The liquidity of capital markets under new banking regulations - - PowerPoint PPT Presentation

The liquidity of capital markets under new banking regulations

Darrell Duffie Stanford University Baffi Lecture Banca d’Italia, September 15, 2017

Duffie Capital market liquidity and banking regulations 1

A bank-intermediated bilateral OTC market

c1 d1 c2 d2 d3 c3 c4 c6 c7 c5

Duffie Capital market liquidity and banking regulations 2

Regulatory Implications for Capital Market Efficiency

1

More financial stability from higher bank capitalization and BRRD.

2

The leverage-ratio rule distorts market making away from safe assets.

3

Debt funding costs for banks are heightened by BRRD, increasing balance sheet costs.

4

The local monopoly power of banks is mildly reduced by MiFID.

Duffie Capital market liquidity and banking regulations 3

Dealer balance sheet

assets debt equity

Duffie Capital market liquidity and banking regulations 4

More equity to fund more assets

assets debt equity

• ld assets

new assets debt new equity equity

Duffie Capital market liquidity and banking regulations 5

Legacy shareholders have subsidized creditors

assets debt equity

• ld assets

new assets debt new equity equity

Higher capitalization implies a value transfer from legacy shareholders to creditors.

Duffie Capital market liquidity and banking regulations 6

Debt overhang

assets debt equity

• ld assets

new assets debt new equity equity

For shareholders to break even, the new assets must be purchased at a profit that exceeds the value transfer to creditors. (Myers, 1977)

Duffie Capital market liquidity and banking regulations 7

SLR is more binding than risk-based capital ratios

Results of the Fed’s 2017 stress tests for the largest US dealer banks

JPM CITI BAML GS MS CET1 (CCAR) CET1 (DFAST, adj.) SLR (CCAR) SLR (DFAST, adj.) 2 4 6 8 10 Excess capital ratio (%)

CCAR: stressed CET1 after assumed payouts, less 4.5%; stressed SLR less 3.0%. DFAST, adjusted: stressed CET1 (no payouts) less (4.5% + G-SIB surcharge); stressed SLR less the G-SIB minimum of 5%. Data source: Board of Governors of the Federal Reserve, 2017.

Duffie Capital market liquidity and banking regulations 8

European Banks Delever as Reporting Days Approach Daily collateral outstanding in the tri-party repo market and the Federal Reserve’s overnight reverse repo (ON RRP) facility

100 200 300 400 500 600 1/2016 4/2016 7/2016 10/2016 1/2017 4/2017

U.S. banks European banks Other banks Fed (ON RRP) Figure Source: Egelhov, Martin, Zinsmeister, Federal Reserve Bank of New York, August, 2017. Notes: Banks headquartered in the euro area and Switzerland report leverage ratios as a snapshot of their value on the last day of each quarter, while their U.S. counterparts report quarterly averages. Totals only include trades backed by Fedwire-eligible securities–that is, U.S. Treasury and agency securities.

Billions of dollars Duffie Capital market liquidity and banking regulations 9

Impact of the leverage-ratio regulation

• n repo intermediation costs to legacy shareholders
• ld assets
• ld debt

equity repo asset repo claim

• ld assets

repo asset

• ld debt

repo claim equity new equity safe assets

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Impact of SLR on UST repo market efficiency

13−Q1 13−Q3 14−Q1 14−Q3 15−Q1 15−Q3 16−Q1 16−Q3 17−Q1 GCF−triparty rate spread (basis points) 5 10 15 20 25

(a) bid-ask spreads up (b) inter-dealer positions down Figure: (a) Average within-quarter difference between overnight GCF and Tri-party repo rates. Data sources:

Bloomberg and BNY-Mellon. (b) Figure source: Antoine Martin, FRBNY (2016).

Duffie Capital market liquidity and banking regulations 11

Cross-currency basis and bank funding costs

Funding value adjustments now leave wider arbitrage bounds on the basis

−100 −50 50 Basis Points

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 AUD CAD CHF DKK EUR GBP JPY NOK NZD SEK

(a) 5-year USD cross-currency basis. Source: Du,

Tepper, and Verdelhan (2017).

year CDS rate 2004 2006 2008 2010 2012 2014 2016 50 100 150 200 250 300 US banks European banks

(b) 5-year dealer credit spreads

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Cross-currency basis

−250 −200 −150 −100 −50 50 Basis Points

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 AUD CAD CHF DKK EUR GBP JPY NOK NZD SEK

(c) 3-month USD cross-currency basis.

Source: Du, Tepper, and Verdelhan (2017)

• ne−month

three−month six−month

• ne−year

2004 2006 2008 2010 2012 2014 2016 50 100 150 200 year USD LIBOR−OIS spread (basis points)

(d) LIBOR-OIS spreads. Data source:

Bloomberg.

Duffie Capital market liquidity and banking regulations 13

CIP arbitrage can be costly to dealer shareholders

Debt overhang cost for funding synthetic dollar deposits assets debt equity

• ld assets

EUR → USD

• ld debt

USD debt equity

To benefit shareholders, the trade profit must exceed the funding value adjustment (FVA), a debt-overhang cost.

Duffie Capital market liquidity and banking regulations 14

Funding cost to shareholders

• ld assets

EUR → USD

• ld debt

USD debt equity funding value adjustment (FVA)

Duffie Capital market liquidity and banking regulations 15

Example: CIP arbitrage can be bad for shareholders

◮ Suppose the one-year USD risk-free rate is zero. ◮ Our bank has a one-year credit spread of 35 basis points. ◮ We borrow $100 with one-year USD commercial paper, promising $100.35. ◮ We invest $100 in one-year EUR CP, swapped to USD, with the same all-in credit quality as that of our

bank’s CP, and uncorrelated.

◮ Suppose the EUR CP, swapped to dollars, promises $100.60, for a basis of −25bps. ◮ We have a new liability worth $100 and a new asset worth $100.65/1.0035 ≃ $100.25, for a trade profit of

approximately $0.25.

◮ However, the marginal value of the trade to our shareholders is negative, because, conditional on dealer

survival, the expected incremental payoff to equity is $100.25 − $100.35 = − $0.10. Conditional on default, equity gets nothing.

Duffie Capital market liquidity and banking regulations 16

Funding Costs to Dealer Shareholders

From work with Andersen and Song: The marginal increase in the value of the dealer’s equity per dollar of a debt-funded asset purchase is p∗π − δ COV∗ − FVA, where

◮ p∗ is the dealer’s risk-neutral probability of survival to term. ◮ π is the trade profit (P&L). ◮ δ is the risk-free discount. ◮ COV∗ is the risk-neutral covariance of the asset payoff and dealer default event. ◮ FVA is the funding value adjustment p∗δST, where S is the dealer’s credit spread and T is the term.

The extra marginal cost to dealer shareholders when a fraction α of the funding must be equity is α(1 − p∗ − FVA), which annualizes to roughly αS (assuming a loss given default of 0.5). For safe assets, the shareholder breakeven “arbitrage” yield is thus the total annualized funding cost to shareholders of roughly (1 + α)S.

Duffie Capital market liquidity and banking regulations 17

When should a dealer arbitrage the USD-JPY CIP basis?

100 200 300 400

12/31/14 3/31/15 3/30/15 9/30/15 12/30/15 3/31/16 6/30/16 9/30/16

1w deviation 1m deviation 3m deviation ✭❛✮ ▲❡✈❡❧ ♦❢ ❨❡♥ ❈■P ❉❡✈✐❛t✐♦♥s ✭❜✮ ❚❡r♠ ❙tr✉❝t✉r❡ ♦❢ ❨❡♥ ❈■P ❉❡✈✐❛t✐♦♥s

❋✐❣✉r❡ ✼✿ ■❧❧✉str❛t✐♦♥ ♦❢ ◗✉❛rt❡r✲❊♥❞ ❉②♥❛♠✐❝s ❢♦r t❤❡ ❚❡r♠ ❙tr✉❝t✉r❡ ♦❢ ❈■P ❉❡✈✐❛t✐♦♥s✿ ■♥ ❜♦t❤ ✜❣✉r❡s✱ t❤❡ ❜❧✉❡ s❤❛❞❡❞ ❛r❡❛ ❞❡♥♦t❡s t❤❡ ❞❛t❡s ❢♦r ✇❤✐❝❤ t❤❡ s❡tt❧❡♠❡♥t ❛♥❞ ♠❛t✉r✐t② ♦❢ ❛ ♦♥❡✲✇❡❡❦ ❝♦♥tr❛❝t s♣❛♥s t✇♦ q✉❛rt❡rs✳ ❚❤❡ ❣r❡② s❤❛❞❡❞ ❛r❡❛ ❞❡♥♦t❡s t❤❡ ❞❛t❡s ❢♦r ✇❤✐❝❤ t❤❡ s❡tt❧❡♠❡♥t ❛♥❞ ♠❛t✉r✐t② ❞❛t❡s ♦❢ ❛ ♦♥❡✲♠♦♥t❤ ❝♦♥tr❛❝t s♣❛♥s t✇♦ q✉❛rt❡rs✱ ❛♥❞ ❡①❝❧✉❞❡s t❤❡ ❞❛t❡s ✐♥ t❤❡ ❜❧✉❡ s❤❛❞❡❞ ❛r❡❛✳ ❚❤❡ t♦♣ ✜❣✉r❡ ♣❧♦ts ♦♥❡✲✇❡❡❦✱ ♦♥❡✲♠♦♥t❤ ❛♥❞ t❤r❡❡✲♠♦♥t❤ ❈■P ▲✐❜♦r ❈■P ❞❡✈✐❛t✐♦♥s ❢♦r t❤❡ ②❡♥ ✐♥ r❡❞✱ ❣r❡❡♥ ❛♥❞ ♦r❛♥❣❡✱ r❡s♣❡❝t✐✈❡❧②✳ ❚❤❡ ❜♦tt♦♠ ✜❣✉r❡ ♣❧♦ts t❤❡ ❞✐✛❡r❡♥❝❡ ❜❡t✇❡❡♥ ✸✲♠♦♥t❤ ❛♥❞ ✶✲♠♦♥t❤ ▲✐❜♦r ❈■P ❞❡✈✐❛t✐♦♥ ❢♦r t❤❡ ②❡♥ ✐♥ ❣r❡❡♥ ❛♥❞ ❜❡t✇❡❡♥ ✶✲♠♦♥t❤ ❛♥❞ ✶✲✇❡❡❦ ▲✐❜♦r ❈■P ❞❡✈✐❛t✐♦♥ ❢♦r t❤❡ ②❡♥ ✐♥ r❡❞✳ ✺✷

Source: Du, Tepper, and Verdelhan (2016).

Duffie Capital market liquidity and banking regulations 18

Credit spreads: funding-cost wedge and arbitrage bounds

2002 2004 2006 2008 2010 2012 2014 2016 50 100 150 200 250 year

• ne−year IBOR−OIS spread (basis points)

EURIBOR−OIS (Eonia) USD−LIBOR−OIS (Fed funds)

Figure: One-year spreads between interbank offered rates and overnight index swap rates. Data source: Bloomberg.

Duffie Capital market liquidity and banking regulations 19

5-year CDS rates of major European banks

year CDS rate 2004 2006 2008 2010 2012 2014 2016 100 200 300 400 500 Unicredit Intesa Sanpaolo DB−BNP−SG−BARC−RBS

Figure: CDS rates for large European banks average (DB-BNP-SG-BARC-RBS), Unicredit and Intesa-SaoPaolo. Data source: Bloomberg.

Duffie Capital market liquidity and banking regulations 20

CCPs require dealers to post collateral

c1 d1 c2 CCP d2 d3 c3 c4 c6 c7 c5

Duffie Capital market liquidity and banking regulations 21

d1 d2 d5 d3 d4 10 40 60 50 40 d1 d2 d5 d3 d4 10 40 20 10

Figure: A compression trade that eliminates a redundant circle of positions of size 40 (counterclockwise,

involving dealers 2, 3, and 4) with a circle of clockwise trades of size 40. Counterparty exposures and initial margin are reduced without changing market exposures. Example service providers: TriOptima (over $1 quadrillion notional eliminated, largely interest-rate swaps).

Duffie Capital market liquidity and banking regulations 22

Reducing swap exposures, especially from compression trading

10 20 30 40

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Gross market value (USD trillions)

Figure: Data source: Bank for International Settlements

Duffie Capital market liquidity and banking regulations 23

Improving trade competition

Example objective: Migration of active products to all-to-all trade platforms

c1 CLOB d1 d2 c2 c3 c5 c4 c6

Duffie Capital market liquidity and banking regulations 24

OTC competition after Dodd-Frank and MiFID

Buy-side firms request quotes at multilateral trading platforms

c1 MTP d1 d2

Duffie Capital market liquidity and banking regulations 25

But with excessive fragmentation across platforms

c1 MTP1 d1 d2 MTP2 d2 d3

Duffie Capital market liquidity and banking regulations 26

Reducing fragmentation improves competition

c1 MTP d1 d2 d3

Duffie Capital market liquidity and banking regulations 27

At corporate bond platforms Dealer competition lowers buy-side trade costs

• ­‑10 ¡

0 ¡ 10 ¡ 20 ¡ 30 ¡ 40 ¡ 50 ¡ 60 ¡ 1 ¡ 2 ¡ 3 ¡ 4 ¡ 5 ¡ 6 ¡ 7 ¡ 8 ¡ 9 ¡ 10 ¡ 11 ¡ 12 ¡ 13 ¡ 14 ¡ 15 ¡ 16 ¡ 17 ¡ 18 ¡ 19 ¡ 20 ¡

Cost ¡in ¡Basis ¡Points ¡

Number ¡of ¡dealers ¡responding ¡ Investment ¡Grade ¡ High ¡Yield ¡

Figure: Source: Hendershott and Madhavan (2016)

Duffie Capital market liquidity and banking regulations 28

Now typical fragmented two-tiered OTC markets

c1 d1 c2

CLOB

d2

MTP1

d3 c3

MTP2

c6 c7

MTP3

c5

Duffie Capital market liquidity and banking regulations 29