Money market reports are an acquired taste. Few readers who are not in the money business will get completely to grips with their technicalities. But when the money markets are giving an important signal about likely trends in interest rates, a less technical interpretation of what is going on will probably appear elsewhere in the financial pages. Money markets are the markets in which money is borrowed and lent in large quantities for relatively short periods (often very short). Effectively they are a market in deposits and advances. But they are also a market in various forms of short-term security that are almost the equivalent of money.
Responsibility for the money markets is now divided (they used to be virtually the sole responsibility of the Bank of England). Supervision comes courtesy of the Financial Services Authority. The Debt Management Office (an executive agency of the Treasury) is responsible for managing the government’s own cash flows and for issue of Treasury bills (see below). And the Bank of England, as before, operates in the money markets to implement monetary policy and smooth out cash imbalances between the Bank and the private sector. But it also does considerably more than this nowadays.
Very shortly after the New Labour government came to power in 1997, it handed over operational responsibility for monetary policy to the Bank of England. Interest rate decisions had previously been made by the government and simply implemented by the Bank. As from 1997, the government retained the right to intervene only in exceptional circumstances and for a limited period. The Bank’s remit was to aim to hold the level of inflation, on a measure that excluded mortgage interest, at around 2.5 per cent. Since interest rates are the main instrument now used in the control of inflation, this means that the Bank’s decisions on lending rates are crucial.
The extent to which interest rates are determined by the market or dictated by the authorities (in this case the Bank) often gives rise to confusion. Basically, the position is as follows. Interest rates day to day are determined by supply and demand for money and by normal competitive pressures. The Bank of England does not directly dictate the rate that your bank charges on an overdraft! But private-sector commercial banks do, on occasion, need to borrow from the government via the Bank or may be put in a position where they need to do so (we will come to the mechanisms later). In other words, the Bank of England, as the country’s central bank, is lender of last resort to the banking system. The level at which it is prepared to lend, and the terms, can be used to influence the level of interest rates across the economy.
Figure 15.1 Short-term interest rates: nominal and real Short-term interest rates in Britain, as represented by the UK clearing banks’ base rate, reflect the country’s chequered economic history. The peak in 1975 reflects the runaway inflation of that period. The peaks in the earlier 1980s reflect the incoming Conservative government’s attempts to squeeze inflation out of the system (which resulted in a greatly over-valued exchange rate for sterling), while the peak at the end of the 1980s is witness to the medicine applied to compensate for the runaway Lawson (or Thatcher?) boom. The heavier line shows the level of real interest rates, when inflation is deducted. Note that, even with high nominal rates, real interest rates were often negative in the 1970s because of the very high inflation of that era. Source: Datastream.
Commercial banks are not willingly going to lend at a rate of interest below what they have to pay for money themselves. Thus, if the Bank of England raises the rate of interest at which it is prepared to lend money to the commercial banks, they in turn will normally need to push up the rates that they charge to customers. So a rise in the Bank of England’s lending rate will work its way right through the banking system and will, in practice, probably mean that the rate you pay on your overdraft goes up too. Commentators on the broadcast media in particular are often less than precise when they talk about ‘interest rates’ going up or down, without making it clear what interest rates they are talking about.
The body that makes decisions on interest rates at the Bank is the Monetary Policy Committee. It comprises four Bank members and four outside experts, plus the Governor of the Bank. Decisions are made on a majority vote, with the governor having a casting vote in case of deadlock. It meets once a month and its decisions are published immediately. About 13 days afterwards, minutes of the meeting are published. The press comments extensively on the likelihood of a movement in official interest rates ahead of each meeting. Later, the minutes also come in for close scrutiny because they show how much agreement or dissent there was among the members and may therefore give a hint as to the most likely outcome at the next meeting. As we have seen, market rates of interest will reflect demand and supply in the market for short-term funds, but will also, of course, reflect expectations about future official rate moves. The publication of the Committee’s minutes does help to lessen the uncertainties by providing an insight into its thinking.
One function of the money markets is to transmit official interest-rate decisions. Why else are money markets needed? They are a form of short-term counterpart to the long-term investment markets of the stock exchange. The stock exchange funnels long-term savings into long-term investment. The money markets allow money which is available for shorter periods to be directed to those who can use it, and also have the virtue of transmuting very short-term deposits into money which can be lent for longer periods. As we saw, they are not just a market in deposits but also in a variety of forms of short-term IOU or financial instrument which are close to money because they are marketable. In other words, they can be turned quickly into money by a sale in the market. We will look at these later.
So the money markets fulfil several functions. First, at any one time there will be some banks which have a very temporary shortage of money and others which have a surplus: money has been withdrawn from one bank and deposited with another. A mechanism is needed so that banks which are temporarily short can borrow the funds they need, and those with a temporary surplus can put it to work.
Second, banks will in any case want to hold a proportion of their funds in a form which allows them to get at it quickly if needed. This means putting it on deposit with other institutions or buying short-term financial instruments.
Third, while banks derive a large proportion of their sterling funds from the accounts of individual depositors (retail deposits), they also borrow in very large amounts from companies, financial institutions and local government bodies that have short-term surpluses of cash to put to work (wholesale funds). Likewise, these bodies borrow in the money markets when short of cash.
Finally, we come back to the money markets as a bridge between the government and the private sector. A mechanism is needed to iron out imbalances in the supply of money between the banking system as a whole and the government. There will be times when the commercial banking system is short of money because, for example, individuals or companies are withdrawing funds from their bank accounts to pay their tax bills to the government. But the authorities can also influence the amount of money available to the commercial banking system vis-a-vis the government by selling gilt-edged stocks or Treasury bills to the private sector, which has to transfer money to the government to pay for them. However, if these are sold directly to the banks rather than to the non-bank private sector (to individuals and organizations other than banking institutions or government bodies) they will not directly affect broad money supply since they do not act on the liabilities of the banking system.
Operations such as these can create a shortage of money in the banking system. For example, suppose the government issues gilt-edged stock for sale to the public (see Chapter 13 for the mechanisms). To pay for, say, £500m of stock the public would have to withdraw £500m from its deposits with the banking system. Therefore this money would leave the commercial banks and be paid to the government. All else being equal, a shortage of cash would be created in the banking system which the Bank could use to increase its influence on the commercial banks.
The money markets provide mechanisms to cope with all these differing requirements. They fall into two main parts (we are talking now of the sterling money markets – a market in foreign currency deposits exists alongside them). There is the market that provides the interface between the government and the private sector, which used to be known as the discount market when it operated rather differently in the past. And there is the market in money between private-sector institutions, sometimes referred to as the inter-bank market, though its clientele is not limited to banks.
In the past, a specialist kind of bank called a discount house used to act as a buffer between the commercial banks and the Bank of England in its money-market operations. The discount houses made a living by borrowing surplus short-term money from the commercial banks and using it to buy financial instruments such as Treasury bills, commercial bills of exchange and sterling certificates of deposit (these are all forms of short-term IOU which we look at later). The money the commercial banks lent to the discount houses was at call. In other words, the banks could ask to have it back when they needed it. This could pose a problem for the discount houses if they had already used the money to invest in bills of exchange. So the Bank of England stepped in. When the discount houses were short of cash they had the right to sell bills of exchange, Treasury bills and local authority bills to the Bank (rediscount them with – sell them at a discount to – the Bank). This amounted to lending by the Bank to the discount houses and provided them with the cash they needed. And this cash found its way in turn into the banking system as it was used to repay what the discount houses had borrowed from the commercial banks.
The mechanism is rather different today because a far wider range of banks and financial institutions now have a trading relationship with the Bank of England and the discount-house monopoly has gone. But the principles remain much the same. These approved institutions have the right, in effect, to take a loan from the Bank of England when they find themselves short of cash. They take the loan by selling financial instruments to the Bank, as before. But the range of financial instruments that the Bank will accept has been widened, notably by the inclusion of gilt repos (see Chapter 13) and Bank of England Euro Bills.
The crucial point in all of this is the rate of interest at which the Bank is prepared to lend to the commercial banks – its Official Dealing Rate - because this is what influences interest rates throughout the banking system. Nowadays, this rate is called the repo rate (we will come to the reason in a minute). So it is the repo rate that the Monetary Policy Committee announces after its deliberations each month and the repo rate is thus the measure of official interest rates in the UK. The Bank of England’s lending rate had different names in the past, including Minimum Lending Rate (MLR) and, further back, Bank Rate and you will still see these terms referred to occasionally. Do not, incidentally, confuse Bank Rate with Bank Base Rates, which are covered later in this chapter.
Because of the constant flow of funds from private-sector institutions to the government and vice versa, the two will rarely be in balance and this creates the need for the Bank’s open market operations. Early each working day the Bank of England estimates the likely size of the shortage or surplus in the money market on that day (a shortage is the amount by which the commercial banking system is likely to be short of money and will therefore have to borrow from the government) and may revise this estimate at later points in the day if necessary. Its estimates go out on the Reuters and Telerate screen information systems. It also publishes during the day the details of how it dealt with the shortage. It may have bought bills of exchange. It may have entered into arrangements to buy securities and sell them back later (repurchase agreements or repos) which act as a short-term loan. This is where we get the term repo rate, as it is effectively the rate of interest charged for this type of loan. These details will sometimes appear in the press’s technical money-market reports, which often make rather dry reading.
The market participants therefore know the rates at which the Bank will be prepared to deal in the market. And the Bank posts the rates at which it has conducted its open market operations immediately after the completion of each round of operations.
The discount houses got their name because they discounted bills of exchange: they bought them at a discount to their face value. To see how the bill market works we need to examine the mechanism more closely.
Bills of exchange are a form of short-term IOU widely used to finance trade and provide credit. They work like this. Company A sells £1m worth of goods to Company B. It ‘draws’ (writes out) a bill of exchange for £1m which it sends to Company B. This bill is an acknowledgement by Company B that it owes the £1m, and Company B signs it to show that it accepts the debt. The bill may state that the money is not payable until some date in the future: perhaps in three months. The bill returns to Company A.
Company A then has a choice. It can hold on to the bill, in which case Company B will pay it the £1m in three months. Or, if it needs the cash sooner, it can sell the bill to somebody else. Whoever holds the bill when the three months are up gets the £1m from Company B.
Bills of exchange do not pay interest. But if Company A sells the bill before it is due for payment, it will receive less than face value. In other words, it sells at a discount. Remember the basic principle once again: money receivable in the future is worth less than money you have today. So if the bill is due for payment in, say, three months, the buyer might pay only £98.50 for every £100 of face value. The buyer is thus getting a profit of £1.50 per £100 when the bill is repaid at face value, which is equivalent to receiving interest: the discount is usually expressed as an annual rate of interest. When the Bank of England is said to have bought bills at 5.5 per cent, it means that the Bank bought them at a discount to their face value which equated to an annual interest rate of 5.5 per cent. Thus if interest rates generally come down, the prices of bills will rise (the discount will be smaller).
The bill described above is a trade bill, issued by one company to another. But a bill may be accepted by a bank, in which case it becomes a bank bill. By putting its name on the bill, the bank agrees it will pay the amount of the bill on maturity, even if the company which acknowledged the debt should default: it is therefore a form of guarantee. Accepting bills in this way was an important part of the business of the UK merchant banks in the past, hence the term accepting houses which used to be used for the top-tier merchant banks. A bill accepted by a bank, because of the security it offers, sells at the very lowest interest rates (i.e. the highest price). Any monetary sector institution may accept bills, but the Bank of England only buys or lends against bills accepted by eligible banks, hence the term eligible bills. The Bank maintains a published list of eligible banks; in general these are banks which have a substantial and broadly based sterling acceptance business.
Bank bills also provide a substitute for overdrafts in big company financing. A company arranges an acceptance credit with a bank, which allows the company to issue bills up to an agreed limit. Each bill is accepted by the bank in return for a fee and can be sold at a discount to raise cash for the company. The effective rate of interest may be lower than on other forms of borrowing.
Treasury bills work in much the same way as commercial bills of exchange, but are issued by the government. They are sold at a discount, with an implicit rate of interest, via a weekly tender process, now managed by the Debt Management Office (it used to be the Bank of England). The amount supplied at the weekly tender varies to reflect government cash flows and to ensure a minimum stock of bills in issue. The Financial Times carries on a Monday a table with the result of the Treasury bill tender. As well as sterling bills issued by the DMO, bills denominated in euros are now in use. These euro bills are issued by the Bank of England.
Certificates of deposit (CDs) are a method of securitizing bank deposits. A company with spare cash deposits £500,000 with a bank. It agrees to lock the money away for a year, thus getting the best interest rate. The bank issues the company with a certificate of deposit for the £500,000, stating the rate of interest payable and the date when the deposit will be repaid. If the company needs its cash before the year is up, it can sell the certificate of deposit in the money market. The buyer acquires the right to receive repayment of the £500,000 bank deposit (plus interest) when the year is up. Certificates of deposit may, like Treasury bills and eligible bills, be bought and sold by banks and other money market participants. But unlike Treasury and eligible bills, CDs cannot be used in operations with the Bank of England, whereby the market obtains funds through the Bank’s open market operations.
The virtue of the certificate of deposit is that the bank (in our example) has acquired a deposit for a year and knows it will have a year’s use of the money. But the company which lent for a year and received the CD can in practice have its money back at any time by selling the CD.
We started with the market in which the Bank of England deals with commercial banks (the former discount market) because it illustrates how the Bank can influence interest rates. But banks wanting to borrow and lend money in the wholesale markets are not confined to dealing with the authorities. They also operate in the other sectors of the money market, in which banks, local authorities, institutions and companies can borrow from or lend to each other rather than dealing with the government. The largest and most important of these markets is the inter-bank market, where banks and others deal with each other, often through a money broker who puts the parties together in return for a commission. The market divides further into the sterling inter-bank market and the inter-bank market in foreign currencies, particularly the dollar.
There has been enormous expansion in the use made of the money markets by large companies in recent years. And the 1989 Budget introduced changes that helped to break down the distinction between money markets and the established debt securities markets (stock exchange and euromarket) by allowing the issue of financial instruments with a life of up to five years. Thus a company wishing to borrow for five years should have the choice of following the securities market route or the money market route. Whereas the securities markets are open to private investors, the wholesale money markets are very definitely a ‘professionals only’ area.
Commercial paper is another feature of the money markets and an example of the securitization process. For companies it offers an alternative to bank borrowing or to an existing form of short-term security: the bill of exchange.
In essence, commercial paper is just another form of unsecured short-term IOU, issued in bearer form. It is normally issued at a discount rather than paying interest, with an initial life of up to a year, though three months would be more common.
The sterling commercial paper market got under way in London in May 1986 and initially was open only to very large established companies. These conditions have subsequently been relaxed, opening the way for medium-sized companies to tap the market.
The issue process goes as follows. A company wanting to tap the market gets a bank to set up a programme for it: say, £200m. This defines the maximum amount that the company may have outstanding at any one time. At the same time dealers are appointed. When the company wants to raise cash it alerts the dealers, or the dealers may take the initiative by telling the company that there is demand among investors for paper of a particular maturity. The dealers, who are constantly in touch with potential investors, find buyers for the paper. The paper is sold at a discount to its face value which provides the equivalent of a rate of interest. The buyers may be institutions or companies looking for a short-term investment.
When the original issue falls due for repayment, further issues can be made to replace it. Thus, though it is a very short-term market, by rolling over issues in this way companies may use it as a medium-term source of finance. In addition to the sterling commercial paper market there is an active international equivalent – the eurocommercial paper market - where companies can similarly set up programmes, perhaps allowing them to issue in a number of different currencies.
There is also now a longer-term form of money market borrowing in the medium term note or MTN, which has a life of one to five years. Like commercial paper, it has its euromarket equivalent in the euro medium term note or EMTN.
The multiple option facility or MOF is another form of arrangement for tapping the money markets which was popular in the late 1980s and might possibly see a resurgence. It emerged in various shapes but a typical arrangement might have been as follows.
A company got one particular bank to put together a panel of banks who agreed to make available a certain amount of loans – say £150m – for a period of five years. The rate of interest, which would be variable, was set at such-and-such an amount above the benchmark rate of interest when the loans were taken up (say, 20 basis points over the London Inter-Bank Offered Rate or LIBOR - see below). This £150m was what was known as the committed facility or standby facility.
Another group of banks was put together, comprising the original banks plus others which were recruited. They formed a tender panel. When the company decided it needed cash, the tender panel banks were invited to bid to provide the funds. Those that were flush with cash at the time would have responded, and the bank or banks bidding the lowest rate of interest would have made the loans to the company. If none of the tender panel banks bid at a rate below that on the standby facility, the company would have resorted to raising the money via this standby. Thus it was sure of getting its cash when needed.
The loans made under this arrangement would probably have been short-term: say, for three months. But as one loan fell due for repayment new loans could have been arranged, so for the company it provided the equivalent of medium-term borrowing at a competitive rate of interest. The ‘multi-option’ refers to the fact that the arrangement allowed for the money to be raised in a number of different forms, which might have included straight loans, acceptances (bills of exchange), foreign currency loans and so on.
The money markets are also the home of many different types of instrument for limiting exposure to interest rate movements (hedging the interest rate risk). A cap is really an interest rate option. Say the benchmark interest rate is currently 6 per cent and you reckon a rise to over 8 per cent would seriously damage your business. You can buy a cap from a bank, under which you will be reimbursed for the effects of any increase in the benchmark interest rate above 8 per cent.
A floor is an option that works the other way. Suppose you agree with your bank that you will pay a minimum interest rate of 5 per cent, even if market rates drop below this level. The bank will pay you for agreeing this floor, in the same way as you pay the bank for providing a cap. So the proceeds from selling a floor can be used to offset at least part of the cost of a cap. An arrangement that includes both a cap and a floor is known as a collar or cylinder - it can be used to limit the interest you might have to pay within fairly narrow bands. Companies use these and similar instruments quite extensively to limit their interest rate exposure.
Perhaps swaps or interest rate swaps should be included in the same category of hedging instruments. For a description of how they work, see Chapter 17.
You will find in the Financial Times a list of the interest rates for deposits and different types of short-term financial instruments under the heading of London money rates. For each, a range of maturities is covered. Thus, in the case of inter-bank deposits there is a rate for overnight money, for money deposited at seven days’ notice, for a month, three months, six months and a year. You can plot the rates quoted for different maturities to produce a yield curve. Typically, this is a rising curve, showing that money deposited for short periods earns lower interest than money deposited for six months or a year. But when interest rates are expected to drop, there may be a negative yield curve with a lower rate of interest on money deposited for a year than money deposited for a month.
Example 15.1 Rates of interest on deposits and money-market instruments in London. Source: Financial Times.
The London money rates table shows the rates of interest on inter-bank deposits, sterling certificates of deposit, local authority deposits, discount market deposits, Treasury bills and bank bills.
Note that the inter-bank rate (sterling LIBOR) is a far better measure of short-term swings in interest rates than the bank base rates. The latter are the yardstick rates of interest quoted by the commercial banks, to which deposit rates and borrowing rates for private individuals are normally geared (see glossary for more detail). Base rates are changed relatively infrequently, and normally to reflect changes in official interest rates by the authorities. The inter-bank rate, on the other hand, is the constantly changing measure of the cost of money in large amounts for the banks themselves.
In addition to sterling interest rates, the Financial Times provides a table of short-term money rates in the other major economies together with the rate of US dollar LIBOR. Interest rates for currencies traded in the international market (including eurocurrencies – see Chapter 17) are also provided.
Example 15.2 Rates of interest in the domestic money markets of overseas countries. Source: Financial Times.
The rates of interest on floating rate bonds are usually geared to the inter-bank offered rate: the rate at which banks will lend wholesale to each other. A bond might carry a rate of interest of, say, 50 basis points above the inter-bank offered rate. A hundred basis points is equivalent to one percentage point, so 50 basis points is 0.5 per cent. But the rate on an overdraft to a private individual will be related to the lending bank’s base rate and expressed as so many points above base rate. A point in this case is a full percentage point so five points over base means 11 per cent when base rates are 6 per cent.
Thus the London Inter-Bank Offered Rate or LIBOR (see Chapter 17) is the usual benchmark rate of interest for wholesale funds, and is the rate in relation to which other floating rates of interest are set. LIBID is the equivalent bid rate or rate at which banks will offer to borrow. LIMEAN (pronounced ‘lie-mean’) is the rate mid-way between the bid and offered rates.
The personal finance sites listed in Chapter 23 have details of the borrowing and lending rates that are of most interest to private individuals. The Bank of England site at www.bankofengland.co.uk/ has a lot of information on the Bank’s operations in the money markets as well as the minutes of the meetings of the Monetary Policy Committee. The Debt Management Office at www.dmo.gov.uk/ is now the source for information on the Treasury Bill tender. The economic background which forms the framework for monetary policy may be found at the Treasury site at www.hm-treasury.gov.uk/.