BIS Quarterly Review, December 2019 - media briefing

Claudio Borio's remarks | Hyun Song Shin's remarks

Claudio Borio

The previous quarter saw financial markets torn between two forces: trade tensions pushed them down; monetary policy easing pushed them up. During the latest one, it was the ebb and flow of trade tensions that dominated. To be sure, further monetary easing continued to support risky assets, and so did signs later in the period that recession concerns might have been overdone. But it was the easing of trade tensions between the United States and China in mid-October that defined a regime shift in markets.

Until that point, the prices of risky assets had been range-bound; thereafter, a risk-on phase took hold. Equity prices rose, the VIX - a gauge of risk aversion - fell to new lows, corporate spreads narrowed, yields on safe sovereign bonds edged up and the US dollar depreciated, supporting valuation gains in emerging market economies in particular.

This meant that aggregate financial conditions in the United States and the euro area loosened and ended up easy by historical standards. In fact, they were at least as easy as in October 2018: it was then that they had started to become tighter, as market participants began to worry about a darkening macroeconomic outlook and the possibility that the Federal Reserve might not ease in response.

The renewed risk-on phase, coupled with loose financial conditions, has raised questions about the sustainability of risky assets' valuations. Passing judgment on such issues is very difficult. Even so, an examination suggests that the answer hinges on assessments of the factors behind historically low sovereign bond yields, notably the role of the term premium - the compensation for bearing the risk of holding a long-maturity bond as opposed to a sequence of shorter-maturity ones.

Consider equities first. The picture differs across countries, with US valuations in particular being considerably higher than in most other countries. When measured on a standalone basis, such as through the popular cyclically adjusted earnings yield, US equities appear high by historical standards. By contrast, they look roughly in line when compared with the unusually low bond yields. But they look rich again if one adjusts the bond yields by stripping out an estimate of the term premium, which is in fact negative - something unique to the post-crisis experience. Signs of high risk-taking, such as the very low level of the VIX and the record high positions betting on a further decline, also hint at stretched valuations. A similar picture applies to US commercial real estate, where prices have been quite buoyant.

The assessment is more straightforward in the case of corporate debt. In advanced economies, spreads in relation to sovereign bond yields were on the low side by historical standards. The typically tight relationship between manufacturing activity and spreads broke down this year, as activity faltered, yet spreads narrowed further. And all this coincided with clear signs of risk-taking, such as the strong issuance of high-yield bonds and larger inflows into funds specialised in frontier bond markets. At the same time, default rates and downgrades picked up for high-yield issuers.

As signs of risk-taking were evident in the most salient financial market segments, something quite unexpected took place in a perhaps less glamorous but critical segment. On 17 September, US overnight general collateral repo rates spiked to 6%, with some trades reportedly occurring at up to 10% in a disorderly market. This, in turn, pulled in the same direction, but to a lesser degree, the secured overnight financing rate (SOFR), the new reference rate, and, in a more muted fashion, the effective federal funds rate - the uncollateralised overnight rate at which banks and a handful of other institutions trade among themselves in the United States. The tensions had a noticeable impact on closely related market segments, notably that of FX swaps, increasing the wedge between the cost of borrowing and lending across currencies in the cash and derivatives markets - the so-called cross-currency basis. Why did this occur? And what is the broader significance?

The reasons for the dislocations are still not entirely clear. Alongside some temporary factors, structural ones appear to have been at work. A key one has seemingly been the combination of two forces: on one side, high demand for secured (repo) funding from non-bank financial institutions, such as hedge funds heavily engaged in leveraging up relative value trades; and on the other, the big four banks' unwillingness to supply the funding, as their liquidity buffers, notably in the form of excess reserves with the Fed, were running low.

The behaviour of the big four is critical, since they have recently become the marginal lenders to the repo market, replacing money market funds. Their unwillingness, in turn, seems to reflect post-crisis changes in internal risk management practices and, possibly, the lack of flexibility to take advantage of short-lived arbitrage opportunities. The reduced flexibility reflects a long period of abundant excess reserves in the system, which reduce the need to grant and obtain short-term liquidity. The tensions ended only once the Fed injected further reserves into the system.

The significance of this event goes well beyond the short-term dislocations.

First, the dislocations suggest that central banks' post-crisis unconventional operations have left a profound imprint on market functioning. As noted in a recent report by the central banks' Markets Committee, as banks get used to a protracted period of abundant excess reserves, withdrawing them may result in unpredictable and sudden market adjustments - it is as if a muscle had atrophied. Indeed, a special feature in this issue documents how the large-scale ECB purchases have turned the euro area repo market from one driven by funding needs to one driven by the demand for the underlying securities, affecting the behaviour of interest rates.¹

Second, the dislocations highlight how non-banks' growing involvement in markets intimately tied to interbank transactions, themselves increasingly in the form of secured funding, can result in unfamiliar market dynamics. This development is especially relevant at a time when many central banks are gearing up to rely on secured rates as the main benchmark interest rate.

Finally, the dislocations suggest that repo markets, alongside the bigger, geographically much more extensive and closely linked FX swap market for US dollar funding, may again find themselves in the eye of the storm should financial stress arise at some point. The surge in FX short-dated swap trading, which has accounted for much of the growth in FX volume over the past three years, underlines this risk. Against this background, the post-crisis growth in non-bank financial institutions in general, and the asset management industry in particular, can add to the unpredictability of market dynamics.

Rather stretched asset valuations, high risk-taking and hard-to-read changes in the financial system: the mixture points to certain vulnerabilities in financial markets that merit close attention on the part of market participants and central banks alike.

Hyun Song Shin

This issue of the Quarterly Review has a special focus on currency and derivatives markets. It contains five special features that present the results of the latest BIS Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives markets. The articles use this unique source of data to explore what factors drove the recent growth of these markets and what these factors tell us about the evolution of their structure. A sixth feature, on "FX and OTC derivatives markets through the lens of the Triennial Survey" by Philip Wooldridge, summarises the main findings.

The 2019 survey revealed that OTC markets are larger than ever. Following a dip in 2016, FX trading returned to its long-term upward trend, rising to $6.6 trillion per day in April 2019. Interest rate derivatives trading departed sharply from its previous trend, soaring to $6.5 trillion. To give you a sense of how large these numbers are, global exports of goods and services were less than $100 billion per day in 2018.

In FX markets, the US dollar remained the dominant currency. It was on one side of 88% of all trades. As discussed in "Sizing up global foreign exchange markets" by Andreas Schrimpf and Vladyslav Sushko, the dollar's dominance reflects its importance as a vehicle and funding currency. Indeed, the dollar's share of FX swaps - which are a form of collateralised borrowing - was even higher than its share of spot trading. FX swaps accounted for more than half of the rise in overall FX trading between the 2016 and 2019 surveys.

Having said that, the trading of emerging market currencies grew faster than that of major currencies. The share of emerging market currencies in global FX turnover rose to 23% in April 2019, compared with 19% in 2016 and 15% in 2013. The Chinese renminbi was the most actively traded emerging market currency, and the eighth most traded currency globally.

There was a marked increase in offshore trading, ie trading that takes place outside the country where the currency is issued. In "Offshore markets drive trading of emerging market currencies", Nikhil Patel and Dora Xia show that currencies where the relative importance of offshore trading increased showed more growth in overall trading.

Greater offshore trading led to greater geographical concentration in a few financial centres. In FX markets, London, New York, Singapore and Hong Kong SAR increased their collective share of global trading to 75% in April 2019, up from 71% in 2016 and 65% in 2010. In OTC interest rate derivatives markets too, trading was increasingly concentrated in a few financial centres, especially London.

Technological innovation, especially the rise in electronic and automated trading, was a major factor behind the increase in offshore trading. In "FX trade execution: complex and highly fragmented", Andreas Schrimpf and Vladyslav Sushko explain how this so-called "electronification" of trading is reshaping FX markets. It facilitates automated trading, in particular high-frequency trading. This, in turn, makes OTC markets more attractive to those engaged in such strategies, mainly hedge funds and principal trading firms. Some of these firms have expanded into the business of market-making, which is blurring the distinction between the inter-dealer and dealer-customer segments.

The market for non-deliverable FX forwards is another illustration of the impact of electronification. Non-deliverable forwards are typically settled in dollars and other freely traded currencies. So, they are used to settle forward contracts on currencies that are not freely convertible. NDFs recorded some of the fastest growth in FX turnover between the 2016 and 2019 surveys, including for the Indian rupee, Indonesian rupiah and Philippine peso. In "NDF markets thrive on the back of electronification", Andreas Schrimpf and Vladyslav Sushko attribute much of this growth to electronification.

OTC interest rate derivatives markets, too, are shifting from voice brokers to electronic platforms. In "The evolution of OTC interest rate derivatives markets", Torsten Ehlers and Bryan Hardy identify electronification as a key reason why the OTC trading of interest rate derivatives is growing faster than exchange trading. As recently as 2010, exchanges accounted for about 80% of interest rate derivatives trading. Their share has now dropped to around 50%.

Notably, the marked pickup in the trading of FX and OTC derivatives between the 2016 and 2019 surveys did not lead to an increase in outstanding exposures. To be sure, since 2015 the notional principal of outstanding OTC derivatives has trended upwards, and in 2019 it reached its highest level since 2014. However, the gross market value - a more meaningful measure of amounts at risk - has trended downward since 2012, and in 2019 was close to the lows seen before the Great Financial Crisis (GFC). One reason is that a lot of the additional trading was in short-term instruments, such as short-dated FX swaps and overnight index swaps. These boost trading in a mechanical way because they need to be replaced more often. Another reason is reforms such as compression and clearing.

Clearing rates for credit default swaps and OTC interest rate derivatives rose steadily after the GFC, and derivatives subject to mandatory clearing are now almost fully cleared. In "OTC derivatives: euro exposures rise and central clearing advances", Sirio Aramonte and Wenqian Huang analyse the incentives for derivatives not subject to mandatory clearing to migrate to central clearing.

One area of concern is FX settlement. In 2019, the Triennial Survey was expanded to collect information on FX settlement for the first time. In the early 2000s, the establishment of CLS, where payment obligations are settled simultaneously, and other similar initiatives led to a big reduction in FX settlement risk. However, in "FX settlement risk remains significant", Morten Bech and Henry Holden conclude that, in recent years, FX settlement risk has actually risen.