Since the great financial crisis conventional measures of the covered interest parity across currencies have regularly broken down. Two developments seem to explain this. First, money markets have become more segmented, with top tier banks having access to cheaper and easier funding, particularly in times distress. Second, FX swap markets have experienced recurrent imbalances and market makers have been unable or unwilling to buffer one-sided order flows. Profit opportunities arise for some global banks in form of arbitrage and for other investors in form of trading signals for funding liquidity risk premia.

Rime, Dagfinn, Andreas Schrimpf and Olav Syrstad (2017), “Segmented money markets and covered interest parity arbitrage”, BIS Working Papers No 651.

The post ties in with SRSV’s lecture on price distortions, particularly the section on liquidity risk premia.
The below are excerpts from the paper. Emphasis and cursive text have been added.

Covered interest parity: a recap

“Covered interest parity [CIP] postulates that it is impossible to earn a profit by borrowing in one currency and lend in another, while fully covering the foreign exchange risk…If all transactions are closed simultaneously and counterparty risks are zero, CIP boils down to a no-arbitrage condition.”

“An example of the sequence of trades involved is…
[1] Borrow U.S. dollar for, say, 30 days…
[2] Buy euros spot…and simultaneously enter a forward contract reversing  the currency exchange at a predetermined price in 30 days.
[3] Invest the euro-denominated funds at the currently available 30-day euro rate.”

“A requirement is that all transactions (borrowing, spot, forward and lending) are made simultaneously and hence the profits are known ex-ante…The spot-forward combination will be replaced by an FX swap contract since the swap market is more liquid than the (outright) forward market.”

“Recent reports suggest that covered interest parity once regarded as the most robust regularity in international finance no longer holds…Since the onset of the global financial crisis…seemingly large deviations from CIP have emerged, even in some of the world’s most liquid currencies. The breakdown of no-arbitrage during the heights of the global financial crisis and the European sovereign debt crisis…may not be surprising…However, the anomaly has been particularly severe during the much calmer period since mid-2014. This stands in stark contrast to…pre-crisis evidence.”

Breakdown cause 1: money market segmentation

“The post-crisis environment of segmentation and fragmentation in international money markets has manifested itself in an increased degree of heterogeneity…

  • [Funding:] The unsecured interbank market, once regarded as a trustworthy source for banks’ marginal funding costs, is no longer a vibrant source of term funding for banks…It is therefore paramount to investigate non-bank money market instruments…Commercial Paper or Certificates of Deposit can be issued with great flexibility and represent unsecured claims on banks, typically held by non-banks, such as money market funds or cash-rich corporations. Banks’ borrowing costs from the non-bank sector generally tend to be lower than those on inter- bank borrowing. This is because banks have to incorporate balance sheet costs into their quotes of unsecured interbank rates.
  • [Investing:] A key requirement…of CIP arbitrage…is…that the [swapped] funds can be placed into a truly risk-free investment asset. Interbank deposits do not fulfill that criterion due to credit risk. Thus, we turn instead to government T-Bill rates and central banks deposit facilities. The main difference between the T-Bill and the central bank deposit rate is that the former is widely accessible…whereas the latter is only available to eligible counterparties.”

“A key implication of market segmentation is that it has become impossible for the law of one price in international money markets to hold for all different rates, unless risk spreads and liquidity premia evolve symmetrically across currencies…It is not straightforward to interpret common measures of the cross-currency basis based on OIS (or general collateral repo) as risk-less arbitrage profits. Instead, they may reflect differentials in term funding liquidity premia across currencies.”

Breakdown cause 2: FX swap market imbalances

The key market that links money markets in different currencies…is the FX swap market. An FX swap is an OTC derivative which can be thought of as a spot transaction coupled with an opposite forward contract. By any standards, the FX swap market is huge with a daily trading volume exceeding USD 2 trillion. If the functioning of this crucial market is impaired, the relative prices of assets and debt across currencies will be significantly distorted.”

“Three major forces have led to a shift in the FX swap market equilibrium…[1] implementation of quantitative easing and the abundance of central bank reserves has affected funding liquidity conditions differently across key currency areas…[2] substantial tiering across banks has manifested itself in a large degree of funding cost heterogeneity, especially in the U.S. dollar…[2] quantity constraints in the supply of USD funding by non-banks.”

“A market maker typically has a strong preference for…matched flows…This is further reinforced by internal over-night risk limits that effectively force the market makers to end the day ‘flat’…The swap dealer quotes prices such that any USD demand/supply imbalance is absorbed and the corresponding risk appropriately shared between different groups of end-users.”

“In a situation with severe funding constraints in the market for U.S. dollar, lower-tier banks will raise U.S. dollars via the swap market. This will imply a positive swap order flow…into USD at the spot leg. In such a situation, the swap dealer will have to quote a higher swap-rate [forward minus spot]…in order to attract matching  flow…A CIP arbitrage opportunity needs to be granted for top-tier banks that are less constrained in the USD market and are in a position to supply dollars to the swap market.”

View a previous post here on how deviations of the covered interest parity are caused  by the combination of increased cost of financial intermediation in the wake of regulatory reform and global imbalances in investment demand and funding supply.

Profit opportunity 1: Arbitrage

“We find that risk-free CIP arbitrage opportunities do indeed exist, but only for a confined set of highly-rated global banks. We obtain this result by investigating the pricing in major unsecured funding markets such as commercial pape. However, the commercial market in U.S. dollars is fragmented, with large dispersion in funding costs across banks. The vast majority of banks around the globe faces prohibitively high marginal funding costs in U.S. dollars. But, for top-tier banks with access to U.S. Commercial Paper funding on favorable terms and with access to the deposit facilities of foreign central banks (i.e. a risk-free investment vehicle), arbitrage is economically viable.”

Arbitrage profits are much larger involving central bank deposit facilities than when investing in T-Bills. What explains these differences? The main driver is that the T-bill rate responds to the term liquidity premium in the respective currency, while the central bank deposit rate is insensitive to the volumes placed in the central bank facility. Markets are segmented in that only a selected group of financial institutions has access to the deposit facility. Hence, the rate of remuneration of excess reserves does not apply to all market participants and may therefore not act as a solid anchor for the FX swap price at all times.”

Profit opportunity 2: Trading signal

“We distinguish between violations of Covered Interest Parity (CIP) and the “law of one price”. “Law of one price” violations give rise to an incentive to take advantage of cross-country differences in borrowing rates, but they do not necessarily imply (self-financed) arbitrage opportunities…”Law of one price” deviations are negligible for interbank deposit rates and Commercial Paper rates, in stark contrast to interbank offer (IBOR) rates, Overnight-Index-Swap (OIS) or General Collateral (GC) repo rates.

“Drawing on a panel of interbank deposit rates across currencies allows us to extract proxies for funding liquidity premia. We show that “law of one price”/CIP deviations based on OIS rates tend to co-move strongly with measures of funding liquidity premium differentials across countries. This finding suggests that these measures of deviations, while signalling potential trading profits, may not be considered as purely risk-less from the arbitrageurs’ perspective. Instead, they signal an opportunity to enhance returns at the expense of taking additional funding liquidity risk on the balance sheet.”

View previous post here suggesting that FX swap rates deviate from risk-free interest rate differentials in accordance with the relative liquidity risk premia for the currency areas.

Evidence for post-crisis markets

The balance in FX swap markets has been significantly distorted by the excess liquidity due to quantitative easing in major currency areas. In recent years, central banks in the largest currency areas outside of the U.S. (in particular, euro area and Japan) have implemented large asset purchase programs, where financial institutions selling securities have been credited with a large amount of central bank reserve balances. Large part of this liquidity in excess of minimum reserve requirements has been placed in central banks’ deposit facilities…This has meant that the marginal funding costs of banks…have effectively dropped to the rate of remuneration of central bank deposit facilities…This has in turn led to a substantial fall of liquidity premia in the affected currency areas…rate. By contrast, U.S. dollar liquidity premia have remained elevated in large part due to a structural demand for U.S.-funding by global banks.”

“[The figure below] suggests that obtaining term liquidity (even for those banks with direct access to USD markets) has been much more expensive in the U.S. dollar than obtaining funding over the same horizon in other currencies. Moreover, the heterogeneity in funding costs across banks has remained elevated ever since the onset of the global financial crisis.”

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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds.