Academics have been busy figuring out ways to plug the gaps in pre-crisis financial data.
In a BIS working paper, Stephen Cecchetti, Ingo Fender and Patrick McGuire identify and analyse two data sets that they think were lacking in the run-up to the financial crisis. One in particular seems very interesting, and that’s their attempt to quantify speculative yen carry trade — something which has eluded analysts for years.
A carry trade, for reference, involves borrowing at a low interest rate and then lending that out at a higher rate. In the yen carry trade, investors would buy the low-interest rate Japanese currency then do something like sell the yen in the spot market for US dollars, and purchase a US dollar bond with a higher yield than the rate they’d been getting back on the yen-denominated loan.
So far, so good, and the trade was a favourite among hedge funds.
The problem though, is that they’re left massively exposed to changes in currency exchange rates, not to mention interest rate changes and potential maturity mismatches between the two loans. As the authors put it: “when any of these starts to move against the position, there can be a rush for the exits.”
Back to the question at hand — how big was the speculative carry trade before the crisis?
The BIS methodology is a bit complex, so we’re summarising. In order to put on a yen carry trade you generally need to swap your dollars for yen. Someone has to provide that yen swap for you, and that tends to be the Japanese banks. According to the authors, it’s estimated that Japanese banks have supplied upwards of $1 trillion worth of yen to the swap market over the last few years.
That shows up as the red line, in the left-hand chart below:
Counterparties to Japanese banks in the swap market are generally foreign investors who want to invest in yen assets. But unlike a carry trade speculator, they don’t want to immediately sell the yen they get from their swap. They’re real money investors — they want to buy and hold JPY assets. The chart plots the position of real money investors (the dark bit in the left-hand one) and also attempts to gauge the role of non-bank real money investors using BIS data (the lightly-shaded bit).
And now, the BIS authors pull it all together:
. . . we have a measure, albeit rough, of the speculative yen carry trade. What does it look like? Until 2004–05, yen volumes supplied by Japanese banks in the FX swap market roughly matched demand for yen assets from real-money investors, as proxied by the sum of non-Japanese banks’ net on-balance sheet yen positions and total outstanding international yen-denominated bonds. After 2005, however, the gap, that is, the difference between the stacked shaded areas and the red line, widens considerably. Unsurprisingly, this corresponds to a period of yen depreciation (the green line) – the carry trade that we have outlined puts downward pressure on the yen – and, at least until the start of the recent crisis, is consistent with other commonly used indicators of carry trade activity. For example, analysts often rely on information on yen positioning by non-commercial entities (assumed to be hedge funds and other non-bank financial institutions) in the Chicago currency futures markets. While these data capture only a slice of the global currency futures activity (and miss all OTC positions), they are often used to get a sense of the direction of the speculative bid for yen. And, as shown in the right-hand panel of Graph 2, these net short non-commercial yen positions grew substantially after 2004, just as our gap measure widens.
What can we conclude from all this? Is it a coincidence? Or, is the gap that we infer a reliable measure of speculative carry trade activity? We don’t know for sure (given, for example, the gap that opens up between the two measures in the right-hand panel for the most recent observations), but the bigger point is that carry trades are largely off-balance sheet. Without more consolidated information on derivatives positions, there is no way to track them directly. To better understand the FX swap market (and the relative importance of participants therein), what we need is net position data by currency and nationality.
So it’s a rather unpolished measure but an attempt, nonetheless. The wider point, as the authors mention above, is that there needs to be better information-gathering on the whole of the financial system, including off-balance sheet positions and things like banks’ currency and maturity risks.
To that end, regulators seem to be working towards building a global risk map, what the authors call “the holy grail of systemic risk monitoring,” that would gather all the data needed to properly assess risk exposure.
We wish them luck.
‘Gun shy markets’, or 6 reasons why the EUR carry trade has blown up – FT Alphaville
Negative swaps, the Japanese experience – FT Alphaville
Debunking carry-trade denial – FT Alphaville