Going for the extra basis point is a hallmark for those managing large sums of cash. This statement is particularly relevant for institutional money managers who are looking for the best possible returns on parked cash. The first two pieces in this series illustrated how the 9thGear marketplace would benefit banks (market makers) and corporations (price takers). The final section in the series introduces a new participant (lenders) into the FX trading process and opens up what is essentially a new asset class.
The Need for Payment Liquidity
Liquidity may mean different things depending on the situation. In the world of FX, it often can mean trading liquidity. In other words, is the market liquid enough for me to efficiently trade the amount I need to trade at a reasonable price? Liquidity may also relate to availability of funds. Do I have the cash or credit lines available to fund my business for the next three months or three years? These are just a few examples.
But there is another definition that most of us, even those of us in finance, never think about: payment liquidity which sometimes is referred to as intraday liquidity or daylight overdraft. In this context, it tends to be a bigger issue for banks than it is for corporations and is a critical factor in moving to a same day trade and settlement model for FX. Below is a quick example.
A large corporation decides to buy a billion Euros from its bank for $1.1 billion. The bank will typically lay off the market risk with another market maker, such that it is in balance. Just looking at the dollar side from the bank’s perspective, it will receive $1.1 billion from the corporation and have to pay $1.1 billion to the other market maker. No problem, right? Maybe. Sometimes the bank will receive the dollars from the corporation after it pays the dollars to the other market maker. This timing gap leads to an intraday funding need.
The Federal Reserve and the OCC (the key regulating bodies in the US) recognize that such timing gaps are unavoidable for banks to operate efficiently for all types of payment exposures, so they do allow for daylight overdraft. However, banks must monitor the exposure within limits, absorb direct costs for the overdraft amount, and hold excess capital related to overdraft amounts. In other words, these timing gaps create a cost.
The Lending Opportunity
Now imagine if there was an intraday borrowing option for banks. In theory, any one of us can pull cash out of a savings or money market account in the morning, use it during the day, redeposit it before close of market and still earn the full overnight interest rate. The problem has been that there just is not anything to do with the money during the day.
Well, now there is. If a bank can avoid the costs of daylight overdraft by borrowing money for a few minutes or a few hours a day, it may achieve a better economic outcome. After all, a few minutes or a few hours of interest at any reasonable rate will be far less than the explicit and implicit costs of daylight overdraft.
And this outcome becomes a win for the lender as well, who now achieves purely incremental interest on cash balances. The only trade-off is the credit exposure of very short-term loans to highly regulated and capitalized banks. Most will view this result as an extremely attractive risk/return proposition.
Creating the New Asset Class
Calling this situation a new asset class may appear, at first blush, to be a bit of an exaggeration – after all this outcome is just a dollar loan (or perhaps a Euro loan or Yen loan, etc). But intraday loans are something new and creating a marketplace that allows for this result is no mean feat. There are practical challenges in creating instant liquidity and instant loan repayment. For example, a borrower will only know it has an intraday funding need right at the moment the need arises (or perhaps just before); but it could easily take hours to move dollars from a lender’s account to the borrower. The same is true for repayment of the loan. This issue alone would make intraday lending impractical.
9th Gear is developing the marketplace that solves this issue as it relates to FX trading. In addition to partnering with market makers and price takers, we are working with asset managers and potential lenders who will be able to take advantage of this new asset class. If you are interested potentially participating in this new asset class, feel free to contact us through www.9thGear.io or email the author directly at dgopal@9thGear.io.