Introduction To Capital Markets1
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Capital Markets Training Morgan Stanley January, 2006
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Introduction
Lets introduce
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Agenda
Overview of Capital Markets Financial Instruments Participants Life Cycle of a Trade Trade process
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Introduction to the capital markets
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What is capital ?
To many people it is the value of their assets - property, bank deposits, cars, jewelry etc - net of their liabilities In the financial markets capital refers to financing instruments, in particular fixed income securities and equity. That are traded for cash
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Who supplies capital ? (purchases financial products)
Firms Individuals Funds: ÆInvestment/mutual ÆInsurance ÆPension ÆHedge etc Banks, governments and probably everyone else
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Who demands capital? (sells financial products)
Firms Individuals Funds: ÆInvestment/mutual ÆInsurance ÆPension ÆHedge etc Banks, governments and probably everyone else Exactly the same set of participants
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So what are capital markets ?
Capital markets are markets in which financial securities like stocks and bonds are bought and sold. Markets in which medium and long term finance is raised, facilitating the flow of funds
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Capital Markets
generated cash
financial assets Surplus funds
Need financing
Firms
require investment
cash to invest
Investors
dividends/interest Capital markets
Reinvestment
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Importance of Capital Markets
Capital markets serve several important functions in the economy
Match capital providers with capital seekers
Match those willing to take risk with those seeking to mitigate risk
Help with allocation of resources across regions (globally) and industries
Help with integration of world economies and bypass local inefficiencies
Facilitate integration of different markets (e.g. farmers with food products industry)
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The characteristics of capital markets – price discovery
Price discovery process - The interactions of buyers and sellers in the financial market to determine the price of an asset/ required return on an asset. The market price should: Æreflect all available information Æadjust quickly to new information
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Characteristics – operational efficiency
In order for capital markets to be “informationally” efficient, they must be “operationally” efficient as well trading convenience large number of participants low cost of trading rapid execution of trades
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Characteristics - efficiency (cont.)
If capital markets are efficient: The price of an asset is the same everywhere in the market Most financial transactions are zero-sum; i.e. one party gains only at the expense of another The “law of one price” holds; i.e. equivalent securities must sell at the same price Arbitrage opportunities can not exist - arbitrage allows you to earn risk-less profits without any capital commitments
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Characteristics - market types
Primary market ( Eg: Buying a new house from the dealer) Æwhere new securities are created by surplus units lending to deficit units Æoriginal issue of stocks, bonds and other financial assets Secondary market (Eg: Buying a second hand house from user) Æwhere existing securities are traded Æprovide liquidity Æofficial exchanges: stock exchanges, derivatives exchanges ÆOTC market
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Characteristics – types- market mechanisms
Order driven market Æbuy and sell instructions are fed into a central computer system Æautomatic matching Quote driven market Æprices are determined principally by professional dealers bid/offer quotations Æorder management OTC markets Æno standards, all negotiable Æ24 hours trading activity
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Financial Instruments
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Covers Instruments in brief Does not cover Credit Derivatives and exotic derivatives
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Equity
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What is equity ? Equity i.e. stocks & shares, are financial instruments representing ownership interest in a corporation or similar entity
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The characteristics of equities
You share in the profit the company makes ÆDividends - payments declared quarterly, six months, yearly Voting rights at AGM’s ÆPro-rata on your share holding
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Types of shares
Ordinary Preferential Rights Depository receipts
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Ordinary Shares or Common Stock Purpose: Æ To raise long term financing by selling ownership stake in the corporation. • Shareholders have certain rights Æ To Elect/remove Company Board of Directors Æ Voting on resolutions at company meeting (AGM, Special Meetings) • Key Characteristics: • Right to elect directors to the board and vote on corporate resolutions • Right to residual claim in liquidation (after all other claims have been paid) • Entitled to pro-rata share in profits of the company
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Preferred Shares •
Purpose: •
•
Ownership at reduced risk, in exchange for reduced upside
Lifecycle: •
Like common stock but normally no voting rights
•
Can be perpetual, redeemable by holder, callable by issuer or converted into common stock
Characteristics Æ Right to fixed dividends Æ Priority over Common Stockholders Æ Voting rights in exceptional situations, e.g. dividend skipped for 3 years in a row
Characteristics of preferred dividends Æ Can be cumulative, i.e., skipped dividends are not forgotten Æ Can be participating, i.e., in good times, can receive additional dividends
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Rights Purpose Æ To raise additional equity capital without diluting ownership of existing stockholders Lifecycle Æ Offered by corporation to existing stockholders in proportion to their existing holdings Æ Usually trades as intrinsic part of the common stock from announcement of Corporate Action and until completion of distribution. Stock price reflects the value of right. (concepts: announcement, record and pay dates, ex-date, cum-rights) Æ Set to expires after a date in near future Æ Often followed by secondary public offering to make up for quantity yet unsubscribed Characteristics Æ Represents a right to buy shares of common stock at set price within set expiry date Æ Short life (months or weeks) Æ May be listed on exchanges for secondary market trading The rights holder can Æ Sell the right if traded separately, renounce the right in favor of someone else, or sell the stock cum-rights Æ Exercise the rights and purchase additional shares at the set price Æ Let it lapse Copyright ©2005 Kanbay Incorporated. All rights reserved.
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ADR AMERICAN DEPOSITORY RECEIPTS (ADR) •
Purpose •
To facilitate investing in foreign corporations by eliminating burdens of currency conversions, time zones and foreign market regulations
•
Lifecycle •
A custodian creates a pool of shares of original stock from the home market
•
The custodian issues receipts representing proportional shares of this pool. These receipts represent indirect ownership.
•
The receipts are listed on US exchanges for secondary market trading
•
Custodian manages currency issues, home market regulations, dividends and other corporate actions
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Value of stocks
Company profile Sector profile Tax regime Political climate Social climate Cyclical climate Energy prices Commodity prices Interest rates Basically ANYTHING
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Valuing equities - information
Annual reports and balance sheets Research publishers such as S & P, D & B Registrar of Companies Stock Exchanges / Market information / SEBI Stockbrokers’ circulars THE PRESS
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Popular Stock Exchanges / Indices
NYSE (New York Stock Exchange) Æ Dow Jones Industrials (since 1894) Æ Standard and Poors 500 Æ NASDAQ Composite - Technology stocks
Tokyo Stock Exchange: Nikkei 225 Hong Kong Stock Exchange: Hang Seng Frankfurt Stock Exchange: DAX London Stock Exchange: FTSE100 Paris Stock Exchange: CAC40 National Stock Exchange / BSE: Nifty / Sensex
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Fixed Income
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What is a bond ? A bond is a loan made by investors to companies, banks, corporations and governments. They are debt obligations with long-term maturities
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Bonds What is a Debt Instrument ?
It’s essentially an I Owe You (IOU).
Lender lends the money to the Borrower in exchange for Æ Interest payments during the term of IOU Æ Principal repayment at maturity of the IOU
Lender may impose certain terms and conditions on the Borrower.
Why borrow ?
Need funds for limited period
Earnings expectations > interest costs
Tax advantage – typically interest expenses can be expensed
Financial covenants may require company to maintain certain financial ratios
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Bond - forms
Bearer bonds ÆNo registered owner on the certificate hence holder is the owner Registered bonds ÆOwnership is recorded in either physical form on the certificate or on a book entry account
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Bond - coupon payments
Bearer bonds ÆOn each coupon date the bondholder (or their custodian bank) clips the relevant coupon from the bond certificate and claims the interest due from the issuer’s paying agent Registered bonds ÆPaying agent will automatically pay the registered holder Characteristics ÆStraights - the amount of each coupon is the same and is fixed at issue ÆZero-coupon bonds - issued at a discount with a fixed final maturity value. Hence coupon received at maturity ÆFloating rate bond - coupon adjusted at predetermined periods, linked to a benchmark rate
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Examples •
Corporate Bonds
•
US Treasury Bills, Notes and Bonds
•
Municipal Bonds
•
Collateralized Mortgage Obligations (CMO)
•
Asset Backed Securities (ABS)
•
Commercial Paper
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Corporate Bonds •
Purpose •
•
To raise capital for limited duration
Lifecycle •
Issued through public offer or private placement
•
Secondary market trading facilitated by brokers. A small fraction is also listed on exchanges for secondary market trading.
•
Periodic interest payment by issuer. Some bonds are sold at a discount (zerocoupon bonds)
•
Call & Put Option - May permit early redemption by holder, early call by issuer
•
At maturity, issuer repays holder as per issuance terms
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Corporate Bonds
Characteristics Æ Face value, typically $1000. Issuance price may be different from face value Æ Long term instruments in excess of 1 year to maturity usually nearer 10 year life span Æ Maturity date and value. The maturity value may be different from face or issuance price. May be bullet or staggered repayment. Æ Provisions to pre- or post-pone maturity Æ Interest payment terms. Rate can be fixed or floating rate tied to a benchmark, e.g. LIBOR, or Zero coupon Æ Seniority Æ Most bonds are rated by a rating agencies such as S&P, Moody’s, etc. Æ Some bonds allow coupons to be stripped and traded separately
An example - GM JJ15 7.5% of 2022 Æ Face value is $1000 (this can be assumed) Æ Coupon is 7.5%, paid twice a year on 15th of Jan/June. Twice a year is typical. Æ It matures in 2022
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The ratings
Long term debt Best quality grade High quality grade Upper medium grade Medium grade
Short term debt
S&P AAA AA+ AA AAA+ A ABBB+ BBB BBB-
S&P A1+ A1 A2 A3
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Moody’s Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
Moody’s P1 P2 P3 PAGE 37
What are the money markets ? Markets for short term debt instruments with original maturity of one year or less
Technically speaking, “capital markets” are for longer dated securities
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Money markets
Interest (or benefits) paid at maturity (date when the security is returned to the issuer and the debt is repaid) High grade securities with little or no risk of default (sovereign states, banks and major corporations) Money market instruments can be sold on either a: ÆDiscount basis - the money market instrument is sold at a discounted price and bought back at its real face value by the issuer ÆCoupon basis - the instrument is sold at its face value and bought back at its face value plus a coupon element
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Money markets instruments discount basis
Treasury Bills (T-Bills) Æ issued and guaranteed by the Government Æ Sold on a discount basis: difference between the face value and the purchase price represents interest earned by the investors
Commercial paper Æ a promissory note sold by very large, creditworthy corporations Æ issued for a specific amount and maturing on specific date Æ backed by a “standby letter of credit” from a bank Banker’s acceptances Æ Bank promises to pay the face amount when the acceptance is presented to it - made to importers and exporters
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Money markets instruments - coupon basis
Fixed deposits/loans Certificates of deposits (CD’s) Repurchase agreements (Repos)
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Bond - pricing
Issuer rating Coupon rate (compared to MM rate) Time to maturity Yield to maturity
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Bond - prices
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Interest Rates and Time Value of Money Time-value of money – key concepts Æ FV (future value) and PV (present value) Æ NPV (net present value) Æ IRR (internal rate of return) Most financial calculators (and MS-Excel) have built-in functions for FV/PV
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FV & PV
FV = PV * (1+r/100)^t PV = FV/(1+r/100)^t FV = Future Value PV = Present Value r = Interest rate t = Time to Maturity
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Case Study – Bond Pricing
Bond A, FV=$1000, redemption at par
Bond B, FV=$1000, redemption at par
Nominal annual coupon
10%
10%
Yield-to-maturity
8%
9%
Time-to-maturity
5 years
5 years
Market price
?
?
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Case Study… Bond A, FV=$1000, Bond B, FV=$1000, redemption at par redemption at par Nominal annual coupon
10%
Yield-to-maturity (YTM)
8%
Time-to-maturity
5 years
Market price
DISCOUNTING FACTOR (IN %)
10% 9% 5 years
YEARS
7%
8%
9%
10%
1
0.935
0.926
0.917
0.909
2
0.873
0.857
0.842
0.826
3
0.816
0.794
0.772
0.751
4
0.763
0.735
0.708
0.683
= 100*0.926
= 100*0.917
+ 100*0.857
+ 100*0.842
+ 100*0.794
+ 100*0.772
5
0.713
0.681
0.650
0.621
+ 100*0.735
+ 100*0.708
6
0.666
0.630
0.596
0.564
+ 1100*0.681
+ 1100*0.650
7
0.623
0.583
0.547
0.513
= $1079.85
= $1038.90
8
0.582
0.540
0.502
0.467
9
0.544
0.500
0.460
0.424
10
0.508
0.463
0.422
0.386
NB: price and YTM move in opposite directions Copyright ©2005 Kanbay Incorporated. All rights reserved.
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Mutual Funds
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Mutual Funds Purpose •
To create a vehicle for small investors to diversify their portfolio by pooling their investments
Advantages
Diversified portfolio used to reduce risk
Greater financial leverage not available to individual small investor
Lower transaction costs resulting from size
Only investment option in certain markets (e.g., certain retirement plans)
Regulated by SEC
Some key facts: •
Funds are a big business. Over 50% of US stocks are owned by mutual funds
•
a/k/a the “buy side”. Morgan Stanley for example is a “sell side” firm.
Trading in Funds Is Limited
Most funds restrict trading to once a day (at market close)
Most funds impose restrictions on frequent turnover
Funds may also impose penalties for frequent trading – load increases
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Mutual Funds - characteristics
Investment objective (e.g., growth, tax planning, income, balanced)
Benchmark for performance comparison (e.g., SP500, Russel 2000)
Investment universe (e.g., stocks/bonds; large/medium/small caps; sectoral)
Investment policy (asset allocation strategy) : passive, active, immunization
Investment restrictions (e.g., socially responsible, sin fund, restricted list)
Open or Close ended funds
Sales charge (front-end/back-end load, no-load)
Daily NAV computation Æ Varies by country Æ Most funds price shares after market close. Æ Sometimes funds price shares several times during the trading day
Examples of Investment Methods available to investors
Direct investments
Sponsored plans, e.g. 401-k
Periodic investments
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Mutual Fund – entities Analysts & Rating Agencies
Fund Sponsor
Trustee company
Asset Management Company
Auditors Fund Manager
Fund Accountant
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Fund Administrator
RTA and Client Servicing
Marketing and Distribution
Custodian
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Consulting and Legal Firms
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Mutual Fund – Life Cycle
Fund Creation
Subscriptions
Mktg. /
Redemptions
Distribution
Investment
Investor
corpus
Service
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Income
Fund
Distrib..
Mgmt.
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Hedge Funds - Introduction
Entities that collect monies from wealthy and financially knowledgeable investors and invest in securities including derivatives
May borrow monies and invest in securities (leveraging)
May borrow securities and sell them (shorting or short sales)
High minimum investment by investors
Offering documents are privately circulated
Restrictions on redemptions
Focus on high returns
Being unregulated, considerable operating freedom
Try and provide absolute return rather than relative return
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Risk Management
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What is risk ?
Risk is the uncertainty associated with an expected outcome or event
Risks
controllable (diversifiable, unsystematic) uncontrollable (non-diversifiable, systematic)
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Classification of Risks
Broad classification of financial risk
Credit Risk
Market Risk
Operational Risk
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Credit Risk
Basically risk due to exposure to third parties
Counter-party risk / Issuer Risk
Default risk
Exposure risk
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Market Risks
Emanates from movement in market forces
Price Risk
Interest Rate Risk
Currency Risk
Liquidity Risk
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Operational Risks
Emanating from inadequacy or failure of internal processes
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Components of IR risk
Basis Risk
Yield Curve Risk
Embedded Option Risk
Reinvestment Risk
Price Risk
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Risk Mitigants
Credit Risk Mitigants
Credit Enhancements
Guarantees
Loan covenants
Credit Derivatives
Market Risks
Interest Rate Derivatives
Currency Derivatives
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Life Cycle of a Trade
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The life of a trade - a health warning
Generic example Not representative of any specific market In practice some steps may not figure in every trading scenario Takes a functional view of the process It shows a high level overview of all participants
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The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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The life of a trade Morgan Stanley Asset manager 1
8
Deutsche Bank Asset Manager 7 2
HSBC Brokerage
16
CSFB Securities
6
CL Securities
3&4 4
10
5
5
6
5
10
11
11
Citibank (UK) Custody
15
9
10
13 13
8
Deutsche Bank Custody
14
LCH 10
16
14
14
15
Ask Raymond James
3
London Stock Exchange
14
Citibank Custody
2
OTC
3
9
1
7
CREST
12
12
HSBC (UK) Custody
Bank of England
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Trade date
Step 1 Investor/fund manager (the client) places an order to buy or sell securities in a particular market with a broker/ dealer NB. The instruction sent by the client will be in a mutually agreed upon format, most likely by client workstation or by fax
Step 2 Where necessary the broker/ dealer will often utilize the services of a local broker present in the market where the security is to be traded NB. Local regulations, convenience
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Trade date (cont.) Step 3 Stock exchange trades - brokers enter their orders into the trading system of the stock exchange where they are matched. OTC trade - communication would occur between brokers through an organized system, direct via phone, e-mail or some other form of communication where they can find a match
Step 4 Following matching, a trade confirmation is sent to the appropriate brokers
Step 5 Stock exchange trades - End of each stock exchange trading session, the stock exchange sends a summary list of all trades to the CSD which will enable the CSD to begin lining up trades for settlement OTC trade - both buying and selling local brokers send through their trade details to the clearing house for settlement
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Trade date (cont.)
Step 6 Confirmations are the passed on to International Brokers where necessary
Step 7 Brokers inform their clients (fund managers etc) of their obligations; i.e. funding, shares required and relevant accounts
Step 8 & 9 End of trading cycle - Client sends a settlement instruction to their global custodian authorizing the transaction (forwarded to local custodian where necessary). Sent by agreed communication method; i.e. workstation, SWIFT, fax, etc. and containing all information about the pending trade: name of the security, ISIN code, net settlement amount, counterpart, trade date, settlement date, etc. Physical intervention is dependent on STP capabilities
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Trade date + 1 to settlement day – 1 (may cover a period of two days in a T+3 environment) Step 10 On the morning of T+1, the clearing house will send out a pending settlement list to all participants (including custodians) detailing all trades. Report sent each day
Step 11 On receipt of the list, the local custodian will match the trade instructions and assuming they match, will send through an affirming order to the CSD assuring them that they will do their part to settle the trade either on the cash or securities side
Step 12 - if sale (buy involves FX and cash unblocking) The local custodian must release the securities (may involve an ICSD like Euroclear or Cedel) which have been sold by contacting the registry and unblocking the shares. In a physical market, the local custodian would arrange for the securities to be transferred to a holding account at the central depository for the benefit of the buyer
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Settlement day Step 13 The CSD is responsible for arranging all trades entered into its system for settlement. Check necessary shares are in registry/ depository, cash in the a/c and block them. Then arrange their transfer. Safe settlement will see a simultaneous exchange
Step 14 Upon settlement in the CSD system, notifications confirming settlement are sent to all local market participants including local custodians
Step 15 Upon receipt of the settlement confirmation, the local custodian immediately forwards the confirmation on to the global custodian
Step 16 The global custodian in turn forwards the settlement confirmation on to the fund manager
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Participants
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Market participants - intermediaries
Financial institutions/ intermediaries help the flow of money from the users to the suppliers of capital They are the banks, exchanges, brokers etc who: ÆBring buyers and sellers together ÆFacilitate the trading and settlement process ÆParticipate in the issuance process ÆAct as market makers in secondary markets Technically all financial institutions are intermediaries
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Funds/Investors
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The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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Investment funds - description
Investment funds are pools of assets made up from numerous individual investors where the assets are collectively invested in a variety of instruments around the globe They interact with broker/dealers to initiate trades, and with custodians to manage the settlement of the executed trades Types of investments include equities, government bonds, corporate bonds and money market instruments. Mainly quoted on recognized securities markets
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Types of investment funds
Pension funds Insurance funds Hedge funds Unit trusts Collections of high net worth individuals (investors) / private trusts
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Investment funds - Examples
UBS Fidelity Investments Deutsche Bank Credit Suisse Group AXA Group Barclays Global Investors Merrill Lynch
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Fund managers interaction in the life of a trade
broker
T
fund manager
e d a r
Se ttle m
en
t global custodian
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PAGE 78
Fund managers - Operational responsibility
An investment manager decides to make a purchase and informs a broker (diagram lines 1&2) The broker will act on this instruction. The trade will be executed when possible The investment manager will receive a trade confirmation back from the broker stating all the trade details for settlement (diagram line 7) The fund manager will arrange to send settlement instructions to the global custodian (diagram line 8) These instructions contain all the necessary information to settle the securities and cash side of the transactions
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PAGE 79
Fund manager - Operational responsibility (cont.)
The fund managers responsibilities are basically finished, barring failed trades, and waits now to receive confirmation from the global custodian Upon settlement, the global custodian sends through a settlement confirmation stating the number of shares/amount of cash transferred and the date effected. Ideally this is sent at the end on the day which the trade actually settled (diagram line 16) The fund manager may have additional settlement confirmations/reporting duties to underlying owners
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PAGE 80
Fund manager - Operational responsibility (cont.)
Ultimately responsible to all holders of shares/units of the fund - Account maintenance The quality of custodians and brokers chosen The ability to liquidate a client’s holding on request Constant ability to give up to date, marked to market pricing; i.e. valid fund valuation
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PAGE 81
Why do fund managers use a custodian?
Market information from around the globe on market settlement practices Facilitate cross border settlements Assist in monitoring/tracking of assets held as well as entitlements to those assets A local presence acting on behalf of the investors in all markets Maximize asset safety and minimize risk Access to additional banking services
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PAGE 82
Fund manager - Custodian criteria
High credit rating Segregation of client assets from bank’s own assets High SWIFT usage/automation - STP capabilities Customized reporting capabilities No lien taken on customer assets Secure, efficient IT systems Value for money
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PAGE 83
No lien
A fund manager requires that custodians do not use assets within their custody to secure loans or allow any third party legal claim to the assets lien is the right to take and hold or sell the property of a debtor as security or payment for a debt or duty
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PAGE 84
Broker - Dealer
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PAGE 85
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
COMPANY CONFIDENTIAL
PAGE 86
What does a broker/dealer do?
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PAGE 87
Broker/dealers - Description
Broker/dealers ‘arrange’ (broke) deals by either: Æmatching buy and sell orders placed by clients (acting as an agent) Æor by satisfying a client order, if there are no equal and opposite orders from another client, by taking a position onto its own trading book (establishing a proprietary position). The broker/dealer will usually endeavor to offset any such proprietary position against other client orders at the earliest opportunity
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PAGE 88
Broker/dealer - Examples
Merrill Lynch & Co Morgan Stanley Dean Witter Lehman Brothers Credit Suisse First Boston Goldman Sachs Salomon Smith Barney Donaldson, Lufkin & Jenrette Inc Deutsche Bank
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PAGE 89
Broker’s interaction in the life of a trade
Fund manager/ investor
Counterpart broker
Broker
Exchange
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PAGE 90
Broker/dealer - Operational responsibility
Trade capture - the capturing of all information sent to the broker by clients, exchanges, or any party in communication with the broker Information is authenticated and validated for accuracy and completeness The broker’s system forwards all captured information to the order room to determine where the instruction should be sent
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PAGE 91
Broker/dealer - Operational responsibility (cont.)
Order management - Orders enter the broker’s processing system via previously agreed methods of communication Types include: Æat market orders or ‘best’ Ælimit orders Ætime orders Brokers must give priority to client transactions over proprietary ones
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PAGE 92
Broker/dealer - Operational responsibility (cont.)
Matching - Through trading operations of either an exchange or an OTC environment, two orders, one buy and one sell, will be matched ÆThese matched trades are confirmed to the appropriate brokers Brokers are responsible for distributing trade confirmations to their customers by the end of the business day in most markets
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PAGE 93
Broker/dealer - Operational responsibility (cont.)
Settlement - Ensure securities are either on their client’s account for a sale transaction or cash is on account to fund a purchase ÆIf a custodian is used, the broker must communicate with the local custodian For a proprietary trade, the broker will arrange for the transfer of either cash or securities into the central clearing system
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PAGE 94
Broker/dealer - Operational responsibility (cont.)
Post-settlement - Confirmation of the securities and/or cash transfers are sent to all participants daily, reflecting the new positions Æinternal reconciliation Æexternal reconciliation
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PAGE 95
Broker/dealer - Operational responsibility (cont.)
Account maintenance - For clients who hold their shares in a segregated account with the broker, the broker has certain responsibilities in administering the accounts with services such as: Ædividend collection Æcorporate action notifications Æproxy voting services Æaccount statements
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PAGE 96
What is a Prime Broker
A prime broker is a broker offering professional services specifically aimed at hedge funds and other large institutional customers.
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PAGE 97
Services Offered Prime Broker
Custody Clearing Reporting Securities Lending Money Lending Execution Leverage/pricing Capital Introduction Start-up services Relationship/co-ordination Credit intermediation Risk Management Contracts for differences Straight through processing Futures/options clearing
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Swaps NAV fund services Research IPOs Seed Capital Consulting services FX services (hedging) Yield enhancement Fund administration Structuring: wrap products Hedge Fund swaps Partial principal guarantees Trade structuring/finance coverage Global access
COMPANY CONFIDENTIAL
PAGE 98
Exchanges
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PAGE 99
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 100
Exchanges - Description
The primary role of an exchange is to provide a centralized market place where buyers and sellers can meet to negotiate asset prices and to execute trades. Exchanges aim to maximize price transparency and liquidity at the lowest cost by providing a centralized trading platform into which all buy and sell orders are submitted
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PAGE 101
Exchanges - Characteristics There are two main types of central markets: Ætraditional “open outcry” (floor-based) markets, which operate in a specific building with a physical trading floor e.g. NYSE, LIFFE, AMEX, Æelectronic screen-based stock exchanges e.g. Nasdaq, Eurex. Markets may be price/quote-driven or order-driven Æin a price-driven market, market makers will quote both bid and offer prices, but the transaction remains an individually negotiated contract Æin an order-driven market, trading revolves around an order book where market participants post buy and sell orders (quantities and prices) at which they are prepared to trade
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PAGE 102
Exchanges - Examples
NASDAQ American Stock Exchange (AMEX) Tradepoint London Stock Exchange
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PAGE 103
Clearing and Settlement Agents
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PAGE 104
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
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PAGE 105
Clearing & settlement in the bigger picture
External payment system
Custodians
Stock exchange
Clearance & settlement entity Depository/ Registry
Brokers/ Participants
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PAGE 106
What do we mean by settlement ? Settlement is the final, irrevocable transfer of cash from the purchaser to the seller in exchange for the delivery of securities to the purchaser
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PAGE 107
Delivery versus payment
Delivery versus payment (DVP) is the simultaneous and irrevocable transfer of ownership of an asset in exchange for the equivalent assured countervalue in same day funds
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PAGE 108
Settlement conventions - Physical vs book entry Physical delivery ÆShare certificates and duly signed transfer documents lodged with clearing house Book entry ÆDematerialized computerized record only no physical certificate transfer is by Dr sellers account and Cr. buyers
ÆImmobilized as above but physical certificates exist in centralized location
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PAGE 109
Settlement conventions - Rolling vs fixed
Rolling settlement ÆT+ defined market standard - each day the date rolls on ÆMajority of markets Fixed settlement ÆFixed day each week ÆTrading for week settles on one day ÆHigh fail cost ÆSouth Africa
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PAGE 110
Clearing & settlement - Operational responsibility The C&S entity receives initial instructions from a stock exchange or directly from participants immediately after a trade has been matched on the trading system/agreed ‘over the counter’ between participants (diagram line 5) Internally, the C&S entity begins positioning of the pending transactions by matching all buyers and sellers Depending on market system, trades will either be netted or settled trade by trade
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PAGE 111
Clearing & settlement - Operational responsibility Between trade day and settlement day, there is the opportunity for amendments to be made and for custodians to affirm trades On settlement day, all pending trades have been matched and the settlement activity begins, i.e. shares are transferred between buyers and sellers at the same time as cash (or should be!) based on C&S interaction with the payment system and the depository (diagram lines 13)
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PAGE 112
Clearing & settlement - Operational responsibility Upon the settlement, confirmations are sent to all participants detailing the new positions If there were unsettled transactions, a list of failed trades is also sent giving participants a reason for the fail
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PAGE 113
Failed trades
Trades may fail for a variety of reasons increasing the importance of DVP Ælate or incorrect settlement instructions from a counterpart to the custodian or clearing agent Æseller has insufficient quantity of securities to deliver Æpurchaser has insufficient funds to pay Æcertificated securities are not yet available from the registrar from a recent purchase to cover a sale Buy-in
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PAGE 114
Custodian
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PAGE 115
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
COMPANY CONFIDENTIAL
PAGE 116
What does a custodian do?
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PAGE 117
Custodian - Description
Custodians manage the safekeeping of assets on behalf of their clients Custodians handle all administrative issues that arise with regard to assets in their safekeeping Æcorporate actions announcements Ædividend payments Æsecurities lending etc. A global custodian offers both core custody services and value added services; the latter enables the custodian to differentiate itself from other players in the market
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PAGE 118
Local custodian
The vast majority of global custodians select local agents in foreign countries, the local supplier will in turn handle direct interfaces with the domestic clearing settlements and depository systems Local suppliers are able to handle business more effectively as they have connections within the market place, no language barriers, and are knowledgeable of local market regulations
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PAGE 119
Custodian - Examples
Citibank State Street Bank & Trust Co. Paribas Brown Brothers Harriman & Co HSBC Group (formerly Midland Bank) Chase Manhattan Bank of New York
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PAGE 120
Custody within the life of a trade
clearing & settlement entity
investor
global custodian
local custodian
central depository/ registry
payment system
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PAGE 121
Custodian - Operational responsibility
The custodian is ultimately responsible for the safety and securities administration of all client assets placed in their care While both custodians and depositories are responsible for safekeeping, a bank, acting as a custodian, has the obligation to protect clients which differs slightly from a CSD whose responsibility is to the market and its’ participants
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PAGE 122
Custody service provisions
Core services Æsettlement of trades & registration (securities & cash) Æsafekeeping Æcash management & foreign exchange Æcorporate actions notification & processing Æproxy voting Æincome collections Ætax reclaims Æreporting
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PAGE 123
Custody service provisions (cont.)
Value added services Æinvestment accounting (multi-currency, full accrual reporting) Æpricing/valuation (calculation of net asset values) Æperformance measurement (calc. rates of return) Æsecurities lending (collateralized loan of securities) Æcollateral management (managing client’s open positions) Æfutures clearing (exchange traded futures & options) Æmarket intelligence (timely news affecting investments)
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PAGE 124
Custodian - Operational responsibility
Initial receipt of settlement instructions from a client (diagram line 8) via SWIFT, Telex, fax, or workstation Æthe method of communication will be set in a ‘Service Level Agreement’ at the beginning of a relationship between a client and the custodian The settlement instructions will include all the relevant information
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PAGE 125
Custodian - Operational responsibility (cont.)
Once received, the global custodian processes the trade instructions in-house The instruction includes all information mentioned (previous slide) which provides the authorization to release/deliver shares on a sale transaction or authorizes a foreign exchange transaction and payment to be made in the market for the purchase of securities
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PAGE 126
Custodian - Operational responsibility (cont.)
The local custodian receives the information from the clearing and settlement entity (who received it from the stock exchange) informing of all pending trades for which settlement needs to be affirmed (diagram line 10) The local custodian matches the information from the clearing house with the authorization for settlement from the global custodian. If the information matches, the local custodian ‘affirms’ the trade with the clearing house If the information does not match, the local custodian identifies which part of the information is outstanding and will contact the appropriate party to resolve the dispute
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PAGE 127
Custodian - Operational responsibility (cont.)
Depending on whether the trade to be settled is a purchase or sale (diagram line(s) 12): Æfor purchases - the local custodian will, based on instructions, have booked a foreign exchange and will transfer the local currency from the global custodian’s cash account with the correspondent bank (likely to be the local custodian itself) to the central payment system used by the clearing house Æfor sales - the local custodian will need to ensure the securities which are to be transferred to a new owner are delivered to the clearing house if not held centrally (physical markets) / OR are authorized to be released from the register (dematerialized markets with a centralized registry)
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PAGE 128
Custodian - Operational responsibility (cont.)
Once the settlements are complete within the central clearing house, a settlement confirmation will be sent to all participants including the local custodian as will any failed transactions for the day (diagram line 14) The local custodian will send settlement confirmation immediately to the global custodian. This may be manually entered into SWIFT, Telex, etc. or the confirms may be generated automatically if the local custodian has ‘straight through’ processing capability (diagram line 15)
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PAGE 129
Custodian - Operational responsibility (cont.)
The global custodian will forward the settlement confirmation immediately to the fund manager/client (diagram line 16) ‘Straight Through Processing’ may be possible where appropriate system/communication links have been put in place. For the initial settlement instructions, steps 8,9 &11 could go from the system of the client/fund manager straight through to the clearing & settlement house. Additionally, the confirmation steps 14-16 can also flow automatically from the settlement system back to client
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PAGE 130
What is the custodian NOT responsible for?
Investment decisions in terms of investment type or country Communication with beneficial owners below direct customer level i.e. beneficial owners of funds Achieving best prices on securities traded Compliance of fund mangers with local regulations Market inherent settlement risks
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PAGE 131
Central securities depositories & registries
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PAGE 132
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 133
Central Securities Depository Description
Central Securities Depositories (CSDs) are established in domestic markets by governments or privately owned consortium(s) to hold securities in a central depository They provide a mechanism for the transfer and delivery of securities CSDs usually hold and process securities in book entry (or electronic) form. Varies The CSD will inform the registrar if there is a change in legal. In recent years, securities firms have been trying to reduce the flows of physical securities, the depository has been central to this advancement
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PAGE 134
Registrar - Description
A professional securities market participant performing maintenance of the Registry of registered securities holders The registrar will have authorization by way of a contract with the issuer to maintain the register on the issuers behalf The register may be an aggregation of data, in paper form and/or on electronic media, identifying registered persons and confirming their rights to securities registered in their name and recorded in the personal accounts of registered persons, which makes it possible to obtain and forward information to the registered persons
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PAGE 135
CSDs - Examples France
:
Sicovam
Germany
:
Clear stream (previously Deutsche Börse Clearing)
Hong Kong
:
Hong Kong Clearing
Japan
:
Japan Securities Depository Centre (JASDEC)
Switzerland
:
SEGA/INTERSETTLE
United Kingdom & Ireland :
CREST
USA
The Depository Trust Company (DTC)
:
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PAGE 136
ICSDs - Examples
Clearstream Euroclear
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PAGE 137
Central depository / registry interactions with market participants
brokers
clearing & settlement entity
custodians
central depository
national securities commission
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PAGE 138
CSDs - Operational responsibility
Interaction with custodians and brokers who may need to deliver shares or authorize shares for release on settlement day Custodians/brokers send instructions directly to a depository with instructions prior to actual settlement The depository receives instructions from the clearing and settlement entity checking for available shares and orders the blocking of shares for pending settlement
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PAGE 139
CSDs - Operational responsibility
The depository confirms securities present for settlement and blocks them awaiting final instructions The clearing and settlement entity then orders the final movement of securities from sellers to buyers accounts (having checked for available cash) Final settlement/movement statements sent to the clearing house or perhaps to the participants depending on the market practice
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PAGE 140
Activities of the CSD/ registry
Provides central clearing and settlement (CCS) body with status of accounts/available securities Transfers ownership based on instructions from CCS Provides issuers with updated list of shareholders upon their request Performs daily reconciliation of shareholders & issuers Reporting responsibility to securities commission regarding ownership limits/ restrictions When participation is mandatory and legislation supports the activity, it is the one place where ownership is determined
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PAGE 141
Trade Process
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PAGE 142
Trading Process Institutional Investor
Sales & Service Delivery
Retail Investor Private Client
Risk management - Market, Credit & Operational Risks Front Office ¡ Trade Execution ¡ Trade Delivery ¡ Pre Trade Decision ¡ Reference Data
Market Data
Exchange
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Middle Office ¡ Trade Support ¡ Risk Management ¡ Reconciliation ¡ Portfolio Management
Back Office ¡ Settlement ¡ Clearing ¡ Accounting
Other Institution
COMPANY CONFIDENTIAL
Custodian
Market Clearing
PAGE 143
Roles in Trading Process
Sales
Front Office
Facilitate, Control and monitor trade execution and settlement
Back Office
Focuses on research, trade execution at the best possible price, identifying potential profitable trades
Middle Office
Focuses on sales of financial products, fee based buy / sell orders for execution and client relationship
Payment / Receipt, Settlement and Accounting
Custodian
Completion of deliveries of securities and safe keeping of securities
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PAGE 144
Straight Through processing
Automating the information flow from one stage to another stage without manual intervention
Includes the information flow within internal system / systems
Involves interfacing with external systems
Stock exchanges
Custodian
Counter-party
Payment Systems
Results in ability to handle volumes of transactions without increasing the processing cost
Reduces possible human errors in data processing
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PAGE 145
Trading system Products
Front Office
Equities Equities
Money Money Market Market
Credit Credit Derivatives. Derivatives.
Fixed Fixed Income Income
FX FX
Interest Interest Rate Rate Derivatives. Derivatives.
Trade Trade Capture Capture
Real Real time time blotter blotter
Analytics Analytics
Pricing Pricing
Middle office
Back Office
Technology
Limits Limits
Analysis Analysis (MTM,Hedge…) (MTM,Hedge…)
Reconciliation Reconciliation
Documentation Documentation
Accounting Accounting
Revaluation Revaluation
Settlements Settlements
Payments Payments
Real Real Time Time
Event Event Driven Driven
Database Database
Web Web Enabled Enabled
Scalability Scalability
Extensibility Extensibility
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Inventory Inventory
PAGE 146
Thank You
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PAGE 147
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Introduction
Lets introduce
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PAGE 2
Agenda
Overview of Capital Markets Financial Instruments Participants Life Cycle of a Trade Trade process
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PAGE 3
Introduction to the capital markets
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PAGE 4
What is capital ?
To many people it is the value of their assets - property, bank deposits, cars, jewelry etc - net of their liabilities In the financial markets capital refers to financing instruments, in particular fixed income securities and equity. That are traded for cash
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PAGE 5
Who supplies capital ? (purchases financial products)
Firms Individuals Funds: ÆInvestment/mutual ÆInsurance ÆPension ÆHedge etc Banks, governments and probably everyone else
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PAGE 6
Who demands capital? (sells financial products)
Firms Individuals Funds: ÆInvestment/mutual ÆInsurance ÆPension ÆHedge etc Banks, governments and probably everyone else Exactly the same set of participants
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PAGE 7
So what are capital markets ?
Capital markets are markets in which financial securities like stocks and bonds are bought and sold. Markets in which medium and long term finance is raised, facilitating the flow of funds
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PAGE 8
Capital Markets
generated cash
financial assets Surplus funds
Need financing
Firms
require investment
cash to invest
Investors
dividends/interest Capital markets
Reinvestment
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PAGE 9
Importance of Capital Markets
Capital markets serve several important functions in the economy
Match capital providers with capital seekers
Match those willing to take risk with those seeking to mitigate risk
Help with allocation of resources across regions (globally) and industries
Help with integration of world economies and bypass local inefficiencies
Facilitate integration of different markets (e.g. farmers with food products industry)
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PAGE 10
The characteristics of capital markets – price discovery
Price discovery process - The interactions of buyers and sellers in the financial market to determine the price of an asset/ required return on an asset. The market price should: Æreflect all available information Æadjust quickly to new information
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PAGE 11
Characteristics – operational efficiency
In order for capital markets to be “informationally” efficient, they must be “operationally” efficient as well trading convenience large number of participants low cost of trading rapid execution of trades
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PAGE 12
Characteristics - efficiency (cont.)
If capital markets are efficient: The price of an asset is the same everywhere in the market Most financial transactions are zero-sum; i.e. one party gains only at the expense of another The “law of one price” holds; i.e. equivalent securities must sell at the same price Arbitrage opportunities can not exist - arbitrage allows you to earn risk-less profits without any capital commitments
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PAGE 13
Characteristics - market types
Primary market ( Eg: Buying a new house from the dealer) Æwhere new securities are created by surplus units lending to deficit units Æoriginal issue of stocks, bonds and other financial assets Secondary market (Eg: Buying a second hand house from user) Æwhere existing securities are traded Æprovide liquidity Æofficial exchanges: stock exchanges, derivatives exchanges ÆOTC market
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PAGE 14
Characteristics – types- market mechanisms
Order driven market Æbuy and sell instructions are fed into a central computer system Æautomatic matching Quote driven market Æprices are determined principally by professional dealers bid/offer quotations Æorder management OTC markets Æno standards, all negotiable Æ24 hours trading activity
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PAGE 15
Financial Instruments
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PAGE 16
Covers Instruments in brief Does not cover Credit Derivatives and exotic derivatives
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PAGE 17
Equity
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What is equity ? Equity i.e. stocks & shares, are financial instruments representing ownership interest in a corporation or similar entity
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PAGE 19
The characteristics of equities
You share in the profit the company makes ÆDividends - payments declared quarterly, six months, yearly Voting rights at AGM’s ÆPro-rata on your share holding
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PAGE 20
Types of shares
Ordinary Preferential Rights Depository receipts
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Ordinary Shares or Common Stock Purpose: Æ To raise long term financing by selling ownership stake in the corporation. • Shareholders have certain rights Æ To Elect/remove Company Board of Directors Æ Voting on resolutions at company meeting (AGM, Special Meetings) • Key Characteristics: • Right to elect directors to the board and vote on corporate resolutions • Right to residual claim in liquidation (after all other claims have been paid) • Entitled to pro-rata share in profits of the company
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PAGE 22
Preferred Shares •
Purpose: •
•
Ownership at reduced risk, in exchange for reduced upside
Lifecycle: •
Like common stock but normally no voting rights
•
Can be perpetual, redeemable by holder, callable by issuer or converted into common stock
Characteristics Æ Right to fixed dividends Æ Priority over Common Stockholders Æ Voting rights in exceptional situations, e.g. dividend skipped for 3 years in a row
Characteristics of preferred dividends Æ Can be cumulative, i.e., skipped dividends are not forgotten Æ Can be participating, i.e., in good times, can receive additional dividends
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PAGE 23
Rights Purpose Æ To raise additional equity capital without diluting ownership of existing stockholders Lifecycle Æ Offered by corporation to existing stockholders in proportion to their existing holdings Æ Usually trades as intrinsic part of the common stock from announcement of Corporate Action and until completion of distribution. Stock price reflects the value of right. (concepts: announcement, record and pay dates, ex-date, cum-rights) Æ Set to expires after a date in near future Æ Often followed by secondary public offering to make up for quantity yet unsubscribed Characteristics Æ Represents a right to buy shares of common stock at set price within set expiry date Æ Short life (months or weeks) Æ May be listed on exchanges for secondary market trading The rights holder can Æ Sell the right if traded separately, renounce the right in favor of someone else, or sell the stock cum-rights Æ Exercise the rights and purchase additional shares at the set price Æ Let it lapse Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 24
ADR AMERICAN DEPOSITORY RECEIPTS (ADR) •
Purpose •
To facilitate investing in foreign corporations by eliminating burdens of currency conversions, time zones and foreign market regulations
•
Lifecycle •
A custodian creates a pool of shares of original stock from the home market
•
The custodian issues receipts representing proportional shares of this pool. These receipts represent indirect ownership.
•
The receipts are listed on US exchanges for secondary market trading
•
Custodian manages currency issues, home market regulations, dividends and other corporate actions
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PAGE 25
Value of stocks
Company profile Sector profile Tax regime Political climate Social climate Cyclical climate Energy prices Commodity prices Interest rates Basically ANYTHING
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PAGE 26
Valuing equities - information
Annual reports and balance sheets Research publishers such as S & P, D & B Registrar of Companies Stock Exchanges / Market information / SEBI Stockbrokers’ circulars THE PRESS
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PAGE 27
Popular Stock Exchanges / Indices
NYSE (New York Stock Exchange) Æ Dow Jones Industrials (since 1894) Æ Standard and Poors 500 Æ NASDAQ Composite - Technology stocks
Tokyo Stock Exchange: Nikkei 225 Hong Kong Stock Exchange: Hang Seng Frankfurt Stock Exchange: DAX London Stock Exchange: FTSE100 Paris Stock Exchange: CAC40 National Stock Exchange / BSE: Nifty / Sensex
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PAGE 28
Fixed Income
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What is a bond ? A bond is a loan made by investors to companies, banks, corporations and governments. They are debt obligations with long-term maturities
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PAGE 30
Bonds What is a Debt Instrument ?
It’s essentially an I Owe You (IOU).
Lender lends the money to the Borrower in exchange for Æ Interest payments during the term of IOU Æ Principal repayment at maturity of the IOU
Lender may impose certain terms and conditions on the Borrower.
Why borrow ?
Need funds for limited period
Earnings expectations > interest costs
Tax advantage – typically interest expenses can be expensed
Financial covenants may require company to maintain certain financial ratios
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PAGE 31
Bond - forms
Bearer bonds ÆNo registered owner on the certificate hence holder is the owner Registered bonds ÆOwnership is recorded in either physical form on the certificate or on a book entry account
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Bond - coupon payments
Bearer bonds ÆOn each coupon date the bondholder (or their custodian bank) clips the relevant coupon from the bond certificate and claims the interest due from the issuer’s paying agent Registered bonds ÆPaying agent will automatically pay the registered holder Characteristics ÆStraights - the amount of each coupon is the same and is fixed at issue ÆZero-coupon bonds - issued at a discount with a fixed final maturity value. Hence coupon received at maturity ÆFloating rate bond - coupon adjusted at predetermined periods, linked to a benchmark rate
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PAGE 33
Examples •
Corporate Bonds
•
US Treasury Bills, Notes and Bonds
•
Municipal Bonds
•
Collateralized Mortgage Obligations (CMO)
•
Asset Backed Securities (ABS)
•
Commercial Paper
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PAGE 34
Corporate Bonds •
Purpose •
•
To raise capital for limited duration
Lifecycle •
Issued through public offer or private placement
•
Secondary market trading facilitated by brokers. A small fraction is also listed on exchanges for secondary market trading.
•
Periodic interest payment by issuer. Some bonds are sold at a discount (zerocoupon bonds)
•
Call & Put Option - May permit early redemption by holder, early call by issuer
•
At maturity, issuer repays holder as per issuance terms
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PAGE 35
Corporate Bonds
Characteristics Æ Face value, typically $1000. Issuance price may be different from face value Æ Long term instruments in excess of 1 year to maturity usually nearer 10 year life span Æ Maturity date and value. The maturity value may be different from face or issuance price. May be bullet or staggered repayment. Æ Provisions to pre- or post-pone maturity Æ Interest payment terms. Rate can be fixed or floating rate tied to a benchmark, e.g. LIBOR, or Zero coupon Æ Seniority Æ Most bonds are rated by a rating agencies such as S&P, Moody’s, etc. Æ Some bonds allow coupons to be stripped and traded separately
An example - GM JJ15 7.5% of 2022 Æ Face value is $1000 (this can be assumed) Æ Coupon is 7.5%, paid twice a year on 15th of Jan/June. Twice a year is typical. Æ It matures in 2022
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PAGE 36
The ratings
Long term debt Best quality grade High quality grade Upper medium grade Medium grade
Short term debt
S&P AAA AA+ AA AAA+ A ABBB+ BBB BBB-
S&P A1+ A1 A2 A3
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Moody’s Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3
Moody’s P1 P2 P3 PAGE 37
What are the money markets ? Markets for short term debt instruments with original maturity of one year or less
Technically speaking, “capital markets” are for longer dated securities
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PAGE 38
Money markets
Interest (or benefits) paid at maturity (date when the security is returned to the issuer and the debt is repaid) High grade securities with little or no risk of default (sovereign states, banks and major corporations) Money market instruments can be sold on either a: ÆDiscount basis - the money market instrument is sold at a discounted price and bought back at its real face value by the issuer ÆCoupon basis - the instrument is sold at its face value and bought back at its face value plus a coupon element
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PAGE 39
Money markets instruments discount basis
Treasury Bills (T-Bills) Æ issued and guaranteed by the Government Æ Sold on a discount basis: difference between the face value and the purchase price represents interest earned by the investors
Commercial paper Æ a promissory note sold by very large, creditworthy corporations Æ issued for a specific amount and maturing on specific date Æ backed by a “standby letter of credit” from a bank Banker’s acceptances Æ Bank promises to pay the face amount when the acceptance is presented to it - made to importers and exporters
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PAGE 40
Money markets instruments - coupon basis
Fixed deposits/loans Certificates of deposits (CD’s) Repurchase agreements (Repos)
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PAGE 41
Bond - pricing
Issuer rating Coupon rate (compared to MM rate) Time to maturity Yield to maturity
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PAGE 42
Bond - prices
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Interest Rates and Time Value of Money Time-value of money – key concepts Æ FV (future value) and PV (present value) Æ NPV (net present value) Æ IRR (internal rate of return) Most financial calculators (and MS-Excel) have built-in functions for FV/PV
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PAGE 44
FV & PV
FV = PV * (1+r/100)^t PV = FV/(1+r/100)^t FV = Future Value PV = Present Value r = Interest rate t = Time to Maturity
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PAGE 45
Case Study – Bond Pricing
Bond A, FV=$1000, redemption at par
Bond B, FV=$1000, redemption at par
Nominal annual coupon
10%
10%
Yield-to-maturity
8%
9%
Time-to-maturity
5 years
5 years
Market price
?
?
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PAGE 46
Case Study… Bond A, FV=$1000, Bond B, FV=$1000, redemption at par redemption at par Nominal annual coupon
10%
Yield-to-maturity (YTM)
8%
Time-to-maturity
5 years
Market price
DISCOUNTING FACTOR (IN %)
10% 9% 5 years
YEARS
7%
8%
9%
10%
1
0.935
0.926
0.917
0.909
2
0.873
0.857
0.842
0.826
3
0.816
0.794
0.772
0.751
4
0.763
0.735
0.708
0.683
= 100*0.926
= 100*0.917
+ 100*0.857
+ 100*0.842
+ 100*0.794
+ 100*0.772
5
0.713
0.681
0.650
0.621
+ 100*0.735
+ 100*0.708
6
0.666
0.630
0.596
0.564
+ 1100*0.681
+ 1100*0.650
7
0.623
0.583
0.547
0.513
= $1079.85
= $1038.90
8
0.582
0.540
0.502
0.467
9
0.544
0.500
0.460
0.424
10
0.508
0.463
0.422
0.386
NB: price and YTM move in opposite directions Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 47
Mutual Funds
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PAGE 48
Mutual Funds Purpose •
To create a vehicle for small investors to diversify their portfolio by pooling their investments
Advantages
Diversified portfolio used to reduce risk
Greater financial leverage not available to individual small investor
Lower transaction costs resulting from size
Only investment option in certain markets (e.g., certain retirement plans)
Regulated by SEC
Some key facts: •
Funds are a big business. Over 50% of US stocks are owned by mutual funds
•
a/k/a the “buy side”. Morgan Stanley for example is a “sell side” firm.
Trading in Funds Is Limited
Most funds restrict trading to once a day (at market close)
Most funds impose restrictions on frequent turnover
Funds may also impose penalties for frequent trading – load increases
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PAGE 49
Mutual Funds - characteristics
Investment objective (e.g., growth, tax planning, income, balanced)
Benchmark for performance comparison (e.g., SP500, Russel 2000)
Investment universe (e.g., stocks/bonds; large/medium/small caps; sectoral)
Investment policy (asset allocation strategy) : passive, active, immunization
Investment restrictions (e.g., socially responsible, sin fund, restricted list)
Open or Close ended funds
Sales charge (front-end/back-end load, no-load)
Daily NAV computation Æ Varies by country Æ Most funds price shares after market close. Æ Sometimes funds price shares several times during the trading day
Examples of Investment Methods available to investors
Direct investments
Sponsored plans, e.g. 401-k
Periodic investments
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PAGE 50
Mutual Fund – entities Analysts & Rating Agencies
Fund Sponsor
Trustee company
Asset Management Company
Auditors Fund Manager
Fund Accountant
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Fund Administrator
RTA and Client Servicing
Marketing and Distribution
Custodian
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Consulting and Legal Firms
PAGE 51
Mutual Fund – Life Cycle
Fund Creation
Subscriptions
Mktg. /
Redemptions
Distribution
Investment
Investor
corpus
Service
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Income
Fund
Distrib..
Mgmt.
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PAGE 52
Hedge Funds - Introduction
Entities that collect monies from wealthy and financially knowledgeable investors and invest in securities including derivatives
May borrow monies and invest in securities (leveraging)
May borrow securities and sell them (shorting or short sales)
High minimum investment by investors
Offering documents are privately circulated
Restrictions on redemptions
Focus on high returns
Being unregulated, considerable operating freedom
Try and provide absolute return rather than relative return
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PAGE 53
Risk Management
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PAGE 54
What is risk ?
Risk is the uncertainty associated with an expected outcome or event
Risks
controllable (diversifiable, unsystematic) uncontrollable (non-diversifiable, systematic)
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PAGE 55
Classification of Risks
Broad classification of financial risk
Credit Risk
Market Risk
Operational Risk
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PAGE 56
Credit Risk
Basically risk due to exposure to third parties
Counter-party risk / Issuer Risk
Default risk
Exposure risk
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PAGE 57
Market Risks
Emanates from movement in market forces
Price Risk
Interest Rate Risk
Currency Risk
Liquidity Risk
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PAGE 58
Operational Risks
Emanating from inadequacy or failure of internal processes
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PAGE 59
Components of IR risk
Basis Risk
Yield Curve Risk
Embedded Option Risk
Reinvestment Risk
Price Risk
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PAGE 60
Risk Mitigants
Credit Risk Mitigants
Credit Enhancements
Guarantees
Loan covenants
Credit Derivatives
Market Risks
Interest Rate Derivatives
Currency Derivatives
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PAGE 61
Life Cycle of a Trade
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PAGE 62
The life of a trade - a health warning
Generic example Not representative of any specific market In practice some steps may not figure in every trading scenario Takes a functional view of the process It shows a high level overview of all participants
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PAGE 63
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 64
The life of a trade Morgan Stanley Asset manager 1
8
Deutsche Bank Asset Manager 7 2
HSBC Brokerage
16
CSFB Securities
6
CL Securities
3&4 4
10
5
5
6
5
10
11
11
Citibank (UK) Custody
15
9
10
13 13
8
Deutsche Bank Custody
14
LCH 10
16
14
14
15
Ask Raymond James
3
London Stock Exchange
14
Citibank Custody
2
OTC
3
9
1
7
CREST
12
12
HSBC (UK) Custody
Bank of England
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PAGE 65
Trade date
Step 1 Investor/fund manager (the client) places an order to buy or sell securities in a particular market with a broker/ dealer NB. The instruction sent by the client will be in a mutually agreed upon format, most likely by client workstation or by fax
Step 2 Where necessary the broker/ dealer will often utilize the services of a local broker present in the market where the security is to be traded NB. Local regulations, convenience
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Trade date (cont.) Step 3 Stock exchange trades - brokers enter their orders into the trading system of the stock exchange where they are matched. OTC trade - communication would occur between brokers through an organized system, direct via phone, e-mail or some other form of communication where they can find a match
Step 4 Following matching, a trade confirmation is sent to the appropriate brokers
Step 5 Stock exchange trades - End of each stock exchange trading session, the stock exchange sends a summary list of all trades to the CSD which will enable the CSD to begin lining up trades for settlement OTC trade - both buying and selling local brokers send through their trade details to the clearing house for settlement
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Trade date (cont.)
Step 6 Confirmations are the passed on to International Brokers where necessary
Step 7 Brokers inform their clients (fund managers etc) of their obligations; i.e. funding, shares required and relevant accounts
Step 8 & 9 End of trading cycle - Client sends a settlement instruction to their global custodian authorizing the transaction (forwarded to local custodian where necessary). Sent by agreed communication method; i.e. workstation, SWIFT, fax, etc. and containing all information about the pending trade: name of the security, ISIN code, net settlement amount, counterpart, trade date, settlement date, etc. Physical intervention is dependent on STP capabilities
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Trade date + 1 to settlement day – 1 (may cover a period of two days in a T+3 environment) Step 10 On the morning of T+1, the clearing house will send out a pending settlement list to all participants (including custodians) detailing all trades. Report sent each day
Step 11 On receipt of the list, the local custodian will match the trade instructions and assuming they match, will send through an affirming order to the CSD assuring them that they will do their part to settle the trade either on the cash or securities side
Step 12 - if sale (buy involves FX and cash unblocking) The local custodian must release the securities (may involve an ICSD like Euroclear or Cedel) which have been sold by contacting the registry and unblocking the shares. In a physical market, the local custodian would arrange for the securities to be transferred to a holding account at the central depository for the benefit of the buyer
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Settlement day Step 13 The CSD is responsible for arranging all trades entered into its system for settlement. Check necessary shares are in registry/ depository, cash in the a/c and block them. Then arrange their transfer. Safe settlement will see a simultaneous exchange
Step 14 Upon settlement in the CSD system, notifications confirming settlement are sent to all local market participants including local custodians
Step 15 Upon receipt of the settlement confirmation, the local custodian immediately forwards the confirmation on to the global custodian
Step 16 The global custodian in turn forwards the settlement confirmation on to the fund manager
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PAGE 70
Participants
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Market participants - intermediaries
Financial institutions/ intermediaries help the flow of money from the users to the suppliers of capital They are the banks, exchanges, brokers etc who: ÆBring buyers and sellers together ÆFacilitate the trading and settlement process ÆParticipate in the issuance process ÆAct as market makers in secondary markets Technically all financial institutions are intermediaries
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PAGE 72
Funds/Investors
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PAGE 73
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 74
Investment funds - description
Investment funds are pools of assets made up from numerous individual investors where the assets are collectively invested in a variety of instruments around the globe They interact with broker/dealers to initiate trades, and with custodians to manage the settlement of the executed trades Types of investments include equities, government bonds, corporate bonds and money market instruments. Mainly quoted on recognized securities markets
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PAGE 75
Types of investment funds
Pension funds Insurance funds Hedge funds Unit trusts Collections of high net worth individuals (investors) / private trusts
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PAGE 76
Investment funds - Examples
UBS Fidelity Investments Deutsche Bank Credit Suisse Group AXA Group Barclays Global Investors Merrill Lynch
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PAGE 77
Fund managers interaction in the life of a trade
broker
T
fund manager
e d a r
Se ttle m
en
t global custodian
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PAGE 78
Fund managers - Operational responsibility
An investment manager decides to make a purchase and informs a broker (diagram lines 1&2) The broker will act on this instruction. The trade will be executed when possible The investment manager will receive a trade confirmation back from the broker stating all the trade details for settlement (diagram line 7) The fund manager will arrange to send settlement instructions to the global custodian (diagram line 8) These instructions contain all the necessary information to settle the securities and cash side of the transactions
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PAGE 79
Fund manager - Operational responsibility (cont.)
The fund managers responsibilities are basically finished, barring failed trades, and waits now to receive confirmation from the global custodian Upon settlement, the global custodian sends through a settlement confirmation stating the number of shares/amount of cash transferred and the date effected. Ideally this is sent at the end on the day which the trade actually settled (diagram line 16) The fund manager may have additional settlement confirmations/reporting duties to underlying owners
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PAGE 80
Fund manager - Operational responsibility (cont.)
Ultimately responsible to all holders of shares/units of the fund - Account maintenance The quality of custodians and brokers chosen The ability to liquidate a client’s holding on request Constant ability to give up to date, marked to market pricing; i.e. valid fund valuation
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PAGE 81
Why do fund managers use a custodian?
Market information from around the globe on market settlement practices Facilitate cross border settlements Assist in monitoring/tracking of assets held as well as entitlements to those assets A local presence acting on behalf of the investors in all markets Maximize asset safety and minimize risk Access to additional banking services
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PAGE 82
Fund manager - Custodian criteria
High credit rating Segregation of client assets from bank’s own assets High SWIFT usage/automation - STP capabilities Customized reporting capabilities No lien taken on customer assets Secure, efficient IT systems Value for money
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No lien
A fund manager requires that custodians do not use assets within their custody to secure loans or allow any third party legal claim to the assets lien is the right to take and hold or sell the property of a debtor as security or payment for a debt or duty
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PAGE 84
Broker - Dealer
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PAGE 85
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 86
What does a broker/dealer do?
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PAGE 87
Broker/dealers - Description
Broker/dealers ‘arrange’ (broke) deals by either: Æmatching buy and sell orders placed by clients (acting as an agent) Æor by satisfying a client order, if there are no equal and opposite orders from another client, by taking a position onto its own trading book (establishing a proprietary position). The broker/dealer will usually endeavor to offset any such proprietary position against other client orders at the earliest opportunity
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PAGE 88
Broker/dealer - Examples
Merrill Lynch & Co Morgan Stanley Dean Witter Lehman Brothers Credit Suisse First Boston Goldman Sachs Salomon Smith Barney Donaldson, Lufkin & Jenrette Inc Deutsche Bank
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PAGE 89
Broker’s interaction in the life of a trade
Fund manager/ investor
Counterpart broker
Broker
Exchange
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PAGE 90
Broker/dealer - Operational responsibility
Trade capture - the capturing of all information sent to the broker by clients, exchanges, or any party in communication with the broker Information is authenticated and validated for accuracy and completeness The broker’s system forwards all captured information to the order room to determine where the instruction should be sent
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Broker/dealer - Operational responsibility (cont.)
Order management - Orders enter the broker’s processing system via previously agreed methods of communication Types include: Æat market orders or ‘best’ Ælimit orders Ætime orders Brokers must give priority to client transactions over proprietary ones
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Broker/dealer - Operational responsibility (cont.)
Matching - Through trading operations of either an exchange or an OTC environment, two orders, one buy and one sell, will be matched ÆThese matched trades are confirmed to the appropriate brokers Brokers are responsible for distributing trade confirmations to their customers by the end of the business day in most markets
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PAGE 93
Broker/dealer - Operational responsibility (cont.)
Settlement - Ensure securities are either on their client’s account for a sale transaction or cash is on account to fund a purchase ÆIf a custodian is used, the broker must communicate with the local custodian For a proprietary trade, the broker will arrange for the transfer of either cash or securities into the central clearing system
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PAGE 94
Broker/dealer - Operational responsibility (cont.)
Post-settlement - Confirmation of the securities and/or cash transfers are sent to all participants daily, reflecting the new positions Æinternal reconciliation Æexternal reconciliation
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Broker/dealer - Operational responsibility (cont.)
Account maintenance - For clients who hold their shares in a segregated account with the broker, the broker has certain responsibilities in administering the accounts with services such as: Ædividend collection Æcorporate action notifications Æproxy voting services Æaccount statements
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PAGE 96
What is a Prime Broker
A prime broker is a broker offering professional services specifically aimed at hedge funds and other large institutional customers.
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PAGE 97
Services Offered Prime Broker
Custody Clearing Reporting Securities Lending Money Lending Execution Leverage/pricing Capital Introduction Start-up services Relationship/co-ordination Credit intermediation Risk Management Contracts for differences Straight through processing Futures/options clearing
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Swaps NAV fund services Research IPOs Seed Capital Consulting services FX services (hedging) Yield enhancement Fund administration Structuring: wrap products Hedge Fund swaps Partial principal guarantees Trade structuring/finance coverage Global access
COMPANY CONFIDENTIAL
PAGE 98
Exchanges
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PAGE 99
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 100
Exchanges - Description
The primary role of an exchange is to provide a centralized market place where buyers and sellers can meet to negotiate asset prices and to execute trades. Exchanges aim to maximize price transparency and liquidity at the lowest cost by providing a centralized trading platform into which all buy and sell orders are submitted
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Exchanges - Characteristics There are two main types of central markets: Ætraditional “open outcry” (floor-based) markets, which operate in a specific building with a physical trading floor e.g. NYSE, LIFFE, AMEX, Æelectronic screen-based stock exchanges e.g. Nasdaq, Eurex. Markets may be price/quote-driven or order-driven Æin a price-driven market, market makers will quote both bid and offer prices, but the transaction remains an individually negotiated contract Æin an order-driven market, trading revolves around an order book where market participants post buy and sell orders (quantities and prices) at which they are prepared to trade
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PAGE 102
Exchanges - Examples
NASDAQ American Stock Exchange (AMEX) Tradepoint London Stock Exchange
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PAGE 103
Clearing and Settlement Agents
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PAGE 104
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
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PAGE 105
Clearing & settlement in the bigger picture
External payment system
Custodians
Stock exchange
Clearance & settlement entity Depository/ Registry
Brokers/ Participants
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PAGE 106
What do we mean by settlement ? Settlement is the final, irrevocable transfer of cash from the purchaser to the seller in exchange for the delivery of securities to the purchaser
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PAGE 107
Delivery versus payment
Delivery versus payment (DVP) is the simultaneous and irrevocable transfer of ownership of an asset in exchange for the equivalent assured countervalue in same day funds
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PAGE 108
Settlement conventions - Physical vs book entry Physical delivery ÆShare certificates and duly signed transfer documents lodged with clearing house Book entry ÆDematerialized computerized record only no physical certificate transfer is by Dr sellers account and Cr. buyers
ÆImmobilized as above but physical certificates exist in centralized location
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PAGE 109
Settlement conventions - Rolling vs fixed
Rolling settlement ÆT+ defined market standard - each day the date rolls on ÆMajority of markets Fixed settlement ÆFixed day each week ÆTrading for week settles on one day ÆHigh fail cost ÆSouth Africa
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Clearing & settlement - Operational responsibility The C&S entity receives initial instructions from a stock exchange or directly from participants immediately after a trade has been matched on the trading system/agreed ‘over the counter’ between participants (diagram line 5) Internally, the C&S entity begins positioning of the pending transactions by matching all buyers and sellers Depending on market system, trades will either be netted or settled trade by trade
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PAGE 111
Clearing & settlement - Operational responsibility Between trade day and settlement day, there is the opportunity for amendments to be made and for custodians to affirm trades On settlement day, all pending trades have been matched and the settlement activity begins, i.e. shares are transferred between buyers and sellers at the same time as cash (or should be!) based on C&S interaction with the payment system and the depository (diagram lines 13)
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PAGE 112
Clearing & settlement - Operational responsibility Upon the settlement, confirmations are sent to all participants detailing the new positions If there were unsettled transactions, a list of failed trades is also sent giving participants a reason for the fail
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PAGE 113
Failed trades
Trades may fail for a variety of reasons increasing the importance of DVP Ælate or incorrect settlement instructions from a counterpart to the custodian or clearing agent Æseller has insufficient quantity of securities to deliver Æpurchaser has insufficient funds to pay Æcertificated securities are not yet available from the registrar from a recent purchase to cover a sale Buy-in
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PAGE 114
Custodian
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PAGE 115
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
COMPANY CONFIDENTIAL
PAGE 116
What does a custodian do?
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PAGE 117
Custodian - Description
Custodians manage the safekeeping of assets on behalf of their clients Custodians handle all administrative issues that arise with regard to assets in their safekeeping Æcorporate actions announcements Ædividend payments Æsecurities lending etc. A global custodian offers both core custody services and value added services; the latter enables the custodian to differentiate itself from other players in the market
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PAGE 118
Local custodian
The vast majority of global custodians select local agents in foreign countries, the local supplier will in turn handle direct interfaces with the domestic clearing settlements and depository systems Local suppliers are able to handle business more effectively as they have connections within the market place, no language barriers, and are knowledgeable of local market regulations
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PAGE 119
Custodian - Examples
Citibank State Street Bank & Trust Co. Paribas Brown Brothers Harriman & Co HSBC Group (formerly Midland Bank) Chase Manhattan Bank of New York
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PAGE 120
Custody within the life of a trade
clearing & settlement entity
investor
global custodian
local custodian
central depository/ registry
payment system
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PAGE 121
Custodian - Operational responsibility
The custodian is ultimately responsible for the safety and securities administration of all client assets placed in their care While both custodians and depositories are responsible for safekeeping, a bank, acting as a custodian, has the obligation to protect clients which differs slightly from a CSD whose responsibility is to the market and its’ participants
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PAGE 122
Custody service provisions
Core services Æsettlement of trades & registration (securities & cash) Æsafekeeping Æcash management & foreign exchange Æcorporate actions notification & processing Æproxy voting Æincome collections Ætax reclaims Æreporting
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PAGE 123
Custody service provisions (cont.)
Value added services Æinvestment accounting (multi-currency, full accrual reporting) Æpricing/valuation (calculation of net asset values) Æperformance measurement (calc. rates of return) Æsecurities lending (collateralized loan of securities) Æcollateral management (managing client’s open positions) Æfutures clearing (exchange traded futures & options) Æmarket intelligence (timely news affecting investments)
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PAGE 124
Custodian - Operational responsibility
Initial receipt of settlement instructions from a client (diagram line 8) via SWIFT, Telex, fax, or workstation Æthe method of communication will be set in a ‘Service Level Agreement’ at the beginning of a relationship between a client and the custodian The settlement instructions will include all the relevant information
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PAGE 125
Custodian - Operational responsibility (cont.)
Once received, the global custodian processes the trade instructions in-house The instruction includes all information mentioned (previous slide) which provides the authorization to release/deliver shares on a sale transaction or authorizes a foreign exchange transaction and payment to be made in the market for the purchase of securities
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PAGE 126
Custodian - Operational responsibility (cont.)
The local custodian receives the information from the clearing and settlement entity (who received it from the stock exchange) informing of all pending trades for which settlement needs to be affirmed (diagram line 10) The local custodian matches the information from the clearing house with the authorization for settlement from the global custodian. If the information matches, the local custodian ‘affirms’ the trade with the clearing house If the information does not match, the local custodian identifies which part of the information is outstanding and will contact the appropriate party to resolve the dispute
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PAGE 127
Custodian - Operational responsibility (cont.)
Depending on whether the trade to be settled is a purchase or sale (diagram line(s) 12): Æfor purchases - the local custodian will, based on instructions, have booked a foreign exchange and will transfer the local currency from the global custodian’s cash account with the correspondent bank (likely to be the local custodian itself) to the central payment system used by the clearing house Æfor sales - the local custodian will need to ensure the securities which are to be transferred to a new owner are delivered to the clearing house if not held centrally (physical markets) / OR are authorized to be released from the register (dematerialized markets with a centralized registry)
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PAGE 128
Custodian - Operational responsibility (cont.)
Once the settlements are complete within the central clearing house, a settlement confirmation will be sent to all participants including the local custodian as will any failed transactions for the day (diagram line 14) The local custodian will send settlement confirmation immediately to the global custodian. This may be manually entered into SWIFT, Telex, etc. or the confirms may be generated automatically if the local custodian has ‘straight through’ processing capability (diagram line 15)
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PAGE 129
Custodian - Operational responsibility (cont.)
The global custodian will forward the settlement confirmation immediately to the fund manager/client (diagram line 16) ‘Straight Through Processing’ may be possible where appropriate system/communication links have been put in place. For the initial settlement instructions, steps 8,9 &11 could go from the system of the client/fund manager straight through to the clearing & settlement house. Additionally, the confirmation steps 14-16 can also flow automatically from the settlement system back to client
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PAGE 130
What is the custodian NOT responsible for?
Investment decisions in terms of investment type or country Communication with beneficial owners below direct customer level i.e. beneficial owners of funds Achieving best prices on securities traded Compliance of fund mangers with local regulations Market inherent settlement risks
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PAGE 131
Central securities depositories & registries
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PAGE 132
The life of a trade foreign buying fund manager 1
8
foreign selling fund manager 7 2
int’l buying broker
16
local broker/ participants
6
OTC 3&4
10 14
13 12
5
16
5
8
14 10
global custodian
14 11
15
9
10
13
10
local custodian
5
6
int’l selling broker
3
clearing & settlement
11
15
local broker/ participants
stock exchange
14
global custodian
2
4
3
9
1
7
registry/ depository
12
local custodian
Central Bank payment system
The national securities governing body Copyright ©2005 Kanbay Incorporated. All rights reserved.
COMPANY CONFIDENTIAL
PAGE 133
Central Securities Depository Description
Central Securities Depositories (CSDs) are established in domestic markets by governments or privately owned consortium(s) to hold securities in a central depository They provide a mechanism for the transfer and delivery of securities CSDs usually hold and process securities in book entry (or electronic) form. Varies The CSD will inform the registrar if there is a change in legal. In recent years, securities firms have been trying to reduce the flows of physical securities, the depository has been central to this advancement
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PAGE 134
Registrar - Description
A professional securities market participant performing maintenance of the Registry of registered securities holders The registrar will have authorization by way of a contract with the issuer to maintain the register on the issuers behalf The register may be an aggregation of data, in paper form and/or on electronic media, identifying registered persons and confirming their rights to securities registered in their name and recorded in the personal accounts of registered persons, which makes it possible to obtain and forward information to the registered persons
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PAGE 135
CSDs - Examples France
:
Sicovam
Germany
:
Clear stream (previously Deutsche Börse Clearing)
Hong Kong
:
Hong Kong Clearing
Japan
:
Japan Securities Depository Centre (JASDEC)
Switzerland
:
SEGA/INTERSETTLE
United Kingdom & Ireland :
CREST
USA
The Depository Trust Company (DTC)
:
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PAGE 136
ICSDs - Examples
Clearstream Euroclear
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PAGE 137
Central depository / registry interactions with market participants
brokers
clearing & settlement entity
custodians
central depository
national securities commission
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PAGE 138
CSDs - Operational responsibility
Interaction with custodians and brokers who may need to deliver shares or authorize shares for release on settlement day Custodians/brokers send instructions directly to a depository with instructions prior to actual settlement The depository receives instructions from the clearing and settlement entity checking for available shares and orders the blocking of shares for pending settlement
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PAGE 139
CSDs - Operational responsibility
The depository confirms securities present for settlement and blocks them awaiting final instructions The clearing and settlement entity then orders the final movement of securities from sellers to buyers accounts (having checked for available cash) Final settlement/movement statements sent to the clearing house or perhaps to the participants depending on the market practice
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PAGE 140
Activities of the CSD/ registry
Provides central clearing and settlement (CCS) body with status of accounts/available securities Transfers ownership based on instructions from CCS Provides issuers with updated list of shareholders upon their request Performs daily reconciliation of shareholders & issuers Reporting responsibility to securities commission regarding ownership limits/ restrictions When participation is mandatory and legislation supports the activity, it is the one place where ownership is determined
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PAGE 141
Trade Process
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PAGE 142
Trading Process Institutional Investor
Sales & Service Delivery
Retail Investor Private Client
Risk management - Market, Credit & Operational Risks Front Office ¡ Trade Execution ¡ Trade Delivery ¡ Pre Trade Decision ¡ Reference Data
Market Data
Exchange
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Middle Office ¡ Trade Support ¡ Risk Management ¡ Reconciliation ¡ Portfolio Management
Back Office ¡ Settlement ¡ Clearing ¡ Accounting
Other Institution
COMPANY CONFIDENTIAL
Custodian
Market Clearing
PAGE 143
Roles in Trading Process
Sales
Front Office
Facilitate, Control and monitor trade execution and settlement
Back Office
Focuses on research, trade execution at the best possible price, identifying potential profitable trades
Middle Office
Focuses on sales of financial products, fee based buy / sell orders for execution and client relationship
Payment / Receipt, Settlement and Accounting
Custodian
Completion of deliveries of securities and safe keeping of securities
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PAGE 144
Straight Through processing
Automating the information flow from one stage to another stage without manual intervention
Includes the information flow within internal system / systems
Involves interfacing with external systems
Stock exchanges
Custodian
Counter-party
Payment Systems
Results in ability to handle volumes of transactions without increasing the processing cost
Reduces possible human errors in data processing
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COMPANY CONFIDENTIAL
PAGE 145
Trading system Products
Front Office
Equities Equities
Money Money Market Market
Credit Credit Derivatives. Derivatives.
Fixed Fixed Income Income
FX FX
Interest Interest Rate Rate Derivatives. Derivatives.
Trade Trade Capture Capture
Real Real time time blotter blotter
Analytics Analytics
Pricing Pricing
Middle office
Back Office
Technology
Limits Limits
Analysis Analysis (MTM,Hedge…) (MTM,Hedge…)
Reconciliation Reconciliation
Documentation Documentation
Accounting Accounting
Revaluation Revaluation
Settlements Settlements
Payments Payments
Real Real Time Time
Event Event Driven Driven
Database Database
Web Web Enabled Enabled
Scalability Scalability
Extensibility Extensibility
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COMPANY CONFIDENTIAL
Inventory Inventory
PAGE 146
Thank You
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COMPANY CONFIDENTIAL
PAGE 147
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