Hidden Liquidity: A Lesson from the Collapse of Silicon Valley Bank
Introduction
This article builds upon the great explanation of the collapse of Silicon Valley Bank, specifically the work Banks as Synthetic Hedge Funds by Elham Saeidinezhad.
In today's monetary-financial system, the concept of liquidity is fundamental, but its existence depends on a complex financial infrastructure. In mainstream thinking, liquidity is often mistakenly associated with monetary aggregates, when in reality, these only measure assets based on their degree of liquidity, from highest to lowest.
Moreover, the concept of liquidity is often oversimplified, conflating different types of liquidity, such as central bank-provided liquidity, funding liquidity, and market liquidity. However, these types of liquidity are not equivalent and respond to distinct and more complex mechanisms.
For liquidity to increase and flow through the financial system, a network of financial mechanisms and intermediaries is necessary. The infrastructure that supports it includes shadow banking, clearinghouses, and global networks of primary and auxiliary financial centers, including those located in offshore jurisdictions. This ecosystem of institutions and intermediaries plays a crucial role in generating liquidity and money within the global financial system.
The collapse of Silicon Valley Bank (SVB) exposed how depository institutions can structure synthetic financing mechanisms, allowing liquidity to flow through new structures that transform banks—in this case, regional banks—into a type of synthetic hedge fund, with significant exposure to private equity and, in particular, highly leveraged funds.
The risk in these synthetic structured credit mechanisms does not initially stem from defaults but rather from the complex layering of synthetic financing, giving rise to a new concept: hidden synthetic liquidity.
In the case of SVB, its operations relied on two main synthetic structures:
On-balance sheet:
Leveraged loans.
Subscription lines that were used and effectively committed.
U.S. Treasury bonds and commercial mortgage-backed securities (CMBS).
Off-balance sheet:
Relative value trades with bonds and interest rate swaps.
The fundamental issue with SVB was its excessive concentration in the technology and crypto sectors. Its liabilities consisted of deposits from tech companies and private equity firms, while its assets were poorly diversified and exposed to duration and counterparty risks.
This combination resulted in an inefficient capital structure, with high duration risk and inadequate asset-side diversification. Instead of implementing hedging strategies to strengthen its collateral position and ensure access to repo financing or other liquidity markets during periods of stress, SVB resorted to off-balance sheet transactions, replicating relative value strategies typical of hedge funds.
SVB needed to generate high returns to sustain its business model, which led it to build speculative synthetic positions without proper hedging. In a stressed environment, this strategy became unsustainable, as the entire system’s liquidity structure is referenced to SOFR.
What SVB and many other banking entities had built were synthetic liquidity creation mechanisms, in which elements such as subscription lines were not accounted for as leverage but as deferred capital, effectively concealing the true leverage risk within the system.
The central problem with this structure was the poor modeling of payment distribution and the misexecution of relative value strategies, based on the incorrect assumption that the Fed would not raise interest rates. This flawed assumption led SVB to design a payment scheme that ultimately generated significant losses in the strategies used to increase yield, rather than employing them as a hedge.
When the bank was forced to unwind its long positions in interest rate swaps, it was left exposed to an unhedged speculative position, further amplifying its losses. This was compounded by the fact that its collateral—primarily U.S. Treasuries and commercial mortgage-backed securities—was losing liquidity as interest rates rose. Lacking proper hedging, the deterioration in payment modeling began to create a significant hole in its balance sheet and capital structure.
This situation cast doubt on SVB’s solvency, triggering a chain reaction: its short-term liquidity sources began to evaporate, leading to a bank run driven by a funding mismatch. As a result, the bank was forced into fire sales, further exacerbating the crisis and accelerating its collapse.
The key to everything still lies in the money markets and repo rates, particularly SOFR, which is the secured overnight financing rate for the U.S. dollar. SOFR serves as the benchmark for determining the cost of interest rate swaps, subscription lines for private equity funds, CLO financing, and, more broadly, all mechanisms that generate the necessary dollar liquidity, either directly or indirectly.
SOFR is a weighted average of different rates within the repo segment, making it a more accurate reflection of the cost of money in the secured interbank market. Its evolution is directly influenced by the relationship between bank reserves and collateral, as movements in the Velocity of the Multiplication of the Ledger Reserves (VMLR) can push repo rates higher, thereby increasing the cost of financing across the entire system. Any change in the repo market dynamics is immediately transmitted to credit markets, swaps, and structured financing.
The repo market is the foundation of visible liquidity and has a direct impact on synthetic liquidity created in hybrid models like SVB’s or in hidden liquidity, which often does not even register as leverage. This happens because certain OTC transactions are structured as CLOs or other vehicles that do not explicitly appear as financing on bank balance sheets, yet still depend on the cost of repos and interest rate swaps.
Ultimately, the repo market and SOFR form the core of the dollar liquidity system. Their impact extends from traditional bank financing to the most complex structures of leverage and capital markets financing. Understanding this interconnection is essential to grasp how global liquidity truly moves.
Exploring Synthetic Financing: The Case of Silicon Valley Bank (SVB)
Synthetic financing has become a fundamental pillar of modern financial architecture. It is based on the creation of liquidity through derivatives, hybrid structures, and off-balance-sheet financing, allowing institutions to expand their access to capital without relying exclusively on traditional debt issuance or deposits. However, when not properly managed, it can lead to severe financial imbalances, as seen in the collapse of Silicon Valley Bank (SVB).
The growth of private equity in recent decades has been meteoric, solidifying its role as a key mechanism for mobilizing liquidity in an environment where traditional banks face regulatory constraints imposed by frameworks such as Basel III. As this sector has gained prominence, it has given rise to the proliferation of hidden liquidity sources based on synthetic mechanisms, which have become increasingly central to the financial system.
This is closely tied to the shadow banking system, whose expansion since the 2008 crisis has been exponential and which now plays a crucial role in liquidity transmission and money creation, often through over-the-counter (OTC) markets. At the same time, banks like SVB have resorted to sophisticated financial engineering strategies to participate in this segment, effectively bypassing certain traditional regulatory constraints.
What Mechanisms Do Hybrid Systems Like SVB’s Use to Generate Synthetic Liquidity Through Private Equity?
Private equity funds, especially those focused on venture capital and leveraged strategies, can be financed in various ways through banks and investors. Many of them fund instruments such as ETFs, CLOs, and other structured products.
Typically, a private equity fund has two main types of partners:
General Partner (GP): The entity that usually provides the initial capital, manages the fund, and earns profits both from the internal rate of return (IRR) and fund management fees.
Limited Partners (LPs): Investors who contribute additional capital through capital calls, allowing them to benefit from the fund’s returns.
Capital calls are not immediate and are usually executed within 30 to 90 days, which can create liquidity challenges and inefficiencies in fund management.
The Two Main Mechanisms for Synthetic Liquidity Creation
There are two primary mechanisms for creating synthetic liquidity in the private equity ecosystem:
1. Leveraged Loans
Leveraged loans are provided by banks to companies within a private equity portfolio. These companies are often not publicly traded—though not exclusively—or already have high levels of leverage and seek additional debt to finance acquisitions or capital investments.
In this process, private equity funds acquire assets from these companies and use them as collateral, while banks gain exposure to the returns generated by these loans. This facilitates leveraged buyouts and creates a direct connection between the banking system and private equity investments, increasing the level of shared risk.
2. Subscription Lines
Subscription lines have grown exponentially in recent years, with SVB serving as a representative example. These lines have been a key driver in the expansion of synthetic liquidity, as they function as a series of bridge loans structured within revolving credit lines.
This means that as long as the line remains active, each time the private equity fund repays part of the credit, the same amount becomes available again automatically, without the need to request a new loan.
These lines are granted to General Partners (GPs), preventing banks from being directly exposed to private equity businesses. Although considered short-term instruments, they can be extended for up to four years. They are secured credit lines, but instead of traditional collateral, the guarantee consists of unexecuted capital calls.
To support this structure, mechanisms similar to those used in repo markets are employed, backed by safe harbor legal provisions. Additionally, General Partners grant banks a power of attorney, allowing them to execute capital calls in case of default. Moreover, banks charge underutilization fees on these lines, which incentivizes private equity funds to use them more aggressively, fostering an investment strategy that maximizes the available credit line.
Synthetic Exposure and Hidden Risks
If General Partners fail to repay the credit line, banks can execute capital calls. However, if this occurs in a context of stress and illiquidity—where Limited Partners also fail to fulfill their capital commitments—banks effectively become synthetic Limited Partners, directly exposed to the fund and participating in its internal rate of return (IRR).
In the event of a collapse of the General Partners, the fund would be managed by the bank, which would assume the role of a synthetic General Partner.
Subscription lines allow banks to gain synthetic exposure to private equity returns while enabling funds to artificially enhance their internal rate of return (IRR). However, this mechanism creates synthetic structures that obscure leverage, as it postpones the execution of capital calls, effectively generating leveraged positions without formally registering them as such.
From a regulatory perspective, this deferral of capital is not accounted for as leverage but rather as deferred capital, concealing the true risks of over-indebtedness. However, in times of financial stress, these structures can unravel abruptly, exposing the real level of leverage and causing systemic instability.
As I have explained, this entire method of liquidity creation through credit is referenced to SOFR. Therefore, any monetary tightening can have devastating effects, triggering cascading liquidations.
These mechanisms are bilateral, although in many cases—such as leveraged loans—they are structured as syndicated loans to mutualize risks and costs. However, ultimately, their stability depends on the balance of the money markets. Any disruption in these markets can directly or indirectly impact synthetic liquidity mechanisms, jeopardizing the stability of the financial system.
More Ways Synthetic Liquidity Interacts and Risks Are Transferred Through Synthetic Structures
While the foundation of synthetic liquidity arises from hybrid financial structures like SVB’s, it can be further expanded through financial engineering mechanisms and risk transfer strategies.
One such strategy is Significant Risk Transfer (SRT), a mechanism used by banks to shift risks to investors in exchange for a premium. This allows them to improve their capital metrics relative to their leverage levels, expand their balance sheet, and increase their operational capacity.
These strategies combine derivatives such as Credit Default Swaps (CDS) with structured debt vehicles. One of the most commonly used instruments is the Credit-Linked Note (CLN).
In these structures, an investor sells a CDS, while the bank pays them a premium to assume default risk. As risks materialize, the capital invested by the investor in the CDS is gradually reduced, absorbing losses.
These types of strategies are tied to SOFR, as the premium payments are referenced to this index. Therefore, instability in the repo market could create cascading pressures, impacting risk coverage and leading to loss realization.
These mechanisms allow banks to mitigate risks while generating synthetic liquidity through structures like those used by SVB. However, they can also introduce systemic vulnerabilities, as their functionality depends on the stability of money markets and derivatives markets.
While the mechanisms described above explain risk transfer in synthetic liquidity creation, there are other ways to expand this liquidity through its interaction with private equity.
Private Equity’s Role in Expanding Synthetic Liquidity
One such mechanism is the capital contributions of investors to private equity funds. Not all guarantees used in these processes are backed by traditional debt instruments like U.S. Treasuries. In many cases, capital flows themselves are used as collateral in mechanisms such as subscription lines.
Another option is the issuance of commercial paper backed by subscription lines or CLOs (Collateralized Loan Obligations). In this case, credit is structured into tranches ranging from lower to higher risk, allowing leveraged loans to be packaged and transformed into additional liquidity. Furthermore, subscription lines themselves can be used as assets, which are later packaged to further expand the available liquidity in the system.
Many of these CLO tranches can be used as collateral in repo transactions, enabling their rehypothecation to obtain cash. This means that CLO tranches can act as collateral in repo markets, creating a chain of synthetic liquidity expansion.
Total Return Swaps and Their Role in the Expansion of Synthetic Liquidity
Another key mechanism in the expansion of synthetic liquidity is Total Return Swaps (TRS), which allow private equity firms and hedge funds to gain leveraged exposure without owning the underlying assets.
These derivatives are also present in leveraged ETFs, where instead of directly holding the asset in custody, the fund gains exposure to its price movements and dividends through synthetic contracts.
Many of these ETFs not only invest in these funds but are also designed as vehicles to obtain synthetic financing, as their commercialization enables additional capital inflows. Furthermore, this mechanism facilitates the transmission of risk from leveraged portfolios, incorporating retail investors into the synthetic liquidity framework.
As I have explained, these instruments remain tied to SOFR as the benchmark rate. Therefore, an increase in SOFR can trigger asset liquidations, as the cost of leverage becomes unsustainable, forcing the sale of positions and amplifying instability in the financial system.
Repo Market: Collateral, Reserves, and Repo Rates – A Fragile Balance
As Sebastian Infante of the Federal Reserve, along with James A. Clouse and Zeynep Senyuz, explains in their paper Market-Based Indicators on the Road to Ample Reserves, monitoring the relationship between bank reserves and collateral is crucial. This relationship is a key factor that directly impacts repo rate movements, which, through spillover effects, influence interest rates in funding markets, financial markets, and hybrid instruments such as those used by SVB.
The balance between collateral and reserves determines the evolution of the VMLR metric (Value of Marginal Liquidity in Reserves). When financial intermediaries, such as dealers, are unwilling to take on risks and restrict the circulation of collateral and reserves, this metric rises, pushing SOFR above the Effective Federal Funds Rate (EFFR). This reflects a dollar shortage, impacting other key rates such as the Interest on Reserve Balances (IORB) and the discount window.
The impact is clear: a rise in SOFR spreads to other markets, causing a rapid widening of spreads and differentials, which invalidates leveraged strategies and leads to forced asset sales.
The Repo Market as a Catalyst for Synthetic Liquidity
The repo market is the mechanism that allows illiquid assets to be immediately converted into transactional liquidity. In other words, it facilitates the acceptance of lower-quality collateral for rehypothecation.
In a repo transaction, a market participant sells a U.S. Treasury bond to another party with an agreement to repurchase it in the future, obtaining immediate cash without having to liquidate the asset. However, the repo market can also use other less liquid types of collateral, such as CLO tranches or subscription lines, as long as market liquidity is maintained.
When the VMLR (Value of Marginal Liquidity in Reserves) increases, it means that even though reserves remain ample, their circulation decreases, which invalidates certain collateral types and triggers a collateral trap. This occurs due to the ratchet effect, where even if intermediaries have the ability to facilitate transactions, regulatory constraints and risk perception discourage them from doing so. As a result, a threshold is reached where intermediaries no longer feel comfortable with reserve levels, further restricting liquidity.
The Role of Repo in Leverage and Synthetic Liquidity
This process enables banks and investment funds to continuously refinance their positions, using the same collateral multiple times through rehypothecation.
In an environment where SOFR is low, repo becomes an extremely cheap financing mechanism, allowing credit expansion and fueling leveraged strategies, which indirectly contribute to the creation of synthetic liquidity.
When SOFR rises or repo market liquidity contracts, funding costs increase, and market participants face pressure to liquidate assets or reduce leverage.
This creates a domino effect, amplifying financial crises, as a lack of liquidity in the repo market limits short-term refinancing capacity. In this context, synthetic liquidity also becomes illusory, as many of these instruments are backed by less liquid collateral, exacerbating illiquidity when markets experience turbulence.
This is the spillover effect, where a crisis in one market rapidly transmits to others, especially to synthetic financing structures.
Lessons from the Repo Market Collapse in March 2020
A clear example of this phenomenon occurred in March 2020, when the repo market collapsed due to the liquidity crisis triggered by the pandemic.
SOFR spiked, making short-term funding significantly more expensive.
Market participants faced forced liquidations, amplifying the crisis.
The Federal Reserve had to intervene with massive liquidity injections to prevent a financial catastrophe.
With the current levels of leverage, even in the less opaque segments of shadow banking, such as hedge funds, the risk of a new crisis with cascading liquidations remains significant, especially if a large portion of collateral is concentrated in clearinghouses.
Conclusion: Repo as a Critical Indicator of the Financial System
The repo market is far more than just a short-term lending market—it is the thermometer of financial system stability. Its functioning impacts everything from synthetic liquidity to monetary policy, asset valuations, and market leverage.
A low SOFR encourages credit expansion, fueling the growth of leveraged strategies.
A high SOFR restricts liquidity, triggers forced asset sales, and can lead to a systemic crisis.
This is why monitoring how repo rates interact with the financial system is essential to understanding hidden liquidity flows and anticipating potential financial crises.
How Synthetic Liquidity Amplifies Systemic Risk
As I have explained, synthetic liquidity does not emerge out of nowhere; it is created indirectly through subscription lines, such as those developed by SVB, and then the system itself can expand this liquidity multiple times, often concealed in the form of deferred capital.
The exponential growth of private equity has enabled the proliferation of liquidity expansion mechanisms, reinforcing the central role of shadow banking in this process. The SOFR-based financial system and the repo market operate efficiently during stable periods, but in times of crisis, they become amplifiers of systemic risk.
Synthetic liquidity, whether generated through complex financial structures or secured leverage, can vanish rapidly when funding costs rise or when the availability of high-quality collateral declines. This happens primarily because these structures rely on less liquid collateral, making them vulnerable to shifts in market conditions.
The Impact of a SOFR Increase
In an environment where SOFR rises too quickly, funding costs surge, affecting all structures reliant on cheap credit.
Hedge funds, private equity funds, and investment banks that have used secured financing through the repo market may be forced to rapidly deleverage, triggering massive asset liquidations.
This forced liquidation contracts global liquidity, amplifying market instability.
This phenomenon is particularly problematic in markets like private equity, where subscription lines are referenced to SOFR and rely on cheap financing to delay capital calls from investors.
When the cost of these credit lines increases, funds may be forced to execute capital calls abruptly, leading to:
Financial stress for investors, who must contribute capital at an unexpected moment.
Deterioration of market stability, due to a reduction in available liquidity.
The Fragility of Synthetic Liquidity
While synthetic liquidity facilitates credit growth and financial intermediation, it also introduces systemic vulnerabilities. Its expansion depends on a cheap and stable financing environment, but when conditions change, excessive leverage and the use of less liquid collateral can trigger a large-scale financial crisis.
This risk is especially critical in highly leveraged markets like private equity, where dependence on subscription lines and repo financing makes them highly vulnerable to shifts in SOFR and the availability of high-quality collateral.
Conclusion: SOFR and Repo – The Foundation of Synthetic Liquidity and Its Systemic Risk
The modern financial system is built on a secured financing model, where SOFR and the repo market serve as the fundamental pillars of synthetic liquidity creation. Through these mechanisms, liquidity is generated without a proportional increase in the monetary base or bank reserves. This system has enabled an unprecedented expansion of credit and global investment, facilitating leveraged strategies in markets such as private equity and shadow banking.
However, this architecture introduces hidden vulnerabilities. Synthetic liquidity, relying on less liquid collateral and leveraged structures, can disappear rapidly when financial conditions deteriorate. If SOFR rises abruptly or if the repo market experiences disruptions, funding costs increase, triggering cascading liquidations, invalidating leverage, and causing liquidity crises.
The interconnection between traditional banking, shadow banking, and the collateralization system amplifies these effects. In times of stress, financial intermediaries restrict collateral circulation, raising the VMLR (Value of Marginal Liquidity in Reserves) and creating a collateral trap. This, in turn, limits the financial system’s ability to recycle liquidity, leading to an even deeper contraction.
The SVB case demonstrated how synthetic liquidity can remain hidden in structures such as subscription lines and deferred capital, creating the illusion of stability as long as financial conditions are favorable. However, when access to funding becomes more expensive, these structures can become unsustainable, forcing abrupt liquidations and triggering systemic effects.
Synthetic liquidity has been a key tool in the evolution of the financial system, enabling greater flexibility and credit expansion. However, it has also created an extreme interconnection between short-term liquidity and financial market stability.
In this context, any disruption in SOFR or the repo market can have far-reaching systemic effects. When funding costs become unsustainable or the availability of high-quality collateral declines, accumulated leverage turns into a catalyst for financial crises.
Understanding how synthetic liquidity functions and its relationship with SOFR and repo is essential to assessing the real risks of today’s financial system. Beyond surface-level stability, the system remains dependent on the ability of financial intermediaries to sustain the collateral and secured financing infrastructure.
In an environment where leverage continues to grow and dependence on synthetic liquidity is increasing, the key to anticipating financial risks is not in bank reserves but in repo market dynamics and SOFR’s evolution.