Cash Management sweep systems have been a customary way of accumulating end-of-day balances onto a single account, thereby eliminating overdrafts on individual, linked accounts, and then either investing the net balance overnight or at least exempting it from charges.
Sweeps have been extended into the fund management side but with some hurdles: why would one fund have multiple accounts at the same bank in the same currency? Where a fund manager has access to several accounts at the same bank in the same currency, surely they cannot sweep together the balances in the accounts of different funds and thereby co-mingle the funds of unlinked entities?
As ever, in a financial crisis like the one that COVID-19 has caused, poor practice will be revealed in the shortcuts that have been applied by those seeking to maximise returns, at the cost of overlooking risks and legal hurdles.
Fund managers are looking to automate the distribution of sharp losses on fund assets, and to do this through sweep systems. This seems to be happening particularly where the funds are both leveraged with debt and "tranched": there are different levels of investor units, such that rises and falls in the value of the fund's assets are attributed to a tranche according to a formula in the fund offering documents. The first-loss tranche gets the biggest return in the good times, but gets eliminated first in the bad times, which is now.
Once assets fall by a given degree, the formula will value the units in first-loss tranche at zero, and then those units are eliminated: this should now be a function carried out by the sweep system. The overall fund value will not conveniently land at and stay at the point where the value of the first-loss tranche rests at zero: it will go through and downwards, so as to eat into the value of the next tranche up in seniority.
In this way you have a first-loss tranche, a second-loss tranche, a third-loss tranche and so on. With an unleveraged fund the tranches get eaten up until a point where the assets are worth nothing and everyone lost their money.
With a leveraged fund, a trigger point is reached where the assets are worth something like 110% of the debt, and then the lenders take control of the fund, sell the remaining assets and try to cover the debt, with any surplus returned to the holders of the most senior tranche.
It is all very reminiscent of 2007/8, and very concerning, because automating these actions through a sweep system can preclude intervention in order to avoid a systemic meltdown. If a lender repossesses assets and needs to achieve 91% of their supposed value at the trigger point (i.e. 100 loan/110 assets), you are set up for a "firesale".
This was precluded in 2007/8 in particular by JPMorgan buying Bear Stearns. BoNYM was about to repossess the assets in two large Bear Stearns funds and would have sold them off, driving the prices of the assets down, compelling other market actors to mark their books of the same assets down to lower prices, invoking triggers themselves, having to sell other assets to reduce their own borrowings Ė a self-feeding downward spiral. Letís hope we learned something from 2007/8 but the auguries are not good.
Bob Lyddon is an author for accountingcpd. To see his courses, click here.