NEGOTIABLE CERTIFICATES OF DEPOSIT: A PRIMER
By AP Faure

Definition
negotiable certificate of deposit, usually abbreviated to NCD, is a fixed deposit receipt issued by a bank that is negotiable in the secondary market for financial assets. The issuing bank undertakes to pay the amount of the deposit plus the interest on maturity date (in the case of short term NCDs), or interest six-monthly in arrears and the deposit amount on maturity (in the case of long NCDs). An NCD certificate contains the following information:

• Name of issuing bank
• Issue date
• Maturity date
• Amount of the deposit
• Rate of interest per cent per annum
• Maturity value (amount of the deposit plus interest) in the case of short NCDs
• Interest dates (in the case of long NCDs)

Historical background
The United States was the first country to create NCDs, and this took place in February 1961. As far as can be ascertained, South Africa was the second country to issue NCDs, and the first issue was made in July 1964. The first English issue took place on 28 October 1968. Building societies first issued NCDs in South Africa on 12 October 1983.

A joint press statement of the four large banks was released on 21 July 1964 regarding the introduction of NCDs from 22 July. The first issuers were Barclays Bank DCO (now First National Bank) and the Netherlands Bank (later Nedbank and now Nedcor Bank). The exact date of the first issue is not known, but it was within days of the press release. Barclays Bank issued their first NCD on 25 July 1964 (see accompanying image).

The discount houses played a major role in the NCD market from its inception. Banking correspondence reveals that the two discount houses in existence in 1964 were approached by the first issuers to act as brokers and market makers in NCDs.

Purpose of issue
As the name of the instrument hints, NCDs are deposits for fixed periods that are negotiable. Thus, a NCD is issued in exchange for a deposit, ie it is an evidence of a deposit. The fact that it is negotiable makes it an attractive instrument for investors, ie investors are not locked into the deposit.

This instrument is available only in large denominations, ie R1 million and above, and this renders it a “wholesale” instrument. Thus the primary (and secondary) market is limited to the large investors.

Legal environment
NCDs are common law instruments, ie there is no specific law that provides for and regulates NCDs. However, the Regulations under the Banks Act 94 of 1990 limits the term of the instrument, and the amount which banks may issue. In summary:

• NCDs may not be issued for periods of longer than 3 years, unless the Registrar grants authorisation in writing
• Total NCDs issued may not exceed 30% of the total amount of liabilities to the public
• NCDs with maturity of 12 months or less may not exceed 20% of liabilities to the public

NCDs do not rank as liquid assets for banks, and they are not eligible for use as repo assets with the Reserve Bank.

Characteristics
In South Africa a standard set of conditions applies to the issue of NCDs. These are found on the reverse of the certificate.

As noted, NCDs may be issued for periods of up to three years (unless the Registrar of Banks has authorised a deviation from the Regulations). When issued for periods of less than one year, interest is usually payable at the end of the period. When issued for longer than one year, interest may be payable either at the end of the period or six-monthly in arrears, but usually the latter. NCDs are also issued at variable rates, usually with reference to some benchmark rate.

NCDs are usually issued in bearer form (ie not payable to any particular person), and only occasionally in the name of the depositor. In this case the endorsement of the investor is required for transfer.

NCDs may be issued in any amount, but are usually issued in denominations of R1 million. At times a bank may issue denominations of R500 000 and even R100 000 but only when part of a larger parcel.

Banks are willing to split larger denomination NCDs into smaller denominations.

Amount in issue
Between the first issue in 1964 and the first quarter of 1965 the total amount of NCDs issued grew slowly, ie up to R3 million, and stood at only R104 million at the end of 1967. It was after this period that NCDs issued grew rapidly, the amount of R2 billion being first breached in 1982.

Since 1969 total NCDs issued has kept pace with the growth in bank deposits and as a ratio thereof has fluctuated between 10% and 20%. The amount outstanding for banks was approximately R28 billion at the end of 1991, and approached R90 billion ten years later.

Of all the money market instruments, NCDs have the largest market capitalisation (outstanding amount). The chart below shows NCDs outstanding as a ratio of deposits.

Primary market
Demand for NCDs arises from a wide array of institutions including money market funds, banks other than the issuer, mining houses, pension funds, insurance companies, cash-rich commercial and industrial companies, and high net-worth individuals.

These instruments are available across the full maturity spectrum and quality spectrum. Banks are willing to tailor maturity dates to meet the needs of investors. NCDs offer the same security as a term deposit with the bank in question, but are fully negotiable before the date of maturity.

Not all banks are able to issue NCDs at the same rate. The rates payable depend on the rating of the bank by a recognised rating agency. The smaller banks have difficulty in issuing NCDs.

The method of issue of NCDs could be called “pro-action and re-action”. Banks (via their treasury divisions) are in daily contact with the larger investors and endeavour to market their NCDs to cover maturities and to accommodate new funds available. The banks also respond to contact initiated by investors.

Ownership distribution
No statistics on ownership distribution are available in South Africa at present, but they are held by the same institutions that are involved in the primary market, as mentioned above. The main holders tend to be the financial intermediaries, particularly pension funds, money market funds and insurance companies. Cash-rich companies, such as mining houses, are also large investors.

Secondary market
An NCD issued to bearer is transferable by delivery alone. If an NCD is issued repayable to a particular depositor, it is transferable by delivery plus the endorsement on the reverse of the certificate. The endorsement may be in blank or to order.

A secondary market in NCDs is “made” by the larger banks themselves in their own paper. This means that they are prepared to quote firm buying and selling rates, for immediate settlement, on their own NCDs, and in amounts of R20-30 million. They are usually only prepared to make a market in NCDs with a currency of up to one year.

The discount houses were prepared to make a market in all prime NCDs during the period of their existence, from 1957 to 1992. No institution, other than the banks, at this stage is prepared to make a market in all NCDs.

The main participants in the secondary market are the money market funds, the pension funds, insurance companies and mining houses.

Issue and dealing mathematics
The NCD, which is simply a fixed deposit that is negotiable, is the most issued and traded money market instrument in the South African money market. NCDs are issued in a number of ways and different mathematics applies in each case. The most “common” type of NCD is one with a tenor of less than one year where the amount invested (deposited) is given (for example R1 million) and where interest is payable at maturity.

At issue the typical simple interest calculation is involved, as follows:

FV = PV [1 + (ir x t)]

where

PV = present value (amount of deposit)
FV = future value (PV + the interest amount)
ir = interest rate negotiated
t = term of deposit in days, expressed as t / 365.

An example will make this clear:

PV = R1 000 000
ir = 9.8% pa
t = 180 / 365

The maturity value (MV), which is the FV, is calculated by the deposit-taking bank and placed on the certificate:

Maturity value (FV) = PV [1 + (0.098 x 180/365)]
= R1 000 000 (1.04832877)
= R 1 048 328.77.

When NCDs are traded in the money market, the “givens” are:

• The maturity value (MV or FV)
• The maturity date
• The settlement date
• The rate at which the trade takes place.

These variables are used to calculate the consideration, ie the amount to be paid by the purchaser (or received by the seller). The consideration is nothing else but the PV. The formula used in secondary market trades is as follows:

PV = FV / [1 + (ir x t)].

An example will be useful. A company would like to invest an amount close to R1 million and approaches its broker in this regard. The broker makes a few phone calls and offers the investor a NCD with the following characteristics:

Maturity value (FV) = R1 054 246.58 (this was calculated at issue)
Maturity (due) date = 20 June 2002
Date of transaction = 21 January 2002
t = 150 / 365 (ie 21 January to 20 June)
Rate traded at (ir) = 9.2% pa.

The investor accepts the deal and the consideration is calculated:

Consideration (PV)
= R1 054 246.58 / [1 + (0.092 x 150/365)]
= R1 054 246.58 / 1.03780822
= R1 015 839.50.

Payment on maturity date
On maturity date the holder of an NCD presents the certificate to the issuing bank, which issues a cheque for the face value plus the accrued interest, ie the maturity value. NCDs are in the process of being dematerialised, and when complete ownership will be evidenced by an electronic entry in the books of the central scrip depository (CSD - to be STRATE) and in the books of the relevant central scrip depository participant (CSDP). Payment will be automatic and electronic to the holder on maturity.