Effects of Continuous Interest Rate Payment

BizFOREX makes continuous interest rate payments second by second. This is in contrast to other financial markets, where interest rate payments are made at daily intervals with the shortest increment of one business day. To illustrate the traditional convention is comparable to an electricity company that bills on the basis of lights being used at 7 PM in the evening and charging for a usage of electricity of 24 hours based on the usage at 7 PM only. If an electricity company would actually do this, it would create an uproar.

So far, the public press and academic literature has failed to draw attention to the fact that the convention of daily interest rate payments in financial markets has a negative impact on exchange and interest rate stability. With the growth of international capital flows and the increased speed at which financial transactions are executed the negative impact has become a serious issue. Just remember the exchange rate crisis in Turkey that started in November 2000 and continued on in February and March 2001, or the Asian and Russian crisis in 1998. Intraday trading is an important source of market liquidity for the capital movements of long term investors. The BizFOREX FX Trade platform has been designed to support this type of trading opening the market to transactions of any size starting at 1 USD and charging 0.02 percent spread (2 pips) in the common case, with no commissions.

For exchange and interest rate stability, it is important that intraday trading does not introduce unnecessary instability into the system. Unfortunately, the convention of daily interest rate payments does exactly that. To give you an indication of the importance of introducing continuous interest rate payments, lets analyze the USD/JPY exchange rate.

If we assume that an intraday trader is able to assume a yearly Sharpe ratio of 1, where the Sharpe ratio is a direct measure of reward-to-risk with the following definition:

Sharpe ratio = (return - rfree) / (standard deviation of return)
return: is the average rate of return on investment for a given period
rfree: is the best available rate of return of a "risk-free" security

If for instance the yearly standard deviation of the trader's P&L is 10%, and if we neglect his cost of capital, and set therefore the risk-free rate of return to 0 (rfree = 0), his yearly return will also need to be 10% for the Sharpe Ratio to be equal to 1.

If the trader does not have any overnight positions, his cost of carry is zero.

On average, for each of the 250 business day in a year, the trader earns 4 basis points of interest: 10% / 250 = 4 (3.8 basis points if you assume compounding of return), and has a daily standard deviation of 60 basis points: 10% / sqrt(250) = 60.

If the trader in question had to pay an average intraday carry of 2 basis points (it is about 1.5 basis points a day in USD/JPY), his Sharpe ratio would have to be 0.5 a year (assuming the standard deviation of his P&L remains the same). Because every trader has the conviction that he can outwit the market, he will definitely prefer a scheme with continuous interest rate payments, because he can use the interest rate differential in his favor to earn additional income on the interest rate carry.

With the introduction of continuous interest rate payments, the yield curve will extend to a shortest increment of one second - today, the shortest term interest rate is one day. In the same way, as central banks can influence the daily interest rate, they will be able to intervene on the micro yield curve.

The ability to set intraday interest rates will give a central bank defending its currency a powerful weapon. In fact intraday interest rates will play the role of a 'tax' on intraday sales of the currency under attack.

Continuous interest rates can have similar effect on the Tobin tax (the proposal, which we do not support, by Tobin, to tax all financial transactions, such as FX deals, to curb speculation), but one that can be tuned according to market conditions.

Paying intraday interest requires real-time gross settlement. It is incompatible with deferred net settlement. If the idea of paying intraday interest catches on, it will cause a major rethinking (or more likely a revolution) in money markets/treasury operations, and also central bank operations. Central banks would have to learn how to manage/set intraday rates without causing interbank settlement systems to hang for lack of liquidity.

BizFOREX's IFT pays continuos interest rates on currency trading accounts!