Category Archives: Market Infrastructure

Trimming the Hedge: How can CCPs efficiently manage a default?

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.

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Filed under Financial Markets, Financial Stability, Market Infrastructure

Bitesize: Flourishing FinTech

Aidan Saggers and Chiranjit Chakraborty

Investment in the Financial Technology (FinTech) industry has increased rapidly post crisis and globalisation is apparent with many investors funding companies far from their own physical locations.  From Crunchbase data we gathered all the venture capital investments in FinTech start-up firms from 2010 to 2014 and created network diagrams for each year.
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Filed under International Economics, Market Infrastructure, New Methodologies

Reducing counterparty credit risk in uncleared markets – but what are the costs?

Darren Massey

When you rent a house, the landlord – your counterparty – will take a security deposit as prepayment to cover potential costs such as unpaid rent or bills. New regulations introduced in major jurisdictions will require major participants in uncleared over-the-counter derivatives (OTCDs) markets to uniformly exchange initial margin – a more complicated version of a security deposit. Much like a rental deposit, OTCD parties must agree the deposit amount, who should hold the funds, and crucially, when a claim can be made. And just like the rental deposit, the protection provided brings new challenges and risks. This blog outlines some of these risks in the OTCD market, and as the framework is implemented, suggests that firms and regulators should consider these risks.

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Filed under Financial Markets, Financial Stability, Macroprudential Regulation, Market Infrastructure

Beyond blockchain: what are the technology requirements for a Central Bank Digital Currency?

Simon Scorer

What type of technology would you use if you wanted to create a central bank digital currency (CBDC) i.e. a national currency denominated, electronic, liability of the central bank? It is often assumed that blockchain, or distributed ledger technology (DLT), would be required; but although this could have some benefits (as well as challenges), it may not be necessary. It could be sensible to approach this issue the same way you would any IT systems development problem – starting with an analysis of requirements, before thinking about the solution that best meets these.

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Filed under Banking, Currency, Market Infrastructure

Central Bank Digital Currency: DLT, or not DLT? That is the question

Simon Scorer

The topics of central bank digital currency (CBDC) and distributed ledger technology (DLT) are often implicitly linked. The genesis of recent interest in CBDC was the emergence of private digital currencies, like Bitcoin, which often leads to certain assumptions about the way a CBDC might be implemented – i.e. that it would also need to use a form of blockchain or DLT. But would a CBDC really need to use DLT? In this post I explain that it may not be necessary to use DLT for a CBDC, but I also consider some of the reasons why it could still be desirable.

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Filed under Banking, Currency, Market Infrastructure

Big Data jigsaws for Central Banks – the impact of the Swiss franc de-pegging

Olga Cielinska, Andreas Joseph, Ujwal Shreyas, John Tanner and Michalis Vasios

The Bank of England has now access to transaction-level data in over-the-counter derivatives (OTCD) markets which have been identified to lie at the centre of the Global Financial Crisis (GFC) 2007-2009. With tens of millions of daily transactions, these data catapult central banks and regulators into the realm of big data.  In our recent Financial Stability Paper, we investigate the impact of the de-pegging in the euro-Swiss franc (EURCHF) market by the Swiss National Bank (SNB) in the morning of 15 January 2015. We reconstruct detailed trading and exposure networks between counterparties and show how these can be used to understand unprecedented intraday price movements, changing liquidity conditions and increased levels of market fragmentation over a longer period.

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Filed under Currency, Financial Stability, Market Infrastructure, New Methodologies

Of Goosebumps and CCP default funds

Fernando V. Cerezetti and Luis Antonio Barron G. Vicente 

A vestigial structure is an anatomical feature that no longer seems to have a purpose in the current form of an organism. Goosebumps, for instance, are considered to be a vestigial protection reflex in humans. Default funds, a pool of financial resources formed of clearing member (CM) contributions that can be tapped in a default event, are a ubiquitous part of central counterparty (CCP) safeguard structures. Their history is intertwined with the history of clearinghouses, dating back to a time when the financial sector resembled a Gentlemen’s Club. Here we would like to address the following – perhaps impertinent – question: are current mutualisation processes in CCPs a historical vestige, like goosebumps, or do they still hold an important risk reducing role?

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Filed under Financial Markets, Financial Stability, Market Infrastructure

Macroprudential policy beyond banking

Jon Frost and Julia Giese.

A seismic shift is occurring in the European financial system. Since 2008, the aggregate size of bank balance sheets in the EU is essentially flat, while market-based financing has nearly doubled. This shift presents challenges for macroprudential policy, which has a mandate for the stability of the financial system as a whole, but is still focused mostly on banks. As such, macroprudential policymakers are focusing increasing attention on potential systemic risks beyond the banking sector. Drawing from a European Systemic Risk Board (ESRB) strategy paper which we helped write along with five others, we take a step back and set out a policy strategy to address risks to financial stability wherever they arise in the financial system.

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Filed under Financial Stability, Insurance, Macroprudential Regulation, Market Infrastructure

How credit risk can incentivise banks to keep making payments at the height of a crisis

Marius Jurgilas, Ben Norman and Tomohiro Ota.

The final, practical determinant of whether a bank is a going concern is: does it have the liquidity to make its payments as they become due?  Thus, the ultimate crucible in which financial crises play out is the payment system.  At the height of recent crises, some banks delayed making payments for fear of paying to a bank that would fail (Norman (2015)).  This post sets out a design feature in a payment system that creates incentives, especially during financial crises, for banks to keep making payments.  This feature could address situations where banks in the system would otherwise be tempted to postpone their payments to a bank that is (rumoured to be) in trouble.

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Filed under Market Infrastructure, New Methodologies

Life below zero – the impact of negative rates on derivatives activity

James Purchase and Nick Constantine.

In 1995, Fischer Black, an economist whose ground-breaking work in financial theory helped revolutionise options trading, confidently stated that “the nominal short rate cannot be negative.”  Twenty years later this assumption looks questionable: one quarter of world GDP now comes from countries with negative central bank policy rates.  Practitioners have been forced to update their models accordingly, in many cases introducing greater complexity.  But this shift is not just academic.  Models allowing for a wider distribution of future rates require market participants to hedge against greater uncertainty.  We argue that this hedging contributed to the volatility in global rates in early 2015, but that derivatives can also play an important role in facilitating monetary policy transmission at negative rates.

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Filed under Financial Markets, Market Infrastructure, Monetary Policy, New Methodologies