4.      FINANCIAL ASSETS AND INSTRUMENTS   

 

The history of finance can also be understood in terms of the development of financial assets, instruments and payment. Financial assets and instruments can be classified in various ways. Payment provides for the transfer of cash or currency directly or for the transfer of funds through a financial intermediary using another payment instrument. Payment instruments were originally developed to avoid the difficulties that arose with the transportation of heavy coin and specie with its possible loss through theft or piracy. The three most important early instruments were promissory notes, bills of exchange and cheques. Each of these is considered further below. Payment can also now be made in an electronic form such as through a debit card (which provides for the direct transfer of funds from one account to another) or credit card (which includes a loan or credit element) or some form of digital money or card (with monetary value having been loaded on and recorded on the card itself).

 

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All types of financial rights, assets, instruments or contracts may be dealt with on financial markets. Financial rights include both financial assets (property with an inherent value) and financial claims (payment obligations). Financial assets principally consist of coinage and banknotes along with financial instruments. Financial instruments are strictly chattels (personal property) that embody a payment obligation and principally include negotiable instruments (promissory notes, bills of exchange and cheques) as well as certificates of deposits and bonds. These are referred to as ‘documentary intangibles’ to payment of money. Specific types of negotiable instruments in the form of cheques include bankers’ drafts and traveller’s cheques with bankers’ acceptances being accepted bills of exchange.

 

Financial instruments can be distinguished from documents of title to negotiable securities (including shares, bonds or notes) which are bought documentary intangibles. These are again distinct from pure claims or payment obligations (principally loans or advances) and other types of contracts that provide for payment on a contingent or non-contingent basis (including insurance contracts). The total stock of financial assets can also be considered to include gold and foreign exchange, which are strictly commodities of investment assets, and other payment structures, including principally financial derivates and structured finance instruments. All of these may collectively be referred to as financial assets or instruments although the term instruments strictly only applies to documentary intangibles to the payment of money, including principally negotiable instruments.

 

(1)    Coinage and Currency

 

Legal money can be considered to consist of coinage and bank notes. Wider concepts of money may also include bank accounts or accounts with other financial intermediaries with other forms of electronic or digital money also being available which are considered further below.

 

(i)   Coinage

 

Metal coinage is still produced under authority of the state for low denomination payments. This is a form of representative money with the coins being stamped and authenticated to show their legal value. These constitute legal tender to the extent provided for under local law. They no longer have intrinsic value as commodities or commodity money as with earlier silver or gold coinage. UK coins are issued under authority of the Royal Mint.

 

(ii)  Banknotes

 

Banknotes are issued under authority of the monetary sovereignty of the state or sovereign. These are most often issued through the central bank as agent on behalf of the state or sovereign. These are in law negotiable instruments in the of form promissory notes (below) which constitute a promise by the central bank to pay the bearer the sum specified. These formerly operated on a representative basis and were exchangeable for an underlying amount of specie, either in the form of silver or gold. Modern notes are no longer convertible into specie and are issued on a purely fiat or fiduciary basis. These were historically issued by private banks with the notes , me being transferred for less than face value (discounted) depending upon the credit standing of the issuing institution. Issuing powers have since almost exclusively been reserved to the national central bank which acquired monopoly rights. The value of these notes is further confirmed with legislation making them legal tender which means that payment obligations can only be discharged using designated monopoly issued state notes. As these are no longer convertible into or backed by specific gold or other specie, their value depends solely on the credit standing of the issuing central bank and state.

 

(iii) Foreign Exchange

 

Foreign exchange or foreign currency is strictly not money and only legal tender in its country of issuance. Outside the country of issuance, it is only a commodity with its value being expressed in terms of its exchange rate volume with other currencies and as agreed by the parties purchasing and selling them at any time.

 

(iv) Certificates of Deposit (CDs)

 

Certificates of deposit are receipts evidencing underlying deposits of money (coinage or banknotes) with a bank or other depository institution. These are issued in the form of a transferable certificate which allows them to be separately traded as a security. Certificates of deposit in the UK are issued under special regulations published by the Bank of England.

 

(v)  Account Credits

 

The most important types of financial claims are claims and loans in the form of account credits advanced by depository institutions, including specifically banks and building societies in the UK, savings and loan institutions in the US and similar entities elsewhere. Such institutions on-lend deposited funds which create new ‘bank money’ in the form of account credits or transfers with other institutions. This can be considered to amount to the creation of new money (in the form of account balances) through a ‘credit multiplier’ effect the amount of which is only limited by central bank reserve and regulatory liquidity and capital requirements. This often represents the largest stock of money in any economy. The different types of money available (including coins, notes and credit balances) are reflected in the different monetary aggregates used (such as MO, M1, M2, M3 and M4 and MB).  

 

(2)    Credit and Payment

 

Payment can either be made through the direct transfer of coins or notes or through the indirect issuance of instructions to financial institutions to make payment on the payer’s behalf. This has historically principally involved the use of paper instruments with the most common devices being negotiable instruments in the form of promissory notes, bills of exchange and cheques. Payment instructions can now be issued in various ways and monetary amounts transferred through a number of electronic and digital means.

 

(vi) Promissory Notes

 

Promissory notes are written undertakings by one party to pay the holder or bearer of the note the amount specified either on demand or on an agreed future date. These constitute one of the three main forms of negotiable instruments historically with bills of exchange and cheques. These were issued in the UK under the Bills of Exchange Act 1882 with similar legislation in other Commonwealth countries and in the US.

 

 

 

(vii)         Bills of Exchange

 

Bills of exchange are tripartite payment obligations used to settle trade accounts. Historically, one merchant (the drawer) would direct another to whom the first merchant was owed money (the drawee) to make payment to another party (the beneficiary) either on demand or at a future specified time. The English law on bills was codified under the Bills of Exchange Act 1882 which set out the conditions for the legal use and discharge of bills. Bills were the most important means of domestic and cross-border payment for hundreds of years until cheques became more commonly used after World War II and then electronic forms of funds transfer and payment were developed more recently.

 

 

 

(viii)        Cheques, Travellers Cheques and Bankers’ Drafts

 

Cheques are specific types of bills of exchange with the payer drawing the bill on his or her bank as payee. Banks generally provide their customers (drawers) with a number of pre-printed bills (cheques) that allows them to make payment to third parties (beneficiaries) by directing the originating bank (as drawee) to make payment on receipt. These were again dealt with under the Bills of Exchange Act 1882 in which a cheque is defined to constitute a bill of exchange drawn on a bank. Extended clearing systems have been set up in most countries to provide for the processing and settlement of payment obligations through cheques in light of their large volume of usage for business and retail purposes. These have become of less importance more recently with the development of debit and credit cards and other electronic forms of payment. A number of countries, including the UK, have announced that they are considering abandoning or restricting the availability of cheques for this reason.

 

Travellers’ cheques are specific types of cheques designed for use on a cross-border basis issued by an entity that will undertake to make payment in a specified currency on receipt.

 

Bankers’ drafts are particular types of cheques issued by banks drawn on themselves. The amounts will have been debited from customer accounts on customer instruction for a fee. The objective is to guarantee payment on the draft with the use of the bank as drawer and drawee which effectively adds the credit standing of the bank to the cheque.

 

 

(ix) Bankers’ Acceptances

 

A bankers’ acceptance is a bill of exchange that has been signed or stamped by the bank to confirm its acceptance of the obligation to make payment under the bill. This adds the credit of the bank to the bill which effectively makes it as good as cash in practice. The accepted bill can then be sold to another institution, including specifically a discount house, which will pay on the bill less a discount calculated with regard to the interest due on the residual time before payment is obliged to be made on the bill. As has been discussed, bills of exchange in international trade were commonly sent back to London with specialised banks developing as Accepting Houses, to accept bills, which could then be sold to other specialised banks, acting as Discount Houses. International bills of exchange were often issued on standard London terms which were referred to as ‘Bills on London’ which was a key form of payment instrument in international trade.

 

Discount houses would later emerge as a small group of specialised banks with which the Bank of England would deal in making funds available in the primary money market. The Bank would purchase instruments issued by the Discount Houses which would put them in funds which could then be on-lent to other banks within the financial system. This was referred to as the Discount Market. This was subsequently extended to include a larger range of institutions beyond the Discount Houses with the Bank of England now generally operating on sale and repurchase (repo) terms. The rate at which the Bank would deal with the Discount Houses (the ‘bank rate’) would then become the minimum base rate for the financial system with the Houses on-lending to the commercial banks at bank rate plus a margin.

 

The rate at which banks in London would then lend to each other became known as the London Inter-bank Offered Rate (or LIBOR) which is still set through the British Banker’s Association (BBA) with reference to a selected group of banks operating in London.[1] Similar rates have been introduced in other markets which operate on similar terms, such as Euribor.

 

(x)  Electronic and Digital Money

 

Electronic money generally operates through the passing of payment instructions to move underlying amounts of money, which usually exists in the form of account credits, through electronic means. This can be considered to include debit and credit cards as well as internet or telephonic (mobile phone) account management software. Digital money uses electronic storage devices to hold records of money amounts that have been credited to the device and are then available for onward transmission. In both cases, electronic means are used to hold or transfer existing monetary amounts or values with no new separate types of money being created.    

 

(3)    Public Debt

 

Government or public debt can either be issued in the form of shorter duration instruments for monetary policy purposes or longer term borrowing and debt management. Short-term instruments are usually referred to as bills or notes and longer-term instruments referred to as bonds. Specific types of instruments may also be issued in particular countries such as ‘Gilts’ in the UK (below).     

 

(xi) Government Bills

 

Bills are short-term debt instruments issued on behalf of the finance ministry or government for money market purposes. Treasury bills are issued by the Bank of England in the UK money market. Money market instruments generally have a duration of less than one year with bills generally either being issued for 91 or 182 days. The bills are issued on a tender basis with the issue being underwritten by the Discount Houses.

 

(xii)         Government Bonds and Gilts

 

Bonds are longer-term debt instruments issued on behalf of the government for debt management purposes. These are transferable debt obligations issued in a security form to allow secondary trading. They generally attract an interest payment which was formerly paid on presentation of a coupon attached to the bond. The bills may alternatively be issued at a discount to their face (par) value with an equivalent amount of interest being paid when the bonds are redeemed at full price. UK bonds are referred to as ‘gilt-edged’ securities due to the former gold edging on the certificates. These may either be issued for under five years (short deals), 5-10 years (medium) or over 10 years (longs). Issuance is now managed through the Central Gilts Office (CGO). US public debt is either issued in the form of Treasury bills (up to one year), Treasury notes (1-10 years) or Treasury bonds (over 10 years).

 

Government bond markets are now among the largest in the world due to the size of government deficits which rose substantially following the crisis in financial markets in 2007-2008. This has require that special lending facilities be set up to support particular countries, such as Greece, Ireland and Portugal within the Euro zone, with other countries have to agree special budgets to avoid breaching debt limits, such as the $1.3 trillion ceiling in the US. A Euro 750 billion European Financial Stability Facility (EFSF) and European Financial Stabilisation Mechanism (EFSM) was set up in March 2010 under Article 122 of the EU Treaty[2] to be replaced by a more permanent euro 500 billion European Stability Mechanism (ESM) from 2013.        

 

 

 

(4)    Corporate Securities

 

Corporate bodies can raise funds through the issuance of either debt instruments, in the form of bonds or debentures, or various forms of shares or equity instruments.

 

(xiii)        Corporate Bonds and Shares

 

Corporate securities may either be issued in the form of bonds (debentures) or shares (equity). Corporate bonds or debentures are the same as government bonds and simply constitute payment obligations issued in a transferable form with an interest payment attached or with the bonds being issued at a discount.

 

Shares constitute a proportionate interest in the equity or share capital of a company. Companies are divided into a specific number of shares (UK) or common stock (US) with shareholders owning a proportionate interest in the company as a whole. Shareholders have a right to receive a dividend payment (rather than interest) and have other associated information, reporting and voting rights over the activities of the executive board and the company as a whole. The nominal share value of the company and its share structure will be set out in its Memorandum of Association. Different types of shares may be issued, such as ordinary shares or preference shares (including participating or non-participating, fixed or variable and cumulative or non-cumulative) and exchangeable or convertible shares.

 

Bonds and shares may be issued with warrants which entitle the holder to acquire a further specified number of bonds or shares on specific conditions (above).

 

(xiv)        Depository Receipts

 

Shares may be deposited with a custodian in exchange for a transferable certificate in the form of a depository receipt (above). These are the equivalent of certificates of deposit for money balances. The receipts are fully transferable as independent securities which can avoid sales and distribution restrictions that would otherwise apply to the underlying shares. Depository receipts include American Depository Receipts (ADRs), Global Depository Receipts (GDRs) and European Depository Receipts (EDRs). ADRs can be cleared through the US Depository Trust and Clearing Corporation (DTCC in New York).[3] The DTCC was created in 1999 with the merger of the Depository Trust Company (DTC) and National Securities Clearing Corporation (NSCC).

 

(5)    Risk and Investment Assets

 

A number of basic as well as more specialist types of instrument have been developed for separate risk management as well as possible investment purposes. The most simple of these is a forward contract which provides for settlement at a subsequent date although other more complex products include financial derivatives and structured finance instruments. Credit derivatives have been developed more recently which provides cover against credit or counterparty before on underlying contracts. Credit derivatives were also commonly used in the structured finance market which created new combination products. Loss can also be managed through the taking our or purchase of insurance cover while other types of assets or commodities, including gold and art, can be used for investment purposes. 

 

(xv)         Forward Contracts

 

A forward contract is a contract that provides for completion or settlement of a purchase at an agreed subsequent date and price. This is distinct from a spot contract which provides for immediate settlement. Many financial derivatives developed out of simple forward contracts in the agricultural or commodity areas.     

 

(xvi)        Financial Futures

 

A future is a form of financial derivative that constitutes an obligation to purchase (or sell) a specified item at an agreed future date and price. These are generally issued in standard terms and dealt with on recognised exchanges. These may also be issued in a purely electronic form. The main futures markets developed in the US following the collapse of the Bretton Woods system of managed currency arrangements and new levels of currency and interest rate risk that arose. Futures developed out of earlier foreign exchange forwards.

 

(xvii)       Financial Options

An option is a financial derivative that provides the right or election to buy (or sell) a specific item at a future agreed date and price. This is effectively a form of a voluntary future with the exercise right being purchased in return for a premium payment. These are again generally issued on standard terms on exchanges although OTC contracts may also be entered into.

        

(xviii)      Swaps

 

A swap is an exchange of payment obligations between two counterparties. This may either be used for currency payments or interest rate (fixed or floating) payments or be tied to other equity or commodity obligations. Currency swaps involve simple exchanges of agreed currencies. Payments are calculated on the basis of notional amounts which are multiplied by the specified reference rate on each due settlement date.

 

(xix)        Total Return Swaps (TRSs)

 

A total return swap is a specific type of credit derivative. This provides for the transfer of payment obligations in the event of a specified credit event arising. Payments are then passed through under the TRS contract.

 

(xx)         Credit Default Swaps (CDSs)

 

A credit default swap is a more sophisticated form of credit derivative with the purchaser buying credit protection in the event of the credit event arising. Payments are then only made on the specified event arising. This acts as a form of credit insurance.

 

(xxi)        Credit Spreads Swap (CSS)

 

A credit spread swap is a more specialist type of credit derivative that provides for the payment of an amount equal to the difference in the credit spreads involved between the parties, instruments or contracts  in the event of the credit event arising.

 

 

 

(xxii)       Credit Linked Note (CLNs) and Repackagings

 

Credit linked notes are specific types of securities that incorporate a credit derivative (usually a CDS) to provide credit protection or support. These are effectively integrated or combined notes and credit derivatives. These emerged out of earlier repackagings that arose where older lending structures, using more traditional instruments such as longer fixed bonds, were restructured using more modern instruments to provide additional funding and repayment flexibility at lower cost with higher ratings and improved investment profiles for institutional investors.

 

(xxiii)      Collateralised Debt Obligations (CDOs)

 

A collateralised debt obligation (CDO) is a generic term for any type of security made up of a securitised pool of underlying securitised assets. Securitisation arises where an underlying pool of credit assets, such as a number of receivables, credit card or student loans, are transferred to a special purpose vehicle (SPV or Special purpose entity (SPE) or special purpose corporation (SPC) in the US). This is paid for through the issuance of new bonds, notes or commercial paper by the SPV. The underlying credit pool is in this way converted into a new set of securities or capital market instruments. Securitisation developed in the US in the 1970s and was commonly used to transfer bank-based forms of credit to the capital markets which increased liquidity and investor returns.

 

Structured finance is distinct from securitisation in that it provides for the secondary securitisation, or ‘re-securitisation’, of the income streams from underlying securitisations rather than their original credit assets directly.  CDOs are then created by re-securitising the notes, paper or bonds issued by the separate underlying SPVs. Common forms included collateralised mortgage obligations (CMOs), collateralised loan obligations (CLOs) and collateralised equity obligations (CEOs). The ultimate CDO SPV generally issued a number of different types of securities through tranches with different payment and risk profiles which corresponded with the different investment and return needs of institutional investors. Complex structures and documentation issues arise due to the large number of underlying credit pools involved and their separate securitisation and then re-securitisation within the larger CDO structure.

 

One of the core objectives of structured finance products is to ensure that the various tranches of securities issued by the CDO SPV are highly rated by credit rating agencies (CRAs) to allow them to attract investor interest. This was a key factor in the global financial crisis in that many instruments were incorrectly rated and then downgraded which forced prices to drop even more substantially during the 2007-2009 phase of the financial crisis. Rating errors arose where the CRAs had failed specifically to include sufficient data on possible housing price falls and on correlation effects (where separate markets and prices move in parallel). Complexity and the associated lack of transparency were also important factors which lead to the collapse in confidence in the structured finance market more generally during 2007-2009. While many CDOs only included between 1-3% sub-prime debt and should therefore have fallen in value by a corresponding amount, they had to be  marked down by much larger multiples and ultimately to only around 25-35% of their original value or less.      

 

(xxiv)      Insurance Policies

 

Insurance policies are contracts providing for the payment of either lump sums or income streams in the event of defined event arising. These may either be entered into on a contingent (non-life) basis, including car, fire, accidental damage, injury or professional cover insurance, or a non-contingent (life) basis, such as on retirement or death. Policies are purchased in exchange for premia payments made by policy holders on either an initial one-off or continuing regular basis. These funds are invested by the insurance company in other securities and capital market instruments to generate a sufficient return to cover ongoing payment liabilities created. Insurance companies (including pension and life companies) are among the largest institutional investors in the world in light of the accumulated amount of premia invested in stock markets and exchanges for investment purposes over a large number of years.

 

(xxv)       Gold, Specie and Commodities

 

Following the abandonment of convertibility of banknotes into gold during the early 20th century, gold is strictly only a commodity now unless it is separately issued in the form of gold coin and included within the definition of legal tender under particular country laws. It can still be considered to constitute an investment asset to the extent that it is held for return purposes as it can hold and increase in value over time. Investment assets may include all possible property items, including gold, oil, minerals or metals and other commodities as well as commercial or residential property, which may be purchased for investment purposes. These are not strictly financial assets as they do not provide for any specific money or payment component although they can be considered to constitute different forms of investment asses or wealth more generally. Wealth comprises all financial and non-financial tangible and intangible property items held by a governmental, corporate entity or private individual. Financial assets only constitute one set or sub-category of tangible and intangible property items or assets more generally.

 

[1]        http://www.bba.co.uk.  

[2]        http://www.efsf.europa.eu.

[3]        http://www.dtcc.com/ .