Much of what is written on this blog stems from the “OG” Financial Crisis back in 2008. Without that, we would not have seen the Dodd Frank Act or post trade transparency in OTC derivative markets.
Back in 2008 I was trading cross currency swaps. These were one of the hardest hit instruments as the world went on a mad rush for dollars. With that experience, I thought it might be interesting to look at what is happening with SVB and Signature Bank and what might be different this time round.
What has happened so far?
First up, we need a neat summary of what has happened so far. As ever, Matt Levine nails it:
Plus the important facts that:
- All deposits have now been insured in the two banks. Even above the $250k cap.
- The UK subsid of SVB has been “bailed-out” by HSBC for the princely sum of GBP1.
What Happened in 2008?
Of course, we are all looking for signs that these relatively small banks are the “canaries in the coalmine”. So what was trading like in 2008? Here are some recollections:
- XCCY basis used to move in increments of 1/8th to a 1/4 of a basis point.
- Stop losses in such a market would typically take place after a 0.5-0.75 basis point move. That was a big move against you back in those days, and there would be ample opportunity to transact.
- Then, basis markets started moving in 5 BASIS POINT increments. The pricing increment literally increased by a multiple of 40!
- In reality, every bid that was shown versus almost any currency was “given” on some days. If you could get a price within 5 basis points of the last bid, it was considered somewhat of a triumph – if you really needed to raise dollars, “the price was the price”.
- Trading desks went into the crisis running risk calibrated to 1/4 basis point daily moves. Daily moves then increased to 5, 10, 20 even 75 basis points every day in the short-end of the curve. Risk limits became meaningless – it was all about market access, access to trading liquidity and of course name credibility – would banks even lend you dollars if they thought your credit was at risk?
- The term structure changed from relatively flat between 1Y to 30Y to massively steep – the demand was predominantly for short-dated dollars, dragging the XCCY basis down to -150bp in EURUSD.
- At times it was like staring into a black-hole – no one knew whether a trade had really taken place, or at what price. Liquidity collapsed, nervousness went through the roof and electronic screens struggled to keep up with the reality of the markets.
- This was a true market-based reaction. There was no consideration whatsoever that central banks might offer FX swap lines or step-in to supply USD liquidity to non-US banks.
- No-one wanted to face a US bank in the market.
- There was also no QE. The pricing signals were pure.
- XCCY basis markets were also not being influenced by monetary policy – who cares about a 75 basis point interest rate cut when XCCY basis has already moved 100 basis points against you that day?
- Those banks who could potentially supply the markets with USD were not doing so because they were not 100% sure of the mark-to-market losses other areas of the bank may be facing.
- The lack of transparency over both price action and potential mark to market losses contributed to the wild swings each day in XCCY basis….
- …but the wild swings were symptomatic of pure supply-demand imbalances for USD funding.
In essence, it was a very “pure” market. There were no stabilizing factors to dampen the price swings. The lack of transparency was a bad thing, without doubt. But the policy backdrop was probably a good thing – it allowed the market each day to find a true clearing price of dollars.
What Does it Mean?
That experience creates a particular mindset in a trading community. It is dangerous to pursue a single strategy when trading, but largely speaking these market moves created the following thought process:
- The clearing price of dollars at any given time is not very good at identifying the potential for the next “tail event”.
- As a result, there is a consistent skepticism as to the depth of the bid – is there really a willing supplier of large amounts of dollars to “the market”. If so, why?
- There really is no “bottom” or limit to the price of dollars. Basis could go anywhere.
- XCCY Basis is a uniquely periodic market, with bouts of trading liquidity followed by extreme famine.
The “knee jerk” reactions of Eurozone crises & COVID were driven by this relatively simple thought-process.
Is That Mind-Set Still Prevalent?
No-one can tar any single market with one brush (heterogeneity is what makes markets), but consider how watered down these experiences have become over the past 15 years. I have not traded for over 10 years now (writing blogs is way too time consuming :-P) but imagine the experience of traders who joined the market since 2012:
- The GFC resulted in regulations. The OTC markets used to be the “wild-west”, now we stream quotes 24 hours a day to regulated markets and everything is cleared (apart from XCCY 😛 ).
- There is “liquidity” when you need it, but at a price.
- Governments bail-out banks.
- Central banks have accepted their role as lenders of last resort – including to other central banks by way of USD swap lines.
- Monetary policy is the first to react and fiscal policy might eventually catch up.
What Do Markets Tell us Now?
The first two points should increase the transparency of current market prices (“the true clearing price of dollars”), but the last three act as dampeners to the wild swings we see in markets.
If 100% of deposits are insured, will I really rush to move my dollars to JPM and HSBC this time round?
If government facilitated bail-outs are the expected market outcome, why should I hesitate from lending a broker-dealer with a highly leveraged balance sheet (including hard to value assets) my dollars? The worse a bank looks, the more likely a bail out! Great.
If central banks step in to lend USD at SOFR + 25 basis points in COVID times, will basis really go much below -50 again?
If monetary policy will result in a cheap flood of dollars, why should I rush to shore up my position now?
The Vicious Circle
All of this means that there is a reduced price signal in the market price for the true demand of USD these days. It is no longer a pure signal of dollar demand, but rather the more extreme the price becomes, the more likely it is that market intervention occurs and the pricing of the market intervention itself becomes the limiting factor in the price setting.
As if to prove my point, 3 month EURUSD XCCY basis shows this exact dynamic today, continuing its extreme moves lower before reaching a “crisis point” and intervention starts to be priced in:
In my opinion, there is no re-setting this market dynamic – the genie is out of the bottle thanks to the numerous crises we have faced in my short career. It also means that if there had been no reaction from the Fed/Government/HSBC over the weekend to SVB, that the resulting price moves on Monday morning would have been even more wild. Resulting in a much higher possibility of action from the authorities, resulting in reversals before the event etc!
At the risk of sounding like a neurotic, cynical and wizened old hand;
- Prices in markets such as Cross Currency Swaps no longer contain the unfiltered “purity” of times past.
- Market participants must now constantly assess a price in terms of multiple dynamics.
- These include the amount of stress in the market…
- Versus the likelihood of market intervention.
- Markets may be far more transparent these days, but they are a lot more complex to understand and trade.