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The links of international reserves, exchange rates, and monetary policy can be understood through the lens of a modern incarnation of the “impossible trinity” (aka the “trilemma”), based on Mundell and Fleming’s hypothesis that a country may simultaneously choose any two, but not all, of the following three policy goals: monetary independence, exchange rate stability, and financial integration. The original economic trilemma was framed in the 1960s, during the Bretton Woods regime, as a binary choice of two out of the possible three policy goals. However, in the 1990s and 2000s, emerging markets and developing countries found that deeper financial integration comes with growing exposure to financial instability and the increased risk of “sudden stop” of capital inflows and capital flight crises. These crises have been characterized by exchange rate instability triggered by countries’ balance sheet exposure to external hard currency debt—exposures that have propagated banking instabilities and crises. Such events have frequently morphed into deep internal and external debt crises, ending with bailouts of systemic banks and powerful macro players. The resultant domestic debt overhang led to fiscal dominance and a reduction of the scope of monetary policy. With varying lags, these crises induced economic and political changes, in which a growing share of emerging markets and developing countries converged to “in-between” regimes in the trilemma middle range—that is, managed exchange rate flexibility, controlled financial integration, and limited but viable monetary autonomy. Emerging research has validated a modern version of the trilemma: that is, countries face a continuous trilemma trade-off in which a higher trilemma policy goal is “traded off” with a drop in the weighted average of the other two trilemma policy goals. The concerns associated with exposure to financial instability have been addressed by varying configurations of managing public buffers (international reserves, sovereign wealth funds), as well as growing application of macro-prudential measures aimed at inducing systemic players to internalize the impact of their balance sheet exposure on a country’s financial stability. Consequently, the original trilemma has morphed into a quadrilemma, wherein financial stability has been added to the trilemma’s original policy goals. Size does matter, and there is no way for smaller countries to insulate themselves fully from exposure to global cycles and shocks. Yet successful navigation of the open-economy quadrilemma helps in reducing the transmission of external shock to the domestic economy, as well as the costs of domestic shocks. These observations explain the relative resilience of emerging markets—especially in countries with more mature institutions—as they have been buffered by deeper precautionary management of reserves, and greater fiscal and monetary space. We close the discussion noting that the global financial crisis, and the subsequent Eurozone crisis, have shown that no country is immune from exposure to financial instability and from the modern quadrilemma. However, countries with mature institutions, deeper fiscal capabilities, and more fiscal space may substitute the reliance on costly precautionary buffers with bilateral swap lines coordinated among their central banks. While the benefits of such arrangements are clear, they may hinge on the presence and credibility of their fiscal backstop mechanisms, and on curbing the resultant moral hazard. Time will test this credibility, and the degree to which risk-pooling arrangements can be extended to cover the growing share of emerging markets and developing countries.

Article

In the wake of the 2008 financial collapse, clearinghouses have emerged as critical players in the implementation of the post-crisis regulatory reform agenda. Recognizing serious shortcomings in the design of the over-the-counter derivatives market for swaps, regulators are now relying on clearinghouses to cure these deficiencies by taking on a central role in mitigating the risks of these instruments. Rather than leave trading firms to manage the risks of transacting in swaps privately, as was largely the case prior to 2008, post-crisis regulation requires that clearinghouses assume responsibility for ensuring that trades are properly settled, reported to authorities, and supported by strong cushions of protective collateral. With clearinghouses effectively guaranteeing that the terms of a trade will be honored—even if one of the trading parties cannot perform—the market can operate with reduced levels of counterparty risk, opacity, and the threat of systemic collapse brought on by recklessness and over-complexity. But despite their obvious benefit for regulators, clearinghouses also pose risks of their own. First, given their deepening significance for market stability, ensuring that clearinghouses themselves operate safely represents a matter of the highest policy priority. Yet overseeing clearinghouses is far from easy and understanding what works best to undergird their safe operation can be a contentious and uncertain matter. U.S. and EU authorities, for example, have diverged in important ways on what rules should apply to the workings of international clearinghouses. Secondly, clearinghouse oversight is critical because these institutions now warehouse enormous levels of counterparty risk. By promising counterparties across the market that their trades will settle as agreed, even if one or the other firm goes bust, clearinghouses assume almost inconceivably large and complicated risks within their institutions. For swaps in particular—whose obligations can last for months, or even years—the scale of these risks can be far more extensive than that entailed in a one-off sale or a stock or bond. In this way, commentators note that by becoming the go-to bulwark against risk-taking and its spread in the financial system, clearinghouses have themselves become the too-big-to-fail institution par excellence.