Financial Markets Operations Management

By Keith Dickinson

A comprehensive text on financial market operations management

Financial Market Operations Management offers anyone involved with administering, maintaining, and improving the IT systems within financial institutions a comprehensive text that covers all the essential information for managing operations. Written by Keith Dickinson—an expert on the topic—the book is comprehensive, practical, and covers the five essential areas of operations and management including participation and infrastructure, trade life cycle, asset servicing, technology, and the regulatory environment. This comprehensive guide also covers the limitations and boundaries of operational systems and focuses on their interaction with external parties including clients, counterparties, exchanges, and more.

This essential resource reviews the key aspects of operations management in detail, including an examination of the entire trade life cycle, new issue distribution of bonds and equities, securities financing, as well as corporate actions, accounting, and reconciliations. The author highlights specific operational processes and challenges and includes vital formulae, spreadsheet applications, and exhibits.

• Offers a comprehensive resource for operational staff in financial services
• Covers the key aspects of operations management
• Highlights operational processes and challenges
• Includes an instructors manual, a test bank, and a solution manual

This vital resource contains the information, processes, and illustrative examples needed for a clear understanding of financial market operations.

• Language: English
• Publisher: Wiley
• Release date: Jan 20, 2015
• ISBN: 9781118843901

Book preview

Preface

I have been involved in Operations for over forty years as a practitioner, an executive education trainer and university lecturer. In my practitioner days, there was very little by way of reference books that addressed Operations; in addition, the Internet had yet to enter our collective consciousness. As a consequence, it was difficult for those working in Operations to find any literature that dealt with their topic.

Today, we can research any topic we choose, including Operations, by accessing the Internet, clicking through websites managed by exchanges, depositories, custodians, regulators and various trade associations. In spite of this, and with one or two notable exceptions, there is a dearth of books that enable Operations professionals to navigate the settlement and post-settlement environment for securities and derivatives.

This book, Financial Markets Operations Management, fills that information gap.

The intended audience is fourfold. Firstly, the text may be used in a teaching context as a course reader for staff already working in an operational environment. Secondly, as a reference guide for students taking a financially focused first degree or Masters course. Thirdly, for staff working in non-operational areas that are interested in what happens after the trade has been executed. Finally, for those who are about to enter the financial world or who simply have a passing interest in the subject, this book is for those readers.

The text covers the trade lifecycle for securities and derivatives products from trade capture, pre-settlement and settlement through to the custody of assets and asset servicing. It is divided into four parts, as follows:

Part One: An understanding of operations in the context of financial instruments, data management and the different types of organisation.

Part Two: The post-trade processing of financial instruments; trade capture, clearing and settlement.

Part Three: The post-settlement environment of safekeeping, asset servicing and asset optimisation.

Part Four: A consideration of two key controls – accounting for securities and asset reconciliation.

Chapters are broken down as follows:

Chapter 1 looks at the organisational structure of a typical investment company and at the Operations Department in particular. We consider the internal and external relationships that Operations manage.

Chapter 2 defines the main financial instruments, explains the operational features and shows the transaction calculations including accrued interest for bonds.

Chapter 3 considers the importance of data and its management.

Chapter 4 explains how the various intermediaries and market infrastructures enable lenders and borrowers to operate.

Chapter 5 starts the post-trade processing phase by looking at the clearing systems and distinguishing between clearing houses and central counterparties.

Chapter 6 continues looking at the infrastructure and in particular the securities depositories.

Chapter 7 follows the initial post-trade processes of clearing and the pre-settlement forecasting of cash and securities.

Chapter 8 describes the different types of settlement including delivery versus payment, the reasons why trades fail to settle and what actions can be taken to manage the fails.

Chapter 9 changes focus from securities to derivatives with a look at how exchange-traded and over-the-counter derivative products are cleared.

Chapter 10 looks at the safekeeping of securities including the use of nominee names and the relationships between the beneficial owner and the securities issuer, together with the intermediaries such as custodians and securities depositories.

Chapter 11 introduces the reader to what is considered to be the most risky area within Operations – corporate actions. This chapter looks at the complexities, processing requirements and information flows of this topic.

Chapter 12 describes the different forms of securities financing and includes user motivations and the lifecycle. Securities financing is not risk-free; this chapter addresses the risks and the ways in which these risks are mitigated.

Chapter 13 looks at the impact of securities transactions on the Profit & Loss Statement and Balance Sheet together with the transaction lifecycle from an accounting perspective.

Chapter 14 explains the importance of efficient and timely asset reconciliation and how it might be used as a predictive tool to prevent problems from occurring.

To cover the entire operational spectrum would require a text containing many hundreds, if not thousands, of pages. In order to overcome this problem I have concentrated on what I consider to be the main operational processes for securities and derivatives. Whilst I do not cover every type of equity, bond and derivative, there is sufficient detail to enable the reader to understand what happens in the engine room of the financial markets, i.e. after the trade is executed.

Therefore, I have not included regulation other than by occasional reference. We are subjected to regulation for a variety of reasons – for example, to maintain confidence in the financial system – and it is both complex and technical. Furthermore, in a global context, there are different and sometimes conflicting regulations from country to country.

I have also excluded commodities for two reasons. Firstly because in the physical world, types of commodities behave in different ways – think of the processes that enable you to pump petrol/gas into your car or electricity to light up your home. By contrast, commodities derivatives are cleared in similar ways to financial derivatives. Secondly, there is already an excellent book written by a friend and colleague, Neil Schofield.1

Finally, this book does not cover funds administration. This relates to activities that support the running of a collective investment scheme (for example, a traditional mutual fund, hedge fund, pension fund, unit trust or similar variation).

In any event, there is more than enough material within the regulatory, commodities and funds administration world for an additional three books.

Students and instructors can find additional resources at www.wiley.com.

NOTE

1 Schofield, N. C. (2007) Commodity Derivatives: Markets and Applications. Published by Wiley Finance (ISBN 978-0-470-01910-8).

Acknowledgements

Thanks to John Evans, FMT, who suggested the idea of writing the book, and to Colin Hill, Shelby Limited, who reviewed the first draft of the manuscript. At Wiley, I'd like to acknowledge the work of Development Editor Meg Freeborn, Acquisitions Editor Thomas Hyrkiel, Assistant Editor Jennie Kitchin, Senior Production Editor Tessa Allen and Copy-Editor Helen Heyes.

PART One

CHAPTER 1

Introduction to Operations

1.1 INTRODUCTION

For every action there is a reaction. For every transaction, there has to be an appropriate sequence of processes such as a payment, a delivery of an asset, an exchange of information or a combination of these. We refer to this as an operational process. In this introductory chapter, we will see how an investment company's Operations Department relates to other departments within the company and other external organisations.

Firstly, we need to distinguish the operations of an organisational entity and the entity's post-transactional operations.

What do the following types of business actually do?

Vineyard?

Publisher?

Hotel?

Insurance company?

In simple terms, these businesses produce something (often referred to as outputs):

Vineyards produce wine;

Publishers produce books, newspapers and computer software;

Hotels produce satisfied customers;

Insurance companies help customers reduce their financial risks.

These outputs are the results of the transformation of a variety of inputs, including some of the following (the list is not exhaustive):

Vineyard – grapes, yeast, water, sugar, etc.

Publisher – authors, ideas, paper, digital resources, etc.

Hotel – premises (rooms, dining areas), food, staff (front of house, catering, cleaning), ambiance, etc.

Insurance company – products, sales staff, research & development staff, distribution channels, etc.

This is what businesses do; we know this as the business operations and the transformation of inputs into outputs are how each business operates.

Q&A

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Question

An investment company is also a business operation. What do you think are the inputs and outputs? How might an investment company be profitable?

Answers

Table 1.1 gives the answers.

TABLE 1.1 Inputs and outputs of an investment company

What is missing here is the processing that occurs after the inputs have taken place. A trader executes a transaction; the decision-making that led to the requirement to transact, the negotiation with a counterparty and the final execution of the transaction are all part of the business operation. What happens next is the completion of that deal. By completion, we mean the settlement, the exchange of the financial instrument for cash. This processing, this completion, is what financial market operations is all about. It is what we in the Operations Department do.

There is, therefore, a distinction between the operations of a business and Operations in the sense of processing most of the inputs. In this opening chapter you will learn:

How an investment company is typically structured;

What the departments' roles are;

What relationships Operations have with internal departments and external entities;

Other service functions within the business.

1.2 ORGANISATIONAL STRUCTURE OF AN INVESTMENT COMPANY

There is no right or wrong way to organise the structure of an investment company. It depends on the size of the company, the products in which it deals and the locations of its offices.

The biggest companies, for example the investment banks, will have several thousand staff located in offices based around the world. By contrast, the smallest, such as a hedge fund, might have less than 100 staff working from one office.

What is usually certain is that there will be one department that generates business for the company and one that ensures that the business is administered in an efficient, controlled, timely and risk-free manner. In many companies there will be a third department that supports these two.

We refer to these three departments or offices as follows:

Front Office – the business generator;

Middle Office – the administrator;

Back Office1 – the supporter.

1.2.1 Front Office

The Front Office generates revenue and is responsible for the buying and selling of financial products.

Within the Front Office (see Figure 1.1) there are generally five areas:

Corporate Finance – This area helps clients to raise funds in the capital markets and advises clients on mergers and acquisitions. Corporate finance can be divided into industry coverage (e.g. financial institutions, industrials, healthcare, etc.) and product coverage (e.g. leveraged finance, equity, public finance, etc.).

Sales – The sales desk will suggest trading ideas to clients (institutional and high- net-worth individuals) and take orders. Orders must be executed at the best possible price and this can mean placing an order internally or with an external trading desk.

Trading – The trading desk (aka the dealing desk) executes trades on behalf of the investment organisation (known as principal, proprietary or own-account trading). The traders can take both long and short positions in financial instruments that they have been authorised to trade in. This desk also executes trades on behalf of the sales desk, as noted above.

Repo Desk – The repo desk supports the traders by helping to finance their positions. When the traders go long, they need to borrow cash. The repo traders borrow cash through repo. Conversely, when the traders go short, they need to borrow securities. The repo traders borrow securities through reverse repo.

Research – Research is undertaken for a variety of reasons. For example, equity research review companies write reports about their prospects and make buy, sell or hold recommendations. Predominantly, research is a key service in terms of advice and strategy; it covers credit research and fixed-income research amongst others.

FIGURE 1.1 Investment organisation – structure

There are other, similar types of Front Office used by organisations, such as:

Stockbrokers – These act in an agency capacity on behalf of clients. They can offer execution only (without any advice) brokerage, non-discretionary services (provide advice but can only trade subject to a client's instructions) and fully discretionary services (the broker decides what to do based on the client's overall investment objectives without seeking case-by-case instructions).

Market makers – These make their money by using their company's capital to quote bid and offer (buy and sell) prices in pre-specified securities. Market makers are obliged to make a two-way price in any and all market conditions.

Investment managers – These use their clients' cash to make investment decisions in accordance with the clients' investment objectives. Having made the investment decisions, orders are placed with their brokers for execution in the market.

Broker/Dealers – These can act as both a dealer (trading for the organisation's own account) and as a broker (on behalf of clients).

Inter-dealer brokers – These are specialised intermediaries that execute transactions on behalf of sell-side institutions such as broker/dealers and market makers. The IDBs provide anonymity so that the market is not aware of the sell-side institution's positions.

In whatever capacity it is acting, the Front Office executes transactions either on a stock exchange or in the over-the-counter (OTC) markets.

1.2.2 Middle Office

Not every investment company is obliged to have a Middle Office, but the larger the company, the more likely it is to have one. The Middle Office is the link between the Front Office and the various operational departments (see Figure 1.2).

FIGURE 1.2 Investment organisation – structure

It both supports and controls output from the Front Office; it ensures that any trade is correctly booked and the economic consequences of the trade comply with various pre-agreed limits, for example:

The value of the trade must be within counterparty limits;

The value of the trade must be within the trader's limits;

The trader must be authorised to trade that asset.

The Middle Office monitors existing trades and identifies any that do not meet these limits. Assets held in the dealers' blotters should be checked and revalued daily. The Middle Office needs to ensure that pricing data are correct and investigate prices that do not look right.

The Middle Office will exchange confirmations of executed trades with the counterparties and, where necessary, identify discrepancies, obtain the dealer's confirmation of the change and update the trading systems accordingly. Changes cannot be made without reference back to the trading floor, as it could appear that the Middle Office is actually trading rather than simply making a correction to a trade.

As part of the monitoring process, the Middle Office ensures that all the trades executed during one particular day are fully booked in the system, that valuations have been made and that reports have been produced.

Q&A

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You work in the Middle Office of Masham Dealers (account number 859327) and the following transaction appears on your system:

Purchase: USD 1 million ABC 5% bonds due 15 September 2021

Price: 99.1250 plus 72 days of accrued interest (Annual, 30/360)

Trade date: 30 June 2015

Settlement date: 03 July 2015

Counterparty: Skipton Bank Limited (account number 132546)

Total cost: USD 1,031,125.00)

A few moments later, the confirmation arrives from your counterparty:

Confirmation from: Skipton Bank International (account number 132654)

Sale: USD 1 million ABC 5% bonds due 15 September 2021

Price: 99.0625 plus 72 days of accrued interest (Annual, 30/360)

Trade date: 30 June 2015

Settlement date: 03 July 2015

Counterparty: Masham Dealers (account number: 859327)

Total cost: USD 1,030,625.00

Question

What, if anything, is wrong with the confirmation, who is correct and what action would you take?

Answer

There are two discrepancies:

Counterparty – you have Skipton Bank Limited and the incoming confirmation has come from Skipton Bank International. Although both counterparties are from the same banking group, they are different counterparties.

Price – You have 99.1250 and they have 99.0625.

There is no sure way of knowing what the correct situation should be:

Counterparty – You may have traded with both entities in the recent past, so either might be right.

Price – If the market was showing 99.140625 (bid) and 99.203125 (offer) at the time the trade was executed, whose trade is more likely to be correct? If we are the sell-side (and therefore Skipton the buy-side), our price looks more likely to be correct. As the sell-side dealer, we would purchase at close to the bid (i.e. lower) price.

Our only course of action is to talk to the trader concerned and get him or her to check the details by contacting, if necessary, the counterparty dealer. Our dealer will have to authorise any alteration to the contract. Then, and only then, can you make the corrections in the system.

In most cases where there are discrepancies in transaction details, the Middle Office would have to investigate with the Front Office. In Table 1.2 there is a list of typical types of query together with the department that is responsible for making any changes.

TABLE 1.2 Primary responsibilities for resolving trade discrepancies

1.2.3 Back Office/Operations

For those organisations that do not have a Middle Office, the initial trade capture from the dealing systems would start here in the Operations area (see Figure 1.3). It is here that all the post-trade processing takes place, and this includes activities such as settlement of all transactions. Settlement requires the receipt and delivery of securities together with the payment and receipt of cash; as we will see later, we expect the movements of securities to occur at the same time as the corresponding movements of cash. We refer to this as delivery versus payment or receipt versus payment (DVP and RVP, respectively).

FIGURE 1.3 Investment organisation – structure

More often than not, securities held centrally in a type of organisation known as a central securities depository (CSD) are recorded as electronic records by the CSD. For this reason, Operations will also have responsibility for ensuring that when transactions settle, the correct amount of securities is either credited (for purchase) or debited (for a sale) at the relevant CSD.

Operations may or may not be a direct participant within a CSD; if not, Operations will make use of an organisation such as a custodian bank that does have direct participation with the CSD. So we now have a custody or safekeeping responsibility in addition to settlements.

As we will see throughout this book, many of the operational responsibilities refer to the processing and final completion of transactions that have come out of the Front Office. There are other aspects to consider as well:

Monitoring and control – Operations must make sure that any payments and deliveries are made with the appropriate level of authorisation. Authorisation can include a tested telex, an authenticated email, an authenticated fax, a signed (and possibly countersigned) hardcopy instruction or a message delivered through a secure and automated electronic messaging system such as SWIFT.

Reconciliation – This is a key control designed to ensure that the organisation can verify that assets recorded in the books and records of the organisation agree with external statements received from counterparties, banks, custodians, etc.

Protection of revenues – Revenues are generated in the Front Office and there will be certain, known costs that each transaction will be subject to. Examples of these costs can include brokerage fees, transaction fees, custody charges, clearing fees and stamp duty.

These represent the cost of doing business; however, if there are processing errors, there is every likelihood that there will be penalty costs associated with this. In a perfectly efficient environment where no mistakes are made, there should be no need for any penalty costs to be incurred. If, for example, a payment is made late, then it is quite possible for the interest charge to be greater than the profit made on the underlying transaction. Operations staff members have to pay great attention to detail in their attempts to avoid problems such as these.

1.3 OPERATIONS' RELATIONSHIPS

The Operations Department does not and cannot operate in isolation. It has to maintain relationships with many different types of organisation including:

Clients – external;

Clients – internal;

Counterparties;

Suppliers;

The authorities.

1.3.1 Clients – External

These are your fee-paying clients; you provide a service for which you are compensated. Table 1.3 lists some examples.

TABLE 1.3 Examples of external clients

You could be in contact with your clients on a regular basis for a variety of reasons, such as responding to their queries, taking instructions for an optional corporate action events and sending them securities and/or cash statements including evaluations and performance-related information.

1.3.2 Clients – Internal

Internal clients would include your colleagues in other departments such as the Front Office. The Front Office looks to you for reports and you look to it for decisions on certain types of transaction query or voluntary corporate action event. Therefore, this relationship is based on information swapping rather than fee generation. Other business functions (see below) would also be regarded as internal clients.

1.3.3 Counterparties

The term counterparty can have two meanings. On the one hand, a counterparty is one party to any transaction and your organisation is the second party. The term can also refer to any legal entity to which you could be exposed financially (this is known as counterparty or credit risk).

Please refer back to the transaction that Masham Dealers entered into with Skipton Bank Limited. In this case you would regard Skipton Bank as your counterparty with whom you had exchanged confirmations of the trade in ABC bonds and whom you would have contacted as a result of the discrepancies in the contract terms.

Regardless of how competitive the business is, it is always a good idea to maintain good working relationships with your counterparties.

In our example we would have a financial exposure to Skipton Bank.

Q&A

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Question

What exposure(s) might you be exposed to?

Answer

If we pay Skipton Bank on the settlement date and the bank fails to deliver the bonds to us, we run the risk that the bank might decide not to deliver the bonds to us or that it has gone into default and is not able to. We call this counterparty risk, and it is a variation on the term credit risk.

If, however, we agree to receive the bonds against payment and the bank is unable or unwilling to deliver, then we retain the cash. This is a lower type of risk, settlement risk, which might expose us to market risk if we subsequently have to go back into the market and purchase the bonds at a higher price.

For this reason, our organisation would analyse any counterparty from a credit perspective and establish some trading limits with the counterparty. So long as the value of all our transactions with the same counterparty is within the limit, the organisation will be comfortable with this. These limits should be under constant review and if the creditworthiness of a counterparty deteriorates, the trading limits should be reduced accordingly.

1.3.4 Suppliers

The financial markets depend on a wide range of intermediaries (suppliers) to enable investment organisations to do their jobs. Table 1.4 shows a small selection of typical suppliers.

TABLE 1.4 Typical suppliers

1.3.5 The Authorities

The final relationship is that with the various governmental and market organisations that have the power to regulate, supervise and censure organisations which come under their authority.

The majority of markets require organisations to be authorised in order to participate in certain regulated activities and to be subjected to regular inspections. Failure to meet requirements and breaches of the rules can expose organisations to financial penalties, public censure and even a restriction in their business activities.

Organisations must submit reports to their regulators and comply with their rule books.

Financial organisations are businesses that are liable to pay corporation tax on profits made. There therefore needs to be a good working relationship with the tax authorities in the organisation's country of incorporation.

Corporation tax is not the only tax to deal with; other taxes include:

Stamp duty, which might be payable in certain circumstances (typically on purchases of securities based on a pre-specified percentage of the market value of the transaction).

Withholding tax (WHT) is often deducted from dividends paid to shareholders. Depending on the shareholder's tax status, it might be possible to reclaim some or all of this tax. In which case, the Operations Department will have to submit reclaim documentation to the appropriate tax authorities.

Financial transaction tax (FTT), which is levied on certain types of transaction (stamp duty is one such example). The European Commission has proposed the introduction of an EU FTT that would impact transactions between financial institutions. The charge for equities and bond transactions would be 0.1% and derivatives contracts 0.01%. In 2011, it was expected that this FTT would raise EUR 57 billion annually.2 The proposal, supported by eleven EU Member States, has been approved by both the European Parliament and the Council of the European Union. Details, however, have yet to be decided.

1.4 OTHER BUSINESS FUNCTIONS

There are other business functions that work outside of the direct Front Office/Middle Office/Back Office triangle but are nevertheless important elements in a well-run investment organisation. Again, the exact management of these functions depends on the size of the organisation and how it chooses to run its own business.

These functions include:

Accounting

Compliance

Human Resources

Information Technology/Systems

Internal Audit

Risk Management

Treasury.

See Table 1.5 for details.

TABLE 1.5 Other business functions

1.5 SUMMARY

An Operations Department is the engine room of an investment organisation and the conduit along which transactions that have been executed in the Front Office flow.

Operations have a processing role – ensuring that these transactions are completed (settled) in an accurate and timely manner.

Operations also have a supporting role – they help the Front Office by reducing costs and making sure that any profits are not reduced through late interest claims.

Operations have a safekeeping role – ensuring that assets are held in custody and are only released on properly authorised instructions.

Operations do not work alone – they provide information to other functions and require resources such as staff (Human Resources) and cash (e.g. Treasury). To do this effectively, Operations maintain many different types of relationship, both internally (e.g. with the Front Office) and externally (e.g. with counterparties, clients, custodians, etc.).

NOTES

1 Although there is a logical progression from Front to Middle to Back, the term Back Office has been effectively replaced by the term Operations in today's lexicon.

2 Source: EU Inside (online). The EU Expects 57 Billion Euros a Year from a New Financial Tax. Available from www.euinside.eu/en/news/the-eu-expects-57-billion-euros-a-year-by-a-new-bank-tax. [Accessed Thursday, 10 April 2014]

CHAPTER 2

Financial Instruments

2.1 INTRODUCTION

Financial instruments are negotiable (i.e. they can be traded) assets that can be divided into cash instruments and derivative instruments. Cash instruments are issued in response to a legal entity, a corporate or a government raising capital and are either securities or loans. We will concentrate on securities.

Derivative instruments derive their value from the value and characteristics of one or more underlying entities, for example, a security, an interest rate or a market index. Derivatives are not created by the issuers of the underlying entity; rather they are created either by a derivatives exchange (known as exchange-traded derivatives – ETDs) or by participants in the market (OTC derivatives – OTCDs).

Another way to look at these examples is to consider the differences between the money markets and the debt and equity markets (both collectively known as the capital markets). We can differentiate the money markets from the capital markets on the basis of maturity, the credit instruments and the purpose of the financing (see Table 2.1).

TABLE 2.1 Money market and capital market differentiators

2.2 WHY DO WE ISSUE FINANCIAL INSTRUMENTS?

As we are going to see in this chapter, there is a great variety of financial instruments, each with a varying degree of complexity from an operational point of view. For what purpose, though, are these instruments issued?

Entities that issue financial instruments do so for one fundamental reason and that is to raise capital. If you take a look at a company's annual report and accounts, you will notice on the Balance Sheet that the company has assets that are matched by liabilities. Assets are what the company owns and liabilities reflect the ways that the assets have been financed. Depending on the individual circumstances, a company can finance its assets by issuing securities (equity, bonds, etc.), borrowing cash or a combination of both.

The type of securities issued depends on the purpose for which the cash is being raised and the time horizon for which the cash is needed. Table 2.2 shows some examples.

TABLE 2.2 Purposes and time horizons of securities

A soft benefit of issuing securities is that the issuer gains a presence in a particular market; there is a certain cachet for a company that has its shares listed on a major stock market, such as Tokyo, New York or London.

One of the features of equity and bonds is that these are negotiable and the investor community is free to buy and sell these instruments under rules and regulations laid down in the markets where the instruments are issued. We refer to this as a secondary market.

Investing is an inherently risky business. The market price might move away from the investor, resulting in a loss if the investor decides to sell the asset. It is also risky in the sense that the issuer might default, leaving the investor with a worthless asset, and risky in the sense that the benefits of ownership may either not be received or not be as high as expected.

By contrast, derivative financial instruments are issued by the market rather than the issuer of the underlying asset from which the derivative derives its value. The market issues and uses derivatives for a number of purposes, including:

To hedge an existing position in a related underlying asset;

To obtain exposure to an underlying asset;

To create an option of doing something;

To speculate and make a profit.

It is not the purpose of this book to teach you about the reasons why entities issue debt and equity securities; there are excellent books that fulfil this purpose. Rather, it is to illustrate that the ways in which we administer financial instruments are determined by some of the features of these instruments. The main learning objective is to know enough about any particular instrument to enable you to understand the main processes within a settlements or custody or asset servicing context.

By the end of this chapter you should be able to:

Define the different types of financial instrument;

Describe the operational features of these instruments;

Calculate accrued interest on debt securities using the correct day-count conventions;

Calculate the transaction amounts of a selection of financial instruments.

2.3 MONEY MARKET INSTRUMENTS

Together with the capital markets, the money markets form the financial markets. The main distinction between the two is that the money markets focus on short-term debt financing, whereas the capital markets focus on the longer term through the issuance and subsequent trading of equity, bonds and all the other types of securities.

In this section, we will look at the main money-market instruments including deposits, coupon securities (such as certificates of deposit) and discount securities (such as treasury bills and commercial paper). Due to the short-term nature of these instruments, interest can be paid to the lender in one of two ways:

Instruments are issued at a discount to their face value and, on maturity, the repayment will be at par (i.e. the face value). We refer to these as discount instruments.

Instruments are issued at their face value and mature at par together with interest. We refer to these as accrual instruments.

2.3.1 Euro-Currency Deposits

Any currency that is traded outside the country of the currency is referred to as a Euro-currency trade. For example, if you are a dealer based in Tokyo wishing to borrow US dollars, you would be borrowing Euro-dollars.

Euro-currency deposits are non-negotiable and there is no secondary market as such. Title to a deposit cannot be assigned or transferred without the approval of the lender and borrower. This makes it a rather complex situation if either party wishes to liquidate the deposit; the normal practice if one party wishes to cancel the deposit is to enter into an equal-and-opposite transaction for the same maturity.

Euro-currency rates are quoted on a percentage per annum basis based on inter-bank offered rates and bid rates. Traditionally, the key benchmark rate has been the London Interbank Offered Rate (LIBOR – the rate which the market charges to lend money) and the London Interbank Bid Rate (LIBID – the rate which the market pays for taking money).

LIBOR and LIBID rates for the major currencies (see Table 2.3) are fixed every day in London by groups of banks known as panel banks (see Table 2.4) across a range of maturities (see Table 2.5).

TABLE 2.3 British Bankers' Association – LIBOR currencies

Source: www.bbalibor.com.

TABLE 2.4 Panel banks for EUR LIBOR

Source: www.bbalibor.com.

TABLE 2.5 Range of maturities

Fixing, Value and Maturity Dates

When a deposit is transacted, there will be a difference between the dates on which the transaction is executed (the fixing date), the start date of the deposit (the value date) and the finish date of the deposit (the maturity date).

In general, there are two business days between the fixing date and the value date. The maturity date will be the number of days/months after the value date, as noted in the transaction (e.g. three months). In the BBA's LIBOR guidance notes, the period between the fixing and the value date for the ten currencies is as noted in Table 2.6.

TABLE 2.6 Period between fixing and value dates

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