Introduction to Investments in South Africa

Part 1:- The Capital Markets: An Introduction28 January 2015

Antonie Kotzé (PhD)

Before I came here I was confused about the subject. Having listened to your lecture I am still confused. But on a higher level.

Enrico Fermi (1901-1954)

Niels Bohr and

Albert Einstein

Country Performance: finviz.com

Historical Development of Financial Markets

It is difficult to state with any degree of certainty at what date or at which of the commercial centres a particular instrument or market convention originated. Braudel and Reynolds make the following statement:

“Notes and cheques between market traders and bankers were known in Babylon twenty centuries before the Christian era. The same devices were found in Greece and Hellenistic Egypt, where Alexandria became ‘the most popular centre of international transit’. Rome was familiar with current accounts, and debit and credit figures in the books of the argentarii. Finally, all instruments of credit — bills of exchange, promissory notes, letters of credit, bank notes cheques — were known to the merchants of Islam”.

Lending Money

USARY: Oxford English Dictionary specifies this term to be: “The fact or practice of lending money at interest.”

Usury is a financial transaction in which person A lends person B a sum of money for a fixed period of time with the agreement that it will be returned with interest.

Probably the oldest financial contract Major thinkers throughout history - Plato, Aristotle, Thomas

Aquinas, Adam Smith, Karl Marx, and John Maynard Keynes, to name just a few - considered moneylending, at least under certain conditions, to be a major vice. Dante, Shakespeare and Dickens depict moneylenders as villains.

Moneylenders funded grain shipments in ancient Athens and the first trade between the Christians in Europe and the Saracens of the East. They backed the new merchants of Italy and, later, of Holland and England.

Money and Early Contracts I

The use of money pre-dated that of other financial instruments by many hundreds of years.

Coined money was already known in Lydia some eight centuries BC.

As late as the 14th century all dealings between banks and their depositors were primarily based on oral engagements.

The evolution of financial instruments was closely associated with the development of trade.

The Romans engaged in lively trade with the spice-producing countries of the East. From the 7th century the Arab empire expanded rapidly and its merchants traded in China, Indonesia, India and East Africa.

Money and Early Contracts II

An Arab businessman could even cash a cheque in Canton on his bank in Baghdad!

In the 9th century money-changers in the bazaars started to perform the functions of bankers, and from their activities arose an elaborate system of cheques, letters of credit and other financial instruments in the Arab world.

The principle of negotiable paper seems to have had its origin in respect of sea loans in Genoa towards the close of the 12th century.

Businessmen and notaries developed a practise designed to enable a merchant (exporter) to convert his goods into cash without going abroad himself.

In general, monetary documents acknowledging debt, were used as instruments designed to bridge problems of space and time.

Money and Early Contracts III

In the early 16th century bearer notes and bills began to circulate as credit instruments in the Low Countries - Holland.

Merchants in Antwerp initiated the practise of paying for purchases by using promissory notes containing a bearer clause.

The holder of a bearer document possessed all the rights of a principle. Such notes circulated from hand to hand.

The earliest known endorsed bills to order date back to 1610, drawn at Antwerp.

The earliest example of a printed bill is dated 9 December 1715.

Money and Early Contracts in South Africa

In 1782, the Dutch Governor Van Plettenberg was obliged to introduce, for the first time in the history of the Cape, paper money, owing to his inability to procure from the Netherlands a sufficient quantity of coinage.

This earliest paper money was issued in rixdollar and stiver denominations, the currency of the Cape at that time.

As there was as yet no printing press in the Cape, all the notes until about 1803 had to be hand written.

They featured a Government fiscal hand stamp indicating their value and the authority date of the issue.

After 1803, all notes were printed, but for some time to come they continued to show the fiscal hand stamp.

Government Debt

Governments have been issuing debt (borrowing) from quite early on - 12th to 13th centuries AD.

Wealthy families and private bankers advanced loans to municipalities and the governments of Spain, Italy and South Germany.

As collateral they frequently demanded some positive assignment of public revenue to ensure repayment of the loan.

The first major sovereign default was the bankruptcy of the British Crown (namely Edward III), which brought about the downfall of the Florentine (Italy) banking house of Baldi in 1345.

The succession of bankruptcies of the Spanish Crown (1557, 1560, 1576, 1596, 1606 and 1627) brought the High German bankers to a fall.

The banking supremacy of Amsterdam came to an abrupt end after the bankruptcy of the French state in 1789.

History of Modern Banking in Europe and South Africa I Evolved in Italy. The Bardi and Peruzzi families dominated banking in

14th century Florence, establishing branches in many other parts of Europe.

The most famous Italian bank was the Medici bank, established by Giovanni Medici in 1397.

The oldest bank still in existence is Monte dei Paschi di Siena, headquartered in Siena, Italy, which has been operating continuously since 1472.

The first bank to be established in South Africa was the Lombaard Bank in Cape Town, which opened its doors for business on 23 April 1793.

It was a State bank with the view to bringing additional money into circulation, and thus assisting those who suffered from lack of currency.

This bank was entrusted with the issuing of Government notes. Lombard Bank closed in 1883, being forced out of business by the private

banks. The first private bank in South Africa was the Cape of Good Hope Bank

which opened in 1837.

History of Banking in South Africa II

Altogether approximately 30 private banks sprang up between 1837 and 1882.

Most of them issued their own paper money, some only in one, others in more than one denomination.

Three large trading houses as well as one mining firm issued their own paper money between 1850 and 1860.

In 1877 an imperial bank, the Standard Bank of British South Africa Ltd., opened its doors in Cape Town.

Two other imperial banks entered the Cape subsequently. All these new banks issued their own paper money. With large capital behind them they made it their business to open up branches throughout the Colony, and to take over as many of the remaining private banks as was possible. By 1892, they had absorbed all but one of these, namely the Stellenbosch District Bank. Established in 1882, the Bank still exists to this day.

Constituting Central Banks

30 November 1656: Stockholms Banco charterd by King Karl X Gustav of Sweden. Today the Swedish Riksbank.

27 July 1694: King William III charters the Bank of England. 1876: German Reichsbank chartered. 23 December 1913: USA Federal Reserve Bank chartered. 31 March 1920: A SA parliament committee consisting of ten

members was established to examine the practicalities of establishing a central bank.

30 June 1921: The South African Reserve Bank opened for business, making it the oldest central bank in Africa.

19 April 1922: The first banknotes issued to the public by the bank.

1 June 1998: European central bank created.

SA Capital Markets: Growth Path I

South Africa was first a Dutch and then a British colony - we followed the development of the markets in these two countries.

The first public loan (interest of 6% p.a.) was floated by the Dutch authorities in March 1782.

Bills of exchange were readily accepted in the Cape after 1796. The Cape Colonial Government issued its first debentures in 1857

and its first Treasury Bills in 1881. The Republic of the Orange Free State issued its first debentures

in 1865. The Johannesburg Stock Exchange was established in 1887 after

the discovery of gold. Shares and debt were traded on the exchange. New acts

introduced in 1917 made the sale of stock between third parties much easier.

SA Capital Markets: Growth Path II

The full development of the markets occurred relatively late in South Africa (and British ruled Africa), namely in the 1960’s.

This was because most British colonies raised considerable amounts of capital through the issue of securities in London.

By the early 1960’s bankers’ acceptances had established themselves firmly in the South African financial system.

Since 1964 the development of the SA financial system has been rapid.

NCD’s were introduced in July 1964, three years after their first issue in the USA and four years ahead of their appearance in Britain.

Bond Market Association (BMA) formed in 1987. There was an active money market and an open market monetary

policy; however, the bond market was fragmented and illiquid.

SA Capital Markets: Growth Path III

During the latter parts of the 1980’s Eskom started making a market in its own bonds and the E168 bond became the benchmark. Eskom rates traded lower than government during that period.

Eskom’s success led to Transnet and Telkom making markets in their own bonds.

In 1989 the “Financial Markets Control Act” (FMCA) was promulgated.

During 1990 the National Treasury consolidated a number of smaller issues to create the R150 and R153 bonds.

In 1991 the South African Reserve Bank commenced market making in government bonds.

The R150 bond replaced the E168 bond as the benchmark. In 1992 the first corporate bond listed on the BMA - SA Breweries

Limited — one of the top 40 companies in South Africa.

SA Capital Markets: Growth Path IV

In 1996 the BMA was formally licensed and became the Bond Exchange of South Africa (BESA).

In 1997 BESA moved to T+3 rolling settlement and achieved full compliance with G30 “Recommendations for Clearing and Settlement”, the first exchange in Africa to do so.

During 1997 the first Collateralised Debt Obligation was listed (INCA BOND).

In 1998 National Treasury appointed 12 Primary Dealers to make a market in seven government bonds.

The open outcry bond floor was closed in October 1998, and trading now takes place electronically.

During 2001 the Corporate Bond market started to take off and BESA listed its first mortgage-backed securitisation issue.

The JSE acquired BESA during 2009

SA Capital Markets: a new act

FINANCIAL MARKETS ACT 19 OF 2012: a new Financial Markets Act promulgated 1 February 2013 and was operational from 3 June 2013

This new act regulates financial markets and over-the-counter (OTC) derivatives and brought South Africa in line with international norms and standards.

The act seeks to ensure that financial markets in South Africa operate fairly, efficiently and transparently to promote investor confidence.

Our legislative and regulatory framework is now in line with the recommendations of international standard setting bodies such as the G20, Financial Stability Board (FSB), Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO).

IOSCO is an association of organisations that regulate the world’s securities and futures markets.

Trading Listed cash Equities in South Africa South Africa has two primary exchanges. Both are part of the JSE Trading Shares: done through the JSE’s Equity Market. Here you can

trade in South African listed companies, dual listed companies from across the globe and a variety of listed products.

The JSE Equity Market consists of the Main Board and the AltX. Products include Warrants, Exchange Traded Funds (ETFs) and

Exchange Traded Notes (ETNs). More than 800 Securities are currently listed. Trading members electronically trade through the Millennium IT trading

system. At the end of 2014 there were 380 companies listed. There are approximately 60 Equity Market member firms, authorised to

trade on the market. Clients and investors in more than 40 countries. Average daily turnover of R15 billion during 2014 Market capitalisation end of 2014 = R10.8 trillion World: US$55 trillion

Trading Listed Bonds in South Africa Bonds are traded through the JSE’s Debt Market. The JSE regulates the largest listed Debt Market in Africa, both by market

capitalisation and by liquidity. At the end of 2014, the JSE had 1696 listed debt instruments, totaling. Market capitalisation = R2.2207 trillion. Nominal outstanding =

R1.9967 trillion World: US$100 trillion More than half of the debt is placed by the South African government. Other issuers include South African state-owned companies, corporates,

banks and other African countries. The debt market is liquid. Roughly R25 billion is traded daily. You can access the following through the JSE’s Debt Market:

– Government Bonds: More than R1 trillion is currently listed and these instruments account for 90% of all liquidity reported to the JSE.

– Corporate Bonds . Liquidity remains relatively low compared with government debt, but issuance keeps growing.

– Repo Market: The JSE Repo Market is an active and liquid funding market, with daily funding exceeding R25 billion.

Global Financial Markets

Sources: Oct 2014. Bank of England Fair and Effective Markets Review

FICC = Fixed Income, Currency and Commodities

Emerging Markets: Shares in Economic Activity and Financial Markets

Sources: IMF April 2014. Global financial stability report

SA Reserve Bank as Regulator

The primary purpose of the Bank is to achieve and maintain price stability in the interest of balanced and sustainable economic growth in South Africa.

Together with other institutions it also plays a pivotal role in ensuring financial stability and efficiency of key components of the South African financial system.

The Reserve Bank is responsible for bank regulation and supervision in South Africa.

The purpose is to achieve a sound, efficient banking system in the interest of the depositors of banks and the economy as a whole.

This function is performed by issuing banking licences to banking institutions, and monitoring their activities in terms of either the Banks Act (No. 94 of 1990), or the Mutual Banks Act (No. 124 of 1993) and the Regulations relating thereto.

SA Reserve Bank

The Reserve Bank acts as funding agent for the National Government.

The Financial Markets Department auctions 91-day and 182-day Treasury bills and SA government bonds on behalf of the National Treasury.

These auctions are conducted on a weekly basis, normally on Fridays at the instruction of the National Treasury.

In 1998, the National Treasury appointed a panel of Primary Dealers in Government bonds.

A Primary Dealer must be a reputable local banking institution, or a foreign bank with a branch office registered in South Africa.

A Primary Dealer must be a member of the Bond Exchange of South Africa – after JSE takeover of BESA known as the Interest Rate and Currency (IRC) market.

Inflation and Interest Rates

Shadowstats.com: USA

Derivatives Trading: History

Derivatives trades stem back many many years. The Greeks bought maize forward from the Egyptians some 3000 years ago.

The first recorded instance of futures trading occurred with rice in 17th Century Japan.

There are, however, some evidence that there may also have been rice futures traded in China as long as 6,000 years ago.

In 1593 Conrad Guestner brought the first tulip bulbs from Constantinople to Holland and Germany, and people fell in love with them. Tulips became a status symbol and a buying mania evolved.

By 1636, tulips were established on the Amsterdam stock exchange, as well as exchanges in Rotterdam and Harlem.

Options on tulips bulbs traded vigorously.

Derivatives Trading in Modern Times

In 1973 the US dollar was floated and the oil crises sent interest rates rocketing.

In April 1973 the Chicago Board Options Exchange (CBOE) opened its doors.

The CBOE began listing call options on 16 heavily traded common stocks and has subsequently evolved into one of the largest exchanges in the world in terms of the value of securities traded.

This was the first organized trading of options on an exchange. The American Stock Exchange and the Philadelphia Stock Exchange

started trading options in 1975, and the Pacific Stock Exchange introduced option trading in 1976.

In 1977, put options became exchange listed.

On March 11, 1983, the CBOE introduced index options in the form of the S&P 100 Index.

Derivatives Trading in South Africa

Options on equities have been traded on the Johannesburg Stock Exchange (JSE) since the end of the 1800’s.

Most of these options were European, contracted on a principle to principle basis, unstandardised and not transferrable.

In the 1960’s some fixed-interest stocks were issued with an early redemption option (which is a put option) for either the issuer (e.g. Eskom Loan 49) or the holder (e.g. Iscor Loan 19).

The first standardised option contract in South Africa was written in 1987 on E168 stock of Eskom (this still was an OTC option).

The South African Futures Exchange (SAFEX) was launched in September 1988 where standardized option contracts on equity and interest rate futures contracts were traded.

BESA also listed interest rate derivatives

Derivatives Trading in South Africa: JSE

Safex was bought by the JSE during 2001 and BESA was bought during 2009

The JSE has 3 derivatives markets– the Equity Derivatives Market

• Index derivatives• Single stock derivatives• Can-Do structures• IDX

– the Commodity Derivatives Market• Agricultural derivatives• Metal derivatives• Energy derivatives

– The Interest Rate and Currency Derivatives market• Bond derivatives• Interest rate derivatives• Currency derivatives• Can-Do structures

Financial Intermediation: Basics

The financial system may be defined briefly as a complex set of arrangement embracing the lending and borrowing of funds by non-financial economic units and the intermediation of this function by financial institutions to facilitate the transfer of funds, to provide additional money when required, and to create markets in debt in order that the price of funds, and therefore the allocation of funds, is determined efficiently.

This definition identifies the four essential elements of a financial system:– the lenders and borrowers;– the financial institutions which intermediate the lending and borrowing

process;– financial instruments, created to satisfy the needs of the participants;

and– the financial markets for the issuing and trading of financial

instruments.

Financial Intermediation: Definition

Borrowers and lenders can be categorised into 4 categories:– the household sector;– the corporate sector;– the general government sector; and– the foreign sector.

Given the existence of a supply of and a demand for loanable funds, some financial conduit is necessary to transfer the excess funds to the members in deficit.

The bridge between borrowers and savers is financial intermediation, whereby debtors borrow from financial institutions such as banks, who in turn issue financial claims (deposits) to savers.

Financial Intermediation: Lenders, Borrowers and Banks

Generally a conflict exists between borrowers and lenders. Differences exist in their requirements for risk, return and term to

maturity. Definition of a Bank:

– According to the modern theory on financial intermediation, banks exist because they perform two central roles in the economy

• they create liquidity and• they transform risk.

Banks are liquidity transformers: turning illiquid financial instruments into liquid ones

Liquidity: the ability to exchange wealth for goods and services or other assets. A market is liquid if there is unhindered flows among the agents of the financial system:– Central banks– Commercial Banks– Markets

Financial Intermediation: Fragility

Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors’ liquidity needs.

Fragile: something that is breakable, not robust or resilient, and is best handled with care. Fragility certainly pertains to financial systems, as financial crises are quite common throughout the world.

While commercial banks may be the most important of the financial institutions, others also play a vital role in the intermediation process, such as life insurance companies, investment companies, mutual funds, hedge funds, private equity funds, exchange traded funds, money market funds, pension funds, and investment banks.

The noncommercial bank institutions are referred to as the ‘shadow banking system’ because they perform many of the same functions as commercial banks but have different rules, regulations, and reporting requirements.

Financial Intermediation: Capitalistic System

The fundamental function of a financial system is to evaluate and efficiently allocate capital for investment and consumption.

It allows for the smoothing of spending and consumption over the longer term

The system also provides an efficient payment mechanism and liquidity, thereby facilitating financial and economic transactions.

In addition, it helps to combine capital at a low cost and allows for risk sharing.

Finally, financial institutions exist to pool funds, providing savers with diversification, smaller denominations, expertise, and professional management for monitoring risk and return as well as lower search and transaction costs in lending and investing funds.

Without question, an efficient financial system can be a tremendous contributor to economic vitality.

Financial Crisis: Introduction

But as economies become more advanced and global, the financial system becomes more complex, adaptive, innovative, and interconnected, both domestically and globally.

This vast financial network depends upon good information, transparency, trust, and confidence.

What is a financial crisis? It is what occurs when part of the financial system breaks down, causing borrowers - especially savers and investors - to lose faith in the financial institutions and markets.

In this environment, creditworthy borrowers can’t borrow (what we call a credit or funding crisis) and investors can’t sell financial assets quickly and easily (liquidity crisis).

Sometimes only part of the financial system is affected, but in the extreme case, the crisis becomes systemic and the whole financial system is affected.

Financial Crisis: History

1661: Stockholms Banco in Sweden issues first paper banknotes in Europe backed by physical copper.

1668: first financial crisis as Stockholms Banco defaults during a bank run when depositors wanted to access their funds. Banco issues more notes than the value of the copper in its vaults.

1866: British bank Overend, Gurney & Co fails sparking a panic in the London money markets. Reason? Illiquid assets like property could not be transformed into liquid paper notes.

1907: banking panic in New York sparks a global economic downturn.

1929: Black Tuesday as the New York stock market crashes. 1931: Credit-Anstalt, a leading Austrian bank fails with a

subsequent ripple effect throughout Europe 15 August 1971: USA leaves the gold standard where 1 ounce

gold = $35. This fuelled inflation until 1982 1997: Asian crisis started by a Russian bond default

Market Structure

There are currently two rather distinct systems of intermediation– one where capital markets are very important (mainly the English-

speaking “Anglo-saxon” countries; market-based system) and – one where banks dominate (bank-based system).

In bank-based financial systems such as Germany and Japan, banks play a leading role in mobilising savings, allocating capital, overseeing the investment decisions of corporate managers, and in providing risk management vehicles.

In market-based financial systems such as England and the United States, securities markets share center stage with banks in terms of getting society’s savings to firms, exerting corporate control, and easing risk management.

Some analysts suggest that markets are more effective at providing financial services. Others tout the advantages of intermediaries.

What will the consequence of Basel III be?

Inter-relationship between the Markets, the Players and Investors

Financial markets are mechanisms that link surplus and deficit investors, providing the means through which surplus investors can finance deficit investors either directly or indirectly.

The participants in the markets are the borrowers, lenders, the financial intermediaries and brokers.

The term financial market encompasses the interaction between the players in setting a price on financial instruments and so fulfilling their demands and requirements.

Primary and Secondary Markets Primary Market: The market for the issue of new securities for the

purpose of borrowing money for consumption or investment is referred to as the primary market. This usually includes marketing efforts such as “road shows” where issuers try to sell their new instruments to investors.

Secondary Market: The secondary market is the term used for the markets in which previously issued financial instruments are traded between third parties.

A secondary market is important for a number of reasons. – it assists the primary market in placing securities because clients are assured

that they can dispose of the instruments if they wish to do so.– a secondary market determines the rates that have to be offered on new

securities – price discovery. – it registers changing market conditions rapidly thereby indicating the

receptiveness of the market for new primary issues. – an active secondary market enables investors to adjust their portfolios

rapidly, efficiently and at low costs in terms of size, risk, return, liquidity and maturity.

Contact and Disclaimer

Dr Antonie KotzéEmail: antonie@quantonline.co.zaPhone: 082 924-7162

Disclaimer This article is published for general information and is not intended as advice

of any nature. The viewpoints expressed are not necessarily that of Financial Chaos Theory. As every situation depends on its own facts and circumstances, only specific advice should be relied upon.