FREE MARKET TRADE WITHIN THE EUROSYSTEM
Viera Malacká
University of Economics Faculty of National EconomyDepartment of Banking and International Finance Dolnozemská cesta 1 852 35 Bratislava Slovakia email: lisekil@hotmail.com telephone: +0421267291392 Abstract
The European REPO market is at the present time one of the fastest developing sectors of the international capital market and its dramatic increase is expected to continue in the coming years. As the analysis of the International Capital Market Associationshows, the semi-annual growth of this market reaches on the average the rate of 15%. The present value of the contractual REPO trade reaches the value of 6,43 mld. EUR. The intense increase in the REPO market started in the 90s as a result of the stricter demand for the minimal capital securities at the banks and the demand for the lowering of the credit risk, and also as a result of the aim of the banks to utilize the capital more effectively placing it on the global market.
Keywords: repo trade, repo tenders, refinancing operations, „tune-up“ trade, structural reversible trade
JEL codes: G 2
1. Introduction
Free Market Trade plays an important role in the currency policies of the Eurosystem by managing interest rates, managing liquidity of the market and signalizing the intensions and trends in currency development. Key role of the Repo lies in this category of trade.
2. The tools of the free trade market
Eurosystem uses five types of tools to complete the dealings on the free trade market: The most important tool is the reversion trade in the form of contracts to repossess or buy back (REPO) (the owner’s rights to the securities are assigned to the creditor and participating
parties agree on the repossession by transferring the securities onto the debtor by the next term), or as a loan with security CP (the exact right to the assets of the debtor is assigned, but if the debt is paid off the debtor retains the ownership of the securities). The difference between the securing price of the contract and the price to buy back equals the interest on the amount borrowed up to the time of the loan maturity, so in the price of repossessing the interest is included1,
direct trade2 – trade used by the Eurosystem to buy and sell acceptable CPs directly
on the market for only the structural and tune-up reasons,
emission of the debt CPs3 – ECB is allowed to emit the debt CPs for the reason of
influencing the structural position of the financial sector towards the Eurosystem, with the intension to create (or raise) the need for liquidity on the market,
currency swaps – used for tune-ups, with the goal to manage liquidity on the market and influence the interest rates,
acceptance of the term deposits4 – the Eurosystem has the right to ask the participants to the contract to deposit the term deposits in the national central bank of the member country where the contract originated. The term deposits are accepted only for the tune-up reasons, to take the liquidity from the market.
1The interest rate on the reversible trade in the form of the collateral loan depends on the application of the set interest rate on the volume of the loan during the term of the contract. On the reverse trade on the free trade market the simple rate of interest is used and when calculating the interest the method „the actual number of days/360“ aplies.
2 The direct trade means the complete reversal of the ownership from the seller onto the buyer without the right
to buy back. The trade is done in accordance with the market conventions for the loan tools used in the transaction.
3 The loan CPs are issued by the ECB with a discount, which means they are emitted under the named value and
they are paid up in the same value. The difference between the emission price and the paid up price is equal to the interest on the emission sum for the term up to the maturity of the loan CP with the agreed upon interest rate. The simple accounting is used, the calculation is done according to the method „the actual number of days/360“. The loan CPs are issued and kept in the book form with the depositaries of CPs within the Eurozone. The ECB does not impose any restrictions on the transference of these loan CPs.
4 Deposits accepted from the contractual parties are termed and with the fixed interest rate. National central
Trade on the free market is initiated by the ECB, which also decides on the tool that is to be used and on the conditions of the process.
Trade can be conducted on the basis of:
• standard tenders,
• fast tenders,
• bilateral trade.
2. 1 Standard tenders
With standard tenders the time from the application of the tender to the acceptance of the assigned volume can not be greater than 24 hours (the time between the closing term to submit offers and the announcement of the results is about 2 hours). If the need arises, the ECB can make a decision to alter the time frame for the particular steps of the process. The main refinancing operations, long-term refinancing operations and structural trade (with the exception of direct trade) are always done on the basis of the standard tenders.
Only the institutions that under the Eurosystem fulfill the requirement for the compulsory minimal reserves and are at the same time financially strong satisfy the comprehensive acceptance criteria. They should be under the authority of at least one form of the harmonized EU/EHP control administered by the national organs for regulations. Also the financial institutions that are under the authority of the non-harmonized national control of a comparable statute, e.g. institutional branches in the eurozone with the centres outside of the EHP, can be accepted as parties to the contracts. These parties have to comply with all the operation criteria specified in the pertinent contractual or regulation rules of the related national central banks (or ECB) in such a way that they fulfill the effective administration of the currency policies. Institution that realizes/fulfils the set conditions can then use the automatic operations of the Eurosystem and the free trade based on standard tenders only through the national central bank of the country where it resides. If the institution has branches in more than 1 member country, each branch has an access to these operations through the NCB of the member country where it resides under the condition that only one branch in the participating member country can submit the offers.
2. 2 Fast Tenders
When the operations are based on fast tenders and bilateral trade (with the exception of direct trade and currency swaps), the NCB trades exclusively with the contract participants that are chosen by the NCB from among the institutions in the member country and fulfil
obligatory acceptance criteria for the contract parties, the most important criterion being the activity on the financial market. Additional criteria taken into consideration might include the effectiveness of the trade and the offer potential included in their own file collection of contractual parties for the tune-up trade). If, because of the operational reasons, the NCB is unable to trade in each operation with all the contractual parties for the tune-up trade, then the selection of these parties in the particular member country is done on the rotational principle to assure the just treatment for all participants.
The fast tenders are realized within 90 minutes from the announcement with the confirmation right after the announcement of the result. If need be, the ECB has the right to alter the time frame for the particular steps of the process. The fast tenders are used only with the tune-up trade.
Tenders with the fixed and flexible interest rate
Tenders with the fixed interest rate (volume) have the rate set by the ECB and the participating parties offer the volume of the financial sources with which they want to trade at this set rate.
With tenders with the flexible interest rate the contractual parties offer the volume and the interest rates at which they want to trade with the national central banks.
3. The operations of the Eurosystem on the free trade market
Considering the object, regularity and the methods, the operations of the Eurosystem on the free trade market can be divided into four groups:
o the capital refinancing operations
o the long-term refinancing operations
o tune-up trade
o structural trade
3. 1 Capital Refinancing Operations
The capital refinancing operations are the most important trade on the free market done by the Eurosystem. They play the key role when considering the goals in the area of interest rates, managing liquidity on the market and they signalize the intentions of the currency policies. The majority of the financial sector’s refinancing is done by these.
Characteristics of the capital refinancing operations: - they are reversible trade, used to supply liquidity
- they are conducted regularly each week - they are usually payable in a week
- they are executed by national central banks, not centrally
- they are done as standard REPO tenders, from the 28th of April 2000 exclusively with the flexible interest rate (up to this date with the fixed rate of interest)
- the offers for the capital refinancing operations can be submitted by all contractual parties that comply with the common acceptance criteria
- as the support securities for the capital refinancing operations the securities are accepted
The interest rate for the capital refinancing operations is the minimal rate for the realization of these with the contractual parties. The usual trade day for the capital refinancing operations is each Tuesday of each month.
3. 2 Long-term Refinancing Operations
Those are regular trade, usually with the term of three months for reversibility and whose goal is the long-term sufficient refinancing of the financial sector. Only a small portion of the financial sector refinancing is realized by this method5. The intention of the Eurosystem usually is not to signalize anything to the market and its role is to accept the interest rates. The long-term re-financial operations are done usually in the form of tenders with the flexible rate and the ECB usually announces the volume of the trade for the up-coming tenders. Under unusual circumstances the Eurosystem is allowed to conduct the long-term re-financial operations in the form of the tenders with the fixed interest rate.
Characteristics of the long-term refinancing operations: - they are reversible trade, used to supply liquidity - they are conducted regularly each month
- they are usually payable in three months
- they are executed not centrally, by national central banks - they are done as standard tenders
5 The Board of Governors of the ECB decided in December 2006 to raise the given amount of the particular
long-term refinancing trade in the year 2007 from 40 mld EUR to 50 mld EUR. The demand of the bank system to aquire liquidity visibly increases during the last years and it is expected that by the year 2007 will continue to do so. The Eurosystem decided on the mild increase of the amount for the long-term refinancing trade to satisfy the need for liquidity. The majority of liquidity will continue to offer through the capital refinancing operations. The Board of Governors can decide on the further change of the amount by the beginning of 2008.
- the offers for the long-term refinancing operations can be submitted by all contractual parties that comply with the common acceptance criteria
- as the support securities for the capital refinancing operations the securities are accepted
The usual trade date for the long-term re-financing operations is the last Wednesday of each calendar month.
3. 3 Tune-up Reversible Trade
Tune-up trade can be realized also in the form of reversible trade on the free market. Their main objective is the management of the market liquidity and the direction of the interest rates, especially to level the results of the unexpected fluctuation of the market liquidity on the interest rates. The possible need of a quick interference in an unexpected development on the market requires a high level of flexibility in the selection of procedures and operational means to complete these transactions.
Characteristics of Tune-up Trade:
- it is a trade supplying/removing liquidity, without a standard periodicity - it is without standardized maturity date
- tune-up reversible trade to supply liquidity are usually done through the means of fast tenders and the possibility of a bilateral trade is not excluded
- tune-up reversible trade to remove liquidity are usually done by the means of bilateral trade - this trade is decentralized and done by the national central banks (The Board of Governors of the ECB is allowed to decide that under specific conditions this type of trade can be conducted by the ECB)
- the Eurosystem can choose a limited number of the contractual parties to participate in the tune-up reversible trade
3. 4 Structural Reversible Trade
The Eurosystem can use the structural reversible trade on the free market to influence the structural position of the financial sector towards the Eurosystem.
Characteristics of this trade: - it is a trade supplying liquidity
- its maturity does not have to be necessarily standardized - it is usually done in the form of standard tenders
- it is done not centrally by the national central banks
-the offers can be done by all contractual parties that comply the capital criteria for acceptance - as support securities for the structural reversible trade all commercial and non-commercial securities are acceptable
To influence the short-term interest rates the Eurosystem uses besides the free trade market also the automatic operations and the compulsory minimal reserves (these do not correspond to REPO trade).
4. Automatic Operations
They are designed to supply and remove the one-day liquidity, to signalize the intentions of the currency policies and to limit the one-day market interest rates. They are realized on decentralized basis by the National Central Banks (NBC).
The contractual parties can initialize two types of the automatic operations:
4. 1 One-day Refinancing Trade
They are used to acquire one-day liquidity6 from the NCB against the acceptable CP. They can be in the form of a one-day reversible contract (the ownership of the asset is assigned to the creditor and the contractual parties agree on the reversible trade when the securities are reversed onto the debtor on the following working day), or in the form of a one-day loan with the CP as a security (the exact claim becomes an asset, but because of the assumed fulfillment of the loan pay back the securities stay with the debtor). The additional regulations for the reversible contracts are specified in the actual contracts by the particular NCB. Contracts to supply liquidity in the form of a loan secured by CP take into consideration different methods and regulations for the stipulation and realization of the particular interest in the collateral, as supported by the different law systems. Under normal
6 The maturity for the refinancing trade is one day. For the contractual parties that are the direct participants of
the TARGET system the maturity falls on the following day during which are the particular national systems of accounting in the real time (RTGS) and accounting for CPs (SSS) in operation, and at the time when they open. The Eurosystem announces the interest rate in advance; the accounting for the interest is simple and the interest is calculated based on the „the actual number of days/360“ method. The ECB has the right to change the interest rate at will anytime and it becomes binding on the following working day within the Eurosystem. The interest is payable at the maturity.
circumstances the contractual parties are not restricted as to the volume limits or any other restrictions except the requirement to support the contract by sufficient securities. The interest
rate for the one-day refinancing trade is usually the top of the one-day market interest rate.
4. 2 One-day Sterilization Trade
7This trade takes care of the superfluous liquidity in the NCB (during the night). The interest rate is set beforehand and it is usually the bottom of the one-day market interest
rate8. The NCB do not offer any collateral to secure these deposits. Under normal circumstances there are no limits to the volume or any other restrictions considering the approach of the contractual parties to this type of a trade.
5. Conclusion
All loan operations within the Eurosystem have to be secured by sufficient collateral. The Eurosystem worked out and starting on the 1st of January 2007 uses the uniform
collateral framework of the acceptable securities („common list“) in all loan operations of the
Eurosystem.
The uniform framework includes the commercial and non-commercial securities complying with the general acceptance criteria requirements set by the Eurosystem for the Eurozone. There is no difference between the commercial and non-commercial securities when it comes to their quality and acceptability for the different types of operations of the financial policies of the Eurosystem (with the exception of the non-commercial securities not being used in the direct trade by the Eurosystem). All acceptable securities can be used on the
7 The contractual party asks for a one-day deposit by sending an application to the national central bank in the
member country where it resides. In order for the bank to be able to manage it on the same day, the application has to be received at the latest 30 min after the actual closing of the system TARGET on the same operational day, which is usually by 18.00. The deadline for the one-day sterilization trade is extended on the last working day of a period for the compulsory minimal reserve by another 30 minutes. The application has to include the sum that has to be deposited for the trade and there are no limits as to the amount. The maturity for this
automatic operation is one day. For the contractual parties that are members of the TARGET system the deposits mature the following day, when the particular national system for accounting (RTGS) in operation and at the time when this system opens. Also in this case the Eurosystem announces the interest rate beforehand; the simple accounting is used and when calculating the interest the method „the actual number of days/360 is employed. The ECB also can change the interest rate at will anytime and it becomes binding on the following working day at the earliest. The interest is payable at the maturity. In the case of the CPs used as a collateral during the sterilization reversible trade within the Eurosystem there are no deductions (haircut).
8
The ECB directives of the 31 August 2006 that change and supplement the directive ECB/2000/7 regarding tools and procedures of the currency policies for the Eurosystem.
cross-boarder basis through the model of corresponding central banks (CCBM) and in the case of the commercial securities through the acceptable interconnection between the systems of accounting for CP (SSS-securities settlement systems). Up to the 31st of May 2007 the securities that did not comply with the criteria of the uniform list for the acceptable securities were still accepted, but qualified as TIER 2 securities. From this date onwards the Eurosystem realizes the loan operations exclusively using securities on the uniform list.
References
[1] BIATEC. vol. 13, no. 12/2005. ISSN 1335-0900 [2] BIATEC. vol. 13, no. 13/2005. ISSN 1335-0900
[3] Financial markets. vol. 3, no. 4 – 5/2006, ISSN 1336-5711 [4] ICMA. European REPO market survey. 2006
[5] JÍLEK, J.: Moderní finanční produkty. REPO obchody. Praha: Grada Publishing 1999. ISBN 80-7169-803-
[6] www.eurepo.org [7] www.eurexrepo.com
