Cash for Bond Lending

What is Cash for Bond Lending?

Cash for bond lending is a lending structure used in the Federal Reserve's Term Auction Facility (TAF), whereby borrowers receive a cash loan, by using all or a portion of their own portfolio of bonds as collateral.

Understanding Cash for Bond Lending

The cash for bond lending structure is not to be confused with the bond for bond lending structure, in which the borrower takes bonds instead of cash. In the cash for bond lending, all of the lending transactions are based in cash as collateral. Although cash for bond lending might seem like a relatively straightforward, low-risk strategy, experts caution that it does carry significant and, sometimes, hidden risks. Securities loans collateralized by cash are a popular option in the securities lending market.

One major advantage of the cash for bond lending structure is that it allows borrowers to receive a cash loan in a short amount of time, without any other financial aspects to wade through. By using their own portfolio of bonds as a collateral, they are able to, in essence, back themselves and streamline the process of loan approval. A cash for bond lending structure naturally favors borrowers with high levels of cash to work with, something not every borrower will have access to.

Advantages and Disadvantage of Cash for Bond Lending

Another advantage of a collateral cash market transaction is that using cash as collateral mitigates the risk associated with replacing the security if the borrower does not return it, because the cash is used instead. However, despite the advantages and commonality of the cash for bond lending system, some experts warn that overuse of the cash for bonds lending structure can weaken the financial system.

For instance, financial newsletter Current Issues explained how risk surrounding the cash for bond lending system can arise when the cash exchanged is then reinvested, especially if it is reinvested aggressively. The cash reinvestment generally involves both liquidity and maturity transformation, which both can lead to fire sales and run-like behavior.

A liquidity transformation might occur if the time needed to sell the cash assets goes beyond the maturity of the transaction, while maturity transformation can occur if the maturity of the acquired assets is more than the maturity of the loan transaction. The newsletter notes that both excessive maturity and liquidity transformation from cash securities lending contributed to the financial crisis of 2008.