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The Danish Money Market

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The Danish Money Market 19 The Danish Money Market Anders Mølgaard Pedersen, Economics, and Michael Sand, Market Operations INTRODUCTION This article describing the Danish money market and its development in recent years is based on existing statistics for the money market (trading volumes and interest rates), as well as a number of banks' responses to a questionnaire on the Danish money market1. The article follows up on two previous articles in 1996 and 1997 that considered various aspects of the money market2. The introduction of the single monetary policy for the euro area as of 1 January 1999 was a significant change in the external framework for the Danish money market. An integrated money market for the entire euro area was quickly established, with common interest rates and a large share of cross-border transactions. The European Central Bank, ECB, has regularly studied developments in the money market based on questionnaire surveys among market participants3. Where relevant, the article compares the money markets in Denmark and the euro area. The principal conclusion is that the Danish money market is well-functioning, although it is important that participants continue to act responsibly and participate actively in the development of the mar- ket. THE MONEY MARKET The Danish money market is often defined as the market for inter-bank loan agreements and interest-rate contracts denominated in kroner with a maturity of up to around one year. However, the definition is not en- tirely clear, since debt securities with a short remaining term to maturity 1 The following banks contributed to the article by answering a number of questions concerning the money market: ABN AMRO Bank, Amtssparekassen Fyn, Arbejdernes Landsbank, Danske Bank, Handelsbanken, Jyske Bank, Nordea Bank Danmark, Nykredit Bank, Skandinaviska Enskilda Banken, Spar Nord Bank and Sydbank. 2 Palle Duvier Mehlbye and Jacob Topp, Money Market Development, Danmarks Nationalbank, Monetary Review, August 1996, and Birgitte Damm and Anne Reinhold Pedersen, New Money- Market Statistics, Danmarks Nationalbank, Monetary Review, 3rd Quarter 1997. 3 The most recent study is published in The Euro Money Market, European Central Bank, July 2001. 19/06/2002 10:17 Antal sider: 18 Rev. nr. 2 H:\kvo\ENG\2002\2qtr\til tryk\side19-36.doc Oprettet af Michael Sand 20 are often traded on money-market terms. Furthermore, the participants in the money market not only comprise banks, but also institutional investors, mortgage-credit institutes and large business enterprises. The money market serves several purposes, such as the exchange of li- quidity among participants and the management of short-term interest- rate positions. An efficient money market is also an important basis for the securities market. A well-functioning money market is furthermore essential to the clear transmission from Danmarks Nationalbank's official interest rates to the short-term market rates, and is thereby important to monetary policy. The instruments in the Danish money market can be roughly divided into two groups in terms of their initial impact on cash positions. The first comprises cash market products for which the conclusion of a con- tract requires immediate exchange of liquidity. These products include deposits, repo agreements, foreign-exchange (fx) swaps and bonds with a short remaining term to maturity. The second group consists of interest-rate derivatives where liquidity is only exchanged as settlement of interest-rate differences at a fixed time in the future. Interest-rate derivatives include Tomorrow/Next interest-rate swaps (T/N IRS) and FRAs (Forward Rate Agreement). They can be standardised or non- standardised products in terms of maturity, settlement and collateral. Annex 1 gives a brief description of the standardised products in the Danish money market. The cash market products are used primarily for the exchange of li- quidity. Moreover, certain collateralised transactions in the cash market may be driven by demand for the underlying asset. A repo agreement may, for example, be based on a requirement for a specific paper, in which case it is called a "special", cf. Box 1. Interest-rate derivatives are used to hedge interest-rate risks and to actively take market positions in interest rates. Interest-rate derivatives are normally settled in the money market ac- cording to reference interest rates. The most frequently used reference interest rates in the Danish money market are Cibor (Copenhagen Inter Bank Offered Rate) and the Tomorrow/Next interest rate. Annex 2 con- tains a description of various reference interest rates. MARKET PARTICIPANTS AND TRADING STRUCTURE Recent years have seen increased concentration of the Danish money market in term of both participants and marketplaces. After mergers in the financial sector the money market is now characterised by two major players. 19/06/2002 10:17 Antal sider: 18 Rev. nr. 2 H:\kvo\ENG\2002\2qtr\til tryk\side19-36.doc Oprettet af Michael Sand 21 THE SPECIALS MARKET Box 1 A special is a repurchase agreement based on demand for the underlying paper (a specific securities code). Specials thus differ from GC repos (General Collateral) where the main purpose is to exchange liquidity. The lending rate for a special is normally lower than that for a GC repo, since the provider of cash accepts a lower interest rate in return for the specific paper. In practice, it is often difficult to distinguish whether a repo transaction is a special or a GC repo, since it may meet demand for cash as well as for a specific paper. Furthermore, the type of paper will always play a certain role in a repo. For example, the rate of interest for a GC repo with government bonds is typically marginally lower than the rate of interest for a GC repo with mortgage-credit bonds. A large proportion of turnover on the Danish specials market is due to demand for specific securities for the settlement of bond transactions in the spot market. For ex- ample, a bank may have sold a bond that is not in its portfolio so that it needs to ac- quire the bond before settlement. Borrowing the bond in a special gives the bank a little extra time to find a seller of the bond in the spot market. In addition, demand for a securities code in a special can also be attributable to speculation in the price development of the bond. If a bank finds a bond too expensive compared to the rest of the market, the bank can choose to borrow the bond in a special and sell it in the spot market. Should the price then fall, the bank achieves a capital gain when the bond is returned. Such transactions, i.e. selling short, can also be used to hedge the price risk on a bond portfolio for a certain period. In that case the bank will typically prefer to make the transaction in a benchmark bond. The underlying bonds in specials vary over time. Significant criteria are e.g. the amount outstanding and distribution of ownership. If the outstanding amount in a securities code is relatively small and a large proportion is owned by e.g. institutional investors who are less active in the market for securities lending, the paper will often be a special. However, securities which are too difficult to obtain in the market do not trade as specials, since illiquid securities increase the risk in short transactions. Bench- mark bonds are often in demand in specials. This also applies to bonds which are gain- ing status as benchmark securities, but have not yet reached a sufficient outstanding amount. Specials are not covered by the market-maker agreements in the Danish money market. According to market participants the interest-rate differential vis-à-vis GC repos typically varies within 10-40 basis points. Certain government securities, includ- ing on-the-run issues, can also be obtained via the securities lending schemes of the central government and Social Pension Fund that are managed by Danmarks Nationalbank. Loans in these schemes are subject to a premium of 50 basis points, and other government securities are required as collateral. There are no statistics solely covering specials. Danmarks Nationalbank's money- market statistics, cf. Box 2, include data on lending of cash in repos, including specials, by a number of banks. Specials account for by far the largest proportion of such lend- ing for maturities of up to one week, while for maturities of more than 1 month by far the largest proportion is GC repos. Trading in the money market takes place via brokers or directly among the participants. The money-market brokers act as a type of marketplace for the exchange of prices for a number of products. 19/06/2002 10:17 Antal sider: 18 Rev. nr. 2 H:\kvo\ENG\2002\2qtr\til tryk\side19-36.doc Oprettet af Michael Sand 22 The money-market brokers, who are subject to supervision by the Danish Financial Supervisory Authority, provide the best bid and offer prices in the individual products for standardised maturities. With effect from January 2000 the previous two money-market brokers in Denmark merged into one company. This broker today handles most of the broker-based money-market activity in kroner. In addition, several par- ticipants use foreign brokers based in e.g. London or Frankfurt. Most of the trading activity in the money market is via direct contact between the counterparties. This saves broker costs and also provides for trading of non-standardised products, maturities and transaction sizes. In addition to the money market there is the special-term market where major business enterprises and institutional investors can deposit surplus funds with the banks on money-market terms. The only broker in the Danish special-term market discontinued its activities as from January 2000.
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