EURO-CURRENCY MARKET

Workshop at PDIMTR On 11TH of March 2010

WHAT IS EURO-CURRENCY MARKET?

It is a market for Borrowing and Lending of currency at the center outside the country in which the currency is issued.
It is different than the Foreign Exchange Market, wherein the currency is bought and sold.

WHAT IS EURO-CURRENCY MARKET?

This is a Capital Market:
Dollar deposited in London is called as Euro-Dollar deposit Sterling deposit in Germany is called as Euro-Sterling deposit Euro loan extended in Japan is called as Euro-Euro loan

Centers for Euro-Currencies:

London Few other in Europe Singapore (also called as Asian Dollar Market) Hongkong

Features of Euro-Currency Market

1. 2. 3. 4. 5. 6. 7. Types of transactions Control of the country of issue of the currency Huge amounts of transactions Highly competitive Market Floating rates of interest based on LIBOR Dominance of Dollar denominated transactions Four different segments

Features of Euro-Currency Market

Types of Transactions:
1. Japanese Exporter, earning USD, keeps these USD in London Bank (say AMEX)as Deposit. 2. AMEX bank may use such deposits for lending to a French Importer. 3. Indian exporter, earning Japanese Yen, keeps these Yen in Korea as Deposit 4. Nigerian Importer avails loan in INR from Russia to import machinery from India.

Features of Euro-Currency Market

No Direct Control of the country which issued the currency:

Utility of the currency that is being bought and sold is entirely outside the control of the country of its issue.
But Indirect control is possible:

As the settlement always takes place in the country in which the currency is issued, indirect control is possible.

Because of this Euro-Currencies are also referred to as Offshore Currencies.

Euro-Currency Market
Bankers and the Public form the participants of the Euro-Currency Market and the two types of transactions take place:
1. One bank with the other 2. One bank with Public

Features of Euro-Currency Market

Huge amounts of Transactions:
Generally they are in only millions of USD This has lead to Syndication of loans, where large numbers of banks participate in the lending operations It also consists of pool of large number of short term deposits, which provides the biggest single source of funds for commercial banks

Features of Euro-Currency Market

Highly Competitive Market:
There are no entry barriers. There is free access to the new institutions in the market The lending rates are low and deposit rate are high, thus allowing a wafer thin margin for operations

Consumers, i.e. investors and borrowers derive advantage out of this situation

Features of Euro-Currency Market

Concept of Floating Rate of Interest:
The rate of interest in the market is linked to the Base Rate usually LIBOR, i.e. London Inter-Bank Offered Rate The rate of interest on advances and deposits is reviewed periodically and amended according to changed circumstances, if any in LIBOR

Features of Euro-Currency Market

Dominance of Dollar in the market:
Dollar is a leading currency traded in the market (about 90% to 95% market share) However other currencies are now emerging thus reducing the role of dollar somewhat (about 80% market share)
Euro Japanese Yen Pound Sterling

Features of Euro-Currency Market

Euro-Currency Market Segments: There are four predominant market segments as follows: 1. Euro-credit markets:
where international group of banks engage in lending for medium and long term

2. Euro-bond market:
where banks raise funds on behalf of international borrowers by issuing bonds

3. Euro-currency (deposit) market:

where banks accept deposits, mostly for short term

4. Euro-notes market:
where Corporates raise funds
The segmentation is not watertight and different segments overlap each other.

Factors favouring the Growth of Euro-Currency Market

The following five countries are responsible for the growth of the Euro-Currency Market:
China (fear that its Fx in USD would be blocked) USA (indeed blocked identifiable Fx in USD in1950,
federal Reserve Act, regulation Q and M; control and restrictions on borrowing funds in US in 1965, and introduction of interest equalization tax in 1963) Korea (War broke out in 1950) Russia (erstwhile USSR){because of their banking presence in Paris and London} UK (policy of not granting sterling loan outside sterling area in 1957)

China / Korea / Russia

Since 1949, China feared that its dollar earnings would be blocked by USA. So China shifted its dollar earnings to Paris in the Russian banks Korean war broke in 1950 USA indeed blocked Chinese identifiable dollar deposits in USA Russian banks in Paris and London started disguising their balances by placing them in western European banks rather than in N.Y. So communist countries had dollar claim on the western European banks and western European banks had similar claim on USA

UK
British Government in 1957, decided not to grant sterling pound loans outside sterling area. During the same period, however, Western European banks were permitted to foreign currency deposits (say bank in London will accept dollar deposit) So the banks in London offered dollar loans to their non-sterling area customers.

USA: Federal Reserve Act: Regulation Q

This act was about restriction on payment of interest on dollar deposits as well as other currency deposits. No interest was payable on deposits having maturity of 30 days or less. There were restrictions and ceilings on interest payments on deposits having maturity above 30 days. Therefore the dollar deposits of Non Resident US citizens got shifted to Europe as the banks in Europe offered higher rates of interest on dollar deposits (as well as other currency deposits) Foreign (for US) investors also shifted their dollar deposits from US to centers outside US, mostly to banks in London Banks London used these deposits for lending to its customers in non-sterling areas Thus London got the prominence in borrowing and lending Euro-dollar.

USA: Federal Reserve Act: Regulation M

This act was about reserve requirement of the banks on their deposits The act required US banks to block more money in reserves, than European banks US banking regulation was not very tight then (and it is not so even now) American banks found it beneficial to move the deposits of Non Resident US citizens as well as those of resident citizens to banks in Europe.

Interest Rates in Euro-Currency Maket

LIBOR:
The banks (called as reference banks)in London charge different rates of interest on their lending These rate at 11.00 AM London times, are averaged and rounded off at nearest 0.1250 These are calculated for 1 month, 3 month or 6 month period

LIBID:
This is the interest rate paid by the banks in London on the deposits kept with them. They are generally 0.25% or 0.125% lower than LIBOR

LIMEAN: It is average of LIBOR and LIBID Prime Rate: of USA SIBOR: Singapore LUXIBOR: Luxembourg MIBOR: Mumbai BIBOR: Bahrain

Segment 1: Euro-Credit Markets

1. Tenure: Medium and Long Term Loans [up to 10--15 years 10% of loans, 58 years 85% of loans, 1 5 years 5% of loans] provided by group of banks. 2. Amount: It is a wholesale sector of the international capital market. 3. Security: Loans are provided without any primary or collateral security. Credit rating is the essence of lending 4. Type of loan: a) Revolving [like cash credit] b)Term Credit 5. Interest Rate: Generally 1% above the reference rate, rolled over every six moths 6. Currency: Generally USD, but can be any other currency, as required by the borrower and ability of the lender.

Segment 1: Euro-Credit Markets

Syndication of Loan:
Managing banks, as desired by the borrower Lead bank, generally who takes the largest share of lending Agent bank, as required to take interest of the banks in syndication and comply with the procedure Common assessment of the borrower and his country Common documentation In very few cases co-financing with IMF or IBRD is possible

Segment 2: Euro-Bonds
Euro-Bonds are unsecured securities They are therefore issued by borrowers of high financial standing When they are issued by government corporation or local bodies, they are guaranteed by the government of the country concerned Euro-Bond is outside the regulation of a single country. The investors are spread worldwide However foreign bonds are issued in only one country and are subject to the regulation of the country of issue.

Segment 2: Euro-Bonds
Selling of EB is through syndicates of the banks Lead manager advises about size, terms and timing of the issue Entire issue is underwritten Lead managers fees, underwriting commission and selling commission is somewhere between 2% and 2.5% of the value of the issue

Segment 2: Euro-Bonds
Lead manager allocates the bonds to all members of the selling group at face value less their commission Thereafter every member is on his own They can sell to investors at whatever price they can obtain Thus no two investors in the Euro-Bond market need pay the same price for the newly issued bonds

Segment 2: Euro-Bonds
Features of Euro-Bonds:

Most Euro-Bonds are bearer securities Most bonds are denominated in USD 10,000 Average maturity of the Euro-Bond is 5 to 6 years In some cases maturity extends to 15 years
Straight or Fixed Rate Bonds Convertible Bonds Currency Option Bonds Floating Rate Notes

Types of Euro-Bonds:

Straight or Fixed Rate Bonds

1. 2. 3. 4. 5. These are fixed interest bearing securities Interest is normally payable yearly Year is considered of 360 days Maturities range from 3 years to 25 years Right of redemption before maturity may be there or may not be there 6. If the right of redemption is there then redemption is done by offering an agio(premium)

Convertible Bonds
1. These are fixed interest bearing securities 2. Investor has an option to convert bonds into equity shares of the borrowing company 3. The conversion is done at the stipulated price and during the stipulated period 4. Conversion price is normally kept higher than the market price

Convertible Bonds
5. The rate of interest is lower than the rate of interest on comparable straight bond.
6. Sometimes the bonds are issued in a currency other than the currency of the share. This provides an opportunity to diversify the currency risk as these bonds are issued with fixed exchange rate of conversion 7. Bonds with warrants: warrant is part of the bond but is detachable and traded separately, when the conversion takes place. The investor can keep the bond and trade the warrant for shares.

Currency Option Bonds

They are similar to straight bonds Generally issued in one currency and option to take interest and principal in another currency. Exchange Rate is either fixed (generally not) or is spot rate prevailing in the market three business days before the due date of payment of interest and principal

Floating Rate Notes

FRN is similar to straight bonds with respect to maturity and denomination Rate of interest however varies and is based on LIBOR + 1/8%, %,1.5%........ Rate of interest is adjusted every six months Minimum interest rate clause may be included drop lock clause may also be included, which means if minimum interest rate happens to be paid then it is locked for the remaining period of the bond. Generally it is found that banks issue and invest in FRNs

Segment 3: Euro-Currency Deposits

1. Euro-bonds represent the funds amassed by the bank on behalf of international borrower; Euro-currency deposits represent the funds accepted by the bank themselves. 2. The Euro-currency market consists of all deposits of currencies placed with the banks outside their home currency. 3. The deposits are accepted in Euro-currencies, as well as currency cocktails (SDR, ECU etc.)

Segment 3: Euro-Currency Deposits

4. The deposits are placed at call (overnight, two days or seven days notice) for USD, Sterling pounds, Canadian dollars and Japanese Yen; and of two days in any other currencies 5. Time deposits are accepted for periods of 1,3,6 and 12 months for all currencies 6. USD and Sterling pound can be placed for a period of five years 7. Minimum size of deposit is USD50,000 or its equivalent

Segment 3: Euro-Currency Deposits Certificate of Deposit

1. It is negotiable instrument 2. They are bearer instrument and can be traded in the secondary market 3. Period: 1 year (1 month through 12 months) 4. Minimum amount: USD50,000 5. Currencies: USD, Sterling Pound, Yen 6. Interest Rate: 1/8 % below LIBOR 7. Tranche CD: carries different rates of interest for each tranche 8. Discount CD: they are issued at discount

Segment 4: Euro-Notes Market

1. This market constitutes the instruments of borrowing issued by the corporates in the Eurocurrency market 2. The instruments issue may be underwritten or may not be underwritten 3. The borrowers directly approach the lenders without the intermediation of the banks or financial institution. 4. Instruments are of the following categories:
1. Commercial Paper 2. Note issuance Facilities 3. Medium Term Notes

Commercial Paper
1. It is a promissory note with maturity less than a year, generally the period varies between 90 days to 180 days 2. Generally issue is not underwritten 3. Amount: USD 100,000 or equivalent 4. Issued on Discount to Yield basis, but interest rate works out lesser than that is paid on bank borrowing and higher than that is paid by the bank on deposits 5. They are unsecured instrument

Note Issuance Facilities (NIF)

1. Borrowers place short term notes of 3 months to 6 months maturity directly with the investors 2. The notes are rolled over on maturity 3. The banks underwrite at the time of issue as well as when the notes are rolled over 4. With slight variation they are also known as:
1. Revolving underwriting facility (RUF) 2. Standby Note Issuance Facility (SNIF) 3. Note Purchase Facility (NPF)

Medium Term Notes

1. MTN represents Long Term, Non Underwritten and fixed interest rate source of raising finance. 2. It can be comparable with Euro-bonds with a difference that Eurobonds issue is underwritten, where as MYN issue is not underwritten. 3. Their maturity is somewhere between short term CPs(less than one year) and long term Euro bonds(more than five years) 4. They are privately placed and have great flexibility

Euro-Issues
Access to Euro Equity Market is through the following two ways:
1. Foreign Currency Convertible Bonds 2. Depository Receipts
(FCCB has already been explained)

Depository Receipts:
1. Global Depository receipts 2. American depository Receipts

Global Depository Receipt (GDR)

Shares of the issuing company are issued in the name of an international bank, located in foreign country and is called as Depository The physical possession of the shares issued is with the Custodian, in the issuing country Based on the shares issued to depository, depository issues GDR in USD GDR is a negotiable instrument GDR is a bearer instrument and traded in international market, either through stock exchange mechanism or on Over The Counter basis

Global Depository Receipt (GDR)

The settlements are done through international clearing systems like Euro-clear (Brussels) or CEDEL (London) GDR is denominated in US dollars, that represents shares issued in local currency Issuing company pays the dividend to the depository in local currency Depository converts this local currency into USD at the ruling exchange rate and distribute it among the GDR holders pro rata Exchange risk is borne by the investor Voting rights are only with the depository and are regulated by the agreement between issuing company and the depository

American Depository Receipts

They are similar to GDR, but issued in USA.

Issues in Foreign Domestic Market

When bonds (or equities) are issued in only one foreign domestic capital market, they are known as:
Yankee Bonds, if issued in US domestic market Bulldog bonds, if issued in UK domestic market Samurai Bonds, if issued in Japanese domestic market

Reliance industry, ICICI, Infosys Technologies etc. tap the foreign markets

Thank you