|A Tutorial On Managed Buy/Sell Private Placement Programs: Chapter 5
By Michael Weiner
NORMAL TRADING VS. PRIVATE PLACEMENT
All trading programs in the Private Placement arena involve trade with such discounted debt notes in some fashion. Further, in order to bypass the legal restrictions, this trading can only be done on a private level. This is the main difference between this type of trading and “normal” trading, which is highly regulated. This is a Private Placement level business transaction that is free from the usual restrictions present in the securities market.
Usually, trading is performed under the “open market” (also known as the “spot market”) where discounted instruments are bought and sold with auction-type bids. To participate in such trading, the traders must be in full control of the funds, otherwise they lack the means buy the instruments and resell them. Also, there are fewer arbitrage transactions in this market, since all participants have knowledge of the instruments and their prices.
However, in addition to the open market there is a closed, private market wherein lies a restricted number of “master commitment holders”. These holders are Trusts with huge amounts of money that enter contractual agreements with banks to buy a limited number of fresh-cut instruments at a specific price during an allotted period of time. Their job is to resell these instruments, so they contract sub-commitment holders, who in turn contract exit-buyers.
These programs are all based on arbitrage transactions with pre-defined prices. As such, the traders never need to be in control of the client’s funds. However, no program can start unless there is a sufficient quantity of money backing each transaction. It is at this point the clients 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, comprising unused money that belongs to clients, never at risk.
The trading banks can loan money to the traders. Typically, this money is loaned at a ratio of 1:10, but during certain conditions this ratio can be as high as 20:1. In other words, if the trader can “reserve” $100M, then the bank can loan $1B. In all actuality, the bank is giving the trader a line of credit based on how much money the trader/commitment holder has, since the banks won’t loan that much money without collateral, no matter how much money the clients have.
Because bankers and financial experts are well aware of the open market, and equally aware of the so-called “MTN-programs”, but are closed out of the private market, they find it hard to believe that the private market exists.
ARBITRAGE AND LEVERAGE
Private Placement trading safety is based on the fact that the transactions are performed as arbitrage transactions. This means that the instruments will be bought and resold immediately with pre-defined prices. A number of buyers and sellers are contracted, including exit-buyers comprising mostly of large financial institutions, insurance companies, or extremely wealthy individuals.
The issued instruments are never sold directly to the exit-buyer, but to a chain of clients. For obvious reasons the involved banks cannot directly participate in these transactions, but are still profiting from it indirectly by loaning money with interest to the trader or client as a line of credit. This is their leverage. Furthermore, the banks profit from the commissions involved in each transaction.
The client’s principal does not have to be used for the transactions, as it is only reserved as a compensating balance (“mirrored”) against this credit line. This credit line is then used to back up the arbitrage transactions. Since the trading is done as arbitrage, the money (“credit line”) doesn’t have to be used, but it must still be available to back up each and every transactions.
Such programs never fail because they don’t begin before all actors have been contracted, and each actor knows exactly what role to play and how they will profit from the transactions. A trader who is able to secure this leverage is able to control a line of credit typically 10 to 20 times that of the principal. Even though the trader is in control of that money, the money still cannot be spent. The trader need only show that the money is under his control, and is not being used elsewhere at the time of the transaction.
This concept can be illustrated in the following example. Assume you are offered the chance to buy a car for $30,000 and that you also find another buyer that is willing to buy it from you for $35,000. If the transactions are completed at the same time, then you will not be required to “spend” the $30,000 and then wait to receive the $35,000. Performing the transactions at the same time nets you an immediate profit of $5,000. However, you must still have that $30,000 and prove it is under your control.
Arbitrage transactions with discounted bank instruments are done in a similar way. The involved traders never actually spend the money, but they must be in control of it. The client’s principal is reserved directly for this, or indirectly in order for the trader to leverage a line of credit.
Confusion is common because most seem to believe that the money must be spent in order to complete the transaction. 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 is possible to set up arbitrage transactions if there is a chain of contracted buyers.
This is why client’s funds in Private Placement Programs are always safe without any trading risk.
Compared to the yield from traditional investments, these programs usually get a very high yield. A yield of 50%-100% per week is possible.
For example: Assume a leverage effect of 10:1, meaning the trader is able to back each buy-sell transaction with ten times the amount of money that the client has in his bank account. In other words, the client has $10M, and the trader is able to work with $100M. Assume also the trader is able to complete three buy-sell transactions per week for 40 banking weeks (one year), with a 5% profit from each buy-sell transaction:
(5% profit/transaction)(3 transactions/week) = 15% profit/week
Assume 10x leverage effect = 150% profit…PER WEEK!
Even with a split of profit between the client and trading group, this still results in a double-digit weekly yield. This example can still be seen as conservative, since first tier trading groups can achieve a much higher single spread for each transaction, as well as a markedly higher number of weekly trades.
The involved clients (program clients) are not the end-buyers in the chain. The actual real end-buyers are financially strong companies who are looking for a long term, safe investment, like pension funds, trusts, and insurance companies. Because they are needed as end-buyers, they are not permitted to participate “in-between” as clients. The client who participates in a PPOP is just an actor in the picture along with many other actors (issuing banks, exit-buyers, brokers, etc.) who benefit from this trading. Usually, the client does not interact with others involved in the process.
Normally, a trading program is nothing more than a pre-arranged buy/sell arbitrage transaction of discounted banking instruments. Theoretically, an client with a large amount of funds (on the level of $100-500M USD) could arrange his own program by implementing the buy/sell transaction for himself; however, in this case he needs to control the entire process, initiating contact with the banks and the exit buyers at the same time. This is not a simple task, considering the restrictions in place.
For a client it is much simpler (and usually more profitable) to enter a program where the trader and his trading group have everything in place (the issuing banks, the exit buyers, the contracts ready for the arbitrage transaction, the line of credit with the trading banks, all of the necessary guarantees/safety for the client, etc.). The client needs only to agree with the contract proposed by the trader, disregarding any other underlying issues.
It is further advantageous for the client to enter a program with a substantially lower amount of money and benefit from the line of credit offered by the trading group.