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Managing treasury risk: Interest rate risk (Part II)
|31-1-2017 | Lionel Pavey |
There are lots of discussions concerning risk, but let us start by trying to define what we mean by risk. In my first article of this series I wrote about risk managment and what the core criteria are for a solid risk management policy. Today I want to focus on interest rate risk. There are 4 types of interest rate risk.
Absolute Interest Rate Risk
Absolute interest rate risk occurs when we are exposed to directional changes in rates – either up or down. This is the main area of rate risk that gets monitored and analysed within a company as it is immediately visible and has a potential effect on profit.
Yield Curve Risk
Yield curve risk occurs from changes between short term rates and long term rates, together with changes in the spreads between the underlying periods. Under normal circumstances a yield curve would be upward sloping if viewed as a graph. The implication is that longer term rates are higher than short term rates because of the higher risk to the lender and less liquidity in the market for long dated transactions. Changes to the yield curve (steepening or flattening) can have an impact on decisions for investment and borrowings, leading to changes in profit.
Refunding or Reinvestment Risk
Refunding or reinvestment risk occurs when borrowings or investments mature at a time when interest rates are not favourable. Borrowings or investments are rolled over at rates that had not been forecast leading to a potential loss on projects or investments.
Embedded Options Risk
Embedded options are provisions in securities that cannot be traded separately from the security and grant rights to either the issuer or the holder that can introduce additional risk. Benefits for the issuer can include a call option, a right to repay before maturity without incurring a penalty, an interest rate cap. Benefits for the holder can include a put option, a conversion right via convertible bonds, an interest rate floor.
An attempt can be made to calculate the interest rate risk on either a complete portfolio or on individual borrowings or investment. This is done by comparing the stated interest rate to the actual or projected interest rate. Methods include:
These are all forms of quantitative analysis and well recognized. Personally I am of the opinion that VaR is not a very good method for interest rates. Interest rates do not display normal Gaussian distribution – they do not resemble a normal bell curve. Interest rate distribution curves display fat tails compared to normal statistical models.
Financial products that are commonly used to manage interest rate risk include FRAs, Futures, Caps, Floors, Collars, Options, Interest Rate Swaps and Swaptions.
Lionel Pavey
Cash Management and Treasury Specialist
More articles from this author:
Safety of Payments
The treasurer and data
The impact of negative interest rates
How long can interest rates stay so low?
How much are you paying your bank ?
| 30-1-2017 | Patrick Kunz |
Does your bank send you a monthly invoice how much they charge you on banking costs? Some do but some don’t. Even if you receive an overview of these costs – do you look at them? Often organizations don’t and that’s a pity. A bank is as much a services provider as other suppliers of the company. Of course changing banks is not something you do every year but that does not mean you should never do it or never have a look at your banking costs.
Allthough even if another bank proves to be less expensive, it should not always imply to change the bank, as the indirect costs of a bank change should also be taken into account and you always have the option to renegotiate.
The first step when looking at your banking costs is how your payments look like. Is your company doing only national payments or SEPA or are you transferring (or receiving) money from outside the SEPA region and/or transferring non-EUR payments? This matters because a national payment and SEPA payment will cost you around 0,10 EUR per transaction while an international payment can costs on average EUR 6. The potential saving on international payments is much higher.
There are several ways to reduce the transactions costs:
Have a look at the total return of your bank. Your bank is one of your suppliers so it makes sense to compare the costs of the supplier to their competitors, especially if you have multiple banking partners. As for suppliers you do not always choose the cheapest but also take into account service level and worldwide availability. It does make sense to compare banking costs every 3 years for market conformity. My advice would be to take into account all banking costs (so also FX deals, corporate finance, trade finance, guarantees). Banks often cross sell their products and the total fees are never visible so you have to gather this information yourself. I prefer to calculate the RAROC (Risk adjusted return on capital) for each banking partner. This way you can easily compare the total return per bank. This helps a lot when renegotiating fees or (new) credit lines. RAROC calculation is not easy and it takes often quite some work to gather all information but once implemented it is a nice tool for companies with multiple banking partners to compare (and rank) banks.
Patrick Kunz
Treasury, Finance & Risk Consultant/ Owner Pecunia & Finance BV
Blockchain and Central banks: a Tour de Table (Part I)
| 27-1-2017 | Carlo de Meijer | treasuryXL |
Our expert Carlo de Meijer, distinguished blockchain specialist, has published an article that is worth sharing with you. This is Part I and Part II will follow soon. May we invite you to comment or share your experience with this intriguing topic:
In April last year I wrote a blog on blockchain and monetary policy. In this blog I went into a number of still unanswered questions posed by the European Central Bank around blockchain technology. There was a big uncertainty about the impact of this technology on the future role of central bank money and on monetary policy.
While at that time many financial institutions and startups already paid a lot of attention to this technology, only a handful of central banks were interested in blockchain with the most vocal being the Bank of England. Since than a lot has changed with a growing number of central banks around the globe starting to recognise the potential for blockchain to help them in obtaining their key objectives: stable financial system and efficient financial markets. In the first part of this blog I will try to answer why there is nowadays so much interest amongst central banks in blockchain technology, what are the main benefits and what are remaining concerns. In the second part a Tour de Table will be given, looking at the various initiatives of the central banks.
Central banks are experimenting with blockchain
Several central banks are or have been experimenting with different versions of blockchain-backed systems. A growing number are questioning the point of creating digital currencies, such as the Danes. But they are not alone. Also the central banks of Sweden, Japan, China and Russia have launched similar efforts. Others such as the central bank of Singapore and Canada have already tested blockchain-based currency systems for internet payments, while also the Reserve Bank of South Africa has expressed their optimism towards the blockchain technology and its potential impact on finance. The European Central Bank recently announced a new research undertaking in partnership with the Bank of Japan. Earlier last month the US Federal Reserve released its first major research paper on blockchain.
Why is there so much interest?
But why are so many central banks now embracing blockchain, seriously exploring their potential.
The turning point was a three-day event in Washington , hosted by the World Bank, the IMF and the US Federal Reserve where representatives from more than 90 central banks worldwide expressed broad interest “in how the technology might impact both the banks they regulate as well as their own regulatory practices”.
Central banks’ interest in deploying a blockchain “comes in step” with moves by the big banks to use the technology to ease cross-border settlement transactions and overhaul antiquated back-office infrastructure. Experiments by banks with distributed ledgers as a way to settle trades and record data and transactions, have clearly shown its potential to reduce costs and increase the efficiency of its operations. The distributed ledger and its potential to simplify the record keeping, tracking and accounting process makes it hard to ignore by central banks.
Central banks and public stances: some quotes
Over the course of the past half year many central banks representatives have taken a public stance on their potential use of distributed ledgers and digital currencies. Here follow some of the most interesting quotes.
“Innovation using these technologies could be extremely helpful and bring benefits to society. The technology has the potential to transform multiple aspects of the financial system” Janet L. Yellen, Chairwomen Federal reserve
“We are paying close attention to distributed ledger technology, or blockchain recognizing this may represent the most significant development in many years in payments, clearing and settlement” Lael Brainard, Federal Reserve Board
Other interesting quotes include:
“The conditions are ripe for digital currencies, which can reduce operating costs, increase efficiency and enable a wide range of new applications” People’s bank of China
“A state-sponsored digital currency is still on the agenda, and if adopted, the technology could deliver a range of benefits” Russian central bank
“The technology could be worth using for central banks because it would make for a financial system that does not go down even if the central bank’s computer systems are temporarily taken offline” Mark Carney Bank of England
What are the potential benefits for central banks?
Central banks are now exploring the potential of blockchain and distributed ledger technology. As banks experiments have shown blockchain networks may lead to safer and better payments and securities systems..
The inherent property of immutability and transparency associated with blockchain makes it easier for the central banks to trace the money that is in circulation. It would allow them to track every euro, pounds, dollar or renminbi on every step through the financial system in real-time.
Central banks are also interested in blockchain technology as a way to build a single, shared record of all transactions among several institutions. The central banks hope they can use the decentralised method of record-keeping to complete and record transactions in the real economy more effectively, quickly and transparently. The creation of a standardised way of recording transactions would allow all the players in the system to communicate more seamlessly. That could leave much less money sitting idle while banks reconcile their different ledgers, as now happens.
It has also the potential to create efficiency. Blockchain or the distributed ledger technology has the potential to simplify the settlement chain around securities transactions. The resulting cost reductions, speed of settlement and enhanced transparency may all contribute to more efficient and safer payments and capital markets.
It may also drastically reduce the transmission costs and time associated with cross border transfers, by enabling instant transfers between branches both within and outside the country.
The use of blockchain-based digital fiat currency will reduce the amount of banknotes and coins that are in circulation. This will, in turn, reduce the operating costs associated with printing and distribution of currency notes by the central bank.
The wide spread implementation of blockchain based fiat currency will also help the central banks (and government’s) fight money laundering while eliminating the issue of counterfeiting.
The blockchain technology provides a tool to measure leverage in the system and counterparty exposure, and can monitor compliance in real time. It can also answer questions about collateral ownership.
A blockchain could untangle the spaghetti structure of central swap bank lines, which would improve crisis response capabilities.
Digital currencies may eventually benefit the developing world too. Because they are low-cost and easy to use on electronic devices, digital currencies may enable greater access to financial services for the billions of the world’s unbanked.
This all should make the financial system more transparent, fast, efficient and secure. According to a Bank of England research paper produced last year, the economic benefits of issuing a digital currency on a distributed ledger could add as much as 3 percent to a country’s economic output, thanks to the efficiency it could offer.
Remaining concerns
There are however still a range of questions and all sorts of security and regulatory concerns where central banks will need answers for before blockchain technologies are to become a key part of the future central banking landscape.
Questions such as: How may it impact monetary policy?; What are the implications of issuance of central bank digital money?; What is the impact on physical cash?; How would it impact on central bank seigniorage?; What are the implications for the integration of the European capital market?; and What is the impact on exiting projects such as T2S?
In previous blogs I already tackled some of these issues. See: “Could blockchain bring the EU Capital Market Union forward?” November 6, 2016; “Blockchain: What about T2S?” June 30, 2016; and, “Blockchain and Monetary Policy” April 29, 2016.
There are also a number of concerns that are already highlighted, such as assurance around scalability, data integrity, resilience and resistance to cyber-attack. A big concern is regulation of digital currencies. This is a looming challenge that will require cross-border co-operation. Monetary authorities must come together to start thinking about the necessary regulation of digital money that will be flowing around the world.
See my blog: “Blockchain and Regulation: do not stifle innovation!” April 4, 2016.
When can we expect central bank-operated digital currencies?
When a move to official digital currencies might occur is hard to estimate. Central bank-operated digital currencies could be ‘decades away’ according to the more pessimistic (or realistic?). But what is sure is that it will take a number of years before any central bank issues its own currency onto a live distributed ledger. Research is still at an early stage and many puzzles still have to be worked out.
It has become clear that central banks are set to take a much more active role in the development of blockchain technology. But how active that will be is not yet clear. The Fed’s preference at this stage is still to take a fairly hands-off approach and allow banks take lead the way – “as long as they remain within defined guidelines and best practices”. A switch could happen within the next 5 to 10 years. When large parts of the financial system are using blockchain for financial transactions, so will central banks!
Carlo de Meijer
Economist and researcher