Foreign Exchange and Money Markets (2024)

International money market and foreign exchange transactions deal with the issuance and trading of money market instruments in various currencies outside domestic markets. As long ago as the fifteenth century, organized international money and foreign exchange markets existed. Merchants in Italy, for example, wanting to import tapestries made in Belgium from wool produced in England, had to find ways to finance transactions that occurred outside their own country. Italian banks, such as those run by the Medici family, set up foreign branches to effect payments and arrange for the delivery of the goods on behalf of their clients. The banks had to deal in currency exchange and in deposit collecting and lending in other countries and states. These activities have continued throughout the nearly 500 years of modern banking history.

In September 2008, international money markets essentially froze, exposing vulnerabilities and revealing how essential these markets are to the smooth functioning of the world economy. Foreign exchange markets, on the other hand, functioned well during the turmoil, suggesting that clearing and settlements systems set up after previous crises were effective in preventing additional chaos. In this chapter, we discuss the instruments used in both markets and how they fit into the global financial markets system.

Origins of Eurocurrencies

The history of international financial markets, since its modern (postwar) rebirth in the 1960s, is a confluence of three parallel and mutually influential events: (1) major changes in the international monetary system; (2) the evolution of a large international investor base; and (3) continuing deregulation of domestic capital markets in major countries to align them with competitive international alternatives to domestic financing vehicles.

The modern period began at the end of World War II, when capital markets outside the United States were virtually nonexistent. In 1944, the Allied Powers agreed to a postwar international monetary system at Bretton Woods, New Hampshire, in which the dollar would be the principal reserve currency (i.e., used as reserves by other countries). The dollar was to be pegged to gold, at the rate of $35 per ounce, and all other currencies were to be fixed to the dollar. When balance of payments difficulties arose, it was understood to be the obligation of both the deficit and the surplus countries to modify their domestic fiscal and monetary policies to reduce the problem. Governments periodically intervened in foreign exchange markets to help the process along, and they usually relied on broad economic policy changes to effect adjustment. If the imbalance could not be redressed after suitable effort, the currency’s exchange rate could be reset tothe dollar, after which it would have to be defended at the new rate. To make the system work required a world in which the principal economies were growing at about the same rate, and shouldering the world’s military and other burdens equally. It also required, at the national level, strict economic discipline and controls, and a voting public that refrained from blaming others for its problems and understood that it was necessary from time to time to take bitter medicine in the interest of the country’s health over the long run. These conditions were not commonly found in the 1950s and 1960s, any more than they are now.

In 1971, the Bretton Woods system collapsed. Several years of large U.S. balance of payments deficits—resulting from large American purchases of lower cost goods from rapidly recovering economies in Europe and Asia—led to the breakdown. The fixed exchange rate system was replaced by a floating-rate mechanism, in which all currencies were to be priced continually by the market, and it was assumed that economic imbalances would generate corrective pressures on exchange rates. The mechanism obviated the need for capital market controls that restricted cross-border transfers, as harsh policies were no longer necessary: the market would administer the medicine that countries were unable to administer themselves. In time, all of the major industrial nations removed their controls on international capital movements. By the early 1980s, users and providers of capital could look overseas for capital market opportunities that were superior to what wasavailable at home. It also meant, however, that interest rate and exchange rate volatility would be much greater in the new floating exchange rate environment than in the old fixed-rate regime. As we see later in this chapter, increased volatility led to greater opportunities for banks and other market-makers to expand trading activities and hedging strategies.

The postwar investor population was affected by these events, and by the rapid institutionalization of markets in the United States, the United Kingdom, and some other European countries. There was also a large increase in the population of otherwise law-abiding Europeans who wanted to transfer funds into foreign bank accounts that were beyond the scrutiny of tax authorities in their home countries. Additionally, government officials, people engaged in capital flight, and shady characters of various kinds were accumulating irregular or illegal funds in tax haven countries. The institutional investors were not subject to tax concerns, but they were sophisticated asset-allocators looking for underpriced investments. Individuals, mostly investing through banks in Switzerland, Luxembourg, and other European centers, were highly focused on preserving their anonymity. Together, these investors were looking for opportunities that were not available in theUnited States. Eventually, local corporations, European subsidiaries of non-European companies, central banks, and other financial institutions discovered that they could deposit dollars they had accumulated outside the United States with certain banks in London that would retain them as dollars and pay dollar interest rates.

EURODOLLARS FIRST

Thus was born the “Eurodollar,” which was simply a dollar-denominated deposit in a bank or branch located outside the United States. Although they originally tended to be in Europe, these deposits could be anywhere in the world. Such deposits were beyond the U.S. regulatory umbrella, so that neither liquidity reserves nor deposit insurance premiums had to be set aside for them. Original depositors included the financial arm of the Soviet Union, and other East-bloc states wanting to hold dollars but avoid placing their holdings in the United States. Additional dollars were accumulating in Europe as a result of increased economic growth and investment, and the increasing U.S. balance of payments deficits, with many central banks preferring to hold dollars, but not in the United States. Eurodollar investments could be made in the form of bank deposits. Eurodollar interest rates were related to U.S. domestic deposit rates, but only looselyat first—interest rate differentials of 100 basis points or more were not uncommon. Such disparities encouraged American banks to arbitrage the market. Despite the lower deposit rates, depositors were happy to use these accounts to avoid the costs of transferring the money back and forth across the Atlantic, and also to avoid disclosing information about themselves and their financial affairs to U.S. authorities. In time, a small group of banks set Eurodollar deposit and lending rates for the market and established the convention of posting a daily London Interbank Offered Rate (LIBOR). This was the rate at which banks would lend Eurodollars to each other, and is the rough equivalent of the federal funds rate in the Euromarket—the rate a major bank will offer for a loan to another major bank for a specified maturity, such as 30 or 60 days. Today, LIBOR is calculated by examining the rates at which 16 international banks lend to other banks. Thefour highest rates and four lowest rates are eliminated, and the average of the middle eight rates determines the LIBOR. Different rates are determined for the various time periods, so the overnight LIBOR rate is different from the 3-month LIBOR rate.

Major banks post their own rates daily. The rate to be paid on a deposit from another bank is expressed in terms of the London Interbank Bid Rate (LIBID). A nonbank borrower can expect to pay a premium over LIBOR (e.g., LIBOR + ¼%), and a nonbank depositor would receive a rate reflecting a discount (LIBID – ¼%). The spread between these rates, LIBOR and LIBID, has generally been about ¼% or less, much less than the difference between U.S. prime rate and passbook deposit rates. Without this spread, Euromarkets could not exist. Generally speaking, neither depositors nor borrowers would be enticed to leave their home countries unless they receive a higher deposit rate or lower loan rate abroad. Deposit and lending rates are for customers closely tied to LIBOR, which is quoted in most major currencies. Newspapers such as the Financial Times of London publish averages of these posted rates daily.

OTHER EUROCURRENCIES

Banks also quote rates for loans and deposits in other currencies, which, in a way, they manufacture synthetically. They do this by adding the cost or benefit of a forward foreign exchange contract for the prescribed maturity in the desired currency to the U.S. dollar LIBOR rate. If a customer wants a loan based on 60-day sterling LIBOR, the bank first acquires the required amount of sterling in the spot market. The bank then sells sterling forward against dollars for delivery in 60 days, and the cost or benefit of this transaction (in percentage) is added to the dollar LIBOR cost. For example, if LIBOR is 2% and sterling is selling forward at a 0.3% premium, the bank would charge the client 2.3%. We describe how to calculate forward premiums and discounts on currencies in the “Market Functions” section below.

The Eurocurrency market has formed an informal, unregulated, over-the-counter market made up of banks and other professional dealers from around the world transacting in instruments not available in national markets. Occasionally, the Eurocurrency market would devise a financial instrument that would attract a large volume of activity on the part of nationals in various countries. Soon the pressure to deregulate domestic markets to make the same type of financing available became too great for officials to contain. Often involuntarily, most countries have had to give in to the process of imported innovation. The result was a large increase in the number and type of financial instruments available in international markets.

Euromarket participants have tended to be very sophisticated. They understand investment opportunities around the world, foreign exchange effects, and derivative instruments such as warrants and options to purchase or sell securities. With many international banks and investment banks involved in the market, it is highly competitive. Indeed, many firms compete on the basis of innovation and bold initiative. As a result, the Euromarket saw the first significant use of the transferrable certificate of deposit, the floating-rate note, and the Eurobond. It also saw the first use of the “bought deal,” an issue fully underwritten by one bank; the “tap” issue (sold on demand, not all at once); and the “note-issuance facility” for distributing “Eurocommercial paper.” More recently, the Eurobond market has begun to accept some of the more complex and controversial products of the U.S. bondmarket, such as asset-backed issues and non-investment-grade or “junk” bonds.”

Eurobond Markets

Banks, especially U.S. banks, were eager to build up their Eurodollar deposits as a source of funding for their growing international activities. The deposits could be used to fund Eurodollar bank loans or loan participations. They could also be lent to branches in the United States to support lending activity there, if and when the rates were right. And, they could serve as a means of diversifying a bank’s sources of funding for its wholesale lending business. Investors were other banks (there were more than 400 foreign bank branches in London in 1980, all looking to “buy” assets in the interbank market and fund them by “buying” Eurodollar deposits in the market), as well as multinational institutions, and corporations with temporary funds to invest.

The Eurobond market has been a constant source of innovation, with new instruments being introduced as soon as changing regulatory environment or investor preferences dictated. The first Eurobond was offered in 1963 and was sold to investors who were willing to extend their investment horizon to 15 years, at somewhat higher rates. Eurobonds were in “bearer” form (identity of purchaser not disclosed) and were free of withholding taxes on interest. Inevitably, Eurobonds were introduced in other currencies besides the dollar. The Eurobond market soon took off on a continuous expansion that has made it into one of the world’s principal sources of finance. Eurobond innovations include the dual-currency bond, the zero coupon bond, the warrant-bond, the swapped foreign currency bond, the first ECU (European currency unit) and Euro-denominated bonds, and a variety of other new ideas. We discuss the Eurobond market extensively in Chapter 4.

Money Market Instruments

As the name implies, money markets involve borrowing and lending money on a short-term basis, usually up to one year. The international money market developed much more slowly than the Eurobond market. In part, this was because, in the Euromarket, well-known international banks had a lock on the market for short-term funds. The banks were also prepared to offer CDs of whatever maturity an investor might wish. Mostly, there was little demand for trading these instruments. The investors were happy to hold them to maturity unless a special requirement arose to sell them.

Once established, however, the market grew. The various instruments, now available (directly or through simultaneous swaps) in most major currencies, constitute a family of Eurosecurities that makes up a broad and diverse money market. The volume of outstanding paper in these instruments, as well as the secondary market trading in them, increased steadily, from a meager $45 billion in 1986 to over $1.1 trillion in 2007. The global financial crisis that began in 2007, however, has affected these markets, resulting in more funds being repaid than being lent. Despite net issues being negative, the outstanding amount in March 2009 was still over $1 trillion.

The following is a description of the different international money market instruments traded in the Euro money markets.

EURO CERTIFICATES OF DEPOSIT

Euro certificates of deposit (ECDs), like domestic CDs, are time deposits in a bank. They are issued in countries outside the home country of currency, by banks directly or through dealers or brokers. Like Eurobonds, they are issued in bearer form and are free from withholding tax on interest. In 1961, Citibank devised the first transferable ECD. This was a major innovation that soon encouraged secondary market trading in dollar instruments, and eventually led to the creation of the Euromoney market. Although banks do not always want their paper traded in the secondary market, especially when they are issuing new paper that could compete with their older issues in the secondary market, they have bowed to competition. Banks prefer to sell their own ECDs to their clients and correspondent relationships—but often, to extend the market and increase the volume of ECDs outstanding, they resort to dealers to sell the paper for them, for a modestcommission. The banks post their own rates for a spectrum of maturities. Banks will often negotiate with large customers for special rates for CDs with custom-made maturities or other terms. A bank’s posted rates may be slightly higher or lower than rates posted by similar banks, reflecting the bank’s greater or lesser desire to take in funds at particular maturities. Such decisions are made by the bank’s treasury department, which has to balance the entire bank’s requirement for funds and currencies at particular maturities. For most banks, the treasury function in the London branch will conduct most of these Euro-funding operations, generally in close contact with the central office.

The secondary market in ECDs is very active. Banks maintain markets in their own CDs, and encourage their customers to trade with them. As rates change, banks will either increase their issuance of ECDs or attempt to buy in outstanding paper. Brokers may work with the banks as agents, on a nonexclusive basis, to place or buy in ECDs for a commission of a few basis points. Such brokers do not take positions in the bank’s ECDs for their own account. Often, the brokers represent investors seeking the best rates for deposits. Dealers, in contrast, purchase and sell bank ECDs for their own account. They hope to create opportunities for gains from trading in the ECDs, as they would in any money market instrument. Dealers will call the bank in the morning and offer to buy or sell ECDs at particular rates. Then they lay off their positions to customers, or hold them for a few days to wait for an expected market change to occur. Large dealers offer ECDs, along with acomplete menu of other Euromoney market instruments, to customers on a continuous basis.

As an example, a dealer such as JP Morgan Chase might be aware that Mitsui Life Insurance Company is seeking to place $500 million in high-grade short-term investments tomorrow morning, Tokyo time. Mitsui actually wants the investments to have a maturity of 75 days. The posted rate for 60-day ECDs might be 4% and for 90 days, 4.3%. JP Morgan may call a dozen or more high-grade banks during the evening before the next day’s opening in Tokyo to offer to buy 75-day ECDs at a rate of 4.25%, in order to offer them at, say, 4.20% to Mitsui Life . Many banks will turn Citigroup down, but one or two may have a need of their own for a large placement of 75-day ECDs, and thus be willing to pay the somewhat higher rate. Such intense market coverage, together with the willingness of dealers to position paper of all types, including purchasing the entire amount for its own account in order to speed up the process and to be able to beat out competitors, has greatlyimproved the efficiency of the Euromoney market in recent years. The improving efficiency of the market largely explains its rapid growth since the early 1980s.

FLOATING RATE NOTES

In the 1980s, many banks began to offer floating-rate notes (FRNs) as a supplement to their funding activities. These notes were not deposits and, therefore, were subordinate to them. The FRNs might have a maturity of 10 years, but interest would be reset every 90 days at 3-month LIBOR (say, 4.5%) plus a small spread (say, one-eighth of 1 percent). Because of the continuous resetting, the price of the notes was expected to return to par (100%) every 90 days, assuming that the reissue rate continued to be LIBOR + 1/8%. An investor was now given a choice between 90-day ECDs (say, at 4.3%), and purchasing and reselling an FRN 90 days later at a rate of 4.625%, a difference of 32.5 basis points. The investor would have to realize that there was a risk that the FRNs could not be sold at 100% 90 days later, so part of the 32.5 basis points would represent a reserve to protect against selling it at a price below par, plus commissions. The investor might ask adealer to quote a repurchase rate, at which the firm would agree to buy the FRNs back 90 days hence. If a positive spread still existed (and the investor was willing to take the credit risk of the dealer meeting his obligation 90 days later), the investor might prefer the FRN trade to the ECD. However, the investor may prefer to remain a depositor in the bank, rather than a general creditor, and therefore accept a lower rate for the increased security.

To some extent, therefore, the FRN market has traditionally competed with the ECD market. However, as fear about the credit quality of banks emerged in the early 1980s, and again during the financial crisis of 2007–2008, there was less assurance about the ability of banks to roll over funding at the same spread over LIBOR, and the FRN market weakened considerably. So did the market in ECDs, relative to other instruments.

EURO COMMERCIAL PAPER

Commercial paper (CP) constitutes short-term unsecured notes issued by a corporation. CP has been issued actively in the United States since the 1860s, but it first appeared in Europe only in the early 1970s. It was aimed initially at U.S. corporations, which were required at that time by government regulations to finance all overseas investments with foreign borrowings, to provide a money market alternative to bank borrowing. The effort was not successful, despite the advantages of Euro commercial paper (ECP) over domestic CP. U.S. CP is limited by law to borrowings up to 270 days, and can be used only for working capital. Furthermore, it is subject to income tax withholding on interest, and is issued in book-entry form. ECP, by contrast, is exempt from maturity and use-of-proceeds restrictions, is not subject to withholding taxes, and is offered in bearer form. Thus, a substantial difference exists between domestic CP and Eurodollar ECP. Often, thedifference results in an interest rate differential. Commissions and set-up expenses, however, added costs when the ECP market was first established, so that the cost of funds to the issuer was about the same as the cost of a comparable LIBOR-based bank loan. Moreover, Euromarket investors were cautious. They were hesitant to buy the paper of companies that were not already well known, and discouraged by the limited liquidity in the market. Investors were extremely quality conscious at a time when limited international investment-grade rating information was available. Unlike domestic markets, the U.S. and European governments did not offer short-term securities internationally, so investors had to make do with the banks and other corporate issuers that they knew.

In 1974, the regulations requiring U.S. companies to finance overseas were repealed, and the market died away. The economics were simply not there: there was very little benefit to using the market at the time.

If investors were prepared to go out a bit in maturity, they could buy outstanding or newly issued Eurobonds of high-grade, well-known issuers, including some major European governments. The issuers began to shorten the maturities of their bonds (e.g., to 2 or 3 years in some cases) in order to attract these investors, as well as to avoid the extremely high longer-term interest rates of the late 1970s. As trading volume increased in the secondary markets, investors began to accept that they could rely on the liquidity in the market to facilitate a sale of Eurobonds before maturity.

Eurobonds, however, had certain characteristics that limited the flexibility that many issuers wanted. The bonds were of a fixed amount, underwritten, and sold all at once, and they involved considerable expense, which became quite concentrated as the average maturity of the bonds was reduced. Some issuers instead preferred continuous offerings of their paper to the market on a non-underwritten basis. They wanted to simply post rates for a range of different maturities, based on advice from one or more dealers, and then see how many notes the dealers could sell. They could raise or lower the rates based on demand. This is the mechanism used in the U.S. commercial paper market, and in the early 1980s it was applied to the Euromarket in a second attempt to develop a market for ECP.

The second attempt met with greater success. This time, the initiative was aimed at bank investors that needed higher and safer returns on their money market investments. Potential clients also included corporate and institutional investors, who were increasingly concerned by the deterioration in bank credit ratings in the United States and Europe, and wanted to diversify their cash management programs into nonbank investments. Dealers, aware of these concerns, began to approach European money managers with proposals that they switch from ECDs or FRNs to ECP of “name” companies like GE or Exxon. They were only earning 25 basis points less than LIBID from their bank deposits, but they could diversify into higher-grade paper, such as that issued by companies with AAA bond ratings at, for example, LIBID less 10 basis points. Or, if they were prepared to take corporate bond ratings of AA or A (with top-grade U.S. commercial paper ratings of A1 andP1), they could look for a higher rate—for example, the mean between LIBID and LIBOR.

As bank credit worries increased in the late 1980s, and a greater supply of nonbank paper was offered, the market began to develop in earnest. As it did, the recognized rating agencies, Moody’s and Standard and Poor’s, increased their involvement in ECP ratings, and investors became more aware of them. To be rated, issuers had to be able to demonstrate that they had unused bank lines of credit available to provide liquidity to an issuer, should a major market interruption occur in which it would not be possible to roll over maturing ECP. Committed credit facilities in same-day funds, called “swinglines,” had to be in place to cover a few days of the maturities, with “backup” lines, often uncommitted, available for the rest of the maturities.

Unrated paper soon required up to 10 basis points higher interest rates than lower rated (A2, P2) ECP, which itself required 5 to 10 basis points more interest than A1 and P1 rated paper. Ratings became increasingly important after several major defaults in 1989 to 1990. By 1990, the ECP market had increased to about $70 billion of outstanding issues. Citibank, a major ECP dealer, estimated at the time that banks comprised about 45% of the investor market, corporations and money managers and financial institutions 28% each. Among the banks were those which managed substantial investment funds for their clients.

From the issuer’s point of view, ECP provided cheaper funds because the market was pricing it and the issuer did not have to pay significant commitment fees to banks. Accessing the ECP market permitted an issuer to tap into the main investor base in the Euromarket, and represented a diversification of the issuer’s sources of funding.

Dealers initially were enthusiastic about the rapidly expanding ECP market. They wanted to assist existing and new clients for Euromarket services, to appear well placed in the competitive rankings (league tables), and to profit from the growth in the new market. Intense competition forced spreads down, squeezed commissions, and spread too many programs among several dealers. Profits were hard to come by. Of the top 10 dealers at the end of 1987, four (Merrill Lynch, CS First Boston, S.G. Warburg, and Salomon Brothers) had withdrawn from the market by the end of 1990. Subsequently, competitive conditions settled down into a rated-only market, with fixed commissions of 3 to 5 basis points paid by issuers to dealers.

ECP market developments also affected domestic markets. By the mid 1980s, it was possible for issuers to swap dollar-denominated commercial paper into paper denominated in any other major currency. Thus a market grew in “synthetic” Euro-DM, Euro-sterling, and other Eurocurrency commercial paper, including the predecessor to the Euro, the ECU. Such paper began to appeal to issuers from various European and other countries, and this, in turn, put pressure on local regulators to permit the development of domestic CP markets in several countries, such as Japan, Germany, Britain, and France, that had never had commercial paper markets before. The market has grown from $44 billion in 1986 to over $700 billion in 2008.

The development of the ECP market has been one of the more significant innovations in international finance during the past three decades. The market developed to fill a need by international investors for a spectrum of bearer money market paper that was free from withholding and other taxes. Gradually, the spectrum widened to include lesser-quality names, including some speculative Latin American issuers that were appropriately priced by the market. The new market was successful enough to generate further innovation, standardized documentation, and (in time) mature pricing and distribution methods. Its reach extended into note issuance facilities and medium-term notes (MTNs; discussed later in this chapter), and stimulated the development of domestic CP markets almost immediately all over the world. These impressive achievements are examples of the fungibility of money in a marketplace in which capital movements are not restricted, and transactions flow to where theymay be most efficiently effected.

NIFS AND RUFS

Meanwhile, some of the large wholesale banks began to see ECP as a threat to their basic business of providing short-term credit to major industrial and government borrowers. As their clients moved into ECP, they left their bank loans behind. Although the banks furnished the backup credit lines and swinglines needed to access the ECP market, the profitability of these facilities was small in relation to customary bank loans. Banks began to fear a repeat of their experience in the United States, in which the commercial paper market grew rapidly at the expense of bank lending.

To remain competitive in offering short-term credit to their customers, the banks introduced a family of revolving credit facilities, called note issuance facilities (NIFs). NIFs allowed clients the choice of drawing down a loan at an agreed spread over LIBOR, or selling notes (ECP) through the banks at a lower rate. Clients saw NIFs as a souped-up version of an ordinary ECP program, in which all of the benefits of ECP were retained, while still securing the benefits of a committed bank facility. Competition among banks for NIFs resulted in a tightening of the market. Fees (a one-time fee for arrangement, and annual fees for participation and commitment) were squeezed, as were the lending spreads over LIBOR on loans drawn down under such facilities.

A NIF works as follows. An issuer enters into an agreement with a bank for a $200 million revolving credit facility for, say, 7 years. The lead bank syndicates the facility with other banks, according to the normal syndication process described in Chapter 2. Funds drawn down under the facility can be repaid at will, without penalty. The issuer agrees to obtain commercial paper ratings, which in this case we can assume are A1 and P1. If the issuer decides to draw down $100 million for six months, probably to roll it over continually, it has two choices. The issuer notifies the bank that it wishes, as of a prescribed date, either to take down a 6-month loan at the rate provided in the loan agreement, say LIBOR + ¼%, or to issue promissory notes in ECP form to a predetermined group of banks and dealers (usually led by the NIF’s arranging bank) at whatever rate the dealer group mayoffer for distribution to investors. If an ECP alternative superior to the bank loan does not materialize, the banks are obligated to make the loan. Thus, for a modest set of fees, the issuer can have his cake and eat it too. That is, he can have the lower rates of the ECP market, and the guaranteed assurance that funds will be forthcoming, regardless of market conditions.

Well-known, highly rated issuers may decide to forego the underwriting feature offered by NIFs and rely on their ability to continually resell maturing ECP. Such issuers save the arrangement and participation fees charged by the banks, but they must still pay something for backup and swinglines. Over the years, the market has developed efficient pricing for the underwriting function.

A variety of additional NIF features have been introduced by innovative banks. Among these are the ability to use NIFs more comprehensively—that is, for notes issued either in the U.S. commercial paper or the ECP market, for nondollar denominations of drawdown or rollovers, and for bank letters of credit to be used to provide credit backing for issuers who are unable to obtain satisfactory ratings. “Tap” features have also been provided to allow notes to be issued frequently, in small amounts, to satisfy dealer demand. Such issues can involve “continuous tender panels,” in which the placement agent announces daily a rate level at which all bids will be accepted. Aggressive dealers will bid below that rate, to be sure to obtain some of the paper being auctioned. Large U.S. commercial paper issuers, especially those issuing directly (without dealers) often use the tap issue method to obtain the best rates and tospread maturities widely. Direct issuers in the United States account for more than half of all U.S. commercial paper outstandings. Direct issuance is much less common in the ECP market, but, increasingly, large issuers are resorting to self-underwritten tap issues to achieve the most efficient use of the market.

EURO MEDIUM-TERM NOTES

Next in the continuous evolution of new money market products was the Euro medium-term note (EMTN), which followed in the wake of an expanding ECP market and the development of enhanced market activity for medium-term notes in the United States. EMTNs cover maturities from less than 1 year to about 10 years. They were issued, like Eurobonds, by large corporations and by governments and their agencies from all around the world. Though EMTNs had longer maturities, they retained some of the characteristics of commercial paper. EMTNs offer an extension of ECP market practices over greater maturities, and have had the effect of erasing the traditional boundaries between the short-term money market and bond markets.

MTNs have been available in the United States since the early 1970s, but initially they were limited in use because of registration requirements and a lack of a well-developed investor base for 1- to 5-year maturities. The introduction in 1984 of Rule 415, providing for “shelf registration” in the U.S. market, made it possible to offer MTNs continuously in the public bond market. Distribution was through dealers, or directly by large issuers such as GE Capital. Increased volatility in the fixed-income securities market, the steep yield curves prevalent in the 1980s, and the increasing sophistication of fixed-income traders attracted many investors to MTNs in the mid-1980s. Further innovations in product design by dealers and issuers—such as offering floating-rate, as well as fixed-rate returns, deep-discount zero coupons, and multicurrency options—made the MTN into a highly flexible and desirable investment vehicle. Thedomestic U.S. MTN market matured during the period 1988–1992, during which new issue volume rose from $38 billion to $192 billion. The market peaked in 2001, with outstandings over $400 billion. Since 2004, however, the market has been drying up. Several reasons exist for the collapse. Structured Investment Vehicles (SIVs) were important issuers of MTNs. However, SIVs were hit hard by the global financial crisis in 2008, and therefore stopped issuing MTNs. Moreover, many issuers of MTNs were in the real estate industry, which was also hard hit by the global crisis. Also, MTNs are typically over the counter and therefore not very liquid. Finally, the Securities and Exchange Commission has indicated it will make issuing medium-term notes more expensive, so potential issuers are naturally reluctant to set up MTN programs that may become more expensive than planned. Potential issuers explore other financing arrangements.

The growth during the 1990s was largely because of the flexibility that MTN programs offer to large, frequent borrowers, which, in the Euromarket, tend to be sovereign governments and multinational institutions such as the International Finance Corporation (an affiliate of the World Bank) or the European Bank for Reconstruction and Development (EBRD). Such borrowers have continuous financing requirements and use the full spectrum of the yield curve to obtain it. Changes are frequently made in their borrowing “strategies,” which result in changing the maturities of outstanding liabilities to pursue opportunities for lower funding costs, or to hedge against expected interest rate or foreign exchange movements. In considering how to obtain the lowest overall cost of borrowing, such issuers must also consider the cost of issuance. EMTNs involve very low documentation costs and standardized legal documentation, and they may beissued on a continuous non-underwritten basis, in which the issuer only pays a commission of a few basis points, or distributes the notes itself.

In a normal Eurobond offering, an issuer must pick a time, an amount, and a currency, and then auction the bonds off to the highest bidder—that is, at the lowest interest rate. The issue will be large enough (typically $200 to $300 million) to satisfy financing requirements for at least several months, and it will involve payment of underwriting and placement commissions to an underwriting group. In an EMTN program, the issuer announces to the market a program for the issuance of debt securities (PIDS) through continuous offerings over an extended period. Issuers tend to be financial institutions who want to come to the market frequently, and who want the flexibility to take advantage of favorable funding opportunities that arise. The EMTN program allows such flexibility, because the documentation is in place. Importantly, the finance director of an issuer wants to have a large enough EMTN program so that further issuance is preapproved. A complication isthat boards of firms tend to approve debt limits on an annual basis, whereas EMTN programs tend to be multiyear. Ideally, an issuer never reaches the limit and always has room for further issuance. To ensure that an issuer never reaches the limit and always has room for further issuance, the finance director tends to ask for increased limits over time. A document similar to a U.S. Rule 415 shelf registration provides details of the program, and a 1-page supplement is produced when securities are issued under it. The program is rated by the agencies, and sometimes a road show is put together to inform potential investors about the issuer. When the program is ready to go, the issuer can bring out large “tranches” (say, $200 to $300 million each) under normal Euromarket underwriting methods, or resort to tap issues, or both. The issuer can post rates, or have dealers post them, at which it is willing to take all offers. Alternatively, it can auctionthem off one day at a time, in any Eurocurrency it likes. If the market fails to take the paper at a maximum rate, and the issuer has a NIF, the issuer can require its syndicate of banks to take it. If the U.S. market is cheaper, it might go there if a shelf registration is in effect. There are a great many options.

TREASURY SECURITIES

International money markets also include domestic short-term government securities that are purchased by international investors. Mainly, such investors are interested in such (treasury) bills and notes because of their liquidity and high quality. These securities are available in all industrialized countries and many less-developed countries. Foreign central banks hold U.S. Treasury securities as part of their foreign exchange reserves. They usually buy them at auction and hold them until maturity, then replace them with new purchases. Countries such as China, Japan, Korea, and Taiwan have accumulated very large positions in U.S. Treasury securities, as their balance of payments positions have accumulated large surplus over recent years. Chinese investors have increased their ownership of U.S. Treasuries from $60 billion (1% of Treasuries outstanding) in 2000 to over $800 billion (7% of Treasuries outstanding) in 2009. However, Chinaand the other countries that have become major investors in Treasuries don’t have many options to reinvest the money elsewhere without affecting trading relations with the United States, or finding themselves investors in an even less desirable currency. Despite their increased interest in Treasuries, these governments have expressed concerns about their investments being exposed to a decline in the value of the dollar. One Chinese bank regulator noted that the U.S. dollar is sure to fall in value. He said, “We hate you guys. Once you start issuing $1 trillion–$2 trillion … we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do.”1

Investors acquire foreign treasury securities (which, usually, like U.S. Treasuries, are not available in bearer form and may be subject to foreign withholding taxes on interest paid) for essentially two reasons. One is to take a position in a liquid instrument that is subject to an expected price change because of changing interest or exchange rates. Such investments are “uncovered,” or unhedged, positions. The investor wants the risk that the euro will increase in value relative to the dollar, and that foreign “speculators” will bid up the price of German treasury securities, which are denominated in euros. The other reason is to take a “covered” position, through which the investor might pick up several basis points of yield. If the investor can buy a 6-month German treasury bill, which, when swapped from euros into dollars, yields more than 6-month U.S. Treasury bills, he or she may be betteroff. A well-informed investor will scan the world’s treasury and swap markets frequently looking for such opportunities. For a start, the investor can consult the daily posting in the Financial Times of world “money rates,” which reflect the secondary market prices for treasury bills in the various cities (i.e., countries) indicated.

Wholesale banks in most countries are very actively involved in domestic and international treasury securities. A substantial portion of the large volume of trading profits reported by large U.S. commercial banks comes from trading in U.S. and other government securities. Originally, these banks entered into the business to provide services to customers and to effect their own transactions in the government securities market. Later, trading for the banks’ own accounts became a major business. The substantial market liquidity and the wide range of securities available make these securities ideal for trading. Large universal banks in most European countries and large investment banks also trade extensively in the government securities markets of several countries, often serving as a registered market-maker. Several foreign banks are registered primary market dealers in U.S. government securities.

Interpreting Money Markets

Besides LIBOR, another important rate is the overnight index swap (OIS) rate.2 As with any swap, an OIS is an exchange of one obligation for another. In this case, one party has a short-term loan with a fixed interest rate. Another party borrows at the overnight rate, which is a floating rate. The parties exchange interest payment obligations so that the party with the loan at a fixed interest rate pays the floating overnight rate, and the party with the loan that is refinanced every day at the overnight rate pays the fixed rate. Little credit risk exists, because the parties exchange no principal and swap only interest payments. At the end of the contract, the parties settle the net difference between the fixed rate and the geometric average of the overnight floating rates. That is, whichever party has paid less interest will pay the difference to the other party. The OIS rate itself is the fixed rate used in the swap. In the United States, forexample, the fixed rate is the effective federal funds rate for the life of the swap contract. This rate reflects the market’s expectations of overnight borrowing costs for the term of the swap. Since these are very short-term rates, they are influenced more by liquidity risk than by credit risk. That is, day to day, most parties are able to repay their loans, so credit risk is not a major issue. However, parties may experience shortages in liquidity. On the other hand, LIBOR is set for longer periods of time (1 month, 3 months, up to one year) so LIBOR includes not only liquidity risk but also some degree of credit risk.

LIBOR and OIS are used not only to price international loans, but also reveal market sentiment. Subtracting the OIS rate from the 3-month LIBOR rate determines the LIBOR-OIS spread. Liquidity risk is netted out of this calculation, so the spread indicates the market’s perception of the short-term credit risk of the parties transacting the contracts, usually banks. Alan Greenspan, former chairman of the Federal Reserve Board, noted that, “Libor-OIS remains a barometer of fears of bank insolvency.” A narrow spread suggests the market has confidence that borrowing banks will be able to repay their loans. Lending banks are, therefore, more willing to provide money market funds so that banks can lend out more funds to the larger economy. Wider spreads suggest the market is concerned about the short-term credit risk of borrowing banks. Banks are less willing to lend to each other, which leads to credit being choked to the economy as a whole.Historically, LIBOR and OIS rates have been very similar and the spread has been around 10 basis points. Starting in August 2007, however, the spread started to increase, and reached a peak of 354 basis points in October 2008. After the bankruptcy of Lehman Brothers in September 2008, lenders faced two critical uncertainties. They were not sure potential borrowers could repay, and, perhaps more devastating, they did not know their own exposures to other institutions, some of which could go the way of Lehman. This lack of transparency was the result of complex financial instruments such a credit default swaps, which we discuss in Chapter 6. As a result of these uncertainties, lenders stopped lending and money markets essentially froze. Central banks stepped in and lent massive amounts to banks to revive the money markets. OnSeptember 29, 2008 alone, the European Central Bank and central banks from England, Japan, and the United States lent a total of $620 billion to their respective banks. The actions seemed to help. By July 2009, the spread receded to 34 basis points. See Exhibit 1–1.

Exhibit 1–1

Foreign Exchange and Money Markets (1)

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LIBOR-OIS Spread (basis points) September 2005 to September 2010. Source: Bloomberg.com

A similar gauge to market sentiment is the Treasury-Eurodollar (TED) spread, calculated by subtracting from the 3-month LIBOR rate, which reflects both credit risk and liquidity risk, the 3-month futures contract for U.S. Treasuries, which reflects only liquidity risk. As with the LIBOR-OIS spread, the TED spread reflects the market’s perception of short-term credit risk. TED spreads ranged from 25 to 75 basis points until August 2008, when they shot up to almost 250 basis points. The spread topped 450 basis points in October 2008, but fell back to historic ranges starting in May 2009. See Exhibit 1–2.

Exhibit 1–2

Foreign Exchange and Money Markets (2)

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TED Spread (basis points) September 2005 to September 2010.  Source: Bloomberg.com

Foreign Exchange Markets

Dealing in foreign exchange has become an increasingly important activity for all international bankers and money market investors. The importance is due to the continuous increase in world trade, and cross-border financial flows in support of the real economy, in a time of high volatility in foreign exchange markets. Customers of banks need assistance in managing and hedging their international cash flows, and banks have long been in the business of assisting them. In addition, funds flows in support of cross-border financial investments have increased substantially as a result of greater appreciation of international investment opportunities and easier mechanics through which to make them. Investors need to fund these investments, and to hedge them from time to time. Market-making by banks in foreign exchange has been an essential and profitable service to customers in both themanufacturing and financial sectors. Finally, banks and investment banks, and some investment funds—notably hedge funds—have found dealing for their own accounts to be an attractive source of potential profits. As in most trading markets, high volume and volatility create an ideal environment for skillful participants.

Some years ago, government officials, in discussing the foreign exchange markets, referred to participants as “legitimate” commercial users versus “speculators,” presumably indicating the latter group as being something other than legitimate. As market practices have become better understood, this distinction, probably never very useful, is no longer used. All players are simply “investors.” Some have mundane reasons for playing, perhaps, and others have more sophisticated ones. But they cannot be distinguished in the market, which attracts transactions of whatever kind because of changing investment conditions.

INCREASING TURNOVER

The large and active foreign exchange market is like any other “free” marketplace, except for one important difference: governments, through their central banks, sometimes intervene to influence exchange rates. Their purchases and sales, especially when there is international coordination, can make a significant difference in rates and (more important sometimes) in the expectation for future rates. Most nongovernment players see the government role as placing an artificial limit on price movements in one direction or another, and thus they attempt to position themselves to benefit from it. Playing against the governments, in other words, can be extremely profitable for dealers and investors, and this (during a time of significant amounts of government intervention) has helped considerably increase the volume of turnover in the world foreign exchange markets. As of the end of 2010 (even after the consolidation of 12European currencies into the euro), average daily foreign exchange turnover was over $4 trillion. Interestingly, lower international trade in the first quarter of 2009 led to a 20% decrease in FX trading. Despite the volatility, the foreign exchange market is by far the world’s largest financial market.

MARKET ORGANIZATION

The foreign exchange market is an informal, over-the-counter market, organized into trading centers around the world. The market has no central clearinghouse or exchange, and it operates mainly through dealers. Interdealer transactions constitute approximately 75% of all trading in the major centers. The dealer market is highly concentrated, with the ten leading dealers in each major center accounting for roughly 40% of the market. Dealers sometimes specialize in only a few currencies, although some are more broadly active. Dealers make markets in a variety of foreign exchange (forex) products, including spot and forward rates, swaps, and other derivatives.

Although the foreign exchange market is unregulated, central banks are active participants and are able to keep an eye on the behavior of banks, to which regulatory controls apply, and other players from their countries. The leading center for foreign exchange trading is London, mainly because London is the center of the Eurocurrency market and overlaps both the New York and Tokyo time zones. In 2007, London accounted for almost 35% of global forex turnover. The United States accounted for about 17%, and Japan, Switzerland, and Singapore 6% each, of global forex turnover.

MARKET FUNCTIONS

Buying foreign currencies is like buying any other good. The currency has a price, called an exchange rate. Since the early 1970s, most currencies in developed economies are floating. That is, the price of the currency is determined by market forces. The price changes continuously as the market forces of supply and demand change. FX products include spot and forward contracts, as well as swaps. Spot contracts bind two parties to deliver one currency for another within a short period of time, usually two business days. Spot contracts are sold by brokers or dealers. Brokers match buyers and sellers of currencies and charge a commission for the service. Dealers have an inventory of currencies, and stand ready to buy or sell currencies. They earn a spread, known as the bid-ask spread on the transactions. Banks are usually dealers, and will charge the bid price to buy a currency and pay the ask price. Forward and futurescontracts set the price today for delivery of the currency at a specific date in the future. While the mechanics of forwards and futures differ, the result is the same. The buyer of the contract knows how much the currency will cost in the future. Currencies that are more expensive in the future are said to be trading at a premium, while those that are less expensive are trading at a discount. For example, if the spot rate of the euro is $1.00, and the 3-month forward rate is $1.05, the euro is trading at a forward premium of 5% (= ($1.05 – $1.00) / $1.00). Typically, premiums and discounts are quoted on an annualized basis, so the premium would be 20% (= 5% x 12/3) per annum. To determine the forward discount at which the dollar is trading, the reciprocal must be taken. That is, if the euro costs $1.05, then the dollar is trading at € 0.9523 (= 1 / 1.05). The dollar is selling at a forward discount of 4.76% (= € 0.9523– € 1 / € 1), or an annualized discount of 19%. The premium reflects the discount differential in interest rates between the currencies for the period involved. Market makers will buy and sell forward contracts if they get out of line with covered interest parity through arbitrage transactions.

In addition to spot and forward rates, dealers also trade in currency swaps and currency options, futures, and customized currency derivative securities. We discuss these instruments in Chapter 6.

CLEARING AND SETTLEMENT OF FOREIGN EXCHANGE

Unlike the international money markets, foreign exchange transactions flowed smoothly during the global financial crisis that began in 2007.3 A major reason banks were willing to continue foreign exchange transactions with other banks, even in the wake of growing risk that the counterparty may not reciprocate, was the existence of the Continuous Linked Settlement (CLS) Bank. The CLS Bank is an intermediary between the two parties of a foreign exchange transaction. For example, if a Japanese bank and a U.S. bank want to trade yen and dollars, the Japanese bank will send yen to the CLS bank. Several hours later, when the U.S. bank opens, it will send dollars to the CLS Bank. Only after both parties submit their respective currencies will the CLS Bank transfer funds. If for some reason the U.S. bank does not submit its funds (e.g. the bank fails or the government suspends foreign exchange payments), the CLS bank returns the yen to the Japanesebank.

The CLS Bank came into existence as a result of the debacle in 1974, when Herstatt, a German bank, failed. Banks that had submitted their side of an FX trade suddenly did not receive the other side of the trade. This risk of nonpayment in FX transactions as a result of the failure of a bank became known as “Herstatt risk.” The establishment of the CLS Bank in 2002 eliminated Herstatt risk so that banks were willing to continue FX trading, even when they were unwilling to continue other types of transactions.

BEATING THE SYSTEM

As noted, dealers—on their own behalf and for the benefit of customers—often propose forex trading strategies that are intended to take advantage of the market intervention activities of central banks. Such intervention, which can be in market purchases of spot and forward contracts, or in futures or options markets, can also involve resetting domestic interest rates to affect forex rates. Intervention can occur whenever policyholders of one or more countries are unhappy with the foreign exchange between their currencies and seek to adjust it. Intervention usually takes place when a currency is fixed to another. In such systems, the central bank is required to support its currency when it falls below the stated rate. Intervention can also occur in the U.S. dollar market, relative to major currencies, such as the yen or the euro, when such currencies move toward extreme values relative to the dollar. In recent years, the U.S. governmenthas resisted intervention, in order to let market forces work to effect stabilizing changes in trade flows, even at the “cost” of a weaker or stronger dollar.

During periods of currency intervention, great sums can be invested by central banks in support mechanisms, and great fortunes can be made by bold investors who invest heavily against them. Before the introduction of the euro, 12 European countries fixed their currencies to each other. In September 1992, the central banks of Britain and Germany spent approximately £50 billion in an unsuccessful attempt to support sterling. George Soros, a prominent American hedge fund manager, is thought to have made profits of $1 billion from the sterling crisis. Many banks and dealers made large profits as well.

There are principally two trading strategies used by private investors during such crises. One is to sell the vulnerable currency forward for one or two months, often against the stronger currency. Large positions must be taken to make meaningful profits, because even if the weaker currency is devalued, it may not be by more than a few percent. The investor typically borrows the weaker currency and buys government securities in the stronger currency. The investor then enters into a forward contract, which does not require a cash outlay until the maturity date. When the contract comes due, the investor buys the weaker currency in the spot market at a new, hopefully lower, price. The investor delivers the weaker currency and receives the stronger one. A large gain could occur if, say, sterling depreciates relative to the euro by 5%–10% over a 3-week period. The costs of the position are principally the costs of borrowing sterling at a high interest rate (theburden of the weaker currency) minus interest income—from, say, German treasury bills, denominated in euro, which could carry relatively low interest rates during such a currency crisis—plus transaction and margin costs. If the investor bets right, there is an ample margin to fund the interest differential and transaction costs, but if sterling manages to resist depreciation, the investor’s loss will be limited to the interest differential. Once the crisis is past, however, sterling might rally relative to the euro, so it will be important to be flexible enough to get out of the position on a timely basis.

Another strategy is to establish interest rate positions in the weak currency (e.g., through purchases of bonds, or through forwards or futures contracts) once a currency crisis has begun. Here, the investor expects interest rates in the weaker currency, pushed up during the effort to prevent depreciation, to drop sharply, thus causing a corresponding increase in bond values. The value of the bonds the investor bought at the beginning of the crisis is expected to increase.

The two strategies are different and involve different risks. To make money, however, both depend on the weaker currency actually depreciating. Other strategies that bet on the weaker currency surviving the crisis unchanged are also possible. Such a strategy, for example, could involve borrowing euros (at relatively low rates) to buy U.K. treasury bills at relatively high rates.

COMPETING IN MONEY MARKET AND FOREIGN EXCHANGE TRADING

There are a great many competitors in the international money and foreign exchange markets. Some firms specialize in these activities, but most conduct them as a part of a broader commitment to financial market-making. Commissions are very thin in these high-volume markets, and most firms make their money from trading.

In money markets in particular, trading success depends on an effective distribution system through which positions can be bought and sold at reasonable prices. This usually means being closely in touch with investors, corporations, and end users in general. (Nobody gets rich trading only with market-makers like JP Morgan Chase.) It also depends on having good information, through sales force feedback and from contact with other dealers and issuers. Telecommunications systems have to be as modern as possible to stay in contact with market players all around the world; indeed, these are so important that many firms regard their own as “key competitive weapons.”

Foreign exchange trading inevitably means substantial position taking, if a dealer expects to make much money. This is a risky and volatile business for most dealers, and all ways possible are utilized to minimize risk by hedging and using derivatives and technical trading strategies. Most of the larger players are commercial banks, which have a natural competitive advantage in comparison to nonbank dealers, in the daily foreign exchange order flow from their customers. Being able to trade with customers in large volumes helps protect the bank’s overall dealer spread (between the buy and sell rates quoted), and serves to ensure at least a minimal level of profitability. Adding more aggressive trading for the bank’s own account, in which large speculative positions are taken, can considerably boost—or reduce—trading revenues. Exhibit 1–3 shows the foreign exchange trading income of several major U.S. banks from 1983 through 2009.

Exhibit 1–3

Foreign Exchange Trading Income of Major U.S. Banks (US$M)

1983199020002009

Bank of America

102

207

524

972

Bankers Trust

28

425

30

Chase Manhattan Bank

117

217

Chemical Bank

40

207

Manufacturers Hanover

27

106

Citibank

274

657

Citigroup

1243

2762

Continental Bank Corp

24

187

First Chicago

36

103

Bank of New York

13

48

215

Marine Midland

19

3

J. P. Morgan & Co.

74

309

J. P. Morgan Chase

1465

4053

Republic New York Corp.

8

77

TOTAL

762

2547

3477

7787

1983199020002009

Bank of America

102

207

524

972

Bankers Trust

28

425

30

Chase Manhattan Bank

117

217

Chemical Bank

40

207

Manufacturers Hanover

27

106

Citibank

274

657

Citigroup

1243

2762

Continental Bank Corp

24

187

First Chicago

36

103

Bank of New York

13

48

215

Marine Midland

19

3

J. P. Morgan & Co.

74

309

J. P. Morgan Chase

1465

4053

Republic New York Corp.

8

77

TOTAL

762

2547

3477

7787

Source: Annual Reports/10Ks/Call Report Data.

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Consultants and other experts who offer services predicting market behavior, or access to “inside thinking” on the part of government officials, make a good living, but there is little evidence that they know any more than the market reveals in the price of the instruments and contracts. Technical trading strategies can be successful, but like all trading, success seems mainly to depend on discipline, courage, capital, technical skills, and experience. Most market-makers would also add that good luck plays a major role in successful trading. Most of their supervisors would add that effective internal control procedures are no less essential.

Summary

International money and foreign exchange markets have expanded rapidly since the early 1980s, as market liquidity has increased by the removal of capital controls and the encouragement of cross-border investment flows. Increased interest rate and foreign exchange volatility has also made these markets more active. A full array of international money market instruments, closely comparable to those in the United States, now exists. Linkages through swaps and foreign exchange contracts have served to integrate money markets in the world’s major countries. The success of ECP and EMTNs has caused many governments to adopt similar instruments in their own domestic markets.

The story of Euronote programs and Eurocommercial paper is one of rapid change at all levels. The competitive structure of the market has undergone substantial modification, with bargaining power tending to shift away from borrowers toward investors. In the early days, top and lesser-quality names alike benefited from the intense competition among banks that resulted from deregulation and disintermediation. They profited as well from a lack of investor sophistication. Today, most corporate and institutional investors have a full understanding of the workings of the market and what is available to them. And distributive power has been concentrated in the hands of a few firms, which are more interested in volume and profitability than in the number of dealerships they hold. Gone are the days of loss-leading for a place in the market. Attention is on courting the investor base in search of greater diversification of funding.

Other changes have occurred as well. Distribution methods have been modified to suit new conditions and demands. The use of ratings has increased in the ECP market, with the need for investors to react quickly in fast-moving markets. The very nature of the instrument has evolved, with the non-underwritten ECP now predominating over Euronote programs. These changes will continue, as new economic conditions will give rise to new requirements and new responses. The Euronote grew as a substitute for syndicated loans, floating rate notes in the Eurobond market, and euro certificates of deposit issued by banks. Its success came in part from the events shaping the financial world at the time. As increasing globalization brought increasing competition, so the pace of product innovation has quickened.

As the Euronote market deepened, it became obvious that prime borrowers could dispense with underwritten facilities altogether, thus reducing costs. ECP provided greater flexibility for borrowers and investors alike. It offered a faster and more efficient method of placement. These advantages led to a widening of the investor base and, consequently, further reduced costs and increased flexibility. Euronote programs, and subsequently ECP, have had substantial success. They are perhaps best viewed as a complement to, rather than a replacement for, more traditional forms of bank finance—an additional financial string to the borrower’s bow, offered as part of an increasingly efficient international money market. Despite the efficiency, international money markets can freeze, as they did in 2008. Concerted government intervention was instrumental in restoring confidence in the international money markets.

Foreign exchange market volatility, and government intervention (especially in the EU during the early 1990s) to prevent it, has provided traders with many opportunities to make large fortunes. The foreign exchange market is the world’s largest and most liquid financial market, although about three-quarters of its turnover is through interdealer transactions. The power of this market is enormous, and even large-scale government intervention has been ineffective in controlling it. Future government intervention, therefore, may be far less than in the past, with trading opportunities diminished accordingly. The establishment of the Continuous Linked Settlement Bank in 2002 drastically reduced counterparty risk: even during the financial crisis that began in 2007, FX transactions continued smoothly.

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