Are FX swaps and forwards missing global debt? Why the BIS is wrong.

In a fascinating piece of statistical detective work published in the latest BIS Quarterly Review, three of its foremost staff members argue that the use of FX swaps and forwards is hiding a massive quantity of debt because current accounting conventions place it off  balance sheet. They estimate that, in respect of US dollar debt, this financial dark matter is worth some USD10.7 trillion. Their conclusion is that FX swaps and forwards should really be accounted for on the balance sheet like repo.

The BIS paper is well worth reading and, as one would expect from these three authors, is a masterclass on how to make the best use of available statistics. Unfortunately, their basic premise is flawed.

First, a technical criticism. The paper claims that currency swaps and FX swaps are the same. I spend a lot of time trying to explain to students that, just because these instruments are both called swaps, it does not mean they are the same. Currency swaps are not analogous to FX swaps. There are fundamental differences.

A currency swap is an exchange of a series of interest payments in different currencies throughout the life of the swap and an exchange of principal amounts in the same currencies at maturity. At the end, a currency swap leaves each party with the currency they bought through the swap. If they want to get back into their original currency, they will need to transact another FX deal. Consequently, a currency swap creates exchange rate risk (which is typically used to hedge existing exchange rate risk).

An FX swap, on the other hand, creates no exchange rate risk for its counterparties. This is because currencies are sold and repurchase at fixed spot and forward rates. In other words, when you sell one currency for another through an FX swap, you know from the start how much of your original currency you will get back. An FX swap is a liquidity management tool, not a risk management tool.

I fear the BIS paper is working on the basis of a common but fallacious definition of a currency swap, in which there is also an initial exchange of currencies. But this structure, which is indeed equivalent to an FX swap, is actual a combination of a currency swap and a spot deal, with the currency swap acting as a hedge. The combination is found with new bond issues, when the proceeds of the new issue need to be swapped. But where existing issues are being hedge, the spot deal is unnecessary. It is therefore not an essential component of a currency swap.

A correctly-defined currency swap is analogous, not to an FX swap, but to an outright FX forward, which creates the same exchange rate risk. Indeed, there was once a market called long-term FX (LTFX), which offered multi-year outright forwards as an alternative to currency swaps. Currency swaps and outright forwards differ only in the distribution of cash flows. In an outright forward, all cash is exchanged at maturity. In a currency swap, cash is exchanged throughout the life of the transaction. An outright forward is an exchange of two forward deposits or zero-coupon bonds in different currencies. A currency swap is like an exchange of two interesting-bearing bonds in different currencies.

However, to be frank, the misunderstanding about currency swaps and FX swaps is not fatal to the BIS paper. I raise it merely to set the record straight in case any of my students should read the paper.

The basic premise of the BIS paper is that currency swaps and FX forwards are incorrectly classified as derivatives, which inappropriately shifts them off balance sheet, whereas they are “functionally equivalent to borrowing and lending in the cash market” and should similarly be captured on the balance sheet.

To illustrate the point, the paper offers three alternative ways of funding the purchase of a foreign currency security without running currency risk:

  • Buy the foreign currency spot, use it to purchase the security and hedge the currency risk by selling the proceeds of the security forward.
  • Use an FX swap in which the spot leg exchanges domestic for foreign currency to buy the security and the forward leg converts the proceeds of the security back into domestic currency.
  • Fund the security by borrowing foreign currency through the repo market.

The first two transactions are currently accounted for simply as a substitution of a domestic currency asset by a foreign currency asset, with no gross change in the size of the balance sheet, which means the transactions are off balance sheet. The third transaction, the repo, sees the security bought by the investor and repoed out as collateral to raise funding, with the security remaining on the balance sheet of the investor, where it is joined by the cash proceeds of the repo, resulting in a gross increase in the size of the balance sheet. (The security stays on the balance sheet of the investor because he continues to be exposed to the risk of the security and to earn return on it because of his contractual commitment under the repo to repurchase at a fixed price.)

The problem, according to the BIS paper, is that accounting rules allow FX swaps and forwards to be treated as derivatives. But derivatives normally involve a net settlement and not payments of gross principal amounts. The paper is correct in arguing that FX swaps and forwards are not derivatives, but incorrect about the appropriate accounting rules.

A derivative should not be defined merely as an instrument whose value depends on prices derived from other instruments. The financial market is an ecosystem in which the value of everything is ultimately interconnected with everything else. In other words, on the basis of how value is derived, all financial instruments have a claim to be derivatives. It is just that the derivation is easier to see with derivatives because of their explicit contracts.

The real definition of a derivative is an instrument which never pays principal, only profit or loss, ie net not gross settlement. This definition allows a meaningful distinction to be drawn between derivatives and the other class of off-balance sheet of financial instrument, forwards. Forwards pay principal amounts but are off balance sheet because these payments are due at maturity, whereas balance sheets measure only current assets and liabilities. This means that FX swaps and currency swaps are forwards, not derivatives (they have derivative versions in the form of NDFs).

It is important to distinguish forwards from derivatives, despite both types of instrument being off-balance sheet. For most of its life, the credit risk on a forward is a net replacement cost, the same as a derivative. But at maturity, the payment of principal amounts loom and expose the parties to gross settlement risk. In other words, forwards are riskier than derivatives even though they perform the same tasks. This can be seen by comparing the risk profiles of a currency swap and a true derivative such as an interest rate swap. The risk on the currency swap rises as it ages, describing a concave curve, to reach a peak at maturity that can be a multiple of the contract amount. In contrast, the risk on an interest rate swap rises as it ages to a much lower peak (typically below 5% of notional principal amount) before falling to zero at maturity as the settlement of interest payments reduces the impact of further interest rate divergence.

The fact that forwards are riskier than derivatives might seem to support the BIS argument for changing the accounting treatment of forwards by bringing them onto the balance sheet. The problem with that argument is that you would be asking a balance sheet to do things which is not designed to do. Balance sheets are supposed to measure current assets and liabilities. The appropriate way of measuring future assets and liabilities is discounted adjustments in the form of net replacement cost because that is the risk that is actually being taken. If the counterparty fails, the non-defaulting party can sell off the currency he has bought, which means the risk of a net loss.

So, why is repo accounted for differently to FX forwards? The paper says, “in each case, the investor’s economic position is much the same”. I disagree. FX forwards do not increase leverage. In the case of outright forwards and (correctly-defined) currency swaps, you permanently lose one currency in exchange for another. Where’s the hidden debt here?

The case of FX swaps may appear more complicated, because they are analogous in structure and apparent purpose to repos in that they both consist of spot and forward legs at fixed prices and are both used for collateralized lending and borrowing. And in practice, these two transactions are often substitutes (the thin repo market in a number of Asian markets is partly due to competition from the FX swap market, which has the advantage of established liquidity and use of which avoids the cost of collateralization with securities). However, I would argue that an FX swap does not increase leverage, as parties lose the purchasing power of the currency they sell. Their purchasing power does not increase. Again, where’s the debt?[1]

In contrast, in a repo, the seller (cash borrower) converts a security to cash, while keeping the risk/return on the security. The cash increases his purchasing power, which allows him to leverage his position by buying another security.

Of course, things can go wrong with FX swaps. The other party can default, leaving the non-defaulting party with the wrong currency. The sale of that currency for the original can incur loses. However, such loses will be marginal.

Interestingly, if accounting rules do change, they are likely to go in the opposite direction to the BIS suggestion. In 2011, the IASB proposed to account for repo like a derivative and some countries do so. This involves derecognizing the collateral and removing it from the balance sheet but adding the replacement cost of the repurchase leg. That proposal was rejected by the market as likely to inject unwelcome volatility into balance sheets.

[1]  And the argument in the BIS paper that an FX swap is like an outright forward once the spot leg has settled ignores this does not erase the risk created by the spot leg and hedged by the forward leg.


Real-world finance: How my degree is preparing me for industry

By Xuefei Zhu, MSc International Securities, Investment and Banking at the ICMA Centre, Henley Business School.

It feels like only yesterday that I finished my blog talking about my unforgettable first week, and now I have just completed my first term studying at the ICMA Centre at Henley Business School. One term in, and I can now say that I have experienced the practical benefits and industry relevance in the course. I will show you what I mean…

The Dealing Rooms

alfie-dealing-roomThe ICMA Centre has three dealing rooms that simulate stock market trading. I have learned so much in these trading simulations. Our professor, who has been a professional trader for more than 8 years, leads the session. The way he teaches is really different, most of the time he lets us make our own trades. At first I was really confused and frustrated because I always ended up losing money and didn’t know how to earn profits. Looking back, I realize that this is the process we must go through, and part of the solution is to discover the answer by ourselves through experience. The truth is, trading is about trial and error before you finally start earning. Different traders have their own strategies and what you need to do is discover what yours is. When using the dealing rooms, I always made sure to ask the professor questions, and speak to those who were better so that we could share trading experiences and learn from each other.

The more you learn, the more you discover you don’t yet know. I remember one friend who told me that despite choosing more than 10 modules focusing on different fields of capital markets, he still needed to dedicate a lot of time to learning outside the module and developing a keen eye for other areas such as management. This shows the ICMA Centre’s focus on professional education. Especially during the second term, some professors are pioneers in their fields of finance. At the ICMA Centre you will find a new world of finance and be fascinated by it!

Modern Finance Case Studies

alfie-project-filesThe experience I was most impressed with in the first term was the four project assignments. All of them were true finance cases that needed to be solved. I particularly enjoyed the crisis of Deutsche bank, which had only just happened at that time of the assignment. Our team members needed to pull data from the Bloomberg or Thomson Reuters terminals to come up with the best solutions. There is a lot that you need to learn throughout the course, and the whole process has given me a deeper understanding of what abilities I really need to improve and what an efficient team should be like.

Building friendships and networking

alfie-christmasPractical experience at the ICMA Centre is not just learned from the modern trading systems, or challenging case study projects, or even the professors. To some degree, the friends around you are some of the most important teachers. Some of them have great experiences already based on different careers and life paths. More and more I believe that completing several years of work and then going back to study is a better learning model, because you will find out what you truly need and go for it! I will always remember the help I have had from friends and teammates. As the old saying goes: a friend in need is friend indeed. From a long-term perspective, these friends will all become your future career connections.

If you have not studied abroad, you will never know how hard you have to work to go through the final exams and assignments. It is a totally different experience from domestic education where the pressure is just before the exams; in foreign universities, if you want to get a high score, you must work hard and learn more during the whole time. This makes you appreciate the high level and professional experience you gain here.

It is your experience that makes you different from others. The first term has given me a brand-new door to my career in finance. It is the beginning of a new world, and all the fantastic future possibilities are just in front of me.

Young Success: KMS Success Academy’s Talk at the ICMA Centre

The Finance Society’s Event of the Year

Written by Dina Ghanma

picture4“Life begins at 50!” is something those who know me well have definitely heard me say at least once. “Before 50, you’re just struggling for ‘success’, but at 50, things start looking up” was my justification. A bit too pessimistic? Perhaps. But fortunately, our recent guests at the ICMA Centre have probably proved me wrong!

Three successful under-30s

Last Thursday, the Finance Society at the University of Reading held a members-only talk presented by three professionals under the age of 30 that have achieved success very early in their financial careers: Lucas Kollmann, who joined as the youngest analyst in Blackstone’s European office, Soheil Mirpour, one of the most junior hires at KKR, and Christian Schröder, who became a Director of a major Venture Capital fund in his mid-twenties. The successful trio not only remained best friends after having attended the same university, WHU – Otto Beisheim School of Management in Germany, but also created a three-part talk on Structured Success Management under the acronym of “KMS” which they present to university audiences all over Europe on a pro-bono basis. I was lucky enough to attend their event here at the ICMA Centre, and I’m writing this blog to tell you all about the wonderful experience…

Hands: Planning and execution

picture1After an introduction by the President of the Finance Society, Victor Ferrat, Soheil Mirpour took the stage and thanked the Society for their dedication and professionalism in organising the event (and he also commended ICMAC’s modern facilities and fancy lecture theatre, which is always great to hear!). Soheil’s segment was what the trio refer to as the “hands” aspect of their talk, dealing with planning and execution. It was all about how success is not “an arbitrary outcome” of random decisions, but an end goal that can only be achieved through proper planning and effective execution. Soheil urges us to identify what our “big vision” is, and then plan smart to figure out how we can get there from where we are today. Soheil also reminded us that there is a lot of silent work that goes into those loud moments of visible success, so we should never underestimate the need for consistent effort when the spotlight is off.

Mind: Making the right decisions and creating opportunities

picture2Next up was Christian Schröder whose “mind” segment was about how best to make the right decisions and create opportunities. He draws a likeness between decision-making and investing since the former is indeed an “investment of time and resources”, requiring careful judgement and critical evaluation, both ex-ante and ex-post. One of Christian’s core views is that we should increase the number of opportunities available to us through actively increasing our awareness of them, as well as “increasing the number of trials” towards achieving a goal. This will help us “take ‘luck’ out of the equation to a very large degree” and become “more in control of our own success”.

Mouth: Building a network

picture3Last but not least was Lucas Kollmann who spoke to us about networking, i.e. the “mouth” aspect. Lucas shared with the audience many tips and tricks on how to make contacts and very importantly, keep them! He emphasises the value of building strong relationships and establishing trust with the people you encounter – be it at university, in an internship or even at an “awesome party”. Lucas warns us, however, that we need to give ourselves a USP – unique selling proposition – to be able to offer a contact “more value than the average of his or her network” and become part of their community.

Overall, the event was a great hit! One of the elements that made it so was the speakers’ brilliant ability to keep us fully focused and interested. You don’t have to take my word for it, though. Here’s what some of the audience members thought of the presentation…

“I’ve been to a lot of similar talks, but this one definitely stands out because the speakers back up their advice with really great relatable examples.” Christopher, Masters Student in International Securities, Investment and Banking

“It was great to meet people who are currently working in the industry. It was a lot more than just theory in a lecture. Plus, they all had such excellent presentation skills!” Irene, Masters Student in Law

“[The talk was] very rich in quality! They were so engaging! Definitely not something you can just find in a book.” Omar, Bachelors Student in Finance and Investment Banking

Speaking of books… wouldn’t it be great if these guys wrote a book that brings together all their inspirational advice and expands on the insights they shared in their enlightening talk? Ask and you shall receive! The trio are actually in the process of designing a book on Structured Success Management and are hoping to publish within a year, so keep your eyes open for that. To stay posted, sign-up for KMS’s newsletter here.

This event would not have been possible without the initiative taken by the President of the Finance Society, Victor Ferrat, so here’s a word from him…

victor-ferrat-photo“I really do believe in the importance of networking, so I was just on LinkedIn looking for Private Equity professionals whom I can contact and learn from, and I came across Soheil’s profile. I sent him a private message introducing myself, and not only was he kind enough to reply, but he also offered to share his advice and that of his friends with more of my fellow students in Reading. One thing led to another, and we set up a KMS success talk at the ICMA Centre. The organisation of this event was very demanding, but it was definitely worth it. We are incredibly pleased that these professionals went out of their way to share their knowledge with us and help us achieve our goals. To think that all this started with a simple message! We are very grateful to Soheil, Christian and Lucas for their visit and hope they enjoyed their time with us. We would also like to thank the ICMA Centre and Ms. Leanne Ley for facilitating this evening and making it the success that it was.”

To conclude, the talk was jam-packed with eye-opening perceptions and practical advice, but perhaps what resonated with me the most was the general tone of success being absolutely achievable! It all comes down to being honest with yourself, discovering where your true strengths lie and applying yourself in the most effective way to make your ambitions a reality… even if you’re not in your 50’s yet! 

[Photo Credits: Emmanuel D’Arifat, a devoted member of the Finance Society.]

Five Finance Podcasts to Satisfy Your Inner-Geek

If by some miracle you have arrived at this point in your life and haven’t heard the word “podcast”, you might very well be some form of alien creature.
Podcasts are simply recorded audio files, like a radio show, but available for you to listen to at any time. Recently, podcasting (at least in America, where I’m from) has exploded in popularity following the release of a podcast called Serial, which explored the mysterious circumstances around a murder in the U.S. There’s somewhere around 250,000 podcasts that all offer different things.
For our purposes, there’s a lot of excellent podcasts that address markets, finance, and economics. I’m going to give you some recommendations on my favorite podcasts and a brief description of each.
To download podcasts, you can visit the App store on your Apple device, or use any third-party podcasting app. I don’t own an Apple phone, so I don’t know of any third party apps, but my personal favorite for Android is called Pocket Casts.

1. Slate Money
Slate Money is a podcast where host Felix Salmon (a journalist from Fusion) speaks with co-hosts and guests every week. Typically the discussion is oriented around somewhat technical matters, such as how certain hedge funds profited on Argentinian bonds or interviewing a high-frequency trader about some techniques he uses. There’s some swearing occasionally, but these hosts are some of the most interesting people around.

2. Planet Money
This is an NPR (National Public Radio, a massive news organization in the U.S.) show about a wide variety of things related to the economy and financial markets. My favorite episode is about the Onion King, a man who cornered the market on onions by manipulating the futures market. Hilariously, his actions resulted in the banning of onion futures in the U.S. It’s an excellent show that covers a massive amount of content.

3. EconTalker
EconTalker is a show run by an economist at the Hoover Institution, Russ Roberts. He tends to have very dense economic discussions with new authors and Nobel prize winners. Recently he interviewed Angus Deaton, who won the Nobel in economics for his work on inequality and poverty. Even if you’re not a big fan of hardcore economics, there are often lovely nuggets of knowledge for financial professionals.
4. StartUp
Hands down my favorite podcast of all time (and I regularly listen to about 40 different shows), StartUp is about what it takes to start a business. If you subscribe to this show, go back and listen to the first season before anything else. The creator, Alex Blumberg, is a master of storytelling and financial journalism, and he takes you on an emotional ride as he founds his own start-up company.
5. Freakonomics Radio
A radio show by the authors of the book Freakonomics. This show is spectacular, and discusses the often unconsidered sides of the economy.
These are just a small handful of the best shows out there, and I encourage you to find shows that you like. If you would like more recommendations, you want to share your favorites with me, or anything else, leave a comment below!
by Cameron Pfiffer, MSc Corporate Finance student at the ICMA Centre, Henley Business School.

Taking ‘Topics in Finance’? You’ll want to read this… (Don’t worry. It’s good!)

Topics in Finance: The secret prize you didn’t know existed

DinaAs another Spring Term sets off, flashbacks of last year come to mind. I was in the third and final year of my BSc in Finance and Investment Banking degree at the ICMA Centre. ’Twas the year of incredibly high expectations, stress like you’ve never known, goodbyes, the opening of new doors and – of course – optional modules! After much consideration, I decided to go for Topics in Finance as one of them. Like me, you might have chosen this module to challenge yourself in essay-writing, but what you might not know is that it comes with a prize at the end, and I found out in the best possible way…

Getting into the essay-writing

I can’t say the module wasn’t tough! What constitutes a “good essay” is pretty subjective, but there are some basics that we all need to know. Luckily, Dr Tony Moore, the module convenor, made sure to hold a class or two to discuss essay-writing skills and teach us how to reference properly – wouldn’t want to go around plagiarising anyone! I must admit I ended-up thoroughly enjoying the module, especially considering the host of interesting, diverse and knowledgeable speakers that were brought in to discuss all kinds of “topics in finance”.

The topic I enjoyed most was Behavioural Finance – a growing field that challenges many of the assumptions in classical financial models, including investors being “rational”. In fact, not only does the ICMA Centre offer an MSc module on this, but it also has a whole MSc degree specialised in the subject. Since it was my favourite topic, I decided to write my ‘big essay’ on how I believe markets to be informationally inefficient, and that the reasons behind that are behavioural.

The prize for the best essay

Given the firmness of my stance, I was very nervous about the result (to a point where I remember being too scared to pick up my feedback sheet). Fortunately, that anxiety was misplaced and Dr Moore actually awarded me the highest mark in class! It was only then that I found out about the module’s £300 cash prize for the best essay, sponsored by the Worshipful Company for International Bankers.

To top all this off, winning the module’s award also gives access to the WCIB’s Lombard Prize – an even bigger reward for the best essay across all the universities affiliated with the company. The deadline for this is months after graduation, which means you can still celebrate for weeks on end in the summer before you need to get right back to work!

So, for those of you just starting Topics in Finance now, and those of you planning on taking the module next year, this prize is even more of a reason to put in the effort and stay determined!

To sign off, I wish you all a productive Spring Term and a happy 2017!

Until my next blog,


No more culture shock: Adjusting to life in the UK as an international student

My name is Gao Tingting and I’m currently studying MSc International Securities, Investment and Banking at the ICMA Centre, Henley Business School.


I chose to study in the UK because I wanted to have an enriching study experience. Since starting I have seen so many new and different things here as an international student, such as the lifestyle and environment, but when I first arrived at Heathrow Airport there were a few things that I was worried about. Here’s how I got over the culture shock:

Picking up the language

Before coming to the UK I studied English for several years, however I still felt nervous when it came to communicating with people from all over the world. Sometimes people were confused by my Chinese accent and at first I didn’t always understand what they meant. That was until I met my British friends. They shared some cultural experiences with me such as British food (and even how to speak in a British accent!) It was the first time that I understood the beauty of speaking English and began to communicate with others actively.

After several weeks, I found communicating in English much easier and British people were encouraging. Something as simple as smiling and greeting people you meet in the corridor or kitchen makes communicating much easier!

A change of culture

This was a big challenge for me, since I knew little about British culture before I came here. I still remember the first time I was invited to attend a party with my roommates. At the beginning, I was worried about my dress code and what I needed to bring with me. I searched for information about parties, then wore a complex dress and brought a light drink. I found out that this wasn’t quite right, but I later got the hang of things!

In China, having dinner together is a normal social activity, while in Britain people prefer to stand and drink together instead. If you want to integrate into British culture, it is worth considering taking part in these parties and talking with others actively. Although we emphasize intermediate and passive social activities in Chinese culture, I tried to break the traditional thinking pattern and talk to others actively in parties. From doing this I found that British people like humor, and it is relaxing to socialise with them!

These are just a few of my first week’s experiences as I began to taste a new lifestyle and make friends from other countries. We all have many colourful experiences waiting for us in our lifetime, and I know that one of them will be the year I spend here at the ICMA Centre!

Getting through to the UK Investment Banking Series finals

By Brandon Rodrigues, third year BSc Finance & Investment Banking student at the ICMA Centre


I had the opportunity to participate in this year’s UK Investment Banking Series (UIBS) event, and I must say it was a fun ride.

UIBS is an annual competition organized by 5 finance societies of various universities. It consists of a Sales & Trading challenge as well as an M&A challenge. My team and I registered for the trading challenge, out of curiosity (but also to get our mind off the piling workload that goes hand in hand with being third years!)

The Prelimnaries: Stocks

The preliminaries consisted of selecting 10 stocks from the FTSE 100 and holding them for 2 weeks with the aim of maximizing returns, with the opportunity to change our positions after the first week.

Easy enough? Pretty much!

After the first few days, our technical analysis with a dash of fundamentals paid off and 3 of our equities were the top performers of the FTSE. As if testing our patience, the FTSE then plummeted 4% by the end of week 1 and not a single team across the board had a positive figure! Undeterred, we changed our positions and our recovery qualified us for the finals held at Imperial College in London.

The Finals: Hedge Funds and Investment Banks

The finals greeted us in the form of a damp Sunday, but we were warmed by the reception upon arrival. The event started off with a briefing given by the Managing Director of Amplify Trading, William De Lucy, on the various roles we would be assuming as well as an overview of the players of a Sales & Trading desk at any investment bank or fund in the industry. The teams would be sorted either as a hedge fund or an investment bank, then the roles would be reversed after an hour and a half.

We started trading as a hedge fund whose goal was to maximize returns. We soon learned there were 2 types of investment banks; those that are greedy for commission, and those that are greedy for client loyalty. We took full advantage of the latter. It would also seem that the trading simulators at the ICMA Centre definitely gave us an advantage as we joined the flow of trading quite smoothly. For other teams however, it could only be called a nightmare as a ‘fat finger’ or two would wipe out any semblance of profits, causing some hedge funds to delve into 9 figure losses!!

The race to the finish…

After lunch, we scrambled into the sell-side as an investment bank and that’s when we realized just how hectic a sales trader had it. Apart from giving quotes to 20 odd teams and vying for commissions all around we soon fell into the flow of the role and the atmosphere in the room was almost maniacal since all teams now knew of what they were expected to do after round 1. The room’s tempo was hectic and stimulating and we enjoyed every bit of it!

I would recommend the UIBS to any student who is interested in working in trading or risk/portfolio manager roles. The wealth of information and invaluable networking opportunities made the entire day completely worth it. I would like to thank my teammates as well as the organizers for the fantastic experience. Keep it up!

Find out more about our undergraduate degrees in Finance here.

Still fretting about re-hypothecation

There is a widely quoted paper re-use and re-hypothecation by Egemen Eren — Intermediary Funding Liquidity and Rehypothecation as Determinants of Repo Haircuts and Interest Rates (Institute of Global Finance, 2015) — which provides another example of the danger for researchers of disregarding the difference between the re-use of collateral sold in repo (re-selling) and the re-hypothecation of collateral pledged in margin lending (re-pledging). I have gone on about this confusion in several previous blogs (including a Bank of England paper that excited the financial press and one by Issa and Jarnecic).

The consequence of the confusion on this occasion is that the author misinterprets the post-crisis reduction in the recycling of collateral by dealers as an increase in repo haircuts, whereas much of this change would really seem to represent the withdrawal by hedge funds of rights of re-hypothecation on collateral pledged to prime brokers to cover margin lending and derivatives exposures. The confusion is not academic, inasmuch as the paper appears to add weight to a body of literature that tries to identify the pro-cyclicality of haircuts as the source of the Great Financial Crisis. This academic corpus originated with Gorton and Metrick (2010), who extrapolated from a time series of haircuts on exotic collateral from a single unidentified source in the US to make an ambitious inference about the origin of the entire crisis. It is fuelling regulatory interest in extending the imposition of minimum haircuts across the repo market. The consequences of such an initiative for market liquidity could be serious and should not be based on research that is not firmly grounded.

The model

Eren follows Infante (2014) in modelling the intermediation by a dealer between hedge funds supplying collateral and cash lenders supplying collateral but seeks to extend the analysis to show that the demand for funding by the dealer simultaneously determines both repo haircuts and repo rates. Implicitly, given his data, he is also trying to estimate the rates of re-hypothecation and the cost of collateral pledged in margin lending from prime brokers as well as the haircuts on collateral posted against derivatives exposures.

The proposition is that the dealer in the model obtains funding from the spread between the haircuts paid on repos to cash investors and the haircuts received on reverse repos from hedge funds. This ‘haircut spread’ is seen to provide an alternative source of funding to the dealer’s his own cash holdings or fire sales of illiquid assets (all sales of illiquid assets are assumed to be fire sales). As haircuts expose hedge funds to the risk of dealer default, it is argued that an incentive is required to persuade them to agree to repo (and to give rights of re-hypothecation). The incentive proposed is lower repo interest rates.

The model assumes that the haircut spread is determined by the volume of lending available from cash investors and the dealer’s need for funding, while repo rates are determined by the adequacy of the terms offered by the dealer to hedge funds and their outside options (ie alternative sources of funding, including from other dealers). The conclusions are that haircut spreads are narrow when funding is abundant and wide when funding is scarce.

The adequacy of the terms offered by the dealer to hedge funds is modelled by a comparison between:

  • the returns from the investments being funded by the hedge funds plus the value of bonds pledged by the hedge funds but not re-hypothecated by the dealer and instead lodged for safekeeping with a custodian less the costs of repo funding; and
  • the cost of the outside options available to hedge funds.

On this basis, if hedge funds have a net liability to the dealer at maturity, for a given haircut, repo rates will depend only on hedge fund returns and outside options (what they can afford to pay given their investment return). On the other hand, if the dealer has a net liability to the hedge funds at maturity, repo rates will also depend on the probability of the dealer’s default.

The author makes bold claims for his model, stating that it can provide an explanation for all of the empirical evidence about haircuts and re-hypothecation before, during and after 2008.

Empirical evidence

Evidence for the model is adduced in the form of the survey of haircuts in June 2007 and June 2009 conducted in 2010 by the BIS Committee on the Global Financial System (CGFS). Dealers are assumed to the ‘prime’ parties in the survey and hedge funds are assumed to be the ‘unrated’ parties. The implied haircut spreads across all securities increased between June 2007 and in June 2009, which seen as being in line with the predictions of the model.

In addition, it is noted that, in the second quarter of 2008, the fair value of collateral that Lehman Brothers was permitted to ‘repledge’ and the fair value of collateral that it did ‘repledge’ were around a half their values in the first quarter and the second quarter of 2008. Moreover, it is implied from financial reporting of collateral received and ‘repledged’ that, in the third quarter of 2008, that Goldman Sachs needed a haircut spread of 7.2% and Morgan Stanley needed a haircut spread of 7%, while in the fourth quarter, Goldman Sachs apparently needed a haircut spread of 11.2% for Goldman Sachs and Morgan 22%, which is taken to support the model prediction of a sharper reduction in lending to hedge funds by riskier Morgan Stanley than by safer Goldman Sachs.

Is the model and evidence credible?

The problem with the conclusions of this paper is that the haircut spread on repos specified by the author and implied from the investment bank data on re-pledging actually includes the withdrawal of rights of re-hypothecation on margin lending and haircuts on derivatives collateral. In practice, margin lending and derivatives are far more important for hedge funds that repo, which tends to be used for transactions with dealers other than prime brokers. But the withdrawal of re-hypothecation rights by hedge funds is ignored in the analysis.

There are other weaknesses in the paper:

  • The idea of a reduction in repo rate compensating for the exposure of hedge funds to the increasing haircut spread imposed by increasingly risky dealers is based on the assumption of risk neutrality. In reality, as noted by the CGFS and others, parties responded to the crisis, not so much by raising prices and haircuts as by rationing credit. Academics tend not to realise that counterparty credit risk is the primary risk faced by dealers given that collateral does not provide a perfect hedge.
  • On haircuts, the paper offers only ordinal proof (direction of change) rather than cardinal proof (degree of change).
  • The model does not ‘pin down repo haircuts and interest rates jointly’. There is no empirical proof of interest rate behaviour. And the repo rate estimated by Eren is not the market rate but an internal hurdle rate for hedge funds.
  • Looking at the “volume of lending by cash investors and dealers’ balance sheets as determinants of haircut spreads” is too narrow a perspective. Collateral price volatility is a key determinant. Collateral price volatility and cash supply/demand are arguably both driven by risk perception and aversion. So a linear chain of causation is unrealistically simple.

However, the hypothesis underlying the paper is not without any foundation. US dealers do appear to impose haircut spreads. So the real problem may be that the paper is too US-centric. This is certainly one conclusion suggested by the work of Issa et al (2016). On the basis of far more compelling data, these authors contradict both Eren and Infante by showing that haircut spreads in the Australian repo market actually narrowed during the crisis. In repo markets such as Europe, there is anecdotal evidence of occasional trade-offs between repo rates and haircuts but only in particular circumstances and under normal conditions. There is no evidence of a widespread or strong relationship between haircut spreads and repo rates. The two are fundamentally different. Haircuts primarily reflect collateral quality and thus price volatility, whereas repo rates primarily reflect counterparty credit risk. Both will be affected by supply/demand for funding and competition but in different degrees, given that haircuts are less transparent and more under dealer control, while the repo rate is largely exogenous.

The paper’s conclusion is that, “The financial system is still vulnerable to liquidity dry-ups and wild increases in haircuts. This paper highlights the need for further theoretical and empirical research that will be of interest to both academics and policy makers to develop tools to mitigate risks in the financial system.”

Unfortunately, the assertion is not proved, which ironically makes the recommendation for more research all the more apposite but only if that future research is based on a better understanding of the legal differences between re-sale of repo collateral and re-hypothecation of pledged collateral.




Academics, you re-hypothecate at your risk!

In a blog in May 2015, I tried to explain that, outside the US repo market, it was incorrect to use the term ‘re-hypothecation’ to describe the use of collateral purchased in a repo by its buyer. Such use is usually termed ‘re-use’ but would be better called ‘re-sale’. The crux of the matter is that re-hypothecation is a right to dispose of collateral that can be given to a pledgee by a pledgor but such a gift is at the discretion of the pledgor. In contrast, the re-use of repo collateral is the proprietary right of the buyer of collateral to dispose of that collateral. This fundamental difference arises because pledged collateral remains the property of the pledgor (giver), whereas purchased collateral becomes the property of the buyer (receiver).

Recognising the distinction between re-use and re-hypothecation is important because of the confusion over what happened to the collateral that was re-hypothecated to Lehman Brothers International Europe (LBIE) by its hedge fund clients in 2008 in order to secure margin lending and derivatives exposures. The inability or unwillingness of regulators to distinguish between re-hypothecation and re-use has had serious unintended consequences for the European repo market.

Barking up the wrong tree

But it is not just regulators who have difficulty recognizing or accepting the difference between re-hypothecation and re-use. In an interesting paper on ‘Collateral Reuse as a Direct Funding Mechanism in Repo Markets’ by George Issa and Elvis Jarnecic of the University of Sydney, the authors kindly refer to my blog last year but then summarily dismiss the substance on the grounds that, ‘Although they are technically different…, the terms “collateral reuse” and “rehypothecation” are used interchangeably to refer to the use of posted collateral in a source transaction to secure a separate transaction.’

The authors are in fact correct to say that the terms ‘are used interchangeably’ but that widespread usage is incorrect, as I tried to explain. Their failure to see the difference leads the authors to propose an invalid reason for the decline in the re-use of collateral in the Australian repo during the Great Financial Crisis (GFC).

The authors argue, ‘… the exploratory analysis showed that collateral reuse experienced a fairly sudden and permanent decline at the start of the GFC. This is consistent with the statement that collateral providers increasingly demanded segregation of their collateral during the GFC due to concerns about credit risk and the possibility that their collateral would not be returned…Following the shock to financial intermediaries from late-2007, a larger fraction of collateral providers then demand that their collateral be segregated due to an increase in the risk that collateral cannot be returned when requested. Hence, even though dealers have a greater need to reuse collateral to ease their funding constraint, the segregation constraint leads to an overall sharp decline in the repo rate spread. A likely reason for the subsequent persistence of a low repo rate spread is higher risk aversion – and therefore a higher likelihood of collateral segregation requests – relative to pre-GFC levels: not only is collateral more scarce due to regulatory requirements…but also repo market participants are more concerned about counterparty risk due to continued liquidity pressures in global financial markets… although dealers have a greater demand to rehypothecate during crisis periods, the reuse rate declines dramatically at the start of the GFC, reflecting increased demand by source party repos for collateral segregation.’

By segregation, the authors mean no commingling with the assets of the prime broker and, most importantly, no re-hypothecation.

The problem with this explanation for the decline in re-use is that sellers in a repo cannot control what buyers do or do not do with the collateral. Because legal and beneficial title to the collateral is sold to the buyer, it becomes the buyer’s unencumbered property. That is the very essence of a repo.

There was indeed a demand by clients for collateral to be segregated (and the widespread withdrawal of the permission to re-hypothecate) but this was by hedge fund clients to their prime brokers in respect of collateral pledged under prime brokerage arrangements, where the collateral had been pledged to secure exposures arising from derivatives transactions and margin lending, and where the hedge funds had previously given their prime brokers permission to re-hypothecate. It was not in respect of repo collateral and legally could not have been.

The rest of the paper

However, the mistaken explanation for the decline in re-use in the Australian repo market should not detract from the quality of the research underlying the paper. The authors use a Furfine-type algorithm to detect overnight repos from securities settlement data and compile a transaction time series. They use this time series to test the hypothesis proposed by Infante (2014) and Eren (2014) that repo dealers acting as intermediaries impose a higher haircut on reverse repo than on matched-book repos, ie they pay less cash for collateral through a reverse repo than they receive for that collateral in a matching repo. In this way, collateral re-use provides net funding to intermediating dealers. Importantly, Infante further suggests that the higher haircut imposed on the reverse repo is an incentive on the seller to run in the event of a deterioration in the credit of the dealer. The data compiled by Issa and Jarnecic conclusively rejects this hypothesis!

There may of course be local reasons why haircut spreads are negative in Australia and future studies of other markets may discover positive spreads. But there is an important lesson to be learned: not all repo markets are the same. FRBNY and FSB please take note!

Finally, a point of detail worth noting is that Issa and Jarnecic estimate re-use in the Australian repo market at 3.56%, a similar order of magnitude to the estimate of re-use in the Swiss market by Furher et al (2014).

My unforgettable first week in a brand new environment 

zhu-xuefei-92By Xuefei Zhu, China, MSc International Securities, Investment and Banking

When I first arrived in the UK, almost everything was new to me. I came from China to study here and it was my first time studying in a new country. But despite that I had an amazing first week, and several things impressed me from the very start!

alfie-campusThe beautiful campus

I was immediately fascinated by the beautiful view on the University of Reading campus, especially the Whiteknights lake. There are swans, mandarin ducks and other kinds of birds living freely around the lake. I could never imagine such a peaceful view in my country, but here it is part of everyday life! Whenever I walk along the lake, it gives me a sense of inner peace and a great chance to experience nature!

The ICMA Centre

alfie-icmacI was very proud to register at the ICMA Centre in my first week. All of my peers wore business attire and had a professional photo taken. We had several classes in the first week. The teaching methods are different to those in China; our classes are composed of lectures and seminars. In the lectures, the tutors dress formally and present their financial knowledge to students – this format is similar to academic meetings in China. And in seminars, the teacher gives us a review of some main points in the lecture and answers questions in our homework.

The library

alfie-libraryThere is a traditional saying in China: “What makes a good university? Just look at their library”. What makes me quite happy is that the University of Reading library is multi-functional, with high-quality service in the library and the comfortable feeling to study, this is a paradise for us who love to study! I am sure I will fully use this resource.

Dealing rooms

alfie-dealing-roomsOne of the most interesting things for me is trading simulation modules at the ICMA Centre. In this class, you can use advanced computer software like Bloomberg and Thomson Reuters. The dealing rooms are an amazing place to get more practice using your financial skills and it’s the main reason why I choose ICMA Centre. These new things already made me so excited and I am expected to perform well and boost my potential in trading!

My accommodation and flatmates

alfie-flatmatesMy flatmates come from all over the world; UK, Spain, US, Turkey, China and Africa. All of us are living happily together, and they are all so kind and gentle, which makes our flat like a family! It gives me an opportunity to meet people from different countries and find out about their culture. I enjoy the living environment here, and I even made a traditional Chinese dish for our flat at weekend. All of them enjoyed said the food was delicious and even called me chef, which really made me feel good!

During the first week, the university held a variety of social activities for our new and international students to adapt to the environment and get ready for the start of term. I’m already looking forward to enjoying a new life studying at the ICMA Centre in University of Reading, and I hope I will learn more and experience more!