
Revival of off-balance-sheet financing merits close scrutiny
Banks need more diverse funding sources, but new structures must be vetted carefully
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.
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.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Printing this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Copying this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email info@risk.net
More on Our take
FX-style crypto platforms could bridge gap with TradFi
Emergence of execution-only ECNs, prime brokers and clearing houses brings new confidence in crypto
Skew this: taking the computational burden off basket options
Dan Pirjol presents a snap formula for estimating implied volatility skew in an instant
Shhh, don’t tell: the struggle to keep skew under wraps
Liquidity recycling by clients has made it more difficult for banks to keep skews quiet
How a machine learning model closed a hidden FX arbitrage gap
MUFG Securities quant uses variational inference to control the mid volatility of options
The AOCI elephant in the DFAST room
After March’s banking crisis, Fed stress tests should adopt harsher and wider ranging rate scenarios
China needs an RMB liquidity absorber – HK might be the answer
Increasing HKMA’s CNH debt issuance could help cement renminbi’s role in financial markets
Into the quantiverse: real-world pricing goes arbitrage-free
QRM quants claim to have bridged divide across ‘multiverse’ of fixed-income models
A three-point turn in derivative design
Citibank quant’s triangle method allows information geometry to be applied to hedge structuring