Informed trading in government bond markets

Robert Czech, Shiyang Huang, Dong Lou and Tianyu Wang

Government bond yields serve as a benchmark for virtually all other rates in financial markets. But what factors drive these yields? One view is that yields only move notably when important news hit the market, for example monetary policy announcements. Others suspect that some investors have an information advantage due to their access to costly information (e.g. data providers) or more accurate interpretations of public information. In a recent paper, we show that two investor groups – hedge funds and mutual funds – have an information edge in the UK government bond (gilt) market, and that these two investor types operate through different trading strategies and over different horizons.

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Covid-19 briefing: cross-border dollar funding

Saleem Bahaj and Fernando Eguren-Martin

The US dollar has a dominant role in the international financial system. The fact that trade and cross-border investment are overwhelmingly dollar-denominated means that non-US banks are heavily reliant on dollar funding (Aldasoro and Ehlers (2018)). This funding dried up during the Covid-19 epidemic, prompting the use of central bank swap lines as a policy response. This post looks at recent research on why dollar funding dried up in March, the efficacy of swap lines and the implications for cross-border banking, exchange rates and the international financial system.  

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Bitesize: Emerging market currency risk: evidence from the COVID-19 crisis

Simon Lloyd, Giancarlo Corsetti and Emile Marin

A striking regularity around global economic crises is that the dollar tends to appreciate sharply against emerging market (EM) currencies as capital flows out of EMs. In this respect, the adjustments observed since the onset of the COVID pandemic are no exception. Since the end of February, EM currencies have depreciated by around 15% (on average) and non-resident portfolio outflows from EMs summed to nearly $100 billion over a period of 45 days.

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Why fragmentation of the global data supply chain poses risks to financial services

Matthew Osborne and David Bholat

Every minute of the day, Google returns over 3.5 million searches, Instagram users post nearly 50,000 photos, and Tinder matches about 7,000 times. We all produce and consume data, and financial firms are key contributors to this trend. Indeed, the global business models of many firms have amplified the data-intensity of the financial services industry. But potential fragmentation of the global data supply chain now poses a novel risk to financial services. In this blog post, we first discuss the importance of data flows for financial services, and then potential risks from blockages to these flows.

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Pricing GDP-linked bonds

Fernando Eguren-Martin

GDP-linked bonds are sovereign debt instruments with repayments linked to the evolution of a country’s GDP. Originally proposed by Shiller in the 90s, they have recently been re-invoked in the debate around the policy response to the Covid-19 pandemic. These instruments present an obvious attraction for issuers: repayments are lower at times when the economy is growing relatively slowly, which typically coincides with lower tax earnings. A greater share of the risk of weak growth is then transferred to investors, who will require a compensation given they are typically risk-averse. Therefore, while the design is attractive ex-ante, a relevant question facing sovereigns willing to issue this type of instrument is `at what cost?’. In this post (and in an underlying Staff Working Paper) we provide some tentative answers.

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Why cryptocurrency markets defy the laws of economics

Peter Zimmerman

Speculative buying can drive cryptocurrency prices down. This is contrary to the usual laws of economics. Blockchain technology limits how quickly transactions can be settled. This constraint creates competition for priority between different users. The more speculative activity there is, the longer it takes to make a payment. But the future value of cryptocurrency depends on its usefulness as a means of payment. Speculation therefore affects price formation through a channel that does not exist for other asset classes. This can explain the high price volatility of cryptocurrencies, and is consistent with the low adoption rate so far.

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Possible pitfalls of a 1-in-X approach to financial stability

Adam Brinley Codd and Andrew Gimber

Meteorologists and insurers talk about the “1-in-100 year storm”. Should regulators do the same for financial crises? In this post, we argue that false confidence in people’s ability to calculate probabilities of rare events might end up worsening the crises regulators are trying to prevent.

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Fluttering and falling: banks’ capital requirements for credit valuation adjustment (CVA) risk since 2014

Giulio Malberti and Thom Adcock

The financial crisis exposed banks’ vulnerability to a type of risk associated with derivatives: credit valuation adjustment (CVA) risk. Despite being a major driver of losses – around $43 billion across 10 banks according to one estimate – there had been no capital requirement to cushion banks against these losses. New rules in 2014 changed this.

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Does accepting a broader set of collateral in central bank operations incentivise the use of riskier collateral by riskier counterparties?

Calebe de Roure and Nick McLaren

Central banks accept a wide range of assets from participants as collateral in their liquidity operations – but can this lead to undesired side effects? Such an approach can enhance overall liquidity in the financial sector, by allowing participants to transform illiquid collateral into more liquid assets. But, as a result, the central bank then needs to manage the greater potential risks of holding these riskier assets on its own balance sheet. Financially weaker participants may be encouraged to hold these assets if they can benefit from the higher returns, which compensate for the greater risk. In our recent paper we investigate whether central banks’ acceptance of a broad set of collateral incentivises the concentration of risk by examining the experience of the Bank of England (BoE).

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Bitesize: What might pension funds do when bond yields fall?

Matt Roberts-Sklar

Government bond yields fell sharply mid-2019, especially at longer maturities. For defined benefit pension funds, lower yields tend to mean deficits widen as discounted liabilities increase by more than the value of their assets. How might pension funds respond to this?

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