Francis Breedon, Louisa Chen, Angelo Ranaldo and Nicholas Vause
Most academic studies find that algorithmic trading improves the quality of financial markets in normal times by boosting market liquidity (so larger trades can be executed more quickly at lower cost) and enhancing price efficiency (so market prices better reflect all value-relevant information). But what about in times of market stress? In a recent paper looking at the removal of the Swiss franc cap, we find that algorithmic trading provided less liquidity than usual, at worse prices, and that its contribution to efficient pricing dropped to near zero. Market quality benefits from a diversity of participants pursuing different trading strategies, but it seems this was undermined in this episode by commonalities in the way algorithms responded.
Joseph Noss, Liam Crowley-Reidy and Lucas Pedace
James Cui and Marcus Pettersson
Shortcomings of the Basel capital framework became apparent in the 2007-8 crisis. One much reviewed and debated issue is that capital ratios can be increased by changes to methods and models for calculating RWA (M&M changes hereinafter) rather than by changes to balance sheets. How have UK banks fared in this respect?
The interest-only product has undergone tremendous evolution, from its mass-market glory days in the run-up to the crisis, to its rebirth as a niche product. However, since reaching a low-point in 2016, the interest-only market is starting to show signs of life again as lenders re-enter the market.
Fernando Cerezetti, Emmanouil Karimalis, Ujwal Shreyas and Anannit Sumawong
When a trade is executed and cleared though a central counterparty (CCP), the CCP legally becomes a buyer for every seller and a seller for every buyer. When a CCP member defaults, the need to establish a matched book for cleared positions means the defaulter’s portfolio needs to be closed out. The CCP then faces a central question: what hedges should be executed before the portfolio is liquidated so as to minimize the costs of closeout? In a recent paper, we investigate how distinct hedging strategies may expose a CCP to different sets of risks and costs during the closeout period. Our analysis suggests that CCPs should carefully take into account these strategies when designing their default management processes.
Oliver Brenman, Frank Eich, and Jumana Saleheen
The conventional wisdom amongst financial market observers, academics, and journalists is that a steeper yield curve should be good news for bank profitability. The argument goes that because banks borrow short and lend long, a steeper yield curve would raise the wedge between rates paid on liabilities and received on assets – the so-called “net interest margin” (or NIM). In this post, we present cross-country evidence that challenges this view. Our results suggest that it is the level of long-term interest rates, rather than the slope of the yield curve, that drives banks’ NIMs.
Carlos Eduardo van Hombeeck
The UK has a comparative advantage in financial services. But specialisation in this activity brings with it the challenge of the large gross capital flows that are linked to financial services exports.
Ben Guttman-Kenney, Liam Kirwin, Sagar Shah
Consumer credit growth has raised concern in some quarters. This type of borrowing – which covers mainstream products such as credit cards, motor finance, personal loans and less mainstream ones such as rent-to-own agreements – has been growing at a rapid 10% a year. What’s been driving this credit growth, and how worried should policymakers be?
What could falls in sterling mean for UK firms’ ability to sustain foreign currency (FX) debt obligations? The value of sterling began falling around two years ago and dropped further after the EU referendum – remaining around these lower values ever since. There is every possibility that sterling may stay low for the foreseeable future – creating both potential winners and losers. In this piece, I investigate one particular channel for losses related to sterling weakness: whether UK firms could find meeting their FX debt obligations more challenging. By reviewing market intelligence, market prices and derivatives databases, I find limited evidence that sterling weakness has yet produced any significant changes to UK firms’ ability to manage their FX debt obligations.
Stephen Burgess and Rachana Shanbhogue
In 2016 the UK’s current account deficit was 5.9% of GDP, the widest since official records began in 1948. Many economists, including the IMF and FPC have suggested the UK is therefore vulnerable to foreign investors becoming less willing to invest in the country. In this post we challenge the idea that the UK is at the mercy of the “kindness of strangers”. Looking at gross, rather than net capital flows since 2012 suggests inflows have been extremely subdued relative to past levels. Instead, the UK has benefitted from increasing capital gains on past foreign investments and used these to fund its spending. We argue this carries lower financial stability risks than relying on gross inflows to cover the current account deficit.