Is collateralized commercial paper (CCP) the the new "killer app" for liquidity? Finadium, a leading specialist research and advisory firm in the securities and investments industry, has published a a research report, "
Collateralized Commercial Paper: Regulatory Arbitrage or Elegant Solution?" exploring whether innovative forms of CCP may at least in the short term take the place of repo. In this report, Finadium looks at the role that CCP 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, new forms of CCP are effectively reworking existing structures for a new purpose. According to the paper's authors, the small but growing use of new forms of CCP "represents a new sub-category of investment product that warrants attention for its funding and regulatory opportunities, and potential for pitfalls.
Why explore alternatives to repo when there is an active term repo market where cash borrowers trade with cash lenders? According to Finadium, repo leaves many cash investors in the cold because they are precluded from using it by investment or regulatory restrictions. Using new forms of CCP, these investors can create synthetic term repo transactions, without falling afoul of their investment policies or their regulators.
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.
According to Finadium, some are turning to creative CCP alternatives to repo because these novel instruments currently occupy a gap in the regulatory structures implementing the Basel III Liquidity Coverage Ratio that repo does not. These new CCP instruments also are significantly different than the asset backed commercial paper that contributed to the financial crisis, and carry different risk factors.
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.
These new forms of CCP are not without their own layers of risk, however. But these risks are more akin to those of repo transactions, not the ABCP that went so sour in 2008.
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.
So, while new forms of repo-like CCP enjoy a period of regulatory largess, many are taking advantage of the liquidity advantages they can provide. Though use is limited at the moment, it will not be long before the eyes of regulators and central bankers turn to these synthetic repo CCP transactions. The invention of these novel instrument merely demonstrates how financial innovation always manages to identify and exploit regulatory gaps. It is also a lesson on how new risks can arise from surprisingly old types of transactions.