Capital Pool Conundrums

When money moves, en masse, there are typically collateral requirements somewhere. To oversimplify it, that’s basically money (cash) one party has to give someone else in case something goes wrong.

Sophisticated organizations might be able to use a bond, letter of credit, debt vehicle, or some other type of asset but most of us get stuck putting up actual cash to cover the risk we put into a system. It’s cash we can’t spend on other things.

The mildly scary thing is that when things really go wrong and the collateral isn’t managed correctly, things go really wrong anyway. In fact, the amplification of the risk creates a potentially larger problem than just the cash inefficiency.

I always think of this money that sits as dead money. It doesn’t work, it doesn’t earn a return. More often than not an accepted risk control that assumes something might happen.

When you really get down to the nuts and bolts of how organizations behave they will always protect actual cash. I’ll admit this method does work as a result for most situations. If you tie a reward (or punishment) to cash, it’ll get attention.

A few situations where you’d end up with pools of capital to manage risk are payments origination and trading. In both situations the entity introducing risk (or sponsoring it) has to front some cash.

I’m going to ignore collateral requirements for trading for the sake of the topic I’m going to unpack. The origination topic is something that came up on twitter recently in the context of RTP and FedNow. The image below is an oversimplification of how companies get access to these systems. RTP or FedNow operates them and distributes them through a fairly predictable set of participants.

Fednow reseller distribution

RTP and FedNow being two realtime initiatives. One of the questions posed is should the banks be able to get interest on their posted cash reserves to participate in the payment scheme? I think the answer is no unless they are required to pass this through to their clients who post the aggregated collateral. That interest would have to come from the utility provider who is there to enable connectivity.

I worry guaranteeing interest only to the biggest endpoint creates an incentive to unnaturally require large cash deposits or over-utilize dead money as a risk control. It also creates an incentive for the endpoints to require colorization of smaller entities who will actually end up being the ones to post the funds.

Everyone’s interest-free money just flows to the biggest endpoint who earns interest on it if it’s done incorrectly in my opinion. I understand there is a counter argument which is that it should work that way, I just don’t agree with it. Here is how I think about it with numbers much smaller than reality but for demonstration purposes:

Cash collateral requirements for realtime payments

The biggest pool isn’t going to be $100M though. It will be tens if not hundreds of billions of dollars or more. The aggregated collateral in one scenario I can think of off the top of my head has (or did at one time) $80B+ in posted cash collateral. At Fed funds rate, the interest on that is incredible. At 1.5%, that’s $1.2b annually.

If the Fed had to pay (or operator did) fed funds rate the biggest participants would be splitting $100M a month in money generated due to system inefficiencies. I don’t have a problem with collateral as a risk control but I do think it’s unwise to intentionally reward the practice with interest.

If the system design drives cash requirements at this type of scale the benefits should be shared. Even if the numbers are much smaller than the drawing above (which I doubt they are or could be) I still think the interest payments should be shared pari passu with everyone posting cash collateral. If interest were a consideration…

These collateral pools are designed to house enough money so the risk never exceeds the available posted collateral so there is regularly significant headroom and more money than needed sitting in an account somewhere. For example, if there is $50K in actual risk there might be a $250K reserve requirement for a new entity participating in the payments scheme. For an extremely small company or a sole engineer with a big idea that’s a huge hurdle to overcome.

Interest is an incentive program

One of they key issues with the concept of cash reserves as a risk control is that it locks out everyone who can’t financially meet the requirements whose intellectual contributions might greatly reduce the need for the cash controls.

I fear if this is done incorrectly it drives the wrong long term behavior. I don’t really fear the Fed doing the wrong thing here because they’ve done the right thing over so many decades it’s hard to imagine they would get this wrong. That said, there seems to be a desire for them to consider doing things differently in the future and if they or other providers select to I’m hopeful that the rewards are distributed throughout the system and not isolated to a select few organizations.