We’re seeing a hole in the market, one that we thought would be solved already but that remains an attractive opportunity for an institution able to take on some maturity mismatch. On the one hand are institutions with US Treasuries looking for short-term loans. The loan volume for these institutions has fallen heavily; some utilizations are down to 20% or 30% due to a desire for loans of just a day or three. On the other hand are broker-dealers and banks looking for loans over 30 days to meet Liquidity Coverage Ratio obligations. How are these two ends going to meet in the middle?
There seems to be continued demand for term Treasury loans. The counterparties we see in this transaction appear comfortable enough with each other. The trouble is that a cash for Treasuries loan is, while not a collateral downgrade, ineffective in light of the LCR. As a quick recap, the LCR measures the amount of High Quality Liquid Assets divided by total expected net cash outflows in a 30 day period. HQLA is pretty straight-forward to measure, subject to haircuts but not indecipherable. Calculating the denominator of total net cash outflows requires multiple degrees in particle physics, forensic accounting, philosophy, astrology or other advanced divining arts, owing to the many outflow factors involved. A one-to-one loan of US Treasuries vs. cash should not be assumed to result in a one-to-one balance in a firm’s LCR.
The best case scenario for bank borrowers is a loan over thirty days. We have discussed in various venues the growth of evergreen loan and repo transactions that are designed specifically to mitigate the impact of the LCR. Until the Net Stable Funding Ratio comes into play, with the expectations that loans to bank counterparties would have a greater impact than loans to non-financials, the ground rule that a securities loan over 30 days is better than a loan under 30 days is a safe assumption.
So how do loans with one party of, say, three days get transformed into a loan with an over 30 day term. One solution is that an intermediary provides maturity transformation. Some of it could go on a CCP, hence reducing the balance sheet impact. The LCR still matters, but through the miracle of Basel III-allowed CCP netting, the LCR hit can become a fraction of the notional impact. This strategy will become easier once Single Treasury Futures start trading in July and cleared repo extends to the buy-side in some venue or another. Equities might be pretty easy too especially if both trades go on the Options Clearing Corp’s CCP. Another part of the trade will stay stuck in the bilateral world, say corporate bonds for US Treasuries. For institutions with balance sheet capacity, this may be a lucrative trade opportunity. Its just a variation of getting paid for balance sheet usage. The new twist is that in the post Basel III world, a new set of institutions may be better suited to providing business sheet than traditional bank intermediaries.
There is an obvious solution to this problem as well: give US Treasuries away vs. cash at 0 or negative in order to raise cash for reinvestment. The idea is to make the loan cheap enough as to provide no negative to the borrower’s LCR calculation. This works for the lender if the cash reinvestment vehicle produces a return that is worth the while. This solution is completely not viable for non-cash loans and may not be that attractive for cash either, depending on the cash reinvestment guidelines of the lender; this certainly won’t meet the smell test of a 5 or 10 bps minimum intrinsic spread before a loan is made. But in a new world order where short-term loans of US Treasuries have demand, just at a very low price, this may be a good way to go. We don’t see enough lenders excited about this plan to think that it will become a market standard, but it does work for the subset of lenders and borrowers willing to make the deal.