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Page 1 of 2 Financial Instruments, History, Issuance & Distribution, Marketplace
The Financial Instruments for Bank Credit Instruments Markets
The Federal Reserve uses two financial instruments to control and utilize the amount of USD in circulation internationally. These are Medium Term Bank Debentures, also known as Medium Term Notes (MTN) and Standby Letters of Credit (SLC). The Debenture is normally a medium-term note ranging between five to ten years, carrying a coupon paid annually in arrears. Today’s interest rates are in the 7.5% interest range and twenty-year instruments are also sometimes issued.
The SLC is usually a one-year term, zero coupon instrument and is used by the Fed to bring USD back into the Treasury. It is a monetary tool that bids up the price of the USD. When the Fed buys back an SLC, it bids the USD price down. Medium Term Bank Debentures are normally used to raise capital for loans and to assist the development of the world infrastructure projects. The SLC used in the international banking markets is a very different instrument than the typical three-party SLC in the Import/Export market. These SLC’s are two party instruments similar to a one-year corporate note, used primarily to raise funds. Banks issue SLCs on behalf of the Fed and the Fed is the customer on the issuing bank. The Bank operates through the Commitment Holder (defined later in this report) and issues the SLC from the Commitment Holders Contract with the Fed. Once an issue is determined, usually by contract and proof of funds, the issuing bank will exchange the SLC for the funds. Normally, a purchase must be initiated with a pledge of $500,000,000 in tranches of no less than $100,000,000 face value.
Under the BIS rules, the issuing bank is then required to convert the “off-balance sheet” item to an “on-balance sheet” equivalent. This is done by writing on-balance sheet the “risk” in the transaction and setting aside the capital reserved against the risk exposed, based on capital requirements. As the risk is very low, and 97-98% of the face value is paid by the Fed to the issuing bank upon maturity, the capital needed to be reserved is also very low, usually 4-5%. As an example, the issuing bank will issue the MTN at 78% of face value, and sell it to the Commitment Holder at 84%. The issuing bank will reserve 5% for margin cost of capitalization and transfer 79% back to the Fed. The Commitment Holder will sell the MTN to the Investor for 86% of face value. The Investor will sell the MTN to the secondary market for 92.5% where the retail market equivalent is 93.5% for U.S. Treasuries at that time. In this way, each transaction is attractive to the next holder in due course and all parties profit.
Upon maturity, the Fed under its Commitment Holder Contract will remit 95% of face value plus a 2% fee to the issuing bank and in addition a $5 Million USD reserve is released by the issuing bank back to the Fed. The Fed provides these margins to be competitive against other governments for large deposits of USD, and to attract the USD exactly when they require it. Against these margins, the Fed utilizes the funds against another bank’s guarantee for the term and they are able to maintain the benefits as outlined below. The issuing banks for their small cost, but large fee, receive the benefits as listed below inclusively. Benefits for both that by far outweigh the costs.
MTN %of Spread Bank Margin Disc. Issuance Face Earned Fees Fed Price Value Remission;
Issuing Price 78% 6% 5% 79% 97% ; Commitment 84% 2% 86% Holder Price ; Selling Price 86% 6.5% 92.5% ; Secondary Market Price 92.5% 1.0% 93.5% ; Retail Market 93.5% 6.5% 100% ; USD Remitted 95% 2% To Fed at Maturity ; USD Released 5% By Bank to Fed;
Instrument History
The closing years of World War II, most of Europe, the U.K., northern Africa, Baltic’s, Russia, and Asia were devastated. Millions of people were without homes and the basic needs of life. How can the world repair the damage caused by the most destructive war ever in history? Where was the money to rebuild on such a vast scale?
Inaugurated in July 1944, at a conference of 130 western world economists and politicians, held in Bretton Woods, New Hampshire, “the Bretton Woods Convention”, proposals were put forward by the principal architect, John Maynard Keynes, author of “The Economic Consequences of the Peace”, written in 1920. Keynes and his proposals were supported and endorsed by Harry Dexter White, United States Secretary of the Treasury. The heart of Keynes proposals were two basic principals: First, the Allies must rebuild the Axis countries, not exploit them as had been done after World War I. Second, a new international monetary system must be established, headed by a strong international banking system and a common world currency not tied to the gold standard. The principal agreements reached by 1947 by the Bretton Woods Convention were: 1. The United States Dollar replaced the Pound Sterling as the medium of international trade and the world reserve currency, however: 2. The USD was still tied to the gold standard and backed by Gold at $35 per ounce, the pre WWII level. 3. The Bretton Woods convention produced the Marshall Plan, the Bank for Reconstruction and Development (World Bank) the International Monetary Fund (IMF) and the Bank of International Settlements (BIS).
By 1961, the plans adopted by the Bretton Woods Convention of 1947 were succeeding beyond expectation, however U.S. dollars were in short supply as the U.S. was faced with a dwindling gold supply to back additional dollars. The solution was to recycle the current number of dollars back into the world commerce, which would solve the problem by avoiding the printing of more USD. A system was needed to draw the USD back into circulation through the private banking sector. The system was found in the centuries-old framework of Import/Export finance. This system hinged on having the world’s top banks extend the use of forfeit finance, not backed by gold, but by their own good faith and credit. This extension of credit would be backed by banking debentures of all kinds including Letters of Credit, bankers’ acceptances, bills of exchange and guarantees.
Laws, rules and procedures provided by the International chamber of Commerce, Paris, France, as already established and recognized by international accord for forfait financing, were adopted for these Bank Debentures and their use. The international banking sector was encouraged to issue Letters of Credit, Bank Guarantees and Bank Debentures in large denominations, at yields superior to U.S. Treasuries. This was to offset the increased costs to issuing banks due to the high yields accompanying the Bank debentures. Banking regulations within the countries involved were modified in such a way to encourage and/or allow the following: a. Reduced reserve requirements via offshore transactions. b. Support by the Central Banks, World Bank, International Monetary Fund and the Bank for International Settlements. c. Off-balance sheet accounting by the banks involved. d. Instruments to be legally ranked “pari passu” (on the same level) with depositor’s funds. e. The banks obtaining their depositor funds would be allowed to leverage these funds with the applicable central bank of the country of domicile in such a way as to obtain the equivalent of federal funds at a much lower cost. f. When these leveraged funds are blended with all other accessed funds, the overall blend rate cost of funds to the issuing bank is substantially diminished, thus off-setting the high yield given to attract the investor with substantial funds for deposit.
The bank for International Settlements (BIS) rules prohibits banks from buying the newly issued instruments from each other directly in the primary market. However, it does allow banks to buy and own other bank’s financial obligations as long as they are purchased from the secondary market. Therefore, the issuing banks must have third party Clients to process this business through. This ruling has created the investment opportunities we now enjoy in Bank Credit Instruments.
The Federal Reserve Board recognizes a tier of high quality banks, usually in the world’s top 100, which are authorized to deal in these instruments and these are called the Applicant Banks. The criteria for being on the Fed list includes the strength in normal banking ratios as well as countries in which the Fed desires to be active. It is clear that the largest supply of international USD is in Europe and this explains the dominance of European Banks on the Fed list. Major issuing banks then realized other benefits, other than funds recycling and redistribution. The Bank Credit Instruments provided bankers with a means to resolve other major banking problems, such as interest rate risks and meeting capital reserve requirements.
In 1971, the volume of world trading finally exceeded the volume of USD as the medium of exchange and exceeded the ability of the U.S. to support its currency with gold. The Nixon administration let the dollar float in the world markets, not tied to gold, but tied to the full faith and credit of the assets of the United States. The value of the dollar was now in the currency markets hands. Nixon deeded the Bank Credit Instruments as put in place by the Kennedy administration, in conjunction with the International Monetary Fund and the Bank for International Settlements to work hand in hand with the central banks of the Western countries to avoid a collapse of the dollar’s value. The principals of this system realized the following effects:
Issuing Bank Debentures would pull USD out of the private sector and exchange them for guarantees. b. Once the USD had been accessed, then the issuing banks could recycle them back into the world economy as loans. This process increased money supply. c. Alternately, the issuing banks could purchase the U.S. Treasuries from the Fed, thereby retiring the supply of dollars in the world market back into U.S. hands or selling the Treasuries to the Fed to increase the money supply.
Bank Debentures became the tool for the U.S. Government to control the amount of USD floating against other currencies and to help maintain the value of the dollar. Therefore, the fear of “run-away” inflation can be limited by controlling the number of USD available to the world market at any given time. At the present the Fed targets USD held in off shore and foreign banks, not resident in the USA for this “recycling”.
Today, the Bank Credit Instrument Trading Programs are increasingly used to support not only the enormous demand for USD, in particular, through the IMF and World Bank, but also the various nations that the Clinton administration has pledged to assist. These include the U.S. policies to “westernize the former USSR” and support other countries like Haiti, Bosnia, Somalia and Kuwait.
These Bank Credit Instrument programs designed under the Kennedy administration are still very effective to assist in recycling and redistributing USD to meet the world’s demand for commerce. Most importantly, through the Federal Reserve Bank, the U.S. Government uses these programs to control the dollar and its value in the world market. In summary, the use of these Bank Credit Instruments provides instant liquidity and safety. They are a principal factor, which has served to prevent another financial crisis in the world economies.
FORFEITING MARKET
Euro-based, the Bank Credit Instrument trading industry has been operating for a very long time. However, is often misunderstood in the United States. By definition, these transactions are part of trade and project finance. The discounting method used is linked to the forfeiting market, a subset of export/import trade finance. Forfeiting is derived from the French term, “a forfeit”, which means to forfeit. In a forfeit transaction the exporter or borrower, after pledging acceptable notes or bills, forfeits his rights to future payments from the notes or bills and the funder by accepting the notes or bills forfeits his rights to recourse to the exporter/borrower in the event of non-payment from the guarantor of the notes or bills. This method was devised to finance exports of capital goods from West German manufacturers to the growing markets of Eastern Europe, which were opening up in the late fifties and early sixties.
Short of hard currency for such imports, the East Europeans declared that they could not operate within the restraints of the traditionally acceptable three to six month credit periods, and sought credit for five to ten years, with semi-annual payments. The inherent financial and political risks of the Eastern European bloc countries were too vague and uncertain for the West German exporters. They also needed speedy cash settlements in order to invest in projects like installing new capital equipment or expanding their factories. Therefore, they had to seek refinancing in order to operate in this new and vital export market. In addition, the West German exporter’s bankers also considered Eastern Europe as “too risky”, and felt that the requested credit periods were too long, especially at fixed rates of interest.
Consequently, a group of financiers in Switzerland decided to do what the West German banks would not, i.e., discount the promissory notes or bills of exchange without recourse to the exporter, a financial commitment that became known as forfeiting. This meant that if the importer or his bank failed to pay on the due dates, this would not be the problem of the exporter, but the forfeiting house (usually Swiss Banks), which had financed this transaction without recourse and therefore, had taken over the commercial venture. This resulted in the Swiss market being developed. Zurich became the center for such transactions in the Sixties, thus assisting the West Germans’ economic revival.
London however has always been the main financial center for international banking and in the early seventies some London-based banks decided to enter into this field. Their efforts prospered and resulted in causing them to overtake the Swiss and London is now considered the premier center for this type of business.
The advantages of this type of financing and trade for a business/venture, are in the presentation of a low to no-risk loan, or for buy/sell transactions. Many countries across the world have financed their government and infrastructure development requirements through these transactions with the approval, of course, of the G-7 nations.
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