CIP deviation implications for financial stability & FX market

CIP deviation implications for financial stability and FX market have a pronounce effect on global financial system. Covered interest parity is also correlated with USD and USD-denominated asset supply and demand. Knowing this, we can spot new opportunities in the market. Here’s how it works.

01 October, AtoZForex We continue looking into the effects CIP deviation on financial stability and Forex market amid growing monetary policy divergence and tightening financial conditions. You can view the second article here: Covered interest parity deviation effects.

The impact of monetary policy divergence

CIP deviations rise when the growth rate of the central bank’s balance sheet in the non-US jurisdiction outpaces that in the US. This is because such diverging monetary stances encourage non-US financial institutions to “search for yield” on USD-denominated assets and lead to an increase in demand for USD through the FX swap market.

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Two made observations are particularly noteworthy. First and most importantly, the differential in growth rates of the central bank’s balance sheet has contributed to a rise in CIP deviation, in particular after 2014. Its positive contribution is pronounced in two currency pairs, EURUSD and USDJPY. Second, banks’ default probabilities played the key role in increasing CIP deviations for the currency pair EURUSD during the eurozone sovereign debt crisis, possibly through the substitution of funding source.

The impact of regulatory reforms

In the theoretical model, a tightening of regulatory frameworks alters the liquidity position and funding structure of banks in the following three ways.

First, the size of the liquidity needs of both non-US banks and US arbitrageurs increases. For example, the LCR, which came into force from January 2015, requires banks to hold a certain amount of highly liquid assets.

Second, some regulatory reforms may increase the marginal cost of raising USD for non-US banks. Money market reforms require institutional prime money market funds (MMF), which principally invest in CDs and CP, to shift from constant net asset value to floating/variable net asset value, while institutional government MMFs are exempt from this rule. The rule is to be implemented by October 2016, and institutional investors have been switching from prime MMFs to government MMFs, as shown in Figure 7.

CIP deviation implications for financial stability & FX market Source: BoJ WPS

Reduced investment by prime MMFs in CDs and CP issued by non-US banks lowers the availability of their wholesale USD funding. This implies that it costs more for non-US banks to raise USD in the US market than in the past. They have to invest in advertising and promotions, and the more they increase their dollar assets, the greater the marginal costs of dollar funding.

Third, stricter financial regulations increase the marginal cost for arbitrageurs of expanding their balance sheets. Market participants also suggest that uncertainty remains as to whether short-term USD lending through cross-currency funding markets, with USD funded in the money market, may lead to violation of the Volcker rule which came into effect in July 2015.

When the global financial crisis occurred (see Figure 2), financial regulations were tightened in turn enhancing the sensitivity of a CIP deviation to an interest margin differential.

CIP deviation implications for financial stability & FX market Source: BoJ WPS

When an arbitrageur (e.g., a US bank) faces a widening interest margin differential, it seeks to increase its USD-denominated assets. Yet, it is more costly for an arbitrageur to expand its balance sheet. Therefore, an arbitrageur shifts its USD funds away from FX swap transactions toward other dollar-denominated investments, which leads to a larger decrease in the supply of USD in the FX swap market. Similarly, a non-US bank facing a widening interest margin differential seeks to increase its USD-denominated investments. But the marginal cost of raising USD from the US money market becomes larger. Therefore, a non-US bank shifts its USD funding source toward the FX swap market, which leads to a larger increase in the demand for USD in the FX swap market.

Impact on the liquidity of FX swap markets

Market contacts suggest that regulatory reforms affect not only arbitrage trading but also market-making by banks in the FX swap market. Specifically, some of the current regulatory reforms have made it difficult for banks to change the size of their balance sheets flexibly, which has reduced their capacity for market making services, thereby reducing market liquidity.

Market liquidity and CIP deviation are considered to interact closely. For example, a decline in market liquidity may discourage arbitrage trading and market-making activity by banks, amplifying the widening of CIP deviations.

Real money investors as arbitrageurs

Market contacts indicate that SWFs in oil-producing countries have supplied USD in the FX swap market. This seems to hold true especially in the period from 2011 to the middle of 2014 when oil prices were fairly high, which implies an increase in the wealth endowment of SWFs and hence the leftward shift of the supply curve of USD through the FX swap market.

However, market contacts say that since oil prices plummeted in 2015, the SWFs that had formerly allocated their oil money in USD to the FX swap market have started to withdraw from the market.

However, other market contacts indicate that during the period of emerging market currency depreciation in mid-2015, official reserve managers shifted their USD-denominated assets from less liquid cross-currency funding markets to US Treasury bills, driven by their increased need to intervene in the FX markets to support their home-currency.

When real money investors face a fall in total AUM and reduce the supply of USD in the FX swap market, the demand-supply balance of USD tightens, leading to an increase in CIP deviation.

That is, the demand curve of USD in the FX swap market becomes steeper. Consequently, the fall in supply of USD is more easily translated into an even higher CIP deviation

In this sense, an adverse shock in the asset management sector, such as a fall in the AUM of real money investors, is amplified by stricter financial regulations.

CIP deviation implications for financial stability

Historically, non-US bank’s creditworthiness has largely affected their overseas dollar lending and financial stability through variations in CIP deviation.

Instead of banks’ creditworthiness, interest margin differentials due to diverging monetary stances have a larger impact on the dollar funding premium.

Because regulatory reforms raise the marginal costs of USD funding and increase the sensitivity of CIP deviations to interest margin differentials, such reforms dampen the impact of a rise in the US interest margin on non-US financial institutions’ lending and investments and prevent them from engaging in excessive “search for yield” activities. This then helps the US monetary authorities avoid financial imbalances like Alan Greenspan’s “bond conundrum,” and contributes to global financial stability.

An increase in banks’ liquidity needs and a decline in the total AUM of real money investors leads to a tightening of demand-supply balance in the FX swap market and a higher dollar funding premium. This effect is amplified by stricter regulations which increase the marginal costs of dollar funding for banks.

As a result, given interest margin differentials, non-US financial institutions further reduce their USD-denominated investments. If their investments are cut rapidly and on a large scale, this may destabilize the global financial system and result in financial crisis.

About the article:

CIP deviation implications for financial stability & FX market article is a third part of a summary of “Regulatory Reforms and the Dollar Funding of Global Banks“:

Evidence from the Impact of Monetary Policy Divergence” research article as a part of Bank of Japan Working Paper Series from Tomoyuki Iida, Takeshi Kimura, and Nao Sudo.

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