China's Currency

PART III: Futures Imperfect for China

By

Henry C K Liu

Part II: Tequila Trap Beckons China

This article appeared in AToL on November 13, 2004

Liquidity, a fundamental concept in finance, can be defined as the ability to buy or sell large quantities of an asset quickly and at low cost. A liquidity crunch is the main cause of financial cycles of boom and bust. Financial cycles are different from business cycles in that they are predominantly driven by liquidity and illiquidity. Financial cycles are the dominant force in finance capitalism, replacing the business cycles in industrial capitalism.

In a bubble economy, asset values are inflated beyond the level supported by the money supply. The abrupt monetization of assets in a crisis requires large amounts of ready cash in the financial system. But cash is among the lowest-yield financial instruments that are expensive to hold. Thus the main source of cash in times of crisis is always the central bank, which can issue money at will and at no monetary cost, at least for the US. Other central banks cannot issue dollars, the currency of choice in international finance. They cannot issue money even in their own currencies without the penalty of exposing their currencies to speculative attacks because of dollar hegemony. The vast majority of equilibrium asset pricing models do not consider trading and thus ignore the time and cost of transforming financial assets into cash or vice versa. The history of recent financial crises suggests that at times market conditions can be so severe that liquidity can decline or even disappear temporarily. Such liquidity shocks are a potential channel through which asset prices are influenced by liquidity.

Bond of bother

The current yield environment more closely resembles 1994 than 1987. In 1994, the bond market was caught on the wrong side of economic fundamentals by the Fed's low-interest policy and crashed with Fed policy reversal toward higher rates. But unlike 1987, the stock market was spared in 1994 because money merely left bonds for stocks. Yet stock prices eventually need to be supported by corporate earnings, which will be the Achilles' heel of any equity bubble because rising interest rates tend to dampen corporate earnings. In a situation when both bonds and stocks face price collapse, market participants may simply hold on to cash in an attempt to preserve capital. In that case, central banks face what Keynes calls a liquidity trap and become impotent in curing a financial crisis with added liquidity. The last victim of a liquidity trap was Japan in the late 1990s when banks could not find creditworthy borrowers, even with negative interest rates.

For 2004, many traders view the rout in bond prices as merely the unwinding of an overbought unbalance caused by interest rates staying too low for too long. Bond portfolios are mostly still above water for the year, although they lost much of their earlier gains. By historical standards, the rise in interest rates since June 13 can be considered extreme, at least in percentage terms.

The policy of using interest rate cuts to pump up demand incurs economic costs, as evidenced first in Japan and then recently in the US. The costs include the danger of structural damage to long-cycle finance institutions such as those in the insurance sector. The soundness of these finance institutions can be threatened by abnormal spreads between short and long-term interest rates as well as by the adverse effect of new debts on the value of outstanding debts. There is also the question of sustainability and subsequently re-igniting inflationary pressures. In other words, the Fed's low interest strategy between 2000 and 2003 might have led to a bond bubble similar to the equity bubble of the 1990s, and its subsequent reversal on interest strategy creating conditions that ensure the bond bubble will burst.

Long-term yields have fallen to a level that requires a prolonged period of price stability or deflation to justify. Five-year yields slightly above 2% require zero inflation in the US economy over the next five years, a clearly unlikely scenario, particularly so with commodities and oil. US bonds have risen further and faster than at any stage in the past 40 years, a phenomenon that looks jarringly like the Nasdaq run-up of the late 1990s which hit its all-time high on March 10, 2000 at 5132.52. The heavily tech-dependent index would fall more than 77.8% in the three years after the bottom dropped out of the so-called Internet bubble. It now hovers around 1900. Since February 2000, the decline in five-year yields is down from 6.76% to 2.08%, which was greater in percentage terms (68%) than the 59% drop from September 1981 to August 1986 that set the scene for the 1987 crash.

Before 1994, short-term rates fell from 8% to 5% only to climb back to 8% again. Today, 10-year yields have risen from below 3.5% to over 4% and can rise above 5% over an 18-month period. Yet volatility seems built into the market. Ten-year yields again fell below 4%, hitting 3.984% on October 22, 2004. Unsophisticated investors traditionally are lured into bonds as a safe investment when in fact the potential for capital loss in bonds is just as great as in equities in the new economy. Bonds tend to produce a lower return because they are perceived to be less risky than equities. Yet on a three- or five-year view ahead, this perception will be wrong due to the Fed's interest rate vicissitudes. There is at least a possibility of 10-year bonds falling by 25% over the next 18 months as there is of shares falling by the same amount. The threat to bonds even if there is no resurgence of inflation will be that other investments will outperform them in a neutral interest rate environment, putting downward pressure of bond prices. Yet most investors in bonds do not have that same awareness of risk as equity investors.

The consequences of a bond market crash are complex and generally not well understood. That it hurts pension funds and forces governments to borrow at higher rates is obvious. Less obvious is that it also distorts bank balance sheets and is lethal to the financial sector. US Fed chairman Alan Greenspan has expressed the view that markets are now more sophisticated and better hedged than in 1994. But the US now depends more on foreign savings. The market for mortgage-backed securities has tripled in a decade to $4.7 trillion. Participants in that market hedge their bets in the bond market, amplifying bond market moves. Even slight interest rate moves by the Fed may have a bigger and less predictable impact as a result.

Swap to power

The US twin deficits are showing no signs of abating with Greenspan reassuring the market that the US economy is in "reasonably good shape". Derivatives such as total return swaps (TRS) can make short-term dollar loans (liabilities) appear as portfolio investments (assets). Also, the requirement to meet margin or collateral calls on derivatives may generate sudden, large foreign exchange flows that would not be indicated by the amount of foreign debt and securities in a nation's balance of payments accounts. As a result, the balance of payments accounts no longer serve well for assessing country risks. As China liberalizes it credit markets, or pushes the yuan into the global credit markets, its $450 billion-plus foreign exchange reserves will appear less significant as a hedge against speculative attacks on the yuan.

In the event of currency devaluation or sharp downturns in securities prices, derivatives such as foreign exchange forwards and interest rate swaps and TRS function to quicken the pace and deepen the impact of the crisis. Derivative transactions with emerging market financial institutions generally involve strict collateral or margin requirements. The rate of collateralization is estimated at around 20% of the notional principal of the swap. If the market value of the swap position were to decline, the East Asian firm would have to add to its collateral in order to bring it up to the required maintenance level.

Thus a sudden sharp fall in the price of the underlying security would occur at the beginning of a devaluation or a broader financial crisis would require the Asian firm to immediately add dollar assets to its collateral in proportion to the loss in the present value of the swap positions. This would trigger an immediate outflow of dollar reserves as local currency and other assets are exchanged into dollars in order to meet the collateral requirements. This would not only quicken the pace of the crisis, it would also deepen the impact of the crisis by putting further downward pressure on the exchange rate and asset prices, thus increasing losses to the financial sector. An upward revaluation of the yuan may well produce such instability all over Asia.

The EU's GDP is now greater than the US's. Yet the euro economy is still much smaller than the dollar economy due to dollar hegemony. The pool of euro-dollars (off-shore dollars) in circulation is now larger that of dollar circulation within the US. The introduction of the euro led to a surge in euro-denominated bond issues, and this in turn boosted arbitrage and hedging activity by issuers, dealers and investors. Participants in European markets began to use interest rate swaps to hedge their holdings of non-government bonds in the early 1990s, several years before participants in the dollar and other markets began to do so. At that time, financial institutions were the dominant non-government issuers in European markets, and as a result quality conditions in the non-government bond market were similar to those in the swap market. Participants in European markets thus became accustomed to hedging credit products with swaps.

The growth of the euro swap market was driven by hedging and positioning activity. Following monetary union, swaps quickly gained benchmark status in euro financial markets, displacing some of the benchmarks in the legacy currencies as the locus for price discovery about future short-term interest rates.

The fragmented nature of European government securities markets strengthened the incentive to switch to swaps for speculating on and hedging against interest rate movements. The market for unsecured inter-bank deposits was among the first euro financial markets to become integrated and, given that swap rates embody expectations of future inter-bank rates, this contributed to the rapid integration of swap markets in the euro legacy currencies. In fact, a single euro swap curve emerged almost overnight. Therefore, short positions - those taken in expectation of an increase in interest rates - can be created with relative ease in the swap market by choosing the "pay fixed" side of a swap.

In contrast, the secured market, specifically the general collateral repo market, was slower to break out of the segmentation that characterized it prior to monetary union. Differences in governments' credit ratings, settlement systems, tax regimes and market conventions remain obstacles to the complete integration of euro government securities markets. As a result, a single market for general collateral repos does not yet exist; market participants must still specify the nationality of government debt used as collateral before they conclude a repo transaction. This complicates the use of government securities to hedge or speculate on interest rate movements.

The switch to swaps was reinforced by a series of traumatic market events in the late 1990s. Events surrounding the near collapse of Long-Term Capital Management in September 1998 highlighted the risks inherent in the use of government bonds and related derivatives to hedge positions in non-government securities. This had been a routine strategy among dealers up until that time, albeit more so in the dollar market than in the euro market.

Squeezes in German government bond futures contracts over 1998-2002 had a similar effect. Temporary increases in the scarcity premium on euro government securities during auctions of third-generation mobile telephone licenses in 2000 also made government securities less attractive for hedging and position-taking purposes.

Overnight index swaps (OISs) have become especially popular hedging and positioning vehicles in euro financial markets. An OIS is a fixed-for-floating interest rate swap with a floating rate leg tied to an index of daily inter-bank rates. In the euro market, OISs are overwhelmingly referenced to the euro overnight index average (EONIA) rate - a weighted average of interest rates contracted on unsecured overnight loans in the euro area inter-bank market. Trading in EONIA swaps is highly concentrated in maturities of three months or less, and EONIA swap rates are widely considered to be the preeminent benchmark at the short end of the euro yield curve. Banks, pension funds, insurance companies, money market mutual funds and hedge funds all make extensive use of EONIA swaps to hedge and speculate on short-term interest rate movements. OISs are also traded in US dollars and other major currencies, but they have not gained benchmark status in these markets.

The benchmark status of the euro swap curve is reflected in quoting practices for corporate bonds. These practices often depend on the credit quality of the issuer and the nationality of the investor. Euro-denominated bonds issued by investment grade borrowers are usually quoted in terms of a spread over the swap curve. For non-investment grade corporate bonds, prices are quoted in the form of outright yields. Interest rate swaps are becoming more widely used as benchmark instruments in the US dollar market too. However, the shift is less advanced than in the euro market. For example, many US investors still prefer to price dollar-denominated corporate bonds against the treasury yield curve rather than the swap curve.

Notwithstanding the growth of the euro swap market, futures contracts continue to be heavily used as hedging and positioning vehicles. Indeed, trading in euro-denominated money and bond market futures soared in the run-up to and years immediately following the introduction of the single currency. Contracts based on three-month Euribor - a trimmed average of interest rates quoted for term deposits in the euro area inter-bank market - and traded on the London International Financial Futures and Options Exchange (LIFFE) are by far the most actively traded short-term interest rate futures in the euro market. Contracts based on German government securities and traded on Eurex dominate activity in longer-term euro futures.

The growth of the euro swap market has been accompanied by greater diversity in the range of players using interest rate swaps. In the run-up to European monetary union, the inter-dealer segment drove the growth of the euro swap market. At end-1998, positions vis-ŕ-vis other dealers accounted for 52% of the outstanding notional amount of euro interest rate swaps and forwards. Since 1999, the dealer-customer segment has become increasingly important. By end-June 2002, positions vis-a-vis financial customers accounted for 42% of the outstanding notional amount of euro interest rate swaps and forwards, and positions vis-a-vis non-financial customers a further 7%. By comparison, in the dollar swap market, positions vis-a-vis financial customers accounted for 41% of outstanding contracts, and positions vis-a-vis non-financial customers 15%. The smaller share of the dollar swap market accounted for by inter-dealer positions - 45%, compared to 51% in the euro market - is explained in part by greater concentration in the dollar market, which results in dealers offsetting more of their transactions internally rather than with other dealers.

Even European governments have begun to use interest rate swaps to manage their risk exposures. The French government has since October 2001 employed swaps to shorten the average maturity of its debt. As of end-July 2002, it had written swaps totaling 61 billion euro in notional principal, equivalent to approximately 8% of the outstanding French government debt. The German government uses swaps to lower its interest costs. At present, it is authorized to swap up to 20 billion euro, equivalent to about 3% of its outstanding debt. The Dutch, Italian and Spanish governments are also active in the euro swap market. The entry of governments into the interest rate swap market has tended to put a ceiling on euro swap spreads.

Although the range of players using swaps is increasing, the number of intermediaries is declining. Swaps are overwhelmingly traded over the counter (OTC), and so dealers are critical to the functioning of the swap market. Given customers' traditional preference for dealing with high-quality counterparties, trading in OTC markets has long been dominated by a handful of better-rated dealers. In particular, the major dealers have tended to be commercial banks with credit ratings of at least double-A.

In recent years, intermediation in OTC markets has become even more concentrated owing to mergers and acquisitions. For example, following the merger of Chase Manhattan and JP Morgan in 2000, the combined entity's share of the global OTC interest rate derivatives market equaled approximately 25%. In the EONIA swap market, the five largest dealers accounted for 48% of all trading activity during the second quarter of 2001 and the 20 largest dealers 88%. Other segments of the euro interest rate swap market were more concentrated, with the five largest dealers accounting for 60% of turnover. The euro swap market, however, is less concentrated than the dollar market. Two banks hold nearly three quarters of all interest rate derivative contracts booked by US banks, and the five largest banks hold over 90% of outstanding contracts.

Banks headquartered in the euro area are the most active dealers in the euro swap market, writing 46% of notional contracts outstanding in end-June 2002. Among euro area banks, German banks are the largest dealers, with a 21% market share, followed by French banks at 15%. US banks' share of the euro swap market was 35% at end-June 2002. In comparison, US banks' share of the dollar swap market was 54%. Japanese banks play only a marginal role in the euro and dollar swap markets but have a 33% share of the yen market.

The pricing of interest rate swaps in general depends on the interest rate used for the floating rate leg of the contract. The yield used for the fixed rate leg is supposed to embody expectations about the future path of the floating rate for the life of the contract and the risk associated with the volatility of that rate. For euro swaps, the choice of the floating rate tends to depend on the contract's maturity. For short-dated swaps, EONIA is the most common basis for the floating rate leg. Euribor was commonly referenced following monetary union but by 2000, had been superseded by EONIA at the short end of the swap curve. For longer-dated swaps, Euribor remains the key reference rate. The underlying instruments for both EONIA and Euribor are unsecured interbank deposits and therefore these rates reflect a degree of credit risk. Indeed, most banks in the EONIA and Euribor contributor panels are rated double-A.

The pricing convention for euro swaps is to provide quotes in terms of the yields that specify the fixed payments for the contracts. This is unlike the convention for US dollar swaps, which are typically quoted in terms of spreads over US treasury yields. Hence, the price of a five-year euro swap might be quoted as 4%, without any reference to a government bond yield, while that of a five-year US dollar swap might be quoted as 50 basis points over the five year US treasury yield. To be more precise, quoting in spreads for dollar swaps is conventional for dealers in New York, while quoting in yields for this contract would be more typical for dealers in London. EONIA and Euribor are the most common reference rates. Swap rates include a premium for counterparty risk

In spite of the benchmark status of euro swaps, their yields still tend to hover above the yields for the most liquid triple-A rated government bonds in a given maturity, just as dollar swap yields tend to be higher than US treasury yields. At the 10-year maturity, for example, the fixed rate on euro swaps at end-January 2003 was about 20 basis points above the yield on the German bund. Swap rates are typically higher than rates on triple-A rated securities because they contain a premium for counterparty credit risk, which is often associated with the major dealers in the market.

Alternatively, deterioration in the perceived creditworthiness of the government could result in a narrowing of the spread. For example, fiscal difficulties in Germany appeared to contribute to a narrowing of the spread between euro swaps and German government bonds in 2001 and 2002. In the past, a customer could mitigate counterparty risk by spreading positions across several dealers. As consolidation in the financial industry reduced the number of active swap dealers and credit ratings of the remaining dealers were downgraded, daily settlement and especially collateralization became increasingly common. The widespread use of such mechanisms for mitigating counterparty risk resulted in narrower and more stable swap spreads.

Nevertheless, counterparty risk can still at times unsettle the swap market. For example, credit concerns about several large US banks - including major derivatives dealers - caused dollar and, to a lesser extent, euro swap spreads to widen in July 2002. Other possible influences on swap spreads include the general level of interest rates and the slope of the yield curve. However, the economic rationale behind these factors is difficult to explain, and their relationship with spreads tends to be unstable over time. Liquidity was a concern in the past but liquidity in the euro swap market is now such that yields tend not to be driven by imbalances in supply and demand.

Rising Europe

European swap markets were already quite liquid prior to monetary union, and they gained liquidity following the introduction of the single currency. The use of interest rate swaps by some market participants as hedging and positioning vehicles increased the willingness of other participants to do likewise, resulting in a self-reinforcing process whereby liquid markets become more liquid.

A liquid market is one where participants can rapidly execute large-volume transactions with a small impact on prices. There are at least three dimensions to market liquidity: tightness, depth and resiliency. Tightness refers to the difference between buying and selling prices. Depth relates to the size of trades possible without moving market prices. Resiliency denotes the speed with which prices return to normal following temporary order imbalances. Collateralization is increasingly common.

Euro swaps are one of the most liquid instruments available in euro financial markets. Indeed, EONIA swaps are the most liquid segment of the euro money market. EONIA swaps of 2 billion euro are regularly traded in the inter-dealer market for maturities up to three months, and significantly larger trades are not uncommon. Bid-ask spreads are typically 1 basis point. The Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity shows that the average daily turnover of euro-denominated OTC interest rate contracts almost doubled between April 1998 and April 2001, to 231 billion euro. Compared to the $56 trillion in notion value of dollar derivative in 2002, the euro derivative market is still miniscule.

By 2001, the turnover of euro swaps and forwards exceeded that of all interest rate products other than money market futures, US treasuries and German government securities. Trading in EONIA swaps appears to account for much of this growth. Beyond two years, however, the euro swap market is neither as tight nor as deep as the larger European government securities markets. Anecdotal evidence suggests that bid-ask spreads for euro swaps are wider than those for government securities: one basis point for inter-dealer swaps, compared to less than half a basis point for the most recently issued German government securities. Quote sizes are also smaller: approximately 100 million euro for five and 10-year swaps, compared to at least 150 million euro for the most recently issued German bobls (or Bundesobligationen) and bunds. Trading activity in longer-dated swaps is a fraction of that in futures contracts on German government bonds.

Moreover, liquidity in the euro swap market appears more likely to evaporate during periods of extreme volatility than liquidity in the larger government securities markets. In particular, interest rate swaps remain less liquid than they would be if they were traded on an organized exchange, where a central clearing house could act as the counterparty to all trades. Counterparty credit risk becomes of paramount concern during periods of market volatility, when uncertainty about the health of financial institutions often increases. Consequently, arrangements for dealing with counterparty risk play a major role in determining market liquidity under stress.

Assuming that the soundness of the clearing house is ensured, the liquidity of instruments traded on organized exchanges tends to be more robust to stress than that of instruments traded over the counter. Steps have been taken to encourage greater centralization in the swap market. In the early part of 2001, the London Clearing House, supported by several of the largest swap dealers, began clearing and settling interest rate swaps in all of the major currencies. At about the same time, LIFFE introduced futures contracts on two-, five- and 10-year euro swaps. However, trading of swap futures accounts for an insignificant proportion of global swap activity. In contrast, trading of futures contracts on German government bonds accounts for the larger part of activity in the German government securities market. EONIA swaps are the most liquid segment of the euro money market, but government securities markets are more liquid at longer maturities.

It remains unclear whether swaps will continue to erode the benchmark status of government securities and consolidate their position as the dominant positioning and hedging vehicles in euro fixed-income markets. In addition to the previously mentioned concern about counterparty risk, another concern is that the participation of large, one-sided players such as governments could increase the risk of idiosyncratic movements in swap yields - ie it could increase basis risk - and so make swaps less effective hedges.

Repos could eventually compete with EONIA swaps for benchmark status at the short end of the euro yield curve, as they do in the US dollar market. European repo markets are growing rapidly and steadily becoming more integrated, boosted in large part by market participants' efforts to limit counterparty credit exposures. The development of a tri-party repo market - in which settlement and management of the collateral is delegated to a central clearing house - is especially noteworthy because it allows a basket of securities to back a transaction, including lower-quality, less liquid securities. At the longer end of the yield curve, government securities remain attractive benchmark instruments, not least because of the tremendous liquidity of German government futures contracts.

It seems the one thing that emerges from a discussion on the relationship of interest rate to inflation is that clear definitions of economic condition are necessary to fully understand or describe such relationship. Although it is not a derivative instrument until it is structured as a swap, interest is a derivative whose value is derived from the amount of the loan principal and the interest rate. The interest rate determines the amount of interest to be paid over time on a principal sum that in turn determines the size of the cash flow. The total cash flow in a financial system reflects its liquidity. Thus interest rate has a direct effect on liquidity.

In a debt-free economy, interest rate is irrelevant because with zero principal, the interest payment is also zero, regardless of the interest rate. In a saturated debt market, as in Japan now, the interest rate is also relatively irrelevant because all outstanding loans are mostly likely fully hedged and new loans are not being written for lack of demand or creditworthiness common in a liquidity trap. The zero interest rate in Japan has little impact on the economy because qualified borrowers cannot be found even at negative rate. In other words, outstanding bad loans have already absorbed all available collateral.

Thus it follows that the impact of interest rate on inflation is a function of the size of the aggregate debt in an economy in relation to the market value of the collateral. Aggregate demand for new debt is a function of surplus collateral which is in turn a function of market value. A sudden and drastic fall in market value increases the loan to asset ratio and depletes surplus loan to asset ratio. Therein lies the detonator for implosion of a debt economy in a bear market.

What is a bear market? Price is no doubt the intended intersection of supply and demand, provided supply and demand are defined broadly without excluding externalities. But price does not always lead to transactions. And only transactions make a market, not price. There is sometime a price with no market when the asking price is stubbornly too high to attract buyers. In an open market, technical analysts will tell you that when an item is put up for sale, the price is not set by the seller or the potential buyer. Price is the result of open bids, adjusted according to the degree of market friction. What produces a bear market is the absence of bids, the seller in a non-monopoly then lowers the asking price out of fear that another seller may steal the sale. Potential buyers hold back in hope for a more desperate seller. Thus a bear market emerges. Sellers do not compete with buyers, but with other sellers, the same being true with buyers.

A bull market is created by reverse dynamics. Buyers pay asking price or offer above asking price out of fear of losing the deal. Sellers hold back for better offers from competing buyers. If the upward price pressure is greater than interest cost, potential sellers will borrow against the asset rather than sell. This tends to increase the market value of the asset, qualifying it for additional loans, which in turn pushes prices up further. This is what is known as the wealth effect on debt. This spiral could go on forever if it were not for the little problem of interest payment. Loans are not allowed to postpone interest payments. When that happens it is called a default, the worst word in the credit business. Just as the concept of forgetfulness depends on the concept of memory, the notion of debt is dependent on its service and repayment. A debt without the support of regular or pre-arranged interest payment or the prospect of principal amortization turns into a loss. Thus loans rely not just on collateral, but also on the cash flow that the collateral or other assets can generate for servicing the loan by paying interest periodically or at an agreed time. This little convention prevents the existence of perpetual bubbles.

There will come a point when the cash flow capacity of assets will fail to support the interest payments on a ballooning loan perfectly secured by the underlying assets' rising market value. When that happens, the borrower must sell to reduce his debt and the upward price pressure peaks and starts reversing itself as downward price pressure. The bull market then abdicates and the bear market takes over. The nature of the credit market is such that the downward slide is much more forceful and speedy than the upward climb. The rapid downward slide is called a burst of the debt bubble or a debt collapse.

Now, history has shown that two related developments could under normal conditions prevent or soften a debt collapse. They are, first, a sufficient and timely increase of the money supply by the central bank and subsequently reflation that is brought about by increased money supply in a no-growth or negative-growth economy, or inflation which is caused by a money supply growth rate ahead of economic growth rate.

Anatomy of money supply

The money supply then is of critical importance to monetary policy considerations. To monitor the money supply, the Fed tracks three monetary aggregates, M1, M2, and M3, each of increasing scope but decreasing rate of turnover. M1 comprises the traditional definition of money as a means of payment. It includes currency in circulation plus the checkable deposits in depository institutions (banks and thrifts). Currency in bank vaults and bank deposits at the Fed are not a part of M1, although they are part of the monetary base, sometimes designated M0. M2 includes M1 plus retail non-transaction time deposits. M3 includes M2 and wholesale deposits. Each of these money aggregates serves a different purpose for Fed deliberations. At the end of August 2004, M1 measured $1.34 trillion; M2 measured $6.3 trillion and M3 $9.28 trillion, which increased by $390 billion over the $8.89 trillion measured at the end of August 2003. Yet the latest available data on notional values of dollar derivative is $56 trillion for 2002, up from $45 trillion in 2001. The figure could reach $65 trillion for 2003 that would be more than seven times the M3.

Too much money in relation to the output of goods and services leaves money idle and tends to push interest rates down and push prices and inflation up. Inflationary growth in turn requires more money to sustain growth. Too little money tends to push interest rates up, lowers prices and output and causes unemployment and idle plant capacity, which in turn further reduces demand for money. There was a time when the money in deposits with commercial and saving banks roughly equaled to loans outstanding in the economy. The Fed, through setting the cost of funds (interest rate), partial reserves and capital requirements for banks, could manage the rise and fall of the money supply.

The Fed still attempts to manage the money supply by setting bank reserves and the discount rate at which banks borrow to meet their reserves needs, as well as Open Market Operations to achieve Fed funds rate (ffr) targets by trading government securities to inject or drain money in the banking system. The Fed also participates in the repo market to keep the repo rate in line with the ffr. Repos allow banks to skirt the reserves requirement when expanding their loan portfolios. Banks often do not even own the government securities they use to execute repos, the proceeds of which yield banks such interest rate spread from bank loans that the cost of borrowing the government securities are more than covered.

With deregulation, all money except cash has become interest bearing. And with Automatic Teller Machines (ATM) and credit card use, the amount of cash needed in the economy has shrunk dramatically. Everyone is operating with just-in-time cash management. M2 is overnight repos, overnight eurodollars, savings accounts under $100K and money market mutual fund shares. M3 is M2 plus time deposits over $100K and term repos. Finally, L (Long-term liquid funds) is M3 plus T-bills, savings bonds, commercial papers, bankers acceptances and eurodollar holding of US residents (non-bank). Derivatives are not included in money supply data.

With the growth of securitization, banks pass off their loan portfolios to investors in the credit markets. In this process, banks act as reverse intermediaries from their traditional retail role in both deposit and loans and become retail marketers of loans to feed a wholesale credit market. This credit market is totally outside the control and jurisdiction of the Fed. Tax deductibility of interest on home mortgages, interest on margin accounts, interest on loans for corporate mergers and acquisitions affects significantly the impact of interest rates on inflation.

Risk business

Risk arbitrage is a risky play to profit from the simultaneous purchase of stock in a company being acquired and sale of stock in its proposed acquirer. It is also known as takeover arbitrage, a play that profits by cashing in on the expected rise in the price of the target's shares and drop in the price of the acquirer's price. The risk is if the takeover falls through for any number of reasons, the arbitrageur may be left with huge losses. Risk arbitrage differs from risk-less arbitrage, which entails locking into profit from differences in the prices of two securities or commodities trading on different exchanges. Risk arbitrage is done through credit, using the current market value of the shares as collateral.

Risk aversion is not just an attitude, it is a calculable premium. Given the same return with different risk alternatives, a rational investor will seek the security offering least risk, or conversely, the higher the risk, the higher the demanded return. In the credit market, instruments are all priced precisely and with uniform standards to reflect risk aversion. Risk-based capital ratio is a minimum ratio of estimated total capital to estimated risk-weighted assets, required by FIRREA (Financial Institution Reform and Recovery Act). The benchmark for risk-free return is the three-month treasury bill. The CAPM (capital asset pricing model) used in modern portfolio theory has the premise that the return on a security is equal to the risk-free return plus a risk premium.

The ideal of a transaction is to be risk-less. A risk-less transaction guarantees a profit to the trader that initiates it. An arbitrageur may lock in a profit by trading on the difference in prices for the same security or commodity in different markets due to market inefficiency. For instance, if gold is selling for $450 at NY and $449.86 in London briefly due to market inefficiency, a trader who acts with electronic speed may buy a contract in London while simultaneously selling a contract in NY, yielding a risk-less profit. These transactions serve a function in eliminating market inefficiency. Risk-less transaction is also a concept used in evaluating whether dealer mark-ups and mark-downs on OTC (over the counter) transactions with customers are reasonable or excessive. Nasdaq uses the 5% rule, meaning mark-ups (when customer buys) and mark-downs (when customer sells) should not exceed 5%.

Uncertainty is not measurable, but risk is a measurable possibility of losing or not gaining value. The most common risks in finance are inflation risk, interest rate risk and exchange rate risk. These risks are interlinked in complex relationships. Other business risks are inventory risk, liquidity risk, actuarial risk, regulatory risk, political risk, credit risk, risk of principal and underwriting, and guarantor risks. Risk-adjusted discount rate in portfolio theory and capital budget analysis is the rate necessary to determine the present value of an uncertain or risky stream of income. In the so-called New Economy of the 1990s, this discount has been thrown out the window and replaced by fantastic premiums. It is useful to remember that interest rate is the cost of money at an annual rate, interest itself is the cost of using money (debt) over time. The cost of availability of money is a standby fee. Money not used is interest-free, regardless of interest rate.

Interest rate risk exists when changes in interest rate will adversely affect the value of an investor's securities portfolio. For example, holders of long term bonds or utility stocks assume a significant interest rate risk because the value of those bonds or utility stocks will fall if interest rates rise. Interest rate risks can be hedged by buying interest rate futures or interest rate options contracts. It is useful to understand that futures and option contracts are not market prediction, but market implications that are precisely calculable. Interest-sensitive stocks are those of firms whose earnings change when interest rates change, such as banks, insurance companies, financial companies or utilities.

Bank participation in derivative markets has risen sharply in recent years. Average daily global turnover in OTC derivatives markets increased to $1.2 trillion in April 2004, a rise of 112% at current exchange rates and 77% at constant exchange rates as compared to April 2001. OTC derivatives are traded outside exchanges between private counterparties. The notional value of derivative contracts held by all insured commercial banks in the US increased from $6.8 trillion in 1990 to $11.9 trillion in 1993, an increase of 75%, to $45.1 trillion at the end of 2001 and $56 trillion at the end of 2002, and continues to grow dramatically. Nearly 81% of the $56 trillion notional value of derivatives represents interest rate derivative contracts at just 5 dealer banks.

The top five derivatives dealers hold 93% of total notional values. More than 86% of these dealers' holdings are interest rate contracts. Therefore, in terms of the derivatives risk matrix, a vast majority of commercial bank derivative activity is in interest rate contracts at a few dealer banks. These dealers conduct derivative activities as part of their total trading operations, which makes analyzing derivative risk difficult to isolate from total trading risk. Furthermore, if a bank is speculating in derivatives, it occurs within these trading portfolios and is not reported separately. A major concern facing policymakers and bank regulators today is the possibility that the rising use of derivatives has increased the risk profile of individual banks and of the banking system as a whole. The global nature of derivative markets and firms' participation in them suggests that a disruption in these markets could have wide-ranging effects that would be transmitted across national boundaries.

While the number of banks reporting derivative securities use declined from 587 to 369 during by 2001, the dollar volume of assets of the banks utilizing derivatives increased from $2.3 trillion to $5 trillion. This represents about 77% of all commercial bank assets. In 2001, the 25 largest banks in the US accounted for 99% of bank-held derivative securities. Bank mergers have since reduced the number to five. The smaller banks that used derivative securities utilize them for purposes of hedging 75% of the time.

On the other hand, the top 25 banks held most of their derivatives for trading; at the end of 2001, only 0.6% of the derivatives held by these giant banks were held as hedges. The remaining 344 banks utilizing derivative securities held close to 60% of the notional value of derivatives for hedging purposes; compared with 70% in 1999. The biggest banks not only participate in the derivatives market as end-users but also act as dealers by providing OTC derivatives for non-financial companies. Thirteen US-based bank holding companies are primary dealer firms in the derivative market. Derivatives held for trading purposes are accounted for on the balance sheet at fair value, with gains and losses reflected on the income statement.

Risk management techniques that reduce return volatility can be called hedging, but if these same techniques are used to increase return volatility it is generally called speculating. Derivatives not held for trading are being used for purposes of hedging. Most derivative contracts are not traded on organized exchanges, but are traded in the OTC market between counterparties.

Risk management is about the creation and preservation of value rather than the elimination or reduction of risk. Risk-based capital requirements have been associated with a shift of assets from loans to securities or into securitized residential mortgages, and into off-balance-sheet activities at some banks. Less capital is required for holding securities rather than loans and for holding residential mortgage loans rather than commercial or consumer loans. There is evidence that regulation had a greater impact on bank capital decisions than did market discipline.

One of the primary methods banks use to address risk management concerns is the implementation of value-at-risk (VaR) models. Banks make the choice of VaR models based on the response to regulatory penalties for violations. Banks began to use VaR models in the late 1980s to measure the risks of their trading portfolios. Both the Bank of International Settlement Basel I Accord of 1988 and the 1996 Amendment discuss the use of VaR models. VaR is a method of assessing financial market risk by measuring the worst expected loss over a specified time horizon with a given level of confidence.

The Basel Committee on Banking Supervision's paper titled "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" deals with the new capital adequacy framework commo