By Monish Chhabra ǀ 23rd October 2013

Last month, the European commissioner proposed that constant-NAV money-market funds in Europe – that have assets of more than 400 billion euros – be required to set aside 3% of their assets as cash buffer.

Money-market funds in Europe – totaling about 1 trillion euros in size – are an important source of short-term funding, owning up to 1/3rd of all short-term debt issued by governments, banks and corporates. The biggest investors are the corporate treasurers who place their excess cash in these funds. The split between constant- and variable- NAV funds is roughly half.

The constant-NAV funds provide capital guarantee to the investors (by maintaining a constant NAV of 1 euro per share). However, they have no insurance or equity buffer to cover that guarantee.

One such fund in the US, called Reserve Primary Fund, had to break the buck (re-price NAV below $1) in September 2008, when Lehman went bust. Investors panicked and pulled out $300 billion from the American money markets. They calmed down only when the Fed stepped in to guarantee the $1 NAV of all funds, temporarily.

Typically the sponsors of these funds use their own resources to support the constant-NAV during times of panic. Since 9 out the 10 largest money market funds in Europe are sponsored by banks, the risk of the contagion spreading from the money market to the banking sector is high, and hence the proposed regulation.

Banks and their shadows are deeply connected. Banks themselves are the biggest creators, facilitators or operators of the shadow-banking services.

Over the first 9 months of this year, the ‘entrusted loans’ in China – a shadow banking scheme between corporates that is intermediated by the banks - were equivalent to a quarter of the total new RMB loans by the banks. Thus in terms of new lending, the corporates have already become a quarter of the banks’ size and growing at 14 times the pace of bank lending.

It is hard to distinguish where the banking ends and the shadow begins. The companies that can’t obtain funding directly from the banks borrow from other companies who can. However since corporates in China can’t legally lend to each other directly, this transaction take place through the banks and hence ‘entrusted’.

The capital reaches the highest bidder, directly or indirectly. These loans – at rates ranging from 7% to 20% - improve the earnings of the lender, provide funds to the borrower and create fee income for the bank, ostensibly for no additional credit risk.

The risk is the stress-point when the rolling-over stops and the settlement begins. The defaults and the linkages could run deep and wide. The NSEL fiasco in India – that came to its head recently - illustrated this point.

This company – deceptively named National Spot Exchange Limited, even though it had no association with any government institution – ran a commodity exchange since 2007, where illegal forward contracts were traded using illegal settlement terms.

Its parent company called Financial Technologies – run by promoter Jignesh Shah – has shareholding in 5 exchanges outside India, including SMX in Singapore, DGCX in Dubai, BFX in Bahrain, GBoT in Mauritius and Bourse Africa in Johannesburg.

The NSEL trading platform – that was run through various brokers - was nothing more than a source of financing for about 25 borrowers from about 13,000 individual lenders.

It became known for a pair-trading scheme whereby an investor could buy spot commodities and simultaneously sell them 1-month forward at a slightly higher price (embedded carry), thus creating a risk-free return of 14-18% pa. These contracts were usually rolled-over month-on-month with only the ‘interest’ settled in cash.

When regulators finally woke up and ordered the exchange to stop rolling-over and settle all forwards by their due dates, the payment system crashed. The short-sellers (aka borrowers) disappeared. Technically the exchange should have the collateral which it could liquidate. Only one problem; it didn’t.

The custody was forged at the warehouses and is still unclear how much of the real collateral exists. The missing physical stock, the illiquidity of it and the insufficient margin led to the collapse of the exchange.

The ‘risk-free’ investors lost about a billion US dollars and the company’s promoters, directors and key officials are now booked under various legal offences.

Thousands of these HNW investors were not in the business of lending. Typical of shadow banking, these lenders lacked the expertise to evaluate the credit or the power to structure & enforce the covenants. They relied on the perceived safety of an intermediary, which itself did not operate under proper norms.

Some people believe that ghosts have no shadows. In this part of banking, shadows have all the ghosts.