CHAPTER
SIXTEEN
PRIVATE MONEY MARKET INSTRUMENTS

FRANK J. FABOZZI, PH.D., CFA, CPA

Professor of Finance
EDHEC Business School

STEVEN V. MANN, PH.D.
Professor of Finance
Moore School of Business
University of South Carolina

Historically, the money market is defined as the market for assets with original maturities of one year or less. The assets traded in this market include Treasury bills, commercial paper, some medium-term notes, bankers acceptances, federal agency discount paper, short-term municipal obligations, certificates of deposit, repurchase agreements, floating-rate instruments, and federal funds. Although several of these assets have maturities greater than one year, they are still classified as part of the money market.

In Chapter 9, Treasury bills are discussed. In this chapter we will cover private money market instruments: commercial paper, bankers acceptances, certificates of deposit, repurchase agreements, and federal funds. Medium-term notes have maturities ranging from nine months to 30 years. These securities are discussed in Chapter 12.

COMMERCIAL PAPER

A corporation that needs long-term funds can raise those funds in either the equity or bond market. If, instead, a corporation needs short-term funds, it may attempt to acquire those funds via bank borrowing. An alternative to bank borrowing is commercial paper. Commercial paper is short-term unsecured promissory notes issued in the open market as an obligation of the issuing entity.

The commercial paper market once was limited to entities with strong credit ratings, but in recent years, some lower-credit-rated corporations have issued commercial paper by obtaining credit enhancements or other collateral to allow them to enter the market as issuers. Issuers of commercial paper are not restricted to U.S. corporations. Non-U.S. corporations and sovereign issuers also issue commercial paper.

The maturity of commercial paper is typically less than 270 days; the most common maturity is less than 45 days.1 There are reasons for this. First, the Securities Act of 1933 requires that securities be registered with the Securities and Exchange Commission (SEC). Special provisions in the 1933 act exempt commercial paper from registration so long as the maturity does not exceed 270 days. To avoid the costs associated with registering issues with the SEC, issuers rarely issue commercial paper with a maturity exceeding 270 days. To pay off holders of maturing paper, issuers generally issue new commercial paper. Another consideration in determining the maturity is whether the paper would be eligible collateral by a bank if it wanted to borrow from the Federal Reserve Bank’s discount window. In order to be eligible, the maturity of the paper may not exceed 90 days. Because eligible paper trades at a lower cost than paper that is not eligible, issuers prefer to issue paper whose maturity does not exceed 90 days.

The risk that the investor faces is that the borrower will be unable to issue new paper at maturity. As a safeguard against “rollover risk,” commercial paper issuers secure backup lines of credit sometimes called liquidity enhancements. Most commercial issuers maintain 100% backing because the credit rating agencies that rate commercial paper (Fitch, Moody’s, and Standard & Poor’s) usually require a bank line of credit as a precondition for a rating.

Investors in commercial paper are institutional investors. Money market mutual funds are the biggest purchasers of commercial paper. Pension funds, commercial bank trust departments, state and local governments, and nonfinancial corporations seeking short-term investments purchase the balance. The minimum round-lot transaction is $100,000. Some issuers will sell commercial paper in denominations of $25,000.

Issuers of Commercial Paper

According to data provided by the Federal Reserve, the total amount of commercial paper outstanding (in billions) at the end of 2010 was roughly $1.058 trillion. Commercial paper can be categorized along three dimensions: (1) type of issuer; (2) issue channel; and (3) presence of collateral. Issuer classification includes financial firms, nonfinancial firms, and asset-backed securities. Financial firms are the largest issuers ($556 billion outstanding as of year end 2010), followed by asset-backed ($382 billion), and then nonfinancial firms ($120 billion).

Financial and nonfinancial firms differ in their use of the proceeds received from the issuance of commercial paper. Nonfinancial firms utilize the funds for ongoing cash flow needs (e.g., payroll and inventories), while financial firms use the funds to manage short-term liquidity needs such as the mismatch between assets and liabilities.

Although the typical issuers of commercial paper are those with high credit ratings, smaller and less well-known companies with lower credit ratings have been able to issue paper in recent years. They have been able to do so by means of credit support from a firm with a high credit rating (such paper is called credit-supported commercial paper) or by collateralizing the issue with high-quality assets (such paper is called asset-backed commercial paper). An example of credit-supported commercial paper is an issue supported by a letter of credit. The terms of such a letter of credit specify that the bank issuing it guarantees that the bank will pay off the paper when it comes due if the issuer fails to. Banks charge a fee for letters of credit. From the issuer’s perspective, the fee enables it to enter the commercial paper market and obtain funding at a lower cost than bank borrowing. Paper issued with this credit enhancement is referred to as LOC paper. The credit enhancement also may take the form of a surety bond from an insurance company.2 Asset-backed commercial paper is issued by large corporations through special-purpose vehicles that pool the assets and issue the securities. The assets underlying these securities consist of credit card receivables, auto and equipment leases, healthcare receivables, and even small business loans.

Directly Placed versus Dealer-Placed Paper

Commercial paper is classified as either direct paper or dealer paper. Direct paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary. A large majority of the issuers of direct paper are financial companies. Because they require a continuous source of funds in order to provide loans to customers, they find it cost-effective to establish a sales force to sell their commercial paper directly to investors.

In the case of dealer-placed commercial paper, the issuer uses the services of a securities firm to sell its paper. Commercial paper sold in this way is referred to as dealer paper. Competitive pressures have forced dramatic reductions in the underwriting fees charged by dealer firms.

The Secondary Market

Commercial paper is one of the largest segments of the money market. Despite this fact, secondary trading activity is much smaller. The typical investor in commercial paper is an entity that plans to hold it until maturity, given that an investor can purchase commercial paper with the specific maturity desired. Should an investor’s economic circumstances change such that there is a need to sell the paper, it can be sold back to the dealer, or in the case of directly-placed paper, the issuer will repurchase it.

Yields on Commercial Paper

Like Treasury bills, commercial paper is a discount instrument. That is, it is sold at a price less than its maturity value. The difference between the maturity value and the price paid is the interest earned by the investor, although some commercial paper is issued as an interest-bearing instrument. For commercial paper, a year is treated as having 360 days.

For the period January 1, 1997 to December 31, 2010, the average weekly spread between three-month commercial paper yields and three-month U.S. Treasury bill yields was about 41 basis points, the lowest spread being 4 basis points (second week of March 2010) and the highest being 325 basis points (second week of October 2008).

The commercial paper rate is higher than that on Treasury bills for three reasons. First, the investor in commercial paper is exposed to credit risk. Second, interest earned from investing in Treasury bills is exempt from state and local income taxes. As a result, commercial paper has to offer a higher yield to offset this tax advantage. Finally, commercial paper is less liquid than Treasury bills. The liquidity premium demanded is probably small, however, because investors typically follow a buy-and-hold strategy with commercial paper and so are less concerned with liquidity. The rate on commercial paper is higher by a few basis points than the rate on certificates of deposit, which we discuss later in this chapter. The higher yield available on commercial paper is attributable to the poorer liquidity relative to certificates of deposit.

BANKERS ACCEPTANCES

Simply put, a bankers acceptance is a vehicle created to facilitate commercial trade transactions. The instrument is called a bankers acceptance because a bank accepts the ultimate responsibility to repay a loan to its holder. The use of bankers acceptances to finance a commercial transaction is referred to as acceptance financing.

The transactions in which bankers acceptances are created include (1) the importing of goods into the United States, (2) the exporting of goods from the United States to foreign entities, (3) the storing and shipping of goods between two foreign countries where neither the importer nor the exporter is a U.S. firm,3 and (4) the storing and shipping of goods between two entities in the United States.

Bankers acceptances are sold on a discounted basis just as Treasury bills and commercial paper. The major investors in bankers acceptances are money market mutual funds and municipal entities. Bankers acceptances have declined in importance in recent years in favor of other forms of financing.

Illustration of the Creation of a Bankers Acceptance

The best way to explain the creation of a bankers acceptance is by an illustration. Several entities are involved in our transaction:

• Car Imports Corporation of America (“Car Imports”), a firm in New Jersey that sells automobiles

• Germany Autos, Inc. (“GAI”), a manufacturer of automobiles in Germany

• Hoboken Bank of New Jersey (“Hoboken Bank”), a commercial bank in Hoboken, New Jersey

• Berlin National Bank (“Berlin Bank”), a bank in Germany

• High-Caliber Money Market Fund, a mutual fund in the United States that invests in money market instruments

Car Imports and GAI are considering a commercial transaction. Car Imports wants to import 15 cars manufactured by GAI. GAI is concerned with the ability of Car Imports to make payment on the 15 cars when they are received.

Acceptance financing is suggested as a means for facilitating the transaction. Car Imports offers $300,000 for the 15 cars. The terms of the sale stipulate payment to be made to GAI 60 days after it ships the 15 cars to Car Imports. GAI determines whether it is willing to accept the $300,000. In considering the offering price, GAI must calculate the present value of the $300,000 because it will not be receiving the payment until 60 days after shipment. Suppose that GAI agrees to these terms.

Car Imports arranges with its bank, Hoboken Bank, to issue a letter of credit. The letter of credit indicates that Hoboken Bank will make good on the payment of $300,000 that Car Imports must make to GAI 60 days after shipment. The letter of credit, or time draft, will be sent by Hoboken Bank to GAI’s bank, Berlin Bank. On receipt of the letter of credit, Berlin Bank will notify GAI, who will then ship the 15 cars. After the cars are shipped, GAI presents the shipping documents to Berlin Bank and receives the present value of $300,000. GAI is now out of the picture.

Berlin Bank presents the time draft and the shipping documents to Hoboken Bank. The latter will then stamp “accepted” on the time draft. By doing so, the Hoboken Bank has created a bankers acceptance. This means that Hoboken Bank agrees to pay the holder of the bankers acceptance $300,000 at the maturity date. Car Imports will receive the shipping documents so that it can procure the 15 cars once it signs a note or some other type of financing arrangement with Hoboken Bank.

At this point, the holder of the bankers acceptance is the Berlin Bank. It has two choices. It can retain the bankers acceptance as an investment in its loan portfolio, or it can request that the Hoboken Bank make a payment of the present value of $300,000. Let’s assume that Berlin Bank requests payment of the present value of $300,000.

Now the holder of the bankers acceptance is Hoboken Bank. It has two choices: retain the bankers acceptance as an investment as part of its loan portfolio or sell it to an investor. Suppose that Hoboken Bank chooses the latter and that High-Caliber Money Market Fund is seeking a high-quality investment with the same maturity as that of the bankers acceptance. The Hoboken Bank sells the bankers acceptance to the money market fund at the present value of $300,000. Rather than sell the instrument directly to an investor, Hoboken Bank could sell it to a dealer who would then resell it to an investor such as a money market fund. In either case, at the maturity date, the money market fund presents the bankers acceptance to Hoboken Bank, receiving $300,000, which the bank in turn recovers from Car Imports.

Credit Risk

Investing in bankers acceptances exposes the investor to credit risk. This is the risk that neither the borrower nor the accepting bank will be able to pay the principal due at the maturity date. Accordingly, bankers acceptances will offer a higher yield than Treasury bills of the same maturity.

Eligible Bankers Acceptance

An accepting bank that has decided to retain a bankers acceptance in its portfolio may be able to use it as collateral for a loan at the discount window of the Federal Reserve. The reason we say that it may is that bankers acceptances must meet certain eligibility requirements established by the Federal Reserve. One requirement for eligibility is maturity, which with few exceptions cannot exceed six months. The other requirements for eligibility are too detailed to review here, but the basic principle is simple: The bankers acceptance should be financing a self-liquidating commercial transaction. Conversely, finance bills are acceptances that are not related to specific transactions and are generally ineligible.

Eligibility is also important because the Federal Reserve imposes a reserve requirement on funds raised via bankers acceptances that are ineligible. Bankers acceptances sold by an accepting bank are potential liabilities of the bank, but no reserve requirements are imposed for eligible bankers acceptances. Consequently, most bankers acceptances satisfy the various eligibility criteria. Finally, the Federal Reserve also imposes a limit on the amount of eligible bankers acceptances that may be issued by a bank.

Rates Banks Charge on Bankers Acceptances

To calculate the rate to be charged the customer for issuing a bankers acceptance, the bank determines the rate for which it can sell its bankers acceptance in the open market. To this rate it adds a commission. In the case of ineligible bankers acceptances, a bank will add an amount to offset the cost of the reserve requirements imposed.

LARGE-DENOMINATION NEGOTIABLE CDs

A certificate of deposit (CD) is a certificate issued by a bank or thrift that indicates that a specified sum of money has been deposited at the issuing depository institution. CDs are issued by banks and thrifts to raise funds for financing their business activities. A CD bears a maturity date and a specified interest rate, and it can be issued in any denomination. CDs issued by banks are insured by the Federal Deposit Insurance Corporation (FDIC) but only for amounts up to $250,000. As for maturity, there is no limit on the maximum, but by Federal Reserve regulations CDs cannot have a maturity of less than seven days.

A CD may be nonnegotiable or negotiable. In the former case, the initial depositor must wait until the maturity date of the CD to obtain the funds. If the depositor chooses to withdraw funds prior to the maturity date, an early withdrawal penalty is imposed. In contrast, a negotiable CD allows the initial depositor (or any subsequent owner of the CD) to sell the CD in the open market prior to the maturity date.

Negotiable CDs were introduced in the early sixties. At that time, the interest rate that banks could pay on various types of deposits was subject to ceilings administered by the Federal Reserve (except for demand deposits, defined as deposits of less than one month that by law could pay no interest). For complex historical reasons, these ceiling rates started very low, rose with maturity, and remained below market rates up to some fairly long maturity. Before introduction of the negotiable CD, those with money to invest for, say, one month had no incentive to deposit it with a bank because they would get a below-market rate, unless they were prepared to tie up their capital for a much longer period of time. When negotiable CDs came along, those investors could buy a three-month or longer negotiable CD yielding a market interest rate and recoup all or more than the investment (depending on market conditions) by selling it in the market.

This innovation was critical in helping banks to increase the amount of funds raised in the money market, a position that had languished in the earlier postwar period. It also motivated competition among banks, ushering in a new era. There are now two types of negotiable CDs. The first is the large-denomination CD, usually issued in denominations of $1 million or more. These are the negotiable CDs whose history we just described.

In 1982, Merrill Lynch entered the retail CD business by opening up a primary and secondary market in small-denomination (less than $100,000 at the time) CDs. While it made the CDs of its numerous banking and savings institution clients available to retail customers, Merrill Lynch also began to give these customers the negotiability enjoyed by institutional investors by standing ready to buy back CDs prior to maturity. Today, several retail-oriented brokerage firms offer CDs that are salable in a secondary market. These are the second type of negotiable CD. Our focus in this chapter, though, is on the large-denomination negotiable CD, and we refer to them simply as CDs throughout the chapter.

The largest group of CD investors consists of investment companies, and money market funds make up the bulk of them. Far behind are banks and bank trust departments, followed by municipal entities and corporations.

CD Issuers

CDs can be classified into four types, based on the issuing bank. First are CDs issued by domestic banks. Second are CDs denominated in U.S. dollars but issued outside the United States. These CDs are called Eurodollar CDs or Euro CDs. Euro CDs are U.S. dollar–denominated CDs issued primarily in London by U.S., Canadian, European, and Japanese banks. Branches of large U.S. banks once were the major issuers of Euro CDs. A third type of CD is the Yankee CD, which is a CD denominated in U.S. dollars and issued by a foreign bank with a branch in the United States. Finally, thrift CDs are those issued by savings and loan associations and savings banks.

Yields on CDs

Unlike Treasury bills, commercial paper, and bankers acceptances, yields on domestic CDs are quoted on an interest-bearing basis. CDs with a maturity of one year or less pay interest at maturity. For purposes of calculating interest, a year is treated as having 360 days. Term CDs issued in the United States normally pay interest semiannually, again with a year taken to have 360 days.

The yields posted on CDs vary depending on three factors: (1) the credit rating of the issuing bank, (2) the maturity of the CD, and (3) the supply and demand for CDs. With respect to the third factor, banks and thrifts issue CDs as part of their liability management strategy, so the supply of CDs will be driven by the demand for bank loans and the cost of alternative sources of capital to fund these loans. Moreover, bank loan demand will depend on the cost of alternative funding sources such as commercial paper. When loan demand is weak, CD rates decline. When demand is strong, the rates rise. The effect of maturity depends on the shape of the yield curve.

Credit risk has become more of an issue. At one time, domestic CDs issued by money center banks traded on a no-name basis. Recent financial crises in the banking industry, however, have caused investors to take a closer look at issuing banks. Prime CDs (those issued by high-rated domestic banks) trade at a lower yield than nonprime CDs (those issued by lower-rated domestic banks). Because of the unfamiliarity investors have with foreign banks, generally Yankee CDs trade at a higher yield than domestic CDs.

Euro CDs offer a higher yield than domestic CDs. There are three reasons for this. First, there are reserve requirements imposed by the Federal Reserve on CDs issued by U.S. banks in the United States that do not apply to issuers of Euro CDs. The reserve requirement effectively raises the cost of funds to the issuing bank because it cannot invest all the proceeds it receives from the issuance of a CD, and the amount that must be kept as reserves will not earn a return for the bank. Because it will earn less on funds raised by selling domestic CDs, the domestic issuing bank will pay less on its domestic CD than a Euro CD. Second, the bank issuing the CD must pay an insurance premium to the FDIC, which again raises the cost of funds. Finally, Euro CDs are dollar obligations that are payable by an entity operating under a foreign jurisdiction, exposing the holders to a risk (called sovereign risk) that their claim may not be enforced by the foreign jurisdiction. As a result, a portion of the spread between the yield offered on Euro CDs and domestic CDs reflects what can be termed a sovereign-risk premium. This premium varies with the degree of confidence in the international banking system.

Since the 1990s, the liquidity of the Eurodollar CDs has increased dramatically, and the perception of higher risk has diminished considerably. For the period January 1, 2000 to December 31, 2010, the average weekly spread between three-month LIBOR and three-month CD rate was 9 basis points, the lowest spread being –7 basis points (third week of September 2010) and the highest being 106 basis points (second week of October 2008).

CD yields are higher than yields on Treasury securities of the same maturity. For the period January 1, 2000 to December 31, 2010, the average weekly spread between the three-month CD rate and the three-month Treasury bill rate was about 48 basis points, the lowest spread being 5 basis points (second week of March 2010) and the highest being 437 basis points (second week of October 2008). The spread is due mainly to the credit risk that a CD investor is exposed to and the fact that CDs offer less liquidity. The spread due to credit risk will vary with economic conditions and confidence in the banking system, increasing when there is a flight to quality or when there is a crisis in the banking system.

At one time, there were more than 30 dealers who made markets in CDs. The presence of that many dealers provided good liquidity to the market. Today, fewer dealers are interested in making markets in CDs, and the market can be characterized as an illiquid one.

REPURCHASE AGREEMENTS

A repurchase agreement is the sale of a security with a commitment by the seller to buy the security back from the purchaser at a specified price at a designated future date. Basically, a repurchase agreement is a collateralized loan, where the collateral is a security. The agreement is best explained with an illustration.

Suppose that on September 28, 2006 a government securities dealer purchases a 4.875% coupon on-the-run 10-year U.S. Treasury note that matures on August 15, 2016. The face amount of the position is $1 million and the note’s full price (i.e., flat price plus the accrued interest) is $1,025,672.55. Further, suppose the dealer wants to hold the position until the next business day which is Friday, September 29, 2006. Where does the dealer obtain the funds to finance this position? Of course, the dealer can finance the position with its own funds or by borrowing from a bank. Typically, however, the dealer uses the repurchase agreement or “repo” market to obtain financing. In the repo market, the dealer can use the Treasury security as collateral for a loan. The term of the loan and the interest rate that the dealer agrees to pay (called the repo rate) are specified. When the term of the loan is one day, it is called an overnight repo; a loan for more than one day is called a term repo. Alternatively, open-maturity repos give both counterparties the option to terminate the repo each day. This structure reduces the settlement costs if counterparties choose to continuously roll over overnight repos.

The transaction is referred to as a “repurchase agreement” because it calls for the sale of the security and its repurchase at a future date. Both the sale price and the purchase price are specified in the agreement. The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan.

Let us return to the dealer who needs to finance a long position in the Treasury note for one day. The settlement date is the day that the collateral must be delivered and the money lent to initiate the transaction which, in our example, is September 28, 2006. Likewise, the termination date of the repo agreement is September 29. At this point, we need to address who might serve as the dealer’s counterparty (i.e., the lender of funds) in this transaction. Suppose that one of the dealer’s customers has excess funds in the amount of $1,025,672.55 and is the amount loaned in the repo agreement. Accordingly, on September 28, 2006, the dealer would agree to deliver (“sell”) $1,025,672.55 worth of 10-year U.S. Treasury notes to the customer and buy the same 10-year notes back for an amount determined by the repo rate the next business day on September 29, 2006.4

Suppose that the repo rate in this transaction is 5.15%. Then, as will be explained below, the dealer would agree to deliver the 10-year U.S. Treasury notes for $1,025,819.28 the next day. The $146.73 difference between the “sale” price of $1,025,672.55 and the “repurchase” price of $1,025,819.28 is the dollar interest on the financing. From the customer’s perspective, the agreement is called a reverse repo.

The following formula is used to calculate the dollar interest on a repo transaction:

image

Notice that the interest is computed on a 360-day basis. In our illustration, using a repo rate of 5.15% and a repo term of one day, the dollar interest is $146.73, as shown below:

$146.73 = $1,025,672.55 × 0.0515 × (1/360)

The advantage to the dealer of using the repo market for borrowing on a short-term basis is that the rate is less than the cost of bank financing. We will explain why later in this section. From the customer’s perspective, the repo market offers an attractive yield on a short-term secured transaction that is highly liquid.

The example illustrates financing a dealer’s long position in the repo market, but dealers also can use the market to cover a short position. For example, suppose a government dealer shorted $10 million of Treasury securities two weeks ago and must now cover the position—that is, deliver the securities. The dealer can do a reverse repo (agree to buy the securities and sell them back). Of course, the dealer eventually would have to buy the Treasury securities in the market in order to cover its short position.

There is a good deal of Wall Street jargon describing repo transactions. To understand it, remember that one party is lending money and accepting security as collateral for the loan; the other party is borrowing money and giving collateral to borrow money. When someone lends securities in order to receive cash (i.e., borrow money), that party is said to be reversing out securities. A party that lends money with the security as collateral is said to be reversing in securities. The expressions to repo securities and to do repo are also used. The former means that someone is going to finance securities using the security as collateral; the latter means that the party is going to invest in a repo. Finally, the expressions selling collateral and buying collateral are used to describe a party financing a security with a repo on the one hand, and lending on the basis of collateral on the other.

The collateral in a repo is not limited to government securities. Money market instruments, federal agency securities, and mortgage-backed securities are also used. Moreover, repos can include substitution clauses that permit the counterparty to substitute alternative securities as collateral over the repo’s life.

Credit Risks

Why does credit risk occur in a repo transaction? Consider our initial example, in which the dealer used $10 million of government securities as collateral to borrow. If the dealer cannot repurchase the government securities, the customer may keep the collateral; if interest rates on government securities have increased subsequent to the repo transaction, however, the market value of the government securities will decline, and the customer will own securities with a market value less than the amount it loaned to the dealer. If the market value of the security rises instead, the dealer firm will be concerned with the return of the collateral, which then has a market value higher than the loan.

Repos are now structured more carefully to reduce credit risk exposure. The amount loaned is less than the market value of the security used as collateral, which provides the lender with some cushion should the market value of the security decline. The amount by which the market value of the security used as collateral exceeds the value of the loan is called margin.5 The amount of margin is generally between 1% and 3%. For borrowers of lower creditworthiness or when less liquid securities are used as collateral, the margin can be 10% or more.

Another practice to limit credit risk is to mark the collateral to market on a regular basis. When market value changes by a certain percentage, the repo position is adjusted accordingly. Suppose that a dealer firm has borrowed $20 million using collateral with a market value of $20.4 million. The margin is 2%. Suppose further that the market value of the collateral drops to $20.1 million. A repo agreement can specify either (1) a margin call or (2) repricing of the repo. In the case of a margin call, the dealer firm is required to put up additional collateral with a market value of $300,000 to bring the margin up to $400,000. If repricing is agreed on, the principal amount of the repo will be changed from $20 million to $19.7 million (the market value of $20.1 million divided by 1.02). The dealer would then send the customer $300,000.

One concern in structuring a repo is delivery of the collateral to the lender. The most obvious procedure is for the borrower to deliver the collateral to the lender. At the end of the repo term, the lender returns the collateral to the borrower in exchange for the principal and interest payment. This procedure may be too costly, though, particularly for short-term repos, because of the costs associated with delivering the collateral. The cost of delivery would be factored into the transaction by a lower repo rate offered by the borrower. The risk of the lender not taking possession of the collateral is that the borrower may sell the security or use the same security as collateral for a repo with another party.

As an alternative to delivering the collateral, the lender may agree to allow the borrower to hold the security in a segregated customer account. Of course, the lender still faces the risk that the borrower uses the collateral fraudulently by offering it as collateral for another repo transaction.

Another method is for the borrower to deliver the collateral to the lender’s custodial account at the borrower’s clearing bank. The custodian then has possession of the collateral that it holds on behalf of the lender. This practice reduces the cost of delivery because it is merely a transfer within the borrower’s clearing bank. If, for example, a dealer enters into an overnight repo with customer A, the next day the collateral is transferred back to the dealer. The dealer can then enter into a repo with customer B for, say, five days without having to redeliver the collateral. The clearing bank simply establishes a custodian account for customer B and holds the collateral in that account.

There have been a number of well-publicized losses by nondealer institutional investors—most notably Orange County, California—that have resulted from the use of repurchase agreements. Such losses did not occur as a result of credit risk. Rather, it was the use of repos to make a leverage bet on the movement of interest rates. That is, the repo was not used as a money market instrument but as a leveraging vehicle. This can be accomplished by mismatching the maturity of repos and reverse repos. For example, if one has a view that rates will rise, one could borrow money via a term repo (say, three months) and lend money overnight. Conversely, if rates are expected to fall, one could reverse the maturity mismatch. Leverage can be increased many times if market participants are able to borrow and lend a single piece of collateral multiple times.

Participants in the Market

Because it is used by dealer firms (investment banking firms and money center banks acting as dealers) to finance positions and cover short positions, the repo market has evolved into one of the largest sectors of the money market. Financial and nonfinancial firms participate in the markets as both sellers and buyers, depending on the circumstances they face. Thrifts and commercial banks are typically net sellers of collateral (i.e., net borrowers of funds); money market funds, bank trust departments, municipalities, and corporations are typically net buyers of collateral (i.e., providers of funds).

Although a dealer firm uses the repo market as the primary means for financing its inventory and covering short positions, it also will use the repo market to run a matched book, where it takes on repos and reverse repos with the same maturity. The firm will do so to capture the spread at which it enters into the repo and reverse repo agreement. For example, suppose that a dealer firm enters into a term repo of 10 days with a money market fund and a reverse repo rate with a thrift for 10 days in which the collateral is identical. This means that the dealer firm is borrowing funds from the money market fund and lending money to the thrift. If the rate on the repo is 0.30% and the rate on the reverse repo is 0.35%, the dealer firm is borrowing at 0.30% and lending at 0.35%, locking in a spread of 0.05% (5 basis points).

Another participant is the repo broker. To understand the role of the repo broker, suppose that a dealer firm has shorted $50 million of a security. It will then survey its regular customers to determine if it can borrow via a reverse repo the security it shorted. Suppose that it cannot find a customer willing to do a repo transaction (repo from the customer’s point of view, reverse repo from the dealer’s). At that point, the dealer firm will use the services of a repo broker. When the collateral is difficult to acquire, it is said to be “on special.”

The Fed and the Repo Market

The Federal Reserve influences short-term interest rates through its open market operations—that is, by the outright purchase or sale of government securities. This is not the common practice followed by the Fed, however. It uses the repo market instead to implement monetary policy by purchasing or selling collateral. By buying collateral (i.e., lending funds), the Fed injects money into the financial markets, thereby exerting downward pressure on short-term interest rates. When the Fed buys collateral for its own account, this is called a system repo. The Fed also buys collateral on behalf of foreign central banks in repo transactions that are called customer repos. It is primarily through system repos that the Fed attempts to influence short-term rates. By selling securities for its own account, the Fed drains money from the financial markets, thereby exerting upward pressure on short-term interest rates. This transaction is called a matched sale.

Note the language that is used to describe the transactions of the Fed in the repo market. When the Fed lends funds based on collateral, we call it a system or customer repo, not a reverse repo. Borrowing funds using collateral is called a matched sale, not a repo. The jargon is confusing, which is why we used the terms of buying collateral and selling collateral to describe what parties in the market are doing.

Determinants of the Repo Rate

There is no one repo rate; rates vary from transaction to transaction depending on several factors:

Quality. The higher the credit quality and liquidity of the collateral, the lower is the repo rate.

Term of the repo. The effect of the term of the repo on the rate depends on the shape of the yield curve.

Delivery requirement. As noted earlier, if delivery of the collateral to the lender is required, the repo rate will be lower. If the collateral can be deposited with the bank of the borrower, a higher repo rate is paid.

Availability of collateral. The more difficult it is to obtain the collateral, the lower is the repo rate. To understand why this is so, consider the case when the borrower (or equivalently, the seller of the collateral) has a security that is a hot or special issue. The party that needs the collateral will be willing to lend funds at a lower repo rate to obtain the collateral.

These factors determine the repo rate on a particular transaction; the federal funds rate discussed below determines the general level of repo rates. The repo rate will be a rate below the federal funds rate. The reason is that a repo involves collateralized borrowing, whereas a federal funds transaction is unsecured borrowing.

FEDERAL FUNDS

The rate determined in the federal funds market is the major factor that influences the rate paid on all the other money market instruments described in this chapter. When the Federal Reserve formulates and executes monetary policy, it sets a target level for the federal funds rate. Announcements of changes in monetary policy specify the changes in the Fed’s target for this rate. The Federal Reserve influences the level of the federal funds rate through open market operations.

Depository institutions (commercial banks and thrifts) are required to maintain reserves. The reserves are deposits at their district Federal Reserve Bank, which are called federal funds. The level of the reserves that a bank must maintain is based on its average daily deposits over the previous 14 days. Of all depository institutions, commercial banks are by far the largest holders of federal funds.

No interest is earned on federal funds. Consequently, a depository institution that maintains federal funds in excess of the amount required incurs an opportunity cost—the loss of interest income that could be earned on the excess reserves. At the same time, there are depository institutions whose federal funds are less than the amount required. Typically, smaller banks have excess reserves, whereas money center banks find themselves short of reserves and must make up the shortfall. Banks maintain federal funds desks whose managers are responsible for the bank’s federal funds position.

One way that banks with less than the required reserves can bring reserves to the required level is to enter into a repo with a nonbank customer. An alternative is for the bank to borrow federal funds from a bank that has excess reserves. The market in which federal funds are bought (borrowed) by banks that need these funds and sold (lent) by banks that have excess federal funds is called the federal funds market. The equilibrium interest rate, which is determined by the supply and demand for federal funds, is the federal funds rate.

The federal funds rate and the repo rate are tied together because both are a means for a bank to borrow. The federal funds rate is higher because the lending of federal funds is done on an unsecured basis; this differs from the repo, in which the lender has a security as collateral. The spread between the two rates varies depending on market conditions; typically, the spread is approximately 25 basis points.

The term of most federal funds transactions is overnight, but there are longer-term transactions that range from one week to six months. Trading typically takes place directly between the buyer and seller—usually between a large bank and one of its correspondent banks. Some federal funds transactions require the use of a broker.

KEY POINTS

• The money market is comprised of debt instruments with original maturities of one year or less.

• Commercial paper is a short-term unsecured promissory note issued in the open market as an obligation of the issuing entity.

• A bankers acceptance is a debt instrument used to facilitate a commercial trade transaction.

• A certificate of deposit is issued by a financial institution that indicates that a specified sum of money has been deposited at the issuing depository institution.

• A repurchase agreement is the sale of a security with a commitment by the seller to buy the security back from the purchaser at a specified price on a designated future date.

• Federal funds are deposits held by depository institutions at their district Federal Reserve Banks.

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