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FUNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM
THE SECONDARY MARKET
FOR NEGOTIABLE CERTIFICATES
OF DEPOSIT
PARKER B. WILLIS
Prepared for the Steering Committee for the Fundamental Reappraisal ofthe
Discount Mechanism Appointed by
the Board of Governors of the Federal Reserve System
The following paper is one of a series prepared by the research staffs of the Board of Governors
of the Federal Reserve System and of the Federal Reserve Banks and by academic economists
in connection with the Fundamental Reappraisal of the Discount Mechanism.
The analyses and conclusions set forth are those of the author and do not necessarily indicate
concurrence by other members of the research staffs, by the Board of Governors, or by the Federal
Reserve Banks.
February 23, 1967
FUNDAMENTAL REAPPRAISAL OF THE DISCOUNT MECHANISM
The Secondary Market for Negotiable Certificates of Deposit
CONTENTS
I.
Introduction
II. Major Findings
III. Negotiable Certificates of Deposit
IV.
1
2
14
A. Growth
B. Characteristics
1. Denominations
2. Prime, Lesser-Prime, and Off-Prime Issuers
3. Issuing Rates
4. Maturities
C. Buyers
D. Bank Uses of Funds
16
21
21
23
24
24
26
28
The Secondary Market for Certificates
31
A.
B.
C.
D.
E.
Participants and Operating Methods
Dealer Purchases and Financing
Buyers
Supply and Demand Variables
Measures of Trading
1. Trading Vs. Issues Outstanding
2. Inventories Vs. Issues Outstanding
3. Transactions to Positions
Market Rates and Yield Spreads
Certificate Characteristics
Dealer Bid and Offering Rates
General Features — 1961-65
The Course of Market Activity — 1961-65
Changes in Market Activity — 1966
Market Activity Mid-December 1966-January 1967
Future Market Activity
31
34
37
38
41
42
43
45
45
51
52
54
57
68
77
80
Proposals to Improve Marketability of Certificates
83
A.
B.
C.
D.
E.
F.
G.
H.
83
84
84
85
85
87
88
88
F.
G.
H.
I.
J.
K.
L.
M.
V.
PAGE
Issuance of Certificates on a Discount Basis
F.D.I.C. Insurance Coverage
Dealer's Endorsement
Provision of Information by Federal Reserve Banks
Group Marketing of Certificates of Smaller Banks
Purchase of Certificates by the System Account
Extend System Repurchase Agreements to Dealers
Permit Greater Market Freedom with Respect to CD Rates
ii
TABLES AND CHARTS
PAGE
Table 1 - Selected Money Market Instruments, December 31, 1960
and 1962
17
Table 2 - Outstanding Negotiable CD f s by Federal Reserve District
19
Table 3 - CD f s $100,000 and Over Outstanding by Size of Bank
23
Table 4 - Average Maturities of Negotiable Certificates of Deposit
of $100,000 or More
Table 5 - Ratio of Outstanding Negotiable CD's to Total Deposits,
26
Selected Dates
29
Table 6 - Net Change in Selected Money Market Investments Outstanding.. 48
Table 7 - Yield Spread Changes — U. S. Treasury Bills and Other
Short-Term Investment Paper
Table 8 - Net Increase in Negotiable Certificates of Deposit
Outstanding in Denominations of $100,000 or More
49
69
Table 9 - Yields on Short-Term Money Market Investments
73
Table 10 - Yields on Short-Term Money Market Investments
79
Chart 1 - Secondary Market Certificates of Deposit Rates 90 Days
and Other Related Market Rates
47
Chart 2 - Dealer Activity in Negotiable Certificates of Deposit
55
Chart 3 - CD Issuing Rates — N.Y.C. Banks
59
Chart 4 - Negotiable Certificates of Deposit — All Weekly
Reporting Member Banks
75
Prepared for the Committee for the Fundamental Reappraisal of
the Discount Mechanism.
Author: Parker B. Willis, Federal Reserve Bank of Boston.
-1I
INTRODUCTION
This study is designed to serve several purposes:
(1) to evaluate
the operations of the secondary market for negotiable certificates of
deposit (CDfs) as a source of funds complementary to the discount
window; (2) to determine whether it is feasible and desirable to promote a further development of this market so as to modify commercial
bank reliance on the discount window; and (3) if such is the case, to
recommend the degree, if any, to which the Federal Reserve should become
involved in promoting the development of this market.
The study includes an analysis of available data on CD's to determine how the existing market functions and the extent to which
banks of various types operate in it. The analysis has been supplemented by "personal interviews with knowledgeable market participants."
These interviews attempted to assess the current nature of this market
with respect to "depth, breadth, and resiliency" and to ascertain any
changes in these market qualities over time — seasonally, cyclically,
or secularly. An attempt has also been made to determine the underlying causes for any deficiencies in market operations for the several
classes of banks studied.
Some consideration has been given to procedures that could improve market operations.
The problems that the Federal Reserve would
encounter if it were to act as a clearing house for information on
the market, to function as a broker, or to deal in such liabilities
as an integral part of open market operations have also been considered.
II MAJOR FINDINGS
The development of the secondary market for CD's accelerated the
growth in amounts of certificates outstanding, increased the acceptance
of certificates as a money market instrument, and enabled them to become
competitive with Treasury bills, commercial and finance company paper,
bankers' acceptances, and other short-term instruments as a medium for
investment.
In this connection one of the principal functions of the
market has been to provide CD's with shorter maturities than those
originally permitted issuers by Regulation Q; these shorter maturities
have made it possible for original holders of CD's to liquidate them
before maturity, if need be, and for buyers to acquire desired shortterm certificates at attractive rates. The market served this purpose
most fully after its initial development —
that is, after the period
1962-65, when CD's that might have had shorter-term maturities were
not issued because permissible ceiling rates were too low.
The increased versatility of CD's issued by leading banks in
principal money centers where a secondary market for certificates has
developed has enabled issuers to tap the national pool of short-term
funds without a concurrent obligation to make a loan to a customer.
The mere existence of the market, however, has increased the acceptance of CD's of all issuers.
The market has been most active when profits could be obtained
by "riding the yield curve." The potential for such profit was greatest
during the years 1962-65 when prospects sometimes suggested that shortterm interest rates would be stable or would decline. During these
years Regulation Q ceilings on the shorter maturities were somewhat
below market rates for long periods, and the ceiling —
in effect —
-3provided a cushion against market loss as holdings approached maturity.
The yield curve descended as maturity shortened, and this made it
possible for original holders to offer their CD f s at lower rates
(higher prices) than those available at the time the certificates were
acquired —
thus establishing a profit over and above the interest
earned during the period held.
Dealers often were able to acquire
certificates on a favorable "carry11 — either with repurchases or with
dealer loans; to hold them for an additional period to shorten the
maturity; and then to sell them or offer them for repurchase again,
depending upon the money market outlook. Third-party buyers were also
attracted by the possibility of profits. In general, however, there
was a tendency for over-all market activity to decline after the change
in Regulation Q in November 1964, which permitted issuance of certificates with maturities of less than 3 months.
The secondary market underwent radical deterioration during 1966
after the establishment of a single rate for all CD's with maturities
of 30 days or more. The year is distinguished from the previous period
by the extreme influence of both rate and nonrate factors. The
potential for profits from "carries" largely disappeared, and original
issues were available at maturities as short as 30 days at maximum
ceiling rates — particularly during the last half of the year. Dealer
positions were exposed to undercutting. With the single rate of 5 1/2
per cent on all maturities, issuers could make unexpected changes in
rates on various maturities. As market rates approached and later
exceeded ceiling rates during the summer, dealer positions and trading
volume dropped to very low levels. Distress selling also characterized
the market at times during the year. After July, if certificates were
-4sold before their due dates, there was a constant risk of loss on the
principal.
During the latter part of December 1966, dealers began to rebuild
positions in anticipation of taking profits as interest rates eased.
By the year-end dealers had made large additions to their inventories
as prospects seemed to indicate an abrupt and rapid movement toward
lower levels of the over-all structure of rates. Positions reached a
record high average in January 1967. Dealers acquired some volume
of CD's with desirable maturities at 5 1/2 per cent. Trading increased
but less correspondently than dealer inventories. While there was some
lengthening in maturities on new offerings of CDfs as rates fell
below the ceilings, some issues with shorter-term maturities were also
available.
This episode seem to represent a complement to the one in 1966
characterized by the dramatic rise in rates. The secondary market
under "normal conditions" —
a period of general stability in inter-
est rates without constraints on various maturities resulting from
rate levels set by Regulation Q —
is still to be tested.
Certificates of roughly 30 to 35 banks form the bulk of the
market and have accounted for most of the trading.
The market
classifies certificates according to 3 categories of issuing banks
prime, lesser-prime, and off-prime. Although the designation given
to any bank may vary from one buyer to another, the prime category
generally includes from 12 to 20 banks; the lesser-prime category,
from 35 to 45 banks; and the off-prime group, all other banks. In
general, prime and lesser-prime names include banks with deposits of
-5at least $500 million.
Most prime-name banks are banks of international and national
prominence, and their certificates trade at the lowest yields.
Certificates of lesser-prime names trade at a small spread above this
level. Those of off-prime names, if traded, carry a somewhat larger
spread; or at times their spreads are negotiated.
The common unit of
trade is $1 million, but denominations of as little as $100,000 —
like lesser-known names —
trade at slightly higher yields.
In 1966, with the change in character of activity in the market,
trading of bank issues was limited to 15 to 20 of the best names.
Buyers revised their authorities to purchase, and some firms even
rescinded the authority to buy CD f s. By February 1967, most of the
previous authorities had not been fully restored.
While the secondary market for CD f s performs the basic function
of enhancing liquidity of certificates, it is limited in "depth,
breadth, and resiliency."
Limitations in terms of these qualities —
particularly when compared with competing markets — arise principally
from the existence of Regulation Q provisions that set maximum rates
on various maturities of certificates. Moreover, some of its limitations may reflect its relatively short period of development, during
part of which it has been exposed to an unusual conjecture of events.
In contrast, markets for bankerfs acceptances and for Treasury bills
have developed over long periods and have received official aids.
Commercial and finance company paper are not subject to rate
limitation.
From the viewpoint of "depth11 there is no substantial evidence
of large orders on dealers1 books at prices either above or below
-6the market, even at its peak of activity. At times dealers find it
difficult to match demand and supply, and they cannot always adjust
their positions readily, because of the irregularities that occur in
both supply and demand.
These irregularities are caused by a number
of variables arising from interconnection of market and ceiling rates,
rigidity of the authorities under which many borrowers operate, and
the attitudes and expectations of both issuers and buyers. Holders
sometimes face delays in "pressing sales,11 that is, when they need to
sell a large block of CD's in a short period of time.
Corporations,
for example, often make purchases in the market only in response to
dealer offerings. On the other hand, dealer purchases at times reflect merely an accommodation of the customer —
the dealer being
repaid with other business.
From the viewpoint of "breadth," buyers and sellers represent
an increasing number of divergent investor groups, but the principal
buyers and sellers have been and still are corporations.
In many
ways the CD market is analogous to the municipal market, in which
there are many issuers but a relatively small group of large investors.
From the viewpoint of "resiliency," the market is generally slow
to adjust to rapid changes in rates. New orders do not flow in
promptly to take advantage of sharp and unexpected fluctuations in
prices, and changes in the rates cause no substantial or rapid changes
in inventories. Even with a consistent increase in outstanding CD's,
trading has declined.
The volume outstanding rose steadily from early
1961 to a peak of about $18 billion in August 1966 — with a tendency
toward progcesssive shortening of maturities, in part in response to
Regulation Q changes. But trading on an average day in August 1966
-7was only $22 million, in contrast to $85 million in January 1965.
This was true despite the fact that an increasing volume of short
maturities was available from issuers.
During the last quarter of 1966 both dealer positions and trading
reached virtual historical lows.
rapidly in January 1967
Although dealer positions rose
in anticipation of profits as rates shifted
downward, trading did not rise in proportion.
Regulation Q ceilings
since 1961 have made the connection between the primary and secondary
markets more intimate and have made trading activity dependent to a
large extent on levels at which the ceilings were set on various
maturities in relation to other market rates.
If Regulation Q continues to maintain a single ceiling rate for
CD f s with maturities of 30 days or more, trading in the secondary market
will continue at very low levels as long as new-issue rates are at the
ceiling and market rates on comparable maturities are above the ceiling
rate.
The secondary market supply of CD's declines.
Investors in
outstanding issues sell into the market only as a last resort to avoid
capital loss.
well, there is
Dealers face a penalty cost in carrying positions.
As
a competing supply of desirable investments with coupons
or yields not subject to the restriction of regulation.
Although
dealers will make some bids which vary with maturity and reflect the
structure of market rates, there is evident discontinuity in this
market as compared with some others when money is tight.
are negotiated on an individual basis.
Many trades
Expectations of both investors
and dealers include the possibility of a change in Regulation Q.
Trading should increase as market rates of interest fall below the
Regulation Q ceiling and conditions permit issuance of new CD f s.
However, trading will fluctuate with the ability of banks to issue
-8-
maturities in excess of the 30-day minimums, and it will be the market
that will supply paper with the shorter maturities.
Under these con-
ditions dealer positions will be more exposed than when the Regulation
restricted issues of certain maturities, and the potential for profits
may tend to be relatively small•
Hence, dealers will run the risk of
having issuers make unexpected changes in rates at various maturities,
thereby undercutting their positions.
They are also exposed to the
risk of an unexpected change in Regulation Q.
Even with a new-issue market substantially larger than at present
(mid-February 1967), secondary trading probably will not reach the
levels of 1964-65.
Further development of the market on comparatively
smaller volume under conditions that suggest stable or declining rates,
however, could lead to a narrowing of spreads such as has characterized
trading in certificates of lesser-prime and off-prime banks.
Assuming
that the rate of growth that has characterized the new-issue market
subsides, yields may also decline relative to competing investments.
Yields to date (mid-February) have probably been sweetened to promote
the market.
The spreads in yields that both the primary and secondary markets
have established for CD's of some lesser-prime and off-prime names arise
from several factors.
When their authorizations permit discretion,
buyers will refuse certificates of lesser-known names when those of
better-known names are available at or near the same rate.
In this
sense buyers discriminate against certificates of the smaller and less
well-known banks.
Differentiation of names became more widespread
after the failure of banks in Texas, California, and Colorado in 1964
and 1965.
Premium yields arise in part as an inducement to the buyer to take
lesser-known names and in part as compensation to the dealer for additional
marketing effort and cost. Dealers state that they have to make more
effort and have to educate customers in order to sell CD?s of lesserknown names. Such certificates must be carried in position longer; they
are more difficult to place on repurchase or on loan, even though CD's
of some prime names may be included in their package; and they cause the
dealer trouble and expense in checking the volume of outstandings and
in considering other relevant information of the particular bank.
Some smaller banks with good reputations issue CD's to local
customers at the same rates as prime banks issue them to national
customers, or possibly at lower rates. Markets are differentiated,
however, and sales of locally oriented certificates in the secondary
market call for a higher yield because the bank in effect is tapping
the national market at one step removed. Yield spreads thus are
viewed as an impersonal market mechanism for regulating new issues.
Both the rate on the new issue and the premium yield in the secondary
market in this case do not reflect arbitrary actions but rather a
response to influences of the national short-term money market.
Yield spreads could be eliminated if cash guarantee were made
by the Federal Deposit Insurance Corporation.
certify credit on a bank's certificate —
as is the practice with acceptances —
Or if a dealer would
charging 1/8 of a per cent
such spreads could be reduced
and standardized, with improved marketability for the CD's. However,
dealers believe that impersonal market evaluation of credit risk
should be encouraged, and they do not want to assume the obligation
of certifying credits. Participating dealers view the market as
-10presently selecting, on this impersonal basis, those banks that can
grow or be "tided over" on the basis of CD's, but these dealers will
not give a guarantee of credit soundness.
If the Federal Reserve Banks were to act as clearinghouses for
information or to function as brokers in matching the demands of smaller,
expanding banks for funds with any supplies of surplus CD funds of
other banks, these actions would be viewed with concern by participants
in the market.
Both issuers and buyers state that action would be
considered as tantamount to a guarantee of soundness of the expanding
bank. And if the bank should become overextended, the Federal Reserve
would be blamed.
If there were no effective ceiling on rates —
so participants
argue — any bank could bid for funds, but the problem of rate differentials would remain.
The rate paid by the individual bank would become
an increasing function of the average rate prevailing in the market,
the volume of CD f s outstanding, and the amount of new issues proposed.
This development could conceivably lead to a more even flow in the
marketing of issues. Under these conditions, the preliminary cost of
offerings by smaller banks might be reduced but not eliminated.
Such
premiums would bring interest costs on offerings by these banks to the
ceiling sooner where they would encounter other inelasticities in the
current market, such as the inability to issue —
difficulty in issuing —
market.
or the increased
certificates when large banks are in the
Improved market techniques and the increasing familiarity
of buyers with good reputations will help to reduce current differential yields in trading on a number of names.
In early 1966 a large commercial paper house, commenting on the
-11"inequity of money rates," stated that the secondary market yields on
certificates of major money market banks had consistently been higher
than those on major finance company paper of similar maturities since
August 1964. This was attributed to weak secondary market support of
CD's. Money costs for smaller regional and money-center banks reflected
premiums above these rates. In an attempt to improve the liquidity of
CD's and the mechanical ease of trading —
looking toward reduction of
the premium and a proper yield relationship to the other money market
instruments —
this firm suggested organization of a consortium of
regional banks and recognition of the firm as the leading dealer in
their secondary market certificates. The firm would then undertake to
make a market that would reflect an "appropriate dealer spread11 such as
exist in acceptances. For instruments of members the dealer would post
daily rates and would advertise a market with a spread of 10 basis points,
This market would be quoted in units of 5 basis points with various
maturity categories similar to those for acceptances. Adjustment to the
rate scale would be made when the dealer's position reached key levels
in relation to the amount of financing available to the dealer.
Participating banks could post rates for original issues of certificates at the sell side of the dealer's posted market rate, or at a
lesser rate. The participating banks would provide the dealer with
any financing necessary to carry reasonable positions at a rate equal to
the interest earned on certificates held in loan position less any
trading loss on certificates sold out of positions. In such an arrangement no profit would result to the dealer on certificates in position.
This plan was expected to provide that the issue rate for members would
be reduced substantially.
On the assumption that the participating
banks would obtain Federal funds to provide dealer financing, it was
-12expected that there would be a profitable arbitrage between the
Federal funds rate and the interest earned on certificates held in
loan. By establishing a known and advertised market for the certificates, it was anticipated that the issue rate for participating banks
would be reduced to levels prevailing for major finance company paper
and bankers' acceptances.
The consortium, however, could not be formed.
One reason was that
most of the prospective participants thought that they were placing CD f s
satisfactorily.
Another was that some participants thought that customer
relationships would be taken advantage of and that the benefits of the
arrangement favored the dealer.
Since losses would be absorbed by the
lending banks and the cost of "carry" would equal the CD rate, there
would be no cost of "carry" to the dealer.
Many participants continue to describe the certificate as a
clumsy instrument, and they state that the preference among institutional
portfolio managers is for issuance of CD's on a discount basis. Issuance on a discount basis would facilitate computation of purchase and
sale prices and would avoid the awkward formula presently in use.
Furthermore, issuance on a discount basis would generally make it possible for holders to avoid showing book losses unless a very sharp
change in rates occurred; some large buyers currently will not sell
into the market if a book loss would result.
If these changes were
made, the resulting advantages might increase the marketability of
certificates substantially.
Market participants stated that they believed that the Federal
Reserve would perform a disservice if it entered the market for CD's
on a bid basis. Destruction of impersonal relationships was feared.
-13Others thought that the "feel of the market,11 which is provided now
by changes in flows and rates, would be lost.
A letter of inquiry from the Joint Economic Committee of the U. S.
Congress forwarded to monetary economists in late 1965 asked whether
the Federal Reserve should "supplement its portfolio of Federal
Government securities with other types of assets such as commercial
loans, foreign exchange, municipal securities, corporate bonds, mortgages, and commodities?"
Replies were received from 86 economists and others interested in
monetary economics, and these were published in January 1966*
About
one-third of the respondents expressed the opinion that current policy
should be maintained because acquisition of private credit instruments
would involve entrance into relatively narrow markets and impose burdens of credit analysis. Purchases and sales of selected issues would
subject the Federal Reserve to political pressures and criticisms
that should be avoided.
Less than one-tenth of the respondents pre-
ferred to give the System as much flexibility as possible. They
indicated, however, that the System should be free to determine its
own policy.
About one-sixth favored operations in private credit and municipal markets. Advantages that were cited include increased ability to
influence the cost and availability of credit and to stimulate certain
sectors of the economy and certain types of spending. One economist
specifically recommended dealing in CD's.
-14III NEGOTIABLE CERTIFICATES OF DEPOSIT
Certificates of deposit have been used for many years by commercial banks in the United States to attract time deposits•
In
part these instruments represented long-term savings, but they were
also used as temporary investment havens for interest-sensitive funds
of business firms and large investors. As far back as 1900>certificates were popular instruments at many banks, particularly in the
Midwest and in parts of the South.
Even national banks —
although
they lacked the express authority to accept time deposits —
reported
the issuance of some certificates.
By 1913, when the Federal Reserve Act was passed and the powers
of national banks to accept time deposits were clarified, competition for these deposits was common among national as well as state
banks and trust companies. As time deposits grew rapidly during
the 1920 f s, observers noted that a large part of the increase represented funds that would ordinarily go into demand or commercial
departments of banks. They referred especially to funds that were
placed in savings deposits or CD's without definite maturity.
Issuers did not expect that these certificates would be traded, even
if they were issued in negotiable form.
In fact, there was no
organized secondary market for such certificates, and their volume
was limited.
But after World War II a new setting emerged — a more closely
integrated banking system along with a national money market.
Many
commercial banks accepted time deposits as an accommodation to corporate and other organizational customers, but they did not actively
solicit such deposits. Many certificates offered to corporations
-15-
were tied to loan agreements and did not draw interest.
As the postwar period developed, the money market structure
changed —
passing from one with an overhang of surplus reserves to
one of relative reserve scarcity.
of financial officers emerged.
In addition, a new generation
These officers, in charge of corporate
treasuries and in responsible positions in banks and the money markets stimulated by large cash flows, rising interest rates, and other costs •
established new arrangements for sources of financing as well as
investment.
As interest-sensitive corporate treasurers trimmed their
companies1 operating balances to low levels, some instability and
shrinkage of deposits resulted, particularly at banks in New York City.
At the same time major banks in other areas of the nation were growing,
and many concerns were turning to these banks for some of their
principal banking services.
Deposits of New York City banks fell
from 21 per cent of the total for all banks in the United States at
the close of World War II to about 15 per cent at the end of 1960.
In order to combat both instability and shrinkage of deposits,
the New York City banks announced in early 1961 that they would begin
to issue interest-bearing certificates.
Issuance was expected to
attract short-term corporate funds lodged elsewhere in the banking
system and to provide an instrument that would compete for corporate
balances being invested in a variety of money market instruments,
principally in Treasury bills.
In late February 1961, the First National City Bank of New York
began offering certificates to domestic business corporations, public
bodies, and foreign sources.
Two things concerning these certificates
represented innovations in financial markets.
One was that, according
to public announcement, the certificates would be negotiable.
And
-16-
secondly, the Discount Corporation of New York, a leading dealer in
U. S. Government securities, announced that it would make a market
for certificates to provide liquidity, thus broadening the appeal
of this type of investment.
A.
Growth
Public awareness of the negotiability of these certificates and
provision of a secondary market for them increased their appeal considerably.
Other banks quickly followed the lead of National City
Bank in offering certificates, and other dealers joined in making
a market for the certificates.
A little more than a year later,
negotiable certificates of deposit outstanding at the nine largest
banks in New York City were estimated to total $1.3 billion, and
almost that amount was outstanding at the leading banks outside New
York —
Chicago and other principal cities.
countrywide total to about $2.5 billion.
The great bulk of these
certificates were in large denominations —
or more —
This brought the
units of $1 million
which trade easily in the secondary market.
Member banks have been the chief issuers of CD's.
Most non-
member banks are small, and more than 90 per cent of the number hold
deposits of less than $5 million.
certificates to any extent —
These banks are ikiable to issue
and in any event none in denominations
that appeal to investment buyers.
Issues of certificates in de-
nominations of $100,000 or more by member banks accounted for 40
per cent of the increase in time and savings accounts at the weekly
reporting banks from 1961 to the end of 1965.
Certificates of deposit underwent very rapid expansion in 1962
—
reflecting (1) the increasing acceptance of the instrument and (2) the
-17development of the secondary market, which had begun in the spring
of 1961. By the end of 1962 leading commercial banks in New York
City and Chicago had become by far the largest issuers. They
accounted for one-third and one-sixth, respectively, of the $5.8
billion outstanding.
The marked growth of the certificates at the
large banks reflected a liberalization of banks1 offering policies.
Their previous policies had, for the most part, limited issuance of
certificates to occasional customers and had been in sharp contrast
to the more liberal issuance policies followed by many smaller banks
and by banks located in the South and Southwest.
The decision of
the larger banks created a new market for certificates and accelerated
the increase in volume of all issuers. At the year-end the total
outstanding amounted to $5.8 billion and was in excess of, or close
to, the totals for most other short-term investment instruments, as
shown in Table 1.
Expansion continued at a rapid pace until December 31, 1965,
Table 1
SELECTED MONEY MARKET INSTRUMENTS,
DECEMBER 31, 1960 and 1962.
Billions of dollars
Certificates of deposit
Bankers' acceptances
Commercial paper
Short-term municipal
securities
Treasury bills
1960
1962
0.8
2.0
5.8
2.6
5.9
4.5
4.0
39.4
4.8
48.3
-18with year-over-year monthly rates usually ranging from 29 per cent to
35 per cent.
In 1966, however, the rate of gain slowed from 22 per
cent in January to 7 per cent in September; and in November the total
actually declined by 6 per cent. At the end of 1963 outstanding CD's
reached $10 billion; in 1964, $13 billion; in 1965, $16 billion;
and in August 1966, a peak of more than $18 billion. After August
the total began to decline as short-term market rates on certificates
rose and remained above the 5 1/2 per cent ceiling established by
Regulation Q.
By the end of November more than $3.2 billion of
CD's had run off and they could not be renewed because of the tight
money market and the suppressing effect of the Regulation Q ceiling.
In December, however, the atmosphere changed.
Largely in response
to the easing of rates during the month and the subsequent rapid
decline after the year-end, banks were able to resume issuance of
CD's.
Between mid-December and the end of January 1967, they issued
about $3.1 billion of certificates, bringing the total outstanding
back to $18.1 billion.
By the first of February most banks with
deposits of $1 billion had posted rates of 5 1/4 per cent for all
maturities, while a few were offering rates of 5 per cent.
The growth in CD's was widespread geographically as well as by
size of bank but differed somewhat among Federal Reserve districts,
as shown in Table 2.
In part these differences reflect changes in
certificate-issuance practices before 1961 and the policies of
various bank managements. Banks in the South and the Southwest,
which had issued certificates before 1961, have a larger base;
hence, they reported a slower rate of growth.
-19-
Table 2
NEGOTIABLE CERTIFICATES OF DEPOSIT, BY FEDERAL RESERVE DISTRICT
December 30, 1961, and May 18, 1966
(Denominations of $100,000 or more)
Issuing; banks
Amounts
Federal
Reserve
district
In millions
of dollars
Dec. 30,
May 18,
1961
1966
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Number
Percentage
increase
82
829
1,102
8,165
911
640
Dec. 30,
1961
May 18,
1966
16
26
59
83
19
24
47
59
84
16
27
64
86
6.0
5.5
1.0
3.0
3.0
3.0
3.0
2.5
1.0
3.0
5.5
64
19.0
41
525
1,181
7
233
93
53
351
34
30
78
340
456
1,363
484
233
1,115
2,053
$2,893
$17,723
106
606
516
747
827
328
225
350
512
16
13
13
32
12
374
2,166
288
278
334
Percentage of all
banks in district
Dec. 30,
May 18,
1961
1966
4
26
36
31
232
23.0
20.0
4.5
5.0
11.5
14.0
8.0
3.0
5.5
7.5
13.0
29.0
632
Note — Data for December 30, 1961, are based on a survey of 410
member banks (351 weekly reporting banks and selected additional banks believed to have
an appreciable volume of negotiable CD's outstanding). Some adjustment in the data for
several Federal Reserve districts has been made to eliminate CD's under $100,000 in
denomination. Data for May 18, 1966, are based on a survey of virtually all member
banks and on Federal Reserve Board Release H.4.2. Results of the surveys without adjustment appear in the Federal Reserve Bulletins» for April 1963, p. 458 ff.; and
August 1966, p. 1102 ff.
Issuance of CD's is concentrated in banks with deposits of $1
billion or more.
This group of banks accounted for 72 per cent of
the total outstanding at the August 1966 peak as compared with 54 per
cent at the end of 1961.
Even at that time certificates issued by
the largest banks accounted for about the same percentage of outstaadings as did the total deposits of these banks to total deposits
of all issuers.
-20-
Issuance is further concentrated in the leading banks in New York
City, and banks there have consistently maintained or increased their
relative share.
It is New York's position as a money market that gives
it the major fraction —
almost 40 per cent —
with any other financial center.
of issues as compared
Within the city are the headquarters
or financial offices of most of the large domestic business corporations, and they normally would be expected to deal with local banks.
Even if they do not have offices in New York, financial officers often
visit the city, and some take out CD's there in anticipation of
future customer relationships.
Issues of smaller banks, however, have experienced sharp increases, and the participation of these banks is reflected in the size
of the certificates issued relative to the size of the issuer.
As
early as 1961,about two-thirds of such issuers had some certificates
outstanding in denominations of $500,000 or more, a denomination
ordinarily traded in the secondary market, and about 83 per cent of the
issuers had some CD's at least as large as $100,000, a denomination
traded on occasion in the early market and with more frequency as the
market has developed.
Although the rise in volume has been rapid and continuous, some
seasonal patterns in outstanding CD's are evident.
The amounts de-
cline around the quarterly tax and dividend dates and subsequently
rise in substantial amounts in preparation for the next payments.
Some bankers argue that the ability of the larger banks to increase or decrease time deposits by large amounts with small shadings
in rates or by lengthening* or shortening the maturities offered, has
-21-
contributed to increased flexibility in the expansion and contraction
of the total supply of money market instruments.
In turn, this factor
has tended to reduce the size of changes in money market rates associated with a change in demand.
The market from time to time over the period of development has
exhibited a short-run elasticity as to the size of the market.
When
New York City banks withdraw certificates or issue fewer of them,
banks outside of New York may increase offerings and attract more
funds.
Regulation Q ceilings also affect smaller banks more severely
at times than they do the large prime-name banks, unless offerings
are in local markets.
B.
Characteristics
In view of the growth in CD's as a financial instrument, a
description of the characteristics most common to them would seem to
be in order.
1.
Denominations.
denominations.
Certificates are offered in a variety of
These range from about $25,000 to $10 million and higher,
Denominations larger than $1 million, however, became a rarity as the
secondary market developed.
Limits are closely and directly related
to the size of the issuing bank.
Smaller banks holding the excess
balances of the generally smaller local or regional organizations that
they serve cannot set limits beyond their customers1 reach, and CD's
of these banks account for most of the outstandings at the lower
end of the denominational range.
Most often, however, denominations
are $100,000, $500,000 or $1,000,000.
The larger banks set their
lower limits in these ranges because they compete only for funds that
are interest-sensitive and that would otherwise enter the money
-22-
market.
Limits have some flexibility, and the large banks may set
aside these limits at times to accommodate valued customers.
In August 1966, about 2,200 member banks —
third of all member banks —
just over one-
were issuing certificates.
Certificates
of $100,000 or more were being issued by some 632 banks ranging in
deposit size from over $8 billion down to less than $10 million.
About 75 banks were found in the latter size group, and 225 banks in
the $10 million to $50 million size group.
This represented more
than a four-fold increase in the number of issuers holding total deposits of less than $100 million as compared with the year-end 1961.
Banks with deposits of $500 million and over, however, accounted for
more than three-fourths of the total amount of certificates of
$100,000 or more outstanding.
In May 1966, 1,549 member banks reported having negotiable CD's
outstanding of less than $100,000 in denomination.
These banks were
widely scattered across the nation, the largest number being found
in the Chicago, Kansas City and Dallas Federal Reserve Districts.
1
These certificates are not traded.
Federal Reserve Bulletin, August 1966, p. 1122.
-23Table 3
CD'S $100,000 AND OVER OUTSTANDING BY SIZE OF BANK
December 30, 1961,and August 31, 1966
Size
(total
deposits,
in millions
of dollars)
August 31, 1966
Dec . 31, 1961
Amounts
Amounts
In
Percentage
millions
of dollars increase
Under 100
100 - 500
500 - 1,000
1,000 and
over
Number
of
banks
In
millions
of dollars
Percentage
increase
Number
of
banks
82
559
689
3
19
24
72
105
35
175
2,435
2,470
1.0
13.2
13.4
382
172
41
1,563
2,893
54
100
20
232
13,289
18,369
72.4
100.0
37
632
Note — Based on materials in Federal Reserve Bulletin, April 1963,
p. 458, and August 1966, p. 1125 and Federal Reserve Board release G.9, October 6, 1966,
2.
Prime, Lesser-Prime and Off-Prime Issuers. As certificate
volume grew, buyers in both the primary and secondary markets developed
several classifications of certificates — prime, lesser-prime, and offprime.
These designations do not represent an evaluation of the sound-
ness of the issuer, but they are generally representative of the
relative marketability of the instrument.
The prime-name group
comprises from 12 to 30 banks; lesser-prime about 45 banks; and offprime all other issuers.
Classifications of the leading banks in the
principal money centers as prime or lesser-prime will differ from
buyer to buyer.
Differentiations reflect
the buyer's estimate of
the management and his opinion of whether the bank has been prudent
in its issues. All of the banks classified as prime by one buyer or
2
another generally have deposits exceeding $1 billion, and as noted
Several banks with deposits of about $500 million are considered
prime by some buyers.
-24-
already, they have issued the bulk of the certificates.
3.
Issuing Rates*
Prime-name banks issue certificates at the
"best rates11 when Regulation Q ceilings permit —
about 1/4 of a per-
centage point above rates on comparable maturities of Treasury bills.
Certificates of lesser-prime names carry a spread of 5 or 10 basis
points above the best rates.
banks —
Other issuers —
generally the smaller
must pay 1/8 to 1/4 per cent of a percentage point more than
prime banks, or they negotiate a rate with the buyers.
Thus rates
tend to vary with the size and reputation of the issuing bank
rising as size of bank declines.
—
All rates may be slightly higher if
CD denominations are less than $1 million.
Some smaller banks, which
are well known and respected in their communities and have strong
customer relationships, tap regional or local markets at the same
rates as prime banksy or sometimes at lower rates.
Certificates are
issued and traded on a yield-to-maturity basis, and a comparison with
instruments issued and traded on a discount-from-par basis —
as Treasury bills —
such
overstates the actual difference in yield.
3
In issuing certificates, it is necessary to consider returns on competing
instruments other than Treasury bills —
that is, on sales finance
company paper, commercial paper, and bankers1 acceptances.
Finance
company paper is the most important of these, because the volume
outstanding is large and denominations can be arranged to suit the
buyer.
4.
Maturities.
Maturities of certificates have varied from time
to time along with changes in current and prospective conditions in
3
This difference will vary with levels of interest rates. Equivalent
coupon yields on 3-month Treasury bills will be 15 basis points higher
than discount at rates of 5 1/2 per cent and 5 basis points higher at
levels of 2 1/2 per cent.
-25the money market, supplies of competing instruments, buyers1 and issuers1
preferences, and the strength of demand for bank credit, as well as
the provisions of Regulation Q in setting rate ceilings for maturity
ranges. As the outstanding volume rose, average maturities of certificates tended to shorten, dropping from about 8 months in 1961 and
1962 to 2 months in November 1966.
Regulation Q ceilings restricted issuance of maturities of less
than 6 months prior to July 1963, and less than 3 months prior to
December 1964. Buyers who wanted such short maturities could find
them only in the secondary market at the going rate. Although some
certificates have been issued with maturities of 2 to 5 years, these
generally represent special situations. Maturities of certificates
issued by the larger banks tend to be shorter and those of smaller
banks longer, reflecting in the latter case less interest-rate sensitivity on the part of customers of the smaller banks.
Increasingly,
during the first several years certificates issued by the larger
banks matured on quarterly tax and dividend dates. Maturities
were later spread out when market conditions permitted in an attempt
to avoid concentrations and associated "binds" on these dates.
-26-
Table 4
AVERAGE MATURITIES OF NEGOTIABLE CERTIFICATES
OF DEPOSIT OF $100,000 OR MORE
Date
Months
1961 - Nov. 30
8.0
1962 - Nov. 30
7.5
1963 - June 30
5.3
1964 - May 19
Aug. 19
Nov. 18
4.1
3.8
3.4
1965 - Feb. 17
May 19
Aug. 18
Nov. 17
3.5
3.7
3.9
3.4
1966 - Feb. 10
May 18
June 29
Aug. 31
Sept. 28
Oct. 26
Nov. 30
3.3
3.8
3.7
3.0
2.2
2.5
2.0
Note — Data for 1961-63 are estimated. Data for other years
are from surveys of the Federal Reserve Board.
The over-all shortening of maturities that has occurred is the
result of liberalization of Regulation Q ceilings and the activities
of the larger banks, principally, in meeting competition in the money
market as Federal Reserve credit policy was gradually tightened.
Variations in average maturity arise from defensive shortening to avoid
paying higher rates or from defensive lengthening as the spread between market and ceiling rates widens. Buyers1 preferences at times
are also factors.
C.
Buyers
The major buyers of certificates, from issuers as well as in the
-27-
secondary market, are corporations. Other buyers include commercial
4
banks,
foreign official institutions; a range of institutional in-
vestors such as insurance companies, savings banks, and savings and
loan associations; mutual funds; and individuals. On occasion
dealers have bought certificates directly, with the intent of reselling in the secondary market.
In some regional markets State
and local government units are important buyers. When rising interest
rates reduce new-issue volume, some banks in placing CD's resort to
the use of brokers and dealers with wider business contacts. These
intermediaries obtain payment for services by charging a finder's
5
fee or by charging more than they paid.
The deposit of time money at commercial banks in exchange for a
certificate is governed by both rate considerations and customer relationships. Most corporate treasurers prefer to place funds only with
banks at which they maintain working balances or important credit lines.
Since the larger corporations generally deal with several leading
banks, they place their funds with those that offer the highest rates.
Corporate treasurers may place limits on both total holdings of certificates and on amounts held in individual banks. The finance committees
Member banks may issue CD's to other member banks without restriction, but a member bank may issue CD's to nonmember banks only
to 10 per cent of its capital and surplus.
A part of the finder's fee in some instances may be passed on to
the purchaser either directly or indirectly through concession pricing. If
such practices raise the effective yield paid by the bank above the ceiling
rate, they are considered to violate Regulation Q. When these interest
payments exceed the ceiling, the Federal Deposit Insurance Corporation
may consider the certificates not to be deposits and refuse insurance
payments if the bank should fail. Cases involving broker CD's and
FDIC insurance coverage are still in litigation.
-28-
of some leading corporations have set rigid lists of the banks with
whom they will place funds, and they allow the treasurer no discretion
in selection.
These lists apply to original issues as well as certi-
ficates bought in the secondary market.
Other buyers generally have
less specific guides, but like the larger corporations, they may
recognize degrees within the prime and other categories when taking
certificates.
Most banks have imposed no formal restrictions on resale of
certificates by original holders.
Some banks, however, caution cus-
tomers to hold their certificates and sell them into the market only
as a last resort.
This caution became more widespread with the dis-
appearance of the yield curve on CD's in 1966.
In general, the liquidity
of the CD market has not been considered constant and completely
dependable.
Issuers prefer not to have buyers take losses because
they fear that losses might inhibit future takings.
Furthermore,
the issuers want their CD's to "stand up n when they do appear in
the market.
D.
Bank Uses of Funds
Banks generally try to avoid issuance of certificates at the ex-
pense of a reduction in their holdings of demand deposits.
The over-all
total of certificates a bank will issue is somewhat flexible.
It
may be raised as long as there are profitable uses for the funds and
the outlook for certificates is favorable.
Some banks may express
their maximums in dollar terms; and some as a percentage of total deposits.
In setting limits, smaller banks are concerned about the effects
that certificates may have on the deposit totals shown in their
-29-
published balance sheets.
Inability to roll over certificates may
result in a decline in total deposits from year to year.
However, the
ratios of CD's to total deposits at issuing banks have been quite
stable over time, particularly at the smaller banks.
The level seems
to be closely related to bank size, with the smaller banks maintaining
lower ratios than the larger banks.
Table 5
RATIO OF OUTSTANDING NEGOTIABLE CD'S TO TOTAL DEPOSITS, SELECTED DATES
(Per cent)
Size
(Total
deposits,
1964
1965
1966
in millxons
Nov. 17
of dollars)
Nov. 18
All issuers
6.1
6.4
6.7
Under 100
100-200
200-500
500-1,000
1,000 and over
Prime:
4.4
4.2
7.0
7.5
4.6
4.0
7.4
7.8
N.Y.C.
12.6
Outside
N.Y.C.
Nonprime
8.2
8.4
Note —
the dates shown.
Aug. 31
Oct. 26
6.8
10.1
8.9
4.6
4.6
7.4
7.8
4.7
4.6
7.3
7.8
5 0
15.2
17.2
8.3
8.4
9.6
9.1
May 12
May 18
sn
•j. KJ
7.7
6.7
7.5
17.9
15.0
13.2
10.3
10.7
9.0
7.5
10.9
10.1
7.0
Figures are from surveys conducted by the System for
Banks issuing certificates generally place the proceeds in a
"pool of funds."
The larger banks, believing that certificates afford
greater stability of deposits, have used the funds to seek attractive
loans and investments, with more emphasis on loans as markets tightened
in 1965 and 1966.
Unlike other money market instruments, CD's may
influence the reserve position of banks because of the lower reserve required
-30-
against time deposits.
As the market evolved, a number of leading
banks adopted the practice of varying the rate offered on certificates
and in so doing used certificates as one means of adjusting their
money position.
Smaller banks,on the other hand, feeling less sure of their
ability to avoid run-offs of certificates, generally do not use the
funds to support loans to the same extent as large banks.
Smaller
banks employ the proceeds largely for the purchase of municipal
securities, in the belief that such holdings can be liquidated to
advantage in the market when necessary.
For years commercial banks have been important purchasers of
municipal securities; in the period from 1952 to 1965 they supplied
about one-fifth of all such funds.
As banks began to compete for
time money after 1957 with the more liberal rates permitted by Regulation Q, they increased their taking of municipal securities.
And as
certificates gained in acceptance, the banks became the dominant
purchasers of municipals.
As of year-end 1966, they held almost
three-fourths of the total supply.
Certificates have increased the ability of the banks to attract
deposits from beyond their normal service or market areas, thus making
it possible for them to meet a broader range of demands.
Some banks,
however, have opposed the use of certificates and have issued none
because they feared that they would be misled in determining minimum
levels of funds to be held as reserves and thus the maximum amounts
that could safely be used for lending and investing.
Furthermore
they prefer not to incur a heavy burden of interest expense.
-31-
IV THE SECONDARY MARKET FOR CERTIFICATES
Since the initial stage of development in 1961, the secondary
market has provided marketability —
to third parties before maturity —
that is, has facilitated sales
for most certificates.
not all certificates are marketable.
However,
A number are issued by banks
that are not well known outside their service areas, and others are
too small in denomination to attract the large investors who participate actively in the secondary market.
Furthermore, many original
buyers of CD's do not buy with the intention of selling, and if they
need to rearrange their portfolios, they use other investments such
as Treasury bills first.
The increased versatility that the market provides for CD's
issued by the leading banks in principal money centers enables these
banks to tap the national pool of short-term funds without a concurrent
obligation for making loans to the customer.
The mere existence of
the market, however, has increased the acceptance of CD's of all issuers regardless of their size or location.
In the secondary market certificates compete principally with
Treasury bills, bankers' acceptances, and finance company paper.
Partici-
pants rate the markets for these short-term investments as excellent
for Treasury bills and good for both bankers' acceptances and certificates.
While finance company paper has no secondary market, issuers
under certain conditions will buy back the paper prior to maturity, thus
providing some flexibility to buyers.
A.
Participants And Operating Methods
The primary and secondary markets for certificates are quite
closely related.
The parties include (1) the issuers, (2) the
-32dealers who provide an intermediary function, and (3) the buyers
of certificates.
The dealers buy, carry, and sell certificates at
rates that reflect current market conditions. Certificates usually
come into possession of dealers from original holders, but at times
they come directly from issuers.
Certificates not acquired from
these sources find their way into the market through brokers and
to to a more limited extent as resales to the dealer by third
parties.
Buyers from dealers are for the most part corporations,
trustees, and institutional investors.
To a certain degree the issuers also participate in the
market from the demand side as buyers of, or lenders against, certifi7
cates (other than their own). A number of banks buy certificates
for investment only when rates on certificates are "out of line"
with rates on other instruments.
Some banks, however, prefer not to
buy certificates for investment because they must be carried in the
"Cash and due from banks" account, which suggests possible inefficiencies
in employment of funds. Furthermore, certificates are not thought to
provide the same degree of liquidity as other instruments.
As an auxiliary to the market, some issuing banks assist customers who need to liquidate their own certificates by canvassing
other customers as possible buyers, thus assuring a better price
^Some dealers criticize this practice as being one that "violates
the spirit of Regulation Q." In effect no deposit has been made with
the bank until the dealer finds a buyer. Meanwhile the certificate is
carried with borrowed funds.
A bank is permitted to make a loan secured by its own certificate
only if it charges an interest rate at least 2 per cent above the rate
at which the certificate was originally issued.
-33-
than if the CD's were sold into the market.
Development of a secondary market for CD's began early in the
spring of 1961 when the Discount Corporation of New York announced
it would make a market —
them if necessary.
that is, buy or sell certificates, or hold
Salomon Brothers & Hutzler took similar action
soon afterward, and as the volume of issues grew, other nonbank
dealers in U. S. Government securities entered the field.
The core
of the market came to be centered around five leading houses:
in
addition to those cited, the group included First Boston Corporation,
8
C. J. Devine and Co., and New York Hanseatic Corporation. These
houses generally carried large inventories of certificates —
ranging
from $40 million to $70 million for an individual firm.
Other nonbank dealers were also active in the market from time
to time, but as a rule they held only modest positions —
$15 million to $30 million.
perhaps
As the market developed, several bank
dealers in U. S. Government securities acquired inventories of varying
size.
These included Bankers Trust Company, Bank of America, and
the First National City Bank of New York.
National City Bank in March 1965.
The last entrant was
Some banks are opposed to assuming
a dealer function, however, on the grounds that they would help other
issues at the expense of their own rather than helping the market
as a whole.
Others state that costs are too great in relation to
potential returns.
Although smaller nonbank dealers seldom take certificates into
their inventories, they act as brokers or as an auxiliary to the
dealer function.
Similarly, a number of large banks operate service
^Suceeded by Merrill, Lynch, Pierce, Fenner & Smith, Inc.
through purchase on May 13, 1964.
-34-
departments for correspondents and other customers —
on orders from them.
buying or selling
While Regulation Q does not permit a bank to
purchase its own certificates for investment, it may, as an agent,
acquire them for customers.
Banks also purchase certificates issued
by other banks for the account of a customer•
B.
Dealer Purchases arid Financing
While on occasion dealers secure a market before bidding on
certificates, they do not handle certificates on a consignment basis
but rather purchase the CD's outright.
Dealers are generally care-
ful not to buy too large an amount of any given issue, and they try
to guard against development of too large a floating supply of certificates in general.
They consider the issuer's credit standing as
well as the amount of certificates that he has outstanding.
In their purchases, dealers emphasize profits to be gained from
trading as well as from carrying an issue.
They buy the longest
maturities available that seem to offer profits, considering the
probabilities of negative, even, or positive carries.
Aside from
the usual sales into the market, dealers at times prompt customers
to acquire large amounts of CD's from an issuer.
Later that day, or
on the next, the dealer will take over the certificates at an agreed
price, one that provides the original buyers with a profit of 1 or
2 basis points.
These are often referred to as "take outs."
In
other cases dealers' customers that have temporary surpluses of funds
will take CD's from issuers with the understanding that the dealer
will purchase them within a short period of time at par plus interest.
These arrangements may run from several days to 2 weeks, depending on
the rate outlook.
reverse
Occasionally dealers acquire certificates on
repurchases to accommodate customers.
-35-
During the years 1961 through 1965 there were relatively long
periods of stability in short-term interest rates and even some periods
when these rates showed a tendency to small declines.
This stability
made it possible for dealers to place portfolios of certificates on
profitable "carries.11
Since Regulation Q ceilings precluded issuers
from offering certain shorter maturities, dealers took issues with
long maturities, placed them on repurchase or loan, and held them for
a period to reduce the maturity to shorter term.
The certificates
could then be sold or placed on repurchase again, depending upon the
money market outlook.
In the short run dealer positions vary more or less inversely
with the volume of trading.
Dealer inventories vary widely from week
to week but much less from quarter to quarter.
On a quarterly basis
they average about four times the volume of trading, a ratio somewhat
larger than for Treasury bills or acceptances.
The capital of the dealers is small relative to the volume of
their business —
particularly since CD f s have been added to the line
of their investments.
Hence, dealers have been relying more and more
on outside funds to carry inventories.
The rate paid for borrowed
money, as in the case of Treasury bills and acceptances, must bear a
close relationship to the market rate for certificates.
Higher rates
on bank loans make borrowing unprofitable.
Dealer portfolios are financed in several ways:
(1) on re-
purchase agreements with corporations, insurance companies, State
funds, and other nonbank short-term lenders; (2) on repurchase
agreements with agencies of foreign banks; (3) on loans from commercial
-369
banks in New York City ; or (4) under repurchase with out of town
banks.
Dealers prefer repurchase agreements because of lower cost,
but they do use bank loans for residual needs.
Repurchase agreements
may be for overnight or may run for several weeks or months.
Bank
loans usually run for a day and must be renewed each morning if
necessary.
Federal Reserve facilities for repurchase agreements are
not available as they are in the case of bankersf acceptances and
U. S. Government securities, including those of Federal agencies.
As a matter of practice the securities that underlie repurchase
agreements or the collateral on loans consists wholly of CD's.
This
arrangement is preferred to mixed collateral for ease of administration if substitution of securities is necessary or if the loan is
reduced in size.
Mixing CD's with U. S. Government securities, or
with other acceptable collateral, depends upon the relative amounts of
securities in inventory.
Some banks make loans at the rate charged
for call loans on U. S. Government securities while others impose a
higher rate on certificates.
Rates on repurchases are almost always
lower than those on loans, as is the case with repurchases on U. S.
Government securities and on acceptances.
Dealer loans and repurchases
were generally available during the 1961-65 period at reasonable, and
at times attractive, rates.
In 1966, however, as rates rose, costs
became virtually prohibitive, and at times some dealers could not
9
The lending bank's own certificates are generally excluded from
the collateral on the grounds that if the loan is defaulted, the bank
as new owner would be redeeming the certificate prior to maturity.
Additionally, Regulation Q provides that a borrower shall be charged
2 per cent in excess of the interest rate on the certificate for any
loan collateralized by the bank's own certificates.
-37obtain funds. Others, fearing that financing would not be available,
halted their acquisitions of CD's.
Banks as well as most of the parties to repurchase agreements
are careful about issuers and will insist that the best names underlie
the transaction.
A mixture of names that includes lesser-prime or
even some off-prime names is acceptable on occasion, but these arrangements become less desirable to lenders as markets tighten.
Banks
whose outstanding certificates are believed to be excessive are
avoided even if the name is well known.
Proceeds of the repurchases
and proceeds from bank loans are available in Federal funds.
C.
Buyers
Since inception of the market, corporations have been the
principal buyers of certificates. Maturities of certificates are
generally determined by negotiation between the issuing bank and the
purchaser, and to an increasing degree, CD's have been written to
mature on tax and dividend dates or at the end of a quarter, halfyear, or year.
In this way CD's are useful as an investment outlet
for corporate tax and dividend accumulations and other special purposes, whether acquired from the issuer or in the secondary market.
As the secondary market broadened, however, an increasing number
of divergent investor groups having temporary surpluses of funds
became purchasers of CD's. These include foreign official institutions,
States and municipalities? commercial banks, individuals, and the
range of institutional investors including foundations.
Some in-
stitutional investors such as insurance companies buy certificates
only when the yields are higher than those on finance company paper.
States and municipalities use certificates for temporary investment
-38-
of the proceeds of bond issues, and savings banks for the accumulations
of mortgagees1 tax monies.
Many buyers were more interested in the
market when it provided an opportunity to "ride the yield curve"
than when the certificate provided only investment income.
Most
purchasers take round lots, but on occasion investment management
firms will buy odd lots at higher yields and add them to their accounts.
Investments in certificates are also made through repurchase
agreements in which certificates underlie the transaction as an alternative to direct investment.
The repurchase allows the "lender"
to invest without risk of fluctuation in price and at the same time to
suit the maturity to his needs.
All buyers tended to become more selective toward the end of 1965
as issues of certain banks increased substantially and several other
banks failed.
Buyers further restricted purchases as the market
10
softened in 1966.
And some withdrew from the market completely.
Dealers do not endorse the CD's that they sell to the market, and
usually they make it a policy not to provide a credit opinion on
the issuer.
P.
Supply and Demand Variables
A number of interacting and interdependent variables or factors
affect both the primary and secondary markets for CD's.
These forces
affect not only the volume of issues and maturities but also the
Restrictions involved reduction in amounts of CD's of particular
banks, reduction in number of eligible bank names from the 50 largest
to the 21 largest, and one large corporate buyer excluded from the
authorized list of the CD f s of all banks west of the Mississippi.
-39volume of trading.
1)
These factors are discussed below:
Regulation Q ceilings —
As offering rates reach the ceilings
set by the Regulation Q, banks are forced to withdraw from the issue
market, because certificates become noncompetitive with other instruments.
Under these conditions short-term interest rates in the market rise
relative to the Regulation's ceiling.
The rise of open market rates
above, or their fall below, the existing rate ceilings leads to retardation or acceleration, respectively, of new issues as interest-sensitive
investors move to obtain highest possible yields.
Maturities are also
affected under these circumstances; they tend to shorten as rates
approach the ceiling and lengthen as they fall away.
Similarly as rates
move above the Q ceiling or fall below it, supplies of CD's in the
secondary market become less or more plentiful respectively, and trading
volume is affected accordingly.
Dealers' willingness and ability to
carry inventory is strongly influenced by such rate movements.
2)
Pattern and size of corporate tax and dividend payments —
The
volume of funds being accumulated for corporate tax and dividend payments
has a strong influence on maturities of CD's as well as on the amount of
the increase in issues at various times and has led to a concentration of
maturities on these dates.
Tax and dividend dates significantly affect
dealer positions and trading, and inventories are determined with these
dates in mind.
The peak of demand in the market for certificates maturing
on tax and dividend dates comes about 1 or 2 months before the payment
dates.
3)
Liquidity position of corporations —
When cash flows shrink,
lessened liquidity leads corporations to reduce both their takings of
certificates from issuers and their purchases in the secondary market;
and when they make an investment, they put considerable emphasis on
-40the ability to liquidate if necessary.
preferred.
Treasury bills are generally
Under these conditions increasingly large premiums over
other investments must be offered in order to move new issues and to
induce takings in the secondary market.
4)
Strength of loan demand at the banks — Expectations of con-
tinued or increasing loan demands suggest profitable employment of funds
and encourage banks to become more aggressive bidders for CD f s.
If pos-
sible, they tend to extend maturities of issues. This factor has been
an alternating influence in» every year and has affected issue volume
particularly at large banks, both in New York and outside.
5)
Supply of attractively priced substitutes —
If the supply of
CD substitutes such as Treasury tax anticipation bills is good, it is
more difficult for banks to issue certificates with comparable maturity
dates.
Trading volume in the secondary market also tends to be smaller
than it is when there are no tax bills outstanding.
6) Rate relationships and money market conditions — At times
banks refuse to pay the rates that are necessary to replace run-offs of
certificates, and they withhold issues temporarily.
If so, would-be
CD issuers seek needed funds elsewhere.
7) Inflows of other time and savings deposits —
If inflows of
other time and savings deposits are good, banks become less willing to
issue certificates not only because of usual higher cost relative to other
savings forms but also because of fear of transfer of time deposits from
one form to another.
8) Legal list statutes — Lists of legal investments vary from
State to State for savings banks and for trusteed and public funds. As
of August 1966, the Massachusetts savings bank statute was changed to permit those banks to hold certificates of commercial banks; this broadened
-41the issue market and moderated the rollover problem of Boston banks.
Some short-term investors are legally required to invest temporary holdings
of funds in U. S. Government securities.
And the Comptroller of New York
State is authorized to buy CD's only if secured by collateral.
9)
Corporate treasurers1 authorities to hold certificates
—
Although some policy limits on takings of CD's may be liberalized from
time to time, the existence of these limits contributes to widening spreads
between Treasury bill yields and those on other obligations —
as supplies increase —
particularly
thus influencing trading at various times.
Limits
apply to new issues as well as purchases in the secondary market.
10)
Overissuance of certificates —
Overissuance of CD's by some
banks, which arouses suspicion of the soundness or possible failure of
banks with substantial amounts of certificates outstanding, induces
reappraisal of policy limits of buyers and at least temporarily affects
the market as a whole or the outlook for interest rates will induce
reviews of authorities, which may lead on occasion to temporary termination
of buying authorities.
E.
Measures of Trading
The general acceptance of CD's as a money market instrument is
evidenced by comparing market activity in certificates with that for
bankers' acceptances and Treasury bills.
The volume of trading in the
certificate and acceptance markets is quite similar.
In 1964 and 1965,
years of active markets for both instruments, the daily average volume
of trading by months ranged between $43 million and $79 million
for certificates and $44 million and $49 million for acceptances.
But both of these markets were dwarfed by trading in Treasury bills;
-42-
such trading on a daily average basis ranged between $1.1 billion and
$1.5 billion per month.
To a considerable extent the greater volume
of trading in Treasury bills reflects the larger volume of these
securities outstanding.
Bills outstanding in 1964 and 1965 averaged
from $52 billion to $55 billion per month, acceptances a little over
$3 billion, and certificates between $11 billion and $12 billion in
1964 and $13 billion to $16 billion in 1965.
1.
Trading Vs. Issues Outstanding.
Comparison of the dollar
volume of trading with the volume of issues outstanding for each instrument shows that somewhat larger percentages of both acceptances
and Treasury bills are traded.
In 1964 and 1965 daily-average
trading volume ranged from .31 per cent to .64 per cent of certifiates outstanding , from 1.10 per cent to 1.78 per cent for acceptances,
and from 2.05 per cent to 2.80 per cent for Treasury bills for various months. These differences reflect variations from one buyer to
another in use of the various instruments to adjust portfolios, homogeniety of the instruments, and the amounts outstanding at various
maturities.
In contrast to both certificates and acceptances, Treasury
bills are the most homogeneous of all money market paper, for they
differ essentially only in maturity.
Corporate holders of certificates frequently consider them an
adjunct to short-term U. S. Government securities. However, if large
blocks of investments must be sold quickly to raise cash, financial
officers usually use Treasury bills because of the dependable continuity of one market. At times it is difficult to liquidate large
blocks of certificates in the market, although the market can usually
-43-
handle transactions of $5 million to $10 million without any problem
and $20 million on occasion.
In other cases demands by investors can-
not always be met from dealers1 inventories, and in many instances
switches in holdings among customers may be necessary to supply the
specified issuer and maturity.
applies to acceptances.
To a much lesser extent the same
She market trades only prime acceptances,
and the several maturity ranges for which quotes are posted overcome
some of their diverse characteristics.
2.
Inventories Vs. Issues Outstanding.
Comparisons of the dollar
volume of dealer inventories with the dollar volume of the several
instruments outstanding are also significant.
In 1964 and 1965 the
daily-average volume of inventories as a percentage of daily-average
volume of outstandings resulted in ratios for various months ranging
between 1.12 per cent and 2.54 per cent for certificates, 3,20 per
cent and 10.74 per cent for acceptances, and 3.84 per cent and 6.12
per cent for Treasury bills.
The larger percentages of outstanding
acceptances carried in inventory reflect not only the relatively
smaller amounts outstanding in contrast to Treasury bills and certificates but also the prime character of the acceptance instrument.
The high degree of quality of acceptances is based upon the combination of the name of the accepting bank, the contingent liability
of other parties to the instrument, the feature of self-liquidity,
and eligibility for purchase or discount at the Federal Reserve Banks,
as well as the preferred position accorded holders of acceptances of
failed banks.
Even the prime eligible acceptances of smaller banks
with proven experience are traded at the same rates as acceptances
of the leading banks.
In addition acceptances have had about 50 years
-44-
of development in American practice.
Like Treasury bills, acceptances
may be bought under repurchase agreements with the Federal Reserve under
certain conditions, and on occasion the System may buy them outright
in the course of its open market operations, a policy that was
developed in the 1920fs and renewed in 1955 as the Federal Reserve
fostered the growth of the market.
Certificates on the other hand do not represent a standardized
form of credit risk.
Thus the several rates that prevail in the mar-
ket correspond to the buyer's analysis of the issuer's credit stand11
ing.
Dealers, by and large, trade only the better names, principally
those of the 30 to 35 largest banks, most of which have deposits of $1
billion or more.
The market supply of these prime CD's in relation to
total CD's outstanding is not so large as it is in the case of accept12
ances.
Occasionally certificates of banks with deposits as small as
$150 million to $250 million are traded.
In contrast to acceptances,
certificates of medium-sized and smaller banks, despite a reputation
for good management, generally must carry a concession of about 1/4
of 1 percentage point to attract buyers.
Treasury bills are the pre-
dominant instrument in the short-term market, and dealer inventories
must be related to the large quantities outstanding of each bill
Even in the absence of an analysis, buyers know that CD's of
some big-name banks trade better than others and will prefer the better
names even though careful examination of the record shows there is no
difference between names.
12
Acceptances are in effect a loan, and the accepting bank can
sell or hold the acceptance at its option. CD's are taken out by a
depositor generally to be held to maturity, and the initiative to sell
rests with the holder. In part, these distinctions explain the differences in supply in relation to outstandings.
-45maturity.
As a rule this assures continuous availability of bills
in the market as compared with variations in supplies of both acceptances and certificates at times.
3.
Transactions to Positions,
Activity in the market may also
be measured by comparing the volume of transactions to the volume of
dealer positions.
favorably.
On this basis certificates and acceptances compare
In 1964 and 1965 the ratios computed on a daily-average
basis ranged from 16 per cent to 50 per cent and from 13 per cent to
38 per cent, respectively, for various months.
Ratios for both
instruments were somewhat smaller than those for Treasury bills,
which ranged from 38 per cent to 70 per cent.
Acceptance portfolios were generally smaller in relation to turnover before 1964.
The increased inventories in 1964 reflected the
more continuous sales by banks to meet reserve needs and the ability
of dealers to carry the larger amounts, for the most part at favorable
rates.
Portfolios of certificates in relation to turnover are some-
what larger than the ratios for Treasury bills.
This difference
arises from the potentials for profits and reasonable "carries" in
the absence of abrupt rises in interest rates.
Potentials for pro-
fit on inventories of certificates are greater than for acceptances,
which have a flat yield curve in each maturity range, in contrast to
the descending pattern to maturity provided by Regulation Q prior to
December 1965.
Potentials for profit have also frequently been
greater for CD's than for Treasury bills.
F.
Market Rates and Yield Spreads
In the secondary market, CD's compete with the primary paper of
the issuing bank, and since the buyer of an original certificate has
the advantage of selecting the date of maturity, the paper in the
-46-
secondary market must trade above current primary rates.
Above
this minimum, quotations are determined largely by the movement of
money market rates as a whole, and particularly by prices of competing
instruments such as Treasury bills, finance company paper, and acceptances .
Secondary market rates for CD's generally fall between those
for finance company paper and acceptances on the one hand and those
for Treasury bills and issues of Federal agencies on the other.
Generally, rates on finance company paper and certificates are within
1/8 of a percentage point of each other.
Acceptance yields are more
often below certificates, by about 1/8 of a percentage pqint.
These
spreads widen in tight markets.
Changes in relative supplies of market instruments (including
bills) are an important influence on yields and on spreads among the
various types.
This is well illustrated in the first half of 1965
as compared with 1964 and was quite striking in 1966.
Treasury bill rates remained quite stable during the first half
of 1965 and 1966, but most other short-term market yields rose some 12
to 19 basis points and 40 to 70 basis points, respectively, in these
periods.
These increases reflected in part the retirement of tax-
anticipation bills and official purchases of U. S. Government securities.
More important, however, was the fact that the outstanding volume
of most other money market instruments rose substantially (Table 6 ) .
-47-
SECONDARY MARKET CERTIFICATES OF DEPOSIT RATES 90 DAYS
AND OTHER RELATED MARKET RATES
Chart 1
1961-1966
par cent
Maximum Interest Rates Payable
Jan 1, Jan 1, July 17, Nov 24, Dec 6,
1962
1957
1963
1964
1965
1 year or more
6 months-1 year
90 days-6 months
Less than 90 days
3
3
2.5
1
4
3.5
2.5
1
4
4
4
1
4..5
4.,5
4.,5
4
5 .5
5.5
5.5
5.5
Maximum i n t e r e s t r a t e s payable
on CD's, 30 days and over
Maximum interest rates payable
on CD's, 90 days and over
Maximum interest rates payable
on CD's, 1 year or more
Maximum interest rates payable
on CD's, 6 months - 1 year v
Maximum i n t e r e s t r a t e s payable
on CD's, 6 months and over
Maximum interest rates payable,
on CD's, less than 90 days
J
j
Maximum interest rates payable
on CD's, 90 days - 6 months
Maximum interest rates payable
on CD's,less than 90 days
Secondary Market CD's 90 day
Major Finance Company 90 day
Prime Banker1? Acceptances 90 day
Treasury B L I I S (rate new issue) 3 month
Rates are averages of daily figures
Secondary Market CD's, Salomon Brothers & Hutzier Series
All other r a t e s from G 13 Release, Federal Reserve Board
A S O N D J F M A M J J A S
19 6 6
-48Table 6
NET CHANGE IN SELECTED MONEY MARKET INVESTMENTS OUTSTANDING
First 6 Months, 1964, 1965, and 1966
(Billions of dollars)
Type
3-month maturities of:
Treasury bills
Bankers' acceptances
Finance paper
Negotiable CD's
Issues of Federal
agencies
1964
1965
1966
-0.5
+0.2
+1.2
+2.0
-2.8
+1.3
+2.7
-5.3
+0.2
+1.5
+1.6
-0.9
-0.3
+2.0
0.0
Changes in demand for certain types of instruments also affect
yields.
For example, as indicated earlier, some short-term investors
may not invest temporary funds in any securities except U. S. Government securities while others from time to time reach policy limits on
holdings of CD's and other private obligations.
Although these limits
are sometimes liberalized, their existence tends to contribute to a
widening of spreads between bills and other obligations in the
secondary market at various times.
Dealer bids must be enough above bank issuing rates on CD's
—
with distinctions being made for paper of prime, lesser-prime, and
off-prime banks —
to insure a trading profit while at the same time
making a competitive offer.
In the first year of market trading,
spreads for certificates of prime-name banks ranged from 10 to 30
basis points above bill yields, and they have generally remained
within this range since then.
CD's of prime-name banks outside New
York trade from 5 to 10 points higher than those of similar banks in
New York, and 15 to 40 points above bills; for off-prime paper the
ranges are 10 to 15 basis points and 20 to 55 basis points higher,
-49-
respectively.
CD f s in denominations of less than $1 million generally
carry higher rates.
Denominations of $500,000 are traded with some
frequency, and denominations of $100,000 occasionally.
Market rates
for prime certificates at times, however, have been as much as a full
percentage point higher than those on Treasury bills.
(See Table 7.)
Table 7
YIELD SPREADS—U.S. TREASURY BILLS AND OTHER SHORT-TERM
INVESTMENT PAPER
1964
1965
1966
Jan. 1 June 30 Jan. 1 June 30 Jan. 1 June 30
3-month Treasury bill rate
(per cent)
Spread from bill rate
(basis points):
Bankers' acceptances
Federal agencies
Finance paper
Certificates of deposit
(prime category)
3.53
3.48
3.83
3.89
4.48
4.54
+10
+11
+36
+27
+27
+40
+17
+16
+30
+36
+32
+36
+27
+32
+36
+85
+35
+39
+34
+41
+42
+101
+75
+85
Spreads between prime and nonprime certificates and between certificates and bills vary from time to time as the appraisal of the outlook for short-term rate changes.
Spreads narrow when a trend toward
lower rates (higher prices) is anticipated.
Under these conditions,
participants feel more confident of the marketability of higheryielding though less liquid instruments such as certificates.
they bid strongly for higher yields to maximize income —
tation of greater potential for future profits.
Accordingly,
with the expec-
When higher interest
rates and lower prices are expected, the less liquid instruments become
relatively less attractive, and yield spreads widen.
In this context
CD's maturing around certain tax-payment and dividend dates will always
-50command higher prices (lower yields) than those maturing on other dates.
The amounts by which yields on CD's of prime-name banks exceed those
of some lesser-prime and off-prime banks in the market arises from several factors.
Even when the authority to purchase permits discretion,
buyers will refuse certificates of lesser-known names when those of
better-known names are available at about the same yield, despite the
fact that an analysis would show about the same standing.
In this sense
buyers discriminate against certificates of smaller, less-well-known
banks.
Differentiation of names became more widespread after the failure
of banks in Texas, California, and Colorado in 1964 and early 1965.
A
part of the premium consequently represents an inducement to the buyer
to take CD's of banks not so well known.
Dealers state that it takes more effort to educate customers to the
point where they will be interested in CD's of lesser-known names.
Such
certificates must be carried in position longer; they are more difficult
to place on repurchase or loan, even though mixed with prime names; and
they afford trouble and expense in checking amounts already outstanding,
and other relevant information of the particular bank.
In some cases
data are available only quarterly or semiannually, and comparative data
are lacking.
For this reason a part of the premium represents compen-
sation for additional marketing effort and cost.
A number of smaller banks that are well known in their communities
issue CD's to local customers at the same rates, as prime banks issue CD's
to national customers, or at even lower rates.
Markets are thus dif-
ferentiated, and sales of locally oriented certificates in the secondary
market call for added yields, since in effect the bank is tapping the
national market at one step removed.
In a sense, premiums are viewed as
an impersonal market means of regulating new issues.
They may be a
-51warning that a particular bank is issuing a disproportionate volume of
CD's.
Both the rate on the new issue and the premium yield in the secondary
market in this case do not reflect arbitrary actions but a marginal
response to influences of the national short-term money market.
If there were no effective ceiling on rates, any bank could bid for
funds, but rate differentials would remain.
The rate paid by the indi-
vidual bank would become an increasing function of (1) the average rate
prevailing in the market, (2) the amounts of certificates outstanding,
and (3) the size of the proposed new issue.
rent market —
Inelasticities in the cur-
as exemplified by the added cost paid by smaller banks,
which brings them to the ceiling sooner, or by the inability or increased
difficulty in issuing certificates when the large banks are in the market —
might be reduced but they would not be eliminated.
Similarly with no ceiling on rates trading in CD f s would develop by
competitive forces in a fashion similar to that of comparable investments
which are not regulated.
The secondary market freed from expectations
about Regulation Q would fall into place as a division of the money
market.
Market yields would be determined by the usual forces of supply
and demand and the reputation of the issuers.
G.
Certificate Characteristics
Certificates offered for sale in the early period often had terms
and final payment dates that did not suit the requirements of new buyers
and consequently had to be carried by dealers for long periods.
Many CD's
were carelessly executed and the instrument had to be standardized.
Most
of the early certificates were issued to a named payee or order; this
contributed to some awkwardness in trading until authority was granted
or the practice developed for issuance in bearer form.
Similarly, banks
outside New York found it necessary, in order to reduce delivery and
-52collection expenses, to arrange for issuing agents and alternate
paying agents in New York and other principal money centers.
In
addition the practice became general of paying-off maturing issues in
Federal funds as opposed to clearinghouse
checks.
Currently, unless
otherwise agreed, CD f s bought and sold in the secondary market are
deliverable in New York the next business day following the date of
transaction and payments are in Federal funds.
The certificate market then and now is more diverse than the
other short-term markets, including the acceptance market.
Acceptances
are analogous in many ways to certificates, but the market for them
has overcome many of the problems associated with diversity through
the establishment of posted rates for three maturity ranges —
91-120, and 121-180 days.
1-90,
Additionally the distinction between prime
and lesser-prime acceptances is practically eliminated by the market
convention (recognized by the Federal Reserve Open Market Desk) that
any acceptance in the market is a prime acceptance.
Certificates can
be and are written in sizes large enough to trade on an individual
basis, and maturities are mutually agreed upon by the issuer and buyer.
The maturity groupings used for acceptances, which were designed to
overcome size and maturity differences related to the underlying goods
transactions, are not appropriate for certificates.
H.
Dealer Bid and Offering Rates
Certificates are individual instruments, and they differ by
maturity and/or by issuer.
a particular CD —
Dealers do not know of the existence of
of any specific maturity of a particular bank
until that CD appears in the market.
—
The possible number of maturity
dates is large, and the certificate may be prime, lesser-prime, or
off-prime.
CD f s of several hundred issuers may appear in the market,
-53-
but the bulk of the trading has involved the certificates of 30 to 35
of the leading banks.
from time to time.
Issues of another 20 to 30 banks have appeared
Only occasionally are certificates of banks with
deposits of $150 million to $250 million traded.
In making a market
for CD's, dealers cannot be expected to be familiar with the credit
standing of all issuers.
Furthermore, certificates are considered
easy to counterfeit, and dealers examine the issues of even the bestname banks with care.
Lack of homogeneity of certificates prevents the establishment
of posted bid and offered rates and of real breadth in dealer trading.
A dealer will bid only in response to a specific certificate offering,
although as the market has developed, the certificates of best names
have come to trade at yields very close to each other.
In the early
market the dealers' spread between bid and offered quotations was
generally about 5 basis points on 90-day maturities, but this subsequently narrowed to 2 to 3 points as strong competition developed.
The spread widens as CD's approach maturity —
value of a basis point.
with the decrease in
If certificates are held in position for
several days or longer, the rate will reflect interest accrual,
financing costs, and the lesser number of days to maturity, as well
as any change in short-term rates.
Spreads between bid and asked
prices also widen in tight markets as dealers move to protect themselves.
Some inventories must be liquidated, potential sales are
fewer, and purchases must be made in a market where prices are declining.
Hence, dealers keep their offers down and at the same time
bid less for the certificates bought.
In 1966 bids declined by 5 to
10 points on 90-day paper of better names and 25 points for lesser-known
names •
-54-
In recent years some dealers have posted offering rates for better
names, but this is not a general practice.
Many issuers object to the
practice on the grounds that it gives the appearance of rating the
credit of issuers by differentiating the prices of similar maturities
even though the shadings are small.
however, posted rates —
In markets where they exist,
bids and offers —
permit dealers to lighten
or increase inventories rapidly at prevailing rates.
Short sales in
the CD market are unknown because of the great difficulty in covering
such a sale —
considering the need for matching maturity, coupon,
and day of offering.
Thus the CD market lacks much of the continuity
and closeness in pricing that is characteristic of other markets.
I.
General Features —
1961-66
Activity in the secondary market divides itself into two periods
—
the first running from the establishment of the market in 1961 through
1965; and the second, the year of 1966.
Until the end of 1965 Regula-
tion Q ceilings and money market conditions generally provided a
favorable atmosphere for new issues.
The expanding economy stimulated
both an increasing variety of uses for funds and changes in the total
and pattern of business borrowing.
Time deposits in the form of
certificates became a larger share of the liquid asset holdings of
corporations and to some extent displaced both money and market securities
such as Treasury bills in their liquid asset portfolios.
The maximum rates permitted issuers effectively restricted offerings of short maturities —
market at attractive rates.
making them available only in the secondary
Market rates for much of this period, it
should be noted, were sufficiently above the Regulation Q ceilings on
"0
0!
3
CM
o
-56-
restricted maturities as to permit considerable leeway in potentials
for profits, and the volume of trading was large.
Inasmuch as Regulation Q ceilings on the shorter maturities
were somewhat below market rates with some frequency, the ceilings
provided a cushion against market loss as holdings approached maturity.
The descending pattern of the yield curve for certificates as they
approached maturity permitted dealers to offer certificates at lower
rates (higher prices) than when acquired —
thus establishing a profit
over and above the interest earned during the period of holding.
Important in this connection were the relatively long periods of
rate stability, which enhanced profit possibilities and encouraged
acquisition of inventories.
The upward adjustment in Regulation Q ceiling rates to 5 1/2
per cent in December 1965, along with the shortening of the minimum
maturity from 3 months to 1 month, against which the rate applied,
virtually eliminated the slope in the yield curve for certificates.
This development coupled with the rises in market rates in 1966 —
in response to System policy and very strong aggregate demand
brought to an end much of the potential for dealer profits.
—
This
was particularly true after rates pierced the Q ceilings in midsummer.
Trading volume, which had already diminished, dropped sharply
and then continued at very low levels for the balance of the year.
The supply of certificates declined, and the character of trading
changed•
The volume of certificates outstanding rose quite steadily from
early 1961 to mid-1966, then leveled off before declining.
Over
-57-
the whole period there was some tendency toward a progressive shortening of maturities. Both dealer positions and trading volume increased
along with the rise in CD's outstanding until the end of 1965.
After that, although outstandings continued to rise, the market
activity was substantially less than in previous years —
in part
because of risk of exposure to new issues of short maturities
and the constant risk of principal if sales were made by holders
before maturity.
Trading dropped sharply after July 1966, as rates
rose to record levels and new issues of certificates became competitive with other short-term investments of only 1 month or slightly
longer maturity.
Dealers' carrying costs became prohibitive, and
at times there were fears that financing would not be available.
Trading in the secondary market concentrated on maturities unavailable to original buyers. Dealers' bids frequently represented
book losses to investors and corporate treasurers and others held
their CD's.
J.
The Course of Market Activity —
1961 —
1961-1965
Banks were unable to issue certificates of less than
90-day maturity during 1961 because of the 1 per cent ceiling set
by Regulation Q.
Treasury bills with 1-month maturities comparable
to the shortest certificate maturity that could be issued, traded
well above this level. Similarly, issue rates on certificates of
90-days to 6-months maturity were only briefly competitive with bills
of the same maturity for several months during the spring and summer,
and they were at the 2 1/2 per cent ceiling from August to the end
of the year (see Chart 3 ) . Certificates of 6 months or more maturity
afforded the most flexibility during the year because offering rates
-58-
on these did not press the 3 per cent ceiling until November.
The
bulk of issues consequently had maturities of 6 months or more.
The market in 1961 was generally thin.
Original buyers in many
cases were content to hold their certificates, and dealers had
difficulty in matching demand and supply of certificates at quoted
rates.
In the early part of the year dealer transactions were under-
taken for the most part only on order.
began with small positions —
One or two dealers, however,
say, $5 million to $10 million.
As
trading developed, however, dealers cautiously acquired inventories,
and during the autumn their positions are estimated to have ranged
from $10 million to $100 million and averaged from $20 million to $30
million.
Individual dealer positions, however, showed wide departures
from the averages,and variation has been a characteristic of positions
even in years of peak activity in the market.
correspondingly was spotty to light —
million —
The volume of trading
ranging from nothing to $34
and probably averaged from $10 million to $15 million.
Dealers were able to adjust their positions only with difficulty.
and asked prices could be moved only within fairly narrow limits
because large changes would induce arbitrage with other markets.
Interdealer trading was sporadic because of the small market supply
of certificates.
1962 —
Regulation Q ceilings were raised on January 1, 1962,
and banks increased rates on new CD's by about 1/8 of a percentage
point on 6- to 9-month maturities and 3/8 of a percentage point on
maturities of a year or more.
The new ceilings were established
at 3 1/2 per cent and 4 per cent for maturities of 6 mon.ths, and of
1 year or longer, respectively.
Rates for other maturities were
Bid
-59-
Chart 3
CD ISSUING RATES-NYC BANKS
ill. 1,1182 - Jily 17,1913
April 1,1111 . 111. 1,1112
111 211 lays
lays
4.11-
hi I. Ciiliif
2.50
,
Typical lati
3.00-
2.00-
I •
•
•
Typical Rate
t ii
I
100-200 lays
3.503.00 •
.
•
2.511961
1963
liter
Niv. 24,1004 • 0ic. 0,1005
Illy 17,1903 • M i . 24,1904
98-179 lays
00-170 lays
I I I I . Ciilfaii
5.00
4.00-
lag 0. Cailiif
4.50
Typical lati
3.50-
U
4.00
3.00-
.
* *
. . . . . . .
Tvaical Rate
Typical
D I f il i 1 i i i S 0 H D i
2.50-—-'
110-200 lays
i i i i I tI
5.004.504.00
•>»'
1903
lac. 0,1015 • let. 31,1000
10170 lays
5.50-
tot i.
• « • •«•»•«•
Typical Rati
5.014.50-
i i i r wi i i i i s 0
100-200 lays
5.515.014.51-
1005
1000
1005
-60-
unchanged.
This action renewed the appeal of 6-month or longer
maturities and resulted in substantial new issues.
Larger amounts of certificates then became available to dealers,
and the volume of trading increased.
Dealers acquired reasonable
inventories of 6-month maturities from original holders and "aged11
them placing some on repurchase agreements and held other for sale
in the relatively near future.
Interest rate prospects were attractive
for capital gains. Expectations for generally stable interest rates
encouraged dealers to build positions.
Since the Regulation Q ceilings
established lower rates on the shorter maturities than on the longer
ones, the yield
curve descended as maturity shortened.
This enabled
the dealers to offer CDfs at lower rates (higher prices) than when
acquired —
thus making a profit over and above the interest earned
during the period held.
Dealer positions are estimated to have
averaged between $125 million and $225 million and trading between
$25 million to $45 million on an average day.
Certificates of per-
haps as many as 50 banks appeared in the secondary market at one time
or another during the year.
1963 —
In 1963 the secondary market became stronger, attracted
more participants, and served a greater variety of investor groups.
Trading was more active during the first half of the year but was
affected by fluctuations in interest rates during the spring as the
market anticipated higher levels. Dealer positions are estimated
to have ranged from $100 million to $500 million and averaged $150
million to $250 million.
Trading volume ranged between $15 million
and $75 million and averaged $20 million to $30 million.
Both
dealer positions and the transactions reached peaks for the year
-61-
during the spring.
Issue rates on certificates of less than 6 months
maturity had been at the ceiling all year and maturities of 6 to 9
months reached the ceiling in July.
Only maturities of 9 months
to 1 year were competitive
The market received its first major test with the increase in
the discount rate in mid-July and the accompanying sharp rise in
Treasury bill rates.
Regulation Q ceilings were revised, establishing
a 4 per cent Veiling for certificates with maturities of 90 days to
1 year and permitting banks to offer shorter maturities than previously.
Following these changes all market rates adjusted upward during the
last half of July, and offering rates were raised from 3 3/8 to 3 1/2
per cent on 3- to 6-month maturities and 3 1/2 to 3 3/4 per cent on
6-month to 1-year maturities.
Issue rates and market rates on certi-
ficates continued to move upward during the remainder of the year
—
increasing by as much as 10 to 20 basis points in 3- and 6-month
maturity areas in some months.
(See Charts 1 and 3.)
The rise in market rates of interest lowered the market values
of outstanding certificates, and some investors who normally would
have sold before maturity, chose to hold their certificates rather than
accept a loss —
thus contributing to a substantial decline in
trading after midyear.
Activity remained
at low levels until fall.
Trading fluctuated between a low of $15 million on the average in
September and $55 million in the last month of 1963.
Dealer inventories
were also lightened, and some dealers were reported to have sustained
large losses.
The adjustment of the secondary market for CD's to the abrupt
rise in interest rates was more sluggish than the adjustment in
-62-
Treasury bills.
The spread in yields between certificates and Treasury
bills narrowed sharply in July and remained narrow until October.
After October the volume of trading picked up, with activity centered
in maturities of less than 3 months.
In contrast to the decline in
dealer positions and secondary trading, the volume of CD's outstanding
rose sharply after July in response to lifting of the Regulation Q
ceiling and to strong loan demand, which permitted and induced banks
to seek funds aggressively.
The new terms of Regulation Q, as noted,
also made possible issuance of maturities of less than 90 days for
virtually the first time.
Some banks took advantage of this, and so
provided competition in this area with the market supply.
By the end
of 1963, the larger banks were quoting issuing rates close to the 4
per cent maximum.
The market as a whole, however, was substantially
strengthened and broadened during the year.
1964 *~ The volume of trading in certificates reached new high
levels during 1964, considerably above those in 1963.
there was a $10 million quarter-over-quarter increase.
On the average
Broad patterns
of activity associated with the four principal quarterly tax and
dividend dates, as well as some trading for midyear and year-end
needs also developed.
Dealer positions fluctuated, but inversely to
trading; and positions averaged about four times the volume of trading.
Both positions and trading reflected the relationships of both market
and issuing rates to Regulation Q ceilings as well as the spread
between these rates and Treasury bill yields.
These factors of course
influenced the maturities available in the market.
Divergent trends
in the supplies of the various money market instruments moderately
influenced the yield spreads between Treasury bills and other obligations.
-63-
During the first quarter of 1964 CD market rates, which generally
tended to be 30 to 40 basis points above Treasury bill yields of a
comparable maturity were near the 4 per cent ceiling on maturities
of 3 months or longer.
At the end of March most large banks were
quoting interest rates of 4 per cent on new certificates of 6 months
or longer and about 3.9 per cent on 3- to 6-month maturities.
banks quoted 4 per cent across the board.
Smaller
Since some shorter
maturities were available from issuers, dealers were reluctant to
increase inventories, and investors met most of their needs from the
banks•
The opening of the second quarter in April brought a decline in
market rates, and rates on new 9-month certificates backed away from
the ceiling —
thus providing banks with a chance to sell longer-
term certificates.
Rates changed little in May, and dealers
anticipating favorable "carries11 —
—
began to increase their positions.
During the first half of the year dealer inventories averaged between
$120 million and $280 million and trading volume between $60 million
and $70 million.
Over the early summer the bulk of outstanding certificates continued to have relatively short maturities; about half carried dates
within 3 months; and three-fourths, within 5 months.
Some declines
in rates in June and July again permitted issuance of a modest amount
of longer-term certificates.
Expectations for favorable "carries11
and a strong demand for certificates maturing around the September
tax and dividend date led dealers to make further increases in their
inventories.
Induced by high interest rates in the market in August, September,
-64-
and early October, new issues maturing in 6 months or more were at the
4 per cent ceiling from the end of September until the change in the
discount rate and increase in Regulation Q ceilings in late November.
For some weeks prior to the change, prime banks had not been able to
attract any volume of certificates, and most issues were in the 4to 5-month maturity range.
Heavier dividend payments relative to tax
payments in December and a step-up in estimated tax payments for 1965
also influenced the shortening of maturities and at the same time
heightened interest in trading.
The increase in certificates in the
September-November period was only about $500 million.
Dealer positions reached new highs just before the change in
the discount rate and the Regulation Q change in November, and they
have never regained these levels since then.
Active trading during
the fall under the umbrella of the 4 per cent issue ceiling on
maturities of less than 90 days emphasized the desirability of having
CD's mature on or near tax and dividend dates or around the year-end.
During the last half of the year dealer positions averaged between
$210 million in October and $322 million in November, with trading
averaging from $70 million in July to $80 million in October.
The
bulk of the trading during the year was again in maturities of less
than 3 months.
The new ceilings under Regulation Q permitted issue rates of 4 1/2
per cent for maturities of 90 days or more and payment of 4 per cent
on maturities of less than 90 days.
The latter action ended the pro-
hibitive 1 per cent ceiling on short maturities, which had been in
effect since 1936.
Banks used the new authority to obtain funds
maturing in less than 90 days and only reluctantly paid the higher
-65-
rates necessary to issue longer-term certificates.
As the year closed, dealers began to adjust inventories to the
new interest rate structure through run-offs and sales.
Both new
issue and secondary market rates moved higher in December (see
Charts 1, 2, and 3 ) .
1965 —
After a tendency for short-term rates to level off in
January, they edged higher in February and moved upward through the
remainder of the first quarter.
generally unavailable.
Funds in the short maturities became
Banks turned from the 30- to 89-day maturities
and began to seek deposits in the 4- to 6-month or longer range.
banks in New York City and elsewhere —
Large
anticipating strong loan
demands, heavy redemptions of CD's in June, and reduced liquidity
—
aggressively competed for funds and extended maturities.
In contrast the smaller banks shortened maturities.
They
experienced net reductions in outstanding certificates during the
late winter and early spring.
In part these banks were hampered by
rate ceilings and the inelasticity in the market, which makes it
difficult for them to issue CD's when the big money market banks are
seeking funds.
higher rates*
There was also some unwillingness to pay the necessary
New York City banks accounted for nearly all of the
increase in outstanding certificates over the quarter, and all were
in the form of longer maturities (see Table 4 and Table 8 ) •
In response to the changes in Regulation Q, the new rate setting,
and issuance of some shorter-term CD's over the year-end, dealers
cut their positions to an average of $150 million in January, an
amount about half the level at the end of December.
trading reached a record high of $90 million.
The volume of
Both buyers and sellers
-66-
were active in rearranging their portfolios, and trading tended to
center on certificates maturing on the March and April 15 tax dates
as well as certain spring dividend dates.
After appraising the new
context of market rates and possibilities for new issues of CD's,
dealers began to rebuild positions.
It seemed clear that upward
fluctuations in rates would continue and would foreclose short-term
issues.
Positions were increased to about $225 million on the average
in March.
Through the spring New York banks continued aggressively to seek
funds with longer maturities.
As a result, issuing rates were mark'ed
up, and market rates also tended to be higher.
The*larger banks were success-
ful in issuing a sizable volume of longer-term certificates.
However,
during the spring,banks outside New York experienced net reductions in
outstanding CD's in all size groups.
These banks were more severely
affected by rate ceilings than they had been earlier in the year
(see Table 8 ) .
In response to these factors, dealers increased their positions
to a peak for the second quarter of about $275 million in April.
The
volume of trading remained low, averaging about $45 million in
February, March, and April.
Trading became more active after April
until July when it reached $75 million.
Trading as usual centered
on certificates maturing on tax and dividend dates.
tax-anticipation bills maturing in June —
spring of 1962 —
The $3.3 billion
the largest since the
moderated corporate buying to some extent.
Banks outside New York, faced with increasing requests for loans,
stepped up their offerings of CD's during the early summer.
The New
York banks had temporarily withdrawn, and Treasury bill rates had
-67-
moved down. With the re-entry of New York banks after midsummer, CD
issues at the outside banks slowed.
From August through November, issuing rates of New York banks
were close to or at Regulation Q ceilings about half the time, and
total certificates outstanding showed only a small increase. Aside
from the rise in market rates relative to the ceiling, lessened
corporate liquidity and wider use of the capital market — with a
consequent reduction in demand for bank credit — were factors
checking the rate of growth of CD's. Contrary to experience since
1961, when long-term rates had tended to fall and short-term rates
had moved up slowly, both long- and short-term rates rose rather
steadily after mid-1965. Trading in the secondary market reached
a peak of about $78 million in July, with
demand centered on certi-
ficates maturing on fall tax and dividend dates. After that, activity
declined irregularly until the year-end, except for a small pick-up
in trading in October for year-end maturity dates. As in the
second and third quarters of 1963, some of the decline in activity
was caused by the unwillingness of many holders to liquidate at
a loss.
Although dealer positions reached a high for the year of $280 million in October 1965, both positions and the volume of trading failed to
reach levels attained in the last half of 1964. As the fourth quarter
progressed, the market became thin and uncertainty about the outlook for
rates developed —
culminating with the changes in the discount rate and
Regulation Q early in December.
In general the market lacked the
-68-
breadth that had been characteristic of 1964 and early 1965 and reflected
some lessened over-all interest in new issues of CD's and some slowing
in their volume offered.
It also was affected significantly by the
removal of the 1 per cent ceiling on issues maturing in less than 90
days.
Dealer positions were influenced by less strong potentials for
profits.
K.
Changes In Market Activity -- 1966
The secondary market suffered a sharp setback in 1966.
The year
is distinguished from the previous period in several respects all of
which significatly influenced activity in the market.
Among these
forces are the pattern of both long- and short-term rates; the new
Regulation Q ceilings, which established a single rate at 5 1/2 per
cent for all maturities of 30 days or more; the large increases in the
ceilings; a record rise in amount of CD's outstanding during the
spring, followed by a marked decline later in the year; the change
in character of trading; and greater diversity in the supply of all
short-term money market instruments.
(See Table 6.)
While the December increase in Regulation Q ceilings provided
considerable flexibility for banks to raise their rates, it also
made it practicable for banks to issue maturities as short as 30 days.
Over the year-end, as market rates rose sharply and competition
quickened, the banks —
particularly those in New York —
preferred to
emphasize issuance of shorter maturities rather than to pay the rates
necessary to attract longer-term money.
Leading banks paid 4.80
per cent on 3-month certificates, and out-of-town banks were paying up
to 5 per cent.
term —
At the same time there were small increases in longer-
6 months and over —
maturities, which limited further average
-69-
shortening.
In February the average maturity was 3.3 months.
The
volume of March and June Treasury tax-anticipation bills outstanding
made it more difficult to issue certificates for those dates.
Between November 1965 and February 1966, there was a small net decline
in certificates outstanding.
This was the first over-all decline
within any 12-month period since CD's were first issued.
As the year developed, both short- amd long-term rates continued
the sharp rises that had begun in the summer or fall of 1965, and the
advance in rates became more rapid as monetary restraint intensified
and reinforced upward rate pressures stemming from heavy credit demands.
New issues of certificates accelerated with these developments in
March, and by mid-May the volume had increased about $1.4 billion
one of the largest quarterly increases.
rate after December —
—
Two increases in the prime
particularly the one in March to 5 1/2 per cent
—
made it possible and profitable to seek certificates aggressively.
Table 8
NET INCREASE IN NEGOTIABLE CERTIFICATES OF DEPOSIT
OUTSTANDING IN DENOMINATIONS OF $100,000 OR MORE
(Millions of Dollars)
Size of Bank
(Total Deposits in
pillions of
dollars)
Under
100 200 500 1,000
100
200
500
1,000
and over
Total
1
{
8-19-64 11-18-64 2-17-65 5-19-65
to
11-18-64
to
to
8-18-65 11-17-65 2-16-66 5-18-66
to
2-17-65 5-19-65 8-18-65 11-17-65
574
16
40
195
88
668
676
1,007
120
2
-45
25
to
-13
-42
-76
-29
to
to
to
to
2-16-66 5-18-66 8-31-66 10-26-66
8
24
1
101
225
8
7
-28
-38
40
2
-2
19
96
D
—11
8
193
-76
-97
1.470
21
37
90
160
644
1,259
-404
-2,094
1,310
952
359
-11
1,374
-109
-2,778
i i
Note — Data are based on Federal Reserve surveys for dates specified,
Surveys
of
May
18, 1966, and Aug. 31, 1966, adjusted for change in sample.
8-31-66
-70-
Emphasis shifted towards sales of 6-month and over maturities,
in part to avoid earlier rollover problems on tax dates and in part
because loan demands were expected to continue strong*
Offering rates
were increased more on longer maturities than on short ones, and the
average maturity in May rose to 3.8 months. Market rates rose above
the CD ceiling in July, and certificates outstanding leveled off and
began to decline in August.
at the end of November.
Run-offs amounted to about $3.0 billion
Certificates became competitive only with 1-
month maturities of market instruments. With the increase in the
prime rate in early July to 5 3/4 per cent, leading banks began issuance
of 30-day maturities at 5 1/2 per cent.
Certificates of these banks
subsequently became available in the secondary market at rates above
5 1/2 per cent.
The situation became intensely competitive in th&
summer as rates of all short-term and long-term investments approached
or reached record levels.
Dealer positions in certificates during the first quarter of 1966
averaged only about $70 million, the smallest first-quarter holdings
on record.
This contrasts sharply with inventories which ranged from
$150 million to about $210 million in an average month in 1964 and 1965.
Although dealers will purchase certificates for inventory at even or
negative "carries" if the prospects for reselling at a small profit
are good, the situation in the first quarter of 1966 exposed them to
undercutting of positions.
rates at various maturities.
Issuers could make unexpected changes in
Trading averaged only $40 million, about
$10 million to $15 million below the levels of the comparable quarter
in the previous 2 years. Trading was affected by the increased
availability of shorter maturities from issuers, and the Treasury
-71-
tax-anticipation bill maturing in March tended to cut market demand.
One or two corporations that were pressed for cash and did not want to
sell certificates at a loss arranged reverse repurchases with dealers
until the March tax date.
These transactions accounted for part of
the increase in dealer positions in February and March.
During the second quarter of 1966, although the competition for
funds intensified, the supply of certificates with emphasis on longer
maturities increased substantially.
Banks were willing to pay higher
rates, and corporations improved their liquidity by selling new bonds.
Treasury bill rates had begun to drop in March, and the yield spread
between certificates and bills widened substantially.
seemed favorable for "carries.!!
cautiously —
Expectations
Dealers accordingly added to positions
buying principally certificates maturing around the
September and December tax and dividend dates.
Inventories rose from
an average of $80 million in March to a peak of $215 million in May.
This level, however, was well below that of previous years (see Chart 2 ) .
Trading volume increased with the March and April tax and dividend
dates and reached a high point in June for the midyear and early fall
dates.
The trading level, however, never exceeded an average monthly
level of $55 million —
1965.
roughly equal to the trading lows in 1964 and
The money market atmosphere had changed, and concern had developed
about their ability to finance inventories and about the availability
of supplies.
As rates rose, the spread between yields on Treasury
bills and CD's reached 101 basis points at the end of June, with a
large part of the spread reflecting diverse movements in the supplies
of short-term investments during the half year.
(See Tables 6 and 7.)
Toward the end of June rates on loans to securities dealers approached
-72-
the bank prime rate and subsequently exceeded it.
Dealer bids for
CD's in part came to be based on the cost of carrying them on loan and
not on the basis of resale price.
Spreads between bid and asked
quotations widened.
As the secondary market weakened, the authorities of some corporate
treasurers
to purchase certificates were revoked and other were limited
or further restricted as to which banks1 certificates they could buy.
Dependence upon the Treasury bill market for liquidity was increased.
During the summer quarter both trading and positions declined
sharply to very low levels.
Inventories were cut from an average
level of $180 million in June to $35 million in September when they
leveled off.
loss.
The sharp drop reflected some "dumping11 by dealers at a
Trading volume was cut almost two-thirds, to an average level
of $20 million.
The decline occurred at a time when market rates broke through the
Regulation Q ceilings and then moved substantially above them.
Charts 1-3.)
(See
Many sales by investors thus could be made only at a loss
of principal funds, and there was some distress selling.
During most
of the time only 1-month maturities of new issues had yields that were
competitive with those on other money market investments.
Trading in
the market continued to concentrate on maturities of less than 30 days
and special situations.
Market preference turned almost exclusively to
certificates of the major banks, and the number of issuers in the
market was generally between 20 and 25.
This condition characterized
the market until mid-December.
Banks had begun to have difficulties in rolling over certificates
-73-
in late August.
From August on, outstanding CD's declined steadily
and by early December about $3.2 billion had run off.
and nonrate factors were contributing causes.
to customer loyalties to lessen runoffs.
Both rate
Some banks appealed
Worry, apprehension, and
even desperation "dogged11 dealers and investors alike.
Yields on short-term money market investments reached peak levels
in September and October, as shown in Table 9, and remained high
throughout October.
As the banks became still more restrictive in
granting credit during the early fall, the increased costs and shrinkage
of availability of dealer loans and repurchases compounded market
problems.
Table 9
YIELDS ON SHORT-TERM MONEY MARKET INVESTMENTS
Yields (per cent)
Type of
Investment
Peak
(Sept.Oct.)
Treasury bills
Finance paper
Federal agency
issues
Bankers' acceptances
Certificates
Note —
Nov. 3,
1966
Dec. 22,
1966
Net change (basis
points) from peak to-
•
Nov. 3,
1966
Dee. 22,
1966
5.59
5.87
5.33
5.87
4.81
5.87
-26
0
-78
0
5.77
6.00
5.90
5.58
5.75
5.70
4.98
5.75
5.65
-19
-25
-20
-79
-25
-25
Three-month maturities for all.
Some easing in short-term market rates began in November and
continued into December, supported in part by a shift in credit policy
towards ease.
The market atmosphere improved slightly, and dealers
cautiously began to consider small increases in positions.
There
was also some revival of interest in market purchases by investors, but
-74the market remained soft.
Attraction to the market was chiefly the
result of the decline in Treasury bill yields, as they fell substantially
below certificate yields.
Issue rates remained at 5 1/2 per cent for
30-day or longer maturities, and banks continued to have trouble in
rolling over maturing certificates.
In contrast to these changes in the certificate market, activity
in both the acceptance and Treasury bill markets over the year exceeded somewhat the levels of the previous period.
Average daily
volume of trading in acceptances in 1966 was about $63 million monthly,
up noticeably from 1964 and 1965.
Treasury bill trading rose to an
average monthly level of $1.5 billion, up about $150 million.
Positions of acceptance dealers averaged about $280 million, some
$60 million higher than the levels in 1964 and 1965.
The larger
inventories carried by dealers resulted from increased sales into
the market by accepting banks as their money positions came under
pressures.
Banks' holdings of their own acceptances declined to
about 30 per cent of their total acceptance portfolio as compared
with 49 per cent and 36 per cent in 1964 and 1965, respectively.
By-passing of the dealer market was reduced.
Investors were attracted
to acceptances by their high interest rates relative to those on
other investments.
Dealers1 positions in Treasury bills were about
the same as in the previous 2 years.
Holdings of acceptances and Treasury bills, however, were sharply
reduced as the cost of "carry11 mounted during the summer and funds
became short in supply.
Acceptance inventories averaged only $181
million in contrast to an average of $350 million for the first two
quarters.
Repurchase agreements by the Federal Reserve had been
-75consistently available until mid-July, but from then until the end of
September there were none. Withdrawal of these agreements at 4 1/2
per cent materially raised cost of "carry" and forced the lightening of
inventories during the third quarter.
Similarly, Treasury bill
positions were cut about in half during the summer quarter, in part
because of rising costs but also because of scarcity of bills and
heavy demand.
The volume of acceptances outstanding remained close to the 1964
and 1965 levels as did Treasury bills. This contrasts with the pattern
of outstanding CD's, which rose to a peak in August and subsequently
declined very sharply (see Chart 4 ) .
Chart 4
NEGOTIABLE CERTIFICATES OF DEPOSIT
ALL WEEKLY REPORTING MEMBER BlANKS
(actual cumulativiej change from Jan. 1 of each year)
$
Billions
$
+4
4
-
19! 55/'
+3
*
V
r
+2
V
-
+1
y
7
V
*19< >4
A\
+4
h
V
• V
Billions
y
+3
+2
\
+1
-
19 se\
-1
—1
J
F
M
N
-76-
Comparison of the dollar volume of transaction with the dollar
volume of outstandings for each instrument indicates that trading in
both acceptances and Treasury bills rose substantially.
From January
through June trading volume ranged on the average from .23 per cent
to .30 per cent of CD's outstanding; from 1.22 per cent to 1.52 per cent
for acceptances; and from 2.38 per cent to 2.73 per cent for bills.
The percentages for certificates were less than half those reported
for earlier years, while the ratios for acceptances and bills were
more or less unchanged.
As noted earlier, activity in certificates
was materially affected by the establishment of a single rate for all
maturities and by the increases in market rates relative to the ceiling.
After June trading in certificates shrank to .13 per cent of the total
outstanding, while trading in acceptances and bills remained the same
or increased slightly —
ranging between 1.6 per cent and 1.8 per
cent and 2.53 per cent to 3.00 per cent, respectively,
Comparison of the dollar volume of dealer inventories to the
dollar volume of outstandings also shows a marked change for certificates in 1966 as compared with the previous period.
From January
through June this ratio ranged on the average from .33 per cent in
February to 1.20 per cent in May, and in September and October declined
to .19 per cent and .27 per cent, respectively.
All of these ratios
are small fractions of those of previous periods and reflect a
greater change in positions than in outstandings. For acceptances
the ratios ranged from 11.3 per cent in January to 8.6 per cent in
June, dropped to 4.0 per cent in August as markets tightened, and
returned to earlier levels during the fall. These ratios for
acceptances, except for the summer quarter, are similar to those of
-771964 and 1965.
Ratios for Treasury bills averaged about 3.21 per cent
and showed little significant variation from earlier years.
They
were lower, however, during the tight market of the summer.
Perhaps the most striking contrast in activity in the secondary
market is the change in the dollar volume of transactions in relation
to the dollar volume of positions.
During the first half of the year
these percentages for certificates ranged from 70 per cent in February
to 27 per cent in May and were substantially above most months in
1964 and 1965.
cent.
After June they ranged between 22 per cent and 65 per
Positions dropped somewhat more than transactions did.
For
Treasury bills too the ratios were larger than in the earlier period
and reflected higher levels of trading and some reduction in position
as costs mounted.
During June and July, trading in bills exceeded
positions by 40 and 18 per cent, respectively.
Transactions in ac-
ceptances reflected the increase in investor interest.
Both
trading volume and positions rose, however, and the ratios were unchanged,
L.
Market Activity Mid-December 1966-January 1967
A shift from outflow to inflow of certificates began at banks in
mid-December and accelerated rapidly in January as declines in market
rates of interest made the instruments relatively more attractive.
CD's
issued by large weekly reporting banks increased by about $2 billion
in January, a new monthly record.
The increase for December and January
combined amounted to $2.3 billion and brought certificates outstanding
back to a level of about $18.1 billion.
As short-term rates declined
further after mid-January, many of the larger banks reduced their
offering rates, and at the month-end a number of banks were offering
rates of 5 1/8 per cent for all maturities, and some banks posted a
-785 per cent rate for CD's with 3-month maturities. Even at this
level, yields on new 90-day certificates exceeded Treasury bill discounts by 50 basis points.
Some extensions in maturity ranging up to
3 months were also made.
In the easier atmosphere in December and with prospects for
further ease, dealers began to rebuild positions in anticipation of
profits.
Toward the year-end they made large additions to inventories
as developments seemed to suggest an abrupt and rapid movement in
the over-all structure of rates to lower levels. Dealers acquired
as long maturities as possible, most of them with June and December
dates carrying coupons of 5 3/8 per ceftt and 5 1/2 per cent.
Some
dealers subsequently cut back on their holdings of some of the longer
maturities and emphasized instead certificates with early summer and
early fall maturities. Dealer positions for January averaged $360
million, a record high, and although trading volume increased, it
failed to rise commensurately.
million.
For the month it averaged only $60
Positions were six times larger than the volume of trading
as compared with typical ratios of four to one in the active markets
of 1964 and 1965.
In part trading volume did not increase to its earlier proportions
relative to positions because of competition from new issues and some
lack of a balance in maturities in inventories. Dealers were also
reluctant sellers.
Improvement in availability of financing at lower
rates provided a "running carry11 or at least one that was only modestly
negative.
In other markets dealers1 holdings of securities also in-
creased but not to the same extent relative to trading.
This dramatic resurgence of postions accompanying the rapid drop
-79-
in market rates was a complement to the equally dramatic decline in
inventories in 1966 associated with the sharp upward movement in ratesIt reflects largely the speculative tendencies that may accompany
the unwinding of extremely tight markets.
Table 10
YIELDS ON SHORT-TERM MONEY MARKET INVESTMENTS
Yields (per cent)
Type of
Investment
Treasury bills
Finance paper
Federal agency
issues
Bankers' acceptances
Certificates
Note
Net Change from
Peak
(Sept.Oct.)
Dec. 22,
1966
Jan. 31,
1967
5.59
5.87
4.81
5.87
4.51
5.25
-108
- 62
- 30
- 62
5.77
6.00
5.90
4.98
5.75
5.68
4.87
4.75
5.20
- 90
-125
- 70
- 11
-100
- 48
Sept.-Oct.
1966 to
Jan. 3X, 1967
Dec. 22, 1966
to
Jan. 31, 1967
Three-month maturities for all .
-As shown in Table 10, downward adjustments in yields on acceptances, finance paper, and certificates were substantial in January 1967,
and they accounted for all of the adjustment from the SeptemberOctober peaks for finance paper and somewhat more than half for the
other two investments.
These drops in rates on money market paper,
which had previously shown only sluggish moves, accompanied declines
in rates at the bank counter and in the capital markets.
The secondary market for certificates awaits a test of what it
may consider are normal conditions, that is, a period characterized
by stable or declining yields and one free from the changes in
Regulation Q that have been a feature of market activity to date.
-80Patterns and levels of activity under such conditions are unknown.
M.
Future Market Activity
As long as Regulation Q provides a single rate for maturities of
30 days or more —
with issue rates at the ceiling and market rates on
comparable maturities above the ceiling —
trading in the secondary
market will continue at relatively low levels.
CD's tends to undergo a constant decline.
The floating supply of
New issues are prohibited.
Holders of outstanding issues are deterred from selling because of
13
capital loss,
and dealers face a penalty cost in carrying inventory.
Buyers show a strong reluctance to extend maturities.
Participants
are also concerned with the possibility of an unexpected change in
Regulation Q.
As well, there is a competing supply of desirable invest-
ments with coupons or yields not subject to the constraint of regulation.
Although dealers will make some bids which vary with maturity and reflect the structure of market rates, there is evident discontinuity,
and many trades are negotiated individually.
This background does not
produce a well-defined yield curve characteristic of some other markets,
even though tight.
When market rates fall below the Q ceiling and stable or declining
rates encourage issuance of new CD's, trading volume should advance
moderately.
The volume will fluctuate with the ability of the banks
to issue longer-term maturities, and the market will supply the desired
shorter maturities.
Dealer positions may
be somewhat smaller under
these conditions, because they are exposed to greater risk than when the
13
This is particularly true of corporations which cannot make the
same flexible use of capital losses as banks do in offsets against income,
-81Regulation prohibited issues of shorter maturities.
The potential for
profits will be relatively limited unless there is an opportunity to
"age11 CD f s.
Under the circumstances the dealer, as noted, runs the
risk of having issuers make unexpected changes in rates at various maturities.
The new supply comes out and competes with the old.
The dealer is
also exposed to the risk of a change in the Regulation Q ceiling.
Even
with a new-issue market substantially larger than at present, secondary
trading probably will not reach the levels of 1964-65, which to a great
extent resulted from provisions of Regulation Q.
The secondary market for certificates has had a relatively short
period of development and testing.
Nevertheless, it may be said that a
basic framework has emerged on which future activity can build.
While
comparisons of the certificate market with competitors are frequently
made, they are not altogether valid.
None of the other markets have been
exposed to constraint similar to that provided by Regulation Q.
The
acceptance market and Treasury bill markets, on the other hand, are
offically recognized as markets in which the System conducts open market
operations, and dealers in both markets may have repurchase facilities
extended to them at times to help finance inventories.
Aside from these
important aids, these markets have the distinct advantage over the certificate market of a long period of development in which practices and
mechanisms have evolved that contribute to their greater breadth and other
qualities.
With or without official recognition or help, the certificate market
of the future is likely to be somewhat different from the past.
future market —
The
reflecting shifts and refinements based on the historical
experience of the monetary authorities, issuers, buyers, and dealers
—
-82should be more continuous•
Diverse characteristics of CD f s should be
further reduced, supplies should be less variable, and progress should
be made toward a more standardized form of credit risk.
It is also to
be expected, if Regulation Q remains, that the spasmodic periods of
illiquidity for certificates associated with changes in the Regulation
will be avoided or substantially moderated.
Official and private action
along these lines should help to encourage a widespread increase in
demand, and this factor alone should help to eliminate differentials in
issuing and trading rates for many banks1 CD's.
-83V,
PROPOSALS TO IMPROVE MARKETABILITY OF CERTIFICATES
As the CD market expanded, various proposals designed to improve
the marketability and appeal of certificates to both buyers and
issuers were made by the monetary authorities and participants.
Some
of the proposals have the objective of providing easier access to
the market by the smaller banks. Other suggestions involve merely
changes in market practices.
A.
Issuance of Certificates on a Discount Basis
Many observers believe that the appeal of certificates to
corporate and institutional portfolio managers would be greatly increased if the certificates were issued on a 360 day discount basis instead
of yield to maturity.
Issuance on a discount basis would facilitate
computation of purchase and sale prices and would avoid the awkward
formula now used to make the conversion.
In addition, issuance on a
discount basis would make it possible for most holders to avoid
showing book losses unless a very sharp change in rates occurred.
Some large buyers currently are not willing to sell into the market
if the sale would cause a book loss, and this factor lessens the
appeal of certificates as compared with competing instruments. A
change to issuance on a discount basis might result in a substantial
gain in marketability.
Some banks state that placing CD's on a discount basis was considered when the market began.
This method was rejected because
(1) according to convention, certificates had been issued on a yield
to maturity basis; (2) effective costs would be higher; (3) interest
accrues daily, and the value of the deposit changes daily; hence
-84there would be a mechanical problem in computing required reserves;
(4) some customers insist on a yield to maturity basis; (5) issuance
of certificates on both bases would split the trading market into
divisions and this would lead to confusion.
Although some banks now
believe that these reasons exaggerate possible difficulties, they
think that it would be almost impossible to turn the market around.
B.
F.D.I.C. Insurance Coverage
Some observers suggest that complete insurance coverage be
granted certificates.
This proposal would obviously provide a high
degree of marketability.
It is not clear, however, how this proposal
can be justified without applying the same coverage to other deposits.
Individual unit banks are separately capitalized, differ substantially
in performance, and rise and decline in profitability with their
managements.
ment.
Complete insurance coverage would subsidize poor manage-
This cost would be seemingly greater than the benefit of im-
proved marketability and attendant improved flow of funds.
C.
Dealer's Endorsement
If a dealer would stamp or endorse bank certificates —
a customary fee as in the case with acceptances —
charging
yield spreads of
lesser known banks could be standardized and marketability improved.
Dealers, however, state that they do not want to assume the obligation
of certifying credits.
Furthermore, they believe that impersonal
market evaluation of credit risk should be encouraged.
The market
currently decides on this impersonal basis which banks can grow or
be tided over, but it does not give a guarantee of credit soundness.
Yield spreads frequently give valuable warning signs to the purchaser
and perhaps to the issuer.
-85-
D.
Provision of Information by Federal Reserve Banks
If the Federal Reserve Banks were to act as a regional clearing-
house for information about banks wanting to issue certificates and
those willing to buy them, or if they were to function as brokers in
matching deficit needs for funds of smaller banks with surplus funds
of other banks through an exchange of certificates for deposits,
the market would view these actions with concern.
Participants state
that such actions would be considered tantamount to guaranteeing the
soundness of the bank receiving the deposit.
And if the bank should
become overextended, the Federal Reserve would be subject to criticism.
While this proposal would promote flows of funds and provide easier
access to the market than currently exists for some banks, it is not
clear that those banks1 needs are closely suited to the average
certificate maturity.
Their needs by and large are considered to be
somewhat longer-term.
E.
Group Marketing of Certificates of Smaller Banks
In early 1966 a large commercial paper house, commenting on the
"inequity of money rates,ff stated that the secondary market for certificates of major money market banks had consistently yielded more than
the market for major finance company paper of a similar range in
maturity since August 1964.
market support of CD's.
This was attributed to weak secondary
Money costs for smaller banks, whether
in major centers or in outlying regions, were reflected in spreads
above these rates.
In an attempt to improve the liquidity of CD's
and the mechanical ease of trading them —
looking toward reduction
of the premium and a proper yield relationship to the other money
market instruments —
the firm suggested that a consortium of regional
-86-
banks be organized and that the firm be recognized as the leading
dealer in their secondary market certificates.
Under this proposal
the house would undertake to make a market reflecting a "proper
dealer-spread11 such as exists in acceptances.
For instruments of
members the dealer would post daily quotations and would advertise
a market with a spread of 10 basis points.
Yields in such a market
would be quoted in .05fs of a percentage point by various maturity
categories, as in markets for acceptances and direct-issue commercial
paper.
Adjustment to the rate scale for CD's would be made when the
dealer's position reached key levels in relation to the amount of
financing available to the dealer.
Participating banks could post a rate on an original issue of
certificates at the sell side of the dealer's posted market, that
is to say, at a lesser rate.
that posted by the dealer.
They could not post a rate higher than
The participating banks would provide
the dealer with financing necessary to carry reasonable positions
—
the rates on such financing to be equal to the interest earned on
certificates held in loan position less any trading loss on certificates sold out of positions.
In the arrangement the dealer would not
realize any profit on certificates held in position.
This plan was
expected to allow the issue rate for members to be reduced substantially.
On the assumption that the participating banks would
use the Federal funds market as a source of money to provide dealer
financing, it was expected that there would be a profitable arbitrage
between the Federal funds rate and the interest earned on certificates held in loan position.
By establishing a known and advertised
market for the certificates, it was argued that the issue rate for
-87-
participating banks would be reduced to levels prevailing for major
finance company paper and bankers1 acceptances.
The consortium could not be formed.
Most of the prospective
participants felt that they were placing CD f s satisfactorily.
Some
thought that customer relationship would be taken advantage of.
Others felt that the advantage rested largely with the dealer.
Since
losses would be absorbed by the lending banks and the cost of "carry11
would equal the rate earned on CD's, the dealer would sustain no
cost at all for the financing.
F.
Purchase of Certificates by the System Account
In the interest of increasing the marketability of certificates
of smaller banks, the proposal has been made that the manager of the
Federal Open Market Account make direct purchases of certificates
from time to time.
Participants in the market state, however, that
such action would subject the System to political pressures and
criticisms, which should be avoided.
Beyond this it is believed that
the "feel of the market" and the warning signs that changes in flows
under current conditions provide would be lost.
Although having
little substance as to the likelihood, the eventuality of offical
rate pegging is also a background fear.
In this general connection
about one-third of the replies from monetary economists to a Joint
Economic Committee questionnaire in late 1965 requesting an opinion
about broadening of the list of credit instruments eligible for
purchase by the System Open Market Account favored the maintenance
of current policy.
Acquisition of private credit instruments would
involve entrance into relatively narrow markets.
Less than one-
tenth of the replies favored giving the Federal Reserve more
-88flexibility in this regard.
One economist, however, specifically
recommended dealing in CD's.
G.
Extend System Repurchase Agreements to Dealers
Repurchase agreements by the System are now entered into with
dealers in acceptances and in U. S. Government securities, and
some market participants favor the addition of repurchase agreements
on certificates.
Unless the certificate were made eligible for
purchase by the System Account and eligible for discount, there
seems little to favor this proposal.
Some have raised the question
as to why this market should be distinguished from municipals
or mortgages of short-dated
maturity.
If a recent proposal to make
acceptances ineligible for repurchase is acted upon, inclusion of
certificates would be still harder to justify.
H.
Permit Greater Market Freedom with Respect to CD Rates
The secondary market for certificates for most of 1966 was a
market by designation rather than transaction. Although this may
not be an accurate characterization of the current market, it is
still a matter of concern to participants in the market and it
raises a question about the kind of secondary market that can be
expected in the future if Regulation Q is used aggressively as one
of the policy instruments to control bank credit. The administration
of Regulation Q at various times in the past has maintained unrealistic maxima of rates, with the result that the CD facility as
a whole — both the new-issue market and the secondary market
—
has not always been attractive to users. Rigid ceilings have also
been responsible for development or expansion of several financial
arrangements that may be considered questionable.
These include
-89-
use of repurchase agreements between banks and corporations, use of
brokers in placing CD's, expansion of the Euro-dollar market, issuance
of short-term unsecured negotiable notes, and some loss of interestsensitive funds by nonprime —
to large prime-name banks.
Market participants favor greater freedom in the establishment
of certificate rates.
To this end they argue that all buyers would
use the facility more regularly if there were assurance that it would
generally be attractive to them. Under these conditions issuers
would not be forced to experience liquidation of CD's at maturity,
and investors would find marketability more reliable.
In the absence of official action to permit the underwriting or
subsidizing of CD's, and without radical change in the structure of
the banking system, economic forces and the momentum of the national
money market will continue to draw a preponderant share of CD's to the
large prime banks.
Corporate customer relationships and the size
of these banks are interacting and interdependent factors, which
explain these banks' share of market trading as well as investors'
preferences for these names.
As in the acceptance market where there is a high degree of
concentration —
40 of the 125 accepting banks account for 80 per
cent of all acceptances outstanding and the acceptances of these 40
banks comprise the bulk of the trading —
the market for interest-
sensitive CD funds is concentrated in the more important financial
centers.
The banks outside these areas service local markets, and
their customers by and large are less interest-sensitive.
CD's issued
in these markets should not be considered as being the same as those
issued by large banks.
@FedFRASER