FINANCIAL TRADING INSTRUMENTS – TRADING WITH BG’S, SBLC, DLC AND MTN’S

Posted on October 14, 2015

Introduction

This brief account aims at helping you find out about some of the obscure, or unclear, aspects relating to the Private Placement Opportunity Programs (PPOP), also known as Private Placement Programs (PPP), or under other acronyms like Private Placement Investment Programs (PPIP), etc. There are lots of people who know something, but cannot grasp the whole picture.

The following account is based on our personal experience of several years in this business. To explain the involved matter, we will study it mostly from an investor’s standpoint and a broker’s standpoint.

Topics

Before speaking of Private Placement Opportunities (as aforementioned PPO), we need to realize some basic reasons for the existence of this business. It means that there is a need to learn some basic concepts about what money really is and about how money is created and how the demand for money/credit can be controlled, and that someone can issue a debt note which can be discounted and sold then resold in an arbitrage transaction (the basic system for running most of these programs), etc.

The Basic Reasons

To fully understand what it’s all about, there are some basic principles that you must understand:

Money Creation

The first reason why this business exists is to create money. More money is created by creating debt. You as an individual can lend out USD100 to a friend and you can make an agreement where the interest for that is 10%, so that he must pay you back USD110. What you have done is to actually create USD10, even though you don’t see that money. Don’t consider the legal aspects of such an agreement, just the facts. Now, the Banks are doing this every day, but with much more money. Banks have the power to create money out of nothing. Since PPO involves trading with discounted bank issued debt instruments, money is created due to the fact that such instruments are deferred payment obligations (debts). Money is created out from debt. Theoretically, any person/company/organization can issue debt notes (don’t look at the legal aspects of it). Dept notes are deferred payment liabilities.

Example: A lawful person (individual/company/organization) is in need of USD100, so he writes a debt note for USD120 that matures after 1 year, which he then sells for USD100 (this is called “discounting”). Theoretically, the issuer is able to issue as many such debt notes at whatever face value he wants – as long as there are those that believe that he’s financially strong enough to honor them upon maturity, and thereby is interested in buying such debt notes. Dept notes like Medium Terms Notes (MTN), Bank Guarantees (BG), Stand-By Letters of Credit (SBLC), etc. are issued at discounted prices by some of the major world banks in a very large amount of Billions USD every day.

Generally speaking they do “create” such notes (debt notes) “out of thin air”, so to speak. That is, they only have to write the documents. It’s as easy as if you, as an individual, write a debt note. Now, the core problem: to issue such a debt note is very simple, but the issuer would have problems in finding a buyer, unless the buyer “believes” that the issuer is financially strong enough to honor that debt note upon maturity. Any bank can issue such a debt note, sell it at discount and promise to pay back the full face value at the time the debt note matures. But would that issuing bank be able to find any buyer for such a debt note without being financially strong enough?

An example: If you had USD1 Million, and had the opportunity to buy a debt note with the face value of USD1 Million issued by one of the largest banks in Western Europe for let’s say USD-800,000 a debt note that matures in 1 year, wouldn’t you then consider buying it if you had the chance to verify it? Now, if a Mr. Smith approaches you on the street and asks you if you want to buy an identical debt note issued by an unknown bank, would you consider that offer?  As you see, it’s a matter of trust and credibility only. And now, maybe, you will also understand why there’s so much fraud, and so many bogus instruments in this business.

Large Debts Instruments Market

As a consequence of the previous statements, there is an enormous daily market of discounted bank instruments like MTN, BG, SBLC, Bonds, PN, etc. involving issuing banks and long chains of exit- buyers (Pension Funds, large financial Institutions, etc.) in an exclusive Private Placement arena.

All such activities on the bank side are done as “off-balance sheet activities” and as such, the bank can benefit in many ways. Off-Balance Sheet Activities are contingent assets and liabilities, and as such the value depends upon the outcome upon which the claim is based, similar to that of an option.

Off-Balance Sheet Activities appear on the balance sheet ONLY as memorandum items, and it’s first when they cause a cash flow that they will appear as a credit or debit in the balance sheet. The bank does not have to consider binding capital constraints, as there’s no deposit liability.

Normal Trading – Private Placement

All programs in the Private Placement arena involve trade with such discounted debt notes in one way or another. And to bypass the legal restrictions, this can only be done on a private level. This is the reason why this type of trading is so different from the “normal” trading, which is highly regulated. In other words, this business can be done and restricted on a private level only (the private Placement level) that falls down in a special regulation without the usual strict restrictions present on the securities market.

The normal trading known by the public is the “open market” (as the “spot market”), where discounted instruments are bought and sold with bids and offers like an auction. To participate here the traders must be in full control of the funds; otherwise, they cannot buy the instrument and sell them on. And there are no arbitrage buy-sell transactions on this market, because all participants can see the instruments and their price.

However, besides this “open market”, there’s a “closed, private market” where a restricted number of “master commitment holders” is the inner circle. These master commitment holders are Trust with huge amounts of money that enter contractual agreements with banks to buy a certain number of new issue (fresh-cut) instruments at a specific price during a specific period of time. Their job is to sell these instruments on, so they contract sub-commitment holders, who contract exit-buyers.

These “programs” are all based on arbitrage buy-sell transactions with pre-defined prices, and as such, the traders never need to be in control of the investor’s funds. However, no program can start, unless there’s enough money behind each buy-sell transaction. And it’s here the investors are needed, because the involved banks and commitment holders are not allowed to trade with their own money, unless they have reserved enough funds on the market– money that belongs to the investors which is never used and never at risk.

The involved banks (the Trading Banks) can lend out money to the “trader”, and it’s typically 1:10, but can during certain conditions be as much as 20:1. So if the trader can “reserve” USD100M, then the bank can lend out USD1B (actually, the bank giving the trader a line of credit based on how much money the trader/commitment holder has, since the bank doesn’t lend out that much money without collateral, and not depending on how much money the investors have.

So, if a trader says that he must be “in control” of the investor’s funds, then it means that he’s not one of the “big boys”, but plays on the open spot market. Lots of different “instruments” are traded. If the trader only needs to reserve the investor’s funds, and doesn’t need to be in control of the funds, then he’s trading in this “private market”.

Because lots of bankers and other people in the financial world are well aware of the open market, as well as being aware of the so-called “MTN-programs”, but are closed out from the private market, however; they find it hard to believe that the private market exists.

Arbitrage and Leverage

The real core of the trading and its safety is due to the fact that they arrange the buy-sell transaction as arbitrage, which means that the instrument will be bought and sold at the same time with a pre-defined price, and that a chain of buyers/sellers are contracted, including the exit-buyers who often are institutions, other banks, insurance companies, big companies, or other wealthy individuals. The issued instruments are never sold directly to the exit-buyer, but to a chain of up to 3-7, or even perhaps 50 investors. The involved banks cannot for obvious reason directly participate in this as in-between buyers and sellers, but they are still profiting from it indirectly, because they are lending out their money (with interest) to the trader, or to the investor as a line of credit. This is the Leverage. Furthermore, the banks profit from the commissions involved in each buy-sell transaction of debt bank instruments in the trading circle. Now, the investor’s principal doesn’t have to be used for the transactions, but it’s only reserved as a compensating balance “mirrored”, if you will, against this credit line. And this credit line is then used to back up the arbitrage buy-sell transaction. Now, since the trading is done as arbitrage, the money (the credit line) doesn’t have to be used, but it must still be there available to back up each and every buy-sell transaction. Such programs never fail because they don’t start before all actors have been contracted, and each actor knows what role to play and how they will profit from the transaction. This is the real type of PPO’s!

A trader that is able to do leverage is able to control a credit of typically 10 to 20 times that of the principal, but even though he’s in control of that money, he’s not able to spend the money. He only needs to show that he has the money and that he’s in control of the money, and that the money is not used somewhere else at the time of the buy-sell transaction. The money is never spent. And the reason is that the trading is done as an arbitrage transaction.

Let me present an example:

Let’s say that you’re offered the chance to buy a car for USD30K, and that you also find another buyer that is willing to buy it from you for USD35K. If the buy-sell transaction is done at the same time, then you don’t have to spend USD30K, and then wait to earn the USD35K since it can be done at the same time you cash in USD5K in profit. However, you must still have that USD30K and prove that you’re in control of it.

Arbitrage transactions with discounted bank instruments are done in a similar way. The involved traders never spend the money, but they must be in control of it. And the investor’s principal is reserved directly for this, or indirectly, in order for the trader to leverage.

Confusion is rife because most seem to believe that the money must be spent. And even though this is the traditional way of trading – buy low and sell high, and also the common way to trade on the open market for securities and bank instruments, it’s possible to set up arbitrage transactions if there’s a chain of contracted buyers.

You can also realize now why in these Private Placement Programs, the investor funds are always safe without any trading risk, or whatever  other risk, except for the normal bank system risk (a bank can still virtually go bankrupt!!!)

High Yield

Usually these programs get a very high yield if compared with the common yield reachable with the traditional investments. Most people do not believe that a yield of 50%-100% per week is possible. It is again a problem of knowledge of working programs and this example can shed some light on the matter:

Assume a leverage effect of 10:1, which means that the trader is able to back each buy-sell transactions with 10 times the amount of money that the investor has in his bank account. Let’s say that the investor has USD10M, so the trader is able to work with USD100M. Now let’s assume that the trader is able to do one buy-sell transaction per day for 3 days per week for 40 banking weeks (that’s 1 year), and that the profit is 5% in each buy-sell transaction. That makes 5%x3=15%, and with the leverage effect, the profit will be 10 times as high, or 150% per week. Then this return will be split between the investor and the Trading Group (for projects), but the final net yield for the investor will still be a double-digit weekly yield!! Bear also in mind that the above example can be still seen as conservative because tier one level Trading Groups can get a much higher single spread for each transaction as well as a markedly higher number of weekly trades enhancing considerably the final yield!! I understand that such a high yield might seem ridiculously high, but that is because it’s compared to traditional ways of investment and trading.

Investor

The involved investors (the Program’s Investors) are not the end-buyer in the chain, but the real end-buyer are financially strong companies who are looking for a long term and safe investment, like personal funds, trusts, insurance companies, etc. And because they are needed as end-buyer, they are not permitted to participate “in –between” as investors. The investor who participates in a Private Placement Investment Program is just an actor in the picture amongst many other actors (bank funds/insurance, etc, trading groups as traders/ commitment holders, intermediaries/brokers) who gets the advantage to benefit from this trading. The investor usually does not see most of the actors involved in the process, because he will deal with brokers, Trading Groups / Traders and trading Banks only.

Programs Structure

Usually, a trading program is nothing other than a pre-arranged buy-sell transaction of discounted banking instruments made as an arbitrage transaction. Virtually, an investor with large amounts of funds (on the level of 100M-500M USD) could arrange for this own program by implementing for himself the buy-sell transaction, but in this case he needs to gain control of the whole process, making contract with the Provider banks for the bank instruments and at the same time for the exit buyers. This is not a simple task at all considering that there are many FED restrictions to be passed, and at the same time, it is very difficult to get the strong necessary connections with the related parties (the issuing banks/providers for the bank instruments and the exit-buyers).

For an investor, it is much simpler (and usually more profitable) to enter a program where the Trader with his Trading Group has already everything in place (the issuing banks, the exit-buyer, the contracts ready for the arbitrage transaction, the line of credit with the trading banks, all of the necessary guarantees/safety for the investor, etc.) and the investor needs only to agree with the contract proposed by the Trader, forgetting about any other underlying problem.

Another advantage for the client is that he can enter a program with a substantially lower amount of money against the case to proceed by himself because he will take indirectly advantage of the line of credit of the Trading Group.

Non-Solicitation and Non-Disclosure

As a direct consequence of the Private Placements environment where this business has to take place, a non-solicitation regulation has to be strictly followed by all of the involved parties. This factor strongly influences the way the parties, and actors can deal each other, and the way they can make contact. Sometimes, this fact can also be the cause of the origin of scams (or attempts to scam), due to the fact that at an early stage, it is often difficult for the investors to realize if they are really in contact with a reliable source.

There is another reason why so few experienced people talk about this transaction: virtually every contract involving the use of these high-yield instruments contain very explicit non- circumvention, as well as non-disclosure clauses forbidding the contracting parties from discussing any aspect of the transaction for a period of years. Hence, it is very difficult to locate experienced contracts who are both knowledgeable and willing to talk openly about this type of instrument, and the profitability of the transaction in which they figure. This is a highly private business; not advertised anywhere, nor covered in the press and not open to anyone, but the best-connected, most wealthy entities that can come forward with substantial cash funds.

How Banks and Brokers Can Earn

Banks are not allowed to act as investors in such programs. However, they are able to profit from it indirectly in different ways, first by getting large commissions. This fact permits some private entities like brokers, trading groups, and private investors to take part in this business that otherwise would be a banking matter only! The private assets coming from private clients are necessary to start the process. These private, large cash funds are the mandatory requirement for the buy-sell transaction of banking debt instruments, and as a consequence, also the mandatory requirement for the programs through the Trading Groups. Brokers are necessary to introduce the investors to the trading groups! Thus, each of the involved entities takes their part in the sharing of the benefits, commissions for banks/brokers, and proceeds for trading groups/investors.

Projects

Projects are usually involved in these programs. However, the purpose of this type of trading is NOT to finance humanitarian projects. It’s true that projects, not just humanitarian projects, can be funded as a result of this trading, and since this type of trading generates such huge amounts of money on the market, measures must be taken to keep the inflation low, and one way is to finance different projects. If too much money is created, the result is inflation, and in order to be able to continue creating debt, different measures must be taken to keep the inflation low. One way is to adjust the interest rates. However, for this kind of trading, this is not possible; it has little or no effect. A better way is to let some of the profit be used for different projects that need funding; for instance, to rebuild the infrastructure in regions of the world that have experienced catastrophes, war, etc., because that creates jobs for people in those regions, as well as for subcontractors in the west.

So, the reason for project funding is primarily not to support humanitarian organizations, even though that also happens, but to fight against inflation.

Process Synthesis

The complete process involving the issuing of debt-notes, the arbitrage transaction, the programs, the projects, etc. is as a final synthesis a result of combined market forces: banks have a method of increasing their revenues and profits, investors are able to finance different ventures, borrowers are able to access loan funds. There is a supply and demand for such instruments, and as long as the supply and demand exists, then this kind of trading will also exist.

Process Summary

As a summary of the process involved for entering a program:

• An investor with USD10M and up can be an applicant for a Private Placement Investment Program.
• This business is entirely private. To get access to these investment programs, the investor needs to send his preliminary documentation to some broker whom the investor trusts to be in direct contact with the Trading Group. There is no other way for the investor to make contact with the Trading Group at this stage.
• After the investor has sent his paperwork, the Trading Group will proceed to its Due Diligence on the applicant, and if the response is positive, and cleared, then the program manager in the trading group will contact the investor by phone and/or fax and invite the investor to a face-to-face meeting. However, usually, if the investor is not willing to travel, everything can be done by fax, phone, and courier mail. If not cleared, then the program manager will contact the broker, and then tell him that the investor did not qualify, and then the broker forwards on that information to the investor who often gets upset and might discredit the broker and/or intermediary, maybe on a due diligence message board.
• During the contact with the investor, the trader will explain the program’s terms/conditions, the guarantees, the contract details, as well as the next step required to start the program. Then, it’s necessary and required by the program terms, the investor will get instructions to open a new sole signatory bank account at the Trading Bank for transferring the funds there. The Trader has prepared everything; so the investor is able to open the Bank account without delay (because he has already been cleared). Otherwise, the investor will be invited to prepare his own bank to block/reserve the funds into his own account at his own bank for one year without any transfer of money.

• The investor will receive a contract which states the total gross yield, the percentage of the gross profit reserved for projects, the percentage for the Trading Group, and the percentage for commissions/fees to be deducted for brokers/intermediaries. The net return to the investor will be wired to another investor returns account that can be located in any bank worldwide. If the client accepts the contract, the contract is signed, and the program is ready to start.
• The Trader is now able to leverage the investor’s reserved money 10 times and is now able to back up the arbitrage transaction with the money, a credit line that remains in the bank account that is screened before each arbitrage buy-sell transactions. Trading now continues, and the profit is paid out once per week (or per day/month, or whatever depending on the program terms, to the investor. The investor instructs the bank to wire out the commission part to the broker’s bank coordinates. The program continues the above loop for each week until the end of the program, usually 40 banking weeks.

The programs can work with cash only. This fact does not mean that the investor will only be accepted in the case he owns cash. The investor can be accepted by some Trading Groups also with financial assets like MTN, BG, CD, SBLC, SKR, etc. that the Trader then will use for getting his own line of credit at the Trading Bank to run the program. In this case, the investor will have the advantage of profiting both from the program, and still from the yield coming from the instrument (i.e. the scheduled interest of a CD, or MTN).

Analysis of Risk Involved in PPO Contracts

Finalizing PPO contracts with investors is usually always a long stressful process because the involved parties can stumble upon many problems along the way. We will observe a list of possible problems of behavior from the standpoint of the main parties involved at the bottom line of the process:

• The investor
• The brokers/intermediaries
• Then there will follow some hints on possible scams, and warning for scams, in this business.