Bulletin de la Banque de France 235/1 - MAY-JUNE 2021 Economic research Convergence trading, arbitrage and systemic risk in the United States Convergence trading, especially arbitrage, is used on a large scale by investment banks and hedge funds, and contributes to the smooth integration of financial markets. However, it is also a source of systemic risk, as the transactions involve short-term debt that can be cut off by the creditor in times of market stress. In this case, arbitrageurs are forced to rapidly unwind their positions, leading to abnormal falls and divergences in asset prices. This risk materialised in the US Treasury market during the crises of 1998 – with the collapse of the hedge fund Long Term Capital Management (LTCM) – and of 2008, but ultimately proved contained in the 2020 health crisis. The intervention or non-intervention in the market of the US Federal Reserve can be linked to the severity of the financial crises. Hugues Dastarac JEL codes: Monetary and Financial Analysis Directorate G01, Financial Economics Research Division G23, G28 This bulletin presents the findings of research carried out at the Banque de France. The views expressed in this bulletin are those of the authors and do not necessarily reflect the position of the Banque de France. Any errors or omissions are the responsibility of the authors. 3 Convergence trading by US primary dealers and corporate bond spreads number of major financial crises (outstanding amounts in USD billions; spread in %) in the past 25 years Corporate Treasury Spread on A-rated bonds Spread on BBB-rated bonds bonds bonds (right-hand scale) (right-hand scale) involving convergence trading 300 250 July 2007 Bankruptcies of 200 Be ar Stearns USD 200 billion 150 Lehman Brothers net stock of US Treasury bonds 100 shorted by primary dealers 50 as at end-June 2007 0 -50 15 -100 -150 10 -200 5 -250 -300 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Sources: Federal Reserve Bank of New York, FINRA (TRACE database); Dastarac (2020). Note: Stocks of corporate bonds held by primary dealers and stocks of Treasury bonds shorted by primary dealers. Median spreads between corporate bonds with a residual maturity of between 4 and 6 years and rated A or BBB by the strictest agency, and an equivalent Treasury bond (Gilchrist and Zakrajsek, 2012). Bulletin de la Banque de France Economic research 2 235/1 - MAY-JUNE 2021 1 What are convergence trading identical. An investor looking to buy one of the bonds will and arbitrage? most likely choose the cheaper one, causing its price to rise. The prices of the two bonds should thus converge Convergence trading consists in exploiting the difference over time and the risk should remain limited; however, between two asset prices in the expectation that they will the price divergences and potential profits in this case converge over the short or medium term. The strategy are small. In order to generate acceptable returns for the is mainly used by investment banks and hedge funds.1 shareholder, arbitrageurs sometimes have to use massive Another term for convergence trading is relative value leverage, which creates substantial risks (see below). trading or pairs trading. LTCM’s strategy When the two assets involved are almost identical, the practice is known as arbitrage. Launched in 1994, the hedge fund Long Term Capital Management (LTCM) used arbitrage to exploit the How do you profit from price divergences? divergence between recently issued (on-the-run) US Treasury bonds, which are more liquid and To illustrate, take the example of two bonds from the same more expensive, and those issued a few months issuer, with similar maturities and equivalent contract earlier (off-the-run), which are less liquid and cheaper. terms (same seniority, option for early redemption by LTCM shorted on-the-run securities and went long in the issuer, same coupon, etc.). The strategy consists first off-the-run securities, in the expectation that their prices in buying the cheaper bond, which we shall call A, and would converge over the next few months, as had short selling the more expensive bond, called B; short generally been observed. selling a bond means borrowing it from an investor and selling it onwards in the market. In the second step of US banks’ strategy in the 2000s for Treasury the strategy, bond A is sold and bond B is bought back and corporate bonds in order to return it to its owner. In the 2000s, primary dealers3 in the United States built The strategy is profitable if the prices of A and B up long positions in corporate bonds while simultaneously converge. If, for example, the price2 of bond A falls, shorting US Treasury bonds (see Chart 1 below). The the convergence between the two prices will mean that corporate bonds they purchased were rated investment the price of bond B falls even further; the loss on the grade,4 meaning that the associated default risk was purchase/resale of bond A is therefore more than offset moderate to low (Dastarac, 2020). by the gain on the sale/repurchase of bond B. The same applies if the price of bond B rises. The strategy was as follows: all other things being equal, Treasury bonds are more liquid and therefore cost more In general, convergence trading can be just as risky as than corporate bonds; as a result, it appeared profitable gambling on whether the price of any asset will rise or to short sell Treasury bonds and buy top-rated corporate fall. In the case of arbitrage, bonds A and B are almost bonds with similar maturities. 1 Investment banks provide services for businesses: lending, cash management, securities issuance and market making, arbitrage, etc. Hedge funds are investment funds that use leverage to hedge certain components of their assets and increase their exposure to other components (as described in this article). 2 In reality, the price at which an investor can purchase an asset (offer or ask price) is higher than the price at which it can sell it (bid price) to an intermediary. This difference (the bid-ask spread) must be taken into account when assessing the profitability of a convergence trade. Here, the price (singular) of an asset is taken to be the average of the bid and ask prices. 3 Banks and other financial institutions agree to subscribe regularly to issues of US Treasury bonds, and trade them in the secondary market. 4 Bonds top-rated by credit ratings agencies. Convergence trading, arbitrage and systemic risk in the United States Bulletin de la Banque de France Economic research 3 235/1 - MAY-JUNE 2021 C1 US primary dealers’ positions and corporate bond spreads (outstanding amounts in USD billions, spread in %) oo bon bon S on bon in l S on bon in l 300 20 l 200 nkri o 200 Sn 0 n o 00 0 0 0 15 00 0 0 200 5 20 300 0 2002 2003 2004 200 2006 200 2008 2009 200 2011 202 203 2014 2015 2016 Sources: Federal Reserve Bank of New York, FINRA (TRACE database); Dastarac (2020). Note: Stocks of corporate bonds held by primary dealers and stocks of Treasury bonds shorted by primary dealers. Median spreads between corporate bonds with a residual maturity of between 4 and 6 years and rated A or BBB by the strictest agency, and an equivalent Treasury bond (Gilchrist and Zakrajsek, 2012). The benefits of convergence trading and especially 2 The 1998 and 2008 crises arbitrage: intermediation between fragmented markets laid bare the risks of convergence trading Two identical bonds, A and B, generate identical revenues in all circumstances. Consequently, any price divergence In theory, arbitrage is risk-free if (i) bonds A and B between the two bonds reflects a fragmentation between are absolutely identical, and (ii) the arbitrageur markets: participants in the market for bond B, which can maintain their positions5 indefinitely. If these is more expensive, cannot opt instead to buy bond A, conditions are met, the arbitrageur can wait until which is more attractive price-wise. either the bonds mature or the issuer defaults: they will then receive a reimbursement for bond A and, There is therefore a benefit to be gained from bringing instead of returning bond B to its owner, can give participants in both markets together: participants in back an amount corresponding to the security’s full or market A can sell their securities at a higher price partial reimbursement. to participants in market B. While a straightforward merger between markets might be impossible, or indeed Risk 1: the bond prices do not converge undesirable from the point of view of market managers, because the observed divergences are justified arbitrageurs can bring the two together by buying from by the underlying fundamentals sellers in market A and selling to buyers in market B. Betting that the prices of two very different assets will However, the benefits for markets go hand in hand with converge is just as risky as gambling that an asset price substantial risks. will rise or fall. 5 A position in a security can be short or long. A long position is where the investor holds the security. A short position is where the investor has borrowed the security and sold it in the market. Convergence trading, arbitrage and systemic risk in the United States Bulletin de la Banque de France Economic research 4 235/1 - MAY-JUNE 2021 Even in the case of arbitrage, in practice two assets The loan to fund position A takes the form of a repurchase are rarely completely identical, so the revenues they agreement (repo): the lender purchases the security from generate may differ.