Chapter 5 - Other Markets and Investments

Cash Deposits, Money Markets, Property and FX

What are cash deposits?

Nearly all investors keep at least part of their wealth in the form of cash, which will be deposited with a bank or other savings institution to earn interest.

Cash deposits comprise accounts held with banks or other savings institutions, such as building societies.

They are held by a wide variety of depositors, from retail investors, through to companies, governments and financial institutions.

What are the main characteristics of cash deposits?

• The return simply comprises interest income with no potential for capital growth

• The amount invested (the capital) is repaid in full at the end of the investment term or when withdrawn.

What are the types of accounts?

Some accounts are known as instant access and the money can be withdrawn at any time, other accounts are for a fixed term of a year or more, while others require notice to be given before monies can be withdrawn.

What interest rates are paid on deposits?

The interest rate paid on deposits will vary with the amount of money deposited and the time for which the money is tied up. Large deposits are more economical for a bank or building society to process and will earn a better rate. The rate will also vary because of competition, as deposit-taking institutions will compete intensely with one another to attract new deposits. Any interest received is liable to income tax, but is now paid gross (without deduction of tax) to investors.

What changes were made to tax and deposits in 2016?

Until April 2016, interest used to be paid net of tax as deposit-takers were required to deduct tax before it was paid to the depositor and then account for the tax to HM Revenue & Customs (HMRC).

From April 2016, however, there has been a new personal savings allowance to remove tax on up to £1,000 of savings income for basic rate taxpayers, and up to £500 for higher rate taxpayers.

As part of this change, since April 2016, banks and building societies have been required to stop automatically taking 20% in income tax from the interest earned on non-ISA savings.

What are the advantages of investing in cash?

• One of the key reasons for holding money in the form of cash deposits is liquidity. Liquidity is the ease and speed with which an investment can be turned into cash to meet spending needs. Most investors are likely to have a need for cash at short notice and so should plan to hold some cash on deposit to meet possible needs and emergencies before considering other less liquid investments.

• The other main reasons for holding cash investments are as a savings vehicle and for the interest return that can be earned on them.

• A further advantage is the relative safety that cash investments have and that they are not exposed to market volatility, as is the case with other types of assets.

What are the disadvantages of investing in cash?

• Deposit-taking institutions are of varying creditworthiness; the risk that they may default needs to be assessed and taken into account.

• Inflation reduces the real return that is being earned on cash deposits and could mean the real return after tax is negative.

• Interest rates vary and so the returns from cash-based deposits will also vary.

• There is a currency risk, and different regulatory regimes to take into account, where funds are invested offshore or in a different currency.

How are bank and building society deposits protected?

• By a compensation scheme.

• This will repay any deposited money lost, up to a set maximum, as a result of the collapse of a bank or building society.

• The sum is fixed so as to be of meaningful protection to most retail investors, although it would be of less help to very substantial depositors.

• Although most cash products are not regulated, the Prudential Regulatory Authority (PRA) does regulate banks and other deposit-takers, and depositors based in the UK are covered by the Financial Services Compensation Scheme (FSCS).

• The FSCS provides protection for the first £85,000 of deposits per person with an authorised institution.

What are cryptocurrencies?

• A type of digital currency or asset that can be traded, stored and transferred electronically.

• There is no single definition of cryptocurrencies, but one from the European regulatory authorities is that they are a virtual currency that is represented by a digital record, is not issued by a central bank or similar institution, is not a legally established currency and which, in some circumstances, can be used as an alternative to money.

• Undoubtedly, the best-known and most-traded cryptocurrency is Bitcoin which uses blockchain technology to build a decentralised network that has no central trusted authority and is open to anyone to participate.

How has Bitcoin developed?

• The development of both stable coins and central bank tokens continue to evolve the crypto market.

• The market value of Bitcoin has proven highly volatile.

• At times, Bitcoin has been valued at more than $60 billion (circa 2021) before halving in value, as shown in the chart below.

• Ever since, the value of Bitcoin has once again rallied.

• As of October 2024, the total market value of Bitcoin was priced at over $67 billion.

What are the 5 main kinds of cryptocurrencies?

• Exchange tokens – such as Bitcoin and other cryptocurrencies.

• Security tokens – has features similar to general investments such as asset ownership rights, entitlement to a share of future profits, repayment of a specific sum of money, or tradability.

• Stable coins – whose value is pegged, or tied, to that of another currency, commodity, or financial instrument.

• Central bank digital currency (CBDC) – also called digital fiat currency, or digital base money, and is issued by a central bank. It is also a liability of the central bank and denominated in the sovereign currency, as is the case with physical banknotes and coins.

• Utility tokens – gives access to services and products.

How does economic theory define money?

• A store of value.

• A medium of exchange with which to make payments.

• A unit of account with which to measure the value of any particular item that is for sale.

What is fiat money?

• Money that is no longer convertible into gold or any other asset. E.g. banknotes.

• No intrinsic value but is accepted because the parties engaging in exchange agree on its value and governments established as legal tender.

How do fiat currency and cryptocurrency differ?

• Form held

• Centralisation

• Issuance and supply

• Regulatory oversight

• Anonymity and transparency

• Intrinsic value

• Transaction speed and currency accessibility

• Volatility

What are money markets?

• The wholesale or institutional markets for cash and are characterised by the issue, trading and redemption of short-dated negotiable securities.

• These usually have a maturity of up to one year, though three months or less is more typical.

• By contrast, the capital markets are the longterm providers of finance for companies through investments either in bonds or shares.

Historically, how were instruments issued in money markets?

In, physical, bearer form, and at a discount to their face value to save on the administration associated with registration and the payment of interest.

Today, how are instruments issued in money markets?

• Shift from physical, bearer forms to electronic forms

• Issuing securities this way allows for electronic book transfer, making it more efficient to record ownership changes and facilitating the custody of securities.

• This transition reflects the broader trend in financial markets towards dematerialisation and the use of electronic systems for trading and settlement.

Who can you invest in the money market?

Although they are accessible to retail investors indirectly through collective investment schemes, direct investment in money market instruments is often subject to a relatively high minimum subscription and, therefore, tends to be more suitable for institutional investors.

Highly professional, used by banks and companies to manage their liquidity needs.

Not accessible to private investors who need to utilise either money market accounts offered by banks or money market funds.

How are cash deposits and money markets advantageous?

They provide a low-risk way to generate an income or capital return, as appropriate, while preserving the nominal value of the amount invested. They also play a valuable role in times of market uncertainty.

How are cash deposits and money markets disadvantageous?

• They are unsuitable for anything other than the short term as, historically, they have underperformed most other asset types over the medium to long term.

• Moreover, in the long term, returns from cash deposits, once tax and inflation have been taken into account, have barely been positive.

What are the three main types of money market instruments?

• Treasury Bills

• Certificates of Deposits (CDs)

• Commercial Paper (CP)

What are Treasury Bills?

• These are issued weekly by the Debt Management Office (DMO) on behalf of the Treasury.

• The money is used for the government’s short-term borrowing needs.

• Treasury bills are non-interest-bearing instruments (sometimes referred to as ‘zero coupon’ instruments).

• Instead of interest being paid out on them, they are normally issued at a discount to par – ie, a price of less than £100 per £100 nominal (the amount of the Treasury bill that will be repaid on maturity) – and commonly redeem after one, three or six months.

• For example, a Treasury bill might be issued for £999 and mature at £1,000 three months later. The investor’s return is the difference between the £999 they paid, and the £1,000 they receive on the Treasury bill’s maturity.

What are CDs?

• These are issued by banks in return for deposited money and are tradeable on the money markets.

• Until the late 1960s, a rigidity in the interbank market meant that deposits, once taken, could not be traded during their lifetime.

• To overcome this, CDs were introduced which could be traded on a secondary market.

• By market convention, it is a short-term marketable instrument with a maturity up to five years, although the vast majority are issued for periods of less than six months. Interest can be at a fixed or variable rate, although they may also be issued at a discount and without a coupon.

• Most sterling CDs are held by banks, building societies and other money market participants.

What is CP?

• This is the corporate equivalent of a Treasury bill. CP is issued by large companies to meet their short-term borrowing needs.

• A company’s ability to issue CP is typically agreed with banks in advance. For example, a company might agree with its bank to a programme of £10 billion worth of CP.

• This would enable the company to issue various forms of CP with different maturities (eg, one month, three months and six months), and possibly different currencies, to investors.

• As with Treasury bills, CP is zero coupon and issued at a discount to its par value.

How to settle in money markets?

• Typically through CREST on the day of the trade or the following business day.

What are the advantages money market funds?

• There is a range of money market funds available and they can offer some advantages over pure money market accounts.

• There is the obvious advantage that the pooling of funds with other investors gives the investor access to assets they would not otherwise be able to invest in.

• The returns on money market funds should also be greater than a simple money market account offered by a bank.

What are the disadvantages of money market funds?

• By contrast, a money market fund will invest in a range of instruments from many providers, and as long as they are AAArated they can offer high security levels.

• A rating of AAA is the highest rating assigned by a credit rating agency.

How are money market funds regulated?

Money market funds may only invest in approved money market institutions and deposits with credit institutions and meet other conditions on the structure of the underlying portfolio.

What 2 sectors did the Investment Association introduce?

• Short-term money market funds can have a constant or a fluctuating net asset value (NAV). A constant NAV face value means they should have an unchanging net asset value when income in the fund is accrued daily and can either be paid out to the unitholder or used to purchase more units in the scheme.

• Money market funds by contrast must have a fluctuating NAV.

What distinguishing features does property have as an asset class?

• Each individual property is unique in terms of location, structure and design.

• Valuation is subjective, as property is not traded in a centralised marketplace, and continuous and reliable price data is not available.

• It is subject to complex legal considerations and high transaction costs upon transfer.

• It is relatively illiquid as a result of not being instantly tradeable.

• It is also illiquid in another sense: the investor generally has to sell all of the property or nothing at all. It is not generally feasible for a commercial property investor to sell one flat out of an entire block (or, at least, to do so would be commercially unattractive) – and a residential property owner cannot sell their spare bedroom to raise a little cash!

• Since property can only be purchased in discrete and sizeable units, diversification is difficult.

• The supply of land is finite and its availability can be further restricted by legislation and local planning regulations. Therefore, price is predominantly determined by changes in demand.

What is fundamentally different with property?

• The price.

• Only the largest investors, which generally means institutional investors, can purchase sufficient properties to build a diversified portfolio.

• Tend to avoid residential property and concentrate on commercial property, industrial property and farmland.

What are the differences between residential and commercial property?

• Direct investment

• Tenancies

• Repairs

• Returns

What are the advantages of direct investment in property as an asset class?

• Has at times provided positive, real, long-term returns allied to low volatility and a reliable stream of income.

• An exposure to property can provide diversification benefits within a portfolio of investments owing to its low correlation with both traditional and alternative asset classes.

• Many private investors have chosen to become involved in the property market through the buy-to-let market.

What are the disadvantages of direct investment in property as an asset class?

They can be subject to prolonged downturns, and its lack of liquidity, significant maintenance costs, high transaction costs on transfer and the risk of having commercial property with no tenant (and, therefore, no rental income) makes commercial property suitable as an investment only for long-term investing institutions such as pension funds.

What is a mutual fund in property investment?

Other investors wanting to include property within a diversified portfolio generally seek indirect exposure via a mutual fund, property bonds issued by insurance companies, or shares in publicly quoted property companies. The availability of indirect investment media makes property a more accessible asset class to those running smaller, diversified portfolios.

What is the FX as a market?

Trading of one currency for another.

What is the history of the FX market?

• Historically, currencies were backed by gold (as money had ‘intrinsic value’); this prevented the value of money from being debased and inflation being triggered.

• This gold standard was replaced after the Second World War by the Bretton Woods Agreement.

• This agreement aimed to prevent speculation in currency markets by fixing all currencies against the dollar and making the dollar convertible to gold at a fixed rate of $35 per ounce.

• Under this system, countries were prohibited from devaluing their currencies by more than 10%, which they might have been tempted to do in order to improve their trade position.

How did the FX market grow?

• The growth of international trade and increasing pressure for the movement of capital eventually destabilised this agreement, and it was finally abandoned in the 1970s.

• Currencies were allowed to float freely against one another, leading to the development of new financial instruments and speculation in the currency markets.

• Trading in currencies became 24-hour, as it could take place in the various time zones of Asia, Europe and America.

• London, being placed between the Asian and American time zones, was well placed to take advantage of this, and has grown to become the world’s largest FX market.

• Other large centres include the US, Singapore, Hong Kong and Japan.

How are trading currencies organised?

• In pairs

• These are currency pairs when one currency is bought and the other is sold, and the prices at which these take place make up the exchange rate.

• When the exchange rate is being quoted, the name of the currency is abbreviated to a three-digit reference; so, for example, sterling is abbreviated to GBP (for Great British pounds).

What are the major currency pairs?

US dollar and Japanese yen (USD/JPY)

Euro and US dollar (EUR/USD)

US dollar and Swiss franc (USD/CHF)

British pound and US dollar (GBP/USD)

Euro and British pound (EUR/GBP)

What does the currency pair mean in quoting terms?

• When currencies are quoted, the first currency is the base currency and the second is the counter or quote currency.

• The base currency is always equal to one unit of that currency, in other words, one pound, one dollar or one euro.

• For example, if the EUR/USD exchange rate is 1:1.1165, this means that €1 is worth $1.1165.

What does it mean if the exchange rate is ‘going up’?

The value of the base currency is rising relative to the other currency and is referred to as currency strengthening; if the opposite is the case, the currency is said to be weakening.

What happens when a currency pair is quoted?

• A market maker or FX trader will quote a bid and ask price.

• Staying with the example of the EUR/USD, the quote might be 1.1164/66 – notice that the euro is not mentioned, as standard convention is that the base currency is always one unit.

• So, if you want to buy €100,000, you will need to pay the higher of the two prices and deliver $111,660; if you want to sell €100,000, you get the lower of the two prices and receive $111,640.

How is the FX market organised?

• Predominantly OTC, where brokers and dealers negotiate directly with one another. The main participants are large international banks, which continually provide the market with both bid (buy) and ask (sell) prices.

• Central banks are also major participants in FX markets, which they use to try to control the money supply, inflation and interest rates.

What is a spot transaction?

The spot rate is the rate quoted by a bank for the exchange of one currency for another with immediate effect. It is worth noting that, in many cases, spot trades are settled – that is, the currencies actually change hands and arrive in recipients’ bank accounts – two business days after the transaction date (T+2).

What is a forward transaction?

• In this type of transaction, money does not actually change hands until some agreed future date.

• A buyer and seller agree on an exchange rate for any date in the future, for a fixed sum of money, and the transaction occurs on that date, regardless of what the market rates are then.

• The duration of the trade can be a few days, months or years.

What is a future?

• Foreign currency futures are a standardised version of forward transactions that are traded on derivatives exchanges for standard sizes and maturity dates.

• The average contract length is roughly three months.

What is a swap?

• The most common type of forward FX transaction is the currency swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

• These are not exchange-traded contracts and instead are negotiated individually between the parties to a swap.

How are FX transactions settled?

CLS bank or worldwide international banking system.

Who are CLS Bank?

• It is owned by many of the world’s largest financial institutions and is used to settle FX transactions between member banks using a system called ‘payment-versus-payment’ (PvP).

• Member banks input their instructions for the buy and sell side of an FX transaction and, provided the instructions agree and the necessary funds are held, the currencies are exchanged.

• It is also possible that FX trades are settled directly between participants.

• This is because banks hold accounts with each other as well as overseas branches and subsidiaries. Settlement of trades can occur via these accounts.

What are forward exchange rates?

• A forward exchange contract is an agreement between two parties to either buy or sell foreign currency at a fixed exchange rate for settlement at a future date.

• The forward exchange rate is the exchange rate set today even though the transaction will not settle until some agreed point in the future, such as in three months’ time.

What is the difference between spot and forward exchange rate?

• Given by the differential between their respective nominal interest rates over the term being considered.

• The relationship is purely mathematical and has nothing to do with market expectations.

• FWD ER = S ER* ((1+quote currency short-term rate)/(1+base currency short-term rate))