Optimal client recommendation for market makers in illiquid financial products

The process of liquidity provision in financial markets can result in prolonged exposure to illiquid instruments for market makers. In this case, where a proprietary position is not desired, pro-actively targeting the right client who is likely to be interested can be an effective means to offset this position, rather than relying on commensurate interest arising through natural demand. In this paper, we consider the inference of a client profile for the purpose of corporate bond recommendation, based on typical recorded information available to the market maker. Given a historical record of corporate bond transactions and bond meta-data, we use a topic-modelling analogy to develop a probabilistic technique for compiling a curated list of client recommendations for a particular bond that needs to be traded, ranked by probability of interest. We show that a model based on Latent Dirichlet Allocation offers promising performance to deliver relevant recommendations for sales traders.Comment: 12 pages, 3 figures, 1 tabl

Implications for liquidity from innovation and transparency in the European corporate bond market

This paper offers a new framework for the assessment of financial market liquidity and identifies two types: search liquidity and systemic liquidity. Search liquidity, i.e. liquidity in “normal” times, is driven by search costs required for a trader to find a willing buyer for an asset he/she is trying to sell or vice versa. Search liquidity is asset specific. Systemic liquidity, i.e. liquidity in “stressed” times, is driven by the homogeneity of investors - the degree to which one’s decision to sell is related to the decision to sell made by other market players at the same time. Systemic liquidity is specific to market participants’ behaviour. This framework proves fairly powerful in identifying the role of credit derivatives and transparency for liquidity of corporate bond markets. We have applied it to the illiquid segments of the European credit market and found that credit derivatives are likely to improve search liquidity as well as systemic liquidity. However, it is possible that in their popular use today, credit derivatives reinforce a concentration of positions that can worsen systemic liquidity. We also found that post-trade transparency has surprisingly little bearing on liquidity in that where it improves liquidity it is merely acting as a proxy for pre-trade transparency or transparency of holdings. We conclude that if liquidity is the objective, pre-trade transparency, as well as some delayed transparency on net exposures and concentrations, is likely to be more supportive of both search and systemic liquidity than post-trade transparency. JEL Classification: G14, G15, G18.Financial market functioning, liquidity, transparency, credit markets and financial innovation.

Cross-Border Securitization: Without Law, But Not Lawless

The Article discusses two puzzles posed by cross-border securitization. First, why do the innovators in this area give away their creations through publications and other means rather than attempt to extract licensing fees by registering copyrights, patents, and trade names? The Article shows that innovators benefit from giving away their innovations through fees of the first clients or future clients to a greater extent than through licensing fees. Second, how can securitization markets develop under fragmented and unpredictable laws? The Article argues that cross-border securitization is flourishing under a law merchant, which is later incorporated into domestic laws. In fact, innovations and standardization of law are developing in tandem and the same professionals that innovate are those that work on standardization of the law. The Article concludes that cross-border securitization serves as a case study of legal change from the bottom up, rather than from the top down

Monetary Policy, Regulation and Volatile Markets

Turmoil in financial markets causes reflection. Is monetary policy conducted in the most efficient way? Are regulatory and supervisory arrangements adequate when market volatility increases and financial institutions come under stress? In the present SUERF Study, we have collected the reflections by an outstanding group of top officials, researchers and observers. The editors are proud to be able to present their joint insights to SUERF readers. The papers were presented at the 27th SUERF Colloquium in Munich in June 2008: New trends in asset management: Exploring the implications.Financial markets, volatility, regulatory and supervisory arrangements, LATW, bubbles, monetary policy, asset prices, interest rate policy, LTCM, Basel II, MiFID, subprime, CDOs

The heavenly liquidity twin : the increasing importance of liquidity risk

Liquidity and solvency have been called the"heavenly twins"of banking (Goodhart, Charles,'Liquidity Risk Management', Financial Stability Review -- Special Issue on Liquidity, Banque de France, No. 11, February, 2008). Since these"twins"interact in complex ways, it is difficult -- particularly at times of crisis--to distinguish between them, especially in the presence of information asymmetries (Information asymmetry occurs when one party has more or better information than the other, creating an imbalance of power, giving rise to adverse selection and moral hazard ). An insolvent bank can be liquid or illiquid, and a solvent bank may be at times illiquid. In the latter case, insolvency is not far away, since banking is grounded in information and confidence, and it is confidence which in the end determines liquidity. In other words, liquidity is very much endogenous, determined by the general condition of a bank, as well as the perception of it by the public and market participants. Dealing with liquidity risk is more challenging than dealing with other risks, since liquidity is the result of all the operations of a bank and it is fundamentally a relative concept which compares segments of the balance sheet on the asset and liability sides. It does not deal with absolutes, like arguably the concept of capital and it explains why there is not an internationally recognized"Liquidity Accord". This Working Paper addresses key concepts like market and funding liquidity and basic tools to address liquidity issues like cash flows, liquidity gaps and some selected financial ratios. It aims at providing an introductory guide to risk assessment and management, and provides useful and practical guidelines to undertake liquidity assessments which could prove useful in preparing Financial Assessment Programs (FSAPS) in member countries of the Bretton Woods institutions.Debt Markets,Banks&Banking Reform,Currencies and Exchange Rates,Emerging Markets,Bankruptcy and Resolution of Financial Distress

Learning from Enron

This essay argues that the Enron affair has been misunderstood as a failure of monitoring, with adverse consequences for the drafting of the Sarbanes-Oxley Act and the Higgs report. Where Enron’s board failed was in underestimating the risks that were inherent in the company’s business plan and failing to implement an effective system of internal control. Enron demonstrates the limits of the monitoring board and points the way to a stewardship model in which the board takes responsibility for ensuring the sustainability of the company’s assets over time

Liquidity Creation and Liquidity Risk Exposures in the Banking Sector: A Comparative Exploration between Islamic, Conventional and Hybrid Banks in the Gulf Corporation Council Region

Banks as intermediary institutions raise funds by offering deposits and invest them in assets, by means of which they transform the maturities of their positions on the balance sheet. Such a function enables the banks to channel available liquidity into investments whereby they contribute to economic growth. In other words, when banks use their liquid liabilities to finance illiquid assets, they consequently create liquidity and hence promote productive investments that boost the economy. However, as a result of such a function, banks may face the risk of illiquidity that may cause an early liquidation of productive business activities, which in turn may lead to a disruption to the economy. Given the importance of the liquidity transformation function of banks, this research examines the ability of Islamic banks in creating liquidity in a comparative manner with conventional and hybrid banks in the Gulf Corporation Council (GCC) countries. In doing so, this study also explores the key determinants of such a function in the identified bank types. This study, furthermore, assesses the liquidity risk that Islamic banks are exposed to in comparison with conventional and hybrid banks and investigates the significant factors that may affect such exposures in the case of the GCC region. In conducting the empirical study, this research examined 58 GCC commercial banks during the period between 1992 and 2011 through developing two empirical models through panel data regressions with a fixed effects model in relation to the identified aims. In the first empirical model, the results demonstrate that Islamic banks create higher levels of liquidity than conventional and hybrid banks in the examined sample. The results also show that officially supervisory power, stringency on capital regulations and banking activity restrictions negatively and significantly determine the liquidity creation of the examined banks. The empirical results also detect a positive and significant impact of restrictions on the banking market entry standards on liquidity creation. In addition, while this study found that credit risk has a negative and significant impact on liquidity creation, the results show a positive and significant association between liquidity creation and bank size. This study also finds insignificant positive association between GDP and liquidity creation of the examined GCC banks. In the second model in this study, further statistical and empirical evidence demonstrates that Islamic banks are more exposed to liquidity risk than conventional and hybrid banks in the case of the examined sample of the GCC region. In addition, the results show that the stringency on capital regulations, credit risk, banks size and GDP has a negative and significant impact on liquidity risk. Moreover, the results detect that liquid assets and long- term debts are positively associated with liquidity risk exposures. While the empirical results show that the liquid assets significantly affect liquidity risk, the results detect an insignificant impact of long-term debt on the liquidity risk exposures of the examined banks in the GCC region. Accordingly, it can be stated that the empirical results of this study, consistently with the conceptual framework of Islamic financial principles as well as with previous studies, stress the importance of exploring the liquidity creation and liquidity risk in promoting the role of banks in the economic system and highlighting their key determinants that need to be well examined to fully understand the liquidity creation and liquidity risk issues

The Unregulables? The Perilous Confluence of Hedge Funds and Credit Derivatives

This Note examines credit derivatives, hedge funds, and the increase in systemic risk that results from the combination of the two. The issues considered include what method of regulation--entity, transaction, or self-regulation--provides the form and amount of disclosure that best addresses the risk that the markets as a whole will be affected by a financial shock. Emphasizing the role of traders and efficient capital markets, this Note proposes that a system of disclosure for derivatives similar to the Trade Reporting and Compliance Engine, or TRACE, system for corporate bonds would prevent rapid repricings that have the potential to shock the financial system