Good morning, good evening, good afternoon for some, and a very warm welcome to this Felix Live session on money markets.

My name is Thomas Kraus, and I have the honor to take you through the session today. And of course, one of the most important questions to answer right at the beginning is what are we going to talk about here today? As I said, it's going to be an overview session, and that means we're going to provide a pretty fundamental overview about the money market itself.

We're going to start with an introduction to the term money markets, then we're going to look at the main participants and their motives of being involved in those markets. We will have a look at some of those money market cash products and look at the mechanics and how they work.

And then, of course, we will talk about the money market benchmark rates.

IBORs, because yes, some of them are still around.

But we will, of course, also focus on the new near risk-free rates, or not so new really, like SOFR, SONIA, TONNA, ESTA, and the likes.

And if there's time at the end, we will also have a high-level look at how the risk-free rates are driven by monetary policy, and then look at the general idea or general mechanism behind the policy transmission mechanism.

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

And as I said, the starting point would be to look at money markets and start with sort of general definition of this part of the market.

As you can see here on this slide, what we're talking about when we're talking about money markets is actually a specific part of the financial market, and that is the part of the market where short-term debt instruments are traded.

And by short-term, we mean that the maturities, the remaining time to maturities we should say, range anywhere between one day up to one year.

So that's really short-dated stuff, and we're talking about borrowed money here then for that reason, because equity, for example, would be permanent capital by definition, not a money market instrument.

Then you might have heard the analogy that money markets are really considered to be the plumbing of the financial system.

And I do really like this analogy because it is an intuitive way of thinking about the money market and the function that it plays.

Because very much like the plumbing that we have behind those walls in our office or in our residential place, we know it's there, right? But under normal circumstances, if everything works how it should, then we prefer not to think about the plumbing in too much detail for obvious reasons, right? However, the moment something starts to go wrong in the plumbing area, that usually becomes a high priority issue for everyone also for obvious reasons, right? And this is exactly how one can think about the money market, because most investors, if we're not talking about money market funds and the likes here, but the general investor landscape. Think of a long-only equity fund manager.

Think of a credit investor that invests in investment grade, credit, et cetera.

Money markets might, on a normal day, not be the biggest area of interest for them, because this is not the area where you go to chase returns.

This is for managing liquidity, right? So under normal circumstances, we would just probably look at the state of the money market, and as we identify it functions in an orderly fashion, we would probably move on and analyze stocks or credit or balance sheets or whatever it is that we tend to do on a daily basis. However, as soon as cracks in the money market start to appear, as soon as we start to fear that maybe liquidity in money markets is starting to dry up, that is something that really gains investors' attention.

No matter where in the world you are and no matter which asset class you're investing in, because as we've seen countless times in the past, the moment liquidity in money markets starts to dry up, that very quickly can spill over into all other asset classes. And so having an eye on this is utterly important.

So then in terms of products, I think, or the math that is applied, and you see this here on the bottom of the slide.

Fortunately, we're dealing with relatively simple mathematics, and that's for the simple reason that most money market instruments only have one interest rate payment, and that is made at the end of the investment period.

So if you think about a classic deposit here, you go to the bank, deposit money with the bank for six months, you get a fixed interest rate paid on top of that.

And then basically what this means is you don't get interest every single day.

You normally get one interest rate payment at the end of the investment period, i.e. at the six months point. Everything is paid out at once. One single cash flow.

And that means the mathematics, present value and future value calculation and return measures becomes relatively simple.

And we have provided the formula here as a reminder at the bottom of slide, because the amount of interest that you would get on a deposit like this is simply the notional amount, i.e. the amount of money invested times the interest rate, times something called the day count fraction, which is basically just the days over basis. Now, what's the importance of this, or why is this relevant? Because interest rates are, as a reminder here for everybody, usually quoted as per annum terms. So per annum in per annum terms.

So that means an interest rate of 5% here, for example, would apply for a whole year. But in fact, if you invest the money, as in our example, for one month only, you won't get the full 5% over a year.

You will get 5% per annum paid for the one month that you've invested the money. So basically here in our example, this would be 100 million, then times 5%, and then depending on the day count convention that applies here, it would be, let's say, what is this, 31 days over 360 or 31 days over 365. And then the results are given here to you, and therefore you can see because the two different day count conventions use a different denominator, they will differ actually quite significantly here, 430,000 in the case of Actual/360, 424,000 in the case of Actual/365, which are the most frequently used day count conventions in money markets, by the way. If you think about US dollar, you think about euros, you think about some other currencies, then Actual/360 is your choice.

Pound sterling, Japanese yen tend to use Actual/365 in money markets.

But of course, always check before getting involved with any market or with any particular instrument. So simple interest applies simply because there's one single payment at maturity. Now, if you, and we're going to see this later, start thinking about other instruments that are linked to SOFR or the likes, that might change. But historically, money market products all work like the one you can see on the screen. Okay, so we talk about the importance of money markets already using our analogy of the plumbing. The question is, though, why are money markets so important? And I already sort of alluded to this, because this is where liquidity is managed. That means where we have, on the one hand, parties that need to get their hands on cash very quickly and usually for a short period of time to basically remain solvent and to make certain or to meet certain payment requirements.

We also have other participants that have a cash surplus, which they, then by definition, do not need to hold, and then they're looking for relatively safe places to invest those surpluses, again, usually for a very short period. So this money market is basically required to help all those participants that you can see here on the slide to manage their liquidity efficiently.

And of course, especially when you look at a bank, it becomes very obvious as to why a well-functioned money market is incredibly important for the stability of the financial system. So assume that we're working in the treasury division of a bank, and we are in charge of managing The liquidity offset institution. And let's say that we have started our day with a $1 billion dollar balance on our current accounts and well, checking accounts and using a simple word there. So then, what we're going to do at the beginning of the day is we're going to look at our forecast and see how much cash do we expect to come in, and how much cash do we expect to leave the bank today, and let's say we would expect a total amount of 1.2 billion cash coming in. That is because we have loan repayments and also some coupons are coming in.

And let's say we also expect 1.5 billion to go out. That's because we have a bond redemption, i.e., we have to repay a bond that we have borrowed at some point in the past ourselves.

So that would basically suggest that at the end of the day, we would be left with $0.7 billion USD balance in the positive sense.

And assuming we're feeling comfortable with this, then we would...

I don't know. Sorry, just a question that's just come up, that there's an echo on my voice. Is this something that others can confirm? Maybe you could just put yes or no in the Q&A for me. Do I need to check my setup? Nothing seems to come through.

I'll keep an eye on for that, but hopefully that is not my setup because it worked all day so far, so fingers crossed.

Okay, so someone said, "I had this as it opens on the web and also on the Zoom app, so you will have to leave one." Maybe that is a workaround.

Okay, cool. Anyway, let me know if this problem persists and then I can try my backup system. Okay, so we're expecting to have 0.7 billion cash at the end of the day. And assuming this is something we're comfortable with, we don't really have to do much, right? We can just sit there and hope that all the payments will actually materialize and go on with our day job. Now, let's say time trickles by and we reach the afternoon, so we're getting sort of around 5:00, 5:30-ish, and we check our balance and it shows suddenly not an 0.7 billion positive balance, but instead it shows a negative balance of 500 million, right? So 0.5 billion negative. And then we do some digging and figure out where does the difference come from, and basically what we realized is that for some reason, those loan repayment that were supposed to come in today haven't materialized simply because they might have been wired to the wrong account or anything.

Let's not assume here there was a default or anything like that, because then this would become a very different issue.

But from a liquidity management point of view, right now we're having a shortage in our cash accounts, right? Which of course, is something we need to prevent from happening, and it's relatively close to the end of the business day, and we need to find 500 million very quickly in order not to get into a liquidity problem. So that's obviously when we simply could go to the money market and reach out to other banks and try to find $500 million that we can borrow overnight, because we will most likely only need that amount from today to tomorrow or to Monday, in this case, as it's Friday today.

However, if the money market wasn't functioning in an orderly fashion, finding this 500 million would, of course, potentially be quite difficult. And that could have very negative repercussions.

I'm not talking about necessarily default of the institution because we might have some other sources we can tap, but certainly it will make our life relatively more complicated.

So we benefit, obviously, from the money market to be a well-oiled machine that it's very easy for us to find those $500 million reasonably quickly at a reasonable price. And so, that's obviously not just important for banks, but you can extend that to non-financial corporations, where you're thinking about companies.

They also have cash positions to manage.

You can either extend this to the government because also they might have mismatches in cash coming in and cash going out.

But also, I would say that the most important role that the government probably plays in money markets is usually the one of an issuer of short-term debt instruments, if we're thinking about T-bills, for example, quite significant issuance happening at those short maturities.

And then also we have mutual and pension funds that are participating in the money market, not necessarily as much on the borrowing side, but they will usually keep some cash balance here to meet redemption requirements or anything like that, and those cash balances tend to be invested then at the short end of the curve, simply because that's where interest rate sensitivity and also credit risk is fairly low.

And of course, if you're just invest money to keep a redemption or to keep a redemption reserve, you do not want to have high duration or high credit risk, right? So that's basically the top of the slide, and then we also have central banks quite actively involved in money markets.

However, not necessarily because they need to borrow money or they have money to invest, but usually because they use the money market to help with the monetary policy transmission.

So if you think about, for example, what is actually changed when the Fed hikes rates or cuts rates, that is actually something we call the target range for the effective, well, for the Fed funds, effective federal funds rate, right? So the effective federal funds rate, the EFFR, is basically a rate at which banks lend money to each other overnight.

And when the Fed hikes rates or cuts rates by 25 or 50 basis points or whatever it is that they're going to do next, I think the current sort of debate is whether or not they're going to hike by 25 basis points in the next meeting in September.

What they would do if that was the case, no prediction from my side here, then of course, what that means is they are bringing the range, or the current range, of the effective federal funds rate up by 25 basis points.

And if the market then wouldn't follow through, then the Federal Reserve could use monetary policy tools to actually influence those very short-dated interest rates. More on that we're going to see at a later stage.

So central banks are involved in money markets, but more or less in an indirect fashion, not because they have investment or borrowing needs, usually because they want to influence the level of interest rates in certain ways to meet their policy targets. Okay, good. So that's the money market participants.

And then the question is, all those people that are using money market as a sort of financing tool, what instruments are available for them? And here we can see quite a few of them already.

There's a classic deposit, which we have already sort of touched upon.

That is us giving money to a bank for a certain period of time.

That could be overnight. That's an overnight deposit.

That could be for one month or three months or six months.

That would be called a term deposit.

And what all these deposits usually have in common is they are coupon instruments.

Meaning, as I said, you invest 100 million today, agree on an interest rate of 5%, and in one month, then you get the 100 million plus the agreed-upon interest rate that is then applied to the fraction of the year that the money has already or has actually been invested, and then you get 100 plus the coupon at redemption in, let's say, one month's time.

And while these are very easy and very- I say intuitive to understand. They have one shortfall that is mostly an issue for institutional investors, and that is they have very limited liquidity because they are non-negotiable.

It's technically speaking, a bilateral contract between the lender and the borrower. And of course, if the contract says that I'm going to lend you my money for a one-month period, technically, I cannot demand my money back from you before the end of this one-month period.

So if I invested my money with you for a month and then tomorrow I realize that I do need my money because I made a mistake in my calculations, I don't have the right, or, well, you don't have the obligation to give me my money back before the end of the one-month period, even if I ask you to. However, if I'm an important client of yours and we're talking about quite a substantial amount of money here, and I call you and ask you kindly if you could return the money to me, you probably don't say no, right? You will give me my money back. You'll probably ask me to pay some sort of a penalty there. Or at least I'm not going to get a ton of interest here from you. But I think there's, in theory, of course, some flexibility.

But that really depends on your goodwill.

So when I am an investor and I want to have the at least theoretical chance to get my money back without you having the possibility of saying no, then this particular instrument may be not the best choice for me. However, it's a simple way in making a deposit negotiable, and that is basically wrap it in some sort of certificate, i.e., basically issuing a certificate that says the holder of the certificate will receive $100 million on the 12th of February, or whenever it was, 2020 X, and also will receive 5% interest from the period of 12th of January to 12th of February, something like that. And then basically what the certificate is, it's a securitized cash flow. Or basically a cash flow that now can be sold by transferring this certificate from one counterpart to the other.

That means a certificate of deposit, the CD, as we call it, as by this extension of issuing a certificate on top of the deposit, becomes negotiable.

It can be sold to a third party in the secondary market.

What's important to remember, though, is just because something theoretically can be transferred to a third party does not say it's necessarily going to be simple to find a buyer for this certificate under all circumstances.

So, in theory, it is transferable, but that doesn't mean it's highly liquid. It depends on how often these things are traded in the secondary markets.

Then we have as a third instrument the Treasury bills, which is basically the short-dated government debt instruments that we have mentioned already.

One thing that is, I'd say, important to note here in this context is while deposits and CDs were coupon instruments, in other words, 100 invested, 100 plus is what you receive back, these Treasury bills are usually issued as discount instruments. That means you will invest a certain amount of money, but you will buy the security itself at a discount, i.e., you pay less than 100, less than par, and at maturity, you will get par back, i.e., you will get 100 back, not 100 plus a coupon. And the return is not the explicit coupon that you get back at the end on top of your invested money, but the return is basically the difference between the discounted price you're buying the instrument at and par, where this instrument matures. Now, for bonds, I agree that there are very different features between coupon instruments and zero coupon bonds, simply because one has reinvestment risk and the other one doesn't. In money markets, because all money market instruments usually pay all interest in one go at the end, I don't see a big difference here between getting my return as a result of having bought an instrument on a discount basis and get par back, or whether I invest 100 and get 100 plus coupon back.

Maybe there are some tax benefits in some jurisdictions, but generally, it's just different mechanics in which the return is actually paid to the investor.

But because of the short maturity here, I wouldn't see this as a very significant point. However, it's important to understand that the mechanics are somewhat different. So T-bills, think of discount instruments.

You buy them at a price below 100, and you get par back.

They are negotiable, they are securities that can be transferred, and they tend to trade reasonably liquid in the secondary markets, i.e., if you want to sell them, there's a good chance you find a buyer for those securities that you're thinking of selling at a reasonable price over a very short period of time.

And then last but not least, there's the commercial paper market, CP, which are then also typically discount instruments.

Issuer here, however, not the government, but the private sector, and those are corporations. Could be financial corporations, could be non-financial corporations.

What they all usually will have in common is that they are very highly rated, so credit risk is not necessarily very significant here that investors take.

And then, as I said, they will be issued as discount instruments as well.

They are, once again, negotiable, so they are securities.

But I would say in direct comparison, the liquidity of the CP market tends to be somewhat lower than in Treasuries. Depends, of course, on the issuer, et cetera.

But generally speaking, the T-bill market should be the most liquid market there is of all those money market instruments. Okay, so this is the overview.

We also have to think about other ways of raising financing in the money market. We're going to do that later on.

But let's stick with those cash instruments.

And what they all have in common, by the way, is that the only backing that investors have here when they invest in one of these instruments is a promise of the issuer to repay them. So we're talking about uncollateralized borrowing instruments here. Now, remember we talked about the deposits and the issue they have, potentially for institutional investors, that there's total lack of liquidity in them.

And then we said that we can obviously issue certificates.

And then, of course, the question when you have a CD would be, if I'm willing to sell this certificate of deposit in the secondary market, how would we determine the price at which we're going to sell it? And of course, this is a great example to showcase the valuation of money market instruments altogether, but it's also a great reminder of how financial instruments in general are valued. Because there's this general school of thought that the fair value of any financial security is just the present value of the future cash flows that this financial instrument generates.

And if you're thinking about a CD, it is a certificate that basically enables you to receive a future cash flow as the holder, and that future cash flow is two things. One, the redemption of the original invested amount.

Two, the coupon, i.e., the interest over that investment period.

So basically, if we want to calculate the present value or the current value of a certificate of deposit, all we have to do is in step one, work out the future cash flow, and in step two, we have to discount this future cash flow back to today.

So let's have a look at a concrete example for this.

We have 100 million originally that was invested over a six-month period, so a six-month certificate of deposit, and that was a 182-day period, and the coupon rate that was agreed was 5%. Now, couple of months later, more precisely 34 days prior to the maturity of the six-month deposit, the investor in the CD is actually looking to sell this certificate of deposit, calls a market maker, and the dealer basically quotes the current 34-day rate for this particular issuer at 5.1%.

So effectively, what the dealer is telling our investor, for me to buy this certificate from you, I basically want to make sure that my return is going to be 5.1% over the remaining 34 days.

So that basically gives us then the discount rate, right? This is the rate that we need to calculate the future cash flow, and this is the discount rate. Let's call it discount rate there. So two steps, as I said.

First step is to calculate what is the future cash flow.

And the future cash flow is basically nothing else but the redemption amount plus the interest, and so the nominator is doing the job here.

100 million times one plus 5% times 180 over 360.

That gives us the future value, the future cash flow that this CD is going to pay 34 days from now. So if you're visualizing this, this was the original investment point. On this six months point, we get this cash flow pay. But now we're looking at this 34 days before the actual maturity. So now what's missing is we have to discount this cash flow back from here to here, and that's done, again, by using the simple interest rate method because no compounding required because there are no interim interest rate payments, and we have identified the discount rate to be 5.1%.

So basically what we have to do, and the denominator is showing this, one plus 5.1% times 34 over 360. And now what we can see is that the current present value of this future cash flow would be $102,036,302.92. So that is effectively what our dealer is willing to pay to our investor here in return for getting this certificate of deposit. Simple two-step approach.

Calculate future cash flow, discount back to today. Job done.

Now sometimes, of course, this raises the question because we're saying, hey, this certificate of deposit was originally issued with a 5% coupon, and now interest rates have obviously increased. This might be an increase in credit spread or an increase in rates generally. But interest rates have gone up, and then people do remember that they have been told in the past that there's an inverse relationship between price of a debt instrument and the return it generates.

And so it's very odd to see here that this CD trades above par, right? Because effectively the price here is 102 point something percent.

Why is this certificate of deposit trading above par when in fact interest rates have increased and because the return is higher than the coupon? The answer to that question is we're talking about accrued interest here.

Because remember, this investment was made at this point, and now we're thinking of selling it 34 days prior to maturity.

That means that our investor has been holding onto this CD for roughly five months period, and that piece of interest, i.e.

the 5% over the five months period, that belongs to the issuer here. So accrued interest really is causing the price to be above par.

If we would calculate the clean price of the CD, which of course is very unusual to do, but one could of course do this, that would in fact be below par.

Anyway, that's the CD and the way we can calculate the prices. More importantly, though, let's look at the T-bill market because that is, as we said, the part of the market that will display the biggest or the best liquidity, also highest volumes, et cetera.

And we already know the general mechanics.

They are discount instruments, meaning we buy them today at a discounted price, and then we will get par back at maturity.

So basically investing 100 million in a 26-week US Treasury bill that was issued at a price of 97.335722, that means I'm paying $97,335,000 et cetera today, and then I will get, 182 days later, $100 million back.

And then of course I can use these two, i.e.

the amount of money invested today and the amount of money I will receive back in six months, to calculate the implied rate of return.

When we look at T-bills in the secondary market, though, what we often find is that they are not quoted in price terms.

So if you call a market maker and ask for a quote in six months T-bills, they won't give you 96.335, but they will give you something like today, 388.5 to 387.5. On the slide, we have 517.5 to 516.5 just because this is data from 2023 when short-dated interest rates were a lot higher.

But let's stick to this, what's on the slide, just to use the numbers that are there. So, what does it mean now when the market maker quotes 517.5 to 516.5? It basically means that if you are willing to buy the T-bill from the market maker, you're going to get it at a discounted price that basically means the return that you're generating, i.e.

the difference between the discount price and the redemption at maturity, that's going to be equal to a return of 5.16 and a half.

And when you're looking to sell the T-bill to the market maker, they're going to buy it at a discounted price that gives them a return of 517.5.

Sometimes people get a little bit confused when they look at the bid ask here, say, well, normally I'm used to the bid being lower than the ask, and that is true when you're looking at it in price terms.

When you think about stocks, for example, the bid is lower than the ask.

When you think about bonds, if you think about prices, the bid also will be lower than the ask. But if you think about yields or returns, then the bid will be higher than the ask, just because of the inverse price yield relationship.

And so far, hopefully, all this makes a lot of sense.

And now to one part that actually is sometimes a little bit confusing or annoying, whichever term suits you best here, and that is that this number, this 517.5, 516.5, this quotation here is not something we can directly compare across different currencies because different T-bills issued in different currencies have different mechanisms to translate this rate that gets quoted into the actual underlying price. That's a bit confusing, so let me guide you through the exact concrete example. So in the UK, in Euroland, in most other currencies, the rate that you will get quoted here, let's say the 517.5, would be translated into the market price of the T-bill by using this formula here, which sounds or looks very familiar because all we're doing is we're taking the future value and divide it by one plus the interest times days over basis, and that's exactly what we've done here in the certificate of deposit. That's how we would discount future cash flows of an FRA, for example, et cetera. That's a normal standard way of discounting cash flows in a single interest rate environment.

We're basically discounting the future value, meaning that whatever interest is quoted here is paid on the present value, i.e.

the amount of money that you're investing.

Now, when we switch from UK T-bills or European T or Eurozone T-bills to US T-bills, which is the largest, most liquid T-bill market of them all, we have to change the way we're doing the maths.

So the US T-bill uses something that we call a discount quote method, meaning this price here, the 517.5, or this return quote here, will not be translated into the T-bill price in the exact same way than the UK or European equivalent. But instead, we're calculating the price of the US T-bill by taking the future value, which is 100%, right And subtracting 100% times the discount rate, times days over basis, which basically means that this discount rate is paid on 100%.

And remember what we said on the other side, we said the yield is paid on the present value, which is lower than 100%, meaning we cannot directly compare those return quotes from a US Treasury bill to the UK Treasury bill, for example.

In reality, such a comparison makes very little sense because we have different interest rate levels and different levels of inflation, et cetera.

So, a direct comparison across currencies is always a little bit difficult. But if we extend this concept, then we start to realize that even comparing returns in US dollars only will be somewhat more difficult as a result of this, simply because how do normal US Treasury bonds, how are they quoted, right? And usually when you look at-- Well, actually, let me bring up my curve here to demonstrate this.

So this is maybe a little bit small here. No, hang on. There it is.

Okay, so maybe this is a little bit small, but basically the point that I want to show you is the upper left corner here, which is basically my US Treasury yield curve. And what you see here is one month, two months, three months, six months, and one year maturities, and then two years, three, and so on and so forth.

And you see a pretty significant change here in those columns as we move from one year to two years. Because, for example, taking the six months quote here, we see bid is 388 and a half and 387 and a half, and then the bid yield is 4.016 and 4.005. When we go to five-year treasuries, then we see the bid is 99.2617 and the ask is 99.3086, and then the yield is 454.2 or 453.1. That's basically what we're used to seeing in bonds, right? We see the price, and we see the yield.

When we look at T-bills here, we don't see a price.

We see basically two different quotes here that clearly show a return. The question is, why do the returns differ? And the answer is this return here, that says bid, is basically this discount rate that we have to use to calculate the price using the formula that is shown on the slide here. I'm going back to the slide now.

So this would be, at the moment, 388.5.

But of course, investors like to compare instruments.

So for them, if you now are investor and you want to make a decision whether or not you invest in a six-month T-bill that's going to be issued today, or whether you're going to invest in an old treasury bond that is paying a certain coupon, et cetera, and currently trades at a specific price and market that translates into a specific yield.

And because both issuers are the same, or in both cases, issuers are the same as both the US government, you just want to compare the returns directly, right? So what you want as an investor is not necessarily see this return quoted in some weird discount way. You want to see it quoted as a yield.

And therefore, what happens in reality, as you've seen, is we're calculating the equivalent yield. We're basically telling you if you were to buy this T-bill at its current price, this translates into a common yield of this 4.016%, as we have seen. And not just do we do this in the secondary market, but also the US Treasury itself does provide this comparison tool, because here we see the actual announcement of a T-bill auction.

There we see that in or at the auction, the discount rate was determined to be 5.1%.

So that translated then using this formula, right? So future value minus future value times the rate, times days over basis, et cetera. That translated to an issuance price of 97.421667%. And we have then basically derived a yield of 5.308% out of that.

How can we do this? Well, we basically know that the present value is 97.421667%, and we know that this equals 100% divided by one plus the yield times days over basis. I'm running out of space here.

And so basically we know this, we know this, and we have only one unknown.

We can rearrange this formula, solve it for the yield, and that was the 5.308%. So it's just basically different mechanisms in which we're translating a return into price, but we can make it directly comparable. It just requires one extra step.

So takeaway here, when you see T-bills quoted, as I've just shown you, we have a bid and an ask that looks like a return, and we have a bid yield and an ask yield, and they're not the same, then this is basically the underlying reason for it. Okay. All these instruments that we looked at so far are what we call uncollateralized borrowings, meaning the issuer promises you to repay the money and to pay you the adequate interest rate at maturity.

But of course, that sometimes isn't risk-free enough for some investors.

Now, of course, you might argue in case of a T-bill, because they're issued by the government and government instruments are credit risk-free, the difference shouldn't be all that meaningful.

But sometimes someone else in the government has a requirement to raise money. And then, of course, that would normally mean for a provider of debt to this particular counterpart, they are taking credit risk.

But this credit risk could be eliminated almost entirely by switching from uncollateralized lending to collateralized lending.

And the probably most prominent example in money markets for collateralized lending is the repo, which is basically, as we have defined it on the slide here, the contractual agreement between two counterparties, in which one counterparty effectively borrows cash in exchange for valuable collateral, which usually would be, for example, a government bond.

And this cash will be exchanged over an agreed-upon period.

And then, of course, in exchange for having access to that liquidity, the borrower of the cash will pay an interest rate, which is called the repo rate.

Now, in the definition, we say that it's effectively the borrowing of money, and it's effectively because from a legal point of view, it's actually not the case that the cash borrower, which is referred to as the repo party, borrows money. But effectively what happens is they are selling their collateral, so they are selling the government bond to the cash provider, which is the reverse repo party, and get the price for this security in return.

But at the same time, they also agree that at the end of the repo period, which very often is the next business day, because overnight repos are quite common, they agree that on the next business day, in case of an overnight repo, this transaction is reversed. In other words, the cash provider will agree to sell this collateral back to the repo party here at an agreed-upon price. And then, of course, this price will have to be paid by the cash borrower, i.e., the repo party, to the reverse repo party.

And that price paid will usually be slightly higher than the price received in step one. And that difference in price is effectively then the borrowing cost for the cash. Now, sometimes people ask, why are we doing it like this? Why are we just not structuring this as a lending transaction? And the reason is that in case of a default here of the cash borrower, i.e., the repo party, structuring it as a sale and repurchase transaction, which is effectively what it is, is putting the cash provider in a much better position to make use of their collateral.

So it's basically just a bankruptcy legal kind of provision here that is the driver behind this structuring.

But conceptually, what it is very often is someone borrows money and provides useful or valuable collateral in return.

Now, that is in fact one of the most frequent use cases of repos, and that is not just the investor community. This might be the market-making community as well, because if we're, for example, buying government bonds from clients as a result of our market-making activity, those bond positions, if we cannot pass them on to other clients in a reasonable short timeframe, need to be financed.

And the cheapest form of financing will most often be the repo market.

So if we have to finance a bond position overnight, we would enter into a repo transaction where we would borrow the cash and provide the bond we bought from our client there as collateral. So that's a standard way of financing trading positions, for example. We might also, as a market maker, have to enter into reverse repos, which remember, is the opposite of a repo.

In other words, we are now turning into the role of a cash provider, and we take bonds as collateral. In such a case, usually it's not that we're desperately looking for safe investments, but very often this is once again a result of our market-making activities because sometimes we're selling bonds to clients that we don't have in our inventory. And that means T+1, we have to deliver, or T+2 in some jurisdictions, we have to deliver this bond.

If we don't have it, then of course we could go and buy it directly in the market, but that makes us a market taker and we have to pay the bid-offer spread.

We might as well wait until we can buy this bond back through our market-making activity and charge the spread instead.

But in the meantime, we still have to deliver the bond.

And to be able to do so, we might go into the market as a reverse repo party and borrow a specific security that we need to deliver in our bond transaction there.

And then in return for getting the bond from our counterparty in the repo contract, we will have to provide them with cash. Where do we get the cash from? Well, we sold the bond in the morning, so we now have a significant amount of cash that we can put to work here. Reverse repos then are also used by all those investors that are looking to invest current cash surpluses for a short period of time in a relatively safe way. So they might just give cash to a counterparty and to minimize their counterparty exposure, i.e., to neutralize the risk almost entirely on default, they would ask for collateral in return.

And in case that the counterparty they've lent the money to will default over time and not repay the money that they have borrowed, they can then sell the collateral and satisfy their financial demands through that selling off collateral. So many different reasons as to why counterparties might engage in repo transactions.

And here, what we can see on this slide is that this is leading to the repo market actually being very sizable.

And I have to say here, obviously, that I took these numbers almost over a random period in 2023. So we're looking at October to November here.

And over that timeframe, we saw the lowest daily volume here was about one point, let's say three trillion, the highest about 1.7 trillion. And what we're looking at here is basically the underlying volume of transactions that have been used to calculate the sulfur fixing. We're going to see that next.

But it's like a proxy for the size of the overnight repo market, and that was between $1.3 and $1.7 trillion back in 2023. Now, when you look at those numbers, they have gone up quite significantly since then. That's partially because sulfur is being adopted more broadly. But also we had a couple of changes there that led to more participants going into the repo market, et cetera.

So we are currently around $3 trillion worth of daily repo, overnight repo volume. So obviously a quite sizable market.

That indicates how, once again, important this instrument has become over the last couple of years. Okay. And with that now let's have a look at those benchmark rates. Right. In general, as you might know, money market benchmark rates have been around for a long time. I think LIBOR goes back to the 1980s.

And the idea was that as we have instruments that have cash flows that are floating and that means they change along or that they are adjusted in regular intervals to the current level of market rates.

It was then required to have some sort of reference rates that we could agree on in a contract that they, okay, every day or every three months, we're going to look at three months LIBOR and that number plus a spread is what you're going to pay for the next quarter of a year. Because if you don't do that, if you don't have a neutral benchmark to refer to, then every three months when the rate is supposed to be reset, you have a debate between lender and borrower.

And of course, there would be a conflict of interest because the lender would see the rate always slightly higher than the borrower would see it for obvious reasons, right? So the way around that was that we agree on a specific benchmark rate that we're going to look at in regular intervals and take whatever fixing was available on that day as the starting point for our cash flow calculations.

And so this has been then used quite extensively for decades, and these were those term deposit rates that are better known as IBORS, the Interbank Offered Rates, and LIBOR probably being the most prominent example, right? One month, three months, six months, and so on, right, across different currencies provided on a daily basis. They were relatively robust.

So most days we had LIBOR fixings given to us.

But unfortunately, it turned out that they were not immune to manipulation, so we ended up with having about $318 trillion worth of financial instruments having cash flows linked to LIBOR rates. And turns out that LIBOR obviously wasn't 100% free of manipulation. So that then led to a whole overhaul process of saying, okay, how can we make either LIBOR immune to manipulative attempts, or if we can't, what is the alternative here? Because we cannot have such a large amount of cash flows being linked to a rate that is not necessarily 100% representative of current market levels. So in some cases, EURIBOR, for example, we found ways to reform those term deposit benchmarks and make them more robust in the sense that they cannot be manipulated anymore.

In other cases, it was identified that this would be a very difficult thing to do simply because the real market activity has moved away from three and six months deposits into the direction of overnight financing.

And then, of course, when you realize that, then the question is why would we want to keep a LIBOR rate alive if it doesn't really represent the actual financing activities in markets, right? So that then basically moved to this kind of two separate approaches here, if you wish, that in some currencies, we're still having term deposit rates, EURIBOR being the most prominent example. In other currencies, we have completely transitioned away from IBOR rates. That's US dollars, that's pound sterling, for example, where we don't have any IBOR rates anymore.

We only have those risk rates like sulfur and SONIA.

And then, in some currencies, again, like EURIBOR, we have both because yes, there's EURIBOR, three months, six months, and so on, but there's also an overnight rate called ESTRA, right? So the risk rates here is basically Replacement of IBOR, in some cases, we still run a parallel regime.

I would say sooner or later, we transition to those risk-free rates, probably in all currencies there are. Here, a quick overview of all those risk-free or near risk-free rates that have been developed by market-led working groups. So basically taking a very close look at how are the funding markets working these days, what is really the representative rate that we want to look at here, and the results are on the slide.

We have in the US, SOFR being the benchmark that replaced LIBOR, that stands for Secured Overnight Financing Rate.

We have SONIA, the Sterling Overnight Index Average.

We have ESTA, the Euro Short-Term Rate.

We have TONA, Tokyo Overnight Average Rate, and so on.

One thing to point out is that once again, while they are fairly similar, they are all overnight rates.

I.e., one business day to the next. They are not necessarily directly comparable.

Again, of course, because they are across different currencies and different inflations, et cetera, but also because the risk is not 100% identical. Why? Because SOFR is using repos to be determined, i.e., repo transactions, which, if you remember, are collateralized rates, whereas SONIA, ESTA, and TONA are all using unsecured borrowing transactions.

So from a credit point of view, they are not quite as risk-free as SOFR is going to be, because, yes, these are transactions from one business day to the next, and that is a very minimal credit risk. If you think about a bank being financially solvent today, there's a pretty good chance that it's going to be around on Monday, right? However, it's not as risk-free as SOFR is, because in case of SOFR, yes, you do have only credit risk overnight, but even in the unlikely case that your counterparty falls over the weekend, you still have the underlying government bond as collateral. So from a risk point of view, they do not exactly compare perfectly, but they are very similar, you might argue.

And then one thing that they all have in common, once again, is that they are transaction-based, meaning we do not run a survey asking banks, "Hey, where do you think you could borrow money today?" But we actually ask all the banks that are participating in this market and wholesale institutions as well to contribute or to basically report the amount of money they have invested or borrowed and the interest rate that have been agreed with their counterpart. And those sort of pieces of data are reported to the calculation agents, which in all cases here are central banks.

And then those central banks will basically collect all those transactions, i.e., volume and interest, and then basically calculate some sort of a volume-weighted average rate here. And this is then what's going to be published.

However, it's going to be published on the next business day.

Simple reason, if you want to have a transaction-based number, this can only be calculated once all transactions have occurred, which naturally means we have to wait until the end of the business day, and therefore we're allowing ourselves a little bit of extra time to do the calculation, check the data, et cetera, and then publish results on the following morning at different points in time, usually reasonably early in the morning. But that also means that the SOFR that was published at 8:00 U.S. time this morning basically applies for a period from yesterday to today. So it's a backward-looking rate, as you might have heard in other contexts.

So that is basically the overview, but very quick comment here from my side on how those overnight rates are basically behaving.

And I have a slide here that obviously is no longer completely up to date here because we had a couple of rate actions here.

Let me just bring up the up-to-date slide or not the screen here that shows how those rates have recently behaved. For example, we had the ECB here hiking rates in June, same as the Bank of Japan. And obviously, a couple of weeks down the line, we might have another rate hike from the ECB. We might have another rate hike from the Federal Reserve, et cetera. So these things obviously change over time.

But basically, how those rates behave, generally speaking, is they are reasonably well-behaved, so they are pretty sticky for a reasonable amount of time, and then they do move up or down in basically a stepwise fashion, and that is indicating that they are very closely linked to the actual rates that central banks are setting. SOFR is somewhat a little bit more lively than other rates, but that's because obviously there's different forces there at work, given the US significant repo usage, et cetera, month-end effects, and all those other things.

But generally, it still follows more or less in the same line when there's a rate cut. We see SOFR dropping reasonably significantly and then stabilizing in between those central bank decisions.

So basically, as I said earlier, we have those money market benchmark rates being the starting point for the monetary policy transmission mechanism. But that of course means we have a way or establish a toolkit within central banks or for central banks that allows them to influence overnight rates in a fairly clear fashion.

So first, basically by hiking their target rates, and then if rates wouldn't go up as desired, then of course, if central banks could step into the market and absorb liquidity, i.e., enter into the market, for example, as a repo party, borrowing cash from the market, by doing so, reducing the amount of liquidity available, pushing interest rates up, and vice versa.

Now, that of course allows central banks to influence overnight rates, and the question is, how does that trickle down the curve, i.e., how can central banks influence three months, six months, two-year parts of the curve? And generally, the answer to this is by creating certain expectations within markets, because as you might have heard, at least the short end of the yield curve is pretty significantly driven by expectations of market participants with regards to the future development of overnight rates.

Because in a way, you could see as a two-year interest rate, as a sort of average of the overnight rates over the next two years.

So by managing those expectations of market participants, the central banks can influence interest rate levels that go beyond the overnight term. And that, ladies and gentlemen, is all that I wanted to share with you here today. Hope you found it beneficial.

Have a great rest of your Friday, a great weekend.

And if you have any follow-up questions, I answered everything that came up during the session as we went along, but in case you have any follow-up questions, use the feedback form. And I look forward to having you back on one of our sessions in the future. Take care for now, and speak soon. Bye.