Welcome to this Felix live refresher session on money markets.

My name is Thomas Krause. I'm head of financial products here at Financial Edge, and I have the honor to take you through the session here today.

And let's start with a very brief look at the agenda.

So what to expect from today's content here.

Um, well, we are, as I said, gonna approach this as a refresher session.

So that is, um, basically meaning it's gonna be relatively fast paced, and we're going to start with an introduction to money markets.

We're going to, uh, have a look at the main participants and their motives.

We will then move on to cover some of the, uh, cash products that are trading in the money markets.

And then of course, we will also, uh, talk about the money market benchmark rates. That includes IBR rates. Yes, some of them are still around.

Uh, and of course, we're also gonna talk about the new risk free rates or near risk free rates like sulfur, Sonya, toner, um, and the likes.

Um, we may not get to it, but if there's still time, we might have a very, very high level look at how those risk rates are driven by monetary policy.

And then, uh, discuss a general idea behind monetary policy transmission.

Okay. But without further ado, let's get started with today's content.

And as I said, we're gonna start with a general introduction to money markets.

And then of course, first question is what are we talking about when we talk about money markets? And before we even go into the classic definition, I think what's really important to say right from the start is that the money market is a very, very specific part of the market, but it's hugely important, right? And you might have heard this analogy, uh, that people are using, I would say relatively frequently. And that is that the money market is really the plumbing of the financial system.

And I really like this particular analogy because it's so visual, right? Because we all know plumbing exists, right? We all live in, in a flat or a house or whatever, and we know there's pipes behind those beautifully looking walls.

But, um, you know, for obvious reasons, we're not really super interested in what exactly happens there as long as everything works, right? However, as soon as there's a problem in the plumbing of our building, this becomes a high priority issue for all of us, right? For obvious reasons. And I think this is something that, you know, really applies to money markets as well, which is usually a corner of the market that doesn't receive a lot of attention from many investors out there, because obviously the big sort of returns are made in sort of the capital markets where we're talking about long-term bonds, where we're talking about op equities and, and, and all the other, uh, asset classes here.

But, um, that doesn't mean that money markets aren't important at all.

In fact, of course there is a, um, range of very specialized investors that are, uh, heavily involved in the money markets.

But again, under normal circumstances, the financial press, for example, doesn't really cover money market rates specifically, yes, there's a lot of talk about what the Federal Reserve, for example, is expected to do next, how many basis points cuts, hikes, where when, you know, not just the Federal Reserve, but obviously all other central banks as well, but nobody really sort of, uh, has a daily really, really, um, detail look at how fr has changed from one day to the next, for example, right? Um, but that doesn't mean it's not important.

And again, as I said, the analogy applies here.

As soon as there are signs of something going on in the money market, then attention from all investors, I would argue, really starts to focus.

And so that you have seen, for example, last time, uh, in a, in a spectacular fashion back in 2023 when we had, uh, obviously some funding issues in the, uh, in the money market or spilling over into the money markets in more broadly in the United States.

Uh, and so that's kind of, I think what, what happens here, because when there is a sort of disruption of normal day-to-day activity in the market, money market, then this has really a lot of potential to spill over into some broader risk of movement.

And that then will obviously affect other asset classes.

So even equity investors will then carefully monitor what exactly is happening in the money markets, uh, to just kind of get a bit of an idea whether or not this is gonna spill into some sort of more systematic crisis, or if this is something that's relatively short-lived and, and well contained.

So that I think sets a scene what we're talking about here.

And now, let's actually have a look what exactly qualifies as a money market instrument.

And you see it here on the slide.

It's basically, when we talk about money markets, what we're talking about are, first of all, debt instruments borrowed money, right? So this is obviously not, uh, the place where we're trading equities.

Uh, and the second criteria here that needs to apply to qualify as a money market instrument is that the time to maturity at issuance, uh, is between one day and, um, up to one year or 12 months.

So that's really the, if you wish, the market where we're trading short-term debt instruments.

And, um, what most money market instruments then also have in common is the fact that all interest that investors receive for this investment period that is between one day and 12 months is usually paid in one, um, amount.

And this payment is made at the maturity point.

And that means that within those money market instruments, there's no inherent reinvestment risk, no interim coupon payments. Like we, for example, know this from the fixed coupon bond world where, you know, you buy a 10 year treasury and every six months you get a coupon, which you then have to reinvest, um, for the remaining, uh, investment horizon that you had.

So here in money markets, you invest money, for example, in a deposit for six months, and in most cases, you do get your money back.

And all the interest over the six months period in one go, at the end of the period, IE at the six months point, meaning from a calculation of cashflow point of view, money markets tend to be relatively, uh, easy and straightforward because we apply a concept called simple interest because we get all the interest at maturity.

There is no interest on interest in money market instruments.

Yes, of course, investors that get their money back in six months might wanna reinvest, but that's a different story. That's not in the instrument, that's an investor's generally strategic decision to make.

But in the instrument itself, there is no reinvestment because we get all the cash flows at the redemption at maturity point, meaning no reinvestment risk, meaning fixed returns if you wish.

And that's very easy to calculate. You see, the formula here for most instruments, as I said, this applies, the amount of interest is simply gonna be calculated by multiplying the notional amount. Let's say this is a hundred million here.

Um, we have it in our example, right? A hundred million.

The interest rate that we agreed upon, let's say was 5%, and the investment period was from the 12th of January, 2024 to the 12th of February, 2024. So give or take one month, right? Uh, and so what we know is that interest rates are always, always given as per annum rates, IE 5% per year. But of course, we're not gonna get paid 5% for the whole year period, because in fact, our money was only invested for months.

So we need to break it down to the relevant period of investment, and that's where the day count fraction here comes into play.

That's obviously the general principle, how we calculate interest rate payments, it's notional times interest rate times the number of days in the investment period over the assumed number of days per year.

And then obviously there's all those myriad types of different day count conventions. The good news is in money markets, um, at least in all developed currencies that I'm aware of, uh, only two day count conventions really apply in reality, that's actual 360, and that's actual 365.

Um, that is of course, you know, the, one of the questions that can never be answered as to why we still have different day count conventions in different, you know, in, in the same sort of, uh, market parts around, uh, different countries.

But that's just how it is.

Actual 360, for example, being used in, uh, US dollar money markets, also in Euros and Actuarial 365, for example, being applied in, uh, the UK or generally pound sterling, uh, money markets.

Just to give you some examples, it's not really important for all of us to remember exactly which day count convention applies and which particular currency, those currencies that you are gonna, um, be involved with.

You will have to remember this. So, but that's just, uh, something that will be done very, very easily.

The important thing is always to remember to check those day count conventions, which does apply here.

And the reason, again, you can find on the slide in front of us is because the same interest rate on the same notional amount, but using different con account conventions can of course lead to quite significantly different, uh, interest rate payments, right? So here, um, the interest payment differs by about $6,000, uh, when we switch from actual 360 to actual 365, and that's obviously a, an amount of money, uh, worth thinking about anyway.

So, so far, um, 12 months maturity criteria, debt instruments and simple interest does apply.

And I'm saying it again for most instruments that of course there are some where maybe there's a daily, uh, accrual feature or anything like that, but the vast majority of instruments will indeed work this way.

Okay, now, uh, let's, uh, come, uh, to the next point and think a little bit about as to why it is what I said, um, right at the beginning here, that as soon as something starts to go wrong in money markets, as soon as the plumbing starts to or appears to have sort of issues, as soon as it looks like the money markets are clocking up in some way, um, a lot of people will start paying very close attention.

And the reason as to why this is, is that money markets are incredibly important for liquidity management, right? And of course, uh, especially in the banking community, liquidity is absolutely, um, critical.

And so let's just pick, um, here banks as an example.

However, there's many, many other use cases as well. But I think the example of banks highlights most, um, in the, in the most, um, intuitive way as to why the role of money markets is so critical.

So the important thing that obviously is applicable to banks, but also to corporations, uh, and, and, and asset managers, whatever, uh, is really that we have sufficient amount of liquidity when it's required. Meaning the moment we have a payment obligation, we need to be able to meet this payment obligation, right? We need to remain solvent. That's of course, the most critical thing. Meaning if I have to make a hundred million dollars payment, I better have today I need to have a hundred million dollars at disposal to basically make this payment.

And so this then leads to the general idea that especially banks where we are having lots of payments to make, and we're receiving lots of cash flows on a day, we should have always a certain amount of liquidity, um, readily available to fulfill our payment obligations. That's something that's even, uh, been, um, sort of prescribed to us by the regulatory environment where we have certain liquidity ratios, et cetera, et cetera, to hold.

Um, uh, but I think, you know, in general, this is sort of like just common sense.

You need a certain amount of liquidity, and of course, the higher the amount of liquidity that you're holding is the more, uh, or the safer it is, right, the less likely you are to run into payment problems.

So that sort of is certainly an argument for huge amounts of liquidity being held on your balance sheet.

The counter argument then, of course, is that liquidity doesn't really generate high returns.

Yes, you might be able to invest it at, uh, you know, very, very short, uh, periods of time.

Um, but this is not necessarily gonna, uh, give you the highest returns that you can possibly, uh, imagine.

And therefore, you know, we need to find the right trade off here, right? We need to have a sufficient amount of liquidity.

Um, but we also don't want to have huge, or, you know, amounts that are much higher than necessary because it's gonna be a performance, uh, drag, right? So the way this then is approached in reality is, of course, we're setting ourself sort of like a target.

Where do we want to be liquidity wise, on average, for example, or at the end of every day, it doesn't really matter.

Here, we're not giving a, a detailed course on, on treasury management, but you know, you can easily imagine that a bank will say, okay, we aim to hold a liquid daily amount of liquidity of, let's say, just as an example, $5 billion, okay? That's what we want to have as liquidity at the end of every day. And let's say by coincidence, that is the amount of liquidity we're holding as of, uh, today, IE in the morning, we get to the office and we see, okay, we're having $5 billion in cash, IE in liquidity, and that's the starting point of the day.

So that's the start of day, um, 5 billion balance.

Then we look into our cashflow forecast, IE we look into our system and say, okay, how much money do we expect, uh, to leave the bank today? That is, let's say 400 million, uh, dollars outflows that we expect, uh, and we also expect a $500 million inflow.

Um, and that is, for example, a redemption of a corporate loan, whatever, uh, that is, it doesn't really matter.

But just to provide some color around this example.

So that means we have an expected end of day balance of $5.1 billion, right? 5 billion plus 500 minus 400, that gives you to 5.1.

And let's say we're reasonably happy with this. We're not gonna do anything because 5.1, you know, we're very close to where we actually aim to be.

We have a little bit more, but, you know, let's not lose sleep over that. However, now, let's say we're going through our day, uh, and then tonight, uh, just before we're, um, planning to wrap things up and, and go home for the weekend, we realize that this 500 million inflow has not arrived.

So we do some, uh, research about this, and then we find out that the client that was supposed to pay the money back, um, today has accidentally wired this payment to the wrong account.

Um, so basically that's a sort of nice operational risk example.

But what it means for a mal point of view now is that we don't have the balance that we expected to held of 5.1 billion, but now we are 4.6 billion in liquidity.

Now, of course, you might argue, well, you still have a liquidity cushion of 4.6 billion, but let's assume we wanted to bring the balance up to 5 billion because that's the amount of money we always want to hold.

Then what would we have to do Friday afternoon, right? Four o'clock, four 30.

I don't know what the actual cutoff time would be here, but we need to find, uh, $400 million somewhere.

And where would we get this in the money markets? And then of course, for how long would we, uh, like to borrow this amount of money? Well, of course, it's a bit of a tricky one here, because today is Friday.

Under normal circumstance, I would say we would like to borrow money overnight, because tomorrow we will get the 500 million, but tomorrow's Saturday.

So basically we're gonna borrow the money over the weekend from today to Monday.

That means it's three day boring, but still it would be an overnight transaction here because it's the next business day.

Uh, really interest has to be paid for three days.

So, uh, and then on Monday, we would expect to get the 500 million.

So this amount of, uh, well, this boring that we will do will only be done until Monday because that's, as I said, when we expect to receive our money right from the loan client. And why would we borrow for a week or a month if we only really need the money for, you know, the next three, uh, days.

So then of course, that kind of already shows how important it is that we are able to access money markets.

Uh, unscrewed notice can raise reasonable amount of, of money relatively quickly at relatively, um, you know, low costs.

And, um, that is an obviously showing as to why money markets are so important, because it's for managing liquidity.

And liquidity sometimes, uh, can be quite critical.

And for example, for those who remember the, um, global financial crisis in 2007, 2008, that's really where things, um, were, uh, or where, where the biggest problems, um, basically turned up. And that was because, you know, many banks had obviously, um, run a pretty significant liquidity risk.

IE they were borrow a lot of, uh, money through the deposit market with three months, six months times to maturity, uh, and then taking that money and investing into long dated assets, sometimes relatively illiquid assets.

Um, and then obviously when the financial crisis hit and the first one or two banks, um, started to look a little bit shaky and, and, and got into trouble, then of course a lot of those deposit investors started to feel less, um, optimistic about getting their money back. So the next time the deposit expired, they would take it out and maybe, uh, deposited in a safer place, uh, meaning that the banks suddenly had all those deposits rolling off IE they had to repay, uh, those deposits.

Um, but they were not able to sell this now very illiquid, long dated assets.

So that was becoming quickly a liquidity issue, a solvency problem, and then regulators, or sorry, the central banks actually stepped in with all the liquidity, um, measures there to basically keep the system, um, from a total collapse.

And that I think is a very, very good and very, um, you know, drastic, uh, example, but it's important to remember that's the role of well functioning, uh, money markets.

So, as I said, we looked at this from the perspective of banks, but you know, a corporate has very similar, uh, tasks to do.

Governments of course may be slightly different here, but governments are, uh, usually quite active in the money markets as well.

Not so necessarily from a day-to-day liquidity management per se, although they might do this, but mostly on the issu side, if we're thinking, and we're gonna look at t builds, for example, uh, later on, uh, there's a significant amount of short-term borrow by governments, and there's very various reasons, um, for doing so.

But the one that I can probably, you know, uh, understand the, the best is that, you know, it's, it's, it's good from a adjustment perspective.

So if you start the financial year as a government and your projection for tax inflows, for example, uh, is coming in at a certain level, and based on that level of expected tax inflows, you now budget out your year and you sort of plan your borrowing, um, in the capital markets.

And then at the end of the year, you realize that, and let's kind of come up with a nice scenario that the tax, uh, inflow was much higher than originally anticipated.

That means now probably you have borrowed too much money, and if you had borrowed all this money for 30 years, uh, then you would now have some sort of like cash surplus, which doesn't feel like the most efficient way of running a business.

But if you had borrowed a certain amount through short term money market issuances, then you could just allow them to roll off, IE repay them, and you would be in line, uh, with your, with your tax inflows. Whether or not this is a realistic scenario, I leave this up to you to judge, but that would be just a, a, you know, um, I think, uh, a reasonable, uh, way of looking at this.

Now then there's mutual funds, pension funds, and of course you think, okay, those are money market funds, right? That invest, uh, you know, cash in money market products. But I would say every mutual fund will somehow be exposed to the money markets.

And that's not through a ton of investments. But if you think about it, if you're running, for example, a long only equity mandate, um, that's a mutual fund, you will probably have a certain amount of liquidity as part of your assets under management, uh, simply because you want to be able to meet your redemption requirements. Sometimes you want to keep some powder dry, uh, in order to, you know, buy shares cheaply after an expected correction, anything like that. And the moment you hold liquidity, um, you need to think about where to put it, and then you will probably, uh, enter, uh, the money markets for some short term investment and so on. And then last, but not least, of course, they are central banks.

Now, uh, they are quite actively involved in money markets as well.

Sometimes more, sometimes less.

But of course, the main reason for this is that they are using the money markets as sort of like starting point for, um, implementing monetary policy.

And as I said, if there's time, we're gonna talk a little bit about that.

So just a quick reminder for those who have joined after I, uh, kick this off, um, if you do want to ask any questions, feel free to do so.

Just don't use the chat, use the q and a function.

Um, but, uh, you know, obviously happy to address those as they, um, come in.

Okay, so now let's go into the actual cash product.

So today's not about derivatives, we keep that for another day.

Um, but let's just kind of start looking at how different, um, borrowers actually tap the money market investor community here for money.

And we see here four different, uh, names of instruments. They differ across three, uh, dimensions.

And we're gonna talk through this. What I want to say there'll, before we go deeper, is they are all what we call unsecured, uh, instruments, meaning all you have is the promise of the issue to repay.

Should they not be able to fulfill their contractual obligations. There's no collateral of any kind that you will have access to if you, uh, had a deposit with a bank, and that bank is no longer around, maybe if you are a private investor, of course there will be some sort of insurance.

Um, if you are an institutional investor, however, you would have to go through the normal liquidation process and join all other, uh, creditors here asking, uh, for your money back.

Um, so you won't necessarily have access to any specific, uh, asset on the balance sheet of the issuer here. So it's unsecured, um, borrow, that's what they all have in common, but how do they differ? Well, for example, in the dimension of who issues those instruments, deposits, and also certificates of deposits can only be issued or taken, let's say, um, by deposit, taking institutions, IE uh, the classic, um, banks, TBIs is a government, um, funding instrument, so issued by governments commercial paper, that could be corporations, it could be financial corporations, also non-financial corporations.

Um, so there's probably the broadest range of potential issuers.

The next dimension in which those instruments then differ is in the way the interest, in the way the return is paid to investors.

And there are two main, um, ways in which this could happen when we know them from, uh, bond world already, there's coupon paying instruments, and then there are zero coupon instruments which work on a discount basis.

So look at the coupon instruments, that's deposits, CDs, um, at least those are the most important ones.

And here it works that you're depositing a certain amount of money, let's say a hundred million.

And then at maturity, you get a hundred million back plus the crude interest over the investment period.

So you get your money back plus something on top when you buy a discount instrument.

The idea here is that you're buying it at a discount.

So if you were, for example, to buy a hundred million UST bills today, you would not pay a hundred million.

Um, but if they are issued, you would pay less than that. So let's say 97 million, and then at maturity, you will get a hundred million back.

So there's no, you know, coupon payment per se, you will just see a appreciation of capital.

Now, I would argue that in case of money markets, it's not really that important if this thing is now a coupon instrument or if you buy at a discount, because in both cases, there is no reinvestment risk, right? That's what we said right from the start.

Of course, in bond world, when you have multiple coupon payments, and there's a significant difference between receiving money on a regular basis or receiving all the accrued interest in one goal at maturity.

But for money market instruments, I don't think really it matters that much, unless of course I'm overlooking some sort of like tax, uh, aspects here or something that, uh, will of course depend on the jurisdiction and on the tax laws.

Um, so, but generally from a mechanic point of view, I personally don't have a preference whether the, uh, money, the extra money I receive is called a coupon, or whether it's called, you know, the, the, the premium or the, the, the capital appreciation, right? That doesn't make a big difference, um, to me.

And then the third dimension, and very quickly, um, want you to talk about this as well, is, are those instruments or those products here negotiable? Meaning can investors sell those instruments before, uh, the originally, um, scheduled time or maturity is over? IE if you, um, invested money for urgently six months, and now a month later you want to raise, uh, liquidity, or you want to liquidate that holding, can you do this? And the answer is for three of these instruments, yes, but, and for one, it's technically no, that's a deposit, right? A deposit is just a contract between the, um, depositor and the deposit taking institution.

And we agree that the bank will have my money for the next six months, and in return, I will get an interest off X.

Now, of course, um, I'm the client of the bank, and if I realize I need the money, I, nothing stops me from calling the bank saying, Hey, uh, you have my money and I know that technically it's yours for the next six months, but I need it now.

Can you maybe, uh, pay me back earlier and then we work this out, right? We can apply some sort of penalty or whatever.

But I'm relatively convinced that if I'm a, uh, uh, important client and I ask nicely, I probably get my money out, but technically I don't have the legal right to demand early repayment, right? So that's the one thing in the other three, um, CDs, t-bills, and cps, um, they are negotiable.

IE they exist in security format, meaning I can take the security and look for a buy in the secondary market.

That doesn't mean though, it's gonna be easy to find one, right? And, uh, especially in CDs and commercial paper, I think the general caveat there is yes, they are negotiable, they can be sold.

The liquidity in the secondary market, however, is not very, very high.

Meaning you'll probably find the buyer, but the price might not be super attractive.

T-bills a slightly different story there because that's obviously a much more active, uh, market, uh, given the size of issuances and, and, and the number of issuances as well.

Um, but generally, you know, yes, but maybe not super liquid.

Okay? So with that in mind, now, let's go and have a look at some of the, uh, products in more detail and think a little bit about price and valuation and all those sort of wonderful things.

And the first we're gonna start with is the classic deposit, right? And here, as I already sort of indicated at the beginning, is, um, where we've seen a quite significant change over the last couple of decades, I would assume in the sort of way banks, um, you know, or many, many banks at least, um, finance themselves, because they used to be a pretty significant reliance on many, many financial institutions on those three months, six months deposits being rolled over.

And that was one of the, um, you know, main funding vehicles.

I'm not saying it isn't anymore at all, but I would say that many banks have learned from, uh, the problems we have seen in 2007, 2008 and the years after, and sort of started to match the liabilities and assets, uh, in a, in a better way.

So much more funding now happens through long-term bonds, if you have longer dated assets, and, uh, that reduces your alliance on deposits overall.

And then also, you know, remember what we said, a lot of those liquidity needs, short term and liquidity surpluses will actually be fairly short lived.

IE there is still obviously a need for liquidity management, as we have talked about in the example earlier.

But a lot of those transactions will just be made, uh, for very, very short terms.

And that's usually then the overnight market.

So most deposits in the interbank or, um, you know, wholesale market are, um, overnight deposits, meaning, um, the trade, well, the agreed deposit trade settles today, same day settlement. We get the money today if we need it, right? Remember, go back to our example. We needed the 400 million today, we get them today, and then we have to repay them on the next business day.

In our case, because it's Friday, technically, it's not overnight, but you know, it's still call in overnight, um, transaction here because it's the shortest amount of, um, time we can, we can borrow because there's no way to redeem this payment on Saturday, uh, and or Sunday because payment systems, um, are closed, right? So let's end here on the left hand side, how these deposits work today. You get your money, you pay it back Monday, plus the amount of interest, and that will be calculated as we've seen notional times, rate times, days over basis, and that's it.

Then there's still of course, uh, a decent amount of term deposits, especially for example, in Europe.

Uh, we still have a decent amount of three months, six months deposits flying, uh, around.

Um, but in, in many other cases, they have lost significance, um, quite, you know, uh, quite a, quite a bit, um, following those changes in funding markets, um, after the financial crisis.

But that doesn't mean that we're not tapping, um, our clientele for term deposits anymore.

It's just probably not quite as significant anymore.

Um, but of course we have clients that are looking to invest money in the money markets for three months, for six months.

So they have a demand for term, uh, investments or at least short term investments.

They might just not like the classic deposit all that much because as we've seen on the previous slide, it is generally non-negotiable, meaning, um, if they want to get their money back, then that might not be possible.

And then, of course, to improve the liquidity here, at least to some degree, um, we have created something called the certificates of deposits or CDs. And that's basically when is deposit is taken in.

We issue a certificate, IEA security that really recognizes, okay, we have borrowed, let's say a hundred million uh, dollars here for six months, and we commit to pay this amount of money back on the X of Y 2026.

Uh, and we also promised to pay an interest off, let's say 5% here, um, for that period as well to whoever holds that certificate, uh, on the maturity date, right? And that basically then means the deposit now is transferable.

So we can sell this, uh, CD as of course, no piece of paper anymore, or no security that is ex physically, but it's a, you know, entry and a database.

But the principle is obviously, uh, the same thing. So whoever is recognized as a holder of that CD at maturity will receive, uh, those payments.

And with that, it's now transferrable.

So we can look for a buyer if we realize, uh, we want to, um, cash out on this investment for whatever reason.

And here's an example, um, of how this could play out.

We have, uh, a hundred million dollars originally invested for a six months period.

That was at the time, 182 days, depends obviously a little bit on which six months period we're looking at.

And the original agreed upon interest rate was 5%.

So we took a hundred or we gave a hundred million away as deposit for 182 days, 5%.

So we can now with that relatively easily calculate the amount of money that we should get, um, at maturity.

So this was, uh, the issue date, let's say.

And then obviously here we have the issue, day plus six months.

And here, what's the amount of money we should get? Well, first of all, we should get our a hundred million, right? But we should also get a hundred million times 5% times 182. Sorry, this should be at times 182 divided by 360 US dollars.

Actual 360 applies.

So that's basically what we should get at this point in time, right? So that's the future value if you wish of our, um, of our deposit.

And that if you're looking at this box here is the nominator, uh, of the fraction.

So that's the point we know, okay, if everything goes according to plan, six months after we get a hundred million plus, whatever the accrued interest over the six months period would be, and easy to calculate because no unknowns in that.

However, now let's assume that 34 days B before, um, so TI plus six months minus 34 days, so 34 days before the actual expiry date or the maturity date, we now have to sell this CD for whatever reason, or we want to sell this cd, whatever, uh, is, is the reason there, it doesn't really matter.

Uh, but we're now in the market shopping for a buyer.

So we call a market maker and we ask them, um, for, uh, a quote, and let's say we find someone that's willing to make a price here for this, uh, particular certificate of deposit.

And they say, well, I would see the fair rate for this issuer here.

Um, and for this 34 day maturity, um, at 5.1%, meaning they want to, um, they are happy to buy this certificate of deposit from us at a price that implies that if they buy it at this price and then hold this instrument until maturity means they're making a return of 5.1% over this 34 days.

Of course, again, per annum rate applies for 34, uh, day.

So now what we have to do is we know the future value of this, uh, cashflow.

We know what's the implied rate of return is that the dealer is looking to achieve.

And so what we can do now is we can use this, uh, five point 10 uh, percent as a discount rate, and we're basically now discounting this future value, IE this amount of money here at the six months point back by 34, uh, days.

And we're using the 5.1% interest rate.

So now we're looking at the denominator.

That means we divide by one plus 5.1% times, days over basis.

Again, simple interest, no compounding future, nothing to the power of simply because there is no interest on interest.

And the result then would be 102,036,000 stone, and a little bit more than that.

So where does this number come from? Well, basically that's the amount of money that the dealer will actually have to, or will be happy to pay us.

Um, and then get, uh, the, uh, the whatever, a hundred million plus the accrued interest for a six months period, 34 days later.

So what you realize, it's, it's quite significantly about a hundred million.

And of course, there's 2,036,000 that represents basically the accrued interest because we held this certificate of deposit for roughly five of the six months.

So we should receive a decent amount of accrued interest as well. There's some sort of impact of an increase in interest rates, but let's, uh, not focus too much about this. Hopefully it's quite intuitive.

Yes, we should get, uh, a decent amount of money for having deposited a hundred million for five months, um, with an interest rate of 5%.

But that's basically the, you know, the, the, the, the absolute, um, textbook case of security valuation.

You work out the future cash flows or the future value of this, um, cash flows discount, those cash flows back to today.

And then effectively, uh, the present value or the sum of the present values of all the cash flows that the, uh, security represents is gonna be the price.

And that's basically what we've done, worked out the future value or the future cash flows discounted that back to today.

And we have the price, alright, that's a certificate of deposits.

Now, let's move into the tvo market, which as I said is probably the most important part.

This kind of in terms of, uh, the amount being traded here, the liquidity, et cetera.

And we already sort of mentioned that they are issued as discount instruments, meaning, um, when the US Treasury, for example, issues, um, these, um, t-bills, they, uh, calculate or they, they, they did basically publish the issuance price.

And we have an example here, 26 week, 182 days, US treasury bill was issued at 97.3357, whatever.

So that meant if we bought a hundred million notional, we would have to pay 97.335 million today.

And then, um, after 182 days, we would get a hundred million back.

So we know what we're paying today, we know what we're going to get back at maturity, and therefore we can work out what the implied rate of return, um, is.

And I would argue that investors prefer, uh, to look at things from a return perspective, right? Yes, of course, it's important to know how much money do I actually have to pay to the US Treasury today on the auction to get the T bill, but as an investor, we're so used to think about return in percentage terms, right? If interest rates are percent.

And so it would be nice to know, okay, if I buy this at 97.3 something, um, then and hold it to maturity at, you know, and, and get a hundred back, then what's the implied rate of return? What's a percentage? And so when you see the auction results, and this is, um, obviously a different auction, so don't get confused because the numbers are different.

It's just sort of, you know, a more recent one.

Um, and, um, and so here what we have is, um, the, uh, issuance price.

So that was 97.42, um, 1 6, 6 7, but it's also, uh, given to us, um, a high rate, which is basically the highest interest rate that was, uh, was basically then the implied rate of, uh, rate of return of this US treasury.

But there's one special feature, and I come back to this slide, uh, in a minute.

Um, so now that we know, okay, you know, there's a clear link between present value and future value and the implied interest, um, and investors prefer thinking about it in return terms.

Um, we understand as to why in the secondary market, T-bills are often quoted not on a price basis, but instead on a return basis.

Meaning if, you know, the treasury has issued this, uh, treasury bill now, and then we start trading this in the secondary market.

So let's say we were not in the office when this TBI was issued, so we come back two days later and we want to buy some of this.

So we call the market maker and ask for, uh, a quote and they quote us five 17 and a half to five 16 and a half, which is not the price we can buy it at, right? But instead that is the return that, um, we can lock in by buying those T-bills at a specific price.

And then with that, we're already in return space and say, okay, I can buy this TBI at five 17 and a half, or I can buy this treasury bond at five 15 or whatever, and then I can directly compare and we're in this world that we feel comfortable with.

So there is obviously, uh, then the trading happens on a return basis, which then of course can be translated back into a price, because at the end of the day, we need to know how much money do we have to transfer when we buy this tibo, right? And here's then where it gets slightly irritating, uh, and that is that we have, depending on the currency, um, the TBI is issued in and by the government that issues the tbi, there's two different ways in which we can, um, basically transform the, the, the return that's quoted into the price.

And the US dollar TBI market arguably is the most important one.

Uh, so let's start looking at this first.

And they use something called the discount quote method.

Meaning the way to transfer the quote here, um, into the price is taking the future value IE 100%, right? And then subtracting 100% times and let's just kind of use five 17 and a half, um, and then times, days over basis.

And what that tells you is that effectively this return of five 17 and a half in this formula is effectively not paid on the amount of money we're investing, but on the amount of money we're getting back.

And that's a very unusual way of quoting returns because all other instruments, right? If you think about the yield to maturity of a bond, what it tells you is the sort of approximate return that investor gonna make on the invested amount of money right now over the next, uh, couple of years. This is a five year, then over the next five years, if they bought the bond at its current price, reinvest all the coupons and hold the bond to maturity, that's the approximate return they're gonna get.

But on the amount of money invested today, now the discount quote is basically saying, no, we're quoting the return in percent not on the amount of money the investor needs to invest. So the 97 point, but on a hundred IE you get paid this return on the future value of money. And that's a very, very unusual way, and it's the only market where I've ever seen this, um, is the UST bill market.

And, um, and of course this is some sort of like, uh, first of all, it means that we cannot directly compare the UST bill quote with a, you know, um, UK TBI quote, because there we, for example, use the yield code, which basically is what everybody else does in any other market, and that is pay the return on the present value.

IE we're approaching this through a normal discounting routine, simple discounting, very much like the CD that we've seen on the previous slide.

So be a little bit careful there.

But of course, you know, we just need to remember this, and I'm coming back to this slide now.

So if we're looking at this auction results here, we see a, you know, first of all, the high rate that was 5.1, that is sort of like the issuance, uh, discount rate, basically that, um, was determined through the auction process leading to 97.42 as an issuance price. But then there's also something called the investment rate.

What is that? Well, that would be the equivalent rate of return if we would use, uh, the yield quote instead as a little bit more to that, for example, we need to adjust for a semi-annual payment and, you know, potentially at least and day counts and stuff. But generally, what this rate mostly does is saying, okay, let's make the discount quote and the yield quote comparable because the only real market that uses this discount thing is UST bill.

And so let's make it comparable to, um, conventional use treasury yields, for example.

And that is then basically what the investment rate, um, is supposed to be doing.

And what you realize is that the investment rate is quite significantly higher than, uh, the discount quote there.

And the reason as to why this must be the case is remember the 5.1 you get on the a hundred, whereas the 5.308 is calculated as the equivalent return that you would get on your 97 million in the bet, right? So that needs to be a higher number to get to the same amount of dollars at the end.

So hopefully, uh, that is, uh, intuitive.

And with that, now we are leaving the unsecured funding, uh, markets behind us, and now we're moving into secured funding because despite the fact that, you know, money market transactions tend to be relatively short term, IE you know, know, as we've seen many of them are, uh, in the deposit space, uh, overnight, um, and definitely nothing above 12 months.

Um, that doesn't mean that they are completely without credit exposures, right? So I mean, you could argue that t builds obviously, you know, the same argument then to government bond applies here that, uh, you know, government, uh, debt instruments are credit risk free at least when issued in domestic currency.

But, um, you know, let's not, let's not go, uh, too deep into this.

Um, but how sort of, uh, could investors that don't necessarily want to invest in UST bills, um, but want to, uh, lend money to other counterparts rather than the US or the, than the government, for example, um, how could they, um, sort of circumvent even this small amounts of, uh, credit exposure that, uh, will be there when is or lending money unsecured, uh, or even for a short period of time while switch from unsecured to secured? IE Not only do we lend money to a counterpart, but we also would expect to receive some form of, uh, collateral.

And that's basically what brings us into the repo market.

Uh, repo, which stands for repurchase agreement is basically the agreement between the two involved parties, the two counterparties in a repo, uh, where one counterparty borrows cash, and then the other one, um, will provide the cash in exchange for, um, for example, a bond as collateral.

And the most important type of underlying here, or of type of collateral, of course, is, uh, a government bond.

And in the US those would then be, um, US treasuries.

And this, uh, repurchase agreement is entered for an agreed period of time.

Again, the vast majority of transactions probably are in happening in the overnight market.

IEI borrow money today until Monday, and yes, collateral, I give a bond, uh, to my counterparty.

Um, and on Monday I repay the money that I borrowed and I get my collateral back.

And the transaction is over terminology wise, the two counterparties are referred to as the repo party.

That's a party borrowing the cash and then the reverse repo party that is the provider of cash.

And, uh, what we need to understand from the legal setup, and that's why it's called a repurchase agreement, is that's strictly speaking, not a lending transaction where you lend me money and I hand you over a bond and you promise to give that back to me on Monday.

Legally, this works as today I'm selling my bond to you, and you pay for it in cash.

And at the same time, we enter the agreement that I will buy my bo bond back from you on Monday, uh, and you will, um, and I will pay you, uh, the predetermined price for that.

And that price will usually be slightly higher than what you paid me for this bond today. And that difference then represents the interest that I pay you for the money, uh, for your cash that I had.

If there's a coupon payment in between, things get a little bit messier, so let's not, um, worry too much about that.

But it's really structured as I sell the bond to you and I'm buying it back from you on a Monday rather than you lent me cash and I'll, uh, lend you a bond.

And the reason why we set it up this way is if I now default over the weekend, and, um, you wouldn't have legally bought that bond, but it would be a bond that, um, I lend to you, then on Monday, you would still have to sort of give the bond back to me or well, respectively my liquidators, and then you would have to join all the other creditors.

If it's sold to you, then you will be able to sell this bond immediately and satisfy, um, your cash demand through this, uh, transaction.

So that's just a bit of a legal background as to why we structure this, uh, like this.

Um, and then of course, you can see as to why this is a quite useful, um, vehicle.

First of all, it's a relative, uh, low cost way of financing, uh, yourself supposedly you have obviously valuable collateral.

So if you think about a market maker in government bonds, for example, we're buying, uh, government bonds from clients because they are looking to sell those, we're buying them.

We need to finance those positions. And then, of course, a very, well, the cheapest way for us to finance that would probably be through the report market, because, you know, that's not just a very short term borrow, but that's also, um, almost no counterparty exposure involved here for those who are lending us the money because they get a very valuable security in exchange for their cash. So that would be the cheapest form of financing.

Um, but then of course, there's other reasons to apply reposts, for example.

Also, from a reverse repo point of view, again, going back to the market maker, not always do we buy government bonds from our, our clients, but sometimes we also sell, well, sometimes we also sell them, uh, government bonds on a quite frequent basis.

Uh, and those might be bonds that we don't have in our inventory. That means we're now having a short position. This needs to be covered.

So we are looking into the market to borrow a specific, uh, government bond security, and that would mean we're entering into the market as a reverse report party, where we're saying, okay, we are looking to borrow a bond and we're, uh, basically giving cash as collateral, uh, then to, to our counterpart on that transaction.

And then other counterparts have interest in the reverse repo, uh, way of the business as well.

And that is, for example, all this money, uh, those, those investors that are looking for really, really short term extreme, safe, uh, investments, and they don't want to just lend money on an unsecured basis to a wholesale or a financing institution.

They are then using the repo just to increase, uh, the credit quality, uh, a a little bit.

So super credit risk or super safe from a credit risk, uh, point of view investment of money over the short term.

And that altogether leads to, uh, the repo market generally being extremely sizable.

Here. These numbers, of course, require some updating.

Um, but you know, last time I checked we were about 2.4 to 2.6 billion, uh, sorry, trillion, um, daily, um, you know, volume here that underlies the, uh, sulfur, the secured overnight financing rate. So this has been, um, growing, um, over the last couple of years quite significantly.

So what this basically means is that on average we see 2.4 to $2.6 trillion of volume trading and overnight reposts, where the collateral is a US government bond on a daily basis. And that of course shows the significance, uh, of this market in in financing operations.

And as we have now touched on LF r, uh, we're, um, basically going to, um, transition into, um, the part of the course where, what was the session where we're gonna talk about the money market benchmark rates, of which I said there's two conceptually different ones in the intro, there's IBOR, and then there is the near risk rates, which we abbreviate with rs, right? And here's a common misconception.

Those FRS or overnight rates that work similar to how sulfur and, and, and, and, and, and toner et cetera, work nowadays have been around for, in some currencies at least a lot longer than, um, the LIBO transition.

It's just that we, following the LIO transition or the the LIBO scandal, um, we basically redesigned a lot of those, uh, rates.

And we're gonna talk a little bit about what were the criteria, but it's not necessarily exactly in brand new product.

Similar things have been around, Sonia, for example, has been around, uh, for a lot longer than, um, than it's been used as an official replacement of L-I-B-O-R.

There was just a slightly different, uh, way of calculation, et cetera, but um, it was around for a lot longer than that.

But nonetheless, these two are still, um, being applied, uh, especially in Europe, for example, we still use UIOR, uh, which is sort of like the, uh, onshore version of, uh, Euro IBOR.

Uh, and that's still being used, however, it has been, uh, significantly reformed.

Um, and that's basically because obviously the reason why we had to move away from L-I-B-O-R for example, was that we found that despite the fact that a huge amount of financial instruments were using this number, uh, to determine, uh, cash flows on, on the floating legs, if you think about floating rate nodes, if you think about floating legs of interest rate swaps, they all refer to L-I-B-O-R, uh, to determine future payments.

Uh, and, and ISTA did a, uh, re uh, review there and, and, um, realized that about $318 trillion worth of financial instruments were using, uh, L-I-B-O-R as a, as, um, a benchmark to determine future cash flows.

Uh, and then we found that it wasn't immune to manipulation.

And of course, that's, uh, something that cannot be.

Uh, so the first attempt was then can we maybe immunize, um, IBOR in general against, uh, manipulation.

And the reason why they were open to manipulation was because they were usually, um, survey based, right? So we asked banks, where do you think you can borrow money for a certain period of time in a certain currency? And they made submissions and they cut out when, and the calculation agent cut out the highest lowest four and calculated an average of the remaining. And so there was a bit of, um, you know, protection feature embedded, but of course if people colluded, then um, they could lead to artificially low or high, uh, fixings.

So the first idea was, of course, can we move away from a survey to a transaction, uh, based? I, instead of asking, where do you think you can borrow, we asked, where did you borrow? And then we tried that over a certain trial period.

And that's when, um, in a lot of currencies we realized there isn't really a lot of three months, six months deposit business going on anymore.

It's a lot of stuff happening in the overnight market, but three or six months even the sort of maturities that tend to be more liquid, um, don't really produce a lot of, um, transactions anymore. So this is not gonna be a robust interest rate that we can actually publish on a daily basis.

Hence, we, uh, needed to, uh, create new, uh, benchmarks that are reflective of, you know, the current market environment in Euros. However, uh, there still is a decent amount of deposits going around.

Uh, so there we were able to switch to some sort of waterfall methodology, which then has been, uh, signed off.

Um, and is now then leading to the case that in Europe we're still using your IOR as an interest rate, uh, benchmark.

And, uh, the waterfall methodology is if there are transactions, we're gonna submit the transactions.

If there were none, we're trying to, uh, find similar transactions where the underlying is, uh, uh, a UI, right? So this could be some sort of derivative, for example, that we're then using, uh, as a contribution.

And if these two are not, um, possible, uh, then we go back to survey IE per judgment.

Uh, and so, you know, it's not a hundred percent foolproof, but of course you can imagine regulators are much more aware, um, about this, uh, potential manipulation there.

So I think overall, UI borders deemed to be a fit for purpose in many other currencies. However, um, we just couldn't do this.

We couldn't reform, um, those I rates because there was no transactions that, uh, allowed to, to support the transaction, uh, based approach.

So we had to come up with replacements and we obviously had market led working groups, uh, thinking about which are the rates that we should use here to replace libel waste.

And of course, we want a robust number.

IE something that comes out every day is reliable and also is sort of linked to where really the funding market is, uh, or, you know, is, is is most busy.

And then obviously most of these, uh, working groups identified that yes, the busiest part of the money market is the overnight market.

So let's focus on overnight, uh, transactions.

And so all of these rates that you see here on the, uh, screen right now are overnight rates IE money borrowed today, repaid next business day.

That's for the case for sofa, that's for Sonya, that's for esta, that's for Tona, Sarah, and so on and so forth.

They are all overnight rates.

Not all of them work exactly the same way.

Um, for example, one way in which they differ, here we see in the US we are talking about the secured overnight financing rates, sulfur that's using repo transactions.

Sonya Asta Anton here are, uh, unsecured rates, right? That means, oh, sorry, no, this one obviously not.

They are unsecured rates, meaning it's the non collateralized way of borrow on lending money.

But over a one day period, uh, you could argue that the credit risk is relatively low, hence we call them near risk free, uh, rates.

And then there's another thing, um, that's Im important to note in comparison to, um, for example, the IOR rates.

And that is when will these rates be available? And, um, because now we're talking about a transaction based number, uh, it means we can only really calculate this, um, sulfur, for example, when all transactions on a specific day have been done.

Uh, right. And that means, you know, I don't know when exactly the cutoff time for us repos is, but let's say it's four o'clock, so we have to wait until four o'clock or five o'clock or whenever, uh, until the last transactions have been reported to us.

And only then can we start calculation.

And so to allow ourself a little bit of extra time to make sure the numbers are all making sense and there's no data problems and, and, and, and, and so on and so forth, um, the calculation agent, which are usually central banks now, um, give themself until the next morning.

Here, for example, the sulfur is published on 8:00 AM we're at 8:00 AM by the New York Fed.

Meaning this number that we saw, uh, as a sofa fixing a couple of hours ago is basically, uh, not today's sofa rate, but it's the rate that applies for overnight borrow happening yesterday until today.

And that's just the applicable fixing for those meaning in comparison to IBOR, which are basically set today for the future period IE three months from Now, now six months from now.

Um, and therefore are forward looking.

The risk rates or near risk rates are backward looking.

IE we will see sulfur rate from today to Monday on Monday, uh, morning, which then retroactively applies through the time from today to Monday.

And that, ladies and gentlemen, is all I wanted to share with you today.

I thank you so much for, uh, listening and for the active participation. Great questions. Thank you for sending them.

I answered them, um, as I went along.

Um, remember to fill out the feedback form, ask for particularly, uh, interesting topics in this feedback form as well make your voices heard. Ladies and gentlemen, have a great rest of, uh, your Friday, a fantastic weekend, and I look forward to seeing you again, hopefully in the not too distant future.

Take care of yourselves. Bye-bye.