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SIVs and SWFs in the Financial System

Investors and policymakers have been concerned in recent years about a potential collapse of the hedge funds creating panic in the financial markets. That being said it looks as if one of the main threats to financial stability comes from the venerable risk from borrowing funds for short term in order to investment in long term products which are illiquid. In parts of markets where not many people knew about their existence, regulators are trying to understand what is happening in these so called SIVs (Structured Investment Vehicles).

A ‘bunch’ of investment assets attempting to make a profit from credit spreads between short term debt and long term structured finance products, for instance ABS (Asset backed Securities). ABS are financial securities backed by loans, leases or receivables against certain assets other than mortgage backed securities and real estate. From investors’ point of view, ABS are a substitute for investments in corporate debt. Funding for Structured Investment Vehicles derives from the issuance of commercial paper which is short term debt financial instrument.

More exactly its short maturity is within 270 days. The commercial paper is typically rolled over or continuously renewed. The funds received through the issuance of commercial paper are then invested

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in longer term assets that are less liquid but such assets pay higher yields. Thus the profits come from the spread between the incoming cash flow which is the principal and the interest payments on ABS and the high rated commercial paper. Structured Investment Vehicles often make use of high leverage in order to generate higher returns.

SIVs are also known as ‘conduits’ and are less regulated than other financial instruments, and usually kept off the balance sheet by large financial corporations such as investment and commercial banks. These SIVs gathered regulators’ attention during the housing bubble and the beginning of the subprime crisis in 2007. Tens of billions of dollars were written down of their value off the balance sheet as investors were trying to flee from subprime mortgage related assets.

Investors were caught off guard by the large losses because SIVs specifics are publicly known at a small scale, and this includes basics of the type of assets held and the regulations that determine their actions. SIVs fundamentally allow the financial institutions engage in such leverage in a way that the main company or the so called parent company would not be able to exceed the capital requirement regulations. Sovereign Wealth Funds (SWFs) are sums of money coming from countries’ reserves, which are placed aside for the purpose of investments that will profit the economy of the country and citizens themselves.

More exactly the funding for Sovereign Wealth Funds (SWFs) derives from reserves of central banks which are accumulated as a result of trade surpluses and also from income generated from exports of natural resources. The type of investments considered acceptable included in each Sovereign Wealth Fund varies from a country to another, moreover countries which have concerns about liquidity limit their investments to only highly liquid debt instruments mostly public.

A number of countries have created Sovereign Wealth Funds in order to create diversification in their revenue streams. For instance, UAE (United Arab Emirates) relies on oil exports for the country’s wealth, consequently it assigns a fraction of its reserves in a Sovereign Wealth Fund in order to invest in other types of assets which are acting as a guard against risk related to oil. In order to have an idea about the amount of money involved in these SWF the paper continues to use the example of the UAE which in May 2007 had a fund worth more than 875 billion dollars.

The value of all Sovereign Wealth Funds is estimated to be around 2. 5 trillion dollars. SIVs and SWFs are very much different one from another but they also have similarities. In what concerns the source of the funds SWFs may have their origin in commodities such as oil as the example of the UAE or in non commodities which are generally created through the transfer of assets from official foreign exchange reserves.

As nature and purpose SWF has its own sole reason for its creation moreover, all funds have their own specific objectives such as protection and stabilization of the economy and budget from high volatility in exports or revenues, diversification from non renewable commodities exports, earning a greater return than on foreign exchange reserves, assistance of monetary authorities to dissolve unwanted liquidity, longer term capital growth and lost but not least political strategy.

Noticing that all of the above refers to a fund raised by a country SIVs are funds raised by large institutions through commercial paper thus through borrowing not through surplus of a country such as SWFs. Regarding the size and growth, since 2005, twelve Sovereign Wealth Funds have been created and according to the US Department of Treasury these funds control an estimated 2. 5 trillion dollars. This is a large amount mostly because countries participants in these funds grew their currency reserves seeking greater returns and also because of the rise in commodity prices especially gas and oil.

SIVs measurement is made through the percentage of this instrument from the total portfolio of a company which is frequently from 1bn dollars to 30bn dollars depending on the financial institution, more exactly for the whole market of SIVs is 325bn dollars, much smaller than SWFs’ 2. 5 trillion dollars. Similar to SIVs, SWFs are relatively opaque entities. Such a state investment body has never been famous for its transparency, as central banks keep secrets over the reserves management. From some points of view SWFs are similar to central banks such as the amount to be invested at hand.

In contrast to a central bank, SWFs invest in a broader variety of securities with a potentially of a lesser liquidity. Furthermore, central banks indirectly or directly carry a responsibility regarding the stability of financial markets, give an essential incentive for careful market behaviour. SWFs are primarily concerns about portfolio value maximisation and not about the stability of the market, making them more similar to supervised and regulated institutional investors which have SIVs.

To conclude the paragraph, the intransparency of Sovereign Wealth Funds aggravates systemic risks similar to Structured Investment Vehicles, an example that the US and the rest of the global markets have experienced with the latter. In addition what is meant by opacity is the increased risk of SIVs, as there are transactions with complex securities and often these are not displayed on the institution’s balance sheet. There are similarities and differences regarding risk between SIVs and SWFs. The arising risk from transactions is twofold.

Firstly, there is the solvency of an SIV which could be at risk if the value of the long term securities that the Structured Investments Vehicle bought is falling below the value of the short term securities that the same SIV sold. Secondly, there is the liquidity risk, borrowing short term and investing long term, therefore out payments are due before the in payments have to be paid. There is the condition that the borrower refinances the commercial paper at favourable rates, or the alternative is to sell the asset into the secondary market.

On the other hand SWFs are mainly derived from excess of liquidity in the public sector coming from fiscal surpluses of the government or from reserves at central banks. Therefore the money invested is not borrowed and also SWFs invest depending on their objectives in longer term assets or shorter term in liquid assets in the public sector. In this case related to finance there is a bigger difference between SIVs and SWFs and is related to politics.

For example there is this finance minister several large banks in a country are in trouble. An investment fund comes at the right time providing the much needed help in cash thus helping to avoid a financial meltdown. So far so good but if this fund is controlled by a government of another country with unclear intentions or if this fund also intends to buy the country’s largest ports then it will create a barrier between the intentions of the fund and the acceptance of an offer from it.

In this case the SIVs are less political regarding its intentions of investment in Asset Backed Securities. Regulation is difficult to tackle in the case of SIVs for two reasons. The basic business model which is borrow short term and lend long term is very similar to the one of a bank, but the SIVs are conducting their business through capital markets and not by taking deposits and considering that they are off-shore entities, SIVs escape the regulation that banks and financial institutions are subject to.

Moreover having in mind that they can also be kept off balance sheet, SIVs escape indirect restraints through the banks’ regulations that set them up. Secondly regulations discourage trading activities. Consequently such decisions will affect the end users, the banks and the financial institutions by placing a limit to the dealer’s access. Additionally such decisions will also leave a dealer in the US markets in a competitive disadvantage to its foreign counterparts. If the US markets are to become too regulated, SIVs have a choice of trading on the European market.

Regardless of different proposals to save the financial activity, markets work themselves as influential regulators of financial system. Regulation could be imposed and changes could be made more exactly in how much leverage financial institutions use when purchasing assets in the case of the SIVs and in the case of SWFs would be an extra concern and that is political and both could be imposed to provide more transparency. SWFs could also save a financial crisis while the SIVs are one of the causes the current financial turmoil.

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