Treasury Securities- What are they?
For a beginner, they’re just another type of bonds. In my current world, I don’t deal with the pricing or yield measurement of these beautiful instruments. But reading about them along with material on settlements will do no harm. Since I deal with settlement of all securities that are eligible to settle in Fedwire (yes, not just the US treasury securities), I will explain about the Fedwire, the securities that settle therein and dig further till the shovel can dig.
So, what is the Fedwire all about?
Fedwire is a real-time gross settlement system (RTGS) of the Central Bank money (no brownie for you for guessing it’s the Federal Reserve!) used by Fed Reserve banks in USA to settle securities and final payments in U.S. dollars electronically between its member institutions.
Owned and operated by the 12 Federal Reserve Banks, the Fedwire is a networked system for payment processing between the member banks themselves, or other Fedwire member participants. Members can consist of depository financial institutions in the United States, as well as U.S. branches of certain foreign banks or government groups, provided that they maintain an account with a Federal Reserve Bank.
Now let’s make that simpler still if you wish! Let’s focus on important points to take away from the above that should give you a clearer picture:
1. Fedwire is a system used to settle securities and also for inter-member payments.
2. What settles in Fed? - US Treasury bills, notes and bonds (though I am not so sure how many bonds you’d come across!), federal agency securities and Foreign government bonds.
3. Who can trade in fedwire? – You gotta be a member dude! Now here I need a little elaboration.
Members can consist of depository financial institutions in the United States, as well as U.S. branches of certain foreign banks or government groups, provided that they maintain an account with a Federal Reserve Bank. (FRB- I have a penchant for acronyms!)
Me: Hey, the FRB is the central bank of USA.
You: Right mate! So by default, a US bank becomes a member and can settle in Fedwire.
Me: What if I am Reserve Bank of India?
You: Well, you will have to open an account with the Federal Reserve directly.
Me: And what If I am Deutsche Bank Frankfurt?
You: You can open an account with any of the federal reserve bank members (BONY, JP Chase, Northern Trust, State Street etc.). Enough questions! Shoo off!
There’s another key learning above for ya fellas. You may deal, as I mentioned, less with pricing or trading of these beauties and more with their settlement if you ain't a big gun. So you will often come across Settlement details or SSI like below:
ABA 021000018 Bank of NYC/RAMM ABA 0210 Federal Reserve Bank/RBI
ABA 021000021 CHASNYC/CUST/PXXXX ABA 0210 Northern Trust/TRUST/17-XXXXX
It is important that you understand these minute details pertinent to settlement before you go on to master the securities themselves.
The ABA that you see in every SSI is nothing but the American Bankers Association Number. It is a unique number every bank has.
Me: So one bank can have only one ABA?
You: Does the word unique mean anything to you? Yes, ONLY one ABA for a bank. So 021000018 is always representative of Bank of NYC. In an Indian context, think of the nine digit MICR number that you see on your cheques.
Me: So why do some banks have accounts with Bank of NYC and Jp Chase instead of directly having an account with Fedwire.
You: Duh! All Central Banks of the world will have direct Fed relations (though you may have an exception. Generally, people prefer to participate through existing members like BONY/CHASE/NTRS. Enough for today!
Now for the real game- We will look at all securities that settle in Fedwire one by one- Security structure, key features you ought to know and also gyaan on reasons they are traded for, apart from pure profits of course.
US Treasury Securities are direct obligations of the U.S. Govt issued by the Dept. of Treasury, and hence, considered free of credit risk. Now, assuming you have a fair background of fixed income terminology, Treasury securities are either discount or coupon securities.
Me: Discount notes? Fed gives a discount when they sell the notes?
You: Don’t get cheeky! But yes, Fed sells them at a discount to par; say @ $98. The Fed doesn’t pay any interest on these secs.
Me: What? Why buy them? What if its value falls?
You: That’s blasphemous! You are challenging the might of US financial authority! Well, but Fed redeems the securities at par. So technically, you buy at 98 and sell at 100.
Me: Whoa! Not bad! A neat 2% profit!
You: 2.041% approximately-it’s 2/98 remember?! Well, not so important. Just remember disc notes are sold at a discount( though they may trade at a premium to par in the secondary market subsequently) and have no coupons. The Coupon secs obviously pay coupons- twice a year!
The Treasury secs can be bonds/ notes or bills. Bills are the short term secs, notes are medium term and bonds the long term secs. Just some extra gyaan for you: The fed no longer issues long term bonds; they stopped doing that in October 2001 (This I believe is in the best interest of the financial market as a whole!). You will see Bonds still beng traded, these are the ones issued prior to October 2001.
You will also see Treasury Inflation Indexed/Protected Secs or TIPS- the only difference with the TIPS guys is that their principal is adjusted to account for CPI based Inflation; coupons are paid based on this adjusted principal and finally adjusted principal is paid on redemption.
Why trade These Treasury Secs in the first place?
This should be the first question in one’s mind. What makes these securities even attractive to trade? Every security is traded for broadly two purposes: Risk hedging and Return maximization. You need at least one reason; I’ll give you two! You may recall that Treasury secs have the full faith and backing of the U.S. Govt and hence risk free (People’s Bank of China may beg to differ!). This provides the security with ample liquidity in the secondary market. Apart from making profits on pure cash trades, Treasuries are used as a hedge against other volatile securities.
The trading takes place at the three main trading centres- Tokyo (with the thinnest volume), London and NY (You guessed it! NY has the largest volume of all the three!). Remember, settlement, however, will happen during NY hours, as the Fedwire is an RTGS.
It’s not uncommon to see huge volumes in Treasury securities. There are different reasons for different buyers to delve into the world of Treasury Securities. Locally, the treasury securities are exempt from local and federal taxes. Thus, there is an incentive for domestic banks and FIs to buy the Treasuries. In fact, all countries’ banks generally hold a certain amount of their reserves in the form of Central Bank’s paper.
Me: Why would banks park funds in Treasury paper instead of lending in the market? Treasuries don’t sure provide such good return!
You: You are right! Treasuries are not high return investments as they by nature are liquid and safe. First, Banks need to hold some of their assets in the form of Central Bank Paper (It happens in India too buddy! Just check out RBI website or annual report of any Indian bank). But above that, When fed lowers rate, bank may or may not lend. As of early October 2010, despite the Fed lowering the rate, banks are mopping up Treasury Securities and gold instead of lending to the market. Even the market is hesitant to borrow. So you see Treasuries and Gold both going up; a rarity!
Me: Jahanpanah! Tussi Great ho!
You would find a plethora of Central Banks around the world too buying chunks of US Treasuries. Just a brief detour to help you understand the entire business better. You sure would have heard of Forex Reserves and all the hoopla around it. The stupid media- ET or FT, doesn’t matter!- touts countries with better Forex reserves as macho countries and vice versa, without even an understanding of it!
While Forex reserves are not really a big thing and a country like India having lower Forex Reserves than China is not really a problem as projected by the media, it is another argument altogether. What is important for you to know is what these Central Banks do with the accumulated Forex Reserves. Let us take China-US example (it’s also current and relevant to ongoing debates- free advice hai, lena hai toh lo, varna rehne do J )
Chinese Exporter sells to US Importer. Importer pays in USD for the goods, thus earning "precious" Forex for China. (note that the Chinese Central Bank still has had no role in "creation" of these assets.
The above leads to extra foreign currency, which if not absorbed by the Chinese Central Bank, The exporter will not be able to make payment to his employees in Yuan Renminbi or the CNY (demand supply economics)
Why am I telling you this?
Because this extra forex mopped up by Chinese Central Bank will be deployed to buy Foreign currency assets: US Treasury Securities, Agency Issues etc. Just an FYI, China and Japan happen to be one of the largest holders of US Treasury securities.
Now you know why Central Banks around the world hold Treasury Securities. Now, for those who love this business, just want to add a point you may have already had an intuition about- If any day, dollar losses increase or the financial world perceive the dollar as a weakening currency and consequently think the US govt may, just may not be able to repay its huge public debt that is sitting on the central bank’s books, they (central banks holding the US Paper) will dump Treasuries and move their capital out of the U.S and move to something else; may be gold, may be silver, maybe Euro Bonds (If Greece is no longer a problem child then ).
We will see more on terminologies surrounding the securities, in particular price quote conventions that scare the hell out of people. Also coming up is How the repo market functions, and how it is used in US Treasuries market. Keep reading Nonsensexrules.blogspot.com
