Three themes that we have talked about a lot around here recently are:

1. Banking is getting narrower. The classic model of banking is that people need money to buy houses or do business, and they go to banks to borrow the money. This model is risky — if the borrowers don’t pay back the loans, the banks’ deposits will be at risk — and so post-2008 bank regulation has at various margins discouraged bank lending. But people still need loans, so now they increasingly borrow money from other lenders — “private credit” is the big buzzword, but also fintechs and trade finance firms and all sorts of other “nonbank financial institutions” (NBFIs) or “non-depository financial institutions” (NDFIs). Those lenders have safer funding models than the banks: Instead of being funded with deposits, they lend using long-term locked-up investor capital.
2. The banks are re-tranching. Really this is just a slight variation on the previous theme. The NDFIs lend using their own investors’ capital, but not only their own investors’ capital. They also leverage that capital by borrowing from banks. The banks are not moving away from the business of lending, exactly; they are moving up in seniority. Instead of lending money to businesses and consumers, they lend money to lenders who lend it to businesses and consumers. Instead of getting a senior claim on some underlying economic activity, the banks get a senior claim on some pool of senior claims on some underlying economic activity. In theory this should be safer for the banks: The NDFIs bear the first losses on any loans that go wrong, and the banks only have losses if the NDFIs are wiped out. “What’s happened is we’ve moved from the riskier part of the capital structure to the safer part of the capital structure,” as a Goldman Sachs Group Inc. executive put it.
3. “When you see one cockroach, there are probably more.” There has been a rash of what Marc Rowan called “late-cycle accidents” in credit markets, and they all kind of look the same. There is some company — Tricolor Holdings or First Brands Group or Cantor Group or 777 Partners — that is basically in the business of making loans, against cars or car parts or commercial real estate or structured settlements. And that company, in turn, borrows from other lenders, using the loans it made as collateral. [1]  And then there are problems with those loans. The problems are partly of the form “something normal went wrong with the underlying loans” — Tricolor’s car customers run into financial trouble and can’t pay for their cars, etc. — but they are also partly of the form “the underlying loans weren’t actually there.” The company borrowed money using the loans it made as collateral, but there are allegations that it hadn’t actually made those loans, or that it no longer owned them, or that it pledged them as collateral to multiple lenders.

These things are perhaps related. If you are a bank, and you lend someone money to buy a car, you will try very hard to make sure that the car actually exists. You will take the title to the car and keep it in a safe place. You want to get paid back, and the car is your collateral, so you will spend some time thinking about the car.

But if you are a bank, and you lend money to a company that makes car loans, you will have a more indirect relationship to the cars. Oh you might be rigorous and diligent about checking on the cars. You might say to the company “I assume you have taken the titles to all these cars and put them in a safe, so hand us the safe.” But you might not. You might do some diligence on the company and say “ehh, they seem like professionals, we can trust them. And after all they have a lot of skin in the game: They take the first losses if any of these loans go bad, so they have incentives to make sure that the collateral is good.”

That is, one tradeoff in the re-tranching of banking is that banks have more seniority but less visibility. If loans go bad, banks don’t take the first losses, because they didn’t make the loans. (They made loans to the companies that made the loans.) But because they didn’t make the loans, they have less ability to check that the loans are good, or even that they exist in the first place.

Anyway here’s a Moody’s Ratings report titled “US private credit market reshapes bank lending and risk”:

The rise of private credit has altered the competitive landscape for US banks, which have ceded significant lending turf to alternative asset managers on the back of more stringent regulations following the 2007-08 financial crisis. US private credit assets under management (AUM) have tripled over the past decade, a growth rate far outpacing that of most other forms of credit.

Banks have adopted new strategies in reaction to the shifting market environment, with a focus on growing loans to non-depository financial institutions (NDFIs), which reached $1.2 trillion as of late June for domestically chartered US banks. ...

As banks compete with non-bank lenders and simultaneously finance them, asset quality challenges may surface. The recent bankruptcy of Tricolor shows that bank lending to NDFIs can result in significant losses, and underwriting and collateral controls can fail even when loans are secured.

Banks’ lending to private credit providers rather than directly to middle-market borrowers offers a diversification benefit from exposure to the providers’ wide spectrum of portfolio companies. But this benefit is reduced by the incremental leverage that private credit providers often incur at the portfolio company level, and the inherently lower transparency of indirect lending.

One simplistic way to look at it is this. You are a bank. You have $100 of deposits to put to work. [2]  In the olden days, you would make $100 of loans to people and companies. In the new regime of indirect lending, NDFIs will make those $100 of loans to people and companies, and you will lend the NDFIs $50 secured by those loans. But you don’t have $50 to lend, you have $100. You need to earn a return on all of it. How do you make $100 of loans in this new, re-tranched world? The simple answer is “the NDFIs will make $200 of loans, and you will lend them $100 secured by those loans.” [3]  But you were only making $100 of loans in the olden days. How will the NDFIs find an extra $100 of loans to make? One obvious possibility is by making much worse loans. Another is by making fake loans.

One possible model is that the basis trade is a money-market trade. This is not the normal way to think about it, but it is roughly plausible. The classic basis trade — the one in US Treasury futures — goes like this:

1. Short-term cash investors (money market funds, etc.) lend money to hedge funds to buy Treasury bonds. These loans have short terms, pay money-market interest rates (something like SOFR, the Secured Overnight Financing Rate, the benchmark US short-term lending rate), and are collateralized by the Treasury bonds.
2. Hedge funds use those loans to buy the Treasury bonds.
3. The hedge funds sell Treasury futures to bond fund managers. Simplistically, a Treasury futures contract is “In three months I will give you a Treasury bond and you will give me $100,” with no money changing hands upfront.
4. So the bond managers get exposure to Treasury bonds without paying for them: Effectively, they own the bonds, but on the hedge funds’ balance sheets. They are getting “synthetic leverage,” meaning that they are kind of borrowing money from the hedge funds to buy Treasury bonds. [4]
5. The hedge funds essentially earn a spread: They borrow from the money market funds at low rates, and lend (synthetically) to the bond managers at somewhat higher rates.

You could loosely summarize this as “what is happening here economically is that the money-market funds are making short-term secured loans to asset managers to buy Treasury bonds,” though in reality the hedge funds intermediate the trade. I once wrote:

You could imagine a bond manager saying “I would like to own Treasuries but not put up a lot of cash, so I am going to go across the hall to the money market fund manager at my firm and ask him to lend me the money to buy the Treasuries.” 

Other basis-ish trades get a bit closer to that approach. We talked once about the S&P 500 index futures basis trade (buy stocks, sell S&P 500 futures), which some cash investors apparently do directly. [5]  “Unlevered investors looking to deploy unencumbered cash might step in to finance equity exposures,” said a D.E. Shaw & Co. note, “given the attractiveness of the S&P 500 futures spread relative to other common uses of cash.” And Janus Henderson investment manager Natasha Sibley said that “it has been a popular play among sophisticated real-money investors, such as pension funds and sovereign wealth funds, those with cash to put to work.” If you are a cash investor — not necessarily a money market fund per se, but a sovereign wealth fund with some extra cash that would otherwise go into the money markets — financing equity exposures might sometimes be an attractive trade. Not just in the abstract sense of “it pays well,” but also in the narrower sense that it looks like a money-market trade. You are effectively lending your balance sheet to the equity market, without any market risk (you are long and short the S&P 500) and without much credit risk (your futures contracts are collateralized through a highly rated and too-big-to-fail central clearinghouse), to earn a SOFR-like return.

Or a box spread is in a literal first-order sense a combination of options trades (buy a put, sell a call, buy a call, sell a put), but it is effectively a money-market trade: You synthetically lend money to options traders and get paid a SOFR-ish interest rate. We talked once about an exchange-traded fund that does box spreads; Bloomberg’s Zachary Mider explained that it “offers returns that closely track short-term Treasuries, with starkly lower tax bills.” That is, the pitch was “we pay you short-term risk-free interest rates, though we get them in a weird way.” [6] Box spreads obviously aren’t short-term Treasuries, but they kind of are. And so a box-spread ETF could go around saying “look we’re basically a money-market fund when you think about it,” and be roughly correct.

Anyway. Who invests in money markets? Well, “unlevered investors looking to deploy unencumbered cash,” sovereign wealth funds, corporate treasuries, all sorts of investors. Retail investors often put their cash in money market funds, which then invest it in money-market instruments; some of that money indirectly ends up in basis trades.

But of the big novel interesting modern participants in money markets are stablecoins. Big issuers like Tether and Circle own tens of billions of dollars of Treasury bills and other money-market instruments, along with (in Tether’s case) assorted odder investments. There is a widespread view that their investments should not be particularly frisky, even compared to money-market funds: In the US, the GENIUS Act restricts stablecoin issuers to mostly bank accounts and Treasury bills, while the UK might just have them hold reserves at the central bank. But from first principles you could stuff all sorts of money-market-ish trades into a stablecoin. Could you make short-term loans to trading firms secured by their portfolios of securities or, let’s be real here, crypto? Absolutely, and Tether has some history of doing that.

Could you do basis trades? Crypto basis trades? Oh sure sure sure why not. Basis trades obviously are not Treasury bills but, you know, some distant family resemblance. Last week my Bloomberg Opinion colleague Lionel Laurent wrote about USDe:

The third-largest stablecoin – USDe – briefly lost its dollar peg and fell to as low as 65 cents against the dollar on crypto exchange Binance. Things have calmed down since then, but it’s clear that this is not the kind of move investors expect of so-called digital dollars. …

If Circle and Tether resemble tokenized money-market funds, reinvesting dollars into assets like Treasury bills, USDe looks more like a tokenized hedge fund. It makes money from crypto-native revenue like staking Ethereum or hedging crypto derivatives such as perpetual futures – an instrument (unregulated in the US) that allows traders to speculate with leverage around the clock without expiry. These hedges enable the dollar value of the backing assets to remain “relatively stable” in most market conditions, USDe says.

That sounds pretty out-there, but it’s been a very lucrative trade – the demand from investors to go long cryptocurrency with leverage provided on trading platforms has been insatiable, according to Jonathan Bier, chief executive officer of Farside Investors, and USDe’s market capitalization has swelled to $14 billion. Last year, the yields being earned from USDe were over 20%; last month, Binance offered users a 12% annualized yield for holding USDe. “So far so good,” wrote S&P Global Ratings in an assessment of USDe earlier this year. But it warned the token relied heavily on a functional crypto ecosystem of exchanges and had yet to be fully battle-tested; it rated the token’s ability to maintain its peg as “weak.”

USDe is the stablecoin of Ethena, “a synthetic dollar protocol built on Ethereum that provides a crypto-native solution for money, USDe, alongside a globally accessible dollar savings asset, sUSDe.” Here is Ethena’s description of how it works. It’s a basis trade:

1. You deposit $1 of Ethereum and get back 1 USDe.
2. Ethena keeps your Ethereum and also enters into an offsetting short trade on Ethereum perpetual futures, hedging out its Ethereum price risk. It’s long $1 of Ethereum (which you gave it) and short $1 of Ethereum (via futures).
3. Ethereum futures traders, just like Treasury futures traders, want synthetic leverage and will pay for it. “Historically,” says Ethena, “due to the mismatch between demand & supply for exposure to digital assets, there has been a positive funding rate & basis spread earned by participants who are short” the futures. [7]

So with $1 of Ethereum and $1 of short Ethereum perpetual futures, USDe is perfectly hedged against market risk, so it should always be worth $1. And it can generate like 12% interest.

Meanwhile SOFR is like 4.2%, so, uh, 12% is quite a bit more. Why does the crypto basis trade pay so much more (unlevered) than the Treasury basis trade? I mean, to ask the question is to answer it: The Treasury basis trade involves Treasuries, while the crypto basis trade involves crypto. If you trade Treasury futures on regulated US exchanges backed by clearinghouses, you tend to think of your futures as having nearly zero credit risk: You expect that you will always receive the payoff of your futures contracts. If you trade crypto perpetual futures on crypto exchanges, you definitely do not expect that! Crypto exchanges sometimes go bust, and even when they don’t they sometimes socialize losses; we talked just last week about how perpetual futures sometimes get “auto-deleveraged” and don’t pay out as expected. USDe “relied heavily on a functional crypto ecosystem of exchanges and had yet to be fully battle-tested,” and the crypto exchange ecosystem does seem somewhat less functional than Treasury futures.

Still: I kind of love it? For many purposes, you want a stablecoin that will be worth a dollar in any scenario that a normal dollar-native person can think of, so you will come up with ideas like the GENIUS Act to make sure that stablecoins invest only in dollars. For other purposes, though, you might want a stablecoin that is always worth a dollar within the context of your trading on the crypto exchange. If I offered you a stablecoin whose value is “$1 as long as you are cheerfully trading crypto on your current favorite exchanges, and $0 if any of them go bust,” you might take that deal, if it paid higher interest. (If you are a big crypto trader and the exchanges go bust the value of the stablecoin is not your only worry; IBGYBG.) The proper crypto money market rate is apparently 12%, and that’s what USDe pays.

Six Flags Entertainment Corp. has an obvious nostalgic appeal: It runs amusement parks, so a lot of people probably have fond memories of going to Six Flags as a kid but have not spent a lot of time there recently. It has a well-known consumer-facing brand. It was hit hard by Covid a few years ago. Its stock price peaked in 2017, and a lot of short sellers have bet against it; short interest represents 22% of its float, more than GameStop, AMC or Tesla. It has an equity market capitalization of about $2.6 billion and a good ticker symbol, FUN.

When you read that paragraph, what do you think? Do you think “hmm sounds like a meme stock”? I do. I mean, the meme-stock effect is not as strong now as it was in 2021, and Six Flags — unlike some meme stocks — is not in financial distress. Also it does not have a particularly retail-heavy shareholder base; the top 20 holders reported on the Bloomberg HDS page own 77% of its stock. Still it has some meme-y elements.

And so if you are a regular, big, institutional activist investor like Jana Partners, and you have analyzed Six Flags and concluded that it is a good target for an activist campaign, should you be just a touch meme-y about your campaign? I mean, in general, activist investors should be a little meme-y about everything; there has always been a continuum between the techniques of activist investors and people talking up stocks on Reddit. “Activist investing,” I wrote last year, “is among other things an indirect way to monetize media,” and in the modern media environment that requires a certain savvy with social media. But, sure, Six Flags might call for somewhat meme-ier techniques than a logistics company.

The Wall Street Journal reports:

An activist investor pushing for big changes at Six Flags has teamed up with Travis Kelce.

New York-based hedge fund Jana Partners, the National Football League star and other investors have a combined stake of about 9% of the theme-park operator’s shares, or $200 million.

Jana managing partner Scott Ostfeld unveiled the position and detailed their thesis at a conference Tuesday afternoon, confirming an earlier report by The Wall Street Journal.

The news sent Six Flags shares up roughly 18% Tuesday, giving the company a market value of around $2.6 billion. Prior to that, the company’s shares had been down roughly 50% year-to-date, weighed down by bad weather and declining visits to its parks. ...

“I am a lifelong Six Flags fan and grew up going to these parks with my family and friends,” Kelce said in a statement. “The chance to help make Six Flags special for the next generation is one I couldn’t pass up.”

Kelce shared videos of himself enjoying Cedar Point rides as a child on his Instagram account Tuesday afternoon. “I have some exciting news!!!” he wrote of his investment in Six Flags.

Yeah good stuff, good stuff. Also:

As part of its Six Flags investor consortium, Jana also brought in former Gap CEO Glenn Murphy and Reddit chair Dave Habiger. The two men are potential board nominees, according to Ostfeld, while Kelce isn’t.

Right you definitely want a Reddit guy on the board, that could come in handy.

Apparently if you use a London office building for agricultural purposes, it is exempt from local property taxes. At first glance it seems hard to use a London office building for agriculture, but tax arbitrages bring out the best in human ingenuity, and one guy figured it out. If you get two snails and put them in a box in your office building, you are “breeding snails” and thus doing agriculture. We talked about this a few months ago because how could we not. It is such a pure and perfect tax trade, and one could hope that whoever invented it got a big job at a hedge fund.

But Jim Waterson at London Centric found the guy and talked to him and, no, he’s apparently just a guy with (possible Mafia ties and) a deep aesthetic appreciation for snails and evading taxes:

The farmer, a 79-year-old former shoe salesman called Terry Ball who has made and lost multiple fortunes, has been cheerfully telling me in great detail for several hours about how he was inspired by former Conservative minister Michael Gove to use snails to cheat local councils out of tens of millions of pounds in taxes. …

“They’re sexy things,” chuckles Ball in a broad Blackburn accent, describing the speed with which two snails can incestuously multiply into dozens of specimens if they’re left alone in a box for a few weeks. Snails love group sex and cannibalism, he warns. …

Over the ensuing hours, Ball makes confession after confession about his attempts to outwit the taxman with increasingly elaborate plans, his decades-long links to the Naples underworld, and how at this very moment there are buildings across London where he is deploying his unique snail-breeding method in a bid to cheat exasperated local councils out of millions of pounds. ...

The old man is proudly committed to spending his remaining years on this earth finding innovative ways to get revenge on the “bastard” authorities who he feels screwed him over in the past: “I just do it for devilment. I do it just to get away with it.”

It is very satisfying to learn that the guy who invented snail-based tax evasion did it for the very best reason to do any sort of tax trade, not to make money but just for the sheer joy of it.