Becoming a bank?
“In the middle of every difficulty lies opportunity.” - Einstein
At the simplest level, banks make profit by lending money to borrowers at a higher rate than they pay out to the savers. Over the past few weeks, the repo market, a central piece of the U.S. financial system, has experienced unexpected volatility. The primary purpose of the repo market is to function as a source of liquidity—allowing investors with cash to earn interest by making short term loans to entities with securities that can be used as collateral for the loan. This transaction is the bedrock of a healthy financial system, with the main participants being banks, mutual funds, leveraged investors, and asset managers. In the days leading up to the September FOMC meeting, an imbalance of supply and demand in the repo market led to elevated overnight funding rates, briefly jumping above 10%.
While the repo market has been capturing the headlines, this topic is symptomatic of a more fundamental shift that has occurred in the banking system over the last decade. Today, many banks’ balance sheets and funding activities are much more limited relative to history, and thus too is their ability to meet market demand. As Einstein alludes to in his quote, this difficulty creates an opportunity for investors with cash and high-quality liquid assets to fill this void.
This is a classic story of supply and demand economics 101. Traditional supply of liquidity from banks has declined as post-crisis regulatory changes have reduced the economic benefit of providing this service to investors. At the same time, there also has been increased demand for high quality liquid assets in the financial system. Consequently, this recent regulatory induced disintermediation provides long-term investors holding high quality liquid assets, such as cash and U.S. Treasuries, the ability to earn a liquidity premium by providing marginal supply within the system.
It is important for investors to recognize that there are opportunities to take advantage of this supply and demand dynamic to earn the “spread” within their investment solutions. This opportunity can be realized with investors looking to earn an attractive risk-adjusted, enhanced cash return when implementing a short-term liquidity solution and even within a LDI interest rate hedge completion portfolio. Investors can also leverage these opportunities within beta overlay mandates. One key aspect is that these solutions do not seek to dial up market or active risk to deliver incremental returns, but instead take advantage of the imbalances and dislocations of the current landscape forged out of the ashes of the 2007-08 financial crisis.
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