Foreign Exchange and Money Markets

Foreign Exchange and Money Markets

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GlobalBankingRoyC.Smith,IngoWalter,andGayleDeLong

Printpublicationdate:2012PrintISBN-13:9780195335934PublishedtoOxfordScholarshipOnline:May2012DOI:10.1093/acprof:oso/9780195335934.001.0001

ForeignExchangeandMoneyMarketsRoyC.SmithIngoWalterGayleDelong

DOI:10.1093/acprof:oso/9780195335934.003.0001

AbstractandKeywords

Thischapterdiscussestheevolutionoftwoessentialmarketstoglobalbanks.Foreignexchangemarketsallowforthetradingofforeigncurrencies,usinginstrumentssuchasspottransactions,futures,forwards,andswaps.Moneymarketslinkinternationallendersofshort-termfundswithborrowersusinginstrumentssuchasEurocurrenciesandEurobonds.SuchloansarepricedusingtheLondonInterbankOfferedRate(LIBOR).Thechapterdetailshowthemoneymarketsfrozeupduringtheglobalfinancialcrisisin2008andexplainswhytheforeignexchangemarketstayedliquid.

Keywords:Eurobond,Eurodollar,foreignexchangemarket,libor,moneymarket

Internationalmoneymarketandforeignexchangetransactionsdealwiththeissuanceandtradingofmoneymarketinstrumentsinvariouscurrenciesoutsidedomesticmarkets.As


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longagoasthefifteenthcentury,organizedinternationalmoneyandforeignexchangemarketsexisted.MerchantsinItaly,forexample,wantingtoimporttapestriesmadeinBelgiumfromwoolproducedinEngland,hadtofindwaystofinancetransactionsthatoccurredoutsidetheirowncountry.Italianbanks,suchasthoserunbytheMedicifamily,setupforeignbranchestoeffectpaymentsandarrangeforthedeliveryofthegoodsonbehalfoftheirclients.Thebankshadtodealincurrencyexchangeandindepositcollectingandlendinginothercountriesandstates.Theseactivitieshavecontinuedthroughoutthenearly500yearsofmodernbankinghistory.

InSeptember2008,internationalmoneymarketsessentiallyfroze,exposingvulnerabilitiesandrevealinghowessentialthesemarketsaretothesmoothfunctioningoftheworldeconomy.Foreignexchangemarkets,ontheotherhand,functionedwellduringtheturmoil,suggestingthatclearingandsettlementssystemssetupafterpreviouscriseswereeffectiveinpreventingadditionalchaos.Inthischapter,wediscusstheinstrumentsusedinbothmarketsandhowtheyfitintotheglobalfinancialmarketssystem.

OriginsofEurocurrenciesThehistoryofinternationalfinancialmarkets,sinceitsmodern(postwar)rebirthinthe1960s,isaconfluenceofthreeparallelandmutuallyinfluentialevents:(1)majorchangesintheinternationalmonetarysystem;(2)theevolutionofalargeinternationalinvestorbase;and(3)continuingderegulationofdomesticcapitalmarketsinmajorcountriestoalignthemwithcompetitiveinternationalalternativestodomesticfinancingvehicles.

ThemodernperiodbeganattheendofWorldWarII,whencapitalmarketsoutsidetheUnitedStateswerevirtuallynonexistent.In1944,theAlliedPowersagreedtoapostwarinternationalmonetarysystematBrettonWoods,NewHampshire,inwhichthedollarwouldbetheprincipalreservecurrency(i.e.,used(p.4) asreservesbyothercountries).Thedollarwastobepeggedtogold,attherateof$35perounce,andallothercurrenciesweretobefixedtothedollar.Whenbalanceofpaymentsdifficultiesarose,itwasunderstoodtobetheobligationofboththedeficitandthesurpluscountriestomodifytheirdomesticfiscalandmonetarypoliciestoreducetheproblem.Governmentsperiodicallyintervenedinforeignexchangemarketstohelptheprocessalong,andtheyusuallyreliedonbroadeconomicpolicychangestoeffectadjustment.Iftheimbalancecouldnotberedressedaftersuitableeffort,thecurrencysexchangeratecouldberesettothedollar,afterwhichitwouldhavetobedefendedatthenewrate.Tomakethesystemworkrequiredaworldinwhichtheprincipaleconomiesweregrowingataboutthesamerate,andshoulderingtheworldsmilitaryandotherburdensequally.Italsorequired,atthenationallevel,stricteconomicdisciplineandcontrols,andavotingpublicthatrefrainedfromblamingothersforitsproblemsandunderstoodthatitwasnecessaryfromtimetotimetotakebittermedicineintheinterestofthecountryshealthoverthelongrun.Theseconditionswerenotcommonlyfoundinthe1950sand1960s,anymorethantheyarenow.

In1971,theBrettonWoodssystemcollapsed.SeveralyearsoflargeU.S.balanceofpaymentsdeficitsresultingfromlargeAmericanpurchasesoflowercostgoodsfrom


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rapidlyrecoveringeconomiesinEuropeandAsialedtothebreakdown.Thefixedexchangeratesystemwasreplacedbyafloating-ratemechanism,inwhichallcurrenciesweretobepricedcontinuallybythemarket,anditwasassumedthateconomicimbalanceswouldgeneratecorrectivepressuresonexchangerates.Themechanismobviatedtheneedforcapitalmarketcontrolsthatrestrictedcross-bordertransfers,asharshpolicieswerenolongernecessary:themarketwouldadministerthemedicinethatcountrieswereunabletoadministerthemselves.Intime,allofthemajorindustrialnationsremovedtheircontrolsoninternationalcapitalmovements.Bytheearly1980s,usersandprovidersofcapitalcouldlookoverseasforcapitalmarketopportunitiesthatweresuperiortowhatwasavailableathome.Italsomeant,however,thatinterestrateandexchangeratevolatilitywouldbemuchgreaterinthenewfloatingexchangerateenvironmentthanintheoldfixed-rateregime.Asweseelaterinthischapter,increasedvolatilityledtogreateropportunitiesforbanksandothermarket-makerstoexpandtradingactivitiesandhedgingstrategies.

Thepostwarinvestorpopulationwasaffectedbytheseevents,andbytherapidinstitutionalizationofmarketsintheUnitedStates,theUnitedKingdom,andsomeotherEuropeancountries.Therewasalsoalargeincreaseinthepopulationofotherwiselaw-abidingEuropeanswhowantedtotransferfundsintoforeignbankaccountsthatwerebeyondthescrutinyoftaxauthoritiesintheirhomecountries.Additionally,governmentofficials,peopleengagedincapitalflight,andshadycharactersofvariouskindswereaccumulatingirregularorillegalfundsintaxhavencountries.Theinstitutionalinvestorswerenotsubjecttotaxconcerns,buttheyweresophisticatedasset-allocatorslookingforunderpricedinvestments.Individuals,mostlyinvestingthroughbanksinSwitzerland,Luxembourg,(p.5) andotherEuropeancenters,werehighlyfocusedonpreservingtheiranonymity.Together,theseinvestorswerelookingforopportunitiesthatwerenotavailableintheUnitedStates.Eventually,localcorporations,Europeansubsidiariesofnon-Europeancompanies,centralbanks,andotherfinancialinstitutionsdiscoveredthattheycoulddepositdollarstheyhadaccumulatedoutsidetheUnitedStateswithcertainbanksinLondonthatwouldretainthemasdollarsandpaydollarinterestrates.

EURODOLLARSFIRSTThuswasborntheEurodollar,whichwassimplyadollar-denominateddepositinabankorbranchlocatedoutsidetheUnitedStates.AlthoughtheyoriginallytendedtobeinEurope,thesedepositscouldbeanywhereintheworld.SuchdepositswerebeyondtheU.S.regulatoryumbrella,sothatneitherliquidityreservesnordepositinsurancepremiumshadtobesetasideforthem.OriginaldepositorsincludedthefinancialarmoftheSovietUnion,andotherEast-blocstateswantingtoholddollarsbutavoidplacingtheirholdingsintheUnitedStates.AdditionaldollarswereaccumulatinginEuropeasaresultofincreasedeconomicgrowthandinvestment,andtheincreasingU.S.balanceofpaymentsdeficits,withmanycentralbankspreferringtoholddollars,butnotintheUnitedStates.Eurodollarinvestmentscouldbemadeintheformofbankdeposits.EurodollarinterestrateswererelatedtoU.S.domesticdepositrates,butonlylooselyatfirstinterestratedifferentialsof100basispointsormorewerenotuncommon.SuchdisparitiesencouragedAmericanbankstoarbitragethemarket.Despitethelower


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depositrates,depositorswerehappytousetheseaccountstoavoidthecostsoftransferringthemoneybackandforthacrosstheAtlantic,andalsotoavoiddisclosinginformationaboutthemselvesandtheirfinancialaffairstoU.S.authorities.Intime,asmallgroupofbankssetEurodollardepositandlendingratesforthemarketandestablishedtheconventionofpostingadailyLondonInterbankOfferedRate(LIBOR).ThiswastherateatwhichbankswouldlendEurodollarstoeachother,andistheroughequivalentofthefederalfundsrateintheEuromarkettherateamajorbankwillofferforaloantoanothermajorbankforaspecifiedmaturity,suchas30or60days.Today,LIBORiscalculatedbyexaminingtheratesatwhich16internationalbankslendtootherbanks.Thefourhighestratesandfourlowestratesareeliminated,andtheaverageofthemiddleeightratesdeterminestheLIBOR.Differentratesaredeterminedforthevarioustimeperiods,sotheovernightLIBORrateisdifferentfromthe3-monthLIBORrate.

Majorbanksposttheirownratesdaily.TheratetobepaidonadepositfromanotherbankisexpressedintermsoftheLondonInterbankBidRate(LIBID).AnonbankborrowercanexpecttopayapremiumoverLIBOR(e.g.,LIBOR+%),andanonbankdepositorwouldreceivearatereflectingadiscount(LIBID%).Thespreadbetweentheserates,LIBORandLIBID,hasgenerallybeenabout%or(p.6) less,muchlessthanthedifferencebetweenU.S.primerateandpassbookdepositrates.Withoutthisspread,Euromarketscouldnotexist.Generallyspeaking,neitherdepositorsnorborrowerswouldbeenticedtoleavetheirhomecountriesunlesstheyreceiveahigherdepositrateorlowerloanrateabroad.DepositandlendingratesareforcustomerscloselytiedtoLIBOR,whichisquotedinmostmajorcurrencies.NewspaperssuchastheFinancialTimesofLondonpublishaveragesofthesepostedratesdaily.

OTHEREUROCURRENCIESBanksalsoquoteratesforloansanddepositsinothercurrencies,which,inaway,theymanufacturesynthetically.TheydothisbyaddingthecostorbenefitofaforwardforeignexchangecontractfortheprescribedmaturityinthedesiredcurrencytotheU.S.dollarLIBORrate.Ifacustomerwantsaloanbasedon60-daysterlingLIBOR,thebankfirstacquirestherequiredamountofsterlinginthespotmarket.Thebankthensellssterlingforwardagainstdollarsfordeliveryin60days,andthecostorbenefitofthistransaction(inpercentage)isaddedtothedollarLIBORcost.Forexample,ifLIBORis2%andsterlingissellingforwardata0.3%premium,thebankwouldchargetheclient2.3%.WedescribehowtocalculateforwardpremiumsanddiscountsoncurrenciesintheMarketFunctionssectionbelow.

TheEurocurrencymarkethasformedaninformal,unregulated,over-the-countermarketmadeupofbanksandotherprofessionaldealersfromaroundtheworldtransactingininstrumentsnotavailableinnationalmarkets.Occasionally,theEurocurrencymarketwoulddeviseafinancialinstrumentthatwouldattractalargevolumeofactivityonthepartofnationalsinvariouscountries.Soonthepressuretoderegulatedomesticmarketstomakethesametypeoffinancingavailablebecametoogreatforofficialstocontain.Ofteninvoluntarily,mostcountrieshavehadtogiveintotheprocessofimportedinnovation.Theresultwasalargeincreaseinthenumberandtype


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offinancialinstrumentsavailableininternationalmarkets.

Euromarketparticipantshavetendedtobeverysophisticated.Theyunderstandinvestmentopportunitiesaroundtheworld,foreignexchangeeffects,andderivativeinstrumentssuchaswarrantsandoptionstopurchaseorsellsecurities.Withmanyinternationalbanksandinvestmentbanksinvolvedinthemarket,itishighlycompetitive.Indeed,manyfirmscompeteonthebasisofinnovationandboldinitiative.Asaresult,theEuromarketsawthefirstsignificantuseofthetransferrablecertificateofdeposit,thefloating-ratenote,andtheEurobond.Italsosawthefirstuseoftheboughtdeal,anissuefullyunderwrittenbyonebank;thetapissue(soldondemand,notallatonce);andthenote-issuancefacilityfordistributingEurocommercialpaper.Morerecently,theEurobondmarkethasbeguntoacceptsomeofthemorecomplexandcontroversialproductsoftheU.S.bondmarket,suchasasset-backedissuesandnon-investment-gradeorjunkbonds.(p.7)

EurobondMarketsBanks,especiallyU.S.banks,wereeagertobuilduptheirEurodollardepositsasasourceoffundingfortheirgrowinginternationalactivities.ThedepositscouldbeusedtofundEurodollarbankloansorloanparticipations.TheycouldalsobelenttobranchesintheUnitedStatestosupportlendingactivitythere,ifandwhentherateswereright.And,theycouldserveasameansofdiversifyingabankssourcesoffundingforitswholesalelendingbusiness.Investorswereotherbanks(thereweremorethan400foreignbankbranchesinLondonin1980,alllookingtobuyassetsintheinterbankmarketandfundthembybuyingEurodollardepositsinthemarket),aswellasmultinationalinstitutions,andcorporationswithtemporaryfundstoinvest.

TheEurobondmarkethasbeenaconstantsourceofinnovation,withnewinstrumentsbeingintroducedassoonaschangingregulatoryenvironmentorinvestorpreferencesdictated.ThefirstEurobondwasofferedin1963andwassoldtoinvestorswhowerewillingtoextendtheirinvestmenthorizonto15years,atsomewhathigherrates.Eurobondswereinbearerform(identityofpurchasernotdisclosed)andwerefreeofwithholdingtaxesoninterest.Inevitably,Eurobondswereintroducedinothercurrenciesbesidesthedollar.TheEurobondmarketsoontookoffonacontinuousexpansionthathasmadeitintooneoftheworldsprincipalsourcesoffinance.Eurobondinnovationsincludethedual-currencybond,thezerocouponbond,thewarrant-bond,theswappedforeigncurrencybond,thefirstECU(Europeancurrencyunit)andEuro-denominatedbonds,andavarietyofothernewideas.WediscusstheEurobondmarketextensivelyinChapter4.

MoneyMarketInstrumentsAsthenameimplies,moneymarketsinvolveborrowingandlendingmoneyonashort-termbasis,usuallyuptooneyear.TheinternationalmoneymarketdevelopedmuchmoreslowlythantheEurobondmarket.Inpart,thiswasbecause,intheEuromarket,well-knowninternationalbankshadalockonthemarketforshort-termfunds.ThebankswerealsopreparedtoofferCDsofwhatevermaturityaninvestormightwish.Mostly,therewaslittledemandfortradingtheseinstruments.Theinvestorswerehappytohold


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themtomaturityunlessaspecialrequirementarosetosellthem.

Onceestablished,however,themarketgrew.Thevariousinstruments,nowavailable(directlyorthroughsimultaneousswaps)inmostmajorcurrencies,constituteafamilyofEurosecuritiesthatmakesupabroadanddiversemoneymarket.Thevolumeofoutstandingpaperintheseinstruments,aswellasthesecondarymarkettradinginthem,increasedsteadily,fromameager$45billionin1986toover$1.1trillionin2007.Theglobalfinancialcrisisthatbeganin2007,(p.8) however,hasaffectedthesemarkets,resultinginmorefundsbeingrepaidthanbeinglent.Despitenetissuesbeingnegative,theoutstandingamountinMarch2009wasstillover$1trillion.

ThefollowingisadescriptionofthedifferentinternationalmoneymarketinstrumentstradedintheEuromoneymarkets.

EUROCERTIFICATESOFDEPOSITEurocertificatesofdeposit(ECDs),likedomesticCDs,aretimedepositsinabank.Theyareissuedincountriesoutsidethehomecountryofcurrency,bybanksdirectlyorthroughdealersorbrokers.LikeEurobonds,theyareissuedinbearerformandarefreefromwithholdingtaxoninterest.In1961,CitibankdevisedthefirsttransferableECD.Thiswasamajorinnovationthatsoonencouragedsecondarymarkettradingindollarinstruments,andeventuallyledtothecreationoftheEuromoneymarket.Althoughbanksdonotalwayswanttheirpapertradedinthesecondarymarket,especiallywhentheyareissuingnewpaperthatcouldcompetewiththeirolderissuesinthesecondarymarket,theyhavebowedtocompetition.BanksprefertoselltheirownECDstotheirclientsandcorrespondentrelationshipsbutoften,toextendthemarketandincreasethevolumeofECDsoutstanding,theyresorttodealerstosellthepaperforthem,foramodestcommission.Thebanksposttheirownratesforaspectrumofmaturities.BankswilloftennegotiatewithlargecustomersforspecialratesforCDswithcustom-madematuritiesorotherterms.Abankspostedratesmaybeslightlyhigherorlowerthanratespostedbysimilarbanks,reflectingthebanksgreaterorlesserdesiretotakeinfundsatparticularmaturities.Suchdecisionsaremadebythebankstreasurydepartment,whichhastobalancetheentirebanksrequirementforfundsandcurrenciesatparticularmaturities.Formostbanks,thetreasuryfunctionintheLondonbranchwillconductmostoftheseEuro-fundingoperations,generallyinclosecontactwiththecentraloffice.

ThesecondarymarketinECDsisveryactive.BanksmaintainmarketsintheirownCDs,andencouragetheircustomerstotradewiththem.Asrateschange,bankswilleitherincreasetheirissuanceofECDsorattempttobuyinoutstandingpaper.Brokersmayworkwiththebanksasagents,onanonexclusivebasis,toplaceorbuyinECDsforacommissionofafewbasispoints.SuchbrokersdonottakepositionsinthebanksECDsfortheirownaccount.Often,thebrokersrepresentinvestorsseekingthebestratesfordeposits.Dealers,incontrast,purchaseandsellbankECDsfortheirownaccount.TheyhopetocreateopportunitiesforgainsfromtradingintheECDs,astheywouldinanymoneymarketinstrument.Dealerswillcallthebankinthemorningandoffertobuyor


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sellECDsatparticularrates.Thentheylayofftheirpositionstocustomers,orholdthemforafewdaystowaitforanexpectedmarketchangetooccur.LargedealersofferECDs,alongwithacompletemenuofotherEuromoneymarketinstruments,tocustomersonacontinuousbasis.(p.9)

Asanexample,adealersuchasJPMorganChasemightbeawarethatMitsuiLifeInsuranceCompanyisseekingtoplace$500millioninhigh-gradeshort-terminvestmentstomorrowmorning,Tokyotime.Mitsuiactuallywantstheinvestmentstohaveamaturityof75days.Thepostedratefor60-dayECDsmightbe4%andfor90days,4.3%.JPMorganmaycalladozenormorehigh-gradebanksduringtheeveningbeforethenextdaysopeninginTokyotooffertobuy75-dayECDsatarateof4.25%,inordertoofferthemat,say,4.20%toMitsuiLife.ManybankswillturnCitigroupdown,butoneortwomayhaveaneedoftheirownforalargeplacementof75-dayECDs,andthusbewillingtopaythesomewhathigherrate.Suchintensemarketcoverage,togetherwiththewillingnessofdealerstopositionpaperofalltypes,includingpurchasingtheentireamountforitsownaccountinordertospeeduptheprocessandtobeabletobeatoutcompetitors,hasgreatlyimprovedtheefficiencyoftheEuromoneymarketinrecentyears.Theimprovingefficiencyofthemarketlargelyexplainsitsrapidgrowthsincetheearly1980s.

FLOATINGRATENOTESInthe1980s,manybanksbegantoofferfloating-ratenotes(FRNs)asasupplementtotheirfundingactivities.Thesenoteswerenotdepositsand,therefore,weresubordinatetothem.TheFRNsmighthaveamaturityof10years,butinterestwouldberesetevery90daysat3-monthLIBOR(say,4.5%)plusasmallspread(say,one-eighthof1percent).Becauseofthecontinuousresetting,thepriceofthenoteswasexpectedtoreturntopar(100%)every90days,assumingthatthereissueratecontinuedtobeLIBOR+1/8%.Aninvestorwasnowgivenachoicebetween90-dayECDs(say,at4.3%),andpurchasingandresellinganFRN90dayslateratarateof4.625%,adifferenceof32.5basispoints.TheinvestorwouldhavetorealizethattherewasariskthattheFRNscouldnotbesoldat100%90dayslater,sopartofthe32.5basispointswouldrepresentareservetoprotectagainstsellingitatapricebelowpar,pluscommissions.Theinvestormightaskadealertoquotearepurchaserate,atwhichthefirmwouldagreetobuytheFRNsback90dayshence.Ifapositivespreadstillexisted(andtheinvestorwaswillingtotakethecreditriskofthedealermeetinghisobligation90dayslater),theinvestormightprefertheFRNtradetotheECD.However,theinvestormayprefertoremainadepositorinthebank,ratherthanageneralcreditor,andthereforeacceptalowerratefortheincreasedsecurity.

Tosomeextent,therefore,theFRNmarkethastraditionallycompetedwiththeECDmarket.However,asfearaboutthecreditqualityofbanksemergedintheearly1980s,andagainduringthefinancialcrisisof20072008,therewaslessassuranceabouttheabilityofbankstorolloverfundingatthesamespreadoverLIBOR,andtheFRNmarketweakenedconsiderably.SodidthemarketinECDs,relativetootherinstruments.(p.10)


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EUROCOMMERCIALPAPERCommercialpaper(CP)constitutesshort-termunsecurednotesissuedbyacorporation.CPhasbeenissuedactivelyintheUnitedStatessincethe1860s,butitfirstappearedinEuropeonlyintheearly1970s.ItwasaimedinitiallyatU.S.corporations,whichwererequiredatthattimebygovernmentregulationstofinancealloverseasinvestmentswithforeignborrowings,toprovideamoneymarketalternativetobankborrowing.Theeffortwasnotsuccessful,despitetheadvantagesofEurocommercialpaper(ECP)overdomesticCP.U.S.CPislimitedbylawtoborrowingsupto270days,andcanbeusedonlyforworkingcapital.Furthermore,itissubjecttoincometaxwithholdingoninterest,andisissuedinbook-entryform.ECP,bycontrast,isexemptfrommaturityanduse-of-proceedsrestrictions,isnotsubjecttowithholdingtaxes,andisofferedinbearerform.Thus,asubstantialdifferenceexistsbetweendomesticCPandEurodollarECP.Often,thedifferenceresultsinaninterestratedifferential.Commissionsandset-upexpenses,however,addedcostswhentheECPmarketwasfirstestablished,sothatthecostoffundstotheissuerwasaboutthesameasthecostofacomparableLIBOR-basedbankloan.Moreover,Euromarketinvestorswerecautious.Theywerehesitanttobuythepaperofcompaniesthatwerenotalreadywellknown,anddiscouragedbythelimitedliquidityinthemarket.Investorswereextremelyqualityconsciousatatimewhenlimitedinternationalinvestment-graderatinginformationwasavailable.Unlikedomesticmarkets,theU.S.andEuropeangovernmentsdidnotoffershort-termsecuritiesinternationally,soinvestorshadtomakedowiththebanksandothercorporateissuersthattheyknew.

In1974,theregulationsrequiringU.S.companiestofinanceoverseaswererepealed,andthemarketdiedaway.Theeconomicsweresimplynotthere:therewasverylittlebenefittousingthemarketatthetime.

Ifinvestorswerepreparedtogooutabitinmaturity,theycouldbuyoutstandingornewlyissuedEurobondsofhigh-grade,well-knownissuers,includingsomemajorEuropeangovernments.Theissuersbegantoshortenthematuritiesoftheirbonds(e.g.,to2or3yearsinsomecases)inordertoattracttheseinvestors,aswellastoavoidtheextremelyhighlonger-terminterestratesofthelate1970s.Astradingvolumeincreasedinthesecondarymarkets,investorsbegantoacceptthattheycouldrelyontheliquidityinthemarkettofacilitateasaleofEurobondsbeforematurity.

Eurobonds,however,hadcertaincharacteristicsthatlimitedtheflexibilitythatmanyissuerswanted.Thebondswereofafixedamount,underwritten,andsoldallatonce,andtheyinvolvedconsiderableexpense,whichbecamequiteconcentratedastheaveragematurityofthebondswasreduced.Someissuersinsteadpreferredcontinuousofferingsoftheirpapertothemarketonanon-underwrittenbasis.Theywantedtosimplypostratesforarangeofdifferentmaturities,basedonadvicefromoneormoredealers,andthenseehowmanynotesthe(p.11) dealerscouldsell.Theycouldraiseorlowertheratesbasedondemand.ThisisthemechanismusedintheU.S.commercialpapermarket,andintheearly1980sitwasappliedtotheEuromarketinasecondattempttodevelopamarketforECP.


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Thesecondattemptmetwithgreatersuccess.Thistime,theinitiativewasaimedatbankinvestorsthatneededhigherandsaferreturnsontheirmoneymarketinvestments.Potentialclientsalsoincludedcorporateandinstitutionalinvestors,whowereincreasinglyconcernedbythedeteriorationinbankcreditratingsintheUnitedStatesandEurope,andwantedtodiversifytheircashmanagementprogramsintononbankinvestments.Dealers,awareoftheseconcerns,begantoapproachEuropeanmoneymanagerswithproposalsthattheyswitchfromECDsorFRNstoECPofnamecompanieslikeGEorExxon.Theywereonlyearning25basispointslessthanLIBIDfromtheirbankdeposits,buttheycoulddiversifyintohigher-gradepaper,suchasthatissuedbycompanieswithAAAbondratingsat,forexample,LIBIDless10basispoints.Or,iftheywerepreparedtotakecorporatebondratingsofAAorA(withtop-gradeU.S.commercialpaperratingsofA1andP1),theycouldlookforahigherrateforexample,themeanbetweenLIBIDandLIBOR.

Asbankcreditworriesincreasedinthelate1980s,andagreatersupplyofnonbankpaperwasoffered,themarketbegantodevelopinearnest.Asitdid,therecognizedratingagencies,MoodysandStandardandPoors,increasedtheirinvolvementinECPratings,andinvestorsbecamemoreawareofthem.Toberated,issuershadtobeabletodemonstratethattheyhadunusedbanklinesofcreditavailabletoprovideliquiditytoanissuer,shouldamajormarketinterruptionoccurinwhichitwouldnotbepossibletorollovermaturingECP.Committedcreditfacilitiesinsame-dayfunds,calledswinglines,hadtobeinplacetocoverafewdaysofthematurities,withbackuplines,oftenuncommitted,availablefortherestofthematurities.

Unratedpapersoonrequiredupto10basispointshigherinterestratesthanlowerrated(A2,P2)ECP,whichitselfrequired5to10basispointsmoreinterestthanA1andP1ratedpaper.Ratingsbecameincreasinglyimportantafterseveralmajordefaultsin1989to1990.By1990,theECPmarkethadincreasedtoabout$70billionofoutstandingissues.Citibank,amajorECPdealer,estimatedatthetimethatbankscomprisedabout45%oftheinvestormarket,corporationsandmoneymanagersandfinancialinstitutions28%each.Amongthebankswerethosewhichmanagedsubstantialinvestmentfundsfortheirclients.

Fromtheissuerspointofview,ECPprovidedcheaperfundsbecausethemarketwaspricingitandtheissuerdidnothavetopaysignificantcommitmentfeestobanks.AccessingtheECPmarketpermittedanissuertotapintothemaininvestorbaseintheEuromarket,andrepresentedadiversificationoftheissuerssourcesoffunding.

DealersinitiallywereenthusiasticabouttherapidlyexpandingECPmarket.TheywantedtoassistexistingandnewclientsforEuromarketservices,toappearwellplacedinthecompetitiverankings(leaguetables),andtoprofitfromthe(p.12) growthinthenewmarket.Intensecompetitionforcedspreadsdown,squeezedcommissions,andspreadtoomanyprogramsamongseveraldealers.Profitswerehardtocomeby.Ofthetop10dealersattheendof1987,four(MerrillLynch,CSFirstBoston,S.G.Warburg,andSalomonBrothers)hadwithdrawnfromthemarketbytheendof1990.Subsequently,competitiveconditionssettleddownintoarated-onlymarket,withfixedcommissionsof3


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to5basispointspaidbyissuerstodealers.

ECPmarketdevelopmentsalsoaffecteddomesticmarkets.Bythemid1980s,itwaspossibleforissuerstoswapdollar-denominatedcommercialpaperintopaperdenominatedinanyothermajorcurrency.ThusamarketgrewinsyntheticEuro-DM,Euro-sterling,andotherEurocurrencycommercialpaper,includingthepredecessortotheEuro,theECU.SuchpaperbegantoappealtoissuersfromvariousEuropeanandothercountries,andthis,inturn,putpressureonlocalregulatorstopermitthedevelopmentofdomesticCPmarketsinseveralcountries,suchasJapan,Germany,Britain,andFrance,thathadneverhadcommercialpapermarketsbefore.Themarkethasgrownfrom$44billionin1986toover$700billionin2008.

ThedevelopmentoftheECPmarkethasbeenoneofthemoresignificantinnovationsininternationalfinanceduringthepastthreedecades.Themarketdevelopedtofillaneedbyinternationalinvestorsforaspectrumofbearermoneymarketpaperthatwasfreefromwithholdingandothertaxes.Gradually,thespectrumwidenedtoincludelesser-qualitynames,includingsomespeculativeLatinAmericanissuersthatwereappropriatelypricedbythemarket.Thenewmarketwassuccessfulenoughtogeneratefurtherinnovation,standardizeddocumentation,and(intime)maturepricinganddistributionmethods.Itsreachextendedintonoteissuancefacilitiesandmedium-termnotes(MTNs;discussedlaterinthischapter),andstimulatedthedevelopmentofdomesticCPmarketsalmostimmediatelyallovertheworld.Theseimpressiveachievementsareexamplesofthefungibilityofmoneyinamarketplaceinwhichcapitalmovementsarenotrestricted,andtransactionsflowtowheretheymaybemostefficientlyeffected.

NIFSANDRUFSMeanwhile,someofthelargewholesalebanksbegantoseeECPasathreattotheirbasicbusinessofprovidingshort-termcredittomajorindustrialandgovernmentborrowers.AstheirclientsmovedintoECP,theylefttheirbankloansbehind.AlthoughthebanksfurnishedthebackupcreditlinesandswinglinesneededtoaccesstheECPmarket,theprofitabilityofthesefacilitieswassmallinrelationtocustomarybankloans.BanksbegantofeararepeatoftheirexperienceintheUnitedStates,inwhichthecommercialpapermarketgrewrapidlyattheexpenseofbanklending.

Toremaincompetitiveinofferingshort-termcredittotheircustomers,thebanksintroducedafamilyofrevolvingcreditfacilities,callednoteissuance(p.13) facilities(NIFs).NIFsallowedclientsthechoiceofdrawingdownaloanatanagreedspreadoverLIBOR,orsellingnotes(ECP)throughthebanksatalowerrate.ClientssawNIFsasasouped-upversionofanordinaryECPprogram,inwhichallofthebenefitsofECPwereretained,whilestillsecuringthebenefitsofacommittedbankfacility.CompetitionamongbanksforNIFsresultedinatighteningofthemarket.Fees(aone-timefeeforarrangement,andannualfeesforparticipationandcommitment)weresqueezed,aswerethelendingspreadsoverLIBORonloansdrawndownundersuchfacilities.

ANIFworksasfollows.Anissuerentersintoanagreementwithabankfora$200million


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revolvingcreditfacilityfor,say,7years.Theleadbanksyndicatesthefacilitywithotherbanks,accordingtothenormalsyndicationprocessdescribedinChapter2.Fundsdrawndownunderthefacilitycanberepaidatwill,withoutpenalty.Theissueragreestoobtaincommercialpaperratings,whichinthiscasewecanassumeareA1andP1.Iftheissuerdecidestodrawdown$100millionforsixmonths,probablytorollitovercontinually,ithastwochoices.Theissuernotifiesthebankthatitwishes,asofaprescribeddate,eithertotakedowna6-monthloanattherateprovidedintheloanagreement,sayLIBOR+%,ortoissuepromissorynotesinECPformtoapredeterminedgroupofbanksanddealers(usuallyledbytheNIFsarrangingbank)atwhateverratethedealergroupmayofferfordistributiontoinvestors.IfanECPalternativesuperiortothebankloandoesnotmaterialize,thebanksareobligatedtomaketheloan.Thus,foramodestsetoffees,theissuercanhavehiscakeandeatittoo.Thatis,hecanhavethelowerratesoftheECPmarket,andtheguaranteedassurancethatfundswillbeforthcoming,regardlessofmarketconditions.

Well-known,highlyratedissuersmaydecidetoforegotheunderwritingfeatureofferedbyNIFsandrelyontheirabilitytocontinuallyresellmaturingECP.Suchissuerssavethearrangementandparticipationfeeschargedbythebanks,buttheymuststillpaysomethingforbackupandswinglines.Overtheyears,themarkethasdevelopedefficientpricingfortheunderwritingfunction.

AvarietyofadditionalNIFfeatureshavebeenintroducedbyinnovativebanks.AmongthesearetheabilitytouseNIFsmorecomprehensivelythatis,fornotesissuedeitherintheU.S.commercialpaperortheECPmarket,fornondollardenominationsofdrawdownorrollovers,andforbanklettersofcredittobeusedtoprovidecreditbackingforissuerswhoareunabletoobtainsatisfactoryratings.Tapfeatureshavealsobeenprovidedtoallownotestobeissuedfrequently,insmallamounts,tosatisfydealerdemand.Suchissuescaninvolvecontinuoustenderpanels,inwhichtheplacementagentannouncesdailyaratelevelatwhichallbidswillbeaccepted.Aggressivedealerswillbidbelowthatrate,tobesuretoobtainsomeofthepaperbeingauctioned.LargeU.S.commercialpaperissuers,especiallythoseissuingdirectly(withoutdealers)oftenusethetapissuemethodtoobtainthebestratesandtospreadmaturitieswidely.DirectissuersintheUnitedStatesaccountformorethanhalfofallU.S.commercialpaperoutstandings.DirectissuanceismuchlesscommonintheECPmarket,but,increasingly,(p.14) largeissuersareresortingtoself-underwrittentapissuestoachievethemostefficientuseofthemarket.

EUROMEDIUM-TERMNOTESNextinthecontinuousevolutionofnewmoneymarketproductswastheEuromedium-termnote(EMTN),whichfollowedinthewakeofanexpandingECPmarketandthedevelopmentofenhancedmarketactivityformedium-termnotesintheUnitedStates.EMTNscovermaturitiesfromlessthan1yeartoabout10years.Theywereissued,likeEurobonds,bylargecorporationsandbygovernmentsandtheiragenciesfromallaroundtheworld.ThoughEMTNshadlongermaturities,theyretainedsomeofthecharacteristicsofcommercialpaper.EMTNsofferanextensionofECPmarketpractices


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overgreatermaturities,andhavehadtheeffectoferasingthetraditionalboundariesbetweentheshort-termmoneymarketandbondmarkets.

MTNshavebeenavailableintheUnitedStatessincetheearly1970s,butinitiallytheywerelimitedinusebecauseofregistrationrequirementsandalackofawell-developedinvestorbasefor1-to5-yearmaturities.Theintroductionin1984ofRule415,providingforshelfregistrationintheU.S.market,madeitpossibletoofferMTNscontinuouslyinthepublicbondmarket.Distributionwasthroughdealers,ordirectlybylargeissuerssuchasGECapital.Increasedvolatilityinthefixed-incomesecuritiesmarket,thesteepyieldcurvesprevalentinthe1980s,andtheincreasingsophisticationoffixed-incometradersattractedmanyinvestorstoMTNsinthemid-1980s.Furtherinnovationsinproductdesignbydealersandissuerssuchasofferingfloating-rate,aswellasfixed-ratereturns,deep-discountzerocoupons,andmulticurrencyoptionsmadetheMTNintoahighlyflexibleanddesirableinvestmentvehicle.ThedomesticU.S.MTNmarketmaturedduringtheperiod19881992,duringwhichnewissuevolumerosefrom$38billionto$192billion.Themarketpeakedin2001,withoutstandingsover$400billion.Since2004,however,themarkethasbeendryingup.Severalreasonsexistforthecollapse.StructuredInvestmentVehicles(SIVs)wereimportantissuersofMTNs.However,SIVswerehithardbytheglobalfinancialcrisisin2008,andthereforestoppedissuingMTNs.Moreover,manyissuersofMTNswereintherealestateindustry,whichwasalsohardhitbytheglobalcrisis.Also,MTNsaretypicallyoverthecounterandthereforenotveryliquid.Finally,theSecuritiesandExchangeCommissionhasindicateditwillmakeissuingmedium-termnotesmoreexpensive,sopotentialissuersarenaturallyreluctanttosetupMTNprogramsthatmaybecomemoreexpensivethanplanned.Potentialissuersexploreotherfinancingarrangements.

Thegrowthduringthe1990swaslargelybecauseoftheflexibilitythatMTNprogramsoffertolarge,frequentborrowers,which,intheEuromarket,tendtobesovereigngovernmentsandmultinationalinstitutionssuchastheInternationalFinanceCorporation(anaffiliateoftheWorldBank)ortheEuropeanBankfor(p.15) ReconstructionandDevelopment(EBRD).Suchborrowershavecontinuousfinancingrequirementsandusethefullspectrumoftheyieldcurvetoobtainit.Changesarefrequentlymadeintheirborrowingstrategies,whichresultinchangingthematuritiesofoutstandingliabilitiestopursueopportunitiesforlowerfundingcosts,ortohedgeagainstexpectedinterestrateorforeignexchangemovements.Inconsideringhowtoobtainthelowestoverallcostofborrowing,suchissuersmustalsoconsiderthecostofissuance.EMTNsinvolveverylowdocumentationcostsandstandardizedlegaldocumentation,andtheymaybeissuedonacontinuousnon-underwrittenbasis,inwhichtheissueronlypaysacommissionofafewbasispoints,ordistributesthenotesitself.

InanormalEurobondoffering,anissuermustpickatime,anamount,andacurrency,andthenauctionthebondsofftothehighestbidderthatis,atthelowestinterestrate.Theissuewillbelargeenough(typically$200to$300million)tosatisfyfinancingrequirementsforatleastseveralmonths,anditwillinvolvepaymentofunderwritingandplacementcommissionstoanunderwritinggroup.InanEMTNprogram,theissuer


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announcestothemarketaprogramfortheissuanceofdebtsecurities(PIDS)throughcontinuousofferingsoveranextendedperiod.Issuerstendtobefinancialinstitutionswhowanttocometothemarketfrequently,andwhowanttheflexibilitytotakeadvantageoffavorablefundingopportunitiesthatarise.TheEMTNprogramallowssuchflexibility,becausethedocumentationisinplace.Importantly,thefinancedirectorofanissuerwantstohavealargeenoughEMTNprogramsothatfurtherissuanceispreapproved.Acomplicationisthatboardsoffirmstendtoapprovedebtlimitsonanannualbasis,whereasEMTNprogramstendtobemultiyear.Ideally,anissuerneverreachesthelimitandalwayshasroomforfurtherissuance.Toensurethatanissuerneverreachesthelimitandalwayshasroomforfurtherissuance,thefinancedirectortendstoaskforincreasedlimitsovertime.AdocumentsimilartoaU.S.Rule415shelfregistrationprovidesdetailsoftheprogram,anda1-pagesupplementisproducedwhensecuritiesareissuedunderit.Theprogramisratedbytheagencies,andsometimesaroadshowisputtogethertoinformpotentialinvestorsabouttheissuer.Whentheprogramisreadytogo,theissuercanbringoutlargetranches(say,$200to$300millioneach)undernormalEuromarketunderwritingmethods,orresorttotapissues,orboth.Theissuercanpostrates,orhavedealerspostthem,atwhichitiswillingtotakealloffers.Alternatively,itcanauctionthemoffonedayatatime,inanyEurocurrencyitlikes.Ifthemarketfailstotakethepaperatamaximumrate,andtheissuerhasaNIF,theissuercanrequireitssyndicateofbankstotakeit.IftheU.S.marketischeaper,itmightgothereifashelfregistrationisineffect.Thereareagreatmanyoptions.

TREASURYSECURITIESInternationalmoneymarketsalsoincludedomesticshort-termgovernmentsecuritiesthatarepurchasedbyinternationalinvestors.Mainly,suchinvestors(p.16) areinterestedinsuch(treasury)billsandnotesbecauseoftheirliquidityandhighquality.Thesesecuritiesareavailableinallindustrializedcountriesandmanyless-developedcountries.ForeigncentralbanksholdU.S.Treasurysecuritiesaspartoftheirforeignexchangereserves.Theyusuallybuythematauctionandholdthemuntilmaturity,thenreplacethemwithnewpurchases.CountriessuchasChina,Japan,Korea,andTaiwanhaveaccumulatedverylargepositionsinU.S.Treasurysecurities,astheirbalanceofpaymentspositionshaveaccumulatedlargesurplusoverrecentyears.ChineseinvestorshaveincreasedtheirownershipofU.S.Treasuriesfrom$60billion(1%ofTreasuriesoutstanding)in2000toover$800billion(7%ofTreasuriesoutstanding)in2009.However,ChinaandtheothercountriesthathavebecomemajorinvestorsinTreasuriesdonthavemanyoptionstoreinvestthemoneyelsewherewithoutaffectingtradingrelationswiththeUnitedStates,orfindingthemselvesinvestorsinanevenlessdesirablecurrency.DespitetheirincreasedinterestinTreasuries,thesegovernmentshaveexpressedconcernsabouttheirinvestmentsbeingexposedtoadeclineinthevalueofthedollar.OneChinesebankregulatornotedthattheU.S.dollarissuretofallinvalue.Hesaid,Wehateyouguys.Onceyoustartissuing$1trillion$2trillionweknowthedollarisgoingtodepreciate,sowehateyouguys,butthereisnothingmuchwecando.1

Investorsacquireforeigntreasurysecurities(which,usually,likeU.S.Treasuries,are


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notavailableinbearerformandmaybesubjecttoforeignwithholdingtaxesoninterestpaid)foressentiallytworeasons.Oneistotakeapositioninaliquidinstrumentthatissubjecttoanexpectedpricechangebecauseofchanginginterestorexchangerates.Suchinvestmentsareuncovered,orunhedged,positions.Theinvestorwantstheriskthattheeurowillincreaseinvaluerelativetothedollar,andthatforeignspeculatorswillbidupthepriceofGermantreasurysecurities,whicharedenominatedineuros.Theotherreasonistotakeacoveredposition,throughwhichtheinvestormightpickupseveralbasispointsofyield.Iftheinvestorcanbuya6-monthGermantreasurybill,which,whenswappedfromeurosintodollars,yieldsmorethan6-monthU.S.Treasurybills,heorshemaybebetteroff.Awell-informedinvestorwillscantheworldstreasuryandswapmarketsfrequentlylookingforsuchopportunities.Forastart,theinvestorcanconsultthedailypostingintheFinancialTimesofworldmoneyrates,whichreflectthesecondarymarketpricesfortreasurybillsinthevariouscities(i.e.,countries)indicated.

Wholesalebanksinmostcountriesareveryactivelyinvolvedindomesticandinternationaltreasurysecurities.AsubstantialportionofthelargevolumeoftradingprofitsreportedbylargeU.S.commercialbankscomesfromtradinginU.S.andothergovernmentsecurities.Originally,thesebanksenteredintothebusinesstoprovideservicestocustomersandtoeffecttheirowntransactionsinthegovernmentsecuritiesmarket.Later,tradingforthebanksownaccountsbecameamajorbusiness.Thesubstantialmarketliquidityandthewiderangeofsecuritiesavailablemakethesesecuritiesidealfortrading.Largeuniversalbanks(p.17) inmostEuropeancountriesandlargeinvestmentbanksalsotradeextensivelyinthegovernmentsecuritiesmarketsofseveralcountries,oftenservingasaregisteredmarket-maker.SeveralforeignbanksareregisteredprimarymarketdealersinU.S.governmentsecurities.

InterpretingMoneyMarketsBesidesLIBOR,anotherimportantrateistheovernightindexswap(OIS)rate.2Aswithanyswap,anOISisanexchangeofoneobligationforanother.Inthiscase,onepartyhasashort-termloanwithafixedinterestrate.Anotherpartyborrowsattheovernightrate,whichisafloatingrate.Thepartiesexchangeinterestpaymentobligationssothatthepartywiththeloanatafixedinterestratepaysthefloatingovernightrate,andthepartywiththeloanthatisrefinancedeverydayattheovernightratepaysthefixedrate.Littlecreditriskexists,becausethepartiesexchangenoprincipalandswaponlyinterestpayments.Attheendofthecontract,thepartiessettlethenetdifferencebetweenthefixedrateandthegeometricaverageoftheovernightfloatingrates.Thatis,whicheverpartyhaspaidlessinterestwillpaythedifferencetotheotherparty.TheOISrateitselfisthefixedrateusedintheswap.IntheUnitedStates,forexample,thefixedrateistheeffectivefederalfundsrateforthelifeoftheswapcontract.Thisratereflectsthemarketsexpectationsofovernightborrowingcostsforthetermoftheswap.Sincetheseareveryshort-termrates,theyareinfluencedmorebyliquidityriskthanbycreditrisk.Thatis,daytoday,mostpartiesareabletorepaytheirloans,socreditriskisnotamajorissue.However,partiesmayexperienceshortagesinliquidity.Ontheotherhand,LIBORissetforlongerperiodsoftime(1month,3months,uptooneyear)soLIBORincludesnotonlyliquidityriskbutalsosomedegreeofcreditrisk.


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LIBORandOISareusednotonlytopriceinternationalloans,butalsorevealmarketsentiment.SubtractingtheOISratefromthe3-monthLIBORratedeterminestheLIBOR-OISspread.Liquidityriskisnettedoutofthiscalculation,sothespreadindicatesthemarketsperceptionoftheshort-termcreditriskofthepartiestransactingthecontracts,usuallybanks.AlanGreenspan,formerchairmanoftheFederalReserveBoard,notedthat,Libor-OISremainsabarometeroffearsofbankinsolvency.Anarrowspreadsuggeststhemarkethasconfidencethatborrowingbankswillbeabletorepaytheirloans.Lendingbanksare,therefore,morewillingtoprovidemoneymarketfundssothatbankscanlendoutmorefundstothelargereconomy.Widerspreadssuggestthemarketisconcernedabouttheshort-termcreditriskofborrowingbanks.Banksarelesswillingtolendtoeachother,whichleadstocreditbeingchokedtotheeconomyasawhole.Historically,LIBORandOISrateshavebeenverysimilarandthespreadhasbeenaround10basispoints.StartinginAugust2007,however,thespreadstartedtoincrease,andreachedapeakof354basispointsinOctober2008.Afterthebankruptcy(p.18)

Exhibit11 LIBOR-OISSpread(basispoints)September2005toSeptember2010.Source:Bloomberg.com

ofLehmanBrothersinSeptember2008,lendersfacedtwocriticaluncertainties.Theywerenotsurepotentialborrowerscouldrepay,and,perhapsmoredevastating,theydidnotknowtheirownexposurestootherinstitutions,someofwhichcouldgothewayofLehman.Thislackoftransparencywastheresultofcomplexfinancialinstrumentssuchacreditdefaultswaps,whichwediscussinChapter6.Asaresultoftheseuncertainties,lendersstoppedlendingandmoneymarketsessentiallyfroze.Centralbankssteppedinandlentmassiveamountstobankstorevivethemoneymarkets.OnSeptember29,2008alone,theEuropeanCentralBankandcentralbanksfromEngland,Japan,andtheUnitedStateslentatotalof$620billiontotheirrespectivebanks.Theactionsseemedtohelp.ByJuly2009,thespreadrecededto34basispoints.SeeExhibit11.

AsimilargaugetomarketsentimentistheTreasury-Eurodollar(TED)spread,calculatedbysubtractingfromthe3-monthLIBORrate,whichreflectsbothcreditriskandliquidityrisk,the3-monthfuturescontractforU.S.Treasuries,whichreflectsonlyliquidityrisk.AswiththeLIBOR-OISspread,theTEDspreadreflectsthemarketsperceptionofshort-termcreditrisk.TEDspreadsrangedfrom25to75basispointsuntilAugust2008,whentheyshotuptoalmost250basispoints.Thespreadtopped450basispointsinOctober2008,butfellbacktohistoricrangesstartinginMay2009.SeeExhibit12.


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ForeignExchangeMarketsDealinginforeignexchangehasbecomeanincreasinglyimportantactivityforallinternationalbankersandmoneymarketinvestors.Theimportanceisduetothecontinuousincreaseinworldtrade,andcross-borderfinancialflowsinsupportoftherealeconomy,inatimeofhighvolatilityinforeignexchangemarkets.Customersofbanksneedassistanceinmanagingandhedgingtheir(p.19)

Exhibit12 TEDSpread(basispoints)September2005toSeptember2010.Source:Bloomberg.com

internationalcashflows,andbankshavelongbeeninthebusinessofassistingthem.Inaddition,fundsflowsinsupportofcross-borderfinancialinvestmentshaveincreasedsubstantiallyasaresultofgreaterappreciationofinternationalinvestmentopportunitiesandeasiermechanicsthroughwhichtomakethem.Investorsneedtofundtheseinvestments,andtohedgethemfromtimetotime.Market-makingbybanksinforeignexchangehasbeenanessentialandprofitableservicetocustomersinboththemanufacturingandfinancialsectors.Finally,banksandinvestmentbanks,andsomeinvestmentfundsnotablyhedgefundshavefounddealingfortheirownaccountstobeanattractivesourceofpotentialprofits.Asinmosttradingmarkets,highvolumeandvolatilitycreateanidealenvironmentforskillfulparticipants.

Someyearsago,governmentofficials,indiscussingtheforeignexchangemarkets,referredtoparticipantsaslegitimatecommercialusersversusspeculators,presumablyindicatingthelattergroupasbeingsomethingotherthanlegitimate.Asmarketpracticeshavebecomebetterunderstood,thisdistinction,probablyneververyuseful,isnolongerused.Allplayersaresimplyinvestors.Somehavemundanereasonsforplaying,perhaps,andothershavemoresophisticatedones.Buttheycannotbedistinguishedinthemarket,whichattractstransactionsofwhateverkindbecauseofchanginginvestmentconditions.

INCREASINGTURNOVERThelargeandactiveforeignexchangemarketislikeanyotherfreemarketplace,exceptforoneimportantdifference:governments,throughtheircentralbanks,sometimesintervenetoinfluenceexchangerates.Theirpurchasesand(p.20) sales,especiallywhenthereisinternationalcoordination,canmakeasignificantdifferenceinratesand(moreimportantsometimes)intheexpectationforfuturerates.Mostnongovernment


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playersseethegovernmentroleasplacinganartificiallimitonpricemovementsinonedirectionoranother,andthustheyattempttopositionthemselvestobenefitfromit.Playingagainstthegovernments,inotherwords,canbeextremelyprofitablefordealersandinvestors,andthis(duringatimeofsignificantamountsofgovernmentintervention)hashelpedconsiderablyincreasethevolumeofturnoverintheworldforeignexchangemarkets.Asoftheendof2010(evenaftertheconsolidationof12Europeancurrenciesintotheeuro),averagedailyforeignexchangeturnoverwasover$4trillion.Interestingly,lowerinternationaltradeinthefirstquarterof2009ledtoa20%decreaseinFXtrading.Despitethevolatility,theforeignexchangemarketisbyfartheworldslargestfinancialmarket.

MARKETORGANIZATIONTheforeignexchangemarketisaninformal,over-the-countermarket,organizedintotradingcentersaroundtheworld.Themarkethasnocentralclearinghouseorexchange,anditoperatesmainlythroughdealers.Interdealertransactionsconstituteapproximately75%ofalltradinginthemajorcenters.Thedealermarketishighlyconcentrated,withthetenleadingdealersineachmajorcenteraccountingforroughly40%ofthemarket.Dealerssometimesspecializeinonlyafewcurrencies,althoughsomearemorebroadlyactive.Dealersmakemarketsinavarietyofforeignexchange(forex)products,includingspotandforwardrates,swaps,andotherderivatives.

Althoughtheforeignexchangemarketisunregulated,centralbanksareactiveparticipantsandareabletokeepaneyeonthebehaviorofbanks,towhichregulatorycontrolsapply,andotherplayersfromtheircountries.TheleadingcenterforforeignexchangetradingisLondon,mainlybecauseLondonisthecenteroftheEurocurrencymarketandoverlapsboththeNewYorkandTokyotimezones.In2007,Londonaccountedforalmost35%ofglobalforexturnover.TheUnitedStatesaccountedforabout17%,andJapan,Switzerland,andSingapore6%each,ofglobalforexturnover.

MARKETFUNCTIONSBuyingforeigncurrenciesislikebuyinganyothergood.Thecurrencyhasaprice,calledanexchangerate.Sincetheearly1970s,mostcurrenciesindevelopedeconomiesarefloating.Thatis,thepriceofthecurrencyisdeterminedbymarketforces.Thepricechangescontinuouslyasthemarketforcesofsupplyanddemandchange.FXproductsincludespotandforwardcontracts,aswellasswaps.Spotcontractsbindtwopartiestodeliveronecurrencyforanotherwithinashortperiodoftime,usuallytwobusinessdays.Spotcontractsaresoldbybrokersor(p.21) dealers.Brokersmatchbuyersandsellersofcurrenciesandchargeacommissionfortheservice.Dealershaveaninventoryofcurrencies,andstandreadytobuyorsellcurrencies.Theyearnaspread,knownasthebid-askspreadonthetransactions.Banksareusuallydealers,andwillchargethebidpricetobuyacurrencyandpaytheaskprice.Forwardandfuturescontractssetthepricetodayfordeliveryofthecurrencyataspecificdateinthefuture.Whilethemechanicsofforwardsandfuturesdiffer,theresultisthesame.Thebuyerofthecontractknowshowmuchthecurrencywillcostinthefuture.Currenciesthataremoreexpensiveinthefuturearesaidtobetradingatapremium,whilethosethatareless


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expensivearetradingatadiscount.Forexample,ifthespotrateoftheeurois$1.00,andthe3-monthforwardrateis$1.05,theeuroistradingataforwardpremiumof5%(=($1.05$1.00)/$1.00).Typically,premiumsanddiscountsarequotedonanannualizedbasis,sothepremiumwouldbe20%(=5%x12/3)perannum.Todeterminetheforwarddiscountatwhichthedollaristrading,thereciprocalmustbetaken.Thatis,iftheeurocosts$1.05,thenthedollaristradingat0.9523(=1/1.05).Thedollarissellingataforwarddiscountof4.76%(=0.95231/1),oranannualizeddiscountof19%.Thepremiumreflectsthediscountdifferentialininterestratesbetweenthecurrenciesfortheperiodinvolved.Marketmakerswillbuyandsellforwardcontractsiftheygetoutoflinewithcoveredinterestparitythrougharbitragetransactions.

Inadditiontospotandforwardrates,dealersalsotradeincurrencyswapsandcurrencyoptions,futures,andcustomizedcurrencyderivativesecurities.WediscusstheseinstrumentsinChapter6.

CLEARINGANDSETTLEMENTOFFOREIGNEXCHANGEUnliketheinternationalmoneymarkets,foreignexchangetransactionsflowedsmoothlyduringtheglobalfinancialcrisisthatbeganin2007.3Amajorreasonbankswerewillingtocontinueforeignexchangetransactionswithotherbanks,eveninthewakeofgrowingriskthatthecounterpartymaynotreciprocate,wastheexistenceoftheContinuousLinkedSettlement(CLS)Bank.TheCLSBankisanintermediarybetweenthetwopartiesofaforeignexchangetransaction.Forexample,ifaJapanesebankandaU.S.bankwanttotradeyenanddollars,theJapanesebankwillsendyentotheCLSbank.Severalhourslater,whentheU.S.bankopens,itwillsenddollarstotheCLSBank.OnlyafterbothpartiessubmittheirrespectivecurrencieswilltheCLSBanktransferfunds.IfforsomereasontheU.S.bankdoesnotsubmititsfunds(e.g.thebankfailsorthegovernmentsuspendsforeignexchangepayments),theCLSbankreturnstheyentotheJapanesebank.

TheCLSBankcameintoexistenceasaresultofthedebaclein1974,whenHerstatt,aGermanbank,failed.BanksthathadsubmittedtheirsideofanFXtradesuddenlydidnotreceivetheothersideofthetrade.ThisriskofnonpaymentinFXtransactionsasaresultofthefailureofabankbecameknownasHerstatt(p.22) risk.TheestablishmentoftheCLSBankin2002eliminatedHerstattrisksothatbankswerewillingtocontinueFXtrading,evenwhentheywereunwillingtocontinueothertypesoftransactions.

BEATINGTHESYSTEMAsnoted,dealersontheirownbehalfandforthebenefitofcustomersoftenproposeforextradingstrategiesthatareintendedtotakeadvantageofthemarketinterventionactivitiesofcentralbanks.Suchintervention,whichcanbeinmarketpurchasesofspotandforwardcontracts,orinfuturesoroptionsmarkets,canalsoinvolveresettingdomesticinterestratestoaffectforexrates.Interventioncanoccurwheneverpolicyholdersofoneormorecountriesareunhappywiththeforeignexchangebetweentheircurrenciesandseektoadjustit.Interventionusuallytakesplacewhenacurrencyisfixedtoanother.Insuchsystems,thecentralbankisrequiredtosupportitscurrency


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whenitfallsbelowthestatedrate.InterventioncanalsooccurintheU.S.dollarmarket,relativetomajorcurrencies,suchastheyenortheeuro,whensuchcurrenciesmovetowardextremevaluesrelativetothedollar.Inrecentyears,theU.S.governmenthasresistedintervention,inordertoletmarketforcesworktoeffectstabilizingchangesintradeflows,evenatthecostofaweakerorstrongerdollar.

Duringperiodsofcurrencyintervention,greatsumscanbeinvestedbycentralbanksinsupportmechanisms,andgreatfortunescanbemadebyboldinvestorswhoinvestheavilyagainstthem.Beforetheintroductionoftheeuro,12Europeancountriesfixedtheircurrenciestoeachother.InSeptember1992,thecentralbanksofBritainandGermanyspentapproximately50billioninanunsuccessfulattempttosupportsterling.GeorgeSoros,aprominentAmericanhedgefundmanager,isthoughttohavemadeprofitsof$1billionfromthesterlingcrisis.Manybanksanddealersmadelargeprofitsaswell.

Thereareprincipallytwotradingstrategiesusedbyprivateinvestorsduringsuchcrises.Oneistosellthevulnerablecurrencyforwardforoneortwomonths,oftenagainstthestrongercurrency.Largepositionsmustbetakentomakemeaningfulprofits,becauseeveniftheweakercurrencyisdevalued,itmaynotbebymorethanafewpercent.Theinvestortypicallyborrowstheweakercurrencyandbuysgovernmentsecuritiesinthestrongercurrency.Theinvestorthenentersintoaforwardcontract,whichdoesnotrequireacashoutlayuntilthematuritydate.Whenthecontractcomesdue,theinvestorbuystheweakercurrencyinthespotmarketatanew,hopefullylower,price.Theinvestordeliverstheweakercurrencyandreceivesthestrongerone.Alargegaincouldoccurif,say,sterlingdepreciatesrelativetotheeuroby5%10%overa3-weekperiod.Thecostsofthepositionareprincipallythecostsofborrowingsterlingatahighinterestrate(theburdenoftheweakercurrency)minusinterestincomefrom,say,Germantreasurybills,denominatedineuro,whichcouldcarryrelativelylowinterestratesduringsuchacurrencycrisisplustransactionandmargincosts.Iftheinvestor(p.23)betsright,thereisanamplemargintofundtheinterestdifferentialandtransactioncosts,butifsterlingmanagestoresistdepreciation,theinvestorslosswillbelimitedtotheinterestdifferential.Oncethecrisisispast,however,sterlingmightrallyrelativetotheeuro,soitwillbeimportanttobeflexibleenoughtogetoutofthepositiononatimelybasis.

Anotherstrategyistoestablishinterestratepositionsintheweakcurrency(e.g.,throughpurchasesofbonds,orthroughforwardsorfuturescontracts)onceacurrencycrisishasbegun.Here,theinvestorexpectsinterestratesintheweakercurrency,pushedupduringtheefforttopreventdepreciation,todropsharply,thuscausingacorrespondingincreaseinbondvalues.Thevalueofthebondstheinvestorboughtatthebeginningofthecrisisisexpectedtoincrease.

Thetwostrategiesaredifferentandinvolvedifferentrisks.Tomakemoney,however,bothdependontheweakercurrencyactuallydepreciating.Otherstrategiesthatbetontheweakercurrencysurvivingthecrisisunchangedarealsopossible.Suchastrategy,forexample,couldinvolveborrowingeuros(atrelativelylowrates)tobuyU.K.treasury


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billsatrelativelyhighrates.

COMPETINGINMONEYMARKETANDFOREIGNEXCHANGETRADINGThereareagreatmanycompetitorsintheinternationalmoneyandforeignexchangemarkets.Somefirmsspecializeintheseactivities,butmostconductthemasapartofabroadercommitmenttofinancialmarket-making.Commissionsareverythininthesehigh-volumemarkets,andmostfirmsmaketheirmoneyfromtrading.

Inmoneymarketsinparticular,tradingsuccessdependsonaneffectivedistributionsystemthroughwhichpositionscanbeboughtandsoldatreasonableprices.Thisusuallymeansbeingcloselyintouchwithinvestors,corporations,andendusersingeneral.(Nobodygetsrichtradingonlywithmarket-makerslikeJPMorganChase.)Italsodependsonhavinggoodinformation,throughsalesforcefeedbackandfromcontactwithotherdealersandissuers.Telecommunicationssystemshavetobeasmodernaspossibletostayincontactwithmarketplayersallaroundtheworld;indeed,thesearesoimportantthatmanyfirmsregardtheirownaskeycompetitiveweapons.

Foreignexchangetradinginevitablymeanssubstantialpositiontaking,ifadealerexpectstomakemuchmoney.Thisisariskyandvolatilebusinessformostdealers,andallwayspossibleareutilizedtominimizeriskbyhedgingandusingderivativesandtechnicaltradingstrategies.Mostofthelargerplayersarecommercialbanks,whichhaveanaturalcompetitiveadvantageincomparisontononbankdealers,inthedailyforeignexchangeorderflowfromtheircustomers.Beingabletotradewithcustomersinlargevolumeshelpsprotectthebanksoveralldealerspread(betweenthebuyandsellratesquoted),andservestoensureatleastaminimallevelofprofitability.Addingmoreaggressivetradingforthe(p.24)

Exhibit13ForeignExchangeTradingIncomeofMajorU.S.Banks(US$M)1983 1990 2000 2009

BankofAmerica 102 207 524 972BankersTrust 28 425 30ChaseManhattanBank 117 217ChemicalBank 40 207ManufacturersHanover 27 106Citibank 274 657Citigroup 1243 2762ContinentalBankCorp 24 187FirstChicago 36 103BankofNewYork 13 48 215MarineMidland 19 3J.P.Morgan&Co. 74 309


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J.P.MorganChase 1465 4053RepublicNewYorkCorp. 8 77TOTAL 762 2547 3477 7787Source:AnnualReports/10Ks/CallReportData.

banksownaccount,inwhichlargespeculativepositionsaretaken,canconsiderablyboostorreducetradingrevenues.Exhibit13showstheforeignexchangetradingincomeofseveralmajorU.S.banksfrom1983through2009.

Consultantsandotherexpertswhoofferservicespredictingmarketbehavior,oraccesstoinsidethinkingonthepartofgovernmentofficials,makeagoodliving,butthereislittleevidencethattheyknowanymorethanthemarketrevealsinthepriceoftheinstrumentsandcontracts.Technicaltradingstrategiescanbesuccessful,butlikealltrading,successseemsmainlytodependondiscipline,courage,capital,technicalskills,andexperience.Mostmarket-makerswouldalsoaddthatgoodluckplaysamajorroleinsuccessfultrading.Mostoftheirsupervisorswouldaddthateffectiveinternalcontrolproceduresarenolessessential.

SummaryInternationalmoneyandforeignexchangemarketshaveexpandedrapidlysincetheearly1980s,asmarketliquidityhasincreasedbytheremovalofcapitalcontrolsandtheencouragementofcross-borderinvestmentflows.Increasedinterestrateandforeignexchangevolatilityhasalsomadethesemarketsmore(p.25) active.Afullarrayofinternationalmoneymarketinstruments,closelycomparabletothoseintheUnitedStates,nowexists.Linkagesthroughswapsandforeignexchangecontractshaveservedtointegratemoneymarketsintheworldsmajorcountries.ThesuccessofECPandEMTNshascausedmanygovernmentstoadoptsimilarinstrumentsintheirowndomesticmarkets.

ThestoryofEuronoteprogramsandEurocommercialpaperisoneofrapidchangeatalllevels.Thecompetitivestructureofthemarkethasundergonesubstantialmodification,withbargainingpowertendingtoshiftawayfromborrowerstowardinvestors.Intheearlydays,topandlesser-qualitynamesalikebenefitedfromtheintensecompetitionamongbanksthatresultedfromderegulationanddisintermediation.Theyprofitedaswellfromalackofinvestorsophistication.Today,mostcorporateandinstitutionalinvestorshaveafullunderstandingoftheworkingsofthemarketandwhatisavailabletothem.Anddistributivepowerhasbeenconcentratedinthehandsofafewfirms,whicharemoreinterestedinvolumeandprofitabilitythaninthenumberofdealershipstheyhold.Gonearethedaysofloss-leadingforaplaceinthemarket.Attentionisoncourtingtheinvestorbaseinsearchofgreaterdiversificationoffunding.

Otherchangeshaveoccurredaswell.Distributionmethodshavebeenmodifiedtosuitnewconditionsanddemands.TheuseofratingshasincreasedintheECPmarket,withtheneedforinvestorstoreactquicklyinfast-movingmarkets.Theverynatureofthe


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instrumenthasevolved,withthenon-underwrittenECPnowpredominatingoverEuronoteprograms.Thesechangeswillcontinue,asneweconomicconditionswillgiverisetonewrequirementsandnewresponses.TheEuronotegrewasasubstituteforsyndicatedloans,floatingratenotesintheEurobondmarket,andeurocertificatesofdepositissuedbybanks.Itssuccesscameinpartfromtheeventsshapingthefinancialworldatthetime.Asincreasingglobalizationbroughtincreasingcompetition,sothepaceofproductinnovationhasquickened.

AstheEuronotemarketdeepened,itbecameobviousthatprimeborrowerscoulddispensewithunderwrittenfacilitiesaltogether,thusreducingcosts.ECPprovidedgreaterflexibilityforborrowersandinvestorsalike.Itofferedafasterandmoreefficientmethodofplacement.Theseadvantagesledtoawideningoftheinvestorbaseand,consequently,furtherreducedcostsandincreasedflexibility.Euronoteprograms,andsubsequentlyECP,havehadsubstantialsuccess.Theyareperhapsbestviewedasacomplementto,ratherthanareplacementfor,moretraditionalformsofbankfinanceanadditionalfinancialstringtotheborrowersbow,offeredaspartofanincreasinglyefficientinternationalmoneymarket.Despitetheefficiency,internationalmoneymarketscanfreeze,astheydidin2008.Concertedgovernmentinterventionwasinstrumentalinrestoringconfidenceintheinternationalmoneymarkets.

Foreignexchangemarketvolatility,andgovernmentintervention(especiallyintheEUduringtheearly1990s)topreventit,hasprovidedtraderswithmanyopportunitiestomakelargefortunes.Theforeignexchangemarketistheworlds(p.26) largestandmostliquidfinancialmarket,althoughaboutthree-quartersofitsturnoveristhroughinterdealertransactions.Thepowerofthismarketisenormous,andevenlarge-scalegovernmentinterventionhasbeenineffectiveincontrollingit.Futuregovernmentintervention,therefore,maybefarlessthaninthepast,withtradingopportunitiesdiminishedaccordingly.TheestablishmentoftheContinuousLinkedSettlementBankin2002drasticallyreducedcounterpartyrisk:evenduringthefinancialcrisisthatbeganin2007,FXtransactionscontinuedsmoothly.

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Foreign Exchange and Money Markets