The Present Value

ISDA highlights a selection of research papers on derivatives and risk management         


On the Origin of Systemic Risk

European Central Bank Working Paper Series
By Mattia Montagna, Gabriele Torri, Giovanni Covi

The paper proposes a new definition of systemic risk and suggests a model to quantify the sources of systemic risk based on the information made available to regulators and policy-makers.

The authors define systemic risk as the probability of a systemic event materializing in the financial system over a specified period. A systemic event is characterized by a number of financial institutions going into distress simultaneously in the same period.

The analysis is based on granular data recently developed by the European Central Bank, which includes bilateral interbank exposures, exposures to non-bank financial corporations, and security holdings issued by banks, financial corporations, non-financial corporations and governments.

According to the study, the main drivers of systemic risk are the correlation of shocks from the real economy and market contagion that manifests in terms of fire sales of assets. The authors also highlight that the interaction between different contagion channels can significantly increase the level of systemic risk.

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Regulatory Responses to Cryptoderivatives in the UK and the EU: The Future of Cryptoderivatives in the US

By Sangita Gazi, The University of Hong Kong

The paper provides comparative analysis of regulatory responses to cryptocurrency-related derivatives (cryptoderivatives) in the UK, European Union (EU) and US. The author points out that UK and EU regulators have focused on protecting retail investors from monetary losses arising from investment in cryptoderivatives products. In contrast, US regulatory efforts have been limited to interpreting cryptocurrencies using the existing legal and regulatory framework, despite the novel risk of price volatility in cryptocurrencies and susceptibility to spot market manipulation.

In the UK, the Financial Conduct Authority has prohibited the sale of cryptoderivatives to retail investors on the basis that cryptocurrencies used as a reference for these derivatives are unreliable as a basis for valuation.

In the EU, the European Securities and Markets Authority has also looked to curb cryptoderivatives trading, viewing these products as risky, speculative and volatile, and potentially exposing consumers to significant monetary losses.

In the US, several cryptoderivatives products are available to US retail customers, including Intercontinental Exchange’s bitcoin-settled futures and options, CME Group’s options on bitcoin futures, and Eris Exchange’s Ethereum-based physically settled futures.

The paper argues the Commodity Futures Trading Commission’s current approach to regulating cryptoderivatives, primarily through a self-certification process, is risky, claiming the existing legal framework is not adequate to prevent price manipulation in the cryptocurrency spot market.

The paper proposes that the US Congress develops comprehensive legislation that recognizes the novelty and operational risks posed by cryptocurrency and introduces effective regulatory treatments to curb market manipulation in the cryptocurrency spot market.

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How the Federal Reserve’s Central Bank Swap Lines Have Supported US Corporate Borrowers in the Leveraged Loan Market

Board of Governors of the Federal Reserve System FEDS Notes
By Annie McCrone, Ralf Meisenzahl, Friederike Niepmann, and Tim Schmidt-Eisenlohr

The FEDS note illustrates how disturbances in foreign exchange (FX) markets related to the international cost of borrowing US dollars affected US corporate borrowers during the COVID-19 pandemic.

In February 2020, the cost of borrowing US dollars through FX swap markets increased significantly, as indicated by larger deviations from covered interest rate parity (CIP). CIP holds that the interest rate differential between two currencies in the cash money markets should equal the differential between the forward and spot exchange rate.

The research shows that wider CIP deviations resulted in higher borrowing costs for US corporations in the leveraged loan market. US corporate borrowers had to pay higher interest rates if their loans were originated when international investors faced a higher cost of borrowing US dollars.

Foreign investors often fund their investments in US securities through the FX swap market. The relative cost of borrowing US dollars through the FX swap market is reflected in the cross-currency basis. When the US dollar LIBOR cross-currency basis becomes more negative, foreign investors find investments in leverage loans less attractive. This results in lower demand for the loans, which is reflected in an upward adjustment of the interest rate spread.

The Federal Reserve’s initiatives to provide global US dollar liquidity by enhancing and extending its swap facility with foreign central banks and introducing a new temporary repurchase agreement facility for foreign and international monetary authorities resulted in narrowed CIP deviations and contributed to the easing of financial conditions for US corporate borrowers.

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