Recent trends in cross-currency basis - bis.org

1 2016-E-7. Bank of Japan Review Recent trends in cross-currency basis Financial Markets Department Fumihiko Arai, Yoshibumi Makabe, Yasunori Okawara and Teppei Nagano September 2016. The cross-currency basis , which is the basis spread added mainly to the dollar London Interbank Offered Rate (USD LIBOR) when the USD is funded via foreign exchange (FX) swaps using the Japanese yen or the euro as a funding currency, has been widening globally since the beginning of 2014. This development is driven by (1) increased demands for dollars resulting from a divergence in the monetary policy between the and other advanced countries, (2) global banks' reduced appetite for market-making and arbitrage due to regulatory reforms, and (3) the decrease in the supply of dollars from foreign reserve managers/sovereign wealth funds against the background of declines in commodity prices and emerging currency depreciations. Recent Widening of cross-currency [Chart 1] cross-currency basis basis bps 50.

2 Swiss franc Danish krone Foreign exchange swaps or cross-currency basis Euro British pound Japanese yen swaps (collectively referred to as FX swaps) are often 0. used as a tool for foreign-currency funding or currency-risk hedging by banks and institutional -50. investors. FX swaps are contracts in which one party simultaneously borrows one currency and lends another currency to a second party. The amount of -100. repayment is fixed at the FX forward rates as of the starting date; thus, FX swaps can be viewed as -150. FX-risk-free collateralized CY 2007 08 09 10 11 12 13 14 15 16. The spread added to the USD LIBOR when USD Note: 1-year cross-currency basis . is funded via an FX swap (for example, a USD/JPY or Source: Bloomberg. a EUR/USD swap) is called the " cross-currency relation is called covered interest rate parity (CIP). For basis ." The cross-currency basis has been widening instance, if the cross-currency basis widens, one party for most currencies since the beginning of 2014; can earn profits without risks by borrowing typically banks operating outside the have been dollars in the money market and providing them in the paying larger costs compared with banks operating FX swap market.

3 If these activities increase, such inside the when they borrow dollars (Chart deviations from the CIP converge to zero. 1). This also means that a wide basis typically implies As most global financial transactions are market stress, such as heightened concerns regarding denominated in dollars, USD funding demand counterparty risks. During the global financial crisis tends to be strengthened in the FX swap market. of 2008 2009 and the Euro area sovereign debt crisis Despite potentially strong USD demand, the of 2011 2012, the cross-currency basis in major cross-currency basis theoretically shrinks to zero by currencies had widened amid risk aversion, which was arbitrage trading activities if the FX swap and shown in the sharp rises of credit risk indicators such money markets are not segmented and there are no as sovereign and bank credit default swap (CDS). concerns regarding counterparty credit risks. This premia (Chart 2). 2 Market participants mutually Bank of Japan September 2016.

4 1. EUR proceeds into USD, which also drives the basis [Chart 2] basis and Sovereign CDS Premium widening. bps bps 150 -150. Investors' Demands for USD-denominated 120 -120 Assets 90 -90 The relative attractiveness of USD-denominated assets 60 -60 has increased due to monetary policy divergence. In 30 -30. the situation that Japanese or European government bond yields are extremely low, investors in those area 0 0. have searched for higher-yielding assets and actively (a)+(b). -30 (a) Sovereign CDS premium 30 invested in USD-denominated bonds (Chart 3). -60. (b) cross-currency basis (rhs; reversed). 60 Japanese banks also continue to increase lending CY 07 08 09 10 11 12 13 14 15 16 denominated in foreign currencies. Note: 5-year USD/JPY basis and 5-year sovereign CDS premium for The investment in USD-denominated assets that is Japan. Source: Bloomberg. not hedged for FX risk affects the FX spot rates. Conversely, the hedged investment is economically suspected their counterparties' credits and took a equivalent to the transaction that one party borrows reluctant stance of cash lending, which led to a USD via FX swaps using JPY or EUR as collateral systemic USD shortage in the money market, and invests in USD-denominated assets.

5 An increase including FX swaps. In this situation, the amounts of of these investments is one of the drivers of the wide bids for USD funds-supplying operations by the basis . European Central Bank (ECB) and the Bank of Japan Looking at foreign investments by Japanese significantly increased. financial institutions, pension funds basically invest in Conversely, since the beginning of 2014, the foreign assets without hedging FX risks while life cross-currency basis has widened despite stable credit insurance companies hedge around 70% of their risk indicators and no significant USD funding shortages among [Chart 3] Bond Investment Flows Instead, the Recent basis widening appears to be (1) Outward bond investment from the euro area bil. euros driven by demand/supply factors, including the 150. decrease in arbitrage activities. In particular, market participants indicate the three main drivers of this 100. widening as follows: (1) increased USD demand in 50.

6 Japan and Europe against the backdrop of monetary policy divergence among advanced economies; (2). 0. global banks' reduced appetite for market making or arbitrage trading due to the effect of regulatory -50. reforms; and (3) the decrease in USD supply from real CY 13 14 15 16. money investors, including foreign reserve managers. This review examines these possible drivers of the (2) Outward bond investment among Japanese Recent widening of the cross-currency basis . institutional investors tril. yen Monetary Policy Divergence and Life insurance companies Increased USD Demand Trust accounts of banks (pension funds, etc.). The first driver of a cross-currency basis widening is the monetary policy divergence among advanced countries. investors have increased their investments in USD-denominated assets, and the portion of these investments that is hedged for FX risk or funded via FX swaps exerts a widening pressure on CY 13 14 15 16.

7 The basis . Further, some corporate issuers, Sources: Haver; Ministry of Finance Japan. corporations in particular, have increased the issuance of EUR-denominated bonds and have swapped these Bank of Japan September 2016. 2. foreign bond investments according to their annual [Chart 4] Corporate Credit Spread and Bond reports. Banks also do not seem to take FX risks. The Issuance Bank of Japan's Financial System Report estimates (1) Corporate credit spread and cross-currency that the amount of foreign currency funding by basis Japanese financial institutions via FX swaps has an bps increasing trend, indicating that it is one of the 500. United States triggers for the basis widening. 4 It has also been 400 Euro area pointed out from market participants that life 300. EUR/USD basis insurance companies in Europe have also increased 200. hedged foreign investments. 100. Corporate FX-hedged Bond Issuance 0. The divergence in monetary policy among advanced -100.

8 Countries affects corporate issuers' funding activities, CY 09 10 11 12 13 14 15 16. which also increases USD demand in the FX swap bps 100. Difference of USD funding costs between issuing market (Chart 4). EUR-denominated bonds using FX swaps and 50 issuing USD-denominated bonds Corporate credit spreads in euro areas are lower than those in the as the ECB is expanding its asset 0. purchase program while the Federal Reserve Board (FRB) is taking a step to normalize its -50. Profitable to issue EUR-denominated bonds monetary policy stance. In this situation, corporate -100. issuers, corporations in particular, occasionally CY 09 10 11 12 13 14 15 16. fund the USD by (1) issuing EUR-denominated bonds (2) EUR-denominated bonds issued by and (2) swapping these EUR proceeds into USD via corporations FX swaps. The USD funding cost via this method is 400 bil. euros often more advantageous than that of the direct issuance of USD-denominated bonds.

9 Consequently, 300. the issuance of EUR-denominated bonds by corporations has increased, inducing the increased 200. demand for USD in the EUR/USD swap market. Similar issuances were seen in the JPY corporate 100. bond market, albeit in much smaller amounts. Some 0. overseas companies focused on Japan's low corporate CY 09 10 11 12 13 14 15 16. credit spread and increased the issuance of JPY-denominated corporate bonds on the premise of Notes: asset swap spreads are calculated by Bank of America Merrill Lynch. swapping the raised JPY to USD. 2. 10-year EUR/USD basis . Sources: Bloomberg; Dealogic. In sum, USD demand in the FX swap market has increased against the background of activities by global investors and corporations, which has caused a widening pressure on the cross-currency basis . Market-making Activities in the Money Market Reduced Appetite for Arbitrages and the Decline in Market Liquidity The FX swap market is regarded as a "peripheral" part of the money market in the sense that (1) real The second driver of the Recent basis widening is money investors do not act as main USD suppliers and considered to be the fact that global banks have taken hence (2) USD supply relies on the a more reluctant stance in market making alongside market-making/arbitrage-trading activities of global arbitrage trading activities due to the effects of banks (Chart 5).

10 Regulatory reforms. Under these circumstances, In the , since the middle of 2014, overnight market liquidity in FX swaps has deteriorated, which rates have tended to spike at quarter-ends in amplifies the widening of the basis . "peripheral" markets such as FX swaps and the general collateral finance (GCF) repo markets (Chart 6). Bank of Japan September 2016. 3. detailed below: [Chart 5] Flow of Cash in the Money Market (1) Since 2013, banks have deleveraged due Real Money Investors (Money Market Funds, Asset partly to the stricter leverage ratio in the (in Management Companies, etc.) which a higher ratio is required, and is calculated on the basis of daily averaged assets). Tri-party repo market CP/CD market, etc. (secured) (unsecured) (2) Although banks, European banks in particular, had increased positions in the money market, they have started to shrink their Global Banks (Major Dealers) assets at quarter-ends since the middle of 2014, partly to keep the leverage ratio at quarter-ends low GCF repo market (dealer-to-dealer).