WHY SHOULD SUCH AN INSTRUMENT BE ISSUED?

To understand the logic behind the actual mechanics of the operation, it is necessary to look at the way in which a bank usually operates. The bank credit rating and status within society is judged by the "size" of the bank and its capital/asset ratio. The bank lists its real assets and its cash position, including deposits, securities, etc., against its loans, debits and other liabilities showing a ratio of liquidity. Each jurisdiction of the World banking system has different minimum capital adequacy requirements and, depending on the status of the individual bank, the ratio over assets, in which the bank can effectively trade, can be as high as twenty times the minimum capital requirement.

 

In simple terms, for every $100 held in asset/capital, the bank can lend or obligate at least $1,000 to other clients or institutions against the cash at hand.

 

The money placed on deposit by the bank's customers is dealt with in a different manner to the actual cash reserves or assets of the bank.

 

If the bank disposes of an asset, the reluctant capital can be "leveraged" using the bank's multiplier ratio, based on the minimum capital adequacy requirements.

 

To bring all of this into focus and identify the application of these points to the matter of the question, we will now make the following overview:

 

A bank receives an indication from a client that the client is willing to "buy" from the bank a one-year obligation zero coupon, and effectively unsecured by any of the physical assets of the bank, the credit instrument is based solely on the "full faith and creditworthiness of the bank".

 

Obviously the format of the credit instrument must be one that is acceptable in a jurisdiction and freely transferable, able to be settled at maturity in simple terms and is without restrictions other than its maturity conditions. The instrument, which immediately comes to mind, is the Documentary Letter of Credit or Standby Letter of Credit. However, as the issue is not trade or transaction related, most of the terms and conditions do not apply. The simple "London Short Form" version of the Standby Letter of Credit is perfect. The text is specific and does not contain any restrictions except the time when the credit is validated and can be presented for payment. It is in real terms a time payment instrument due on or after one year and one day from the date of issue, usually valid for a period of fifteen days from date of maturity.

 

Standby Letters of Credit also serve as substitutes for the simple or first demand guaranty. In practice, the Standby Letter of Credit function almost identically to the first demand guarantee. Under both, the beneficiary's claim is made payable on demand and without independent evidence of its validity. The two devices are both security devices issued in transactions not directly involving the sale of goods, and they create the same type of problems. [Extract can be found from the paper entitled "Standby Letter of Credit: Does the Risk outweigh the Benefits?" published in the 1988 Columbia Business Law Review.]

 

The blank piece of paper which is technically an asset of the bank valued at say two cents, is now "issued" and the text added in say "ten million U.S. Dollars face value", signed and sealed by the authorised bank officers. The question now is: "what is the piece of paper worth?" Is it worth two cents or US$ ten million, bearing in mind that it is completely unsecured by any tangible or real asset? In reality it has a "perceived value of US$10 million" in 366 days' time, based upon the "full faith and credit of the bank".

 

The next question, which must be asked, is: "Will the bank honour its obligation when the bank note of credit is presented"? This will, of course, depend upon the reputation and credit worthiness of the issuer.

 

Having now arrived at the "belief" that the "value" is US$10 million in 366 days' time, the "Buzzer" must negotiate a price, or discount, which is acceptable to the Bank to cause it to "sell" the credit.

 

To arrive at the sale price one has to determine the accounting ramifications of the sale. The liability is US$10 million payable "next year", and it is important to note that the reason for the one year and one day period is to take the liability into the next financial year, no matter when the credit is issued. The liability is held "off balance" sheet and is technically a contingent liability, as it is not based upon any asset. On the other side of the model, the bank is to receive cash from the "sale of an asset" and the cash is classified as capital assets, which in turn are subject to the ratio multiplier of say ten times.

 

So in real terms, the issuing bank is to receive say 80% of the face value upon sale which is US$80 million cash on hand against a forward liability of US$10 million in one year and one day's time, the actual contingent liability being US$2 million. The cash received, US$8 million allows the bank to lend ten times this amount under the capital adequacy rules, so US$80 million is able to lend on balance sheet against normal securities such as real estate, etc. If the interest rate is say 8% simple and the loans (without taking into account the principle sums loaned) from interest alone is equal to US$6,400,000.

 

At the end of the year the credit is due for payment against the cash on hand and the interest received; in other words, US$8 million plus US$6,400,000 which total US$14,400,000 less the US$10 million shows a gross profit of US$4,400,000 or 44% plus the full value of the loan amounts (principle).

 

The reason for issuing the credit is now obvious, the resultant yield is well over the given discount and the bank is in a profitable position without risk. They have achieved a greater asset yield than by any conventional means.

 

There is a greater underlying reason that is also indicated if an overview of the complete supply system is taken. To understand the system one must take a view, which is not supported by any physical evidence, but is indicated by actual occurrences of events.

 

If one assumes that the money supply requirements for a specific period shows a need to print, say US$100 million of new issue currency, and the US Treasury is required to issue some, the impact of the release of those "new" dollars in terms of inflation and market effect is quite strong.

 

If, however, the US Treasury through the Federal Reserve Bank was asked to forward "sell" those Dollars for "cash," the amount of "new" Dollars today is reduced by whatever amount is being yielded. If we take the case in question, suppose the Federal Reserve Bank had "contracted" with a major world bank to "issue" Dollar denominated one year of entities so that the "sale" did not appear "on market" and that the "sale" was at a discount of say 80% of face value. The cash yield back to the US Treasury would be US$80 million against a Dollar credit of same amount to the issuing bank, with the bank taking a US$100 million liability position at maturity date.

 

The US Treasury has now received US$80 million in cash back in from the market/system and need only print US$20 MILLION to meet its current obligation to the money supply. This is 20% of the original amount and, as such, its impact on the system is greatly reduced. Of course, if the amount sold is greater than the money supply requirement, the US Treasury has a reduction, which allows lower interest rates to be maintained and/or controlled.

 

The long-term position is not affected as the bank has taken on the liability - not the US Government. The Dollar credit is classed as "cash" for the purpose of capital adequacy and is not required to be physically "printed" as such. A simple ledger entry is sufficient.

 

The off market issue and sale of bank credit instruments is controlled by simple supply and demand techniques, and all US Dollar denominated paper is "issued" through the Federal Reserve Bank.

 

To do this, the FRB enters into an understanding with the UST and the top 100 world banks, excluding state operated banks, American banks (with the exception of Morgan Guaranty), Third World banks and any other banks that may have a capital/credit problem. The current list (based upon the January 1992 Bankers Almanac) totals some 62 banks.

 

Each bank agrees to allow the Federal Reserve Bank to issue, on behalf, a specific amount of US Dollar denominated paper or the alternative applies where the Federal Reserve Bank allocates a specific amount to each bank. The details are not published and no physical evidence has been available to the author. In any case, the result is that a specific volume is available and the Federal Reserve Bank is now able to release it on demand.

 

The various bank papers are "pooled" together to give the total position each year, and it is from the "Federal Pool" that the supply contracts are issued. The existence of the "Federal Pool" is not confirmed. However, various documents, including GNMA transfer documents, contain a "Pool Number".

 

The "Grant master collateral contracts" that one hears about, are effectively issued by the "Federal Pool". It is indicated that these are usually issued in US$500 million units, with each minimum denomination being US$100 million. In other words, the minimum order is US$500 million contracts. From our research, it has been indicated that the "cost" or deposit for one of these contracts is US$100 million cash. This obviously reduces the number of entities who are able to participate.

 

One point which should be raised at this time, although the market places and issue of these instruments is "unregulated", the banks are effectively controlled by the B.I.S. and self-imposed rules. Otherwise the whole system would be subject to possible manipulation and abuse by a bank, entering into a form of "insider trading." This would be detrimental to the system and the long-term effect of some.

 

The entities who are the holders of the "grant master collateral contracts" are commonly referred to as "cutting houses", as they usually reduce the size of the denomination from US$100 million to as little as US$10 million. They in fact "cut down the size of the note" hence "cutting house".

 

The cutting house then in turn "sell" delivery commitments to wholesale brokers, the cost of such is indicated at approximately US$10 million cash.

 

In both cases the cash payment or deposit can be called upon if an order is not met or paid on time, and if called for the contract, holder would lose his contract and would be "blacklisted" in the system to prevent any new contract position. The rules are very simple; cash payment at all times for all notes ordered. This is a cash-driven industry, not credit.

 

It is assumed by the author that each cutting house would normally issue say 50 delivery commitments or "sub master commitments" at US$2,5 million each. Therefore, their deposit of US$100 million is now covered, plus a reserve of US$25 million. This is very similar to the normal activities of post betting where the odds are "laid off" to restrict exposure.

 

The wholesale brokers are responsible to feed the volume of instruments to the clients or customers who are at the retail distribution level and, subsequently, to the secondary market.

 

The issuing banks can be identified as the manufacturers of this product; in this case the product is bank paper. The Federal Reserve Bank can be identified as the importer (80%). The Federal Pool can be identified as the storage depot (82,5%) for the entire product prior to sale and are responsible for the bulk release to the regional distributors. The cutting houses can be identified as the regional distributors (85%) and are responsible for the release of units to the local distributor. The wholesale brokers can be identified as the local wholesaler (87,5%) who releases units on demand to the retail showrooms. The primary clients can be identified as the retail showroom (89%) that delivers the units to the public buzzers. The public buzzer exists in the secondary market (92-94%), such as pension funds, Middle East (Muslim) clients' banks (to buzz on the secondary market is not classed as contrary to the rule). They hold the instruments until maturity and gain the preferred yield from the discount against the face value (100%) from the issuing banks.

 

The biggest problem encountered by the author regarding this matter is the contradictory and somewhat unusual attitude of the banks when any attempt is made to obtain any definite documents or undertakings. Bank officials have denied the very existence of these instruments, at senior level, and yet, within the same bank, requests to purchase said instruments have been received by the author."In smaller markets only Governments are allowed to participate therefore knowledge/existence of this type of transactions in South Africa is limited and or denied.

 

"Also the regulatory position of these instruments creates a major problem for any regulated entity to participate. How can a regulated body handle an unregulated item!

 

It is the opinion of the author, based on all the information available that the main reason for most of the mystery and misinformation is quite simple. This is a sophisticated form of financial 'engineering.' It makes normal accounting principles a complete mockery and basically exposes the banking system for what it is.

 

In reality, the whole system is flawed, and is one that no one really understands; we based our daily life on a "paper house". Nothing has really changed since the very first "money" transactions or even earlier, "I'll swap you two blue shells for three red shells and I'll give you three red shells for your XYZ goods". The whole monetary system is based on "perceived value" including currencies, credit, and day-to-day life.

 

A bank note issued by the Bank of England is in reality an unsecured "Promissory Note" payable on demand. Its face value is its perceived value. However, if the word demand were changed to future date, of say one year and one day, the perceived value has now been reduced to cover the "cost of money" for the period.

 

If we were to discuss the value of one single fifty-pound note, the "value" today would be approximately forty-five pound. However, if we wished to "discount the present value," several million of these notes, it is reasonable to expect that the "wholesale" buzzer would expect a better "price". The note, however, still has a "perceived value" of fifty pounds and a present value of approximately forty five-pound.

 

Very little "cash" is used in the day-to-day operation of business; mostly it is in the form of ledger or "paper" entries. Even when a private bank account is used, over and above all transactions are "paper" driven not cash? A cheque is a "Promissory Note", either unsecured or guaranteed by the bank up to a certain limit (cheque guarantee card). If a bank draft is "purchased" the draft is still unsecured but is perceived to be a 100% guarantee of payment.

 

The current trend towards "plastic" and "electronic banking" is an indication of the future and is based purely upon the amount of business, which takes place daily. The banks can no longer cope with physical "paper" and need to reduce each transaction to a simple ledger entry. The end result is less "money" and more "business".

 

The use of these instruments as a medium for short-term investment is obvious, if one takes the differential between the "invoice" price and the "present value" and moves a client into and out of the instruments on a regular basis, the effective yield is substantial.

 

The downside risk is nil, if one retains strict protocol over the potential purchases, with a worse case scenario of the fact that the client would either not transact or therefore not be at risk. If an instrument had been purchased and for whatever reason could not be onwards "sold or discounted", the client would automatically achieve a substantial yield based on the maturity value against the "invoice paper".

 

The preceding document is a summary of the circumstances and evidence that has been presented and are based purely upon the same, as received. No representation is made or implied as to the legal position of the information contained therein or for any resultant losses, if so incurred as a result of the use of any of the referred to information.

 

Any potential investor or participant is advised to seek independent legal and/or financial advice before making any decisions regarding this type of investment.

 

The preceding information is considered confidential and is not to be copied, reproduced (in part or whole) without the express written permission of the author.

 

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