Citi's latest "Short Duration Strategy" features a brief entitled, "Will collateralized CP (CCP) be a source of growth for the CP market? Author Vikram Rai explains, "Traditional CP programs are promissory notes issued by financial institutions, corporations, asset backed issuers, and sovereigns for short-term financing needs. The new CCP programs that have recently come to market are typically CP programs issued by banks with term repurchase agreements (repos) as underlying asset collateral. In light of the lack of growth in the CP market (the ABCP market in particular, continues to decline) money market investors are hopeful that CCP will become a new source of issuance volume." (Note: Look for Crane Data's Money Fund Portfolio Holdings with data as of Jan. 31, 2014, to be released later this morning.)
He writes, "There are some structural similarities between CCP and repo-backed ABCP (which is a much older product with some conduits dating back to the late 1990s) since both use repo assets as collateral and utilize an issuer/co-issuer structure. However, there are some fundamental differences as well and we highlight some below. Back-up liquidity facility: ABCP conduits are backed by liquidity agreements and these are usually provided by the sponsoring bank. In case of CCP, investors have access to repo collateral in the event that the bank does not meet its obligations under the program."
Citi's piece continues, "Obligations of the sponsor of the vehicle and not anonymous borrowers: CCP has a functional similarity with unsecured CP in the sense that while CCP investors can claim repo collateral if there is any delay or default in payments, it is primarily the obligation of the issuer or the parent to make payments on a timely basis. On the other hand, in the case of ABCP, the ultimate borrowers are often anonymous to the investors and since an ABCP conduit is a legally separate SPV, ABCP investors do not have legal recourse against the sponsors of the vehicle but do have recourse to the underlying assets."
It asks, "What makes the CCP structure attractive to investors? Collateralized, yet cheaper: The access to collateral vs. unsecured CP could appeal to investors who prefer to have collateral backing their CP holdings. While the availability of investable paper is still an issue given the relatively small size of the market (we estimate the current size to be roughly $25 billion), secondary liquidity is less of an issue for the typical buy-and-hold CP investor. If the CCP market remains confined to a smaller buyer base, sophisticated investors might continue to be able to extract a significant yield premium."
Citi's Rai also tells us, "Money funds can overcome maturity restrictions: CCPs are typically backed by term repos which have been designated illiquid securities by the revised Rule 2a-7. Thus, term repos do not meet maturity restrictions imposed on money funds to meet liquidity requirements and are now confined to less than 5% of a money market fund's holdings. The CCP structure allows funds to hold commercial paper which are backed by the same term repos but with much broader maturity restrictions. For instance, a CCP note can qualify for the weekly liquidity bucket if it matures within seven days regardless of the maturity terms of the underlying repo collateral. And, money funds remain starved for investable paper in the face of low yields and shrinking T-bill issuance and thus welcome the supply of newer programs as they come to market."
He adds under, "What makes the CCP structure attractive to issuers? Potential for lower funding costs: Lower funding costs vs. unsecured CP and even term repo can seem improbable for now especially since ABCP, which is more mature product, continues to trade cheaper than unsecured CP. But, the potential for lower funding costs, which is a significant benefit to issuers of CP, definitely exists as investors become more familiar with this product. Capital arbitrage: It is possible that the issuing subsidiary of the parent may receive more favorable capital treatment vs. the parent which allows for issuers to utilize more leverage."
Regarding "Potential obstacles in the growth of the CCP market," Rai writes, "Potential Regulatory Hurdles: The regulatory landscape continues to change dramatically and reforms such as the Dodd Frank Act and the Basel III capital and liquidity requirements for banks could reshape the growth of this sector especially since the major issuers of CCP have only been large financial institutions. Limited potential for scale: The CCP structure seems suitable for large financial institutions which have legacy term repo positions to fund. This is a far cry from the scale and potential offered by the ABCP conduits which are invariably administered by banks which have a very large client base that requires financing and thus offers tremendous collateral, seller and issuer diversity. Thus, if regulatory pressures abate, the ABCP market could scale up substantially as its remains strongly correlated to economic activity."
Finally, Citi says, "The CCP structure does offer some merits and the growth of this sector, even if limited, will offer welcome respite for investors in an asset scarce short term market."
