Zerohedge Nonsense Debunked

Why Did The Fed Inject Banks With A Record Amount Of “Other” Cash In The Past Week? [zerohedge]

Fed did not “inject” anything as zerohedge claims.

Definition: Other Deposits
U.S. law allows a number of government-sponsored enterprises (GSEs) to maintain deposit accounts at the Federal Reserve. Like the U.S. Treasury, these GSEs use their accounts to receive and make payments, which include receipts from issuing debt and payments for redeeming maturing debt. An increase in the line “other deposits” typically reflects a transfer of funds from depository institutions to one or more of these GSEs; thus, an increase in “other deposits” ordinarily is matched by a reduction in deposits held by depository institutions.

Central Bank Collateral Frameworks: Principles and Policies

IMF paper by Simon Gray, Alexandre Chailloux, and Rebecca McCaughrin

Central bank collateral policies came under pressure with the 2007-08 financial market crisis. This paper addresses the rationale for and constraints in taking collateral, and recent practices in different collateral frameworks. It then considers the risks of adverse selection. The paper concludes that (i) the collateral framework needs to include market incentives; (ii) central banks face trade-offs between risk and counterparty access; (iii) emerging markets may see pressure on collateral policies in coming years; and (iv) further work is required to develop pricing incentives and the structure of central bank facilities, both during normal times and in periods of market stress.

Velocity of Pledged Collateral: Analysis and Implications

IMF paper by Manmohan Singh

Large banks and dealers use and reuse collateral pledged by nonbanks, which helps lubricate the global financial system. The supply of collateral arises from specific investment strategies in the asset management complex, with the primary providers being hedge funds, pension funds, insurers, official sector accounts, money markets and others. Post-Lehman, there has been a significant decline in the source collateral for the large dealers that specialize in intermediating pledgeable collateral. Since collateral can be reused, the overall effect (i.e., reduced ‘source’ of collateral times the velocity of collateral) may have been a $4-5 trillion reduction in collateral. This decline in financial lubrication likely has impact on the conduct of global monetary policy. And recent regulations aimed at financial stability, focusing on building equity and reducing leverage at large banks/dealers, may also reduce financial lubrication in the nonbank/bank nexus.

Definition: IMF Quotas

Quota subscriptions are a central component of the IMF’s financial resources. Each member country of the IMF is assigned a quota, based broadly on its relative position in the world economy. A member country’s quota determines its maximum financial commitment to the IMF, its voting power, and has a bearing on its access to IMF financing.

Source: IMF

The Reliability of Voluntary Disclosures: Evidence from Hedge Funds

Paper by Andrew J. Patton, Tarun Ramadorai, and Michael Streatfield

We analyze the reliability of voluntary disclosures of financial information, focusing on widely-employed publicly available hedge fund databases. Tracking changes to statements of historical performance recorded at different points in time between 2007 and 2011, we find that historical returns are routinely revised. These revisions are not merely random or corrections of earlier mistakes; they are partly forecastable by fund characteristics. Funds that revise their performance histories significantly and predictably underperform those that have never revised, suggesting that unreliable disclosures constitute a valuable source of information for current and potential investors. These results speak to current debates about mandatory disclosures by financial institutions to market regulators.

The Impact of Sovereign Credit Risk on Bank Funding Conditions

From the Committee on the Global Financial System [BIS]

Sovereign credit risk is currently a significant issue for European banks and over coming years may have implications for global financial stability.

This report examines the relationship between sovereign credit risk and bank funding conditions, how banks might respond to an environment of ongoing elevated sovereign risk and the implications for policy makers. It was prepared by a Study Group chaired by Fabio Panetta from the Bank of Italy.

The report concludes that increases in sovereign credit risk push up the cost and weaken the composition of banks’ funding, and that banks cannot fully insulate themselves by adjusting their operations. As a consequence, the official sector has a key role in minimising the impact of weaker public finance conditions on banks, but there are trade-offs. First and foremost, governments need to maintain sound public finance conditions. Bank supervisors should also closely monitor the interaction of sovereign risk with regulatory policies that encourage banks to hold large quantities of public debt. Central banks might also consider having flexible collateral frameworks that, during severe crises, allow funding to be supplied against a broad range of collateral, but this is not costless, and hence should be used sparingly and with appropriate safeguards in place.

Speech by Jaime Caruana, General Manager of the BIS.

Recent events underscore the lesson that financial stability depends not only on the links between banks and the corporate and household sectors, but also on those between banks and the sovereign. The sovereign must be prepared to act as ultimate backstop for the financial system. But this requires that fiscal buffers be built up in good times. Otherwise, the sovereign can itself become a source of financial instability, as its credit risk interacts in a malign way with bank and other private sector credit risks. Sovereigns must now earn back their reputation as borrowers that are practically risk-free. Ultimately, the sovereign’s solvency is a precondition for the central bank’s success in dealing with threats to monetary and financial stability.

Evolution of Rating Distribution of Sovereign Issuers on Selected Dates

Source: Moody’s Sovereign Default and Recovery Rates,1983-2010

“Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold”

Paper by Brad M. Barber, Terrance Odean, and Michal Strahilevitz

We establish two previously undocumented patterns in the purchase selections of individual investors. These patterns hinge on investors’ previous experiences with a stock. We demonstrate that investors prefer to (1) repurchase stocks they previously sold for a gain rather than stocks they previously sold for a loss and (2) repurchase stocks that have lost value subsequent to a prior sale rather than those that have gained value. We document these trading patterns by analyzing trading records for 66,465 households at a large discount broker between January 1991 and November 1996, and 665,533 investors at a large retail broker between January 1997 and June 1999. We propose that the first trading pattern results from a simple form of learning whereby investors repeat actions that previously resulted in pleasure while avoiding actions that previously led to pain (i.e., they repurchase their previous winners more readily than their previous losers). We argue that the second trading pattern is tied to counterfactuals. Investors who buy a stock at a higher price than they previously sold it for are painfully aware that they are worse off than if they had simply never sold that stock. Investors who buy a stock at a lower price than they previously sold it experience the pleasure of knowing they are better off than if they had never sold that stock. Investor returns do not benefit from either of the two patterns we document.

Investors driven by emotion, not facts [ ]

Swayed by Friends or by the Crowd?

Paper by Zeinab Abbassi, Christina Aperjis, Bernardo A. Huberman

We have conducted three empirical studies of the effects of friend recommendations and general ratings on how online users make choices. These two components of social influence were investigated through user studies on Mechanical Turk. We find that for a user deciding between two choices an additional rating star has a much larger effect than an additional friend’s recommendation on the probability of selecting an item. Equally important, negative opinions from friends are more influential than positive opinions, and people exhibit more random behavior in their choices when the decision involves less cost and risk. Our results can be generalized across different demographics, implying that individuals trade off recommendations from friends and ratings in a similar fashion.

The Interconnectivity of Central and Commercial Bank Money in the Clearing and Settlement of the European Repo Market

Payments in the wholesale financial markets can be made in central or commercial bank money. The co-existence of these two settlement assets basically reflects a trade-off between the objectives of containing systemic risk and enhancing the efficiency and (in particular) the effectiveness of payments.

Systemic stability, efficiency and effectiveness depend crucially on the ability to make payments safely and smoothly. The malfunctioning of a payment system would be likely to pose systemic risk. A chronically underperforming payment system would make individual financial transactions riskier and impose frictional costs on the financial markets and the underlying economy.

A safe and smooth payment system is critically reliant on:

• the operational soundness of the settlement institution;

• the credit and liquidity of the settlement institution and its settlement asset.

It is in order to mitigate these operational, credit and liquidity risks that central banks — for whom systemic stability, efficiency and effectiveness are core objectives — act as settlement institutions and offer central bank money as the settlement asset in their own currencies. Central banks are able to provide a higher level of assurance than can commercial banks of continuity in the provision of payment services and liquidity. Nor are they exposed to commercial risks.

However, notwithstanding the inherent advantages of central bank money, all developed economies now use central bank and commercial bank money in tandem, in other words, central and commercial bank money are interconnected. Central banks only encourage or require the use of central bank money in systemically-important payment systems (SIPS), which are at the apex of payment activity in each economy, where exposures are generally highest and most concentrated, and where participants have the least control over their exposures. Thus, in most central bank payment systems, only some banks are direct participants and settle in central bank money, whereas the others use the cash settlement agency services of a direct participant to make and receive payments from other banks, producing a tiered architecture in payment activity.

The Interconnectivity of Central and Commercial Bank Money in the Clearing and Settlement of the European Repo Market [ICMA]
(See Annex: Illustrating the flows of central and commercial bank money in repo clearing and settlement in Europe)

Scenario Analysis for Italy’s Sovereign Debt

While the debt ratio in the optimistic scenario noticeably declines to about 90% of GDP by 2020, it falls only slightly in our baseline scenario to just over 110% of GDP. In our low-growth scenario it would in fact remain unchanged at a high level. Whether Italy succeeds in substantially reducing its debt load (or whether this debt load perhaps even continues to increase) hinges largely on the assumptions made – this holds particularly for the future development of market interest rates. For example, on our assumption of an increase in the primary balance to +3.75% of GDP a medium-term reduction of debt falls out of reach from a market interest rate of around 7% per year. Given an even more significant increase in market rates, to say 8% p.a., the debt burden would climb to nearly 130% of GDP no less by 2020. In both cases there would cease to be any further grounds for long-term debt sustainability without additional measures (such as large-scale privatisations) and even more swingeing austerity programmes and/or the implementation of more decisive structural reforms that bolster potential growth.

Talking point: Deutsche Bank research

An Analytical Performance Comparison of Exchanged Traded Funds with Index Funds: 2002-2010

Paper by Mohammad Sharifzadeh, Simin Hojat

Exchange bdf Traded Funds (ETFs) have been gaining increasing popularity in the investment community as is evidenced by the high growth both in the number of ETFs and their net assets since 2000. As ETFs are in nature similar to index mutual funds, in this paper we examined if this growing demand for ETFs can be explained through their outperformance as compared to index mutual funds. We considered the population of all ETFs with inception dates prior to 2002 and then for each ETF found all the passive index mutual funds that had the same investment style as the selected ETF and had inception date prior to 2002. Within each investment style we matched every ETF with all the passive index funds in that investment style and compared the performances of the matched pairs in terms of Sharp Ratios and risk adjusted buy and hold total returns for the period 2002-2010. We then applied the Wilcoxon signed rank test to examine if ETFs had better performances than index mutual funds during the sample period. Out of the 230 paired matches of all the styles, ETFs outperformed index mutual funds in 134 of the times in terms of Sharpe Ratio, however, the test of the hypothesis showed no statistically significant difference between ETFs and index funds performances in terms of Sharpe ratio. Out of the 230 paired matches of all the styles, ETFs outperformed index mutual funds in 125 of the times in terms of risk adjusted buy and hold total return, however, the test of hypothesis showed no statistically significant difference between ETFs and index funds performances in terms of risk adjusted buy and hold total return. These findings indicate there is statistically no significant difference between ETFs and passive index mutual funds performances at the fund level and investors’ choice between the two is related to product characteristics and tax advantages.

Italian Repo Fails Due to “Plumbing” Problems

Long-standing concerns over obstacles to interconnectivity between the Italian CSD and the ICSDs were accentuated by a dramatic increase in delivery failures on transactions (mainly repos) cleared through the international CCP, LCH.Clearnet, during 2009-10, but not those cleared through the domestic CCP, CC&G. The problem appeared to coincide with the start of same-day transactions in CCP-guaranteed repos in November 2009 and was widely attributed to this initiative, although other commentators argued that the surge in fails reflected market turbulence and short-selling by international investors, who mainly clear through LCH.Clearnet. The latter argument highlights an institutional fault line across the Italian securities market caused by the lack of securities lending by domestic institutions, who are the predominant holders of Italian government securities, to international investors, who are frequently the most active users.

European repo market white paper
An update on reform of market infrastructure
Another update on reform of market infrastructure