11 - Derivatives, Monetary policy and Financial regulation Flashcards
Derivatives may improve the long-run efficiency of financial
markets in four ways:
They allow risk transfer: adjustment of risk exposures for
hedging or speculative purposes
* They allow the creation of pay-off characteristics at a lower
cost
* They improve pricing efficiency
* They facilitate investment and arbitrage strategies
During periods of stress derivatives:
may worse short-term price volatility on the
financial markets:
* Dynamic hedging
* “Hedging overhangs”
* Liquidation of derivatives and underlying positions
* Assumptions regarding price distributions may become
invalid
Derivatives and Macroeconomics
Derivatives permit economic agents to manage more
effectively and efficiently the risks present in their activities
Firms: face variability in CFs, borrowing
costs and investment opportunities
Households: face variability in interest rates
(mortgages) and income
Derivatives and monetary policy
Derivatives might change the relative importance of three
channels though which monetary policy operates:
- The interest rate channel
- The exchange rate channel
- The credit channel
Derivatives and monetary policy indicators
Monetary Policy Indicators are used by monetary authorities to
help judge the appropriateness of monetary policy measures
Derivatives and Monetary Policy Indicators…
Quantitative Indicators
* Monetary
aggregates
* Credit
aggregates
Price indicators
* Exchange
rates
* Interest rates
* Other asset
prices
Derivatives as providers of new information…
Futures and forwards markets yield information might
provide a good forecast of prices for a wide range of assets
* Option prices can be used to estimate a summary measure
of market views on expected volatility of asset prices and
exchange rates
Monetary policy:UK
The 1998 Bank of England Act states that, in relation to
monetary policy, the Bank of England’s objectives shall be “to
maintain price stability, and subject to that, to support the
economic policy of Her Majesty’s Government, including its
objectives for growth and employment.”
* The current definition of price stability is an inflation target of
2% for ‘strong, sustainable and balanced growth.’
Monetary policy - key features
Key features:
* Bank Rate
* Reserves
Other measures:
* Asset purchases of UK government bonds
* Corporate bonds purchases
Financial crisis 2007-2009 overview
The fundamental cause of the crisis was the combination of a credit
boom and a housing bubble that led to three consequences:
1. The fall in the value of the asset backed by high leverage lead
to margin calls
2. The fall in the asset value reduced the value of the collateral
backing the initial leveraged credit boom.
3. Margin calls and the forced fire sale of the asset and drove
down its price even below its fundamental value, creating a
cascading vicious circle of further asset price deflation.
Derivatives new regulatory principles?
The main principles underlying the regulation of derivatives
must encircle three primary issues:
(1) uncertain counterparty credit risk exposure;
(2) capital erosion
(3) prices that are away from fundamentals
due to illiquidity in the market
Derivatives regulatory principles after the crisis
Issues:
(1) uncertain counterparty credit risk exposure;
(2) capital erosion
(3) prices that are away from fundamentals
due to illiquidity in the market
Suggestions:
- Central Clearing house
- Transparency
- Oversight of derivatives
Main lessons learned
Improved governance and compensation practices to
curb excessive leverage and risk taking.
* Greater disclosure and transparency of compensation
packages and assessment criteria.
* Longer stock holding periods and stricter forfeiture rules
* A bonus/malus approach to compensation
- Fair pricing of explicit government guarantees and ring-
fencing their access in some cases.
* Regulators should revisit the practice of reducing (or not
charging) deposit insurance premiums.
* Given the sheer size of government-sponsored enterprises
(GSEs) and their potential linkage through the risk-transfer
mechanism, the investor function of the GSEs should be shut
down.
Source: Acharya, V. V., & Richardson, M. P. (Eds.). (2009). Restoring financial stability:
how to repair a failed system (Vol. 542). John Wiley & Sons.
. Better transparency to reduce the counterparty risk
externality.
* Credit default swaps (CDSs) and related indexes should be traded
on centralized counterparties-cum-clearing houses or exchanges.
* Smaller, less standardized markets such as in collateralized debt
and loan obligations (CDOs and CLOs) should have at the least a
centralized clearing mechanism so that the clearing registry is
available to regulators to assess contagion effects of a large
institution’s failure.
- OTC markets can continue to remain the platform through which
financial products are innovated; but there should be an explicit
regulator in charge.
- Prudential regulation of large, complex financial
institutions based on their systemic risk contribution to
the financial sector or the economy.
* There should be one in charge of the prudential regulation of
systemic risk.
* The regulator should first assess the systemic risk posed by
each firm.
* We propose that the regulator should estimate the
contribution of each firm to the downside risk of the economy.
* The overall systemic risk assessments would then determine
the regulatory constraints imposed on individual firms
Post crisis changes 201-2019
Key takeaways:
* The daily turnover of OTC interest rate derivatives more than
doubled between 2016 and 2019 to $6.5 trillion,
taking OTC markets’ share to almost half of total trading.
* Asset managers increased their trading of interest rate
derivatives.
* Structural changes including clearing, compression and
automation made OTC markets more closely
resemble exchanges.
current times: financial stability
Main challenges:
* the right balance between microprudential objectives and the
macroprudential objective of system-wide resilience
* The pandemic has increased all material sources of risk for
the banking sector – most prominently, credit risk
* Other risks, such as market and liquidity risk, have also
increased.
* In addition, the pandemic has heightened the risks to banks’
operational resilience.
current times: financial stability
Short-term priorities:
- Balance between the
macro and micro objectives
- Asset quality
Medium-term priorities:
- sector’s consolidation
-systemic risk
- digital transformation
