Innovation In Money Markets

Why is this an important topic?

Cash aka liquidity management. That is the daily bread of both financial institutions and corporate treasuries; Money Market instruments are one of the tools we use to fine tune what we do. At the simplest level, we make sure we have enough cash in the right currency at the right time, in the right place to settle trades and make payments. The next level of sophistication is to make sure we don’t have idle cash; first because long cash at a bank is an unsecured receivable, a risk and secondly because we want yield. 

There are two basic options to deal with long cash. First, a good old fashioned Money Market loan; you lend the cash to somebody, hopefully for more yield than leaving it with your bank, aka Nostro. It is though, still unsecured.  The second is to do a trade where you purchase a security, possibly with a promise to re-sell, aka Reverse Repo. Or you purchase a Money Market Fund, which ideally has a very stable price and can be re-sold on demand. 

ISIN Number explainer: Image Credit / Source Investopedia

The key part here is that as soon as you have a security aka “something with an ISIN number”, then you have less risk than with a simple loan; your security holdings are “bankruptcy remote” from your bank or custodian. So, the Treasury, or Cash Management, team is always balancing risk & return, and as part of that, looking for new instruments which might offer a superior risk/return profile.

What’s new or changing?

Photo: Hugh Macmillen, ilxNotes  

Hugh MacMillen is a Money Market veteran. In the last ten years, Hugh has been focussing on innovation in this space, looking for new marketplaces as well as new instruments. I spoke to him about innovation in the space.

Three ingredients stood out in our conversation:

▪️ First, the need for any investment to be in securitised form and have an ISIN number. This enables the instrument to be easily held and processed by a custodian. And it moves the investment from being unsecured to being secured.

▪️ The second is access; there are borrowers and lenders who are just not connecting and simply missing out on opportunities to fine tune their risk/reward payoff. 

▪️ The third is how something old, the CD, certificate of deposit, is back in favour.

With his latest venture, iIxNotes, Hugh is looking to enrich the offerings in the Money Market space. We spoke about the new possibilities he hopes he can bring to the table. 

First, things UBB, aka Unsecured Bond Borrowing. Banks need HQLA (aka High-Quality Liquid Assets) in their balance sheets. Having enough of these is like a wild animal foraging for food, a continuous and constant challenge. But not everybody wants to lend to them. When supply & demand do not quite connect, there is a role for an intermediary. In this case, there are asset holders who have HQLA, but they would rather lend on a secured basis. There are also institutional investors who would lend cash unsecured, at the right rate or risk premium.

Now comes the moment for the intermediary. Set up a Special Purpose Vehicle (aka SPV), such as a PCC (aka Protected Cell Company), borrow the funds from the cash giver, offering a pickup as high as 40 bps (€STR less 25 to + €STR+10) on the meagre returns from being long cash with a bank. The SPV then uses the cash in a reverse repo to obtain the HQLA from the asset holder and lend to a bank, under a GMSLA. Net result: asset holders can do a secure trade, cash giver makes a greater return, a win. Asset holder makes a return, another win. Bank can source HQLA without dealing with many counterparts, a third win. There can be “double bubble” for the banks too; if the term is more than 30 days, then this has a positive impact on LCR, the Liquidity Coverage Ratio.

A variety of this is also playing out in the Islamic banking space. In an Islamic bank, long client cash is not a good thing. Safe it all might be, but nobody makes a return. Any potential cash borrowers though do not want to deal with multiple private clients. Using a combination of an SPV and the Islamic compliant Murabaha-based product, the cash from multiple clients can be pooled and aggregated before being loaned to institutional borrowers. The investment has a securities identifier and is off-balance sheet. 

UK council debt is another old but new opportunity. Councils are the smaller cousins of the US municipalities. IxNotes is working with a panel of councils to create a single issuance vehicle, enabling cash lenders to have the diversification of lending to all rather than a single one. Maturity is set at 183 days to make the loans count as long-term. UK councils have an implicit state guarantee, which has a positive impact on RWA (aka Risk-Weighted Assets) calculations. 

Another topic in our conversation was the use of an ETP (aka an Exchanged Traded Product), using an FMI (aka Financial Market Infrastructure) as Global Custodian. The ETP acts as intermediary between institutional cash givers and banks as cash takers. For the institutions, the ETP makes the investment a security and as such, easy to process. Typically banks are happier to face one counterpart rather than many, so the intermediation is a win for them too.

Certificate of Depoti (CD) explainer: Image Credit / Source Investopedia

Hugh surprised me when he brought up a product from the past that I have not heard about in years: CDs (aka Certificates of Deposit). “CDs are back in favour!” he announced. I remember these from living in New York; lots of my friends used to buy them. The first reason is simple: more yield for the investor. The second is simple too: more certainty for the bank issuing them. The bank can count on having the money for a fixed period. The third is a nuanced version of the second. In simple terms: hot money vs. not so hot money and a little thing called LCR aka the Liquidity Coverage Ratio. LCR looks at cash flows in the next 30 days. Overall the outflows have to be covered by HQLA, high quality liquid assets at a ratio of 100%. Simply put, if you hold a cash balance at a bank, you are allowed to move it out and in the SVB / CS cases, fingers hit keyboards and out went the cash. So, a CD with a fixed maturity beyond 30 days is outside LCR.

One final thing Hugh wanted to share was both counter-intuitive and a surprise. “Apparently, the Bank of England is looking to urge investors to not rely on Money Market Funds (MMF) to such a degree (as they have)”. This is counter-intuitive, because at the simplest level, owning an MMF is generally less risky than having a cash balance. Reflecting on this, I can see why the Bank, or one of its fellow central banks, might say this. Money flowing into MMFs is money flowing out of the commercial banks and if there is too much money in MMFs, any forced selling can create shockwaves. Think back to all the noise around Facebook with Libra / Diem.  

Why might these new things matter?

Innovation on the issuance front enables new borrowers to come to the market. Securitisation enables institutional investors to readily include them in their range of approved investments. On the council debt and Islamic finance front, the note structure offers an easy way to lend on a secured basis to a diversified range of borrowers.

Even having an old product, the CD, come back into fashion is a useful addition to the options for investors, as well as helping banks have greater planning certainty. The “Not hot money CD” as it were. 

In conclusion

We often have more than a modicum of disdain for middlemen. 

“Start your own revolution and cut out the middleman”, so sang UK singer / songwriter Billy Bragg in his 1998 song 'Waiting for the Great Leap Forwards'. 

Of course, in an ideal world, we would not need middlemen. But we have an imperfect & uncertain world. When intermediation helps drive a better matching of supply & demand, then this type of innovation creates more choice for investors / cash givers and with securitisation, less risk. On any day, cash management is about the here and now. Whether you are at an FI or a corporate, an overnight long cash balance is almost certainly sub-optimal. Understanding and being able to access a range of alternatives is a valuable part of being prepared as a Treasury or Cash Manager. 

Thanks for reading. Please do let me know what you think of these notes. Feedback via the comments would be great.

Please feel free to get in contact via LiquidityFinder here.

Author

Olaf Ransome is a liquidity and financial services expert. He is the founder of 3C Advisory  You can message Olaf directly here.