We have been watching with interest to see how the market develops as banks are forced to reduce their shadow banking activities. Specifically, we are looking at alternatives for repo, securities lending and securitization as trading moves away from banks to market participants that are more able to conduct them. We are starting to see some interesting alternatives.
1) We’ve talked about Direct Repo before and still think it is a good idea. At the same time, we are hearing more pushes in the US towards bilateral repo and repo transactions arranged away from banks to avoid spreads over 20 bps (for agencies at least). This suggests that the market is recognizing the increased costs that banks are charging to use their balance sheets. The more expensive it is for investors to finance assets, and the less valuable it is for investors to provide cash in the repo markets directly to a bank, the more we would expect to see non-bank arranged repo transactions. In Europe we are hearing less talk about a new interest in bilateral, but that market was always more popular than in the US.
2) We are waiting for more funds to emerge that take in repo assets and issue commercial paper. Northcross Capital in the UK does this in their Anglesea Funding Commercial Paper Program, and advertises this program alongside their conduit repo book program. South Street? Direct Repo guys? We think this is your time in the sun.
3) While bilateral repo is a good option for pension plans and others that can determine their own credit risk parameters, is not acceptable for money market funds done must remain within certain risk criteria as defined by ratings agencies. To that end, we are hearing more about securitized commercial paper (also called collateralized commercial paper) that mimics repo but is set up under a structure that provides a credit rating. This paper can be bought by money market funds and others who want a third-party to determine the credit quality of the underlying instruments. We think this topic is important enough that we have put it into our 2013 research report agenda.
4) We are fascinating by the idea of K-Notes, promoted by Karson Capital. Karson says that “The K-Note has been designed to deliver payment on demand. It was initially designed to meet strict criteria imposed by U.S. insurance regulation and has become a safe and effective alternative to traditional bank letters of credit and funded trust accounts (i.e., Regulation 114 accounts). Given the initial success of the K-Note as a qualifying form of security in the insurance / reinsurance markets, its application is being expanded into a number of new markets where high-quality security is required.” Maybe we are late to the game, but K-Notes seem like a pretty new product in the marketplace designed to facilitate the needs of particular market segments by creating derivatives that serve specific collateralization needs. Pretty neat.
Regulations breed new opportunities: this has been shown time and time again, and Shadow Banking is no exception. We look forward to seeing what creative types think up next.