Financial Markets Operations Management (19 page)
Read Financial Markets Operations Management Online
Authors: Keith Dickinson
A central bank (also referred to as a
reserve bank
,
monetary authority
or
bank of
The main functions of a central bank usually focus on the following:
- Controlling the issue of notes and coins;
- Controlling the money supply;
- Controlling non-bank financial institutions that supply credit;
- Overseeing the financial sector to prevent crises;
- Acting as lender of last resort to the banking sector;
- Acting as the government's banker;
- Acting as the government's agent in dealing with its gold and foreign exchange matters;
- Holding the government's gold and foreign exchange reserves.
Of these functions, the most important is undertaking monetary control operations, which can be sub-divided into the following three tools:
- Open market operations:
The money supply is increased by the central bank buying government securities (and/or using reverse repo agreements) and decreased by selling securities (and/or using repo agreements). - Discount window:
The central bank can influence the amount of cash borrowed by the banks by changing its discount rate. The higher the rate, the less cash the banks will usually decide to borrow; the lower the rate, the greater amount of cash borrowed. - Reserve requirements:
Banks are required to hold minimum levels of reserve. The greater the required reserves, the less lending the banks can engage in; the lower the reserve requirement, the more lending the banks can undertake.
Cooperation amongst the central banks has been centred on the Bank for International Settlements (BIS), an institution established in 1930 and, according to its website: “⦠the world's oldest international financial institution⦔. Its mission is to: “⦠serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks”.
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A list of websites for central banks and monetary authorities can be found at
www.bis. org/cbanks.htm
.
In this section, we will look at a group of institutions that are neither banks nor corporations. These institutions are closely linked to governments in one way or another but are not regarded as being governments. Predominantly net borrowers, they can also be investors. Finally, they can be implicitly or explicitly guaranteed by their government and, for this reason, often attract a top-level credit rating.
The institutions fall into three categories:
- Municipalities;
- Government agencies;
- Supranational agencies.
Municipalities (local government, local authorities) generate revenue through local taxation and by funding themselves in several ways:
- Borrowing through central government;
- Borrowing from the banks;
- Raising capital in the bond markets by issuing bonds (known as municipal bonds or “munis”).
If a municipality issues a bond to pay for general purposes, these are referred to as
general securities
and serviced out of general taxation. If the municipality wishes to fund a specific
project, the bonds are known as
revenue securities
. Here, it is expected that the project will generate sufficient cash to service the debt, for example, financing the construction of a toll motorway by issuing a bond and paying the interest and final redemption through the tolls levied on the motorway users.
Municipalities manage their cash and any excess liquidity in the money markets. They also use interest rate derivatives such as swaps to manage their risk. They do not tend to invest in the equity markets.
Governments establish agencies typically for a particular purpose, for example an infrastructural project such as the high-speed rail link, known as High Speed 2 (HS2) between London and the north of England. The project is being developed by High Speed Two Limited, a company limited by guarantee established by the UK Government and the projected cost is estimated to be GBP 42.6 bn, with the Institute of Economic Affairs forecasting the cost to rise to over GBP 80 bn.
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In fact, the first Eurobond was issued in 1963 by an Italian agency, the Autostrade Concessioni e Contruzioni. Bonds issued by these agencies are implicitly or explicitly guaranteed by the government.
Perhaps the most well-known agencies are the US mortgage agencies: the Federal National Mortgage Association, the Government National Mortgage Association and the Federal Home Loan Housing Corporation. All three are known in the markets by their colloquial acronyms: Fannie Mae (FNMA), Ginnie Mae (GNMA) and Freddie Mac (FHLHC). The basic details of these three agencies are shown in
Table 4.17
.
TABLE 4.17
US mortgage agencies
| Agency | Purpose | Comments |
| FNMA | Its purpose is to buy mortgages from mortgage lenders. This is funded by borrowing in the capital markets. | Privately owned, government-sponsored agency. Bailed out by the US Government in 2008 and placed into government conservatorship. |
| GNMA | Its purpose is to enable mortgages for affordable housing and it was an innovator in the mortgage-backed security market. | A government-guaranteed agency. |
| FHLHC | Same business model as FNMA. | Was also placed into government conservatorship in 2008. |
These are agencies owned by more than one government, which, like the other types of agency we have looked at, borrow in the capital markets to raise capital for developing projects either in a specific region or globally. The shareholders of these agencies are countries rather than corporate/retail investors and, as such, are regarded as public bodies. These agencies provide their support to the relevant projects either by lending money or making grants.
The supranational agencies are prolific borrowers in the bond markets and significant investors, using the money markets and FX markets to manage their reserves. The major agencies are listed below, and ownership and purpose details are shown in
Table 4.18
.
- The World Bank;
- The European Investment Bank (EIB);
- The European Bank for Reconstruction and Development (EBRD);
- Inter-American Development Bank (IADB);
- Asian Development Bank (A
s
DB); - African Development Bank (A
f
DB).
TABLE 4.18
Supranational agencies
| Agency | Ownership | Purpose |
| World Bank/International Bank for Reconstruction and Development (IBRD) | Any country member of the International Monetary Fund, with shareholdings based on their economic status. | Supports projects in poor and medium-income countries. |
| World Bank/International Development Agency (IDA) | Supports the poorest countries. | |
| EIB | Owned by the EU countries. | Supports projects mainly in the European region and other areas (to a lesser extent). |
| EBRD | Owned by 61 countries, mainly European but also non-European plus the EU and the EIB. | Provides loans and trade finance especially in central and eastern Europe. |
| IADB | Owned by 48 countries including the USA (30%), 26 borrowing Latin American and Caribbean countries (50%) and 20% by 21 non-borrowing countries, such as Germany and Japan. | Provides loans, grants and guarantees for Latin America and the Caribbean countries. |
| A s DB | As with the IADB, membership comes from a group of international and local countries. | Provides loans, grants and guarantees for Asian countries. |
| A f DB | As with the IADB, membership comes from a group of international and local countries. | Provides loans, grants and guarantees for African countries. |
The World Bank tends to borrow in many currencies, using derivatives to turn them into US dollars, in contrast to the EBRD, which prefers to borrow in the local currencies of the
countries in which the projects are taking place. By far the biggest borrower is now the EIB (previously it was the World Bank).
In market terminology, we use the term
sell side
to refer to those firms that either sell to the investor side of the industry (known as the
buy side
) and/or trade on their own behalf. This section defines the different sell-side intermediaries and briefly describes their roles in the market.
It is generally not possible for the buy side to access the markets directly. Instead, buy-side investors will make use of brokers for this purpose. Also known as stockbrokers, these agents provide a number of services to their clients, including:
- Advising clients on which investments to make;
- Executing transactions based on their clients' instructions (non-discretionary);
- Executing transactions on behalf of their clients (discretionary).
Brokers do not invest their own firm's capital; their prime role is to act on behalf of their clients. Brokers make their money by charging brokerage fees based on the market value of the transaction. The fee structure will reflect the level of service offered to their clients.
Dealers and traders (the terms are synonymous) trade on behalf of their firm. They are free to trade in any markets and in any product subject to their own internal authorisations and limits. They are under no obligation to trade in any particular market or product. Dealers make their money by buying at a lower price than that at which they sell (“buy low, sell high”). The difference between the buy price and the sale price is known as the
spread
or
margin
; the wider the spread, the greater the profit (or loss). In highly competitive markets, this spread will tend to narrow.
Market makers are similar to dealers and traders, in that they invest their firms' capital in securities. The big difference, however, is that market makers are obliged to make a market (quote a bid-offer price spread) and to execute transactions with buyers and sellers subject to price agreement.
This obligation to make a two-way price in securities in which they make markets can become quite onerous; for example, if share prices are going down, investors might wish to sell their securities. For the market makers, this means that they are buying shares and seeing the share price continuing to go down. In addition, they have to pay for the shares and that will require some form of financing. By contrast, if the market is going up, investors might wish to buy and the market maker will be obliged to sell. If they do not hold the securities, then delivery becomes impossible; in this case, the market maker needs access to securities borrowing facilities in order to complete the delivery.
For the very large issuing companies, several competing market makers will make prices in the securities; this makes it very competitive and helps to narrow the bid-offer spread. Market makers will adjust their prices to keep in step with the market and to persuade or dissuade investors seeking to execute a trade with them.
So far we have seen brokers acting on behalf of clients (but not for their own account) and dealers who trade for their own account. There are firms which act in both capacities, as a broker and separately as a dealer. This can lead to a conflict of interest.
In any event it is expected that there is a clear separation between the broker side of the business and the dealer side. We can refer to this “separation” as a
Chinese Wall
.
We have seen that it is quite possible to have several competing market makers for any one particular security. If one of these market makers were to attempt to cover a short position (because somebody wanted to buy from a market maker that had insufficient securities) and was unable to borrow the securities, then the only option would be to go into the market and buy the securities from another market maker. This would make it obvious what the former market maker's situation was and the latter market maker would certainly seek to benefit from this by quoting a high price. To avoid such a situation, the market maker would wish to remain anonymous to its competitors but still obtain the securities needed. What they require is an intermediary that can act as a broker to the market makers, and this intermediary is known as an
inter-dealer broker
(IDB). Trading through an IDB enables the market maker to fill its position without the rest of the market knowing who is
doing this.