Lesson 23 of 25 · 7 min

What a backstop does, and what it does not undo

It restores the willingness to hold risk from a date forward; it cannot restore a holding that was sold the week before.

A backstop changes the future price of liquidity. It does not change any price that has already printed, and it does not return any share that has already been sold.

What it does is real. By standing ready to lend against specified collateral at specified haircuts, a facility puts a floor under the funding side of the problem. Intermediaries that were shrinking inventory can stop shrinking it, because the thing they feared — being unable to fund a position they were stuck with — now has a stated price. The bid returns, impact falls, and the loop in lesson 10 loses the term that was driving it.

Four things it does not do, each of which is a separate mechanism:

It operates on eligible collateral only, and the eligibility list is itself a schedule with its own haircuts. Assets outside it benefit only at second hand, through holders who now have other options.
It reaches intermediaries, not borrowers. Nothing in it obliges any lender to restore any advance rate on any account.
It cannot reverse completed liquidations, and the accounts that were liquidated are by construction the ones that were nearest the line.
It does not touch the trailing volatility window, so the buffer rules stay where the estimator puts them for as long as the estimator says so.

Put the last point in money. An account holding 31,600 shares sells 8,400 at $37.10 to cure a shortfall, raising $311,640 and reducing the balance by the same amount. Nine weeks later the price is $52.40. Had nothing been sold, the position would be worth $1,655,840; it is worth $1,215,680. The $440,160 difference, set against $311,640 of debt no longer owed, leaves $128,520 permanently gone.

A recovery is a price path. A liquidation is a fact. Only one of those two things is reversible.

Key terms

Backstop: A standing commitment to lend against stated collateral at stated terms, which removes the fear of being unable to fund a position.
Eligible collateral: The specific list of assets a facility will accept. Being outside the list is the difference between direct relief and second-hand relief.
Crystallised loss: A loss made permanent by a completed sale. No subsequent price recovery reaches it, because the shares that would have recovered are no longer held.

Worked example

What the recovery reaches and what it does not

Illustrative figures. An account holds 31,600 shares, sells 8,400 at $37.10 to cure a shortfall, and the price is $52.40 nine weeks later.

Proceeds applied to the balance: $311,640
Position if nothing had been sold: $1,655,840
Position as it stands: $1,215,680
Difference in market value: $440,160
Debt no longer owed: $311,640
Permanent reduction in net worth: $128,520

The facility restored the market. It restored nothing about the 8,400 shares, which is the part of the episode that does not reverse.

Check yourself

An account holding 44,000 shares sells 12,900 at $18.45 during a stress. A liquidity facility is announced and the price recovers to $26.80. What is the permanent effect?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.