Revival of off-balance-sheet financing merits close scrutiny

The prime brokerage source sounds frustrated. The bank’s equity financing business is feeling the pinch of funding constraints as rates rise. There is a solution: diversify funding by issuing commercial paper to investors through an off-balance-sheet entity. These facilities already exist, but the business has been waiting months for approval to use them. When asked about the hold-up, the source replies tersely: “Documentation, lawyers, all of that.”

Compliance staff have good reason to be cautious, though. These types of off-balance-sheet vehicles – known as asset-backed commercial paper (ABCP) conduits – helped fuel the 2008 global financial crisis. When investors fled structures that housed subprime mortgage securities, banks suddenly had to bring these assets back onto their books, further adding to their troubles. Post-crisis reforms limited the use of such vehicles, but they haven’t gone away entirely.

Several large banks, including Barclays, BNP Paribas, JP Morgan and Societe Generale, have continued to use ABCP conduits to fund some of their trading activities, primarily in US Treasuries. The structures are typically managed by third parties – Cantor Fitzgerald, Guggenheim Partners and Nearwater Capital are the biggest sponsors – to keep them at arm’s length, with some dating back to 2012. Now, off-balance-sheet financing is being expanded into riskier assets.

New York-based fintech Capitolis is at the vanguard of this shift. Since 2020, it has issued tens of billions of dollars’ worth of ABCP through its Ionic Capital Trust programme to fund equity swap hedges for Citi and UBS. Others are following suit.

It falls to banks’ compliance teams – and their regulators and accounting watchdogs – to determine whether these structures are truly off-balance-sheet or not. Capitolis’s model appears to pass the test – at least in the eyes of Citi and UBS. Banks hedge their client exposures by entering total return swaps with a dedicated special-purpose vehicle (SPV), which issues commercial paper to fund the underlying share purchases. The commercial paper is maturity-matched to the swaps, ensuring the SPV is not left with unfunded assets. Banks can terminate the swaps early, but must compensate investors for any lost interest or principal if they do so. This could be a drag on banks if they need to exit hedges in a hurry – for instance, if multiple clients default – but nothing catastrophic.

Firms are exploring variants on the structure. Nearwater Capital, which is preparing to launch a similar equity total return swap service later this year, will issue commercial paper and enter swaps with bank counterparties via a corporate entity domiciled in Ireland, rather than dedicated SPVs. Unlike Capitolis’s structures, there will be no direct link between the debt issued by Nearwater and the total return swap contracts it executes with banks.

Inside Capitolis’s equity swap platform

This addresses one of the potential risks with Capitolis’s structure. A second prime brokerage source worries that single-seller structures – where each bank faces a dedicated SPV – could give the impression the bank will step in if the SPV runs into trouble.

But Nearwater’s approach brings its own complications. The firm’s legal advisers reviewed its structure and concluded that it would need to register with the US Securities and Exchange Commission as a security-based swap dealer – a requirement that could drive up costs.

Cantor Fitzgerald’s programme, which is scheduled for launch in early 2023, appears to fall somewhere in the middle. Banks will face a single SPV that funds its share purchases by selling short-term debt to a range of investors, including pension funds and money managers.

Capitolis and Cantor maintain that their structures are not required to register as security-based swap dealers – but Capitolis intends to do so anyway as part of its future plans.

Legal and compliance have their work cut out to vet these structures, each of which has its own quirks and complications. Flawed funding models can have serious consequences. With markets looking fragile, and demand for equity financing slipping, this may not be the time to gamble on untested structures. Prime brokers in need of funding may need to show more patience.