominal anchor for price setting and wage formation.

The SNBThe euro area’s new wave of monetary easing added to the appreciation

pressure on the Swiss franc. To stem the inflow of funds, the SNB announced the introduction of negative interest rates, lowering the interest rate on sight deposit accounts further to –0.75%. The goal was to discourage capital inflows and thereby counter the monetary tightening due to the Swiss franc’s appreciation.

The DNSaw a surge in demand for Danish kroner and intervened heavily in the FX market. These measures stabilised the krone, and, towards the end of February 2015, the inflow of funds ceased.

B. Technical Implementation of Negative Policy Rates

For sight deposit accountsThe SNB put in place individual exemption thresholds for sight deposit

HOW HAVE CENTRAL BANKS IMPLEMENTED NEGATIVE POLICY

SECTION 6

58

Design of remuneration schedules

The ECB, DN and SNB: use some combination of exemption thresholds in computing the negative remuneration.

Denmark: tiered remuneration

Riksbank: one-week debt certificates

The Bank of Japan: a remuneration schedule that will divide balances in the current accounts of financial institutions into three tiers.

accounts so that only reserve holdings above the threshold earn negative interest.

Wholesale deposit changes• Many behind-the-scenes work.• In-depth review of its IT systems,

documentation and account rules.• Several minor adjustments were made. • Signal the possibility of negative

interest ahead of time.

C. Market Functioning

A question: whether negative policy rates are transmitted to the wider economy through lower lending rates for firms and households?

Money Markets• So far the introduction of modestly

negative policy rates have not affected the functioning of money markets much.

• The pass-through to short-term money market rates has persisted.

• The impact on trading volumes appears to be small.

• In all four jurisdictions, the overnight rate has followed the policy rate below zero.

• In terms of money market volumes, experiences vary:

- Banks seek to avoid negative rates by either extending maturities or lending to riskier counterparties.

- Banks that hold levels of reserves below their exemption threshold are willing to borrow reserves up to that threshold, whereas those that hold levels of reserves above theirs are keen to lend.

• Problems with money market instruments designed with only positive interest rates in mind have so far not materialised.

Transmission Beyond Money Markets• Market participants initially faced some

uncertainty related to how negative rates would be treated in connection with outstanding securities or existing contract types: such as negative coupons in floating rate instruments.

• These technical issues have for the most part been resolved: such as adding a spread over the reference rates.

A big concern remains• Banks is reluctant to pass negative rates

through to retail depositors for fear that negative deposit rates would lead to substantial deposit withdrawals.

• Banks have responded to lower lending margins by adjusting the lending rates upwards.

59

• If negative policy rates do not feed into lending rates for households and firms, the policies largely lose their rationale!

• But, if negative policy rates are transmitted to lending rates for firms and households, then there will be knock-on effects on bank profitability.

Products innovation• Institutional constraints may also

create a demand for instruments with interest payments floored at zero.

• Such floors can weaken the purpose of passing through negative interest payments.

• The resulting hedging difficulties have led to an increase in the demand for new instruments.

D. Where is the Effective Lower Bound?

• The possibility of earning zero nominal interest by storing value in physical currency is the primary motivation for the concept of the zero lower bound.

• So far, negative policy rates have not led to an abnormal jump in the demand for cash across the four European jurisdictions.

• Agents may start adapting to the new environment and begin to innovate with a view to reducing the costs associated with physical currency use.

• The fact that retail bank customers have so far been shielded from negative rates has probably played a key role in keeping the demand for cash stable.

• The ability of the banking sector to limit the pass-through of negative rates is thus an important factor determining the effective lower bound.

60

A. Introduction

During 1999-2007, the international balance sheets of emerging economies grew stronger through a combination of current account surpluses, a shift from debt funding to equity funding, and the stockpiling of liquid foreign reserves.

However, a tightening of dollar-funding conditions, macroeconomic slowdown in emerging economies ⇒ some emerging economies accumulate significant external debt since 2010.

Reasons• The withdrawal of quantitative easing

by the Federal Reserve ⇒ tighter funding conditions for international borrowers globally.

• The impact could be felt most acutely in those emerging economies with the deepest financial markets and the poorest economic fundamentals.

• Since there might be a tighter supply of dollars, the cost of borrowing might increase in local currency terms.

• Expected dollar appreciation will increase the value of dollar debt.

• Macro-financial fundamentals have deteriorated in a number of emerging economies since 2007.

• Current account balances have declined and foreign debt levels have increased.

• Credit growth has increased and leverage for some sectors has climbed.

• Forecasts of potential output growth have been revised downward.

• The drop in commodity prices has damaged the income prospects of commodity exporters.

A Concern For Policymakers In Emerging Economies• A reversal in international financial

flows risks destabilise their domestic financial markets and the real sectors.

• Countries running high current account deficits are particularly vulnerable to such reversals.

• But those with large outstanding stocks of debt liabilities in foreign currency could be vulnerable as well, facing both rollover risk and risks to their financial terms of trade.

CORPORATE DEBT IN EMERGING ECONOMIES

SECTION 7

61

International Financial Positions Of Nonfinancial Firms• Large corporates can directly obtain

funding from international banks, the international bond market, and non-bank intermediaries, while small firms borrow from their own banks in foreign currency terms.

• Indirectly, the corporate sector may induce financial inflows by borrowing from the domestic financial sector that, in turn, obtains external funding.

Market Facts• Emerging market nonfinancial

corporates have been active in issuing bonds in both domestic and international markets.

• Issuers have continued to favour foreign over domestic currency bonds.

• While these numbers are growing rapidly, the overall quantities are still not all that large, given that the initial level of corporate bond issuance was quite limited.

• Warning the amplification mechanisms: even small shocks can have very large effects on the state of the financial system, and then on the real economy.

• For many globally active corporations, foreign currency liabilities are hedged by revenues in similar currencies ⇒ little net risk.

• However, aggregate mismatches can develop that increase exposures to an array of risk factors.

B. The External Debt of Corporates: Risk Factors

Four Risk Factors1. Maturity mismatches: corporates

relying on short-term funding streams booked against longer-term revenue streams.

2. Currency risk: corporates have domestic currency assets against foreign currency liabilities, which can arise from the fact that covariation between the exchange rate and variables that affect profitability may be underestimated.

3. Rollover risk: bond funds may be forced to sell positions and decline to rollover holdings to meet redemption requests by the ultimate investors; the benchmark-tracing strategies adopted by many of these funds generate a pro-cyclical pattern.

4. Speculative risk: take open positions in currency derivatives or exploit carry trade opportunities across domestic and foreign markets.

Corporate risk-taking

62

• Corporate risk-taking increases, especially for multinational corporations.

• Interconnections among firms mean financial shocks to one firm affect activity levels quite widely.

• Increases in corporate leverage can amplify commodity price dynamics.

Risks To Nonfinancial Corporates Can Be Transmitted To The Financial System

Through direct channel1. The creditworthiness of a corporate

with both foreign and domestic components in its consolidated balance sheet is compromised if it takes losses on its foreign financial activities. These foreign losses would increase the riskiness of the assets on the balance of domestic financial intermediaries with which the firm is engaged.

2. If it cannot rollover its foreign liabilities, the corporate may need to withdraw liquid assets from the domestic financial system or seek to liquidate other domestic financial assets to meet its immediate obligations.

3. If the corporate has hedged its foreign currency exposure using derivatives in which the domestic

bank is a counterparty, settlement could lead to impairment of the bank.

4. When large corporations lose access to bond markets, they turn to banks. The banks then reduce funding to small- and medium-sized enterprises (SMEs).

Through indirect channel1. There is a possibility that corporates

are providing intermediation services, making short-term loans to non-bank financial intermediaries that are in turn counterparties to the banks.

2. Should the corporate lender come under stress and withdraw funding, this type of shock would then be transmitted to the banks.

3. Fiscally stressed sovereigns may default on domestic-currency debt rather than engage in currency depreciation. Knowing this, investors will drive up the sovereign risk premium. If domestic banks hold substantial volumes of domestic-currency sovereign debt, the result will be a loss in the mark-to-market value of some of their assets ⇒ an increase in systemic risk.

4. High corporate leverage may pose macroeconomic or sectoral risks if financial losses threaten the viability of the firm.

63

C. Empirical Trends

• After a sustained period over 1999-2007 in which international balance sheets were improving and risk factors declining, the sharp increase in gross debt liabilities marks a new phase.

• In turn, this has made emerging economies more vulnerable to a shift in international funding conditions and macroeconomic slowdown.

• Much of the bond issuance has emanated from the private sector (financial corporates and nonfinancial corporates).

• Foreign investors are major holders of emerging market bonds.

• The expansion in the size of the financial systems of emerging market economies has been dominated by debt instruments.

D. Case Study I: External Commercial Borrowings in India

External commercial borrowings (ECBs) are the largest component of India’s external debt.

Indian firms that borrow abroad are exposed to the risk that a depreciation in the Indian rupee (INR) would raise their interest costs and debt burden.

Multiple factors• Strong investment demand at home.• Increase in investor risk appetite for

emerging market credit.• Rising domestic interest rates relative

to foreign rates.• Improved sovereign credit ratings.• Continued underdevelopment of India’s

local corporate bond market.

Three Questions

1. Are firms with higher external borrowing more affected by adverse exchange rate movements?• Through natural hedges• Through financial instruments

2. Is effective exposure to foreign exchange risk better captured by market-based measures such as FX β (the sensitivity of a firm’s excess returns to the exchange rate) than by balance sheet ratios of foreign borrowing?The abnormal reaction post event is sharpest for the firms with high β(FX).Market-based measures of foreign exchange risk better capture firm

64

vulnerability than balance sheet measures.

3. Within high FX β firms, are those with a higher proportion of foreign borrowing with respect to total debt or assets more vulnerable to exchange rate shocks?Within high β(FX) firms, those with a high fraction of foreign borrowing had a higher abnormal negative reaction than those with lower foreign borrowing. Unfortunately the difference is not statistically significant.

Policymakers need to be conscious of risks arising from heightened foreign exchange volatilitySharp adverse movements in the exchange rate might hinder corporates from rolling over their debt and lead to real economic distress.

Steps to mitigate the consequences of adverse shocks1. Rely on market-based metrics (such

as FX β) to identify firms that could potentially encounter trouble in the event of a foreign exchange shock, rather than focusing on balance sheet measures of foreign exposure.

2. Hedging activity needs to be taken into account.

3. Risks to the banking system should be taken into account.

4. Limits could be enhanced on off-balance sheet guarantees to firms that are susceptible to foreign exchange risk.

E. Case Study II: The Intermediation of Corporate Debt Through the Domestic Banking System in Turkey

• In Turkey, 80% of the borrowing by corporates is from domestic banks.

• There is also an increase in private sector debt via direct international capital market access.

• When global liquidity is abundant: corporates themselves can borrow directly and easily in the markets, bypassing the domestic banking system.

• When the conditions are tight: banks become the sole source of foreign currency lending to corporates.

- There is a positive correlation between VIX and the share of foreign currency loans in the domestic credit provided by banks.

• Foreign currency borrowing increased at the same rate with the general credit boom.

65

F. Case Study III: Corporate Bond Issuance in Latin America

Bond issuances of nonfinancial corporations headquartered in Latin America and the Caribbean (LAC) kept growing.

Since the crisis, foreign bank credit has stabilised, and international bond issuance has gained prominence.

Nonfinancial firms in Latin America act as financial intermediaries• Nonfinancial corporations based in

emerging markets use the proceeds of external bond issuances to maintain cash or liquid assets when the conditions for pursuing carry trade activities are more attractive.

• Nonfinancial corporations can use their internal capital markets and inter-company loans that are normally considered foreign direct investment to evade capital controls.

• The incentives for corporations to engage in carry trade are greater in countries with greater restrictions on the capital account.

• Therefore, the ability of capital controls is limited by the ability of nonfinancial corporates to issue international bonds.

G. Policy Implications

• Ensure that financial intermediaries are sufficiently resilient to withstand what could be a substantial shock to their capital and liquidity

• Capacity to ensure that aggregate demand does not collapse when their large global corporates come under stress.

Firms face four specific risks1. Risks arising from funding being

shorter term than investments.2. Risks coming from issuing liabilities

that are in different currency from revenues.

3. Roll-over risk caused by a fickle investor base.

4. Trading risks resulting from speculative activities.

Monitoring and controlling any of these would be extremely intrusive and unlikely to succeed. A global firm that is intent on taking on any one of these risks will be able to find a way to do it.

Through Which Channels Failure In A Global Nonfinancial Corporate Influences An EME’s Banks And Macroeconomic Activity

Direct channels

66

1. Impair banking system assets through losses associated with loans to the firm and securities issued by the firm.

2. Create a run on the liabilities of the banking system as a result of withdrawals by the firm to meet its foreign creditor obligations.

3. Increase funding from banks at the expense of SME lending.

4. Put stress on counterparties that provide currency hedges in derivatives markets.

Sufficiently stringent capital and liquidity regulation, including concentration limits, will mitigate the first three.

Indirect channels1. Pull back from intermediation

services financed by foreign currency bonds.

2. Put their sovereign at risk.3. Trigger a recession through a

reduction in aggregate demand.4. Interconnections among firms

through supply chains.

Built-in Regulatory BuffersIf the primary impact of a reversal of fortunes for EME nonfinancial corporates is on the domestic financial system, built-in regulatory buffers should contribute to the stability of individual financial institutions, involving:

1. Adjustment to risk weights in the computation of capital requirementsIn the case of EME corporates, supervisors must be quite conservative in assessing the riskiness of loans and securities from these firms that appear on bank balance sheets.

2. Increases in run-off rates for computation of liquidity requirements (LCR)For corporates with large foreign currency bond exposures, these run-off rates should be higher than the minimum set by the international standard. Again, the FX β’s might be used.

3. Implementation of sufficiently severe stress tests for assets and liabilities.• When international corporates come

under stress, they may turn to banks who will prefer to lend to them rather than to SME borrowers. And banks will face concentration limits on their exposure to individual borrowers.

• Or subsidise lending to SMEs.

Solution To The Off-balance Sheet Activity Exposures Of Banks To Nonfinancial Corporate Counterparties

67

Central clearing of all derivatives contractsCCPs’ benefits1. Margin requirements reduce

counterparty risk.2. Allow for the monitoring of positions.3. Facilitate trade compression and

multilateral netting.4. No exemption: a large corporate

issuing of significant foreign-currency-denominated debt that is a counterparty to derivatives contracts should be forced to centrally clear those transactions.

Solutions To The Indirect Channels • Regulate activities or functions, rather

than the name of entities—any entity that is providing banking services should face the same regulations and the same supervision as a bank.

• We treat the two indirect risks—pressure on the sovereign and the macroeconomic slowdown—together.

• The traditional answer seems the most apt: the less indebted the fiscal authority, the more room for manoeuvre.

68

1. Böhme, Rainer; Christin, Nicolas; Edelman, Benjamin; and Tyler Moor, “Bitcoin: Economics, Technology, and Governance.” Journal of Economic Perspectives, Vol. 29, No. 2, Spring 2015.

2. Dudley, William C., “Market and Funding Liquidity—An Overview,” Remarks at the Federal Reserve Bank of Atlanta 2016 Financial Markets Conference, Fernandina Beach, Florida, 1 May 2016.

3. “Chapter 2: Market Liquidity – Resilient or Fleeting?” International Monetary Fund, Global Financial Stability Report, October 2015.

4. “Algorithmic Trading Briefing Note,” Federal Reserve Bank of New York, April 2015.

5. Morten Bech, Anamaria Illes, Ulf Lewrick, and Andreas Schrimpf, “Hanging up the phone—electronic trading in fixed income markets and its implications,” BIS Quarterly Review, 2016.

6. Linnemann Bech, Morten and Aytek Malkhozov, “How have central banks implemented negative policy rates?” BIS Quarterly Review, March 6, 2016.

7. “Corporate Debt in Emerging Economies: A Threat to Financial Stability?” Committee on International Economic Policy and Reform, Brookings Institution, September 2015.

REFERENCE

lxix

Faithful to the Official FRM Books

lxx