Glossary

Alternative Investment Funds (AIF)

are defined by the European Commission as all funds that are at present not harmonised under the UCITS Directive, see UCITS.

Arbitrage

relates to the competitive pressure to keep standards low to attract and please business. Regulatory and supervisory arbitrage between countries has contributed significantly to the financial crisis.

Assets

are anything with a commercial or exchange value and owned by a business, institution or individual.

Asset

stripping is the practice of buying a company in order to sell its assets individually at a profit

Bank subsidiary

is an office of a bank based in another country than the head office. Subsidiaries are subject to supervision by supervisors from the country of the head office (home supervisors) and those of the host country (host supervisors). Cooperation and decision-making between the two supervisors is somewhat agreed by the Basel Committee on Banking Supervision but is part of the discussions about reform of the supervisory structures.

Capital requirements

Regulations on capital requirements set criteria for minimum capital reserves for banks, so that every loan granted is being covered by a certain percentage of the bank’s own money. This way the bank can cover defaults on loans and not go bankrupt when too many borrowers default. The Basel Committee on Banking Supervision (BCBS) started to work on a new Basel Capital Accord in 1999. After five years of consultations, the Basel Capital Accord II (Basel II) was finalized by the BCBS in June 2004. Basel II not only sets the amount of capital reserves, but also regulates how banks should calculate the risks of the loan for which capital reserves are needed, and describes how supervisors should deal with the Basel II regime.

Carbon derivatives

see derivatives.

Central counterparty (CCP)

is an entity that interposes itself between the counterparties to the contracts traded in one or more financial markets, becoming the buyer to every seller and the seller to every buyer. CCP clearing is a central issue nowadays in the discussion on Credit Default Swaps trading.

CEBS

is the Committee of European Banking Supervisors. This committee consists of the banking supervisors, like central banks and other supervisory authorities of the EU Member States. This committee is currently revised and will be turned into the European Banking Authority.

CEIOPS

is the Committee of European Insurance and Occupational Pension Supervisors. This committee consists of the insurance and pension fund supervisory authorities of the EU Member States. This committee is currently revised and will be turned into the European Insurance and Occupational Pensions Authority.

CESR

is the Committee of European Securities Regulators. This committee consists of the security supervisors of the EU Member States. This committee is currently revised and will be turned into the European Securities and Markets Authority.

Clearing

is the process by which obligations arising from a financial security are managed over the lifetime of a financial contract. It is also the way by which risks are outlined and mitigated. Until now, credit default swap (CDS) trades – like most over-the-counter (OTC) financial derivatives – are predominantly cleared bilaterally between two contracting parties.

Collateralized Debt Obligations (CDO)

consist of a pool of assets and/or mortgage backed securities with loans, bonds or other financial assets as the underlying. A CDO is divided into different risk classes (tranches), whereby “senior” tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher payments (and interest rates) or lower prices to compensate for additional default risk. This implies that junior tranches will be first in line to absorb potential losses in case of default. Each tranche has its own credit rating based on the potential risks.

Commodity derivatives

have commodities, such as oil and agricultural products, as the underlying value of a contract; a derivative. The prices of commodities have become a target of speculation and are now instruments for investors to diversify portfolios and reduce risk exposures.

Credit default swaps

see derivatives.

Credit risk

is the risk that the debtor of a loan or other type of credit will not (be able to) repay it’s debt.

Credit securitization

consists in repackaging loans in tradable securities.

Deposit

is a sum of money lodged at a bank or other depository institution. The simplest forms of deposits are savings of individuals. The money can be withdrawn immediately or at an agreed time. A deposit can also refer to money transferred in advance to show intention to complete the purchase of a property.

Derivatives

are financial instruments whose prices are based on the price of an underlying instrument, such as assets, credits, foreign exchanges, interest rates or commodities. A derivative contract specifies the right or obligation between two parties to receive or deliver future cash flows, securities or assets, based on a future event. The underlying itself is not traded. However, small movements in the underlying value can cause a large difference in the value of the derivatives as a derivative is often leveraged. For example, the financial crisis has shown us the consequence of a decrease in American housing prices, which was an underlying for many derivatives. Derivatives traders speculate on the movement of the value of the underlying, this way attempting to make profit. Furthermore, derivatives are often used to hedge (insure) against the risk) of an investment in the underlying instrument. Derivatives can be broadly categorized by the relationship between the underlying and the derivative

Futures

are contracts to buy or sell a specific amount of commodity, a currency, bond or stock at a particular price on a stipulated future date. A future contract obligates the buyer to purchase or the seller to sell, unless the contract is sold to another before settlement date, which happens if a trader speculates to make a profit or wants to avoid a loss.

Options

are the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of given stock, commodity, currency, index or debt at a specific price during a specific period of time. Each option has a buyer (called a holder) and a seller (known as the writer). The buyer of such a right has to pay a premium to the issuer of the derivative (i.e. the bank) and hopes the prices of the underlying commodity or financial asset to change so that he can recover the premium cost. The buyer may choose whether or not to exercise the option by the set date. Swaps involve two parties exchanging specific amounts of cash flows against another stream. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated.

Equity derivatives

are derivatives with the underlying existing of equity securities

Foreign exchange(currency) derivatives

with the underlying existing of a particular currency or its exchange rate.

Credit derivatives

are contracts to transfer the credit risk of an entity from one counter-party to another. The underlying exists of a bond, loan or another financial asset

Credit Default Swaps (CDS)

are insurance contracts by which investors protect themselves in case of future defaults. For this “insurance” the protection buyer pays a premium to the seller of the CDS and the seller is obliged to make a payment in the event of a default by the ”insured”. The contracts are thus used to transfer credit risks. These type of contracts are usually not closed on the regulated and supervised exchanges but rather over-the-counter. Besides this, there exist so-called “naked” credit default swaps, whereby the protection buyer does not hold (or does not have any interest in) the underlying bond. This way naked CDS’s give purchasers the ability to speculate on the creditworthiness of a company without holding an underlying bond . The overall CDS market has grown many times the size of the market for the underlying credit instruments and causes systemic risks.

Commodity derivatives

have commodities, such as oil and agricultural products, as the underlying. The prices of commodities have become a target of speculation and are now instruments for investors to diversify portfolios and reduce risk exposures.

Carbon derivatives

have pollution permits as the underlying. The emission trading is based on the principle that polluting companies buy carbon credits from those who are polluting less somewhere in the world and have therefore pollution permits to sell. Financial engineers already developed complex financial products, such as derivatives, to speculate and such products are now seen as a potential financial bubble. The market in which derivatives are traded

Exchange traded derivatives

are products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and demands a deposit from both sides of the trade to act as a guarantee to potential credit risks..

Over The Counter (OTC)

trading is an exchange directly between the buyer and seller. Around 85% of the derivatives transactions are over-the-counter. They are not listed on the exchange and there is no trade through third parties, this way making the market much less transparent.

Diversification of portfolios

takes place because the financial sector considers it not prudential to put too many eggs in one basket, if the basket breaks, the whole business might be lost. As a consequence, they combine pool and restructure all sort of financial products.

EFRAG, the European Financial Reporting Advisory Group

was set up in 2001 to assist the European Commission in the endorsement of International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB) by providing advice on the technical quality of IFRS. EFRAG is a private sector body set up by the European organisations prominent in European capital markets, known collectively as the ‘Founding Fathers’ or Member body organisations.

ESCB (European System of Central Banks)

is composed by the European Central Bank (ECB) and the national central banks of all 27 EU Member States.

Equity

is the value of assets after all liabilities have been paid.

Fair value accounting (or mark-to-market accounting)

is a principle of the International Financial Reporting Standard (IFRS) and implies that company assets are valued on the basis of the price they would fetch if they were offered for sale on the market right now instead of what they would be valued were the company to hold on to them until maturation.

Financial bubbles

exist if assets or products are traded with highly inflated values, an example of this is the case of the American housing prices.

Futures

see derivatives.
== H ==

Hedge Funds

are specialist investment funds that engage in trading and hedging strategies. Hedge funds make use of speculative strategies, such as short-selling, leverage and derivative trading to obtain the highest possible return on their investments. These funds aim to make short-term profits by speculating on the movement of the market value of the shares, the sustainability on the long-term is inferior. Moreover, hedge funds are activist shareholders, which use a certain amount of shares to influence the outcome of the general meeting of shareholders and so the long-term strategy of a company with the aim to make short-term profits.

Incurred losses

are the losses that have occurred within a stipulated time period.

Leverage

is the use of borrowed funds at a fixed rate of interest in an effort to boost the rate of return from an investment. Leverage takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. Increased leverage also causes the risk on an investment to increase. Leverage is among others used by hedge and private equity funds. This means that they finance their operations more by debt than by money they actually own. The leverage effect is the difference between return on equity and return on capital employed (invested).

Leveraged buyout

is the main practice of private equity funds. It implies that a healthy company is bought with borrowed money. The ratio of what is invested by the fund and what is borrowed money for a buy-out is usually around 25% (invested) to 75% (borrowed) . As a result, a company is saddled with an enormous debt and the private equity fund starts lending money to repay the money that was borrowed to buy the company. The interest payments are at the cost of the company and are often eligible for tax deduction. As a result of the amount of interest payments, the balance sheet of the company is negative. Such an artificially created loss often leads to a tax rebate. Moreover, the artificially created losses are used as an argument to cut costs at the expense of workers, research and development, environment or consumers. The company structure is overhauled and certain company divisions and assets are sold. After such an overhaul the company is sold to the highest bidder.

Mark-to-market accounting

see fair value accounting.

Moral hazard

refers to the principle that in good times the profits of the financial service industry are privatized, while the losses in case of emergency are socialized. Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So called “too big to fail” lending institutions can make risky loans that will pay handsomely if the investment turns out well but will be bailed out by the taxpayer if the investment turns out badly. It can concluded that moral hazard has contributed significantly to the practices of excessive risk-taking by the financial sector.

Mutual funds

are open-ended funds operated by an investment company, which raises money from shareholders and invests in a (diversified) group of assets, in accordance with a stated set of objectives . This way enabling small private investors to invest in a diversified portfolio of shares, bonds and other securities. Mutual funds are open-ended funds since there is no fixed amount of capital in the fund. If new investors want to invest, the fund can issue new units, accepting the money into the pool.

Naked short-selling

see short-selling.

Off-balance sheet practices

refer to certain assets and debts that are not mentioned on the balance sheet of the company. These practices are not transparent and lack of oversight by supervisors. Banks have traditionally used off-balance-sheet practices to avoid reporting requirements or to reduce the amount of capital they needed to hold to satisfy regulatory requirements.

Options

see derivatives.

Over-the-counter (OTC)

see derivatives.

Prime brokerage

is a package of professional services to hedge funds and other large institutional investors mainly provided by investment banks, such as Morgan Stanley and Goldman Sachs. These services include financing to facilitate leverage, securities lending between hedge funds and institutional investors, clearing and settlement of trade, capital introduction (by introducing hedge fund clients to qualified hedge fund investors who have an interest in exploring new opportunities to make hedge fund investments), risk management advice and operational support. Cash lending to support leverage and securities lending to facilitate short selling are the main prime brokerage services. Globally more than 90% of these activities is based in London. Their revenues are typically derived from three sources: spreads on financing (including stock loan), trading commissions and fees for the settlement of transactions done away from the prime.

Private equity funds

vary from hedge funds as they operate in a different way as an activist shareholder. Generally speaking, private equity funds engage in two types of activities: a) they provide venture capital for start-up firms and small business with growth potential that look for investors; b) their most substantial and striking activities are leveraged buyouts. Private equity firms have a short term focus as they wants their investment back as soon as possible with the highest return as possible. In the first half of 2006 private equity leveraged buy-outs have got 86% of their investment back in just 24 months engagement in the target company . The biggest five private equity deals involved more money than the annual budgets of Russia and India.

Procyclicality

implies that the value of the good, service or indicator tends to move in the same direction as the economy, growing when the economy grows and declining when the economy declines. In particular, the financial regulations of the Basel II Accord have been criticized for their possible procyclicality. The accord requires banks to increase their capital ratios when they face greater risks. Unfortunately, this may require them to lend less during a recession or a credit crunch, which could aggravate the downturn. A similar criticism has been directed at fair value accounting rules.

Public trading

generally refers to regulated markets and multilateral trading facilities subject to public disclosure requirements.

RDMS :Reuters Market Data System

Re-securitizations

have underlying securitization positions, typically in order to repackage medium-risk securitization exposures into new securities. Because of their complexity and sensitivity to correlated losses, re-securitizations are even riskier than straight securitizations. See also: securitization.

Securitization is

the process of converting a pool of illiquid assets, such as loans, credit card receivables (Asset Backed Securities) and real estate securities (Mortgage Backed Securities) into tradable debt securities. These new sophisticated instruments were supposed to refinance pool of assets, to diminish risks and to enhance the efficiency of the markets, but they resulted in increasing the risks by spreading “toxic assets” throughout the financial system.

Securities lending

is the borrowing of securities, which primarily takes place between investors, such as hedge funds and institutional investors. The latter does not want to sell the securities in the short run and earns money from the fees it receives for lending its stocks. Besides short selling, the practice of securities lending may be used for activist practices during the general meeting of shareholders. A lender of a security loses its voting rights to the borrower who may use it for activist short-term goals.

Short selling

is the practice of selling assets, usually securities, which have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as he will pay less to buy the assets than he received on selling them. So, short sellers make money if the stock goes down in price . If many market participants go short at the same time on a certain stock, they call down an expected drop in prices because of the growing amount of stocks that have become available. Such practices hold the risk of market manipulation.

Special Purpose Vehicles (SPVs)

or Special Investment Vehicles (SIVs) are legal entities created (sometimes for a single transaction) to isolate the risks from the originator. As a result, financial firms set up an SPV/SIV in which they usually do not contribute risk capital. The firm transfers assets to the SPV for management or uses the SPV to finance a large project, thereby achieving a narrow set of goals without putting the entire firm at risk. The SPV primarily holds investments of other financial firms or other (institutional) investors. The financial firm that set up the SPV/SIV receives fees for their services that have been agreed in the memorandum of association or the statutes of the SPV/SIV.

Stealth acquisitions

are acquisitions of large stakes in companies without required notifications to the market and the company through the use of cash-settled derivatives.

Swaps

see derivatives.

; Trading book : refers to the portfolio of financial instruments held by a brokerage or a bank. The financial instruments in the trading book are purchased or sold to facilitate trading for their customers, to profit from spreads between the bid/ask spread, or to hedge against various types of risk . The trading book consists of all the financial instruments that a bank holds with the intention of re-selling them in the short term, or in order to hedge other instruments in the trading book.

UCITS (Undertakings for Collective Investment in Transferable Securities)

are investment funds established and authorized in conformity with EU legislation. The UCITS Directive lays down common requirements for the organisation, management, free movement, liquidity and oversight of these funds.

VWAP

is a trading acronym for Volume-Weighted Average Price. VWAP is often used as a trading benchmark by investors who aim to be as passive as possible in their execution (ie. no impact on the market) . Many pension funds, and some mutual funds, fall into this category. The aim of using a VWAP trading target is to ensure that the trader executing the order does so in-line with volume on the market. It is sometimes argued[by whom?] that such execution reduces transaction costs by minimizing market impact (the adverse effect of a trader's activities on the price of a security).