District Bank Wrap up - Part 2

So, I am getting close to leaving the bank now so I had better fill you in on some of the last few interesting items.

I must come back to the discussion regarding the Bank of England support that we were providing. However, first I have to explain how the New York money market worked in those days (sorry!). Unlike in London, where everything is cleared between banks on the same day, there were two processes in New York. There, they had a cleared market (FedFunds) and an uncleared one (Clearing House Funds). Basically, anything transferred between commercial banks in New York was regarded as uncleared until it had been held overnight. Anything transferred over a Federal Reserve Bank of New York account (called the Fed from now on) would be regarded as cleared. Cleared meant that it was accepted that the account being charged had sufficient credit for the charge to be paid and thus would not be returned unpaid on the next day.

All dollar transactions in the London FX markets and all of the money market dollars (called EuroDollars if transacted in London) were in Clearing House Funds and thus not really good value until the next day. As, at that time, most London banks had no real knowledge of these complications, no one actually ever thought about it. However, it came to our notice that the Bank of England was paying us out of their Fed account. Actually, our agent in NY, The Bank of California (BoC), pointed this out. It was important because of the way that the NY market worked. If you, as a bank, needed cleared funds today but only had Clearing funds, then you could buy the Fed Funds on the NY market. Effectively, you did a deal with another bank that had Fed Funds in their account. They released the Fed Funds to you and you transferred the Clearing funds to them along with one working day's interest. This was necessary because there were things that they couldn't do with Clearing funds so they had to hold onto them for the one day to make them cleared. Understand? No, I didn't think you would but just read on and don't worry about it.

So, here was us being paid in Fed Funds and paying out Clearing Funds on a daily basis and sometimes in the region of $200,000,000 at a time. BoC told us that they could buy the FedFunds from us for that one days interest and pay the Clearing Funds on our behalf. This sounded like a good idea, especially if the settlement day was on a Friday because that would mean three days interest over the weekend (more about this later - you lucky people). We thought that we should check with the Bank to see if they had any objections, although what we did with our Fed Funds was our business. In those day, of course, everyone kept on good terms with the Old Lady and never wanted to upset her. She told us that it was fine with her but to remember that, should the Sterling market improve between the trade date and the value date (two days) she could always reverse the trade. BoC was happy to have a cancellation up to 12 o'clock NY time so this was going to work. In fact, if I remember, they only ever reversed one transaction. We made quite a lot of money doing this. In fact, in discussion with National Provincial Bank, who owned the District Bank, it turned out that they hadn't ever thought of this, and better still, didn't have any mechanism for doing the deals. They started paying their Fed Funds over to us to dispose of so we gained even more!

This all came to a halt on 19th November 1967. Valerie and I were sitting in front of the television watching, I seem to remember, Midnight Lace - a film staring Doris Day - when the BBC interrupted the film to announce that the pound had been devalued from it 2.80 parity against the dollar to 2.40. Remember that we had been trading at or around the 2.7810 mark. I own up to actually crying at that point. We had put an awful lot of work into our support operations, as had the other clearing banks and it was now to no avail.

On sitting down on Monday morning, we surveyed the market and were amazed to see that overnight swap transactions were trading at 100s of % per annum where normally they would have traded at the equivalent of around 6 - 8%. The one day premium for purchasing Sterling overnight calculated out at these huge rates, purely because everyone outside of the UK had sold sterling and needed to obtain these overnight funds on a daily basis. They had all been expecting the devaluation but hadn't expected such a high daily cost. If you think about it, an annual interest rate of 365% represented 1% for any single day. You would have to move your shortage of sterling from Monday (as it was) to Wednesday so that you could close out your short trade and take your profit. To do this would cost you 2% of your capital so that reduced your gain from the devaluation. BoC NY always left an overnight order with us to cover their Sterling position but we couldn't execute it because, eventually, the cost reached a daily price of 4%. We called them on their opening and , although they were horrified, they had no option but to do the deal. Because of exchange control restrictions, we were (as was every bank in London) unable to lend Sterling overseas so we couldn't help the directly.  We could take a small advantage from it because we, like every other bank in London, had a small BofE limit to sell Sterling and buy it back later (the so called spot-against-forward limit). As a Clearing Bank we always had access to cheap Sterling to lend on the London money market so we took advantage of our unused portion of this and made a nice little profit ourselves.

For a further comment on how London was affected by the the vagaries of the New York Money Markets, check out my 'aside' about the short term London Eurodollar market.

Sorry that this is so technical but I don't think it would be right just to tell you about the easy things. This was such an important part of my life that I really needed to get it down on "paper". I still have a few things to tell you about before I actually leave the District Bank for pastures new. Once they are cleared up, I can also get back to our newly married life.

The London EuroDollar market in the 1960s and 70s - Fed Funds and Clearing Funds

Having been bored to tears with my description of Fed Funds and Clearing House Funds, I am now going to subject you to a treatise on how this affected the London EuroDollar market.

I have tried to explain how you could convert Fed Funds into Clearing Funds and vice versa - basically there was a one working day interest allowance that accrues to a Fed Fund balance when it is converted to Clearing funds. OK, in English, this means that if you have $1,000,000 of Fed Funds and you exchange them for Clearing Funds with a current interest rate of 5% you get $50,000 (being 5% interest for one year) divided by 360 (the US always uses 360 as a year base whilst the UK always uses 365) so you would transfer away $1,000,000 for Fed Funds and receive 1,000,138.89.

Now the interesting thing is that if you did this on a Friday, the interest received would be $138.89 * 3 because the Clearing Funds would require 3 days (Saturday to Monday) to become cleared funds.

In the early 60s, banks in London were content to deal in Clearing funds and not concern themselves with Fed Funds as no-one (except for a small number of US banks) had access to such things in the normal course of business. Step forward to the influx of regional US banks from about 1965 onwards - more specifically to the arrival of National Bank of Detroit (NBD) onto the London scene. Now NBD were in London for one single reason - to tap the EuroDollar market for funds to repatriate back to Detroit for internal use. They quickly worked out the problem with trading in London, vis-a-vis Fed Funds, which is what they were after. So, if they borrowed money on a Friday, they would pay 3 days interest until Monday but would only get 1 days Fed Funds interest from Monday to Tuesday. Are you beginning to see how this works? But, and it is a big but, if they borrowed Clearing funds in London on a Thursday, they only paid one day's interest but got Fed Funds for the three day weekend. Rapidly, they started to bid up on the Thursday market and everyone cottoned onto the weekend so the  borrowers dropped out until the price plummeted.

E.G. Day to day funds are 5%.
Mon - Tues = 5%
Tues - Wed = 5%
Wed - Thur = 5%
Thur - Fri = 15%
Fri - Mon = 1 5/8%

BTW, the NBD gained a nickname in the market. They were known as the "Flying A**hole" for some reason!

The problem got even more complicated. If a one month trade started on a Thursday but finished on a "standard" day of the week, the rate would be inflated by the 3 day effect of the Thursday - Friday and likewise, if a period started on a Friday and ended on a "standard" day, the rate would be reduced because of the weekend rate effect. This caused great complications and there were dealers out there who spent their lives working out rates for strange periods in the hope of catching people out. In fact, some years later, I wrote a computer program for my bank that did all of the calculations. Until everyone else woke up to trading desk software, this gave us a great edge in the money markets.

I left the market in 1985 so I am not sure when, or if, this pattern dies out.