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How to ‘tap’ the market Back  
In May 1966, the first CD ‘tap issue’ was launched in the London market writes John O’Farrell. Since then the market has gone from strength to strength, and as of November 2003, was worth approximately $470 billion, with CDS set to become a major growth area in the Dublin money market.
Recent developments in the Dublin market
The last several months have seen a substantial interest in certificates of deposit (CDs) in the Dublin market. CDs are negotiable bearer instruments and are transferable without endorsement. Title passes by delivery and there is no contingent liability after sale. Similar to cash deposits, CDs have a known maturity. However, unlike cash deposits, they can be sold before their maturity date and are tradable in the secondary market. This is one of the main advantages for investors, as if they need the liquidity or if the credit rating of the issuer deteriorates, they can close their position by selling the CD. This also gives investors the opportunity to realise their profit if market conditions change, as opposed to waiting for the accrual over the life of a cash deposit. It is this flexibility that makes CDs very attractive to investors. Therefore the highest rated CDs trade at a slightly lower level than a comparable money market deposit, generally somewhere between the deposit levels and the swap levels.

Owing to certain changes in the Finance Act 2003 relating to D.I.R.T. (deposit interest retention tax), CDs can now be sold to Irish residents without collecting D.I.R.T., provided that certain conditions are met: the CD clears through a recognised clearing system and has a minimum investment of €500,000, or, in the case of an instrument denominated in US dollars, a minimum investment of $500,000, or in the case of an instrument denominated in a currency other than euro or US dollars, the minimum investment will be the equivalent in that currency of €500,000. The recognised clearing systems include Euroclear, Clearstream and Depository Trust Co of Neew York.

In May 1966 the first ‘tap issue ‘in the London market of fixed rate bearer US Dollar negotiable Certificates of Deposit was launched. At the same time, a secondary market was established. This was the first new money market instrument in London for nearly three quarters of a century.

In 1967 the maturity range for US Dollar CDs was established at a maximum of five years with the launching of the first ‘tranche issue’ of CDs by a large American bank. Since that time, banks have also become willing to issue medium-term CDs on a ‘tap ‘ basis.

The UK Finance Act 1968 made provision for the issue of sterling CDs by banks in the United Kingdom and the first issue was made on 28 October of that year.

The Floating Rate Certificates of Deposit (FRCD) market was first opened in April 1977, when a member of the International CD Market Association (ICDMA), now the International Money Market Trading Association (IMMTA), sponsored a tranche issue and shortly thereafter a tap issue, both with maturities of three years. In July 1979, the Japanese banks were given permission by the Japanese Ministry of Finance to issue five year FRCDs. Rapid growth during the 1980s and 1990s has resulted in CDs issued in many currencies.

In March 1984 the British Bankers’ Association (BBA) issued guidelines relating mainly to sterling CDs, which replaced earlier guidelines issued by the London Discount Market Association (LDMA).

The BBA guidelines incorporated, from November 1984, ‘London Good Delivery Standards ‘which set out the requirements for security, printing and dealing in CDs on the London market, whether denominated in sterling or other currencies. As such, these standards became a pre-requisite for the negotiation of all CDs on the London secondary market. These standards were also produced in a booklet issued by the ICDMA later that year, which ensured a common standard of practice throughout the London CD market.

From 1 January 1987, the UK Building Societies Act 1986 came into effect allowing building societies to issue CDs in any approved currency and, on 1 June 1987, the tax provisions were extended to enable building societies to pay interest without deduction of tax on CDs of GBP 50,000 or more wwith a maturity of up to five years.

In August 1987, in view of the further development of the London CD market, and to take account of legislative changes affecting that market, a revised booklet embracing all CDs in all currencies circulating on the London market was issued in association with the LDMA, ICDMA and the Building Societies Association (BSA) to assist and guide market participants in order to facilitate an orderly market.

In 1989 the Bank of England (‘BOE’) reviewed the regime for short-term paper issues by institutions authorised under the UK Banking Act 1987 and by building societies authorised under the UK Building Societies Act 1986. The BOE issued a revised notice in March 1989, and this removed the previous constraint under which they could only issue CDs in the sub-five year maturity range. These institutions may now issue paper of any title provided that the title is not liable to cause confusion with CDs. Other changes included the relaxation of the previous restrictions on CDs carrying a guarantee or early repayment options, and of the restrictions on the range of currencies in which CDs could be issued.

The major revision in the BOE Notice (dated 1 November 1996) was that the BOE would no longer require issuers to seek approval for issues of CDs in overseas currencies from the relevant home state authorities, and issuance of London CDs in any currency could now take place. The BOE would appreciate advance notice from any issuer intending to issue London CDs in any previously unissued currency. The BBA should also be given advance notice to enable appropriate denominations to be set. The BOE also raised the minimum denomination of CDs from GBP 50,000 to GBP 100,000. The GBP 50,000 level had remained unchanged since the 1960s. In addition the increase ensured that the CDs meet the criteria for inclusion as wholesale instruments for the purposes of the UK Financial Services Act. The growing use of issuing and paying agents (IPAs) for all currencies has greatly reduced security risks when dealing in the contemporary market.

Today, the CD market is highly liquid. In stable, low interest rate conditions, spreads may be only a few basis points for the most acceptable names, and with increasing attention being paid to differences in credit quality there has been a shift towards individual negotiation rather than trading generic groups on a ‘quoted run ‘. However, in times of extreme interest rate volatility, bid/offer spreads may be quite wide.

CDs can take several forms and can be issued with maturities of up to 5 years, although the most liquid market for them is for maturities of not more than 12 months. CDs may be issued at a discount to par value or alternatively as interest bearing instruments. Both forms are common. The main types of CD are:

• Fixed Rate Interest Bearing CDs
This is a CD certifying that a specified sum has been deposited with the issuer at a stated, fixed rate of interest, to be repaid on a specified date (the maturity date).

• Floating Rate CDs
This is a CD certifying that a specified sum has been deposited with the issuer at a rate of interest which may vary throughout the life of the CD, to be repaid on a specified date (the maturity date). Interest is payable for each of the stated relevant interim periods between issue and maturity at a specified interest rate index (e.g. LIBOR or EURIBOR) for each of the periods plus or minus a specified spread.

• Discount CDs
This is a CD that carries no stated interest rate but specifies that, at maturity, the CD will be redeemed at its face value or par (the sum deposited with the issuer, although not stated on the CD, will have been less than the face value of the CD). Discount CDs are usually dealt on a yield to maturity basis and are sometimes referred to as zero coupon CDs.

Table 2 shows a simple example to explain the difference between Fixed Rate Interest Bearing CDs and Discount CDs.

As you can see from the example, the substance of the CD deal is very similar but it takes a different form.

Primary and secondary markets
It is usual to set up a programme to allow for CD issuance. It is also very common now to have an Issuing and Paying Agent. UniCredito Italiano Bank (Ireland) p.l.c. (UniCredito Dublin) uses Bank One NA, London Branch. In order to be able to issue from Dublin, both for the Irish and European markets, using a London IPA, the issuer first needs to be a European Authorised Institution in the UK. Primary market CDs are sold by the issuer directly to the customer or via a broker or another bank. The agreed interest rate on the CD transaction is either printed on the CD (in the case of Fixed Rate Interest Bearing CDs) or implied in the price (in the case of discount CDs).

In the secondary market, the original customer sells the CD at an agreed rate for the remaining term of the CD. This rate will not be printed on the CD, but implied in the price, similar to a discount CD.
This price will be calculated in a similar manner to discount CDs above. In the example above, if one month has passed (31 days) and the market rate for the remainder of the CD (60 days) is now 2.05 per cent then the price for both CDs above may be calculated as follows :

100/(1+(RxT/360)) or 100/(1+(2.05 per cent x 60 / 360)) = 99.65949672

Therefore the settlement figures for the fixed rate and discount CDs are 50,094,261.28 and 49,829,748.36 respectively as calculated below. It is worth noting that while the settlement figures differ for the two types of CD, they both result in the same yield for the 31 days of 2.1892942 per cent.

Fixed Rate Interest Bearing CD settlement:
50,265,416.67 x 99.65949672 per cent = 50,094,261.28

Discount CD settlement:
50,000,000.00 x 99.65949672 per cent = 49,829,748.36

Generally, the highest rated CDs will be the most liquid in the secondary market and will be easier to dispose of. Please see the table 1 for examples of short-term credit ratings from the main rating agencies.

The issuance process for CDs is quite simple. The issuer, for example UniCredito Dublin, posts CD (guaranteed by UniCredito Italiano S.p.A. rated AA-/Aa2/AA- (Short-Term A-1+/P-1/F1+)) issuance levels for various periods and for several currencies (EUR, USD, GBP and CHF) on bloomberg (UNCR ) and with several brokers and banks. The customer then selects which currency, period and rate best suits them and agrees the transaction with the issuer directly or via one of the above channels, specifying whether they require a fixed rate or discount CD. The issuer then contacts their issuing and paying agent ( ‘IPA ‘) and gives them the details of the CD. The IPA then gives the issuer an ISIN code corresponding to the CD for identification purposes. The issuer lets the customer know this code and settlement takes place the on value date, on a delivery versus payment basis through a recognised clearing system e.g. Euroclear.

CDs are a very significant product in the London and European money markets. Several Irish banks are now issuing CDs in Dublin and they are set to become a major growth area in the Dublin money market.

The author would like to thank the British Bankers’ Association for its permission to reproduce certain sections of their booklet ‘Certificates of Deposit on the London Market’ in this article, which sections are ? BBA Enterprises Ltd. November 1996.

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