Shadow Banking The shadow banking system is something you're probably not familiar with.
Until today!
the shadow banking system is made up of mainly investment banks i.e. your market whales or market makers, money market funds i.e. like schwab and vanguard, and hedge funds. these financial entities dont give out loans to you or I, but rather trade amongst themselves. which is what is known as the shadow banking system.
one of the main functions of the Shadow Banking system is to provide liquidity aka money (which is mostly made up anyways) to the financial system. for example if a whale wants to move a massive amount of money into a position, or what happened to Zimbabwe a while back and give an entire nation a loan at a ridiculous amount of interest they're able to do so, or take a massive position in a promising opportunity and need capital fast!
How does this work? How do you ensure that a hedge fund will pay back on their loan?
collateral!
Usually in the form of government issued bonds and bills. one can trade an equilivent amount of t-bills plus interest for X-amount of dollars to carry out said transaction.
example:
Hedge fund A wants to take a position shorting the RMBS market. (strictly coincidental) Hedge Fund A is so confident in their analysis they are willing to take a whales position. they need the capital. well like all good risk management practices they have off set their high beta shares with low risk positions. the lowest risk investment you can have is a US Bond or Treasury Bill.
So, Investment bank A says okay I can lend you 10 Billion Dollars at a 4% interest rate per day for 3 days, if you default I keep your Bonds. The swap happens.
Now, Hedge Fund A has not only to make their money back on the bond trade, but they have to make at least 4.01% to make the trade profitable and they have 3 days to do it.
Another way this can be done is Hedge Fund B says I too am going to short the RMBS market but i am going to offer it to all the investment banks and other hedge funds. So they offer it as an investment opportunity. the offering fund takes a small fee and the winnings or losings are dealt accordingly.
while this might sound a a little familiar... well it is! names and places have been changed to protect the innocent.
The major critique the financial system has with this Shadow Banking is that its not really regulated. becasue going back to our example with Hedge Fund A
If Hedge Fund A Doesnt pay then Investment Bank A can shoot their interest rate from 4% to 40% in one day making the loan almost impossible to pay back causing the Hedge Fund to collapse and all the unsuspecting investors in the Hedge Fund are out of pocket.
Or my personal favorite. Lets Say Hedge Fund (HFA) A is going to short the RMBS market with a 10 Billion dollar Position for 3 days and Investment Bank A (IBA) wants to short the CMBS market with a $20 billion position for 5 days. well the trade between HFA and IBA happens 10 billion will float to HFA at a 4% interest rate per day for 3 days.
Now, IBA wants to short CMBSs they will approach Life Insurance Group A (LIA) and will offer $20 billion dollars in bonds 10 from their reserve and the 10 billion from HFA. at a 5% per day interest rate for 5 days.
Now, you might see the problem. but i will continue.
Day 3 is up. HFA made their little profit. IBA doesnt have their bonds (because theyre with LIA). So, IBA will probably give HFA 10 billion of their own bonds which for this post is what happens.
HFA is squared away with IBA.
Now, in the 5 days that IBA is holding LIAs money the fed decided to raise interest rates 200 base points. the bond market yields sky rocket causing their prices to plummet.
but fortunately IBA made 10% on their risk they pay LIA their 5% interest and take a 5% loss on their bonds and come out BE or Break even.
As you can see in this overly simplified example how if any one part of these parties failed it could be detrimental for a lot of people. Because peoples pensions are held by hedge funds, countries and other governments have their investments with the Investment Bank peoples money and loans are held with the Life Insurance groups.
I believe this shadow banking system is also the Stock Markets (yes the entire stock markets) Stop Loss!
