I continue with educational stuff, so as to help my students with their graduation projects. This time, I take on finance, and on the projects that my students are to prepare in the curriculum of ‘Foundations of Finance’. The general substance of those projects consists in designing a financial instrument. I know that many students struggle already at the stage of reading that sentence with understanding: they don’t really grasp the concept of designing a financial instrument. Thus, I want to sort of briefly retake it from the beginning.
The first step in this cursory revision is to explain what I mean by ‘financial instrument’. Within the framework of that basic course of finance, I want my students to develop intellectual distinction between 5 essential types of financial instruments: equity-based securities, debt-based securities, bank-based currencies, virtual currencies (inclusive of cryptocurrencies), and insurance contracts. I am going to (re)explain the meaning of those terms. I focus on those basic types because they are what we, humans, simply do, and have been doing for centuries. Those types of financial instruments have been present in our culture for a long time, and, according to my own scientific views, they manifest collective intelligence in human societies: they are standardized parcels of information, able to provoke certain types of behaviour in some categories of recipients. In other words, those financial instruments work similarly to a hormone. Someone drops them in the middle of the (social) ocean. Someone else, completely unknown and unrelated picks them up, and their content changes the acquirer’s behaviour.
When we talk about securities, both equity-based and debt-based, the general idea is that of securing claims, and then making those secured claims tradable. Look up the general definition of security, e.g. on Investopedia. If you want, in your project, to design a security, the starting point is to define the assets it gives claim on. Equity-based securities give direct, unconditional claims on the assets held by a business (or by any other type of social entity incorporated in a business-like way, with an explicit balance sheet), as well as conditional, indirect claims on the dividend paid out of future net income generated with those assets. Debt-based securities give direct, unconditional claim on the future cash flows, generated by the assets of the given business. The basic idea of tradable securities is that all those types of claims come with a risk, and the providers of capital can reduce their overall risk by slicing the capital they give into small tradable portions, each accompanied by a small portion of adjacent risk. Partitioning big risks and big claims into small parcels is the first mechanism of reducing risk. The possibility to trade those small parcels freely, i.e. to buy them, hold them for however long pleases, and then sell them, is the second risk-reducing device.
The entire concept of securities aims, precisely, at reducing financial risks connected to investing big amounts of capital into business structures, and thus at making that investment more attractive and easier. Historically, it literally has been working like that. Over centuries, whenever people with money were somehow reluctant to connect with people having bold ideas, securities usually solved the problem. You were a rich merchant, like in the 17th century-France, and your king asked you to lend him money for the next war he wanted to fight. You would answer: ‘Of course, my Lord, I would gladly provide you with the necessary financial means, yet I have a tiny little doubt. What if you lose that war, my Lord? Who’s going to pay me back?’. Such an answer could lead into two separate avenues: decapitation or securitization of debt. The former was somehow less interesting financially, but the latter was a real solution: you lend to the King, in exchange he hands you his royal bonds (debt-based securities), and you can further sell those bonds to whoever is interested in betting on the results of war.
Thus, start with a simple business concept, e.g. something of current interest, such as a factory of medical ventilators. You have a capital base, i.e. some assets, and you finance them with equity and liabilities. Classical. You can skip the business planning part by going to the investors relations site of any company you know, taking their last financial report and simply simulating a situation when those guys want to increase their capital base, i.e. add to their assets. I mentioned medical ventilators, so you could go and check Medtronic’s investors relations site (http://investorrelations.medtronic.com/ ), and pick their latest quarterly financials. They have assets worth $92 822 mln, financed with $51 953 mln in equity and $40 869 in debt. Imagine they see big business looming on the horizon, and they want to accumulate $10 000 mln more in assets. They can do it either through additional borrowing, or through the issuance of new shares in the stock market.
You can go through the reports of Medtronic as well as through their corporate governance rules, and start by taking your own stance at the basic question: if Medtronic intends to accrue their assets by $10 000 mln, would you advise them to collect that capital by equity, or by debt, or maybe to split it somehow between the two. Try to justify your answer in a meaningful way.
If you go for equity-based securities (shares in equity), keep asking questions such as: what should be the nominal value (AKA face value) of those shares? How does it compare with the nominal value of shares already outstanding with this company? What dividend can shareholders expect, based on past experience? How are those new shares expected to behave in the stock market, once again based on the past experience?
If your choice is to bring capital through the issuance of debt-based securities, go for answering the following: what should be the interest rate on those corporate bonds? What should be their maturity time (i.e. for how long should they stay in the market of debt before Medtronic buys them back)? Should they be convertible into something else, like in the shares in equity, or in some next generation of bonds? Once again, try to answer those questions as if I were just a moderately educated hominid, i.e. as if I needed to have things explained simply, step by step.
See? Chitchatting, talking about kings, wars and medical ventilators, we have already covered the basics of preparing a project on equity-based securities, as well as on the debt-based ones.
If you want to go somehow further down those two avenues, you can check two of my blog updates from the last academic year: Finding the right spot in that flow: educational about equity-based securities , and Unconditional claim, remember? Educational about debt-based securities.
Now, we talk about money, i.e. about a hypothetical situation when my students design a new currency in the framework of their project. Money is strange, to the extent that technically it should not have any intrinsic value of itself, as a pure means of exchange, and yet any currency can be deemed mature and established once its users start hoarding it a little bit, thus when they start associating with it some sort of intrinsic value. Presently, with the development of cryptocurrencies, we distinguish them from bank-based or central-unit-based currencies. In what follows immediately, I am focusing on the latter category, before passing to the former.
So, what is a bank-based currency, AKA central-unit-based currency? A financial institution, e.g. a bank, issues a certain number of monetary units (AKA monetary titles), which are basically used just as a means of exchange. The bank guarantees the nominal value of that currency, which, in itself, does not embody any claim on anything. This is an important difference between money and securities: securities secure claims, money doesn’t. Money just assures liquidity, understood as the capacity to enter into exchange transactions.
When designing a new currency, step #1 consists in identifying a market with liquidity problems, e.g. we have 5 developing countries, which do business with each other: they trade goods and services, business entities from each of those countries invest in the remaining four etc. Those 5 countries have closed or semi-closed monetary systems, i.e. their national currencies either are not exchangeable at all against any other currency, or there are severe limitations on such exchange (e.g. you need a special authorization from some government agency). Why do those countries have closed monetary systems? Because their governments are afraid that if they make it open, thus when they allow free exchange against foreign currencies, the actual exchange rate will be so volatile, and so prone to speculative attacks (yes, there are bloody big sharks in those international financial waters) that the domestic financial system will be direly destabilized. Why any national currency should be so drastically volatile? It happens when this currency is not really exchanged a lot against other currencies, i.e. when exchange is sort of occasional and happens in really big bundles. There is not enough accumulated transactional experience. Long story short, we have national currencies which are closed because of the possible volatility and are so prone to volatility because they are closed systems. Yes, I know it sounds stupid. Yet, once you see that mechanism at work, you immediately understand. In the communist Poland, we had a closed monetary system, with our national currency, the zloty, technically being not exchangeable at all against anything else. As a result, whenever such exchange actually took place, e.g. against the US dollar, you needed to be a wizard, or a prime minister, to predict more or less accurately the applicable exchange rate.
Those 5 countries have two options. For one, they can use a third-country, strong currency as a local means of exchange, i.e. their governments, and their national business entities can agree that whenever they do business transnationally, they use a reference currency to settle their mutual obligations. The second option consists in creating an international currency, specifically designed for settling business accounts between those countries. This is how the ECU, the grandpa of the euro, was born, back in the day. The ECU was a business currency – you couldn’t have it in your wallet, you just could settle your international accounts with it – and then, as banks got used to it, the ECU progressively morphed into the euro. What you need for such a currency is a financial institution, or a contractually established network thereof, who guarantee the nominal value of that business currency.
If our 5 countries go for the second option, the financial institution(s) who step in as guarantors if the newly established currency need to bring to the table something more than just mutual trust. They need to assign, in their balance sheets, specific financial assets which back the aggregate nominal value of the new currency put in circulation. Those assets can consist of, for example, a reserve basket of other currencies. Once again, it sounds crazy, i.e. money being guaranteed with money, but this is how it works.
Therefore, step #2 in designing a new, bank-based currency, requires giving some aggregate numbers. What is the aggregate value of transactions served by the new currency? Let’s go, just as an example, for $100 billion a year. How long will each unit of the new currency spend on an individual bank account? In a perfectly liquid market, each unit of currency is used as soon as it has been received, thus it just has one night to sleep on a bank account, and back to work, bro’. In such a situation, that average time on one account is 1 day. Therefore, in order to cover $100 billion in transactions, we need [$100 / 365 days in the year] = $0,2739726 billion = $274 million in currency. If people tend to build speculative positions in that currency, i.e. they tend to save some of it for later, the average time spent on an individual account by the average unit of that new money could stretch up to 2 weeks = 14 days. In such case, the amount of currency we need to finance $100 billion in transactions is calculated as [$100 / (365/14)] = [$100 * 14 / 365] = $3,8356 billion.
There is a catch. I talk about introducing a new currency, but I keep denominating in US dollars, whence the next question and the next step, step #3, in a project devoted to this topic. The real economic value of our money depends on what we do with that money, and not really on what we call it. One of the things we do with an international currency is to exchange it against national currencies. In this case, we are talking about 5 essentially closed national currencies. For the sake of convenience, let’s call them: Ducat A, Ducat B, Ducat C, Ducat D, and Ducat E. Once again for sheer convenience we label the new currency ‘Wanderer’. So far, our 5 countries have been using the US dollar for international settlements, whence my calculations denominated therein. The issue of exchange rate of the Wanderer against the US dollar, as well as against our 5 national Ducats, is a behavioural one. Yes, behavioural: it is about human behaviour.
We have businesspeople doing international business in USD, and we want to convince them to switch to the Wanderer. What arguments can we use? There are two: exchange rate per se, and exchange rate risk. Whoever is a national of our 5 countries, needs to exchange their national Ducat against the US dollar and the other way around. As neither of the Ducats is freely convertible, exchange with the dollar takes place, most probably, in the form of big, bulk transactions, like once a month, mediated by the central banks of our 5 countries. Those bulk transactions yield an average exchange rate, and an average variance around that average.
We want to put in place an alternative scheme, where the national Ducats (A, B, C, D, E) are exchanged in real time against the Wanderer, and then the Wanderer gets exchanged against the US dollar. The purpose is to make the exchange {Ducat Wanderer USD} more attractive, average-rate-wise or variance-in-rate-wise, than the incumbent {Ducat Individual, National Central Bank USD} one. Some of you might think it is not realistically possible, yet it really is. If 5 central banks of developing countries gang up together to buy and sell US dollars, they can probably achieve a better price, and less volatile a price, as compared to what each of them separately could have. There is even an additional trick, and this is like really a trick: central banks of our 5 countries could hold some of their financial reserves in US dollars, more specifically the part devoted to backing the Wanderer. That’s the trick that our central bank in Poland, the National Central Bank of Poland, uses all the time. We are in the European Union, but we do not belong to the European Monetary Union, and yet we do a lot of business with partners in the eurozone. The National Bank of Poland holds important financial reserves in euros, and thus gives itself a better grip on the exchange rate between the Polish zloty and the euro.
Summing up the case of graduation projects focused on designing a new bank-based currency, here are, rephrased once again, the basic logical steps. Start with identifying a market with liquidity problems, such as closed monetary systems or very volatile national currencies. This is usually an international market made of developing countries. Imagine a situation, when the central banks of the countries in question place some of their financial reserves in a strong currency, e.g. the US dollar, or the Euro, and then the same central banks introduce a currency for international settlements in that closed group of countries. Keep in mind that the whole group of countries will need an amount of currency calculated as: [Aggregate value of international transactions done in a year * [Average number of days that one user holds one unit of currency / 365].
The whole scheme consists, at the end of the day, in obtaining a better and less volatile exchange rate of individual national currencies against the BIG ONES (e.g. the US dollar) through aggregating their exchange transactions in the financial market.
That would be all in this tutorial. I have covered three types of financial instruments that my students can possibly design for their graduation: equity-based securities, debt-based securities, and bank-based currencies. In the coming weeks I will try to write something smart on designing cryptocurrencies and insurance contracts. Till then, you can additionally read entry March, 26th, 2019 – More and more money just in case. Educational about money and monetary systems – and entry March 31st, 2019 – The painful occurrence of sometimes. Educational about insurance and financial risk.