What is Private Placement Investment Program?
Private Placement Program (PPP) is an investment trading program where the investor places a sum of money or a financial instrument, such as unconditional bank guarantee or standby letter of credit from a prime Western European or US bank in an acceptable bank. A contract is entered into between the investor and the trader. The trader then proceeds to trade in Medium Term Note or similar financial notes issued by major financial institutions in Europe and the US, and the yields are shared between the trader and the investor. Some HYIPs require that a portion of the yields be distributed to an approved humanitarian project, but notwithstanding such allocations the yields to the investor are extremely attractive AND SAFE. No part of the moneys or the instrument in deposit is at risk at any time. The money/instrument is NOT pledged or mortgaged or anyway encumbered. AT ALL TIMES the money/instrument remains in the investor's bank account, in the investor's own bank or a designated bank, and only under his control. The investor can withdraw it at ANY TIME which of course means that he will cease to participate in the program.
Procedures and Documents
A. PROGRAMS
We can have the choice among the following Programs:
1. FED Program:
This Program generates high Profit paid weekly, but it requires important amount of investment and strict last bank documents from Investor’s Banks. The Program is for 40 weeks, but certainly the Investor is free to stop it after some weeks.
2. PRIVATE PLACEMENT Program:
This Program generates Profit paid weekly. The level of Profit depends on the numbers of Trade Operations realized weekly. It will be informed in details before the signature of Trading Contract. The Trader has to arrange the credit line based on bank documents provided by the Investor’s Banks. The Program is for 40 weeks, but the Investor is free to stop it after some weeks.
3. SPOT Program: This is a Program of some weeks with fixed Profit weekly. The level of Profit will be informed in details before the signature of Trading Contract. The Trader arranges the credit line based on bank documents provided by the Investor’s Banks.
B. NEGOCIATION OF LAST BANK DOCUMENTS
I have negociated with Trader’s side on the last Bank Documents to ensure the feasibility of the Program at last Steps of Procedures. Indeed, when the Trader and the Investor agree previously on these last Bank Documents and confirm them officially, all the preparation of the paperwork for the complete Dossier will be done quickly and we will have minimum of risk of losing time and fees.
The following last Bank Documents are already negociated and will be provided accordingly bank-to-bank at the last Steps of Procedures:
1. Document MT799:
This is a document to obtain credit line.
2. Document MT760:
This is a document to block the funds.
3. Documents CASH DEPOSIT, STANDBY LC or BANK GUARANTEE
These Documents will be accordingly issued by acceptable Banks. The security of these documents is as follows:
a. The Beneficiary of these documents is the Investor himself.
b. These Documents are in safekeeping in the issuing Bank itself or in its Branches in Western Countries.
c. Against these Documents in safekeeping in the issuing Bank itself or in its Branches in Western Countries, the credit line will be provided in a “Non Drawable, Non Depletion, Capital Preservation” Account (NDNDCPA) under the name of Investor (Beneficiary of Documents). The Banks that provide the credit line can request the transfer of these Documents to themselves.
REMARK: The 3 above bank Documents are separate. A Trader can request only one of these bank Documents according to the need of his Program. The sending of these bank Documents are always by SWIFT and by BANK to BANK directly.
C. STEPS OF PROCEDURES
The Procedures contain the following Steps:
1. STEP 1:
The Financial Advisor Group receives:
11. PROOF OF FUNDS
12. ENLARGED A4 COLOUR COPY OF PASSPORT of Authorized Signatory
2. STEP 2:
The Financial Advisor Group releases the above Documents to Trading Groups and negociate with them on:
=> Conditions of Programs
=> Last bank Documents required by Trading Groups
=> Procedures of realization of the transaction
3. STEP 3:
The Financial Advisor Group communicates to Investor’s side the contents of its negociations concerning:
=> Conditions of Programs
=> Last bank Documents required by Trading Groups
=> Procedures of realization of the transaction
4. STEP 4:
When the Investor accepts the three above points, he will provide to the Financial Advisor Group the following documents:
41. CONFIRMATION OF LAST BANK DOCUMENTS
42. FEE & COMMISSION PROTECTIONS
This is to prectect Fees and Commissions to Financial Advisor Group and to its Partners/Associates
43. POWER AUTHORIZATION
This is a limited Power Authorization agreed to the Financial Advisor in his precise works:
=> To release other documents from the Investor to Trading Group and to communicate documents from the Trading Group to Investor
=> To previously negociate the detailed conditions of Program, Contract.
5. STEP 5:
Preparation of the paperwork concerning the Documents to establish the complete Dossier for the transaction. These Documents are as follows:
51. LETTER OF INTENT
52. CORPORATE RESOLUTION (for Company Investor)
53. CLIENT INFORMATION SHEET
54. SUMMARY OF FUNDS HISTORY
55. AUTHORIZATION TO VERIFY FUNDS (only Bank-to-Bank)
56. NON-SOLICITATION LETTER
57. NON-CIRCUMVENTION & NON-DISCLOSURE AGREEMENT
58. SUMMARY OF PROJECTS
6. STEP 6 :
The Financial Advisor Group transmits the above Documents to the Trading Group and negociate the terms and conditions of the Draft of TRADING CONTRACT.
7. STEP 7:
After the negociation of terms and conditions of the Draft of Trading Contract, the Trader will send this Contract to the Investor directly or through the Financial Advisor Group. The signed Trading Contract will be transmitted first each other by Fax or E-Mail Transmission, then its original by registered courier.
71. TRADING CONTRACT (from Trading Group)
72. AUTHORIZATION TO OBTAIN A CREDIT LINE
After the signature of the TRADING CONTRACT and the AUTHORIZATION TO OBTAIN A CREDIT LINE, the Investor’s Bank sends by SWIFT bank-to-bank the MT799 to the Trader’s Bank. After the verification and the authentication of this MT799, the credit line will be confirmed within two banking days.
8. STEP 8:
Within maximum 24 hours after the confirmation of the credit line, the Trader will communicate directly to the Investor the Full COORDINATES of the Trading Bank.
9. STEP 9:
The Trader can help the Investor to open a Bank Account to receive its own Profit from the Program. This Bank Account is under the unique Name of the Investor. If the Investor has already his own Bank Account, he doesn’t need this help from the Trader.
10. STEP 10:
After receiving the Full COORDINATES of the Trading Bank, the Investor gives Order to his Bank to issue Last Bank Documents and to send them accordingly by SWIFT (directly or through Prime Banks which confirm them with responsibility) to:
=> The Bank that gives the credit line
=> The Bank where the trading operations will be done
Please see the comments on the Last Bank Documents (Paragraph B above). These Documents will be provided according to the precise requirement from the Trading Groups.
11. STEP 11:
The Banks from Trader’s side verify and authenticate the Last Bank Documents sent by SWIFT to these Banks. The trading operations begin. The Investor will receive the reports on the trading operations, normally weekly.
12. STEP 12:
The Investor communicates OFFICIALLY to the Trader the full Coordinates of his own Bank to receive his Profit. The Payment of Profit is for every week.
Thursday, January 25, 2007
Entry into a trading program
This is one of the most difficult areas to invest in that exist. There are plenty of people around who know something about this marketplace, but very, very few know how it truly works. Because enough people know something and the fact that there is significant money to be made, this market attracts many bad players. Two features distinguish these pretenders -- they lack financial and investment acumen and they ask for up front fees. From time to time these pretenders attempt to pull off a major fraud with a significant investor. This prompts warnings issued by the Board of Governors of the Federal Reserve System or the Comptroller of the Currency.These pretenders almost always attempt to setup their fund raising efforts in the U.S. The Fed, of course, will not have any part of that since the process is designed to control and utilize expatriate dollars, not domestic dollars.Banks routinely deny the existence of these programs, even the ones operating them. Most bank officers know nothing in any event. The only way into the system is to be able to certify substantial assets to a commitment holder or one of its sub-licensees. Finding either is not trivial task because there are more pretenders around than legitimate commitment holders. There are very few actual commitment holders. If an investor cannot certify at least $10 million and more likely $100 million, the chances of getting anyone's attention who is genuine are indeed remote. This is why, quite frankly speaking, these offices feel no presumption whatever in jointing for the joint venture, in as much as the funds provided would find it virtually impossible to locate a collateral commitment holder which this program provides on the very highest level.
Nonetheless, there is a way you can get into this interacting market. Designed to provide much of the information required for conducting a due diligence Lender/Investors are skeptical of opportunities that offer above-market returns.
If significant capital is required, little information is readily available with which to conduct a due diligence investigation, there is little motivation for committing funds. This is why XXXX offers the most valuable report on high yield Bank Debentures programs. This report is designed to provide a full understanding of bank debentures trading mechanics. Every statement made in it references either a legal precedent, report or letter issued by a government agency, trade publication or known entity in banking and finance. No pie in the sky deals just facts from official and well known entities.
Here is an overview of what you'll discover:
1. How A letter from the Securities and Exchange Commission, (S.E.C) stating that letters of credit are exempt from registration under the Securities Act of 1933.
2. An opinion from the U.S Supreme Court stating that letters of credit, when acquired for cash, are the equivalent of a deposit liability.
3. A legal historical example of a clean standby letter of credit, the text of which is clean of any requirements of documentation of nonperformance or default for the beneficiary to obtain payment.
4. Why the International Chamber of Commerce is encouraging more equitable practices in the area of standby letters of credit.
5. How to determined when a BANK-TO-BANK transmission is authentic and legal.
6. The issuance of standby LOC involves the separation of many of the services associated with lending, such as credit risk evaluation and underwriting, from funding.
7. Banks argue that they are in the risk management business - whether on or off the balance sheet.
8. An important difference between a standby LOC and conventional financing with uninsured depositors is that a standby LOC beneficiary retains the loan in the event of bank failure as opposed to having to stand in line with the FDIC and other creditors to recover the remaining assets of the bank.
9. The greatest motivation for off-balance sheet banking is the opportunity cost of funding assets with reservable deposits without a binding capital constraint.
10. In issuing an off-balance sheet instrument, the bank acts as a third party in a commercial transaction, substituting the bank's credit worthiness for that of its customer to facilitate exchange while sharing some of its risk with the lender/investor.
11. In effect, banks are willing to rent their credit standing or borrow credit analysis to lender/ investors by guaranteeing the payment of principal and interest-which may be of value to a bank customer who is not well known or established. This enables a bank to receive an underwriting fee that can bolster current profits without tying up capital.
12. A bank may not be asked to issue a guarantee unless it is perceived by the market to be strong.
13. How a standby LOC is similar to an uninsured deposit and subordinated note in that it's value varies inversely with the credit risk of the bank.
14. The incentive to the lender/investor? What is the real return on this arrangement is likely to be greater than that of a deposit while still maintaining insurance against loss.
15. The types of entities who acquire Bank Debentures.
16. A discussion of repurchase programs and credit-enhanced loan transactions.
How a Repurchase Program/Reverse Repurchase Program can enable the note holder to reduce credit risk while facilitating a borrower's need for cash by rolling it over into a secondary market. By utilizing a well-drafted trust, escrow or custody agreement and the trust services of a creditworthy bank, a lender/investor can participate in a repurchase program that combines high return, liquidity and minimum credit and transaction risk
Every statement made in this report references either a legal precedent, report or letter issued by a government agency, trade publication or known entity in banking and finance.
Nonetheless, there is a way you can get into this interacting market. Designed to provide much of the information required for conducting a due diligence Lender/Investors are skeptical of opportunities that offer above-market returns.
If significant capital is required, little information is readily available with which to conduct a due diligence investigation, there is little motivation for committing funds. This is why XXXX offers the most valuable report on high yield Bank Debentures programs. This report is designed to provide a full understanding of bank debentures trading mechanics. Every statement made in it references either a legal precedent, report or letter issued by a government agency, trade publication or known entity in banking and finance. No pie in the sky deals just facts from official and well known entities.
Here is an overview of what you'll discover:
1. How A letter from the Securities and Exchange Commission, (S.E.C) stating that letters of credit are exempt from registration under the Securities Act of 1933.
2. An opinion from the U.S Supreme Court stating that letters of credit, when acquired for cash, are the equivalent of a deposit liability.
3. A legal historical example of a clean standby letter of credit, the text of which is clean of any requirements of documentation of nonperformance or default for the beneficiary to obtain payment.
4. Why the International Chamber of Commerce is encouraging more equitable practices in the area of standby letters of credit.
5. How to determined when a BANK-TO-BANK transmission is authentic and legal.
6. The issuance of standby LOC involves the separation of many of the services associated with lending, such as credit risk evaluation and underwriting, from funding.
7. Banks argue that they are in the risk management business - whether on or off the balance sheet.
8. An important difference between a standby LOC and conventional financing with uninsured depositors is that a standby LOC beneficiary retains the loan in the event of bank failure as opposed to having to stand in line with the FDIC and other creditors to recover the remaining assets of the bank.
9. The greatest motivation for off-balance sheet banking is the opportunity cost of funding assets with reservable deposits without a binding capital constraint.
10. In issuing an off-balance sheet instrument, the bank acts as a third party in a commercial transaction, substituting the bank's credit worthiness for that of its customer to facilitate exchange while sharing some of its risk with the lender/investor.
11. In effect, banks are willing to rent their credit standing or borrow credit analysis to lender/ investors by guaranteeing the payment of principal and interest-which may be of value to a bank customer who is not well known or established. This enables a bank to receive an underwriting fee that can bolster current profits without tying up capital.
12. A bank may not be asked to issue a guarantee unless it is perceived by the market to be strong.
13. How a standby LOC is similar to an uninsured deposit and subordinated note in that it's value varies inversely with the credit risk of the bank.
14. The incentive to the lender/investor? What is the real return on this arrangement is likely to be greater than that of a deposit while still maintaining insurance against loss.
15. The types of entities who acquire Bank Debentures.
16. A discussion of repurchase programs and credit-enhanced loan transactions.
How a Repurchase Program/Reverse Repurchase Program can enable the note holder to reduce credit risk while facilitating a borrower's need for cash by rolling it over into a secondary market. By utilizing a well-drafted trust, escrow or custody agreement and the trust services of a creditworthy bank, a lender/investor can participate in a repurchase program that combines high return, liquidity and minimum credit and transaction risk
Every statement made in this report references either a legal precedent, report or letter issued by a government agency, trade publication or known entity in banking and finance.
Issuing paper
The Federal Reserve decides which banks will issue paper, what kind and how much at any point in time. The United Nations and the World Bank have similar authority with PBGs, but they too must coordinate with the Fed.
A commitment holder and a bank work together to operate a trading program. The commitment holder is the source of funds. It establishes lists of banks from which it will accept paper. The lists reflect the preferences of the owners of the funds. Obviously, the strongest banks will appear on the lists with the highest frequency. This causes them to benefit the most from this activity, The strongest banks attract the commitment holders to operate the trading programs within their establishments.
Banks do the actual trading. They inquire through the Fed to determine who is issuing instruments. They are also informed about the banks that wish to acquire paper. They arrange the trades, verify and confirm the securities and clear the trades. The commitment holder is an integral part of the process although it does not have to be present to make it function. The commitment holder simply must leave the required amount of funds at the trading bank in a custody account after all the procedures have been properly executed.
The commitment holder provides the source of funds which is used to purchase the initial issue of paper and immediately resells it to another bank. There is no room in the system for anyone without funds. This is a principal to principal (bank to bank) business only. The trading bank executes the trades and finds buyers for issued paper. Outsiders can access the system only by finding a commitment holder and lodging funds with it or with one of its sub-licenses. The commitment holder spends most of its time finding "investors."
A commitment holder and a bank work together to operate a trading program. The commitment holder is the source of funds. It establishes lists of banks from which it will accept paper. The lists reflect the preferences of the owners of the funds. Obviously, the strongest banks will appear on the lists with the highest frequency. This causes them to benefit the most from this activity, The strongest banks attract the commitment holders to operate the trading programs within their establishments.
Banks do the actual trading. They inquire through the Fed to determine who is issuing instruments. They are also informed about the banks that wish to acquire paper. They arrange the trades, verify and confirm the securities and clear the trades. The commitment holder is an integral part of the process although it does not have to be present to make it function. The commitment holder simply must leave the required amount of funds at the trading bank in a custody account after all the procedures have been properly executed.
The commitment holder provides the source of funds which is used to purchase the initial issue of paper and immediately resells it to another bank. There is no room in the system for anyone without funds. This is a principal to principal (bank to bank) business only. The trading bank executes the trades and finds buyers for issued paper. Outsiders can access the system only by finding a commitment holder and lodging funds with it or with one of its sub-licenses. The commitment holder spends most of its time finding "investors."
The institutional structure of the system
A number of problems must be overcome to make the structure work. Inevitably, the offshore U.S. dollars find their way into the international banking system by way of deposits. Therefore, banks must be the main buyers of any financial instruments that the Fed causes to be issued. However, the rules of the Bank of International Settlement (BIS) prohibit banks from buying the newly issued debt instruments from each other directly. This prohibition exists for obvious reasons. If banks were allowed to fund one another, the probability of system-wide bank failure would be increased. This system of funding is not intended to support weak banks; in fact, the opposite objective is the goal. Therefore, a methodology has been constructed that allows banks to buy each other's newly issued paper.
BIS rules do not prohibit banks from owning other banks' financial obligations as long as they are not purchased from another bank directly, but instead are purchased in the secondary market. The Fed supports a group of intermediaries that have substantial available cash reserves. These intermediaries purchase paper from issuing banks and almost always immediately resell it to other banks. These intermediaries are called "commitment holders."
The Federal Reserve board "licenses" a small number of commitment holders to participate in a quiet international monetary policy. These commitment holders are identified by confidential, Fed-issued, registration numbers. These numbers are revealed under extremely controlled circumstances, because once revealed, a knowledgeable individual could cause paper to be issued. The commitment holders are few in number, however they are essential to the smooth functioning of the process. Commitment holders often forge relationships with other sources of funds. These relationships are called sub-commitments.
Holding a commitment entails a number of conditions which are extremely important to maintain. First and foremost, there is a demand for utter secrecy. Second, the commitment holder must be able to quickly produce large sums of U.S. dollars, generally in the billions. This explains why commitment holders are prepared to take on sub-licensees to ensure a large supply of readily available funds. Finally, this is a "funds first" business. No one can buy issued Paper on credit. To ensure this happens and not waste time, a commitment holder will not initiate a discussion with anyone unless they can prove cash funds of high quality security of at least 100 million U.S. dollars.
The Fed, as well, identifies a tier of high quality banks, usually in the top 100, which it authorizes to deal in the paper. Criteria for being on the Fed's list would include strength in the normal banking ratios as well as countries in which the Fed desires to be active. It is evident that the largest supply of international U.S. dollars is in Europe, which explains the dominance of European banks on the Fed list.
Another aspect of this fund raising process is the fact that it is conducted entirely off the balance sheets of issuing banks. Both instruments are guarantees and as such, represent contingent liabilities. As contingent liabilities, they are not posted to the balance sheet. However, they do require a risk-adjusted amount of capital reserve as prescribed by BIS rules. By keeping the funding instruments off balance sheets, there is little, if any, disruption of normal financing activities of the banks.
BIS rules do not prohibit banks from owning other banks' financial obligations as long as they are not purchased from another bank directly, but instead are purchased in the secondary market. The Fed supports a group of intermediaries that have substantial available cash reserves. These intermediaries purchase paper from issuing banks and almost always immediately resell it to other banks. These intermediaries are called "commitment holders."
The Federal Reserve board "licenses" a small number of commitment holders to participate in a quiet international monetary policy. These commitment holders are identified by confidential, Fed-issued, registration numbers. These numbers are revealed under extremely controlled circumstances, because once revealed, a knowledgeable individual could cause paper to be issued. The commitment holders are few in number, however they are essential to the smooth functioning of the process. Commitment holders often forge relationships with other sources of funds. These relationships are called sub-commitments.
Holding a commitment entails a number of conditions which are extremely important to maintain. First and foremost, there is a demand for utter secrecy. Second, the commitment holder must be able to quickly produce large sums of U.S. dollars, generally in the billions. This explains why commitment holders are prepared to take on sub-licensees to ensure a large supply of readily available funds. Finally, this is a "funds first" business. No one can buy issued Paper on credit. To ensure this happens and not waste time, a commitment holder will not initiate a discussion with anyone unless they can prove cash funds of high quality security of at least 100 million U.S. dollars.
The Fed, as well, identifies a tier of high quality banks, usually in the top 100, which it authorizes to deal in the paper. Criteria for being on the Fed's list would include strength in the normal banking ratios as well as countries in which the Fed desires to be active. It is evident that the largest supply of international U.S. dollars is in Europe, which explains the dominance of European banks on the Fed list.
Another aspect of this fund raising process is the fact that it is conducted entirely off the balance sheets of issuing banks. Both instruments are guarantees and as such, represent contingent liabilities. As contingent liabilities, they are not posted to the balance sheet. However, they do require a risk-adjusted amount of capital reserve as prescribed by BIS rules. By keeping the funding instruments off balance sheets, there is little, if any, disruption of normal financing activities of the banks.
Conclusion
The financial markets play a very important part in the well-being of every person. They interact with other markets and have an influence on issues such as wealth, inflation and stability in a country. The financial markets have their own characteristics and to operate in them, it is important to comprehend these characteristics.
Factors influencing the financial markets
Each effective market has a supply of a certain commodity, and a demand for that commodity. Savings (investments) represent the supply side in the money markets, and financing needs, as the demand side. Because of the interaction between the various financial commodities, money and service markets in a country, the simple theory of supply and demand determining prices cannot be applied in its basic form in these markets.
The theoretical system would determine that the rate (price for money) would drop if there is a surplus savings (supply) in the market, but if there are savings in the market which are not utilised to finance income-making activities, the national income will eventually decline, probably bringing about a decline in the rate of savings which could work against the fall in interest rates.
Another factor influencing the financial markets is expectations; for instance, if rates are high, with the expectation that the rates are going to decline in the future, the demand for securities and thus the supply of money will be high, pushing interest rates down, and security prices up.
Expectations of higher inflation could push up interest rates. Prices of goods are expected to go up, so consumers tend to buy now rather than later, which pushes up the demand for cash balances and hikes interest rates. Interest rates in turn has an effect on inflation. The level of savings and spending is to a significant extent determined by prevailing interest rates.
Fiscal policy decisions by the government also affect the financial markets. The decisions by the government also affect the financial markets. The decision on how to finance the government’s deficits will affect the supply and demand for cash balances, short and long-term deposits (M3 money supply), and thus influence interest rates. If the government decides to finance its monetary needs with the issuing of short-term securities such as treasury bills, the demand for money in the short-term market increases, exerting upward pressure on interest rates.
Examples of other factors affecting local financial markets are the following:
- The local market seems to overreact on information and expectations. During 1994/95 the expectation of higher inflation was one of the reasons for long-term interest rates going up by more than 5 percentage points
- The level of government spending has an adverse effect on inflation and interest rate movements
- South Africa had a two-tier exchange rate system (the financial and commercial rand) up to March 1995. Some restraining foreign exchange regulations are still in place. The exchange rate determines what a country pays for imports, and what that country gets for exports in terms of its own currency, for example, the rand proceeds of gold exports. These import and export payments have an effect on the foreign reserves have an effect on the foreign reserves that South Africa holds and the amount of money in circulation in the economy. Foreign trade and the resulting foreign exchange rate affect the local economic parameters influencing the financial markets.
- The integrity of the payments system in the financial markets. Trust in the South African system was affected by the credit rating that South Africa received from overseas institutions
- High labour costs, excessive political violence and significant political uncertainties in the country have tended to keep away foreign investors. Because of the local political factors, foreign investors want a premium on their investment yield to compensate for the risk and uncertainty associated with investing in South Africa
- Liquidity in the markets is low, and pooling of funds needs to be done to improve liquidity
- Domestic funds, such as pension funds, tend to invest in shares rather than capital market instruments because of risk and return factors and uncertainties about interest rates and volatility. The demand for capital market instruments is thus lower, pushing up interest rates. Previously, funds were forced to invest in certain government capital market instruments as a certain percentage of their total portfolios
- Financial disclosure concerning transactions, positions and risk involving financial markets is not in line with generally accepted standards world-side.
- Capital adequacy and interest rate risk
The general approach is that financial positions, which are exposed to interest rate fluctuations, should not be more than a certain percentage of the primary capital of a company. Internationally accepted levels are much lower than the levels in South Africa.
The theoretical system would determine that the rate (price for money) would drop if there is a surplus savings (supply) in the market, but if there are savings in the market which are not utilised to finance income-making activities, the national income will eventually decline, probably bringing about a decline in the rate of savings which could work against the fall in interest rates.
Another factor influencing the financial markets is expectations; for instance, if rates are high, with the expectation that the rates are going to decline in the future, the demand for securities and thus the supply of money will be high, pushing interest rates down, and security prices up.
Expectations of higher inflation could push up interest rates. Prices of goods are expected to go up, so consumers tend to buy now rather than later, which pushes up the demand for cash balances and hikes interest rates. Interest rates in turn has an effect on inflation. The level of savings and spending is to a significant extent determined by prevailing interest rates.
Fiscal policy decisions by the government also affect the financial markets. The decisions by the government also affect the financial markets. The decision on how to finance the government’s deficits will affect the supply and demand for cash balances, short and long-term deposits (M3 money supply), and thus influence interest rates. If the government decides to finance its monetary needs with the issuing of short-term securities such as treasury bills, the demand for money in the short-term market increases, exerting upward pressure on interest rates.
Examples of other factors affecting local financial markets are the following:
- The local market seems to overreact on information and expectations. During 1994/95 the expectation of higher inflation was one of the reasons for long-term interest rates going up by more than 5 percentage points
- The level of government spending has an adverse effect on inflation and interest rate movements
- South Africa had a two-tier exchange rate system (the financial and commercial rand) up to March 1995. Some restraining foreign exchange regulations are still in place. The exchange rate determines what a country pays for imports, and what that country gets for exports in terms of its own currency, for example, the rand proceeds of gold exports. These import and export payments have an effect on the foreign reserves have an effect on the foreign reserves that South Africa holds and the amount of money in circulation in the economy. Foreign trade and the resulting foreign exchange rate affect the local economic parameters influencing the financial markets.
- The integrity of the payments system in the financial markets. Trust in the South African system was affected by the credit rating that South Africa received from overseas institutions
- High labour costs, excessive political violence and significant political uncertainties in the country have tended to keep away foreign investors. Because of the local political factors, foreign investors want a premium on their investment yield to compensate for the risk and uncertainty associated with investing in South Africa
- Liquidity in the markets is low, and pooling of funds needs to be done to improve liquidity
- Domestic funds, such as pension funds, tend to invest in shares rather than capital market instruments because of risk and return factors and uncertainties about interest rates and volatility. The demand for capital market instruments is thus lower, pushing up interest rates. Previously, funds were forced to invest in certain government capital market instruments as a certain percentage of their total portfolios
- Financial disclosure concerning transactions, positions and risk involving financial markets is not in line with generally accepted standards world-side.
- Capital adequacy and interest rate risk
The general approach is that financial positions, which are exposed to interest rate fluctuations, should not be more than a certain percentage of the primary capital of a company. Internationally accepted levels are much lower than the levels in South Africa.
Trading in the markets
Trading can take place in a market when information about prices are exchanged. The mechanism of price measurement in the money markets is the interest rate, because the interest that the borrower pays is the price that he has to pay for the privilege of using the money for a certain time.
Financial instruments are quoted at interest rates, from which the transaction amount or the amount that the buyer which the transaction amount or the amount that the buyer (lender) has to pay to the seller (borrower), also called the consideration or settlement amount, is then calculated.
Price in monetary values (the consideration paid for an instrument) and interest rate movements are opposites. Fixed interest rate securities are traded at a discount on the nominal value if the market interest rate is higher than the interest rate on the instrument (called the coupon rate). Consider the following example:
An instrument with a term to maturity of one year, a nominal amount of R1 million with a coupon rate of 12% will probably trade at the following prices at the beginning of the year:
If the market rate is 15%, the investor could invest his money at 15% in the market. He would want to buy the instrument giving only a yield of 12% at a discount, so that the money he invested would earn an effective yield of at least 15%. The cash flow that he would receive at the end of the year if the interest is paid at the end of the period, is: Interest: 12% of R1 000 000 = R 120 000
Capital amount: R1 000 000
Total R1 120 000
The total cash flow discounted at the required yield of 15% for one year gives R973 913. For the investor to earn 15% on his investment, he would be willing to pay only R973 913 for the instrument.
If the market rate and yield required by the investor drops to 14% the instrument (using the same calculation methods) would trade at R982 456. Thus, it is clear that with a fixed interest and redemption payment, a lower monetary amount (consideration) would be offered for an instrument if the yield goes up, because the investor would want to earn more on his investment. The interest rate at which the instrument is eventually traded, is called the yield and could differ from the market rate because of differing views, costs, etc.
For trading to take place, a buyer and a seller must get together and negotiate. This could take place on a specifically allocated floor, or by means of a communication system using computer networks and telephones, for instance, the South African Futures Exchange and the JSE. Where a transaction takes place without making use of an organised exchange, the transaction is called an “over-the-counter” (commonly known as OTC) transaction. The Futures Exchange and the JSE have in recent years implemented fully automated electronic trading systems, which eliminate telephone calls between buyers and sellers or buying and selling agents to a large degree. Although transactions are closed in numerous ways, the exchange of money and products such as contracts, certificates, etc. still takes place between the parties of a transaction, and this is called the settlement of a transaction. Settlement of the transaction can take place at a later date than the date of the transaction.
Owning a financial instrument is called a long position. A short position is the selling of a financial instrument without being the owner thereof. Because the settlement date could be after the transaction date, a seller could sell something he doesn’t own and buy it before the settlement date, to be able to deliver it to the buyer.
Financial instruments are quoted at interest rates, from which the transaction amount or the amount that the buyer which the transaction amount or the amount that the buyer (lender) has to pay to the seller (borrower), also called the consideration or settlement amount, is then calculated.
Price in monetary values (the consideration paid for an instrument) and interest rate movements are opposites. Fixed interest rate securities are traded at a discount on the nominal value if the market interest rate is higher than the interest rate on the instrument (called the coupon rate). Consider the following example:
An instrument with a term to maturity of one year, a nominal amount of R1 million with a coupon rate of 12% will probably trade at the following prices at the beginning of the year:
If the market rate is 15%, the investor could invest his money at 15% in the market. He would want to buy the instrument giving only a yield of 12% at a discount, so that the money he invested would earn an effective yield of at least 15%. The cash flow that he would receive at the end of the year if the interest is paid at the end of the period, is: Interest: 12% of R1 000 000 = R 120 000
Capital amount: R1 000 000
Total R1 120 000
The total cash flow discounted at the required yield of 15% for one year gives R973 913. For the investor to earn 15% on his investment, he would be willing to pay only R973 913 for the instrument.
If the market rate and yield required by the investor drops to 14% the instrument (using the same calculation methods) would trade at R982 456. Thus, it is clear that with a fixed interest and redemption payment, a lower monetary amount (consideration) would be offered for an instrument if the yield goes up, because the investor would want to earn more on his investment. The interest rate at which the instrument is eventually traded, is called the yield and could differ from the market rate because of differing views, costs, etc.
For trading to take place, a buyer and a seller must get together and negotiate. This could take place on a specifically allocated floor, or by means of a communication system using computer networks and telephones, for instance, the South African Futures Exchange and the JSE. Where a transaction takes place without making use of an organised exchange, the transaction is called an “over-the-counter” (commonly known as OTC) transaction. The Futures Exchange and the JSE have in recent years implemented fully automated electronic trading systems, which eliminate telephone calls between buyers and sellers or buying and selling agents to a large degree. Although transactions are closed in numerous ways, the exchange of money and products such as contracts, certificates, etc. still takes place between the parties of a transaction, and this is called the settlement of a transaction. Settlement of the transaction can take place at a later date than the date of the transaction.
Owning a financial instrument is called a long position. A short position is the selling of a financial instrument without being the owner thereof. Because the settlement date could be after the transaction date, a seller could sell something he doesn’t own and buy it before the settlement date, to be able to deliver it to the buyer.
Classification of Financial Markets
Markets can be classified into different categories depending on the characteristic of the market or instrument used to create categories. Securities created by institutions in the markets normally pay an interest on the nominal amount (the amount shown on the certificate or contract). The interest-bearing securities market is split into the money market and the capital market, based on the term to maturity (the term left to redemption of the debt) of the securities.
- The capital market is the market for the issue and trade of long-term securities.
- The money market is that of short-term securities.
When goods such as financial instruments are traded in a market, there are certain differences between transactions done in these markets. The differences in transactions in the financial markets can be categorised in different categories, two of which are the following:
- The timing difference between the closing of the transaction and the delivering of the goods or settlement of the transaction
- The difference in certainty that the other party will honour the transaction.
In the spot market, the closing of the transaction and the delivery of the goods take place simultaneously or within a short-term time span prescribed by the specific market. Uncertainty about delivery from the other party is very limited, otherwise no transaction would take place.
The forward market is the market where a transaction is closed in the present, and the settlement of the transaction and the delivery of goods are in the future. The delivery date and the price are determined at the closing of the transaction. Because of the time lapse between the closing and the settlement of the transaction, the risk that one of the parties might not be able to deliver at the settlement date is higher than in the spot market.
The futures market is similar to the forward market, except that in the futures market, the risks of settlement and quality of the product are addressed. The same transaction as in the forward market would be closed, with the addition of the standardisation of the amount of goods, the quality of the goods and guarantee (by an exchange) of the payment of the price and delivery of goods or cash settlement of the difference.
Risks of Financial Transactions .
Borrowing and lending of money create certain risks, namely
- That the borrower will not be able to repay the money
- That the lender is receiving a fixed rate on his investment while market rates fluctuate in such a way that the yield on his initial investment is now below current market related rates
- That the value of the capital invested could decrease due to movements in the market.
To lower the risk of a financial transaction, the risk can be sold to people or institutions that are willing to take on that risk without immediately taking over the effects of the transaction. The institution willing to buy the risk associated with the transaction would have to be compensated for taking on the risk. In monetary terms, the compensation for taking on the risk would, however, be less than the possible maximum loss associated with the risk. The trading of these risks associated with financial instruments resulted in the development of derivative products.
To hedge a position means to reduce the risk associated with a financial transaction or position, by selling the risk or by taking an opposite financial position, with the effect that a market movement would not result in substantial financial loss. A financial position which is not hedged, is called an open position.
The trading of risks created a market for the hedging of risks involved in financial transactions, which is a market derived from the original financial transaction. Contracts are drawn up for these kinds of transactions and because these contracts are derived from the original financial transaction, they are called derivatives. In a publication by Paul Eloff of the South African Futures Exchange, the following description of derivatives is given:
“Derivatives such as future contracts and options, are instruments whereby price risks are reallocated from those not willing to accept the risk and placed with those who are willing to accept the risk.”
- The capital market is the market for the issue and trade of long-term securities.
- The money market is that of short-term securities.
When goods such as financial instruments are traded in a market, there are certain differences between transactions done in these markets. The differences in transactions in the financial markets can be categorised in different categories, two of which are the following:
- The timing difference between the closing of the transaction and the delivering of the goods or settlement of the transaction
- The difference in certainty that the other party will honour the transaction.
In the spot market, the closing of the transaction and the delivery of the goods take place simultaneously or within a short-term time span prescribed by the specific market. Uncertainty about delivery from the other party is very limited, otherwise no transaction would take place.
The forward market is the market where a transaction is closed in the present, and the settlement of the transaction and the delivery of goods are in the future. The delivery date and the price are determined at the closing of the transaction. Because of the time lapse between the closing and the settlement of the transaction, the risk that one of the parties might not be able to deliver at the settlement date is higher than in the spot market.
The futures market is similar to the forward market, except that in the futures market, the risks of settlement and quality of the product are addressed. The same transaction as in the forward market would be closed, with the addition of the standardisation of the amount of goods, the quality of the goods and guarantee (by an exchange) of the payment of the price and delivery of goods or cash settlement of the difference.
Risks of Financial Transactions .
Borrowing and lending of money create certain risks, namely
- That the borrower will not be able to repay the money
- That the lender is receiving a fixed rate on his investment while market rates fluctuate in such a way that the yield on his initial investment is now below current market related rates
- That the value of the capital invested could decrease due to movements in the market.
To lower the risk of a financial transaction, the risk can be sold to people or institutions that are willing to take on that risk without immediately taking over the effects of the transaction. The institution willing to buy the risk associated with the transaction would have to be compensated for taking on the risk. In monetary terms, the compensation for taking on the risk would, however, be less than the possible maximum loss associated with the risk. The trading of these risks associated with financial instruments resulted in the development of derivative products.
To hedge a position means to reduce the risk associated with a financial transaction or position, by selling the risk or by taking an opposite financial position, with the effect that a market movement would not result in substantial financial loss. A financial position which is not hedged, is called an open position.
The trading of risks created a market for the hedging of risks involved in financial transactions, which is a market derived from the original financial transaction. Contracts are drawn up for these kinds of transactions and because these contracts are derived from the original financial transaction, they are called derivatives. In a publication by Paul Eloff of the South African Futures Exchange, the following description of derivatives is given:
“Derivatives such as future contracts and options, are instruments whereby price risks are reallocated from those not willing to accept the risk and placed with those who are willing to accept the risk.”
The development of financial markets and instruments
The basic needs in the financial world, are the following:
i) the need to invest excess money (supply)
ii) the need to borrow money (demand) where there is a shortage of money.
The government of a country might, for instance, need money for certain projects, while certain private sector companies or individuals might have excess money to invest in profitable investments. The “price” paid for money is interest paid on the amount borrowed, and the interest rate is thus the price mechanism used in financial markets.
To match different financial needs such as the need to borrow and the need to invest, intermediaries are mostly used, for example:
where an institution wants to invest a certain sum of money, for a certain time, giving them a certain yield
another institution wants to borrow a certain amount of money for a period at the lowest cost possible, the lender’s and the borrower’s demands might differ.
An example would be:
Eskom needs R100 million for a period of at least 10 years to erect new power lines
SCMB has R50 million it wants to invest for 7 years
Investec has R50 million it wants to invest for 12 years.
An intermediary would seek to merge these different needs and demands of borrowers and lenders through negotiation and financial instruments. A certificate would be issued to the lender giving him the right to the interest payments and the redemption amount at expiry of the loan. These instruments are called securities.
Large financial transactions involving the lending and borrowing of money (such as the example above), which are done through intermediaries or as principal by the lender, are often structured and standardised regarding:
the amount of the loan or investment
the interest paid and received thereon
the term to redemption of the loan.
In order to enhance the marketability and tradability of these securities, these standards created for transactions are incorporated into financial instruments. A borrowing certificate from a certain institution, where the institution borrows the money and gives the lender (investor) a certificate promising to pay the owner or holder of the certificate R1 million on 1 June 2008 and interest of 11,00% per annum on R1 million up to 1 June 2008 (similarly to the Eskom 168 certificates), is an example of a financial instrument. A certificate representing the contract between the lender and borrower is issued for the duration of the loan. Appendix 1 is an example of a bond (capital market instrument) which is a financial instrument.
Instruments (certificates) issued by the ultimate borrower are called primary securities.
Instruments issued by intermediaries on behalf of the ultimate borrower are called indirect securities.
The market for instruments (also called securities) issued for the first time, is called the primary market. Because of the standardisation of these instruments, different needs in the markets at different times, and different views of economic factors, these instruments are traded between institutions after they have been issued for the first time. If a lender needs his money before redemption date of the loan, the lender could trade the loan by selling the certificate to another institution. The buyer of the instrument pays the seller an amount (the present value of the future cash flows of the loan), and the buyer becomes the new lender. The market where instruments are traded subsequent to the first issue, is called the secondary market.
The secondary market in some of the securities is a very active market. Activities in the secondary market have a strong determining influence on issues in the primary market as liquidity, tradability, market rates, scale of demand, etc. of specific instruments are reflected in the secondary market. The variables of the economy in these markets are expressed through the interest rate (the price mechanism) determined in the secondary market (called the market rate), and this has an influence on the rate and value at which issues can take place in the primary market. If, for instance, I have R1 million to invest and the market rate is 16% (this means that I can invest my money in the market at 16%); I have the following two choices:
(This example ignores the nominal amount of R1 million that the investor would receive at redemption of the loan. The influence of this will be discussed in later sections and chapters.)
a) Invest in a certificate giving me 11% interest per year indefinitely on R1 million,
b) Invest in an investment in the market giving me 16% (the market rate) interest per year on R1 million.
The obvious choice is b). I would only invest in a) if I could get a discount on my investment. The monetary amount of interest that I would receive from the investment in a) would be 11% on R1 million per year, that is R110 000 per year.
For this amount to give me a return of 16%, I would only be willing to invest:
R110 000/16% = R687 500
If I could get a discount of (R1 000 000 – R687 500) R312 500 on the certificate in a), and only pay R687 500 for the certificate while still receiving 11% interest on the nominal amount of the certificate (R1 000 000), my yield on the investment would be:
R110 000/687 500 = 16%,
The same as option b).
Thus, if the market rate in the secondary market is 16%, and an institution wants to issue certificates in the primary market, the institution has to pay the market rate on his certificates issued, or issue the certificates at a discount if the rate paid on the certificate (called the coupon rate) is less than the market rate. Vice versa, if the rate paid on certificates is higher than the market rate, these certificates would be issued and traded at a premium.
The secondary market gives the investor the opportunity to manage his portfolio in terms of risk and return ratios, liquidity, etc. The return that the investor receives or wants to receive on his investment (called the yield), can be managed within certain parameters, and by using different strategies of buying and selling different instruments and investments in the secondary market.
i) the need to invest excess money (supply)
ii) the need to borrow money (demand) where there is a shortage of money.
The government of a country might, for instance, need money for certain projects, while certain private sector companies or individuals might have excess money to invest in profitable investments. The “price” paid for money is interest paid on the amount borrowed, and the interest rate is thus the price mechanism used in financial markets.
To match different financial needs such as the need to borrow and the need to invest, intermediaries are mostly used, for example:
where an institution wants to invest a certain sum of money, for a certain time, giving them a certain yield
another institution wants to borrow a certain amount of money for a period at the lowest cost possible, the lender’s and the borrower’s demands might differ.
An example would be:
Eskom needs R100 million for a period of at least 10 years to erect new power lines
SCMB has R50 million it wants to invest for 7 years
Investec has R50 million it wants to invest for 12 years.
An intermediary would seek to merge these different needs and demands of borrowers and lenders through negotiation and financial instruments. A certificate would be issued to the lender giving him the right to the interest payments and the redemption amount at expiry of the loan. These instruments are called securities.
Large financial transactions involving the lending and borrowing of money (such as the example above), which are done through intermediaries or as principal by the lender, are often structured and standardised regarding:
the amount of the loan or investment
the interest paid and received thereon
the term to redemption of the loan.
In order to enhance the marketability and tradability of these securities, these standards created for transactions are incorporated into financial instruments. A borrowing certificate from a certain institution, where the institution borrows the money and gives the lender (investor) a certificate promising to pay the owner or holder of the certificate R1 million on 1 June 2008 and interest of 11,00% per annum on R1 million up to 1 June 2008 (similarly to the Eskom 168 certificates), is an example of a financial instrument. A certificate representing the contract between the lender and borrower is issued for the duration of the loan. Appendix 1 is an example of a bond (capital market instrument) which is a financial instrument.
Instruments (certificates) issued by the ultimate borrower are called primary securities.
Instruments issued by intermediaries on behalf of the ultimate borrower are called indirect securities.
The market for instruments (also called securities) issued for the first time, is called the primary market. Because of the standardisation of these instruments, different needs in the markets at different times, and different views of economic factors, these instruments are traded between institutions after they have been issued for the first time. If a lender needs his money before redemption date of the loan, the lender could trade the loan by selling the certificate to another institution. The buyer of the instrument pays the seller an amount (the present value of the future cash flows of the loan), and the buyer becomes the new lender. The market where instruments are traded subsequent to the first issue, is called the secondary market.
The secondary market in some of the securities is a very active market. Activities in the secondary market have a strong determining influence on issues in the primary market as liquidity, tradability, market rates, scale of demand, etc. of specific instruments are reflected in the secondary market. The variables of the economy in these markets are expressed through the interest rate (the price mechanism) determined in the secondary market (called the market rate), and this has an influence on the rate and value at which issues can take place in the primary market. If, for instance, I have R1 million to invest and the market rate is 16% (this means that I can invest my money in the market at 16%); I have the following two choices:
(This example ignores the nominal amount of R1 million that the investor would receive at redemption of the loan. The influence of this will be discussed in later sections and chapters.)
a) Invest in a certificate giving me 11% interest per year indefinitely on R1 million,
b) Invest in an investment in the market giving me 16% (the market rate) interest per year on R1 million.
The obvious choice is b). I would only invest in a) if I could get a discount on my investment. The monetary amount of interest that I would receive from the investment in a) would be 11% on R1 million per year, that is R110 000 per year.
For this amount to give me a return of 16%, I would only be willing to invest:
R110 000/16% = R687 500
If I could get a discount of (R1 000 000 – R687 500) R312 500 on the certificate in a), and only pay R687 500 for the certificate while still receiving 11% interest on the nominal amount of the certificate (R1 000 000), my yield on the investment would be:
R110 000/687 500 = 16%,
The same as option b).
Thus, if the market rate in the secondary market is 16%, and an institution wants to issue certificates in the primary market, the institution has to pay the market rate on his certificates issued, or issue the certificates at a discount if the rate paid on the certificate (called the coupon rate) is less than the market rate. Vice versa, if the rate paid on certificates is higher than the market rate, these certificates would be issued and traded at a premium.
The secondary market gives the investor the opportunity to manage his portfolio in terms of risk and return ratios, liquidity, etc. The return that the investor receives or wants to receive on his investment (called the yield), can be managed within certain parameters, and by using different strategies of buying and selling different instruments and investments in the secondary market.
Markets in the financial system
People have different needs, and in trying to fulfill these needs, opposite needs are matched. Where needs are matched on a large scale, markets for those needs develop. Market forces are thus:
the supply of an item or service where there is a demand for that item or service.
Trading of that item or service is created through a price mechanism. The price is based on the value of the item or service to the traders (buyers and sellers), depending on certain market factors. There are different markets in a system, such as the services market the products market the financial markets.
A market is not necessarily a physical and geographically identifiable place, and goods traded are not necessarily physical goods. Trading might take place over the telephone, and goods traded might be knowledge, etc. Goods traded in markets are traded through a price mechanism which expresses the interaction of demand for and supply of these goods as a value. So, for instance, the trading of apples uses the price mechanism of a monetary amount, for example R1,20 per apple.
The different markets in the financial system of a country are not isolated markets, but they interact with each other. With electronic communication and the revolution in computers and computer networks, the markets of the world are busy interacting on a large scale. In a small country like South Africa, one could sometimes feel lost in this “universe” of supplies and demands. As astronomer Bernard de Fontenelle (1657-1757) put it: “Behold a universe so immense, I am lost in it. I no longer know where I am.”
The effect of different markets on each other can, however, clearly be seen in the South African context. The money supply in South Africa is, inter alia, influenced by the gold price, because South Africa is a net exporter (seller) of gold. If the gold price should increase, the supply of money in the markets will increase due to more money flowing into the country. This could lead to a higher demand for products in the product markets because of the availability of money. A higher demand for products could result in prices of products going up (resulting in inflation), which would dampen the demand for products and money. This interactive circle of changes is an ongoing process in markets.
the supply of an item or service where there is a demand for that item or service.
Trading of that item or service is created through a price mechanism. The price is based on the value of the item or service to the traders (buyers and sellers), depending on certain market factors. There are different markets in a system, such as the services market the products market the financial markets.
A market is not necessarily a physical and geographically identifiable place, and goods traded are not necessarily physical goods. Trading might take place over the telephone, and goods traded might be knowledge, etc. Goods traded in markets are traded through a price mechanism which expresses the interaction of demand for and supply of these goods as a value. So, for instance, the trading of apples uses the price mechanism of a monetary amount, for example R1,20 per apple.
The different markets in the financial system of a country are not isolated markets, but they interact with each other. With electronic communication and the revolution in computers and computer networks, the markets of the world are busy interacting on a large scale. In a small country like South Africa, one could sometimes feel lost in this “universe” of supplies and demands. As astronomer Bernard de Fontenelle (1657-1757) put it: “Behold a universe so immense, I am lost in it. I no longer know where I am.”
The effect of different markets on each other can, however, clearly be seen in the South African context. The money supply in South Africa is, inter alia, influenced by the gold price, because South Africa is a net exporter (seller) of gold. If the gold price should increase, the supply of money in the markets will increase due to more money flowing into the country. This could lead to a higher demand for products in the product markets because of the availability of money. A higher demand for products could result in prices of products going up (resulting in inflation), which would dampen the demand for products and money. This interactive circle of changes is an ongoing process in markets.
Saturday, January 13, 2007
Bank Debenture Trading
The driving force behind the financial instruments under discussion in this paper is the U.S. government through its monetary agency, the Federal Reserve Board. The U.S. dollar is the basis of the world's liquidity system since all other currencies base their exchange rate on it. Quite simply this means that the U.S. is the world's central banker. As the world's central banker, the U.S. has an enormous responsibility to maintain stability in the world's monetary system. As well, the U.S. as the most powerful nation has accepted the role as the champion and promoter of democracy in all of its endeavors. While the U.S. has many tools to do this, one in particular is relevant for the purposes of this discussion. The Federal Reserve Board (Fed) uses two financial instruments to control and utilize the amount of U.S. dollars in circulation internationally: Standby Letters of Credit (SLC) and Bank Guarantees (BG). The Fed's domestic tools to control credit creation are interest rate policy, open market operations, reserve ratio policy and moral persuasion. In the domestic context, these tools are not always as effective as the Fed would like them to be. Part of the reason for the less than perfect effectiveness is due to the substantial stock of U.S. dollars in foreign jurisdictions. Several of the Fed's domestic tools cannot be used by it in other countries. For examples, the Fed cannot change foreign reserve ratios. Furthermore, a significant amount of credit creation occurs in U.S. dollars in foreign countries, particularly in the Eurodollar market. The Fed cannot control the credit creation in foreign markets through its use of domestic policy instruments. Internationally the currency of choice is the U.S. dollar as it is considered the safest currency, especially in times of political crisis. Consequently those holding the dollar do so for reasons which are less sensitive to economic stimuli. Because foreign banks readily accept U.S. dollar deposits, those funds, which in the domestic context are the basis of M1 money supply, in the foreign context, they act more like the near money features of M3. This means they are infinitely more difficult to control. The "offshore market" has grown substantially in the last two decades for a number of reasons. First, huge quantities of U.S. dollars associated with the drug trade slosh around the international monetary system, and second, wealthy individuals concerned about high taxes and preserving their wealth opt to keep their assets in offshore tax havens. This significant stock of U.S. dollars cannot be effectively controlled by the U.S. with its normal domestic policy tools. Finally, currency futures markets can be another difficult area to control because of the substantial amount of leverage that is available. For example, for as little as $1500 dollars, it is possible to short or go long for over $150,000 U.S. dollars versus the D Mark. All other major currencies have a similar leverage on the dollar. This means that someone with $1500 U.S. dollars can take the other side in a Fed move to stabilize the currency. Since the currency does not have to be delivered, but the contracts are rolled near the expiry date, it is possible to create substantial pressure on the dollar in either direction. (The Hunts learned this the hard way when they tried to corner the world silver market.) To control U.S. dollars outside the U.S., the Fed resorts to Standby Letters of Credit or, as they are popularly known, SLCs. In its more familiar domestic form, the SLC is a financial guarantee or performance bond issued by a bank for a fee on behalf of a customer that wishes to borrow funds but in unable to do so cheaply in credit markets. A bank guarantees the borrower's financial performance to the lender by issuing the SLC. Since the bank is in a better position to assess credit risk and demand collateral, the issuance of this form of guarantee is a natural service that a bank provides.
In the international markets the use of SLCs is somewhat different. It simply is a money-raising device where the financial guarantee is almost meaningless. Banks issue these SLCs on behalf of the Fed; in other words, the Fed is the customer of the bank. Obviously there is no credit risk here. The net proceeds from the funds raised are immediately wired to the Fed. Using this method, the Fed can reduce the U.S. dollars in circulation in foreign jurisdictions.
Using a different method, the large stock of expatriated dollars is employed by the Fed to promote U.S. foreign policy. For example, during the G7 meeting in Tokyo in April of 1993, the U.S. committed financial aid to Boris Yeltzin to the tune of $6billion. These funds do not come form the U.S. Treasury, nor is the merit of the loan debated in the U.S. Congress. Instead, the U.S. taps the international pool of U.S. dollars through an instrument called a Bank Guarantee (BG). Essentially the instrument has the features of an SLC except it is longer dated with 10 and 20 year maturities. Unlike SLCs which sell at a discount and bear no interest, BGs bear a coupon payable annually in arrears. Like the SLC, it is a form of guarantee ensuring the lender will receive interest as is due and be repaid the principal upon maturity. It is important that the U.S. has these tools to control the dollars that increasingly grow off its borders. The Fed operates its currency stabilization so effectively through the use of SLCs that it seldom resorts to intervening in the foreign exchange markets. Rather than the U.S. government tapping the domestic savings pool to assist foreign governments, it is able to tap the international pool of expatriated U.S. dollars that leak away from its shores in hundreds of millions daily.
In the international markets the use of SLCs is somewhat different. It simply is a money-raising device where the financial guarantee is almost meaningless. Banks issue these SLCs on behalf of the Fed; in other words, the Fed is the customer of the bank. Obviously there is no credit risk here. The net proceeds from the funds raised are immediately wired to the Fed. Using this method, the Fed can reduce the U.S. dollars in circulation in foreign jurisdictions.
Using a different method, the large stock of expatriated dollars is employed by the Fed to promote U.S. foreign policy. For example, during the G7 meeting in Tokyo in April of 1993, the U.S. committed financial aid to Boris Yeltzin to the tune of $6billion. These funds do not come form the U.S. Treasury, nor is the merit of the loan debated in the U.S. Congress. Instead, the U.S. taps the international pool of U.S. dollars through an instrument called a Bank Guarantee (BG). Essentially the instrument has the features of an SLC except it is longer dated with 10 and 20 year maturities. Unlike SLCs which sell at a discount and bear no interest, BGs bear a coupon payable annually in arrears. Like the SLC, it is a form of guarantee ensuring the lender will receive interest as is due and be repaid the principal upon maturity. It is important that the U.S. has these tools to control the dollars that increasingly grow off its borders. The Fed operates its currency stabilization so effectively through the use of SLCs that it seldom resorts to intervening in the foreign exchange markets. Rather than the U.S. government tapping the domestic savings pool to assist foreign governments, it is able to tap the international pool of expatriated U.S. dollars that leak away from its shores in hundreds of millions daily.
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