Is The Global Banking Network Really De-globalising?

An IMF working paper “The Global Banking Network in the Aftermath of the Crisis: Is There Evidence of De-globalization?” released today, shows that contrary to popular belief, the Global Banking Network has not shrunk since the GFC in the simple way often thought. Using complex and innovative modelling, they conclude that the banking world in some ways is connected more deeply, and with greater complexity than before. This means that players in one location could be impacted more severely by events in other geographies. They conclude that the hidden dynamics of the global banking network after the crisis suggest that the assertion that cross-border lending has shrunk globally seems to miss out significant details. They refrain from assessing the risk impact of this observation.

However, we conclude, like our digital world, global banking is more financially networked than ever, suggesting that risks could be propagated widely and in unexpected directions.

The global financial crisis in 2008-09 underscores the unique role of financial interconnectedness in transmitting and propagating adverse shocks. Previous literature stresses the significance of network structure in generating contagion,  lays out detailed mechanisms of contagion through balance-sheet effects, is followed by a large body of theoretical and empirical research on interbank markets, mostly within a single country or region, that focuses on modeling banks’ behavior in response to shocks in the financial system. Cross-border implications of the banking network, however, are mostly ignored due to scarcity of data and rich country-level heterogeneity that may lower the explanatory power of a unified framework.

The sharp fall in global cross-border banking claims after the crisis has been persistent, either measured in Bank for International Settlements (BIS) Locational Banking Statistics (LBS) or BIS Consolidated Banking Statistics (CBS). This persistent aggregate decline in cross-border banking claims has been considered evidence of financial deglobalization. In this paper, we consider the validity of the financial de-globalization argument by studying the evolution of the global banking network before, during and after the crisis, with a particular focus on the aftermath of the crisis. Instead of trying to establish the role of the network in propagating the crisis at a global level, we take the role of the global banking network as given and seek to investigate the impact of the crisis on the network. In this context, our key contributions to the literature are twofold: (i) we measure and map the global banking network using a model-free and data driven approach; and (ii) we analyze the evolution of the network using network analysis tools, including some novel applications, that are relevant given the  characteristics of the global banking network and the available data.

The foremost challenge in constructing the global banking network is to map and identify an accurate and comprehensive network structure using the available data on cross-border banking flows. Researchers face a tradeoff between data coverage and frequency. High frequency data, such as banks’ daily transactions, often contain a limited number of banks within a country, while datasets with a good coverage of global lending mainly report country-level aggregate statistics, and are updated infrequently. This challenge is further complicated by the difficulty in identifying the composition, sources and destinations of bank flows, primarily due to the use of offshore financial centers as important financial intermediaries. Not only are global banks able to conduct cross-border lending via entities in their headquarters and offshore financial centers, but also they can lend domestically through subsidiaries and/or branches within the border of the borrower countries. BIS International Banking Statistics (IBS), through its two datasets (LBS and CBS), offer the best available data to map the international bank lending activity across countries. This is especially the case of the CBS dataset, which consolidates gross claims of each international banking group on borrowers in a particular country, aggregating those claims following the nationality of the parent banks. This nationality-based nature of CBS is an advantage over LBS, which follows a residency-based principle, and thus obscures the linkages between the borrower country and the parent bank institution, when lending originates in affiliates located in third countries (e.g., off-shores financial centers). A disadvantage of using CBS is that it registers the full claims of the affiliates, independent of how those assets were funded (e.g., a claim of a foreign affiliate that is fully funded with local domestic depositors is still counted as a claim from the country of the parent bank on the borrower country where the affiliate is located). In order to avoid this overstatement of financial linkages, which are large in the case of emerging countries as shown in the next section, we combine BIS CBS data with bank level data, taking into account the claims of foreign affiliates and the local deposit funding used by subsidiaries and branches.

We use the improved measure of cross-border banking linkages to  onstruct a sequence of global banking networks, and apply tools from network theory to analyze the evolution of economic and structural properties of the network. We take a step further to incorporate this important discussion into our choice of metrics to identify important players and trace the structural evolution of the global banking network. We provide an in-depth discussion of network measure choice based on the structural context of a core-periphery, asymmetric and unbalanced network structure and in the economic context of characterizing banking flows at the country level.

We introduce measures of node importance that capture  distinct aspects of global banking linkages. In particular, we use recursively defined Katz-Bonacich centrality and authority/hub measure to characterize country importance based on its connection to and dependence on other important countries, as well as a novel application of modularity in order to capture the regional fragmentation of the network. The flexibility of our network configuration allows us to use a small number of network metrics to reveal distinct aspects of network structure and node importance.

We find that the overall shrinkage of cross-border bank lending after the crisis, which has been the key argument behind the claims on financial de-globalization, is also reflected in the average number of links and their strength in the global banking network.

However, rich details on the evolution of the network suggest that this argument is overly simplified.

While connections within traditional major global lenders (banks in France, Germany, Japan, UK, and US) became sparser, many non-reporting countries located at the periphery of the network are more connected, mainly due to the rise of non-major global lenders out of Europe. Measured in metrics of node importance, these lenders have been steadily climbing up the rank, resulting in a corresponding decline of European lenders in status and borrowers’ decreasing dependence on traditional lending countries. Moreover, we find substantial evidence indicating increasing level of regionalization of the global banking network. Even though post-crisis retrenchment of major global and non-major European banks’ operation in the aggregate was just partially offset by the rest of the BIS reporting countries’ regional expansion, their targeted expansions have increased regional interlinkages through both direct cross-border and affiliates’ lending. More formally, using network modularity as a novel application to assess the quality of network cluster structure based on region divisions, we find that this measure increases after the crisis, thus indicating, from the perspective of network theory, that some form of regionalization characterizes the post-crisis dynamics of the global banking network. Finally, we also confirm this regionalization process through a regression analysis of the evolution of cross-border lending. After controlling by geographical distance and trade relationships as well as lender and borrower characteristics, we find a statistically significant increase in cross-border lending when both borrower and lender belong to the same region, especially in the case of peripheral lenders during the post-crisis period.

We show that without proper adjustment, country-level banking statistics suffer from multiple data issues that distort the actual role of each country in cross-border lending, and increase the difficulty of accurately detecting key players in the network. We find evidence confirming the overall shrinkage in the scale of cross-border bank lending using a variety of network analysis tools. Moreover, these methods capture rich dynamics that occur inside the global banking network and are not captured by traditional aggregate indicators.

Using a set of centrality measures with meaningful economic interpretations, we delve substantially deeper to capture the interconnectedness faced by each country. While the structural stability of the highly concentrated global banking network is mainly due to the stability of major global lenders, we observe decline in importance for non-major global European lenders and a corresponding rise in the ranks for lenders from other region, comprised of mostly emerging market lenders. The hidden dynamics of the global banking network after the crisis suggest that the assertion that cross-border lending has shrunk globally seems to miss out significant details.

NOTE: IMF Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

With a new futures market, Bitcoin is going mainstream

From The Conversation.

The Chicago Mercantile Exchange will soon begin trading Bitcoin derivatives (futures contracts), signalling the cryptocurrency is now a mainstream asset class. Bitcoin has had limited use in the mainstream economy in part because the volatility of its price. The value of the currency might go up or down significantly between the time a deal is struck and delivery.

The introduction of Bitcoin futures contracts will allow investors to manage this risk, and make it safer to hold and trade in Bitcoin. This will make the cryptocurrency more accessible to individuals and businesses, and encourage developers to build more products and services on top of the technology.

Futures and other derivatives are contracts between two parties to fix the price of an underlying asset (currencies, shares, commodities etc.) over a period of time or for a future transaction. The buyer of these contracts commits to purchase the underlying asset at a set price and at a certain date, and the seller commits to sell.

There are two main uses for these contracts. First, to reduce price risk by freezing future prices. The second use is speculation. For instance, a speculator would commit to buy a commodity/share/currency at a certain time, hoping that the market price at the time of delivery is higher than the price set in the contract.

Airlines commonly buy long term oil future contracts to hedge against the potential increase in fuel price, or to take advantage of what they believe to be a low price.

Similarly, future contracts will enable traders to lock in the value of Bitcoin for a defined period of time. This effectively removes the risk associated with fluctuation in value. In addition, since these contracts will be traded on the Chicago Mercantile Exchange, the exchange effectively guarantees that both buyers and sellers will abide by the agreement.

In 2010, one Bitcoin was worth less than one hundredth of an Australian cent. As of Monday the 6th of November, the price is near A$10,000.

The market capitalisation of Bitcoin is now well over A$160 billion, which is larger than the GDP of most small countries. As the price of Bitcoin has grown, so too have transaction volumes, showing an increasing use of the cryptocurrency.

As a result, Bitcoin is starting to look like a credible investment in any respectable financial portfolio.

Although, this is not the first futures contract for cryptocurrency. Futures contracts already exist for both Ethereum and Monero.

But the Chicago Mercantile Exchange’s futures contract is significant as the CME group manages not only the Chicago Mercantile Exchange, but also the Chicago Board of Trade and New York Mercantile Exchange and Commodity Exchange. Combined, these exchanges represent the largest derivative market in the world.

The decision to issue futures contracts on Bitcoin rather than another derivative is also significant. So far Bitcoin derivatives have mainly been swap agreements. A swap is a commonly used financial tool where two parties agree to swap financial instruments, such as interest or currencies. The key point is that the two parties, the buyer and seller, make a deal directly with each other.

As a swap agreement is not done through an exchange, the risk of a party not delivering on the agreement can be quite high. If one party decides to opt out, the agreement has to be terminated. This leaves the other party exposed.

Futures contracts eliminate this “counterparty” risk, as the exchange clears the transaction and guarantees delivery. And unlike swaps, futures contracts are standardised (in term of size, how much is going to be traded, and maturity date etc.). This means futures contracts can be traded at any time until maturity, making them very liquid and accessible.

The lack of a futures market in Bitcoin was a significant barrier to it becoming a mainstream asset class. You can buy and sell forward contracts on the Fijian dollar, for instance, meaning that institutional funds anywhere in the world can hold Fijian dollars in their portfolio and manage the risks of that asset.

But they cannot yet do that with Bitcoin. Until now, there has been no way to offload the risks associated with fluctuating prices. An investor could always hold the cryptocurrency, but they would do so fully exposed to price volatility.

The introduction of Bitcoin futures contracts will allow traders to hedge against this volatility and eliminate the currency risk. This will make Bitcoin more attractive for both individuals and corporations.

As crypto-assets become a mainstream investment class, other products emerge around them (such as exchange traded funds). It will also have a similar effect to that of mainstreaming share ownership – enabling a much larger fraction of the population to diversify their asset portfolios and income streams.

This will unlock some of the value currently being built on cryptocurrencies and blockchain technology – new products and services – that are currently only accessible to a relatively small number of the early enthusiasts and those helping build the technology.

The increased flow of investment funds into Bitcoin will likely push prices up further, but it will also incentivise more work to build products and services on the technology. Bitcoin just went mainstream.

Authors: Jason Potts, Professor of Economics, RMIT University; Marie-Anne Cam, Senior Lecturer in Finance, RMIT University

NAB settles BBSW court case for $50m

From InvestorDaily.

In an announcement made late on Friday, NAB admitted that on 12 occasions between 2010 and 2011 its employees “attempted to engage in unconscionable conduct in breach of the ASIC Act”.

The settlement will see NAB fork out a $10 million penalty, cover ASIC’s costs of $20 million and donate $20 million to an ASIC-nominated financial consumer protection fund – all of which will be reflected in its 2017 financial year results.

NAB is the second of three major banks to settle with ASIC following claims of rigging the bank bill swap rate (BBSW). ANZ has already settled, leaving Westpac as the last bank remaining defending the court case.

Commenting on the settlement, NAB group chief executive Andrew Thorburn said the way BBSW was calculated “had changed since that time”.

“We accept we did not meet the high standards of professional conduct that ASIC, the community and NAB expects of itself, in that market during that period,” Mr Thorburn said.

“The ASX is now responsible for the administration of BBSW and NAB fully supports the reforms that are being introduced by the ASX to enhance trust and transparency in the BBSW market.

The Best Indicator Yet Rates Are On Their Way Up

The US 10-Year Bond Rates climbed above 2.4% yesterday and provides a strong signal that interest rates in the USA are on their way up as the FED reduces QE and moves benchmarks higher. After the Trump effect took hold late last year, we reached a peak in March, before falling away but the current rates are level with those in May.

There will be a knock on effect on the global capital markets of course, and as Australian Banks are net borrowers of these funds, will feel the effect of more expensive capital, and this is likely to flow through to their product pricing. As Treasury Head John Fraser said today:

“…though global monetary conditions can also impact upon the wholesale funding costs of Australian banks”.

We suspect the markets are underestimating the potential for rates rises, and soon.


How Might Increases in the Fed Funds Rate Impact Other Interest Rates?

From The St. Louis Fed Blog.

The Federal Reserve’s main instrument for achieving stable prices and maximum employment is the target for the federal funds rate. The idea is that by affecting the rate at which banks lend to each other overnight, other interest rates may be affected. In turn, this would also affect nominal variables (such as inflation) and real variables (such as output and employment).

In December 2015, the Fed ended seven years of near-zero policy rates. Through a series of increases since then, the target rate has been gradually raised by one percentage point. The current monetary policy outlook, as stated recently by Fed Chair Janet Yellen, is to continue increasing the target rate due to worries that a strong labor market may create inflationary pressures.1

Questions about Rate Increase Impacts

The fed funds rate is thus expected to continue rising in the near future. This would undoubtedly mean that other short-term interest rates will increase in tandem.

But what about long-term interest rates? What would the impact be on those rates that arguably matter the most for real economic activity, such as mortgages rates, Treasury bond yields and corporate bond yields?

The future is always hard to predict, but we can take an educated guess by looking at the recent behavior of short-term and long-term interest rates, and how they move with the fed funds rate.

Impact on Treasury Yields

The figure below displays three key interest rates over a period of 30 years:

  • The federal funds rate
  • The interest rate on a one-year Treasury bond
  • The interest rate on a 10-year Treasury bond

As we can see, the fed funds rate and the one-year Treasury rate track each other very closely. Although it is still debatable whether the Fed leads or follows the market, movements in the policy rate are associated with similar movements in short-term interest rates.2

In contrast, the interest rate on a 10-year Treasury bond does not appear to move as closely with the fed funds rate. While there appears to be some co-movement, the 10-year interest rate appears to follow its own declining path.3

Impact on Mortgage Rates

Is the interest rate on a 10-year Treasury bond representative of long-term interest rates? The next figure compares this rate to the average rate on a 30-year mortgage.

Clearly, the two move very closely together, though there is a difference in level due to the higher risk, lower liquidity and longer term of mortgages. If we were instead to look at other long-term interest rates, such as the average rate on corporate bonds, the results would be similar.

Impact on the Yield Curve

Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.4 The next figure compares the fed funds rate with the difference between 10-year and one-year Treasury bond rates.

This difference is meant to represent the yield curve at each moment in time with a single number. Note that there is a strong negative correlation between the fed funds rate and the term premium of Treasury bonds. When the policy rate increases, the spread between one- and 10-year Treasury bonds decreases.

Although it is still too early to tell, this pattern appears to be present in the latest period of interest rate hikes.

Overall Impact of Fed Funds Rate Target Increases

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.

There is, of course, the possibility that some unforeseen and fundamental change in the economy will drive long-term interest rates up, but this increase would unlikely be driven by monetary policy alone.

Notes and References

1 For example, see Appelbaum, Binyamin. “Janet Yellen Says Fed Plans to Keep Raising Rates,” New York Times, Sept. 26, 2017.

2 The interest rate on a three-month Treasury bond would look even more similar to the fed funds rate.

3 For further analysis on these trends, see Martin, Fernando M. “A Perspective on Nominal Interest Rates,” Economic Synopses, No. 25, 2016.

4 The yield curve plots interest rates as a function of maturity dates.

S&P 500 Reaches New Heights (Again)

The US index has reached another high and a 5-year view highlights the strong growth, and momentum since Trump won the election last year.

So, what are the expectations ahead? Well, according to a piece from Moody’s:

An overvalued equity market and an extraordinarily low VIX index offer no assurance of impending doom for US equities. Provided that interest rates do not rocket higher, expectations of corporate earnings growth should be sufficient for the purpose of avoiding a severe equity market correction that would doubtless include the return of corporate bond yield spreads in excess of 700 bp for high yield and above 200 bp for Ba a-rated issues.

For now, the good news is that early September’s Blue Chip consensus expects core profits, or pretax profits from current production, to grow by 4.4% in 2017 and by 4.5% in 2018. Moreover, earnings-sensitive securities should be able to shoulder the 2.5% 10-year Treasury yield projected for 2017’s final quarter. However, the realization of a projected Q4-2018 average of 3.0% for the 10-year Treasury yield could materially reduce US share prices.

Since 1982, there have been seven episodes when the month-long average of the market value of US common stock sank by at least -10% from its then record high. Only two of the seven were not accompanied by at least a -5% drop by core profits’ moving yearlong average from its then record high.

In conclusion, the rich valuation of today’s US equity market very much warns of at least a -10% drop in the market value of US common stock in response to either unexpectedly high interest rates or a contraction of profits. Perhaps, the prudent investor should be braced for at least a -20% plunge in the value of a well-diversified portfolio at some point during the next 18 months.

LIBOR Transition Creates Uncertainty for SF Market

Replacing LIBOR presents challenges for the structured finance (SF) market that are likely to be addressed in the context of industry-wide initiatives, Fitch Ratings says.

The long lead time and a desire to avoid disruption to floating-rate bond markets such as SF should support the transition to standard benchmarks as successor reference rates. The impact on SF will depend on which rates are adopted, how consensual the process is across all market participants, and how they deal with technical and administrative challenges.

LIBOR is the reference rate for SF bonds and related derivatives contracts in several large SF markets. Almost all of the USD450 billion of US CLO notes outstanding reference LIBOR, as do USD186 billion of US sub-prime/Alt-A RMBS and USD24 billion of US prime RMBS. US student loan ABS commonly reference LIBOR. Elsewhere, nearly all UK RMBS reference Libor. Some underlying loans, such as leveraged loans, US hybrid adjustable-rate mortgages, US student loans, and auto loans, reference LIBOR.

Panel banks will maintain LIBOR until end-2021. This gives capital markets four-and-a-half years to agree a successor regime for the bulk of bonds currently linked to LIBOR, enabling a coordinated transition to as few benchmarks as needed. This would avoid costly ad hoc negotiations and potentially complicated bespoke transaction amendments. Loan markets may follow suit, although the risk of fragmentation geographically and by asset class could create SF basis risk in respect of existing loans, or alter the level of credit-enhancing excess spread.

There are practical challenges in co-ordinating transition. Voting rights in SF transactions, in some cases requiring majority consent of all classes of notes, may complicate any amendment process and even increase the scope for inter-creditor disputes. Trustees will also have an important role in determining what conditions are placed on transaction parties. These challenges will require effective use of the long lead time available.

To preserve liquidity, we think bond markets will generally follow initiatives in the derivatives market, where funding is hedged and discount rates determined. The International Swaps and Derivatives Association is examining fall-back provisions in LIBOR swap contracts, and working groups in some jurisdictions have recommended alternative near-risk free reference rates for the derivatives market, including the Sterling Overnight Index Average (SONIA) in the UK and the Broad Treasuries Repo Financing Rate in the US.

But it remains unclear whether the eventual successors to LIBOR will be overnight rate benchmarks or forward rate benchmarks, how far this will vary from country to country, and whether loan markets will adopt the same reference rates at the same time (reducing basis risk). At the heart of these questions is the effect on the value of currently contracted interest payments.

Any move to replace LIBOR with a benchmark that increased interest costs, particularly for retail borrowers, would face political objections. But a reduction in interest earned could also face opposition. Balancing these interests may prompt efforts to adjust margins to leave loan and bond coupons unchanged. Challenges coordinating the transition for assets and liabilities could leave SF transactions with basis risk, or change the level of excess spread. Possible consequences for ratings would also depend on the weighted average life remaining after 2021.

Commercial borrower behaviour may contribute to these risks. For example, some commercial real estate and leveraged loans include fall-back provisions aimed at managing temporary disruptions in LIBOR determination (such as polling a small panel of banks). These could make it harder to co-ordinate the transition for underlying loans and SF bonds, particularly in the leveraged loan market.

Unlike floating-rate commercial mortgages, leveraged loans are typically not hedged against interest rate risk, and may have more latitude in diverging from standardised successor benchmarks emerging from the derivatives market. If leveraged loan borrowers felt it was in their commercial interests to argue that fall-back provisions apply, basis risk would arise if CLOs moved to more liquid successor benchmarks.


RBA Deputy Governor Guy Debelle spoke about Interest Rate Benchmarks at FINSA today. He made three points:

First, the longevity of LIBOR cannot be assumed, so any contracts that reference LIBOR will need to be reviewed.

Second, actions to ensure the longevity of BBSW are well advanced. While these changes entail some costs, the cost of not doing so would be considerably larger.

Third, consider whether risk-free benchmarks are more appropriate rates for financial contracts than credit-based benchmarks such as LIBOR and BBSW.

Today I am going to talk again about interest rate benchmarks, as recently there have been some important developments internationally and in Australia. These benchmarks are at the heart of the plumbing of the financial system. They are widely referenced in financial contracts. Corporate borrowing rates are often priced as a spread to an interest rate benchmark. Many derivative contracts are based on them, as are most asset-backed securities. In light of the issues around the London Inter-Bank Offered Rate (LIBOR) and other benchmarks that have arisen over the past decade, there has been an ongoing global reform effort to improve the functioning of interest rate benchmarks.

I will focus on the recent announcement by the UK Financial Conduct Authority (FCA) on the future of LIBOR, and the implications of this for Australian financial markets. I will then summarise the current state of play in Australia, particularly for the major interest rate benchmark, the bank bill swap rate (BBSW). Our aim is to ensure that BBSW remains a robust benchmark for the long term. I will also discuss the important role for ‘risk-free’ interest rates as an alternative to credit-based benchmarks such as BBSW and LIBOR.

The Future of LIBOR and the Implications for Australia

LIBOR is the key interest rate benchmark for several major currencies, including the US dollar and British pound. Just over a month ago, Andrew Bailey, who heads the FCA which regulates LIBOR, raised some serious questions about the sustainability of LIBOR. The key problem he identified is that there are not enough transactions in the short-term wholesale funding market for banks to anchor the benchmark. The banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this, as they have to rely mainly on their ‘expert judgment’ in determining where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not compel banks to provide submissions and the panel banks may not voluntarily continue to do so.

This four year notice period should give market participants enough time to transition away from LIBOR, but the process will not be easy. Market participants that use LIBOR, including those in Australia, need to work on transitioning their contracts to alternative reference rates. This is a significant issue, since LIBOR is referenced in around US$350 trillion worth of contracts globally. While a large share of these contracts have short durations, often three months or less, a very sizeable share of current contracts extend beyond 2021, with some lasting as long as 100 years.

This is also an issue in Australia, where we estimate that financial institutions have around $5 trillion in contracts referencing LIBOR. Finding a replacement for LIBOR is not straightforward. Regulators around the world have been working closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR, and to strengthen the fall-back provisions that would apply in contracts if LIBOR was to be discontinued. The transition will involve a substantial amount of work for users of LIBOR, both to amend contracts and update systems.

Ensuring BBSW Remains a Robust Benchmark

The equivalent interest rate benchmark for the Australian dollar is BBSW, and the Council of Financial Regulators (CFR) is working closely with industry to ensure that it remains a robust financial benchmark. BBSW is currently calculated from executable bids and offers for bills issued by the major banks. A major concern over recent years has been the low trading volumes at the time of day that BBSW is measured (around 10 am). There are two key steps that are being taken to support BBSW: first, the BBSW methodology is being strengthened to enable the benchmark to be calculated directly from a wider set of market transactions; and second, a new regulatory framework for financial benchmarks is being introduced.

The work on strengthening the BBSW methodology is progressing well. The ASX, the Administrator of BBSW, has been working closely with market participants and the regulators on finalising the details of the new methodology. This will involve calculating BBSW as the volume weighted average price (VWAP) of bank bill transactions. It will cover a wider range of institutions during a longer trading window. The ASX has also been consulting market participants on a new set of trading guidelines for BBSW, and this process has the strong support of the CFR. The new arrangements will not only anchor BBSW to a larger set of transactions, but will improve the infrastructure in the bank bill market, encouraging more electronic trading and straight-through processing of transactions. The critical difference between BBSW and LIBOR is that there are enough transactions in the local bank bill market each day relative to the size of our financial system to calculate a robust benchmark.

For the new BBSW methodology to be implemented successfully, the institutions that participate in the bank bill market will need to start trading bills at outright yields rather than the current practice of agreeing to the transaction at the yet-to-be-determined BBSW rate. This change of behaviour needs to occur at the banks that issue the bank bills, as well as those that buy them including the investment funds and state treasury corporations. The RBA is also playing its part. Market participants have asked us to move our open market operations to an earlier time to support liquidity in the bank bill market during the trading window, and we have agreed to do this.

While we all have to make some changes to systems and practices to support the new methodology, the investment in a more robust BBSW will be well worth it. The alternative of rewriting a very large number of contracts and re-engineering systems should BBSW cease to exist would be considerably more painful.

The new regulatory framework for financial benchmarks that the government is in the process of introducing should provide market participants with more certainty. Treasury recently completed a consultation on draft legislation that sets out how financial benchmarks will be regulated, and the bill has just been introduced into Parliament. In addition, ASIC recently released more detail about how the regulatory regime would be implemented. This should help to address the uncertainty that financial institutions participating in the BBSW rate setting process have been facing. It should also support the continued use of BBSW in the European Union, where new regulations will soon come into force that require benchmarks used in the EU to be subject to a robust regulatory framework.

Risk-free Rates as Alternative Benchmarks

While the new VWAP methodology will help ensure that BBSW remains a robust benchmark, it is important for market participants to ask whether BBSW is the most appropriate benchmark for the financial contract.

For some financial products, it can make sense to reference a risk-free rate instead of a credit-based reference rate. For instance, floating rate notes (FRNs) issued by governments, non-financial corporations and securitisation trusts, which are currently priced at a spread to BBSW, could instead tie their coupon payments to the cash rate.

However, for other products, it makes sense to continue referencing a credit-based benchmark that measures banks’ short-term wholesale funding costs. This is particularly the case for products issued by banks, such as FRNs and corporate loans. The counterparties to these products would still need derivatives that reference BBSW so that they can hedge their interest rate exposures.

It is also prudent for users of any benchmark to have planned for a scenario where the benchmark no longer exists. The general approach that is being taken internationally to address the risk of benchmarks such as LIBOR being discontinued, is to develop risk-free benchmark rates. A number of jurisdictions including the UK and the US have recently announced their preferred risk-free rates.

One issue yet to be resolved is that most of these rates are overnight rates. A term market for these products is yet to be developed, although one could expect that to occur through time. Another complication is that the risk-free rates are not equivalent across jurisdictions. Some reference an unsecured rate (including Australia and the UK) while others reference a secured rate like the repo rate in the US.

As the RBA’s operational target for monetary policy and the reference rate for OIS (overnight index swap) and other financial contracts, the cash rate is the risk-free interest rate benchmark for the Australian dollar. The RBA measures the cash rate directly from transactions in the interbank overnight cash market, and we have ensured that our methodology is in line with the IOSCO benchmark principles. However, the cash rate is not a perfect substitute for BBSW, as it is an overnight rate rather than a term rate, and doesn’t incorporate a significant bank credit risk premium.

Federal Reserve Board Proposes to Produce Three New Reference Rates

Given questions about the transparency of the U.S. dollar LIBOR rate benchmark, and the quest for a more robust alternative, the US Federal Reserve Board has requested public comment on a proposal for the Federal Reserve Bank of New York, in cooperation with the Office of Financial Research, to produce three new reference rates based on overnight repurchase agreement (repo) transactions secured by Treasuries.

The most comprehensive of the rates, to be called the Secured Overnight Financing Rate (SOFR), would be a broad measure of overnight Treasury financing transactions and was selected by the Alternative Reference Rates Committee as its recommended alternative to U.S. dollar LIBOR. SOFR would include tri-party repo data from Bank of New York Mellon (BNYM) and cleared bilateral and GCF Repo data from the Depository Trust & Clearing Corporation (DTCC).

“SOFR will be derived from the deepest, most resilient funding market in the United States. As such, it represents a robust rate that will support U.S. financial stability,” said Federal Reserve Board Governor Jerome H. Powell.

Another proposed rate, to be called the Tri-party General Collateral Rate (TGCR) would be based solely on triparty repo data from BNYM. The final rate, to be called the Broad General Collateral Rate (BGCR) would be based on the triparty repo data from BNYM and cleared GCF Repo data from DTCC.

The three interest rates will be constructed to reflect the cost of short-term secured borrowing in highly liquid and robust markets. Because these rates are based on transactions secured by U.S. Treasury securities, they are essentially risk-free, providing a valuable benchmark for market participants to use in financial transactions.

Comments on the proposal to produce the three rates are requested within 60 days of publication in the Federal Register, which is expected shortly.

The Australian stocks most at risk from a rise in global bond yields

From Business Insider.

Global bond yields are poised to rise again and that will leave key sectors of the Australian share market exposed, according to Credit Suisse.

In a research note called “The Bondcano is back”, equity analysts Hasan Tevfik and Peter Liu have looked into which Aussie stocks are most vulnerable to the effects of higher bond yields.

Here’s the list:

It’s mostly comprised of stocks in stable industries which provide a consistent stream of dividend income to investors. In other words, stocks that act as a proxy for bonds.

It follows that such stocks are more attractive in the current environment, as they provide a safe return on investment that’s still higher than the return provided by low-yielding bonds.

Tevfik and Liu’s list also includes stocks that are currently trading on high price-to-earnings ratios, and stocks with high leverage which have benefited from cheap debt in the low bond yield environment.

Global bond yields have fallen this year as bond markets began to doubt the pace of inflation growth in developed markets.

However, Credit Suisse expects the yield on the benchmark US 10-year treasuries to push higher in the second half of the year.

“Our rate strategists expect US Treasury yields to reach 2.8% by the end of the year driven by a combination of stronger inflation, better economic activity vs expectations and further signs that central banks will continue their process of normalisation,” Tevfik and Liu said.

The two analysts said that the Aussie stock sectors most at risk from a rise in bond yields currently make up 22% of the market capitalisation of the ASX200.

They say the valuation of those sectors is currently trading on a price-to-earnings ratio of 21 times projected earnings over the next 12 months, which is 25% higher than the market average:

Tevfik and Liu also considered the influence of passive investment funds in their analysis.

Stocks which are most vulnerable to a rise in bond yields also make up a large position in the holdings of passive funds, due to their safer and less volatile nature.

Given the huge rise of passive investment vehicles in recent years, the analysts said there would be no major falls in their list of at-risk stocks unless passive funds changed their holdings.

Looking at the market more broadly, Tevfik and Liu said that share prices generally benefit when interest rates are low, and equity investors should be wary of the “Bondcano”.

“We think the Bondcano will continue to erupt, so what has been a tailwind for large parts of the equity market will become a headwind,” they said.

However, the threat to some companies from rising bond yields will be an opportunity for others. The two analysts added a table of stocks which stand to benefit if bond yields rise: