Federal Reserve Rate Rise: The Unintended Trading Cost Consequences for Banks
By Kerril Burke, CEO, Meritsoft
Does anyone long for a return to more benign economic times? A time when a rise in the base rate simply led to immediate benefits for savers. Well, get prepared for a continued long wait, as this week’s decision from the Federal Reserve signals anything but a move to more conventional times.
In fact, this most recent rate hike has much wider indirect effects than simply, “What does this mean for my mortgage repayments?” A lesser-discussed, but just as significant effect of a hike in interest rates means an increase in funding costs for anyone trading in the capital markets. Interest rates are now at the highest level they’ve been in about ten years since after the fall of Lehman Brothers. Some of the biggest players have been losing double digit millions in unrecovered failed funding costs and with additional predicted rate hikes down the road, there are further implications of the Federal Reserve rate increase for the cost of trading.
As of Wednesday, the interest rates are now between a range of 2% to 2.25%. Therefore, any trader looking to borrow say $1 million to finance a trade, now faces an extra 0.25% per annum in funding costs. One of the main strategies traders use to minimize funding is buying and selling for the same contractual settlement date. This means paying funds from the proceeds received from a transaction. Take the example of a trader selling Walmart stock in order to fund a purchase of Amazon shares, both for the same agreed settlement date. The trader expects the cash from the Walmart trade in order to settle the Amazon transaction. There is just one small issue – he or she has not yet received the money for his stake in Walmart. And this is not an atypical scenario – the only way to pay for the Amazon shares is to borrow the money. The trader in question, now has to take on an additional funding cost to borrow the funds to settle the Amazon trade. If the reason for the fail in the Walmart shares was due to the counterparty, it does not seem fair that they are forced to pay this additional cost, does it?
You might be thinking – but these funding costs are negligible. And while it is true that the cost will vary based on the amount of cash open and the length it is outstanding, it could in fact run into USD thousands per trade! And the major trading firms can have thousands of securities, FX, equity and commodity derivatives fails everyday. This may have been hidden because rates have been and are largely still at record lows. But, the trend and market sentiment is now unmistakably upwards.
Failed funding costs are only part of the problem. There are costs and capital for market participants in the wide range of receivables on their balance sheet. These balances, at least the ones in USD, are now a quarter of a percent more expensive to fund. So the cost of failing to settle these transactions are now far more than they would have been before the hike. A bank is now at a distinct disadvantage, particularly if they do not have a way to identify, optimize and recover where they are incurring funding and capital costs through no fault of their own. Essentially, by having receivable items open while waiting for money to come in, it will be borrowing cash to cover itself. If a trade fails to settle for say five days, then that is a whole week of extra funding costs that a bank needs to cough up. And not being able to track additional funding costs due to the late settlements is not the only issue. Many banks are still not even identifying the direct cost impact of a trade actually failing. If a bank can’t work out the cost implications of not receiving funds when a trade fails, then how can they identify whether or not they can claim money back from their counterparties?
Trying to work out the many effects of the Federal Reserve’s latest monetary policy decision is difficult, but like those with a variable mortgage, trading desks are impacted. Late settlement means higher funding, and higher rates means the additional funding costs more. Preparing now to handle the trading cost impact of this small rise and the upwards trend is exactly what is needed to ensure banks are ahead of the curve whenever the Federal Reserve or similar institutions in other countries make the decision to hike rates again in the near future.