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Year-End Balance Sheet Financing

December 2021

As we approach the end of 2021, a lot of attention has turned to year-end financing trades as a way to enhance yield on idle cash. This month we look at how these trades are structured and how they can be implemented at any time of the year.

Year-End Financing

Global systemically important banks (G-SIBs) are required to hold more capital the larger they are and the more important to financial stability they become. The major measurement for these “G-SIB charges” occurs at the end of the calendar year. As such, G-SIBs have an incentive to shrink their balance sheet into year-end. This gives rise to the standard year-end financing trade, where a bank:

  1. Sells a physical asset.
  2. Replaces the exposure synthetically by entering a total return swap where:
    1. Bank receives total return on the asset
    1. Bank pays a financing spread

The economic exposure of the bank is unchanged, but the size of its balance sheet is reduced. Because the bank benefits from, amongst other things, its G-SIB metrics, the bank is willing to pay an elevated financing spread to clients willing to take the other side of this trade. For example, the below schematic shows a representative example where a bank’s client gets paid LIBOR+60bps to finance the bank’s balance sheet.

If we assume the cash deployed for this trade was earning 1m LIBOR, the client has enhanced this return by 60bps p.a. with no change in economic exposure.

Year-end financing trades typically last for 1-month. At 60bps p.a., that equates to an effective return on cash of 5bps. With cash account returns so low – around 6-8bps p.a. – an added 5bps for a 1-month trade with no economic exposure can almost double the return of a “cash” option for the full year.

Baskets & Substitutions

Because banks are willing to pay to optimise and finance their balance sheet, it makes sense to structure the trade in a way that allows them to optimise as much as possible. Instead of transacting on a single security, trading a basket of securities allows the bank to tailor it’s financing needs by more effectively managing their inventory.

Another improvement is allowing for substitutions in and out of the basket. Firstly, banks’ balance sheets are constantly changing. Substitutions allow the bank to finance themselves even if the stocks they need to finance are changing over time. Banks’ will often pay for this flexibility through larger spreads. Secondly, substitutions mean that dividend-paying stocks can be taken out of the basket when dividends are paid. This is appealing to clients who would pay withholding tax on any dividends they receive on physical securities. Substitutions also allow for the financing trade to be a longer duration than otherwise, which increases the absolute dollar value of the transaction (earn a higher interest rate for a longer period).

Financing at any time

Banks are by their very nature leveraged, and as such require effective and flexible financing of their balance sheet at all times. The premium they’re willing to pay at year end is higher because of regulatory constraints, but that doesn’t preclude (a lower) excess spread being available throughout the year. Structuring trades with baskets of securities and allowing for substitutions can increase the excess spread earnt, and allow for longer, or even evergreen trades. We think these types of balance sheet financing trades provide a low-risk way of enhancing returns on idle cash, especially in a zero-yield-low-spread world.

The Solutions Team

The Solutions team provides derivative overlay and risk management fiduciary services to Asset Owners and Managers in Australia. Our goal is to provide asset owners and managers with an experienced overlay advisory and execution service to improve portfolio outcomes and cost efficiency.

Important notice
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