THREAD
Interbank money markets – the trading of money vs the trading of real goods
And how it links with Islamic banking
Interbank money markets – the trading of money vs the trading of real goods
And how it links with Islamic banking
This market is the lifeblood of any major bank. When Lehmanns collapsed, it was the fact that this market closed itself to them that was the final straw. It literally made them insolvent in a matter of hours.
Also, one of my first roles in banking was a dealer in the interbank markets at UBS – it was hard work, but fun. The most interesting transaction I recall was when I saw a large inflow of over £400mn and discovered that was the bonus pool to be paid out to staff the next day.
Ok, let’s get going.
The participants are all major banks, and cash flows occur in the major currencies (USD, GBP, EUR, JPY etc).
In 2016-17 there were over 30 million transactions, that is 120,000 per day, or over 200 per minute. It is a fast moving market.
The participants are all major banks, and cash flows occur in the major currencies (USD, GBP, EUR, JPY etc).
In 2016-17 there were over 30 million transactions, that is 120,000 per day, or over 200 per minute. It is a fast moving market.
It is not easy to find data on cash volumes traded, however small sizes (under $1mn) are frowned upon, and trade sizes of $100-20mn are common.
Duration – they vary from overnight out to 12 months, though not that many are longer than 3-6 months. Most of the flows are, in fact,
Duration – they vary from overnight out to 12 months, though not that many are longer than 3-6 months. Most of the flows are, in fact,
, less than 1 week.
The majority of market players are banks, however they are widely used by funds too – when funds have excess cash, they will deposit it on these markets. It is less likely that these funds will ask for loans from these markets, however.
The majority of market players are banks, however they are widely used by funds too – when funds have excess cash, they will deposit it on these markets. It is less likely that these funds will ask for loans from these markets, however.
The money market is an Over The Counter market (OTC), meaning the trades are NOT occurring on a centralised exchange. They occur directly between two counterparties.
Why do banks need this market?
Banks do not like to keep excess cash. This earns nothing for them. After they are finished allocating their cash books to the funding of the banks positions and assets (and paying their liabilities), then the excess cash is placed on the
Banks do not like to keep excess cash. This earns nothing for them. After they are finished allocating their cash books to the funding of the banks positions and assets (and paying their liabilities), then the excess cash is placed on the
on the interbank markets, to earn a return – even if it is small.
Similarly, if the bank is “short” cash, rather than go to the capital markets (where lending is normally 1year and longer), they will go to the money markets, and borrow the required amount overnight or for
Similarly, if the bank is “short” cash, rather than go to the capital markets (where lending is normally 1year and longer), they will go to the money markets, and borrow the required amount overnight or for
for one week etc.
Also, banks need to maintain some cash to meet customer withdrawals from accounts. Also needed to fund reserve requirements as part of their regulatory requirements.
Also, banks need to maintain some cash to meet customer withdrawals from accounts. Also needed to fund reserve requirements as part of their regulatory requirements.
If customers fear that banks are not able to meet cash withdrawal requirements, it can result in a “run” on the bank
In addition, they play a crucial role in managing liquidity risk at a bank – banks deliver longer term loans to the customers, but they don’t want to always
In addition, they play a crucial role in managing liquidity risk at a bank – banks deliver longer term loans to the customers, but they don’t want to always
always borrow long term money to fund this (they are more expensive and inflexible). Instead banks will go to the money markets to obtain liquidity on a short term basis.
This has risk – Northern Rock in the UK used this model to fund its mortgage books – it delivered 25 year
This has risk – Northern Rock in the UK used this model to fund its mortgage books – it delivered 25 year
loans to customers, but relied on rolling short term liquidity from the market – when this dried up, it was a disaster.
Now, the price at which these market parties lend and borrow to each other has a profound impact on the pricing of many financial products in the market.
There is no fixed or agreed price for the banks to lend money in this market. If one bank calls another and asks to borrow
There is no fixed or agreed price for the banks to lend money in this market. If one bank calls another and asks to borrow
borrow money, the lending bank will quote an offer rate (the return it wants to lend the money for a given duration). The LIBOR rate (London InterBank Offer Rate) is calculated with reference to these offer rates shown in the money markets.
Of course, these LIBOR rates were the source for significant manipulation and illegal activity for certain banks, who tried to rig the rates.
Around $800trillion (that is $800,000,000,000,000) in derivatives and other products are tied to this LIBOR rate – quite a lot.
There are five major currencies for which LIBOR rates are quoted : USD, GBP, EUR, JPY and CHF (Swiss Franc).
And for seven maturities:
And for seven maturities:
Why don’t banks just keep the cash they need, all the time?
Well, when we manage our own money, we need to make sure we have enough money to spend. We earn money, and ideally spend less than we earn. If we need to borrow, we can – but we try to limit that and do it as
Well, when we manage our own money, we need to make sure we have enough money to spend. We earn money, and ideally spend less than we earn. If we need to borrow, we can – but we try to limit that and do it as
Now, the price at which these market parties lend and borrow to each other has a profound impact on the pricing of many financial products in the market.
There is no fixed or agreed price for the banks to lend money in this market. If one bank calls another and asks to borrow
There is no fixed or agreed price for the banks to lend money in this market. If one bank calls another and asks to borrow
borrow money, the lending bank will quote an offer rate (the return it wants to lend the money for a given duration). The LIBOR rate (London InterBank Offer Rate) is calculated with reference to these offer rates shown in the money markets.
Of course, these LIBOR rates were the source for significant manipulation and illegal activity for certain banks, who tried to rig the rates.
Around $800trillion (that is $800,000,000,000,000) in derivatives and other products are tied to this LIBOR rate – quite a lot.
There are five major currencies for which LIBOR rates are quoted : USD, GBP, EUR, JPY and CHF (Swiss Franc).
And for seven maturities:
And for seven maturities:
Why don’t banks just keep the cash they need, all the time?
Well, when we manage our own money, we need to make sure we have enough money to spend. We earn money, and ideally spend less than we earn. If we need to borrow, we can – but we try to limit that and do it as
Well, when we manage our own money, we need to make sure we have enough money to spend. We earn money, and ideally spend less than we earn. If we need to borrow, we can – but we try to limit that and do it as
infrequently as possible.
So why do banks happily execute millions of transaction of lending and borrowing all the time?
The best way to understand this is to examine the actions of a genuine trader in say, tables. He will need to maintain a stock of tables in his shop, so
So why do banks happily execute millions of transaction of lending and borrowing all the time?
The best way to understand this is to examine the actions of a genuine trader in say, tables. He will need to maintain a stock of tables in his shop, so
so people can see them and buy them. So he wants quite a wide stock available to show. However, he is limited by how much stock he can have. Firstly, limited by space. Second, limited by funds. He does not want to invest every penny he has in tables.
Why? Well, he has bills to pay. How can he make cash payments if he has put all his money into stock. Secondly, it is a bad idea to have too much stock. Maybe he finds out he cannot sell them all, what does he do? He has to reduce the price, and find another trader to buy
them from him, and he may make a loss. Also, trends change – maybe his stock may go out of date.
So he will carefully manage his stock with reference to
1)Floor space available
2)How much of his funds he wants tied up in stock
So he will carefully manage his stock with reference to
1)Floor space available
2)How much of his funds he wants tied up in stock
3)How quickly he sells his stock
4)Remain flexible to adapt to changing demands
This is all common sense.
Now, banks do the same, but their stock of trade is CASH, it is money. They trade money.
4)Remain flexible to adapt to changing demands
This is all common sense.
Now, banks do the same, but their stock of trade is CASH, it is money. They trade money.
They want enough money to meet their payment requirements, but not more than that. And if they are short of cash, they can borrow it on the money markets. Equally, if they have excess cash, they place it with someone else who is short of cash.
And this cash, like tables, has a price associated with the buying and selling of it. This price is interest, or LIBOR. As more people demand money, LIBOR can rise, and it can fall if demand falls.
LIBOR reflects the age old rules of demand and supply – of MONEY.
LIBOR reflects the age old rules of demand and supply – of MONEY.
Interest is the price of money.
What does this mean - it means that if someone is trading money, they will be very careful on what interest they charge, and what interest they pay. This is where the Bid and Offer comes from.
What does this mean - it means that if someone is trading money, they will be very careful on what interest they charge, and what interest they pay. This is where the Bid and Offer comes from.
The bid is what one party is willing to pay (as interest) to someone who wants to deposit money with them, and the offer is the interest they want if they place money with someone else. When a market is liquid (ie lots of participants, and lots of cash flows) then difference
difference between the bid and offer is small. The bid-offer spread in money markets is small and is often 1/8 percent.
How does this link to Islamic banking? - it is very simple. If a bank is trading in money, it WILL price money at interest.
How does this link to Islamic banking? - it is very simple. If a bank is trading in money, it WILL price money at interest.
. If it gives you a loan, it WILL charge interest – as much as it can. If you place a deposit with the bank, it WILL pay you interest (as little as it can). This spread is clear profit for the bank.
Investing outside of this debt market means that the interest rate is no longer
Investing outside of this debt market means that the interest rate is no longer
longer that relevant. It is still quite important as a frame of reference. If you want to invest in shares, you want the return to be higher than the interest rate you can get on a deposit (because equity risk is much higher than bank deposit risk).
Your return here will be the performance of the shares.
If you invest in a business, you will get a return based on the performance of that enterprise.
If you invest in a business, you will get a return based on the performance of that enterprise.
Now, if you are buying something and the price of that asset is priced at a reference to an interest rate, or LIBOR, or any time value of money, then what is happening is that you are paying interest on a loan given to you.
Look at the kind of instruments that use LIBOR for pricing:
They are all types of loans, and all charge interest.
If you get money now, and pay more back later, this is interest.
They are all types of loans, and all charge interest.
If you get money now, and pay more back later, this is interest.
. The actual form of delivery can include an asset (like Murabaha, or ijara), but if the price you pay back, above the financed amount, is calculated with reference to interest, then this is a loan at interest.
And if this repayment has a strict repayment schedule
And if this repayment has a strict repayment schedule
schedule (eg monthly, or in full at maturity), this is another clear indication this is interest. When you make a real investment, and real profit from trading, you have no clue how much profit or loss you can make in the future
or when it will occur. Only debt and interest can provide this certainty.
There are many other interesting points that arise from this analysis, including actually how LIBOR is calculated and how it works, what the implications are, and why banks have been trying to rig LIBOR in their favour. I can cover that in a future thread.
SUMMARY
Banks trade money (lend and borrow) like a furniture seller trades his chairs and tables. The price of money is an interest rate (bid or offer). Profit is made from variance on this LIBOR rate.
Islamic banks trade money at LIBOR or interest.
/THREAD
Banks trade money (lend and borrow) like a furniture seller trades his chairs and tables. The price of money is an interest rate (bid or offer). Profit is made from variance on this LIBOR rate.
Islamic banks trade money at LIBOR or interest.
/THREAD
