(Bloomberg) -- The world’s top financial stability watchdog is setting up a dedicated taskforce to unmask areas where shadow banks could spark a broader crisis, the chair of the Financial Stability Board told Bloomberg News.
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The carry trade, used by investors to place leveraged bets on interest rates, and the basis trade, a popular wager using financial gearing to exploit price discrepancies in government-bond markets, are “two excellent examples” of areas the FSB could focus on, said Klaas Knot, who is also governor of the Dutch National Bank.
“These are areas where there is potential for a lot of leverage to build up and to build up pretty rapidly also,” he said of the soon-to-be-launched taskforce. Bloomberg reported in November that the watchdog was considering such a probe.
Difficulties in mapping shadow banking, which includes hedge funds, insurers and investment funds, have led the FSB to concentrate its efforts in the areas where risks are highest. A report earlier this month by the European Securities and Markets Authority found that a group of hedge funds were using 18 times leverage on market bets totaling $220 billion, highlighting the risk that they could pose to financial stability.
The basis trade, best known for trillion dollar bets on US Treasuries that spooked regulators, is now growing in popularity in China. The profit on each wager is small, encouraging traders seeking big gains to load up on borrowings, potentially increasing the risk of blowups when unforeseen events rock markets.
The carry trade, meanwhile, has become increasingly risky as the US’s unpredictable economic policies drive volatility. Last August, hedge funds that shorted Japan’s currency and went long on US equity futures were forced to close positions after receiving increased margin calls during a bout of market turmoil. Forced sales in periods like that can exacerbate losses, with knock on impacts for the banking system.
The FSB’s effort to gather more data on non-bank financial institutions, has been frustrated by obstacles in establishing what was already held across the myriad of regulators that oversee NBFIs, what more could be obtained, and what could be shared.
Knot said that the first step will be to ensure that national supervisors have the data necessary to understand the potential financial stability risks from these kinds of activities, because initial analysis showed that a “lot of data” was either not available to regulators at all, or only available with a delay.