Spreads on bank-intermediated arbitrage trades, known as bases, have persisted since the 2008 financial crisis, attracting significant academic and practical interest. These spreads are often seen as evidence that financial intermediaries play a more complex role than assumed in classical theories. The persistence of bases suggests that intermediaries face frictions that affect asset prices and the broader economy.
Covered-Interest Parity (CIP) is a simple arbitrage trade conducted by banks. It involves borrowing dollars, exchanging them for foreign currency through a foreign exchange swap, and investing the proceeds in foreign safe assets. At maturity, the intermediary returns dollars to the customer and repays the initial loan. CIP implies that the return on this transaction should be zero. Deviations from CIP reflect frictions in the global provision of dollar funding, primarily via currency swaps and forwards.
Three novel forces drive bases:
These forces generate both time-series and cross-sectional variations in CIP deviations.
The study uses confidential supervisory data covering $25 trillion in daily notional exposures. The data provide detailed information on bank positions in specific country interest rates and currencies, allowing for a granular examination.
A stylized model was built to explain the frictions driving bases. The model includes:
The Federal Reserve's FR2052a report provided granular, high-frequency data on the balance sheets of the largest U.S. banks, covering $25 trillion in daily notional exposure. This data allowed for a detailed view of intermediaries' positioning in currency markets.
The study highlights the importance of segmentation and search frictions in even the largest and most liquid markets. These frictions contribute to the persistence of bases, providing empirical evidence for the role of intermediaries in the global provision of dollar funding.