A new report from Finadium reviews the market for Collateralized Commercial Paper, a potential term repo alternative.
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.
But why invest in repo alternatives at all? There is an active term repo market where cash borrowers trade with cash lenders. The cash borrowers are mostly banks and broker/dealers seeking to finance house or client inventory positions, use the markets to express an interest rate view, or both. Cash lenders including mutual funds, pension plans and insurance companies may also have an interest rate bet they are looking to make, but more often than not want to invest their cash in a safe and fully collateralized investment like repo. Some cash investors would like to invest in term repo but they are restricted by broad investment or regulatory policies. And some cash borrowers would prefer to fund themselves purely on an overnight basis, but they cannot. Meanwhile, a Collateralized Commercial Paper trade creates a synthetic term repo transaction. Cash investors buy the commercial paper that is backed by repo trades with the issuer. Their risk, generally speaking, mimics that of a term repo with the cash borrower.
The greatest risk in Collateralized CP is the collateral itself. Programs are allowed a broad set of eligible paper to be repoʼed 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, Finadium looks 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.
For more information and the table of contents for this report, please visit the Finadium website.