RDP 2019-09: Australian Money Market Divergence: Arbitrage Opportunity or Illusion? 5. Leverage, Profitability and the Consequences for Money Markets

We use the results derived in the previous sections to describe the funding structure of an investment and its profitability. Figure 12 graphs the profitability of a foreign exchange swap funded under repo on the y-axis, and its funding mix on the x-axis. The funding composition is measured by the debt-to-equity ratio. We define the break-even frontier as the minimum spread required between gross returns on a foreign exchange swap and the repo rate for the investment to break even (i.e. cover the associated cost of equity). This implies that, for a given level of leverage, the spread must be on the frontier or higher for the investment to be viable. The break-even frontier is convex to the origin and increases exponentially as the debt-to-equity ratio approaches zero. Intuitively, as investments get funded with greater amounts of relatively expensive equity, the minimum spread required for a foreign exchange swap to break even widens to cover the increase in funding costs. If a foreign exchange swap were fully funded by equity, the minimum break-even spread would converge to the difference between the cost of equity and the repo rate. If a foreign exchange swap were entirely funded through repo, the break-even spread would be zero (i.e. this trade would be profitable when the return on swaps is at least as high as the cost of funding the trade in repo).

Prior to the financial crisis, foreign exchange swaps required a minimum spread of around 15 basis points to break even at the estimated debt-to-equity ratio at that time (point A, Figure 12). At the debt-to-equity ratio of around 50, this implies the foreign exchange swap was being funded with approximately 2 per cent equity and 98 per cent debt. In 2018, the minimum spread required by banks to break even on foreign exchange swaps increased to around 35 basis points (point B, Figure 12). This reflects two developments. First, the entire break-even frontier shifted upwards due to the increase in the relative cost of equity over the period. For any given degree of leverage, this implies that the minimum break-even spread is higher than in 2008. Second, the debt-to-equity ratio for foreign exchange swaps has almost halved over the period, moving the break-even point left along the frontier. For every dollar of equity funding the swap, we estimate that the swap is funded by $25 of debt funding in 2018. This is consistent with a leverage ratio of just under 4 per cent. Effectively, the hurdle to achieve profitable arbitrage has been raised substantially.

Major banks were important providers of liquidity in money markets prior to the financial crisis. Since then, a reduced tolerance for risk has diminished the ability and willingness of banks to engage in either proprietary trading or market-making activities (CGFS 2014; ASIC 2018). Since 2008, net returns on money market investments have declined, and are either negative or close to zero if they are funded in the repo market. Our results support the idea that major banks have a reduced incentive to lend in money markets, and may help to explain the persistent price divergence across money markets.

If banks no longer have an incentive to arbitrage, then are there any participants whose funding structure permits arbitrage? In the domestic repo market, around half the cash lent by dealers is borrowed by non-residents. Some of these borrowers are likely to be non-banks which might be better able to take advantage of arbitrage opportunities across money markets, as they are typically not bound by leverage and capital requirements to the same extent as banks. We observe repo rates co-moving with the JPY basis in recent years where the repo-funded yen basis trade has remained marginally profitable. This may indicate non-bank institutions have been bidding up the repo rate to the point where the yen basis trade is no longer a viable investment strategy from the aggregate balance sheet perspective of a bank.

Figure 12: Leverage and Break-even Spread
Minimum spread between gross return on foreign exchange swaps and funding at repo rate
Figure 12: Leverage and Break-even Spread

Sources: APRA; Authors' calculations; RBA

Consider the case of a non-regulated entity seeking to arbitrage across the repo and foreign exchange swap markets. How would this foreign exchange swap need to be funded in order for break-even spreads to return to pre-crisis levels (point C, Figure 12)? In order to return a profit for an institution that exhibits the same funding costs as a major bank, the foreign exchange swap must be funded by a debt-to-equity ratio of more than 75. This corresponds to a leverage ratio of approximately 1.3 per cent. This is well below the regulatory minimum of 3 per cent stipulated by current prudential standards applicable to supervised banking institutions. Consequently, only entities not regulated by prudential standards would have the capacity to leverage up to this extent. This result is based on a break-even frontier which is a function of banks' equity costs. However, the cost of equity faced by a highly leveraged non-regulated entity is likely to be much higher than the cost of equity depicted for a prudentially regulated bank. If this is the case, then the break-even frontier depicted in Figure 12 would shift upwards, and the minimum break-even spread required would widen. Consequently, even our framework underestimates the degree of leverage non-regulated entities would require for arbitrage investments to be profitable.

Non-regulated entities have more flexibility in taking on leverage because they do not face regulatory minimum equity requirements. However, constraints on the balance sheets of the regulated banking sector may also limit arbitrage activities of non-regulated entities who rely on lines of credit from major banks. This is because the ability of banks to lend funds to these institutions will be dependent on regulatory requirements. In the United States, Boyarchenko et al (2018) suggests restrictions applying to broker-dealers have spilled over to non-regulated entities because regulated institutions are less willing to extend credit than in the past. Consequently, this has affected the ability of non-regulated entities to pursue arbitrage opportunities. It is difficult to assess the extent to which funding to non-regulated entities may have been constrained in the Australian context. However, it is possible that bank lending volumes to non-regulated entities in the domestic repo market are too small to close persistent money market arbitrage opportunities (Becker and Rickards 2017).