Collateralized Commercial Paper: Regulatory Arbitrage or Elegant Solution?
Finadium
October 2013
Collateralized Commercial Paper is a classic example of financial innovation, albeit one driven by regulatory arbitrage. For banks, Collateralized CP helps extend liabilities and funding terms – a requirement of the Basel III Liquidity Coverage Ratio – while also generating an asset that money market funds and other investors who avoid term repo can buy. The product is created by embedding repo risk into an Asset Backed Commercial Paper (ABCP) structure. But Collateralized CP should not be directly compared to the type of ABCP that imploded during the financial crisis; there are important differences.
The greatest risk in Collateralized CP is the collateral itself. Programs are allowed a broad set of eligible paper to be repo’ed into the structure. The potential for adverse selection is very real, but like any repo, this contingent risk only becomes a problem should the repo counterparty fail. Nonetheless, since most investors do not focus on the underlying collateral in their analysis, if it becomes a problem, it will likely be too late. To compound the potential for confusion, ratings agencies have based their opinions of Collateralized CP on the quality of the underlying issuer, not the collateral itself.
In this report, we look at the role that Collateralized CP is currently playing in solving funding challenges for banks and broker-dealers, and investment challenges for cash borrowers. While Collateralized CP is not brand new, it effectively reworks existing structures for a new purpose. Its small but growing use represents a new sub-category of investment product that warrants attention for its funding and regulatory opportunities, and potential for pitfalls.
This report should be read by cash investors, repo dealers, commercial paper issuers, regulators, compliance officers and legal counsel at investment firms.
This report is 33 pages with 7 exhibits.
TABLE OF CONTENTS
■ Executive Summary
■ Why Bother with Collateralized Commercial Paper?
– Overcoming the ABCP History
■ The Mechanics of Collateralized CP
– How Do Credit Ratings Get Established?
– Who Are the Issuers?
– What About the Rates?
– Tri-party Infrastructure
■ LCR and the Regulatory Dilemma
– Going After the Numerator
– The Denominator Approach
– The Importance of Compliance
■ Money Market Funds and the SEC
■ Artful Dodge or Better Solution?
■ About the Author
■ About Finadium