Lungo post su come è cambiato il mercato, o meglio, la sua liquidità e quindi il suo funzionamento implicito, dopo la regolamentazione aggiuntiva rilasciata dopo la grande crisi del 2008
Here is a delightful New York Fed staff report on “Bank-Intermediated Arbitrage” by Nina Boyarchenko, Thomas Eisenbach, Pooja Gupta, Or Shachar and Peter Van Tassel. We’ll get to their conclusions in a minute, but I want to particularly recommend the paper as a nice layperson’s introduction to what banks do all day. It is stuff like this:
"Consider the on-the-run/off-the-run (OTR-OFR) basis trade .... In the textbook OTR-OFR basis trade, a market participant would short the more expensive on-the-run Treasury and buy long the cheaper first off-the-run Treasury of similar maturity, earning the liquidity premium enjoyed by on-the-run securities. In practice, the short position in the on-the-run security would be taken through a reverse repurchase agreement, with the market participant lending cash and receiving the OTR Treasury as collateral, and the long position in the off-the-run security would be financed through a repurchase agreement, with the market participant borrowing cash and posting the OFR Treasury as collateral. Thus, the overall profit (“carry”) that the participant makes by participating in the trade is the OTR-OFR basis, net of the difference between the interest rate paid on the OFR repo and the interest rate earned on the OTR repo, and net of the cost of financing repo haircuts (if any)."
"In the covered interest rate parity (CIP) trade, an institution trades off the cost of borrowing in U.S. funding markets against the costs of borrowing in foreign markets and swapping the foreign funding into U.S. funding via a forward exchange rate swap. When the basis is positive, U.S. dollar funding is relatively cheap and institutions take advantage by entering into a long position in U.S. Treasuries, a pay-fixed forward exchange rate swap, and shorting a foreign sovereign security with the same maturity. When the basis is negative, U.S. dollar funding is relatively expensive, and institutions take advantage by shorting a U.S. Treasury security, entering into a pay-floating forward exchange rate swap, and buying a foreign sovereign security with the same maturity."
"In the CDS-bond basis trade, institutions trade off the cost of taking on credit risk exposure to individual entities through either the cash bond market or through the single-name CDS market. When the CDS-bond basis is positive, corporate bonds are relatively more expensive than single-name CDS, and institutions take advantage by selling protection in the single-name CDS market and shorting the corresponding corporate bond. When the CDS-bond basis is negative, corporate bonds are cheap relative to singlename CDS, and institutions enter into a long position in the corporate bond market and buy protection on the same reference entity in the single-name CDS market."
Obviously banks do lots of other things too, and institutions other than banks do lots of these things. But there is something rather bank-y about the characteristic that these things share, which is that they involve buying a whole lot of one thing and selling a whole lot of an almost-but-not-quite identical thing to profit from small differences between the prices of the two things.
For one thing, that activity—it is normally called “arbitrage”—can shade into the classic bank activity of “market making.” One thing that you do in market making is buy some Stock X from one customer, then sell some Stock X to another customer, keeping your overall inventory of Stock X close to zero. But in more complicated products—options or swaps or exchange-traded funds or even bonds really—your goal is not necessarily to keep your absolute levels of inventory low, but to keep your risk low. If you buy a bunch of Bond X from one customer, and sell the same amount of Bond Y to another customer, and Bonds X and Y are essentially identical—if, say, they are U.S. Treasuries that mature a month apart—then that is almost as good as having no inventory at all. (Or if you buy an ETF and sell the underlying stock, or buy an interest-rate swap and sell a related future, etc. etc.) Market makers in many products think in terms of risk sensitivities—How much net credit or rates or volatility or whatever exposure do I have? How much will I make or lose if interest rates move by a basis poin?—rather than in terms of absolute dollar amounts of particular instruments, which means that they look a bit like arbitrageurs.
For another thing, if you are going to make money off of tiny differences in prices between two almost-identical things, then you need to buy and sell a lot of those things, which means you will need a lot of money. Banks, being where the money is, have a lot of money, which makes them better suited to do these trades than, you know, I am.
Again banks are not the only institutions who do these trades. But in many case the sorts of arbitrage hedge funds that do the trades get the money to do them by borrowing it from their banks: The bank, as prime broker to the hedge fund, lends it money to buy the thing it wants to buy, and lends it the thing it wants to sell so that it can short it. The bank does this because, one, it has the money (and the securities to lend), and, two, because the risk is manageable: The two positions should move together, so if the hedge fund loses money on one side it will make money on the other, so it should be able to pay the bank back.
Another reason this stuff is a natural fit at banks is that it is, essentially, plumbing. Buying the off-the-run Treasury and selling the on-the-run is not the sort of bold call on future economic activity that fundamental investors are supposed to make. It doesn’t directly allocate capital to productive uses, or take big risks in the search of big returns. It just makes the system work a bit more smoothly. If index ETFs track their underlying stocks, then it’s easier for fundamental investors to hedge out market risk, so it’s easier for them to make bold bets allocating capital to the best uses. The work of arbitraging that index ETF is boring and invisible, a work of endlessly making sure that the system is tuned correctly so that other people can use it effectively. It makes sense that banks, as operators of the system, would be involved in a lot of that tuning.
Anyway the paper! The basic gist of it is that the banks can’t do as much of this anymore, so the system is not as finely tuned as it used to be:
"We argue that post-crisis bank regulation can explain large, persistent deviations from parity on basis trades requiring leverage. Documenting the financing cost and balance sheet impact on a broad array of basis trades for regulated institutions, we show that the implied return on equity on such trades is considerably lower under post-crisis regulation. In addition, although hedge funds would serve as natural alternative arbitrageurs, we document that funds reliant on leverage from a global systemically important bank suffer significant declines in assets and returns relative to unlevered funds. Thus, post-crisis regulation not only affects the targeted banks directly but also spills over to unregulated firms that rely on bank intermediation for their arbitrage strategies."
The Volcker Rule—which prohibits “proprietary trading” by banks, though some forms of proprietary-ish trading (market making, trading in Treasuries) are still allowed—has had an effect, making it harder for banks to make big bets that one thing will converge with another thing.
But the much bigger impact comes from the supplementary leverage ratio. The main bank capital regulation before the crisis involved risk-based capital; banks had to fund a certain percentage of their “risk-weighted assets” with equity. Risk-weighting allows banks to do (or fund hedge funds that do) a whole lot of these trades, because these trades are not—on the conventional measures used to compute capital, and also probably in reality—particularly risky. If you buy a whole ton of Treasuries, and then sell a whole ton of near-identical Treasuries, it will not use a lot of risk-based capital, because (1) Treasuries are very safe and (2) your positions offset and the net position is small.
But since the crisis the more binding regulatory constraint is often the supplementary leverage ratio, which requires banks to fund a certain percentage of their total unweighted assets (plus some asset-like things like derivative exposures) with equity. Buying a whole ton of Treasuries and selling a whole ton of other Treasuries leaves you, in an SLR world, with two whole tons of Treasuries exposure, which means that you need a lot of equity, which makes the trades less attractive than they used to be if you are optimizing return on equity:
"For all the trades we consider, the implied ROE under the supplementary leverage ratio is significantly smaller than the implied ROE under the risk-weighted capital requirement and often does not meet the 12 percent ROE targets that most large financial institutions target. Thus, in the post-SLR regulatory regime, institutions must either accept lower ROE when participating in basis trades or not participate until the absolute level of the trade reaches unusually high levels."
And so the trades just happen less—because banks do less of them, and because hedge funds that rely on big-bank funding also do less of them—and the expected relationships break down more than they used to.
Am I supposed to Have an Opinion About Whether This Is Good? I don’t know. The tradeoffs, broadly speaking, seem straightforward and obvious. The system is less finely tuned, but it is also less tightly wound; the banks are safer but also less useful; the markets are less perfect but also less fragile. There are occasionally efforts to measure those tradeoffs—more in lending than in, like, covered-interest-parity arbitrage—but they are hard to commensurate. If the system is less efficient, then a lot of hedge funds will grumble about the breakdown in covered-interest parity every day, but no one outside of the financial world will care, or even understand what it is they are complaining about. If the system is more finely balanced and fragile, then all of its power users will be a bit less grumbly every day, until one day it all goes wrong and everyone notices.
Sezione ignoranti, educande e quinta colonna maronita