Arbitraging The Silicon Valley Banking Crisis
Step into the high-flying world of cross-asset arbitrage.
"Muddy waters make it easy to catch fish"
The recent events in Silicon Valley has definitely caught some of us off-guard, but this uncertain volatility is where the most opportunities are found. To understand how this multi-asset arbitrage structure works, we must first understand the big picture behind the thesis:
To start, let’s head over to the world of fixed income. As you may know by now; when interest rates rise, the value of already existing bonds fall. When more attractive bonds are issued at higher rates, the older, lower-yielding bonds become less attractive and are sold-off to buy the newer, higher-yielding bonds:
As shown above, buying $100m of a bond that returned 1.5% annually in 2020 would result in that bond being worth significantly less in 2023. Normally, this is fine if you’re holding the bond to maturity, as you’d get back the full principal. However, if for any reason you need to sell the bond before maturity, you would have to sell it at the market price which would lock-in a steep loss.
Silicon Valley Bank was no exception to this concept, and it started with their $120B position of long-term bonds having an unrealized loss of $20B due to the rate movement. The increased rate environment also impacted their customers, who had an increased need for liquidity. Fulfilling these liquidity requests would mean locking-in these tremendous losses, so instead, the bank decided to give money from a different, more liquid portfolio of securities that were immediately available for sale (AFS).
Selling off that portfolio and locking smaller losses bought them some temporary breathing room, but have you noticed the vulnerability? Since they essentially sold off the entirety of the liquid assets to cover customer withdrawals, it would mean that future withdrawals and expenses would need to come from the illiquid, long-term bond portfolio. This was the nail in the coffin.
The bond market is extremely liquid, but not that liquid. Bonds follow a similar orderbook to equities, so large sell orders manifest in lower and lower prices. So besides just locking in the already large $20B loss from rates, they would continue to lose more as they drove down the price to fill their orders. By this time, the news had already broke, sending shares lower, which resulted in even more client panic and withdrawals, making them need to liquidate and lower prices even further.
In just 2 days, the bank had collapsed and was shut down by regulators. But not before we were able to generate a solid profit through a creative, multi-asset trade structure: