How the World's Largest Liquidity Provider Motivated the Move to Non-Cash Funding

The secured funding markets have had a turbulent last few quarters.

In Q3 2019 we witnessed a shock reverberate through secured funding markets so significant that the Federal Reserve was compelled to intervene. Three events—a large U.S. Treasury new issue settlement, corporate Tax Day and routine coupon settlements—simultaneously converged to manifest a startling liquidity drainage that resulted in a dislocation of funding levels.

The brief dislocation rendered fear as overnight financing values gapped higher for seemingly no cause. Cash sufficiency concerns drove dealers even further from cash securities lending transactions toward high-quality liquid assets (HQLA) and other on-balance sheet non-cash borrowing, which only amplified liquidity issues. Despite this apparent normalcy and reasonably benign market-wide volatility, the Fed took precautions to supply liquidity.

FAST FORWARD TO 2020. The year began much the same as the few previous. Equity values rose, with slightly stronger currency-adjusted performance for U.S. markets than European and Asian markets. Global rates were stubbornly low. Numerous EU countries and Japanese markets delivered negative yields in the short-dated rates space. European and Asian investors sought U.S. assets for the strong cash reinvestment return profile. Prime brokers focused on optimizing their balance sheets for organizational financing needs (maintaining leverage ratios). Essentially, daily activities were “business as usual.”

Regulatory rules remained the same. The 2019 volatility was subdued, and non-cash trading had become only more commonplace. Leverage ratios were scrutinized, optimized and managed judiciously to ensure collateral was efficiently deployed. The effects of Russian-Saudi oil tussles appeared only minimally in energy markets, and early COVID-19 chatter downplayed the implications we all now know to be true.

Then, on February 20, the world turned on a dime as equity and credit markets began their downward spiral in lock step. A selloff (attributed to the COVID-19 pandemic) erupted, kicking off what came to strip nearly 25% off global equities. Post-selloff, prime broker leverage was materially reduced; forced deleveraging was undoubtedly occurring.

The Fed again intervened, deploying many of the same programs used to reflate the economy post-2008 and further introduced new programs to combat the freeze in liquidity-fueling credit markets.

Following the first of two emergency rate cuts, secured funding market dynamics shifted. Securities lending cash collateralization reduced significantly, making for a cash shortage and a lender base looking to meet term funding obligations.

The resulting volatility made way for a highly stressed landscape where typical upgrade/downgrade trading and dealer non-cash activity remained significant, but efficiency and the benefit of marginal added spread took a backseat to satisfying regulatory and client needs, respectively. Securing the few extra basis points certainly becomes secondary to counterparty and capital risk preservation in times of crisis.

ALL CONSIDERED, the Fed’s policy efforts again dampened market funding fears and, from a liquidity perspective, were successful in lending support to ensure a functional marketplace. What was made abundantly clear is the “business as usual” mentality has become more adaptable to increasing bouts of extreme funding volatility. Recognizing how fast liquidity can drain from the traditional sources has prompted dealers to pivot their market behavior to non-cash collateralization rapidly, a trend clearly seen play out in recent months on NGT.