Archelyon Algorithm
The Archelyon product facilitates the creation of liquidity facilities for both agency and non-agency mortgage-backed securities (MBS). This facility allows for the purchase of MBS from fixed-income investors without exposure to mark-to-market risk or the capital constraints of Basel III. Currently, only government organizations can hold MBS positions free from these capital costs and risks. Archelyon introduces new liquidity, offering organizations a complementary tool to manage their reserves without undermining the liquidity of the MBS markets. It is widely recognized that any liquidity impairment in the U.S. MBS markets— the second-largest fixed-income market in the U.S.—could negatively affect economic growth.
In an Archelyon transaction, a Special Purpose Vehicle (SPV) or Hedge Fund can acquire MBS from government entities, banks, or originators, then enter into an interest rate swap with other parties. This swap transfers the interest rate and prepayment risks to the counterparty, leaving the SPV or Hedge Fund with an instrument that is free from both risks. The SPV or Hedge Fund can then offer floating-rate notes to fixed-income investors with varying legal final maturities.
Mark-to-Market RiskPrimary dealers, banks, and other entities (e.g., REITs) can (and regularly do) finance MBS purchases in the repo market. However, the challenge of doing this in the repo markets is that they only fund a discounted portion of the current market value of those underlying MBS. For example, on a $1 billion face value position, a dealer can only borrow $950 million through repo, requiring the dealer to have $50 million in capital. If the market value of the MBS declines due to rising interest rates or widening MBS/Treasury spreads as we have seen in the past several years, the dealer will need to post additional capital. To protect against market losses, dealers typically hedge price risk using futures, swaps, and other instruments, but these hedging costs can significantly reduce or even eliminate any profits from the repo transactions.
Banks can also avoid repo financing by using deposits. However, the largest banks are required to hold capital to offset losses on MBS held in "Available-for-Sale" (AFS) accounts. Additionally, all banks must report unrealized losses in "Accumulated Other Comprehensive Income" (AOCI). Large AOCI losses can attract regulatory scrutiny and negatively impact share prices. In the last several years we have seen many banks and other institutions holding MBS experience an adverse impact to their AOCI.
Basel III Capital ConstraintsThe largest banks must hold capital against positions in MBS, whether funded by deposits or repo transactions, as part of the Supplemental Leverage Ratio (SLR) requirements. These capital costs impair return on equity, and in some cases, banks may not have sufficient capital to hold the required MBS positions. The Archelyon solution assists in alleviating these pressures through the way that MBS are handled through our proprietary algorithm and returned back to the institutions, or redistributed out into the market.
Archelyon Enables Organizations to Affect Reserves Without Impairing MBS Market LiquidityAn alternative liquidity facility, such as the one provided by Archelyon, enables the organizations to sell MBS from their portfolios. This allows governmental organizations to drain reserves and reduce any of the past monetary stimulus that has been added in the past few years, without disrupting MBS market liquidity. In the past we have seen that in the States, even the mere announcement that the Fed will stop reinvesting principal in MBS has led to significant declines in MBS prices, causing large losses for banks and increasing rates for borrowers. Actual sales of MBS could further exacerbate the negative consequences for banks and borrowers. Changes in Mortgage-Treasury spreads suggest that the liquidity premium for holding MBS has increased since the Fed announced it would cease being a large-scale MBS buyer. An alternative buyer, free from repo market constraints or Basel III capital requirements, could help reduce this liquidity premium.
Archelyon Enables Organizations to Provide Market Liquidity Without Adding ReservesIn the US we have seen that the Fed faces constraints on its ability to drain reserves from the banking system, particularly since banks require a minimum level of reserves—the "Lowest Comfortable Level of Reserves" (LCLoR)—to function. Draining reserves below this threshold could cause severe market disruptions, as we witnessed in 2019. While the Fed has introduced mechanisms like the Standing Repo Facility to allow banks to raise cash during times of stress, repos consume Basel III capital and expose banks to mark-to-market risk. If MBS markets are illiquid, banks may incur significant losses when selling MBS to raise cash.
In this scenario, Cental Banks may need to halt Quantitative Tightening (QT) and add reserves back into the banking system by purchasing Treasury securities or MBS. While this would relieve stress in the banking system, it could also ignite inflation. The Archelyon Special Purpose Vehicle (SPV) provides an alternative solution. The SPV can purchase MBS from the banking system and transfer the interest rate and prepayment risks to those Central Banks, without adding reserves to the banking system. The bank receives cash to meet liquidity needs, while the Central Banks assume the same risk as if they had directly purchased MBS.
Banks can also avoid repo financing by using deposits. However, the largest banks are required to hold capital to offset losses on MBS held in "Available-for-Sale" (AFS) accounts. Additionally, all banks must report unrealized losses in "Accumulated Other Comprehensive Income" (AOCI). Large AOCI losses can attract regulatory scrutiny and negatively impact share prices. In the last several years we have seen many banks and other institutions holding MBS experience an adverse impact to their AOCI.
Basel III Capital ConstraintsThe largest banks must hold capital against positions in MBS, whether funded by deposits or repo transactions, as part of the Supplemental Leverage Ratio (SLR) requirements. These capital costs impair return on equity, and in some cases, banks may not have sufficient capital to hold the required MBS positions. The Archelyon solution assists in alleviating these pressures through the way that MBS are handled through our proprietary algorithm and returned back to the institutions, or redistributed out into the market.
Archelyon Enables Organizations to Affect Reserves Without Impairing MBS Market LiquidityAn alternative liquidity facility, such as the one provided by Archelyon, enables the organizations to sell MBS from their portfolios. This allows governmental organizations to drain reserves and reduce any of the past monetary stimulus that has been added in the past few years, without disrupting MBS market liquidity. In the past we have seen that in the States, even the mere announcement that the Fed will stop reinvesting principal in MBS has led to significant declines in MBS prices, causing large losses for banks and increasing rates for borrowers. Actual sales of MBS could further exacerbate the negative consequences for banks and borrowers. Changes in Mortgage-Treasury spreads suggest that the liquidity premium for holding MBS has increased since the Fed announced it would cease being a large-scale MBS buyer. An alternative buyer, free from repo market constraints or Basel III capital requirements, could help reduce this liquidity premium.
Archelyon Enables Organizations to Provide Market Liquidity Without Adding ReservesIn the US we have seen that the Fed faces constraints on its ability to drain reserves from the banking system, particularly since banks require a minimum level of reserves—the "Lowest Comfortable Level of Reserves" (LCLoR)—to function. Draining reserves below this threshold could cause severe market disruptions, as we witnessed in 2019. While the Fed has introduced mechanisms like the Standing Repo Facility to allow banks to raise cash during times of stress, repos consume Basel III capital and expose banks to mark-to-market risk. If MBS markets are illiquid, banks may incur significant losses when selling MBS to raise cash.
In this scenario, Cental Banks may need to halt Quantitative Tightening (QT) and add reserves back into the banking system by purchasing Treasury securities or MBS. While this would relieve stress in the banking system, it could also ignite inflation. The Archelyon Special Purpose Vehicle (SPV) provides an alternative solution. The SPV can purchase MBS from the banking system and transfer the interest rate and prepayment risks to those Central Banks, without adding reserves to the banking system. The bank receives cash to meet liquidity needs, while the Central Banks assume the same risk as if they had directly purchased MBS.
Archelyon Overview - BGS Specific
- Archelyon enables banks to - Structure Residential Mortgage-Backed Securities (RMBS) transactions to eliminate interest rate risk for banks.
- - Create mortgage instruments with customized risk-return profiles and legal final maturities at various points along the yield curve (e.g., 5, 7, 10 years), even if the underlying mortgages have a thirty-year legal final maturity. This provides an alternative to the traditional 40-year-old Collateralized Mortgage Obligation (CMO) market, which can only offer instruments with thirty-year legal final maturities.
- - Increase prime residential mortgage-backed securitization (RMBS) volume from $5 billion annually (2020 volume) to $100 billion annually, leveraging existing infrastructure.
- - Achieve an incremental profit of 30 basis points ongoing, without using balance sheet capacity (with an up-front NPV of the income stream around 1%, assuming a 15% CPR and an 8% discount rate). At a $100 billion annual volume, incremental profits would approximate $1 billion, with no balance sheet usage and no interest rate risk to banks.
- - Increase up-front transaction structuring fees (i.e., selling all tranches at a price higher than the cost of acquiring the underlying mortgages) by reducing subordination levels on RMBS. For instance, if a bank’s RMBS has 15% subordination levels to attract AAA investors, Archelyon enables a reduction in subordination levels to between 8% and 12%. This reduction boosts profit margins for banks. Increasing the up-front margin by 0.25% on $100 billion would generate an additional $250 million in revenue for banks.
- - Serve as a riskless principal intermediary with Central Banks and Federal Reserve Systems to implement monetary policy, with annual transaction volumes exceeding $1 trillion. Key Feature: Swaps with Multiple Embedded Prepayment Options & Customized Exposure for Banks
- Attracting bank participation at scale in RMBS transactions is key to unlocking significant securitization revenues for banks. Archelyon facilitates this by transforming the long-standing Balance Guaranteed Swap (BGS) product. BGS are interest rate swaps with an embedded prepayment option, carrying only interest rate and prepayment risk, while the credit risk of the underlying mortgages remains with the mortgage originator. The notional balance of a BGS tracks the remaining principal balance of a residential mortgage pool. As the principal balance declines due to amortization, prepayments, or defaults, the notional balance of the BGS decreases proportionally.
- Standard BGS products have a single prepayment option with uniform exercise conditions across all counterparties, exposing both parties to the entire mortgage pool. However, banks require customized prepayment exposure. A generic prepayment option exposes them to unacceptable risks.
- For example, consider a bank seeking to transfer both interest rate and prepayment risks on a specific pool of mortgages. To do so, the bank needs a basis-risk-free hedge, which can only be achieved if the notional balance of the swap matches the principal balance of the bank's own mortgage pool. A BGS where the notional balance declines based on a different pool of mortgages creates material basis risk.
- To achieve a perfect hedge (with no basis risk), a bank would need a bilateral BGS, where the embedded prepayment option mirrors the prepayment behavior of the bank’s own mortgage pool. However, only the largest banks, with sufficient name recognition, can access this type of swap, and even then, they may need to negotiate with multiple counterparties to place a swap of adequate size. Additionally, counterparties may demand a significant premium due to the unique prepayment risks associated with mortgages from a single origination source.
- Archelyon solves this challenge by enabling the creation of a BGS with multiple embedded prepayment options. The exercise conditions for each prepayment option depend on multiple pools of mortgages, which broadens the scope for participation. This modification creates the conditions necessary for attracting bank participation in securitization transactions. Archelyon swaps allow banks, regardless of size, to manage only the interest rate and prepayment risks of mortgages they originated. For example, banks can execute Archelyon swaps to create basis-risk-free hedges that transfer the interest rate risk of their fixed-rate mortgage portfolios (while retaining credit risk and funding costs). Alternatively, they can use Archelyon swaps to transfer both credit risk and funding costs (while retaining only interest rate and prepayment risk).
- Swap counterparties also benefit from the ability to embed multiple prepayment options. These counterparties gain exposure to the interest rate and prepayment risk of mortgages originated by multiple banks, thus eliminating idiosyncratic prepayment risk. This provides the counterparty with the equivalent of a leveraged position in a government-guaranteed mortgage-backed security, with no principal loss risk even at a 100% default rate on the underlying mortgages.
- A key feature of the Archelyon product is the ability to embed prepayment options with varying legal final maturities. For instance, an Archelyon-enabled BGS can include prepayment options that expire in ten years, even though the underlying mortgages have a 30-year legal final maturity. Depending on market conditions, a bank may find that transferring interest rate and prepayment risks for only the first ten years offers superior risk-adjusted returns.
- In this case, the counterparty to the BGS gains access to a synthetic mortgage with a ten-year legal final maturity, a product not available in the CMO market.
Archelyon Advantage
We leverage our proprietary artificial intelligence within our algorithm to enhance the efficiency of pricing and risk allocation in the RMBS markets. With our years of research, development, and vetting with major financial institutions, we are confident this approach will drive higher risk-adjusted profitability for banks, non-bank originators, and investors, while simultaneously expanding access to creditworthy borrowers. Unlike other capital markets, the multi-trillion-dollar RMBS markets have been slow to innovate and adopt state-of-the-art technology. Many still rely on decades old legacy dealer pricing and risk allocation practices, often based on government regulations. Since 2008, these outdated practices have led major investor groups to limit their participation, reducing market liquidity. Our technology platform enables investors to access unique risk/return profiles not available in other fixed income markets. It is through our breakthrough technology which we believe market efficiencies/profitability can be realized
AlgorithmOur algorithmm creates two-way liquidity in markets that would otherwise remain illiquid without federal intervention. This liquidity allows the algorithm to operate on a "best efforts" basis, where transactions are only finalized when all parties agree on the terms (e.g., price, amount, etc.). Operating on this basis eliminates all interest rate and credit risk for the algorithm sponsor. In traditional structuring, a sponsor would typically need to acquire one side of the transaction and warehouse it, incurring substantial funding costs, interest rate, and credit risks while seeking the other side. However, utilizing the Archelyon algorithm, we are able to negate these risks, thereby avoiding unnecessary costs.
Future Outlook
As we enter 2025, we are optimistic about the market opportunity for Archelyon’s transformative technology. The current market conditions are increasingly favorable for our technology. With global inflation and interest rates under the microscope and Central Banks stepping back as the "buyer of last resort" for MBS, we anticipate deepening liquidity challenges in both the PLS and global MBS markets. Our goal is to be a global market leader in addressing these issues.
We believe this potential liquidity gap presents a timely opportunity to leverage the Archelyon platform, attracting new liquidity from large investor groups such as interest rate risk investors, money market mutual funds, insurance companies, and pension funds—who traditionally do not participate in PLS. Additionally with the move of Private Equity groups such as Carlyle Group, Apollo, KKR, etc. leveraging their relationships with large banks to originate transactions where those firms will then take on the credit risk (thus stepping in to what is traditionally the banking sector's space), we are confident that Archelyon's two-way liquidity creation in the Interest Rate and Credit Risk markets provides for an efficient means of transforming the market.
Moreover, we are confident that the unique customization capabilities of the Archelyon technology, including the ability to transform long-term fixed-rate instruments (e.g. 25-year mortgage in England, 30-year mortgage in the States, and others) into floating-rate long-term paper and offer flexible risk-return profiles, will make it an attractive solution for these investors.