Guy Hargreaves ACE-102 Recap of yesterday The role of maturity transformation, aggregation and risk transformation in financial intermediation Credit creation via the credit multiplier The critical payment system Main banking products and services Banking customer base The banking industry within the global financial system 2 Today’s goals Understand concepts of market liquidity and product fungibility List the major instruments traded in global financial markets Understand some of the broad trends that have led to today’s financial instruments 4 Financial markets Definitions vary – but a financial market is generally considered a collection of individual markets made up of “fungible” products in which: Capital (debt and equity) is raised Financial instruments are traded Financial (and physical) risks are managed Markets can be focused on Primary activity or Secondary activity, or both! 5 What is fungibility? “Fungibility is the property of an asset whose individual units are capable of mutual substitution” one unit of an asset can be substituted for another Examples could be 1 ounce of gold, 1 USD banknote, 1 barrel of crude oil Examples of non-fungibility could be two USD bonds issued by the same company but with different maturities Fungibility is critical in financial markets to provide standardisation - which creates certainty and liquidity 6 What is liquidity? Liquidity is the ability to buy or sell an asset (financial or otherwise) without materially the asset’s price Most liquid market in the world is foreign exchange, trades USD 5.3 trillion per day on average Three days FX trade = annual global trade! Low liquidity markets include unlisted shares, highly structured ABS, property Important property of financial markets 7 Financial markets have many pieces: Money Markets Futures and Derivatives Securitisation Fixed Income Commodities Equities Foreign Exchange Syndicated Loans E-markets 8 Money market instruments Short term debt financing and investment markets Terms usually less then 1-year Typical instruments include: Treasury bills Commercial paper (CP) Bankers’ acceptances Deposits Certificates of Deposit Repurchase agreements Federal Funds Short dated bonds, ABS Question: which of the above are the most marketable? 9 Money market instruments Question: which of the above are the most marketable? Typical instruments include: Treasury bills Commercial paper (CP) Bankers’ acceptances Deposits Certificates of Deposit (CD) Repurchase agreements Federal Funds Short dated bonds, ABS 10 Role of money markets Financing trade – provision of working capital and other short term instruments to finance global trade flows Finance corporates – smooth short term financing flows Investment – provide secure short term investments for money market and other short term funds that require high liquidity Interbank liquidity – help banks fully fund their balance sheets every day Central bank policy – CBs can influence monetary policy through money market operations 11 Fixed income instruments Fixed income instruments are debt securities where the borrower (issuer) is required to repay based on a predetermined schedule or rate over a fixed term Public instruments purchased by wholesale or retail investors Coupons (interest) generally either “fixed” or “floating” rate Vast majority are “rated” by a major rating agency such as Standard & Poor’s, Moody’s or Fitch Ratings either “Investment Grade” or “High Yield” (so-called junk bonds) 12 Fixed income instruments Bonds are issued by a wide range of borrowers (issuers) Governments (sovereign or municipal) Agencies (government ownership) Corporates Special Purpose Vehicles (companies) – most commonly in ABS 13 Fixed income ratings (long term) Standard & Poor’s Moody’s Fitch Default Risk profile AAA Aaa AAA Investment Grade: extremely strong AA+ | AA | AA- Aa1 | Aa2 | Aa3 AA+ | AA | AA- Investment Grade: very strong A+ | A | A- A1 | A2 | A3 A+ | A | A- Investment Grade: strong BBB+ | BBB | BBB- Baa1 | Baa2 | Baa3 BBB+ | BBB | BBB- Investment Grade: adequate BB+ | BB | BB- Ba1 | Ba2 | Ba3 BB+ | BB | BB- High Yield : less vulnerable B+ | B | B- B1 | B2 | B3 B+ | B | B- High Yield : more vulnerable CCC Caa1 | Caa2 | Caa3 CCC High Yield : vulnerable CC Ca CC High Yield : highly vulnerable C C C High Yield : highly vulnerable + SD Selective default D D Default NR NR Not rated Credit ratings are a critical component of the efficient operation of the fixed income market 14 Foreign exchange Foreign Exchange (FX) is not a tradable security like Fixed Income An FX transaction is simply the exchange of an amount of money in one currency for money in another! In a globalised economy with multiple currencies and trade almost everyone has exposure to FX rates FX is traded in the market 24/7 and FX rates can move significantly for many reasons 15 A foreign exchange transaction Joe USD100 Linda Joe Linda EUR109 Joe needs EUR to pay for a new book he is expecting shortly The USD-EUR exchange rate is trading in the FX market at 1.09 Joe pays USD100 to Linda’s USD bank account in exchange for Linda paying EUR109 to Joe’s EUR bank account 16 10 days later… Linda USD109 Joe Linda Joe EUR109 10 days later Joe is given the book by a friend and wants to convert his EUR back to USD USD has weakened and the USD-EUR exchange rate fallen to 1.00 Joe pays EUR109 to Linda’s EUR bank account in exchange for Linda paying USD109 to Joe’s USD bank account Joe has made a USD9 profit in being “long” EUR when it “rallied” 17 Futures and derivatives Derivatives is a general term for a range of financial instruments which included Futures Derivatives are contracts between two parties that derive their value from the performance of an “underlying” Underlyings can be almost anything, but more often are assets, indices or rates Generally derivatives are either forwards, swaps, options or futures 18 Futures and derivatives The most common derivatives are: Interest rate swaps FX forwards, swaps and options Bond, bill futures Commodity futures Equity index futures Futures are traded on regulated exchanges such as CBOT, HKEx and Euronext Most non-futures products are traded “Over-the counter” (OTC) 19 Swaps Derivative contracts between two parties where one agrees to “pay” an agreed cashflow linked to an underlying in exchange for “receiving” an agreed cashflow linked to another underlying The “present value” of the expected swap cashflows is calculated using market discount factors to arrive at the market value of the swap Swap market values are dynamic and vary with changing underlying market variables 20 Futures Futures are standardised contracts, traded on a futures exchange, to buy or sell a fixed amount of an asset at an agreed price on a fixed date in the future eg under the CME US Treasury Bond future the participant delivers or receives USD100k of a US government bond on a specific day in one of the contract months of March, June, September or December Because futures are standardised they can be highly liquid, but the standardisation can also introduce “basis risks” for participants using them for hedging 21 Options Options are contracts under which the buyer has the “right but not the obligation” to buy or sell an underlying asset at an agreed price in the future eg an option to sell USD100 and buy EUR109 in 10 days time The power of options lie in the ability of the owner to abandon them should the market move adversely eg if in 10 days the USD-EUR was 1.20 the option owner would not “exercise” the option, instead selling USD100 to receive EUR120 The “option not to exercise” is like insurance and requires the option buyer to pay a non-refundable premium to the seller 22 Commodities In recent years banks have built significant commodity divisions which trade in both physical and derivative contracts Energy commodities such as oil and gas are significant markets for banks Metals, agricultural products also popular 23 Syndicated loans In the traditional banking model most corporate loans were “bilateral” As corporates grew the size of their loans grew aw well, becoming too large for single banks to fund on their own Syndicated loans were a solution – borrowers would enter into a single loan agreement with syndicates of banks - ranging from 5 banks to over 50 banks for very large deals 24 Syndicated loans Banks could earn additional income from underwriting and distributing syndicated loans The loan agreements incorporated “transfer language” which allowed banks in a syndicate to sell their loans to other banks or investors easily 25 Securitisation Securitisation is a financial structuring technique which transforms pools of assets into Asset Backed Securities (ABS) which can be sold to fixed income investors Banks developed the securitisation business initially to allow them to transform their own portfolios of relatively illiquid assets into liquid securities that could be sold for balance sheet management The securitisation business took on a life of its own in the 1990s when banks applied the technique to customer portfolios to generate additional fees 26 Securitisation Mortgages are the most common securitised asset, generating Residential Mortgage Backed Securities (RMBS) Corporate loans, in particular High Yield loans, are also a popular asset class generating Collateralised Loan Obligations (CLOs) Trade Receivable securitisation is a popular product in the post 2007-9 GFC era. Corporates with large portfolios of trade receivables can use securitisation to obtain very cheap funding 27 Securitisation Motivations behind securitisation can vary: Banks might use securitisation to sell off illiquid portfolios and achieve “regulatory capital relief” Corporates might use securitisation to achieve cheaper funding rates CLO managers engage in “arbitrage” in that they are able to purchase portfolios of loans and fund them cheaply with CLO ABS NBFIs might use securitisation as their primary funding tool for their “originate to distribute” business models 28 Securitisation Securitisation has been accused as being a primary cause of the 2007-9 GFC It is true that originators of “sub-prime” mortgages use securitisation to rapidly on-sell poor quality mortgage loans to RMBS ABS investors Confidence in securitisation was very negatively affected during the crisis “Sound” RMBS backed by prime borrowers actually performed quite well New banking regulations and increased risk aversion are a greater hindrance to the recovery of the securitisation industry than anything else 29 Equities The banking industry had played little or no role in equities markets since the 1930s Investment banks and old style stockbroker/securities firms dominated Initial Public Offering (IPO) and associated equity primary and secondary markets In the late 1990s deregulation of securities laws allowed commercial banks to establish or purchase securities firms and participate in equity sales and trading 30 Equities Equity products offered in financial markets included: IPO underwriting Secondary placements Common or preferred shares Equity derivatives (futures, index futures, swaps, options) Secondary trading Research 31 E-markets The age of the internet has seen explosive growth in electronic trading and associated e-markets Banks offer platforms and portals through which their customers can place transaction orders directly into markets Banks offer “market-making” services to clients via these platforms to profit by intermediating buyers and sellers 32 E-markets E-market platforms offer access to: FX (“spot”, forwards, swaps, options etc) Equities and equity indices Fixed income and money market products Derivatives 33