X-CCY BASIS

April 10, 2017

 What does it mean “CCB”?

Similarly to tenor spreads in single currency interest rate markets, basis spreads between cash-flows in two different currencies widened significantly after the financial crisis, resulting in the classic interest rate parity not holding anymore. This means that it is not the same to exchange one USD now into EUR and to invest in a 3 Month EURIBOR, compared to investing one USD in a 3 Month LIBOR and entering now into a fair forward to exchange the resulting USD amount in 3 months’ time into EUR. 

Used in the valuation of cross currency basis swaps, this is the liquidity premium of one currency over the other that is added to the floating rate of one of the legs of the swap. The EUR value achieved by these 2 investment strategies would not be the same anymore! The difference is caused by the currency basis that has been included in fair FX forwards since the financial crisis and is not reflected in EURIBOR and LIBOR rates. It would imply a clear arbitrage opportunity that market participants could exploit and hence should disappear. Reasons why the currency basis has not disappeared since the financial crisis are changed liquidity preferences by market participants regarding currencies and the supply of money in the different currency markets, influenced by differing central bank strategies. Thus, we have to adjust models to capture these effects and such prevent it from implying theoretical arbitrage opportunities, where there are none. To incorporate these effects and make two strategies yielding the same payoff again a spread (positive or negative) has to be introduced on either the LIBOR, or the EURIBOR side. This spread is called cross currency basis. It can be implied from market traded instruments, such as FX forwards currency basis swaps. 

Hence, it is important to incorporate this cross currency basis spread information into the valuation of any cross currency deal (FX forwards, cross currency swaps, etc.). Otherwise, the valuation would not reflect current market conditions and practice in valuation and pricing of such derivatives. Therefore, valuations not taking

these effects into account are not in accordance with the requirements set out in IFRS 13 regarding the determination of Fair Values. Exemplified: Someone not incorporating Cross Currency Basis (CCB) spreads into his/her valuation should observe significant non-zero market values for actually fair FX forwards at deal

inception when valuing them via his/her own valuation engine, e.g. a Treasury Management System. We know for couple of years now that Mark-to-Market from a bank doesn’t match Mark-to-Model from a corporate TMS. The counterparty risk (i.e. CVA/DVA), market perception and expectations and models used, as well as data

picking (e.g. last, bid/offer, mid,… furthermore coming from different sources) are elements to explain such differences. Sometimes, they can be significant.

 

 

Unfortunately, this results in cross currency derivatives having different values depending on whether it is priced from an US investor’s (discounting using LIBOR rates), or that of an EUR zone investor’s (discounting using EURIBOR rates) perspective. The difference in valuation reflects the change in currency basis between inception of the deal and valuation date.

The Cross-Currency Basis measures the deviation from the covered interest parity condition. It emerged during the Global Financial Crisis (GFC) and has not disappeared since then (even increased further since 2014). The existence of the basis implies large, persistent, and systematic arbitrage opportunities in currency

markets for major currencies. The cross-currency basis is highly correlated with nominal interest rate levels in the cross-section and in the time series. These findings are at odds with a frictionless global funding market, but point to key frictions in financial intermediation and their interactions with global imbalances during the post-crisis period.

 

 

Recent widening of CCB

The reasons for explaining such a divergence are multiple: 

(1) Increased demand for USD resulting from a divergence in the monetary policy between US and other advanced countries,

(2) Global banks’ reduced appetite for market making and

arbitrage due to regulatory reforms,

(3) Decrease in the supply of USD from foreign reserve

managers/sovereign wealth funds against the background of

declines in commodity prices and emerging currency

depreciations.

It appears that between the financial theory and the market (economic) reality there is a sort of ditch which can be significant when a financial instrument has to be revalued. Systems have in general “Mark-to-Model” approaches when markets have per definition “Mark-to-Market’s”. The GFC has crystalized these gaps.

A FX cross-currency swap consists of, for example, buying USD SPOT and selling EUR and at maturity (i.e. forward) to sell USD and repurchase the EUR. The amount of repayment is fixed at the FX forward rate as of the starting date. A FX swap could be viewed as an FX-risk free collateralized lending. The spread added to USD LIBOR rate when USD is funded via a currency swap is called “CCB”.

This spread (CCB) should in principles tend to zero by arbitrage and trading activities, providing markets are not segmented and therefore no concerns regarding counterparty risk. Despite the credit conditions which remained stable (i.e. credit risk indicators) and absence of funding shortage among banks, the CCB has increase overtime. There is less demand for dealing and market making arbitrage trading due to appetite reduction as they are under pressure with regulations (e.g. Basel III, Volker rule, etc.. ). There were bigger demands for USD which has caused a widening pressure. It may change over time.

 

 

The market liquidity also played a role with changing banks’ activities and resulted in lowering the liquidity in the FX swap market through several channels. There is a clear reduced appetite for arbitrage trading and market-making activities. All these

elements have amplified the CCB widening. There is eventually a decrease in supply from real money investors (e.g. foreign reserve managers, sovereign wealth funds, etc…).

All these elements explain why the Cross-Currency Basis has increased over time and why theory could sometimes diverge from market reality. It could cause some trouble in reporting, revaluation and checks made at closing periods.

 

François Masquelier

Chairman of ATEL

 

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