Market microstructure
Given institutional knowledge, this paper presents similarities between the survivor pay component (Tranche 2) of the Canadian Larger Value Transfer System (LVTS) and credit default swap (CDS) contracts. Accordingly, the default leg of the financial market infrastructure (FMI) or central counterparties (CCPs) is similar to that of a CDS, whereas liquidity efficiencies are mapped to the premium leg. The paper consequently conducts a simple numerical approximation of the empirical risk neutral daily valuation of Tranche 2 from January 2005 to December 2016. In so doing, the paper identifies conditions under which LVTS participants might withdraw from the loss sharing framework. The results highlights a potential specification of “risk-based access” to clearing and settlement in FMIs. A further policy implication of valuations of the credit risk liquidity risk trade-off is to dampen perceptions of procyclicality in loss sharing arrangements.
Keywords: Risk-Based Access, Credit Default Swap, High Value Payment System, Collateral Requirements, Intraday Liquidity Management, Procyclicality, Financial System Fragility
This paper provides the first steps towards a theoretical framework through which optimisation decisions in payments and settlement systems can be assessed from a market microstructure perspective. In particular, the paper focuses on the application of agent-based computational economics and stochastic games in modelling the bilateral credit limit establishing behaviour of Participants in the Canadian Large Value Payments System. The data-driven stochastic game framework further illustrates how payments data, in conjunction with other financial market and credit data, can be used to assess emergent macroscopic outcomes in clearing and settlement systems from the underpinning interactions of autonomous decision making agents. The paper speaks to potential policy issues such as the effectiveness of the System-Wide Percentage, regulatory concerns about procyclicality and free-riding arising from the market microstructure behaviours, and design of the System.
Keywords: Agent-based computational economics, Market microstructure, High value payment systems, Bilateral credit limits, Intra-day liquidity management, stochastic games
This paper uses a two-sector agent-based computational economics (ACE) model to assess whether a system of dynamic decision making by institutional investors and/or by issuing banks (e.g. loss aversion, decision making according to simplified rule of thumb behaviour) can lead to unsustainable increases in issuance or large scale fluctuation in prices of securitised assets. The paper also highlights policy issues associated with the design of financial market regulations and the financial market infrastructures (FMIs) such as central counterparties (CCPs) that directly participate in trading over-the-counter (OTC) derivatives where the pricing of underlying credit and other risks is key.
Keywords: Securitisation, Basel I, Credit risk transfer, Financial stability, Regulatory capital arbitrage, Reinforcement learning, Markov decision process, Portfolio allocation, Erev-Roth algorithm
A database-driven multi-agent model has been developed with automated access to US bank level Federal Deposit Insurance Corporation (FDIC) Call Reports, which yield data on balance sheet and off balance sheet activity, respectively, in Residential Mortgage Backed Securities (RMBS) and Credit Default Swaps (CDS). The simultaneous accumulation of RMBS assets on US banks’ balance sheets and also large counterparty exposures from CDS positions characterised the US$2tn Collateralized Debt Obligation (CDO) market. The latter imploded by end of 2007 with large-scale systemic risk consequences. Based on available data on FDIC-insured banks, this chapter investigates how synthetic securitization and credit risk transfer (CRT) rules introduced in Basel II and its precursor in the US, the January 1, 2002, Joint Agencies Rule 66 Federal Regulation No. 56914, combined with a CDS negative carry trade, gave rise to perverse incentives and led to unsustainable trends and systemic risk. The model presented provides an analytical framework with which to monitor regulatory incentives on an on-going basis.
Keywords: Synthetic securitisation, Collateralized debt obligations, Credit default swaps, CDS-basis trade, Basel II, Joint Agencies Rule 66 Federal Regulation No. 56914, Credit risk transfer, Financial stability, Regulatory capital arbitrage, Balance sheet fragility, Rule of thumb behaviour
The paperForthcoming
With the continued evolution of the negative CDS-bond basis as highlighted by JP-Morgan's CDS-bond basis data and apparent market participant and policymakers' surprise at ongoing dislocations between the CDS and cash markets, this paper investigates the extent to which an agent-based computational market microstructure model is able to replicate the persistent and pervasive arbitrage opportunities in the cash and derivatives markets for bonds and other debt issuances. The paper extends the work of Amihud and Mendelson in their 1986 paper on "asset bid-ask spreads" by modeling from a truly agent-based market microstructure perspective. The paper further presents some policy implications associated with these persistent arbitrage trading opportunities. Keywords: Credit default swaps, Fixed income, Credit ratings, Auctions, Arbitrage trading, CDS-bond basis
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