PrefBlog

The BoC has released a working paper by Jonathan Chiu, Emre Ozdenoren, Kathy Yuan and Shengxing Zhang titled On the Fragility of DeFi Lending:

We develop a dynamic model of decentralized finance (DeFi) lending that incorporates two/these key features: 1) borrowing and lending are decentralized, anonymous, overcollateralized and backed by the market value of crypto assets where contract terms are pre-specified and rigid; and 2) information friction exists between borrowers and lenders. We identify a price-liquidity feedback: the market outcome in any given period depends on agents’ expectations about lending activities in future periods, with higher price expectations leading to more lending and higher prices in that period. Given the rigidity inherent to smart contracts, this feedback leads to multiple self-fulfilling equilibria where DeFi lending and asset prices move with market sentiment. We show that flexible updates of smart contracts can restore equilibrium uniqueness. This finding highlights the difficulty of achieving stability and efficiency in a decentralized environment without a liquidity backstop.
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Decentralized finance (DeFi) is an umbrella term for a variety of financial service protocols and applications (e.g., decentralized exchanges, lending platforms, asset management) that operate on blockchain technology. They are anonymous permission-less financial arrangements implemented via smart contracts — immutable, deterministic computer programs—on a blockchain that have been designed to replace traditional financial intermediaries (TradFi)
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The growth of decentralized finance has been substantial since the “DeFi Summer” of 2020. According to data aggregator DeFiLlama, the total value locked (TVL) of DeFi had risen to 230 billion U.S. dollars as of April 2022, up from less than one billion two years prior to that time. As DeFi grows in scale and scope and becomes more extensively connected to the real economy, its vulnerabilities might undermine financial-sector stability (Aramonte, Huang, and Schrimpf (2021)). As a result, policymakers and regulators have raised concerns about the implications of DeFi for financial stability (FSB 2022; IOSCO 2022).2 Yet formal economic analysis of this issue remains very limited. In this paper, we examine DeFi lending protocols—an important component of the DeFi eco-system—and the sources and implications of their instability. For example, DeFi lending is much more volatile than traditional lending.3 In addition, Aramonte et al. (2022) argue that DeFi lending generates “pro-cyclicality,” the co-movement between crypto prices and lending activities.
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In this paper, we study sources of fragility in DeFi lending caused by several of its fundamental features. These features are informational frictions, such as asymmetric information about collateral quality, oracle problems, and rigid contract terms. We demonstrate the inherent instability of DeFi lending that results from price-liquidity feedback exacerbated by informational frictions, leading to self-fulfilling sentimentdriven cycles. Stability requires flexible and state-contingent smart contracts. To achieve that end, a smart contract may take a complex form. Such a contract also requires a reliable oracle to feed realtime hard and soft information from the off-chain world. Alternatively, DeFi lending could abandon complete decentralization and re-introduce human intervention to provide real-time risk management— an arrangement that would force the protocol to rely on a trusted third party. Our finding highlights a trilemma faced by DeFi protocols: the difficulty involved in achieving simplicity in smart contracts and stability in asset prices while maintaining a high degree of decentralization.

The BoC has published a paper by Martin Kuncl and Dmitry Matveev titled The Canadian Neutral Rate of Interest through the Lens of an Overlapping-Generations Model:

The neutral rate of interest is an important concept and communication tool for central banks. We develop a small open economy model with overlapping generations to study the determinants of the neutral real rate of interest in a small open economy. The model captures domestic factors such as population aging, declining productivity, rising government debt and inequality. Foreign factors are captured by changes in the global neutral real rate. We use the model to evaluate secular dynamics of the neutral rate in Canada from 1980 to 2018. We find that changes in both foreign and domestic factors resulted in a protracted decline in the neutral rate.
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The biggest domestic contributors to the neutral rate change were the two demographic factors. Firstly, higher domestic savings due to longer longevity contributed -83 bps and -34 bps to the R∗ change in the high- and the low-elasticity case, respectively. Secondly, the reduction in TLI [Trend Labour Input] growth that implies lower investment and borrowing of young households contributed by -75 bps and -34 bps to the R∗ change in the high- and low-elasticity case, respectively.

The New York Fed updated its Corporate Bond Market Distress Index (CMDI):

• Corporate bond market functioning appears healthy, with the overall market-level CMDI remaining stable around its historical 30th percentile.
• Market functioning in the investment-grade segment remained below its historical 75th percentile in February.

PerpetualDiscounts now yield 6.25%, equivalent to 8.12% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.06% on 2023-2-10 and since then the closing price has changed from 15.03 to 14.69, a decline of 226bp in price, with a Duration of 12.32 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies an increase in yield of about 18bp since 2/10 to 5.24%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened to about 290bp from the 270bp reported February 15.

TXPR closed at 576.56, down 0.73% on the day. Volume today was 1.51-million, second-highest of the past 21 trading days.

CPD closed at 11.56, down 0.26% on the day. Volume was 157,140, second-highest of the past 21 trading days.

ZPR closed at 9.54, down 0.94% on the day. Volume was 440,170, highest of the past 21 trading days.

Five-year Canada yields were were up sharply to 3.62% today.

The pundits have, as always, a glib explanation:

U.S. and Canadian stocks posted their worst performance of the year on Tuesday, with the main benchmarks ending down as investors interpreted a rebound in U.S. business activity in February to mean interest rates will need to stay higher for longer to control inflation.

For the S&P/TSX Composite Index, S&P 500 and Nasdaq Composite, it was their third session in a row closing lower, while the decline in the Dow Jones Industrial wiped out its gains for 2023.

The falls came after the S&P Global Purchasing Manufacturer’s index, which reflects business activity in the United States, returned to expansion for the first time in eight months in February. The 50.2 reading, up from 46.8 in January, was buoyed by a robust services sector, according to a survey.

The report added to a recent slew of economic data which has painted a picture of a resilient economy, which continues to perform against a backdrop of multiple rate-rises by the central bank in 2022 aimed at tamping down inflation.

With inflation still far from the Fed’s 2% target, and the economy retaining much of its vigor, money market participants have been revising upwards where they see the Fed fund rates peaking – currently at 5.35% in July and staying near those levels throughout the year.

And Canadian inflation was … OK:

Canada’s annual inflation rate eased more than expected to 5.9 per cent in January due to a so-called base-year effect, even as food and mortgage interest costs continued to soar, Statistics Canada data showed on Tuesday.

Analysts polled by Reuters had expected annual inflation to edge down to 6.1 per cent from 6.3 per cent in December. Month over month, the consumer price index was up 0.5 per cent, again lower than analysts’ forecast of a 0.7 per cent gain after a 0.6 per cent decline in December.

Statscan noted that the annual rate was impacted by downward pressure from the base-year effect of January 2022, when prices had risen amid Russia-Ukraine tensions as well as supply chain disruptions.
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Mortgage interest costs rose 21.2 per cent annually in January, the largest increase since 1982, while food prices rose 10.4 per cent, slightly faster than the 10.1 per cent in December.

The average of two of the central bank’s core measures of underlying inflation, CPI-median and CPI-trim, came in at 5.1 per cent compared with 5.3 per cent in December.

TXPR closed at 580.81, down 0.50% on the day. Volume today was 980,030, below the median of the past 21 trading days.

CPD closed at 11.59, down 0.17% on the day. Volume was 102,580, fourth highest of the past 21 trading days.

ZPR closed at 9.63, up 0.21% on the day. Volume was 150,370, slightly above the median of the past 21 trading days.

Five-year Canada yields were were up to 3.48% today.

It was a poor day all ’round, abetted by Fed commentary:

Adding to recent worries about monetary policy, Fed Governor Michelle Bowman said the central bank will need to keep raising interest rates until it makes much more progress tackling inflation. Richmond Fed President Thomas Barkin said the central bank still needs to raise interest rates, but that it could stick with quarter-point increases.

… and the Canadian Industrial Product Price Index announcement didn’t help:

In January 2023, the Industrial Product Price Index increased 0.4% month over month, following two consecutive months of declines, and rose 5.4% year over year.

Prices for energy and petroleum products rose 0.4% month over month, following a 10.2% decline in December. Year over year, prices were 19.8% higher in January compared with January 2022. In January 2023, the price of finished motor gasoline was up 8.8% and jet fuel rose 14.1%, while diesel fuel fell 4.8%. The price of conventional crude oil, the raw material used to make refined petroleum products, rose by 1.3% in January. In late December, US refinery utilization dropped as a result of severe cold weather conditions, putting upward pressure on refined product prices. The 14.1% jet fuel price increase was the largest January month-over-month increase on record, and the sixth-largest month-over-month gain overall. Jet fuel prices rose partly due to higher global travel demand, as COVID-19 travel restrictions in China were lifted. According to data from Canadian Air Transport Authority, 3.9 million passengers travelled through Canada’s eight largest airports in January, more than double the number from January 2022.

Guess what’s still going through the courts?:

Almost 20 years since harmful market-timing trading in mutual funds was first exposed by U.S. authorities, an Ontario court has found that fund managers breached their duties to investors when they failed to prevent market-timing trading by allowing hedge funds to use their funds to engage in the practice.
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Later, a class action was filed against the five major fund managers that had reached settlements with the Ontario Securities Commission over the practice — IG Investment Management Ltd., CI Mutual Funds Inc., Franklin Templeton Investments Corp., AGF Funds Inc. and AIC Ltd. Three of those five firms have since settled.
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While the mutual funds’ prospectuses warned about the harm from frequent trading and threatened 2% fees to prevent it, “the defendants not only failed to take steps to prevent frequent trading or charge the fees set out in their prospectuses when it occurred, they facilitated frequent trading by entering into ‘switch agreements’ which allowed certain investors to switch in and out of funds for a fee of only 0.2%,” the court noted.

According to the court’s ruling, the firms argued they weren’t aware that the frequent traders were engaged in “time zone arbitrage.”

However, the court found that the specific form of market timing didn’t matter — it was the frequent trading that harmed long-term investors.

“Had the defendants taken steps to prevent or prohibit frequent trading, they would have prevented time zone arbitrage as well,” it said.

At the same time, the court ruled that while the fund firms were negligent, they did not breach their fiduciary duties to investors.

“I do not find that their negligence rises to a breach of honesty or good faith,” the court said in its decision.

“The defendants may have acted with considerable hubris in thinking that their own ‘knowledge’ of the market was superior to that of experienced, sophisticated hedge funds. They acted with a lack of knowledge that fell below the standards of care in failing to recognize the dangers of frequent short-term trading. They acted with carelessness in failing to understand what the frequent traders were telling them. They acted negligently in failing to examine past or current trading records to test their random walk thesis, but I am not persuaded that they acted in breach of their fiduciary duties,” it said.

Based on the finding that the companies breached their duties of care, however, the court directed the case to proceed to a trial to determine investors’ damages.

Well, I haven’t read the actual decision, so I won’t comment too much. Let’s just say that these guys were either crooked or stupid and the most surprising thing is that any of these firms are still in business.

US Producer Prices came in high:

The number of Americans filing new claims for unemployment benefits unexpectedly fell last week, offering more evidence of the economy’s resilience despite tighter monetary policy.

Other data on Thursday showed monthly producer prices increasing by the most in seven months in January as the cost of energy products surged. Even stripping out food and energy, prices for the so-called core goods recorded their biggest gain since last May.
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A second report from the Labor Department on Thursday showed the producer price index for final demand rebounded 0.7% in January, the largest increase since June, after decreasing 0.2% in December. The rise was led by a 1.2% advance in goods prices, which followed a 1.4% decline in December.

A 6.2% jump gasoline prices accounted for nearly a third of the increase in goods. There were also increases in prices for residential natural gas, diesel fuel, jet fuel, soft drinks and motor vehicles.

But fresh and dry vegetable prices tumbled 33.5%. Excluding food and energy, core goods prices shot up 0.6%. That was the biggest increase in core goods prices in eight months and followed a 0.2 gain in December. Services increased 0.4%, matching December’s gain.

In the 12 months through January, the PPI increased 6.0% after advancing 6.5% in December. Economists had forecast the PPI climbing 0.4% and rising 5.4% year-on-year.

Federal Reserve Bank of Cleveland President Loretta Mester talked tough:

The Fed “has come an appreciable way in bringing policy from a very accommodative stance to a restrictive one, but I believe we have more work to do,” Mester said in a speech text. “At this juncture, the incoming data have not changed my view that we will need to bring the fed funds rate above 5 per cent and hold it there for some time to be sufficiently restrictive to ensure that inflation is on a sustainable path back to 2 per cent,” she said.
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Mester, who does not have a vote on the Federal Open Market Committee this year, noted she would have been open to a larger rate rise at the gathering. “Setting aside what financial market participants expected us to do, I saw a compelling economic case for a 50-basis-point increase, which would have brought the top of the target range to 5 per cent,” she said.

Tiff Macklem is fairly upbeat:

The Canadian economy may be on track for a recession this year, but it won’t feel as severe as other downturns the country has experienced over the past few decades, according to Bank of Canada Governor Tiff Macklem.

“It’s not going to feel great. But it is not going to feel like what people think of when you say the word recession,” Mr. Macklem said in an appearance before the House of Commons finance committee on Thursday. “You say recession, they think big job losses, very, very painful.”
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“But this is still going to be a pretty healthy labour market,” Mr. Macklem said. “This is not going to feel like the kind of recessions that we had in ‘08, or ‘81 or ‘91.”

Mr. Macklem reiterated that the Bank of Canada does not expect to raise interest rates further, despite a stronger-than-expected January jobs report published on Friday. But he said he’s willing to hike rates again if inflation does not drop as much as the bank is forecasting. The bank has raised its policy interest rate to 4.5 per cent from 0.25 per cent since March.

The Globe highlighted some Senate fluff:

A Senate committee is calling for greater parliamentary oversight of the Bank of Canada as well as increased transparency, wading into a debate around central bank independence at a moment of heightened political interest in monetary policy.

The Senate committee on banking, commerce and the economy published a report on Wednesday looking at the causes of high inflation and the state of the economy. The report did not make any formal recommendations, but it did suggest that parliamentarians should spend more time looking at monetary policy issues.

“What is evident is the need for enhanced Parliamentary oversight over the deployment of fiscal and monetary tools, particularly in times of crisis and uncertainty,” the report said.

“The Bank of Canada should be more transparent and periodically make public its assessment of the effect of its interventions on inflation and on the evolution of key economic indicators,” it added.

Well, I went to the committee’s report page and got a copy of the report The State of the Canadian Economy and Inflation. It’s garbage. You saw that line in the Globe’s report, “A Senate committee is calling for greater parliamentary oversight of the Bank of Canada”? You know what the Committee’s report says?:

What is evident is the need for enhanced Parliamentary oversight over the deployment of fiscal and monetary tools, particularly in times of crisis and uncertainty.

That’s not a headline. That’s not an introductory sentence. That’s the whole damn thing; there’s not a single sentence in the report that specifies what so-called enhancements are evidently needed; there’s not a single sentence in the report that provides any support for the assertion. Garbage.

The rest of the fluff is along the same lines. There are some fairly big names being interviewed by the committee, but they simply provide unsupported and unchallenged assertions about their views on the economy, BoC policy, whatever. There’s nothing of any substance in the piece, nothing referenced, nothing challenged. Garbage.

The Boston Fed has released a study of forecasting of the ‘shelter’ component of the US CPI:

According to the authors’ forecast, CPI shelter will increase 5.9% from September 2022 to September 2023 and 3.9% over the ensuing 12 months. By contrast, from 2000 through 2019, CPI shelter rose an average of 2.7% annually.

The authors base their forecast of rapidly rising CPI shelter on two trends: (1) Although market-rent growth has slowed recently, it was substantially faster than CPI-shelter growth throughout 2021 and the first half of 2022, and (2) CPI shelter usually catches up with market rents.

The authors explain that CPI shelter tends to lag market rents because of the way that the U.S. Bureau of Labor Statistics constructs CPI shelter. The BLS gathers information for the index through its Consumer Price Index Housing Survey. The survey measures average rental prices for all renters – new and existing – whereas market rents measure only rental prices for new tenants. The authors note that landlords tend to raise the rents of current tenants slowly, so an index that includes current tenants’ rents is going to be lower than one that excludes them.
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If CPI shelter does increase 5.9% from September 2022 to September 2023, as the authors forecast, and 3.9% over the ensuing 12 months, the headline CPI will be 1% higher over the first 12-month period and 0.4% higher from September 2023 to September 2024 compared with what it would be if shelter prices grew at the pre-pandemic pace of 2.7%. The core CPI will be 1.3% and 0.5% higher.

And there’s data from the New York Fed’s Household Debt and Credit Report:

Total household debt rose by $394 billion, or 2.4 percent, to $16.90 trillion in the fourth quarter of 2022, according to the latest Quarterly Report on Household Debt and Credit. Credit card balances increased by $61 billion to reach $986 billion, surpassing the pre-pandemic high of $927 billion; mortgage balances rose to $11.92 trillion, auto loan balances to $1.55 trillion, and student loan balances to $1.60 trillion. The share of current debt transitioning into delinquency increased for nearly all debt types.

And, finally, a complaint about reporting:

An IT failure at Lufthansa stranded thousands of passengers and forced flights to Germany’s busiest airport to be cancelled or diverted on Wednesday, with the airline blaming botched railway engineering works that damaged broadband cables.

More than 200 flights were cancelled in Frankfurt, a vital international transit hub and one of Europe’s biggest airports, a spokesperson for operator Fraport said.

Lufthansa later said all its IT systems were up and running again and that it expected Frankfurt flights to return to normal on Thursday.
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Lufthansa and Germany’s national train operator blamed the problem on third-party engineering works on a railway line extension that took place on Tuesday evening, when a drill cut through a Deutsche Telekom fibre optic cable bundle.

I can’t really do better than to copy-paste my comment on the Globe’s site:

Details are missing here.

We are being told that one cut in one cable caused this system crash. Where’s the redundancy? The whole point of the Internet is to ensure that networks operate with absolutely minimal exposure to single point failure – and if this cable wasn’t part of the Internet, what system was it part of? Who tried to reduce expenses and promote efficiency by building a shoddy system that could be brought to its kness by one cut in one cable?

There was another jump in yields today:

Financial markets have upped their bets on additional rate hikes from the Bank of Canada and U.S. Federal Reserve following blowout employment reports in both countries and higher-than-expected inflation data from the United States.

This amounts to a U-turn for bond traders and investors, who spent much of January and early February doubting the resolve of central bankers in both countries to keep interest rates at highly restrictive levels through 2023.

Interest rate swaps, which capture market expectations about future rate decisions, have gone from pricing in two rate cuts by the Bank of Canada before the end of the year, to pricing in another rate hike in July and no rate cuts until 2024. That would bring the bank’s benchmark rate to 4.75 per cent.

In the U.S., markets now see the Fed increasing its benchmark interest rate to a peak of 5.25 per cent by July, a quarter-point higher than expected two weeks ago.

But people are still buying things:

The S&P 500 ended higher on Wednesday after stronger-than-expected retail sales data offered evidence of resilience in the U.S. economy, but gains were capped as investors worried about more interest rate hikes by Federal Reserve in the months ahead. Canada’s main stock index eked out marginal gains.

A Commerce Department report showed U.S. retail sales surged 3% in January as purchases of motor vehicles and other goods pushed the number well past the 1.8% estimate from economists polled by Reuters.

But not houses:

Canada’s housing downturn deepened further in January, with sales hitting their lowest level since the 2009 Great Recession and home prices declining for the 11th straight month.

The volume of home resales fell 3 per cent from December to January after removing seasonal influences. That was the lowest level for January in 14 years, according to the Canadian Real Estate Association. The home price index, which excludes sales of highly priced properties, fell to $714,700 in January, down 1.9 per cent from December. The index is 12.6 per cent lower than a year ago and 15 per cent below last February’s peak values.

More homeowners put their properties on the market, with new listings increasing 3.3 per cent last month. CREA said this could be the start of more activity heading into spring, which is traditionally the busiest period for home sales.

GOC-5 now stands at 3.45%.

PerpetualDiscounts now yield 6.05%, equivalent to 7.86% interest at the standard equivalency factor of 1.3x. Long corporates yielded 5.06% on 2023-2-10 and since then the closing price has changed from 15.03 to 14.82, a decline of 140bp in price, with a Duration of 12.32 (BMO doesn’t specify whether this is Macaulay or Modified Duration; I will assume Modified) which implies an increase in yield of about 11bp since 2/10 to 5.17%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed to about 270bp from the 285bp reported February 8.