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CDs as a tool for cash management and funding Back  
Since a rule change in the Finance Act 2003, which made it possible for Irish resident financial institutions to issue certificates of deposit (CD) to Irish investors, a number of Irish based financial institutions have availed of the opportunity to issue including EBS, Depfa Bank and UniCredito Italiano Bank (Ireland) plc. In this, our annual update on CDs, we present a Questions & Answers session, where key industry players – Mark Whelan, Caroline O’Connor and John Whelan of EBS; John O’Farrell of UniCredito Italiano Bank (Ireland) plc; Hugh Beattie of McCann Fitzgerald; Christopher Amott of JP Morgan and Damien O’Donoghue of Bank of New York, discuss the main issues in the market, including CDs as a cash management tool, and new types of product emerging.
Q. How do Certificates of Deposit (CDs) compare to other funding tools such as commercial paper? From an issuance point of view, and an investment point of view?
Mark Whelan, Senior Manager, EBS

Mark Whelan, Senior manager, EBS: While there is some overlap between ECP and LCDs they predominantly operate in different markets with different product characteristics and dealing protocols. The following are examples of these differences:
- Euro commercial paper (ECP) tends to be ‘a buy to hold’ instrument whereas CDs are actively traded within a liquid secondary market.
- LCDs are regulated by the Bank of England, with operational procedures specified by the British Bankers Association; ECP is as yet an unregulated instrument. Consequently LCDs qualify as ‘Eligible Debt Securities’ and can be used as collateral in Bank of England Repo operations, ECP does not qualify.

Unlike ECP, London CDs do not have a defined programme size, (hence referred to as ‘Tap’ programmes), the issuer is not contractually required to define the upper threshold on the amount it can borrow.

LCD programmes are not specifically rated by an external rating agency as they constitute deposits which are covered by the general institutional rating. Therefore there are no additional costs in this regard.

There is no mandated programme arranger therefore the only significant documentation necessary is between the issuer and the Issuing & Paying Agent. This reduces the setup/ legal costs in establishing the programme.

The sales and distribution channels for CDs is quite varied, the issuer can choose to issue directly themselves, sell to money brokers who act as agents in arranging transaction or sell to other intermediaries such as major investment banks.

John O’Farrell, Head of treasury, UniCredito Italiano Bank (Ireland) plc: CDs are very similar to CP in terms of characteristics. In the market, average CD ticket size is larger. CDs often offer a slightly lower return than CP.

Q. Why are CDs an effective cash management tool?

John O’Farrell: For the issuer, they can be issued for whatever periods are needed for funding purposes or to meet the needs of the market and thereby achieve an efficient funding rate. For the buyer, they are more flexible than deposits as they can be sold in the secondary market, should the buyer need liquidity or wish to close their position due to market conditions.

Christopher Amott is product manager, DCC, JP Morgan: CDs provide an excellent investment tool for both fund managers, managing investments on behalf of clients and financial institutions looking to obtain the best return possible on surplus cash reserves. Both parties look to maximise their investment return but are subject to certain restrictions imposed by regulatory authorities. These restrictions are concerned generally with capital and liquidity preservation and Certificates of Deposit are included within the range of assets available to treasury and fund mangers in this respect. Issued by European Authorised Institutions they offer short term, low risk and highly liquid investment opportunities. Traded same day to spot investors can generally find the currency and investment grade they are looking for at an attractive interest rate within a relatively short trade to settlement date period. Unlike time deposits the bearer nature of the instruments provide an added flexibility in that the instruments can be sold on, again within relatively short period of time, to realise a short term return should the funds invested be required for other purposes.

Q. What have been the main developments in the European/London CD market over the past year?

Christopher Amott: Following the launch of the Irish CD programme in 2002 and the migration of sterling instruments from CMO to Crest in 2003 the London CD market has experienced a period of stabilisation with very little development in the last 12 months. There has been some interest by issuers in so called exotic currencies and in 2004 the BBA published guidelines for minimum denominations in Polish Zloty and Czech Koruna and in 2005 Turkish Lira and Hungarian Forint were added. JPMorgan Chase Bank’s Depository and Clearing Centre (DCC) are the only known IPA currently to have acted on behalf of issuers in these currencies.

Damien Donoghue, Vice president, Global Trust Sales, The Bank of New York: The long established London CD market has not seen tremendous change over the last 12 months. During 2004 the market spent time developing a greater understanding of the advantages of the Crest system, whether it was the issuing and paying agents attempting to achieve greater straight through processing capabilities or investors realising the cost benefits of Crest versus the physical market.

It is this realisation of the difference in the custody costs base, with Crest having removed the base custody costs to investors in late 2003, that has continued the drive towards issuing USD in Crest versus the traditional method of physical form. Beyond the cost element, the risk associated with walking physical paper around the streets of London is removed when dealing within the Crest system.

Alongside the ongoing changes of settlement patterns, one of the most important recent developments has been the continuing growth of Irish banks accessing the market and the success that has been enjoyed, whether it be issuance of US dollar denominated paper to US investors or euros into Euroclear/Clearstream. That said, there continues to be confusion as to the required status of an issuer in Ireland, whether it is a requirement to be a plc to issue. This is a situation that if clarified may lead to an even greater influx of Irish issuers.

Q. What are the main steps involved in establishing a CD programme?

Caroline O'Connor, Treasury Executive, EBS

Caroline O’Connor, Treasury executive, EBS: Apart from obtaining the necessary internal authorisation, the primary tasks required to establish a CD programme relate to completing the required programme documentation. The main documents involved are as follows;

Agency agreement: this is negotiated with the IPA (issuing & paying agent) to the programme. In our case we appointed JP Morgan Chase London as our IPA, responsible for the issue and settlement of all trades on our behalf. This occurs in JP Morgan’s Depository and Clearing Centre (DCC) in London. In order to issue securities and settle the corresponding cash with the IPA you are required to open cash and securities account in the DCC. All settlements conducted via the IPA are subject to the rules specified in an operating agreement.

Deed of covenant outlines the direct rights of certificate holders if particular specified events occur.
Dealer agreement is the agreement between EBS and any party that wishes to act as dealer on the programme.

Information memorandum (optional) outlines any material information regarding the issuer and the terms and conditions of the notes.

‘Crest’ issuer application form: in order to issue Eligible Debt Securities we were required to complete a ‘Crest’ IAF (the CD’s have to settle on Crest) with associated legal opinions regarding our authority and capacity to issue EDS and the enforceability of the provisions in the application form.

John O’Farrell: Choosing an IPA. Agreeing the legal documentation. Preparing an information memorandum. Choosing dealers. Setting up pricing pages on Bloomberg and/or Reuters.

Q. Where and how are CDs settled and cleared?

Caroline O’Connor: The primary operational issues regarding establishing a LCD programme are as follows:
- The security settlement procedures regarding CDs are similar to those which obtain for the sale/purchase of securities in general.
- LCDs are dealt on the basis that settlement occurs two days after agreeing the trade. Both the seller, (EBS), and the buyer communicate the trade two days prior to settlement. They match the two instructions, confirm the trade, and guarantee simultaneous transfer of the security to the investors account and funds transfer to the EBS. This process is executed, in reverse, on the maturity date of the LCD.
- CDs are settled by both the issuer and purchaser (or whoever is acting on their behalf in this regard) communicating their purchase of the CD via MT598. If both messages match the DCC will contact EBS as the issuer and supply them with an ISIN code (unique security identifier code). Security settlement operates on the basis of simultaneous transfer of the security to the investor and corresponding cash transfer to EBS. It is an extremely efficient and secure way which protects the issuer and the investor.

Q. What legal form of company can issue CDs?

Hugh Beattie, Partner, McCann FitzGerald: In the case of Irish companies, a public company (which term includes plcs and public unlimited companies) can offer securities to the public. A private company can issue CDs but only in a manner that does not constitute an offer to the public.

What is perhaps more important, though, is that, in the Irish context, only a credit institution (generally banks and building societies) may issue CDs. CD issuance is a form of deposit taking, which only credit institutions are entitled to engage in under Irish law. Non-credit institutions can issues commercial paper (and other bonds) but not CDs. The issuance of commercial paper by non-credit institutions requires an initial notification to the Financial Regulator (IFSRA) that the relevant entity is commencing CP issuance.

Q. As an issuer, why did you decide to establish a CD programme?

Mark Whelan: EBS Treasury had over a number of years diversified its sources of long term wholesale funding by utilising syndicated bank loan facilities, establishing a Euro Medium Term Note (EMTN) programme and then securitising portions of its mortgage book via the Emerald series of mortgage securitisations. In late 2003 we began to address our short term funding capabilities. We had already established our €1 billion ECP Programme with the objective of broadening the society’s short term funding capabilities and bring increased geographical and investor diversification. The target investor market was primarily European asset / fund managers.
While ECP offers a generic product across a range of European markets, a number of countries have preserved vibrant domestic short-term debt markets, in France this market is the ‘Billet’s de Tresorie’, in the UK it is the ‘London Certificate of Deposit’ (LCD).

We had been researching the potential for the society to enter the ‘LCD’ market as a complement to our existing short term funding capabilities. As a short-term debt security LCDs are the traditional interbank funding and investment instrument of domestic & international UK financial institutions plus medium & large corporate investors. The LCD market is comparable in size to ECP, and sterling is the predominant currency, but there is significant Euro and USD activity. Our interest was further whetted by the positive experience of other Irish institutions that had begun to issue CDs and the change in the Irish tax legislation regarding deduction of with holding tax.
In mid-2004 we decided to assess the business case for establishing a CD programme. As it was, we were already borrowing sterling and euro from a range of UK banks and building societies, these counterparties would initially form the foundation on which a programme would be based. Therefore it was reasonable to ask why change what we are currently doing? In talking to other issuers and investors we found a number of reasons why limiting ourselves to uncommitted bank borrowing and ECP was not desirable:

Issuing CDs diversifies funding to a wider range of investors, including banks, building societies, asset / fund managers, insurance / assurance companies. The flexibility and liquidity of CDs was cited as the main reason for their popularity as a cash management tool.

Due to UK regulatory requirements regarding liquidity many UK lenders will not lend funds on an uncommitted deposit basis for periods greater than even 1 month. In comparison CDs could regularly be issued for periods out to 6 months.

Many institutions stated that they would review credit lines in the event that we established an LCD programme.

Taking all these factors into account we decided to proceed and establish a programme.

Q. How is your programme performing to date?

John Whelan, Treasury dealer, EBS: Thusfar the performance of EBS’ CD programme has been very satisfactory and has fully achieved our objectives with regard to a cost efficient means of diversifying our short term wholesale funding base. sterling and euro account for over 80 per cent of deal activity with residual interest in USD and CHF. The majority of paper has been issued to non bank financial institutional investors such as asset managers, money market funds, banks and building societies account for the remainder. As one would expect investors are predominantly domiciled in the UK however we have also seen a number of Paris based fund managers participate. Our range of distribution channels for issuing CDs has been quite broad based with good success in selling on a direct basis, using money market brokers and investment bank credit sales desks. Certificates of Deposit have quickly established themselves as an important addition to our funding capability, we anticipate the programme will continue to go from strength to strength and are looking at other customer segments which would welcome the advantages CDs offer versus traditional cash deposits.

John O’Farrell: We are very pleased with the performance of our CD programme to date and we consider it a vital tool in our overall funding strategy.

Q. What new types of CDs are emerging – eg callable notes/index-linked notes etc?

John Whelan: Based on the increased popularity of structured investments we would expect that the market for structured CDs will develop in the near future. In particular, investors in structured deposits should be attracted to the additional benefit of holding a tradeable security due to liquidity considerations. Again, we believe it is essential that in order for this market to grow, issuers will have to be responsive to investor’s requirements and tailor their offerings accordingly.

John O’Farrell: The main one we have noticed recently is eonia linked CDs.

Christopher Amott: Established London based issuers and investors are becoming increasingly interested in instruments with some traits that are usually associated with medium term notes. During the latter part of 2004 and through 2005 there has been increasing appetite for issuing and investing in callable, index linked and floating rate notes. As a percentage of the overall market size these diverse instruments are small beer although the total outstandings has experienced marginal growth over the last 18 months. Due to the short term nature of the CD market, (the vast majority is less than three months to maturity) significant growth is not expected in the future, however index linked floating rate and callable notes do offer the issuer the ability to deal longer dated paper without the added costs of managing maturity rollovers and eliminates the market risk associated with issuing longer dated paper at fixed rates.

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