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CAREER: Empirical Analysis of Auctions in Financial Markets

Sep 2013 to Aug 2018



National Science Foundation


The focus of this proposal is the analysis of several financial markets by employing data from various closely linked auction markets. I aim to use strategic models of bidding behavior to recover information about cost-of-funding contained in bids and analyze its dynamics to gain insights about financial health of individual banks. The recent financial crisis has underlined the importance of understanding the mechanics of the banking system and especially the mechanisms used to allocate liquidity/short-term funds across the system. The first proposed research project analyzes the European Central Banks (ECB) weekly refinancing auctions, the primary mechanism through which the ECB supplies liquidity to the Euro-zone banking sector. I focus on the time of severe distress (2007-09), which includes the onset of the 2007 financial crisis and the failure of Lehman Brothers. This turmoil ultimately resulted in the ECB abandoning auctions altogether and implementing a full-allotment mechanism instead. The project utilizes detailed bank-level data from the auctions, fixed rate tenders, deposit and lending facilities and directly from banks’ balance sheets in order to model banks’ observed actions in these mechanisms and infer interest rates each bank would have to pay in the over-the-counter interbank market to obtain a loan. The dynamics of these funding costs are a useful indicator of distress of individual banks. Further goal of this proposal is to obtain a new measure of systemic risk: a measure of how crucial a particular bank is for the whole financial system. Using even more detailed data from Canadian financial market I hope to verify whether the findings from the European market might hold more generally. Finally, I also propose to study auctions for settlement of credit default swap (CDS) contracts, which have a very unusual format that may provide some strange incentives to dealers. Since the amount of outstanding CDS contracts greatly exceeds the amount of covered bonds, the currently employed two-stage auction procedure is a very important price-discovery mechanism that allows for financial settlement of these contracts after a triggering event. Yet the strange features of this mechanism may cast some doubt on whether the participants have the right incentives to behave in a way that the resulting price of the bond corresponds to its true value. Intellectual merit: The analysis of individual bank behavior in the liquidity market during the crisis will provide us with better understanding of the link between the balance sheets, bidding behavior and the cost of funding of these institutions. The dynamics of these funding costs are a promising direction for quantification of the systemic risk. This research is thus a direct complement to parallel efforts to estimate this important parameter. The proposed study of the auctions for settlement of credit default swap contracts focuses on another important market, which has not been extensively studied to date. The proposed project evaluates the benefits and deficiencies of the two-stage mechanism that is currently used. Broader impact: The proposed research has the potential to generate measures of financial health of individual banks and quantify the importance of a bank for the whole system. Using the proposed methods we thus may be able to formally identify the “too-big-to-fail” banks, and hence we may improve targeting of potential policy interventions. The part of the project on credit default swap auctions should shed some light on the reliability of that mechanism to discover the correct price of bonds of defaulted issuers and potentially point to its deficiencies. This should be of interest to regulators and policy-makers. The results of the research will be disseminated broadly to promote their application by the relevant institutions.