Once upon a time, the world of asset-backed commercial paper was interesting. Not lead-character interesting, but by funding the US subprime mortgage machine it played a major supporting role in making the global financial crisis possible.
Since then it has been less interesting. In fact, setting aside its bit part in the Covid “dash for cash” that embroiled US money markets, it’s been dull. But perhaps things are changing.
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A new note from JPMorgan suggests that the growing ABCP issuance coincides with — and may be intimately connected to — a growth in equity repo volumes. Why might you care? Because it draws a straight line between money-market funds and hedge funds’ (and retail’s) ability to punt stocks using leverage.
Asset-backed commercial paper is one of a range of super-short-dated tradeable debt instruments, that together make up what people like to call the money markets. ABCP is mostly issued daily, and primarily bought by money-market funds and other institutional investors who want to earn a return on their cash. As the name implies, some kind of assets act as collateral for the short-term loans.
ABCP tends to pay an itsy bit more interest than conventional commercial paper issued by plain-vanilla banks or big non-financial companies. And when it comes to cash management, every basis point counts.
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And according to JPMorgan, investment banks are increasingly turning to the ABCP market as a source of financing for their fixed income and equity collateral. As Teresa Ho, Pankaj Vohra and Molly Herckis write:
. . . certain ABCP structures (e.g., independent sponsor programs) can provide banks with off‑balance‑sheet solutions/optimization of funding and potentially favorable accounting treatment by using a conduit to intermediate transactions with a counterparty.
Confused? Let’s rewind a little.
A bit of background
The ABCP market ballooned ahead of the global financial crisis as so-called ‘structured investment vehicles’ proliferated. These bank-sponsored SIVs bought long-term higher-yielding securities like mortgages, CDOs, whatever, and funded these purchases by selling short-term commercial paper.
Of course, lending long and borrowing short is what banks are supposed to do, making them subject to the risk of bank runs. For this reason there are loads of regulations in place to try to put guardrails around the amount and type of risk that banks carry. Because, you know, when they go pear-shaped it’s often taxpayers who are left to pick up the mess. SIVs were just a gimmick to get around some of those regulations, and predictably all went the way of the dodo when the financial crisis struck.
In the post-crisis years, ABCP meant almost only one thing: bank-sponsored multiseller programmes. Or, in English, ultra-short-term debt backed by auto loans, credit card receivables, commercial, trade receivables, etc, where the bank was on the hook for maturity mismatches, but not any underlying credit losses. There were also so-called ‘alternative’ programmes, bank-sponsored or otherwise, but they were pretty small.
Fast forward 10 years and it’s increasingly all about the alternatives:
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What even are ‘alternative’ ABCP programmes? Think of them as debt that is collateralised with financial securities rather than auto loans. So SIVs 2.0? Not exactly.
According to S&P Global Ratings, their evolution has been driven primarily by demand from globally systemically important banks to optimise their balance sheets under post-GFC banking regs and the Basel framework. So basically, they’re a way for these “G-SIBs” to build up their hedge fund-servicing prime brokerages (and securities businesses more generally) without using up precious (and highly regulated) balance sheet capacity.
And this means that ABCP programmes act as a bridge between money-market investors who want a nice quiet life backed by nice interest-paying safe assets (paying just a bit more than T-bills), and banks and dealers who want cheap financing for themselves or their clients.
Back to the present
Assets-backing today’s alternative ABCP are largely things like short term secured loans to broker-dealers, collateralised with US Treasuries. Non-bank alternative sponsors feature among the largest issuers of paper:
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And, according to JPMorgan, it looks like alternative non-bank ABCP conduits are increasingly moving into the equity financing game.
Using DTCC data, the analysts calculate that the overall ABCP market has grown by ca $100bn so far this year, driven mostly by inflating non-bank-sponsored ABCP programmes. And nearly $60bn of the total market growth has occurred in just the last two months — coinciding with a jump in the cost of equity financing.
To be clear, the direction of causation looks to Alphaville to be stonk-lovers-punting-stonks-on-margin ==> more ABCP issuance, rather than the other way around.
Or, in slightly longer-hand, stonk-lovers do more margin-trading => higher equity finance costs => more money to be made lending on a secured basis against equity collateral => ABCPs to issue more commercial paper, backed by loans that are collateralised with stonks => more equity financing available at lower cost.
This is still confusing, can you give me an example?
So, let’s say Alphaville LLC rocks up to its prime broker with $100mn of stocks and wants to borrow another $50mn to punt into even more stocks. It could pledge its $100mn of stocks as collateral. It probably doesn’t need to pledge all of it, but let’s pretend it does for simplicity’s sake. The prime broker has made a $50mn secured loan, backed by a ton of collateral, and will earn a nice little rate of interest.
But where does the prime broker get the $50mn? Maybe its own balance sheet. If so, this commits a chunk of its balance sheet capacity to this particular form of lending. And this — depending on how the prime broker is regulated and what they actually want to do with their balance sheet — might be seriously annoying. In fact, it’s almost certain to be so.
ABCP solves this problem for the prime broker. To avoid taking the secured loan on their balance sheet, the prime broker goes to an ABCP conduit, pledges the collateral and borrows the $50mn cash from them, which it passes to its client. The ABCP entity in turn gets the $50mn by issuing commercial paper to money market funds, insurers, whoever.
Or, in diagrammatic form:
Through the magic of financial intermediation, the hedge fund gets cheap fresh dollars to pour into new stock purchases, the money market fund holder gets a place to park their cash, and everyone sitting between them gets a nice little earner. 🥂
Are there risks in the chain of intermediation? There are risks in every chain of intermediation. But to be fair, we’ve had the odd equity market test or two over the past few months, both at the popular single-stock level and the more general what-has-he-just-tweeted level. And nothing looks like it has broken yet.
There’s a vague chance that this dive into the evolution of the asset-backed commercial paper market won’t have spun everyone’s wheels. But we thought it was interesting and somewhat amusing to see how leveraged bets on stock markets may be being fuelled by the funds of nervous Nellies too concerned by high valuations to commit the money themselves.
Further reading:
— ‘The risk of a deleveraging event is rising’ (FTAV)
