Growing dislocations between financial assets and derivatives are a symptom of increasing fragmentation in global financial markets. This poses a systemic risk which policymakers need to address.
In the world of financial derivatives, strange things are happening.
Attention has recently focused on the sharp move in the spread between US Treasury yields and interest rate swaps.
Swap yields, which have historically traded higher than Treasury bond yields, now trade significantly below.
But it is not just US Treasury asset swap spreads which are behaving oddly.
In foreign exchange markets, the so-called “cross-currency basis” has rocketed. Forward exchange rates should in theory be determined by the interest rate differential between the two currencies.
Since the 2008 financial crisis, the difference between the theoretical and actual forward exchange rate, the “basis”, has become more volatile. Recently, it has collapsed again.
Credit and equity markets have not been immune either. In both cases, cash and derivatives markets have diverged, with the underlying cash assets cheapening significantly versus their related derivatives.
So why is this widespread divergence between assets and derivatives happening?
The first thing to say is that it is not entirely unprecedented: during the 2008 financial crisis, similar dislocations occurred. That was during a period of financial market meltdown, which caused the collapse of several large institutions and was only quelled by massive intervention by monetary and fiscal authorities, the costs of which are well known.
But there is no financial crisis today. So what’s the cause this time?
One frequently offered explanation is that pressure on banks to reduce the size of their balance sheets, especially with year-end approaching, is causing supply-demand imbalances which led to strange market distortions. It would be reasonable to expect these distortions to ease once year-end balance sheet pressures are out of the way.
But this explanation is only part of a much larger picture.
The values of derivatives are ultimately kept in line with the values of their underlying assets by arbitrage. The activity of arbitrageurs seeking to lock in a profit limits the divergence between an asset and its related derivative.
During the financial crisis, many counterparties lost confidence in each others’ creditworthiness and so refused to deal with each other. As markets became fragmented, many theoretical arbitrage opportunities could not be exploited in practice. As a result valuations became dislocated.
The root cause of today’s dislocation between financial assets and derivatives is the same as it was during the financial crisis: the fragmentation of markets. But this time the fragmentation is not due to a loss of confidence, but to regulation.
New regulation has affected many different market participants in many different ways and no doubt each set of regulations has been implemented with the aim of limiting risk within the sphere addressed. Indeed, one could justifiably say that in each individual sphere regulations have largely succeeded in this aim.
But the aggregate effect has been to drive obstacles between different types of market participants, fragmenting markets. The divergence between asset and derivatives pricing is one expression of this. Diminished liquidity in some financial markets is another.
Why should policymakers or regulators care if the pricing of obscure financial derivatives has diverged from their theoretical values?
Here are two reasons. First, the market is very large ($85tn on some estimates): the potential systemic risks of a mispricing of such a large market cannot be dismissed.
Second, derivatives prices have become integral to many regulatory frameworks themselves. Regulators accept derivatives contracts as risk-limiting hedges for banks’ asset portfolios. In many jurisdictions, the calculations of insurance company and pension fund liabilities reference swap rates: mispriced derivatives have consequences for real-world pensions and insurance contracts.
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