Below is the conclusion of a BIS paper on covered interest parity (CIP) arbitrage by Dagfinn Rime, Andreas Schrimpf and Olav Syrstad, which was out earlier this month.
The background is that covered interest parity — the no-arbitrage condition which exists between interest rates and foreign exchange swap rates, once thought to be infallible — has broken down in recent years (much to the shock of finance academics who believed this sort of thing could not happen according to efficient market hypothesis).
The BIS authors, however, suggest CIP might not be broken so much as impacted by an increasingly segmented money market.
Think of it this way. CIP works in a world where everyone’s dollar is worth a dollar. In such a world dollars are perfectly fungible since there’s no discrimination between any of the dollars out there. Libor is Libor for everyone, thus you can quote differentials over and above Libor (Libor + 10 basis points, Libor – 10 basis point et cetera). Yet, in a world where one institution’s dollar is stigmatised and another institution’s is prioritised, CIP can’t work the same way. This is because the medium of exchange itself is no longer operating under the law of one price. Instead we have a segmented market of varying dollars competing against each other. JP Morgan dollars vs HSBC dollars vs Citi dollars vs Wells Fargo dollars, et cetera, et cetera. And all because most institutions cannot actually fund at Libor, which is a mythical price.
Here’s the conclusion from the paper (which is worth reading in full), with our emphasis:
It has been suggested that Covered Interest Parity (CIP) – a no-arbitrage condition once considered to be a cornerstone of international financial markets – is broken. We argue that to understand the CIP conundrum, a new perspective is warranted. In the post-crisis environment of segmented money markets and heterogeneous funding costs across banks, the law of one price cannot hold any longer for the full set of interest rates simultaneously. Careful attention needs to be paid to select the appropriate interest rates and to account for all the costs and risks faced by a potential arbitrageur.
Unpacking the true marginal funding costs faced by banks has become especially difficult. This has been further exacerbated by the abundance of central bank reserve balances resulting from unconventional policies, and their impact on banks’ funding conditions in different currency areas. All this constitutes a major challenge for the main intermediaries in FX swap markets who have a strong incentive to quote prices such that they face a balanced order flow.
We find that the law of one price in international money market holds in fact remarkably well when considering money market rates that reflect banks’ marginal funding costs. Risk-free and economically attractive CIP arbitrage opportunities do indeed exist – but only for a confined set of highly-rated global banks. Access to U.S. dollar funding from non-banks (in particular money market funds) at attractive rates is critical – coupled with access to safe investment vehicles in foreign currency, more specially central bank deposit facilities. Segmentation and funding cost heterogeneity thus matter significantly for market outcomes.
This raises the fundamental question of how a situation with risk-less arbitrage profits can persist over a prolonged period of time. We show that such a situation can indeed be part of an equilibrium outcome in a world of segmented money markets and excess liquidity. If an intermediary wants to avert facing an imbalance in order flow, its quotes need to entail some arbitrage opportunities for certain market participants. And, as we show in the paper, the price impact of FX swap order flow is particularly strong – and arbitrage profits greatest for top-tier banks – when lower-tier have an incentive to turn to the FX swap market to obtain U.S. dollar funding.
The evidence presented in this paper suggests that the main paradigm of CIP – risk-less arbitrage profits are non-existent after accounting for risk and transaction costs – still remains largely valid in post-crisis financial markets: arbitrage profits can only be enjoyed by a small set of players, but not by the vast majority of internationally active banks.
As we argue in this paper, arbitrage capital is difficult to deploy on a large scale. Common measures of CIP deviations will thus likely continue to reflect money market segmentation, heterogeneity in marginal costs and funding liquidity premium differentials across currencies, rather than be an indication of a “free lunch”.
According to the academics then, a heterogeneous and segmented money market ends up delivering excessive risk-free profits to a small portion of the most trustworthy/well capitalised industry players, while locking everyone else out from these opportunities.
The collapse of CIP thus isn’t indicating that economic theory has got it massively wrong, it’s indicating that for a whole slew of institutions taking advantage of open arbitrages is impossible due to the expense of taking additional funding liquidity risk onto balance sheets. This disadvantage turns into an advantage for the confined set of highly-rated global banks which can execute these arbs when called upon.
As the authors succinctly hint, the law of one price has withered on the vine:
The post-GFC constellation of increased heterogeneity in U.S. dollar funding costs, and a compression of liquidity premia in other major currency areas on the back of Quantitative Easing, has rendered it impossible for a single price in the FX swap market to be consistent with the law of one price for all rates in money markets simultaneously.
It would seem we are not all operating on the same standard after all.
A global reserve requirement for all those eurodollars – FT Alphaville
The eurodollar as an economic no-man’s land – FT Alphaville
Bearer securities and eurosystems – FT Alphaville
All about the eurodollars – FT Alphaville