Plans for the Official Gilt Strips Facility

A paper by the Bank ql England

PLANS FOR THE OFFICIAL GILT STRIPS FACILITY

A paper by the Bank of England

In May 1995 the Bank of England issued a consultative paper "Strips and new instruments in the gilt-edged market" . Implementation of the proposals in the paper depended on the introduction of fundamental reform of the taxation of returns from gilts. The Chancellor of the Exchequer announced on 10 July that tax reform would go ahead, and draft legislation was published following the November Budget. The Chancellor also announced in July that the Bank will be introducing a gilt stripping facility. Since then, it has been announced that certain conventional gilt issues will be strippable when the facility is introduced, but !hat other new types of gilt are not currently planned.

This paper summari ses the decisions taken to date, including starting the facility wi th conventional gilts; the Bank's plans for the operation of the facility; and various issues on which the Bank seeks further practitioner input. The start date has not yet been decided. but will probably not be before the introduction of the upgrade of the Central Gilts Office settlement service, due in early 1997.

Comments on this paper are invited and should be sent to:

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The Head of Gilt-Edged and Money MarkelS Division Bank of England ThreadneedJe Street London EC2R 8AH.

Introduction

The tax treatment of stripped gilts

The gilt strips market

The mechanics of the CGO stripping! reconstitution facility

The way forward

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Page II

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I Introduction

Responses to the Bank's May 1995 consultative paper showed strong support for the introduction of an official gilt stripping facility, as a further useful step in the progressive development of the gilt market.

2 Stripping is the process of splitting a s,tandard coupon bond into its individual coupon and principal payments, which can then be separate ly held and traded in their own right as (zero coupon) bonds. For example, a ten year bond could be separated into 21 zero coupon bonds, one from the principal repayment and twenty from the semi-annu al coupons; coupon repayments due in 6 , 12. 18 etc months would become 6, 12. 18 etc month zero coupon bonds.

3 Potential demand for stripped gilts was indicated by a wide range of investors. Domest ic long-tenn savings institutions expressed interest in the higher duration I assets which stripping would make available, and more generally in the enhanced ability to match liabilities without reinvestment risk. Retail investors, and the ir advisors, were attracted by a product which could permit investment with cash flows of their c hoice. Domestic and international traders concentrated on the duration and convexity2 properties of strips, and emphasised the importance of strips being liquid instruments.

4 Although interest a ppeared greatest at long maturities, there were clear signs of potential demand in o ther maturity areas. Fo r exam ple, it was suggested that short strips might be used to back retail products offering a guaranteed minimum return or, at the very short end, as a money market instrument3.

5 The Bank's May paper also sought comments on the pros and cons of direct issuance of various kinds of "designer" gilts: in particul ar, deferred payment gilts, annuities, and limited price indexation

(LPI) gil ts4. As an nou nced by the Bank on 14 December 1995, the authorities do nOl currently have plans to issue such instruments. The scale and nature of demand is very uncertain, and a number of practitioners thought that such stocks might be bought on a buy-and-hold basis, with little trading. There were, therefore, concerns that t he in struments themselves would be illiquid and that their issuance wo uld impair the liqu idity of the market in conventional and index-linked gilts (lGs) by reducing issuance of those standard bonds.

6 Investors will be able to use strips to create deferred payment gilts or a nnuities (by acqu iring strips providing the cash flows specifically desired or, alternatively, stripping a coupon bond and selling the strips that are not desired). An official stripping facility will not make LPI gilts directly available, but as now it wi ll in theory be possible for the private

sector to synthesise them5. The Bank will keep these issues under review.

7 The Bank invited comments on whether direct issuance of zero coupon gilts would be attractive alongside or instead of stripping. As with the other possibl e new types of gilt discussed above, there is uncertainty both as to the scale and pattern of demand for zero coupon bonds. An official stripping facility will enable such demand to be sat is fi ed without the a uthorities hav ing to identify it exactly. It has therefore been concluded that the first step should be to provide a stripping facility, with the possibility of direct issuance of zero coupon gilts being reviewed in due course in the light of experience gai ned with strips.

8 This paper therefore concentrates on the Bank's preparat ions for the official gilt stripp ing facility. Section II summarises how the tax reforms being

The dUnl.lion of a bood is a measure of !he liming of ils cash flows. II is calculaled as lhe weighled average of lhe lilTlCS to each of its cash flows. where the weighl3 are the present values of each of the payments as a proportion of the tOlal present value of all cash flows. Modified duration is an adaplalion of this to give the sensitivity of the price of a bond to changes in ilS yield. At current yields. the duration of the principal Strip of the longest bond so far declared strippable (8% 2015) would he around 19 years, over tw ice the duration of the coupon bond itself.

2 Convcllity is. broadly. the rate at wbich Ihe price sensitivity of a bond with respect 10 yield changes witb yield; it lends to increase with the square of a bond's modified duration.

3 See Seclion IV of the Bank's May 1995 oonsul1ative paper for a more detailed deSCription of the potential demand for gilt strips. The respooses 10 the paper supponed the Bank's analysis.

4 A deferred payment gilt would not pay any coupon income for a set period. An annuity would pay a stream of coupon inoome but there would not be a principal repayment at maturity. An LPI gill wou ld have coupon and priocipal indexed to the lower oflhe increase in the RPI and. say. 5%.

5 A bolder of index-linked gilts could. for example. enter into I contract for differences under which the right to cashflow5 arising from any excess of RPI inflation over 5'1> was transferred to the counterpatly. Also. the reforms 10 the tlulion of bond returns will. in principle. make it easier for the private sector to iuue LPI bonds. as the cost of the indexation will be allowable against tax in the hand!; of the i~suer.

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I (continued)

introduced in April wi lt facilitate a market in gilt strips; Section III sets out the policy decisions taken so far and invites views on a range of further issues; and Section IV describes some of the technical details of the stripping and recons titut ion fac ility to be provided by the upgraded eGO book enlry transfer system, which is being developed by the Bank on the basis of CRESTfi software.

9 Gilt strips will enhance the flexibility of gilts as an investment. In separate reforms, gilt issuance has already been made more transparent and predictable through an annual announcement of the targeted maturity of issuance. an auction calendar, and changes to the tap mechanism. And an open gilt repo market was introduced at the beginning of this year with a view to enhancing further the efficiency and liquidity of the secondary market. In each case, the objective is to contribute to a reduction over the long run of government fund ing costs.

6 CREST is the electronic book entry settlement system beinl developed for the equity market.

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II The tax treatment of stripped gilts

10 The Bank's May paper explained why strips could not sensibly be introduced without changes to the ta xation of g ilt returns. There were three difficulties: the deep discount rule s would not provide ta x neutrality between holding a gilt in unstripped fonn and holding its constituent strips; the deep discount rules would also in practice mean that strips maturing on the same day would not be fungible when they had been created on different days; and withholding tax on dividends from unstripped gilts but not on the redemption of coupon strips would create an incentive to hold gilts in stripped fonn. The Bank's May consultation paper on strips was therefore issued in parallel with an Inland Revenue paper on fundamental refonn of the taxation of returns from gilts and other bonds7.

II The Chancellor of the Exchequer announced on 10 July 1995 that reform of the taxation of gilts and other bonds would proceed, and further details were provided in a press release issued by the Inland Revenue on 28 November 1995. The draft legislation i,s contained in the Finance Bill published on 4 January 1996.

12 The tax provisions as currently drafted will cover three areas: gross payment of dividends on strippable stocks; the tax implications of stripping; and the tax treatment of the return on gilt strips.

(a) Gross payment of dividends on strippable stocks

13 All strippable gilts will pay interest gross to all holders; ie, there will be no withholding tax. Tax will be accounted for on an annual basis for those subject to UK tax . When a particular gi lt issue becomes strippable, the Treasury will make a direction under the Income and Corporation Taxes Act 1988 that future dividend s be paid to all holders without deduction of withholding tax. In addition, from that date, di vidends and manufactured dividends on the stock will not be subject to the quarterly accounting arrangements applying to some market participantsS.

(b) Taxation implications of the act of stripping

14 Under the new "total return" tax regime for bonds, companies will determine their liability for tax by valuing their gilt positions either by marking-to-market or on an accruals basis.

15 For companies using a mark-lo-market basis, the act of stripping (or reconstitution) will count as a di sposal (purchase) of the unstripped gilt and as the purchase (disposal) of the corresponding series of strips.

16 Companies using an accruals basis will be treated as disposing of the gilt being stripped at market value and acquiring the strips at an aggregate value equal to that of the coupon gilt. This value will be allocated among the strips in proportion to the market value of the individual strips at the point of stripping. Reconstitution will be dealt with in the same way.

17 Non-corporates, including individuals and trusts, will not be brought within the new regime , The Accrued Income Scheme will therefore continue to apply to individuals, A gilt held by a non-corporate which is stripped will be treated as being transferred with accrued interest; and a gilt being reconstituted will be treated as having been acquired with accrued interest. This should ensure that the act of stripping or reconstituting a gilt does not produce anomalous results under the Accrued Income Scheme.

(c) Taxation treatment of the return on gilt strips

18 The return on gilt strips held by companies will be treated in the same way as returns from unstripped bonds, namely the total return will be taxed as income in a company's annual tax assessment, In the case of index-linked gilt strips held for non trading purposes, the taxable return would be adjusted by an amount reflecting the movement in the retail price index for the year (just as for unstripped index-linked gi lts); it has been concluded that experience should be gained

7 See Section II of the Bank's May 1995 pa~r for a ITlOI'e detailed description of the obstacles 10 introducing gilt stripping without fundamental laX reform.

S Most holders of gilts (OIlier than indiYiduals) are able to hold their gills in gross paying Star accounts at the Centf'lll Gilts Office. Holders of gilts under these 8ITl1ngements who are taxable in the UK are required to account for tax on a quarterly basis on gross gilt interest received, normally using the quarterly periods already employed by companies for OIher purposes, Quanerly accounting does 00( apply to oyersus holders of gilts (except to the extent that the gilts are held by a braoch or agency trading in the UK) or to UK exempt bodies. such as pension funds.

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II (continued)

with conventional strips before IG stripping is planned (see Section III below).

19 Gilt stri ps held by non·corporates will be "discounted securities'>9. with the difference between the purchase and sale prices being taxable each year; there will be a deemed disposal and acquisition at the end of each tax year. Profits made by individuals will be assessable each year as income, with no charge to capital gains tax; any loss will be relievable against income in the year concerned. The draft legislation provides that special rules could, if necessary, be made to cover non-corporate holdings of particular kinds of strips, such as for example index-linked gilt strips.

9 The new tax provisions will in general apply only to companies, with the prtStnl rules cootinuing to apply to individuals and ttusts. However, !he e)tisting provisions dealing witb deep discoont, deep gain and qualifying indexed sceurities will be replaced by one set of rules covering sceurities blued Dt a discount aoo beld by personal investors.

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III The gilt strips market

20 This section sets out various decisions already reached on how the strips market will operate, and identifies other issues on which the Bank seeks views.

(a) Status of gilt strips

21 Gilt strips will be direct obligations of the UK Government, and will be registered securities on the gilt regi ster kep t by the Bank's Regi st rar' s Department 1o. Gilt strips will therefore be fully fledged gilts, and so will have the same credit characteristics as standard coupon-bearing gilts. They will be zero coupon liabilities of HM Government.

22 The authorities do not plan to include gilt strips on the National Savings Stock Regi ster (NSSR) II, This is partly for investor protection reasons. The secondary market price of a gilt strip will in principle be more volatile than that of a coupon gilt of the same maturity, on account of its greater duration. It would therefore be desirable for personal sector investors interested in buying strips to take professional advice, which is not available from the NSSR service. In addition, the systems upgrade that would be required to enable the NSSR to register gilt strips would be prohibitively expensive.

23 For reasons of operational efficiency, all strips will be held in the CGO book entry system, so paper certificates in respect of stripped gilts will not be available. Gilts held outside the CGO book entry system will therefore need to be lodged with CGO before they could be stripped. Personal investors will be able to hold st rip s through, for example, the nominee services provided by custodians and other professional advisors; this will not affect the ability of investors to hold coupon-bearing gilts in paper fonn.12

(b) Shippable gilt issues

24 It has already been announced that four stocks will be eligible for stripping when the facility begins:

8% 2000, 8 112% 2005, 7 112% 2006 and 8% 2015. As at the end of January, there will be £32.2bn of strippable stock outstanding (including £3bn of 8% 2000 du e to be auctioned on Wednesday 31 January); the annex sets out the value of the individual coupon and principal strips which it will be possible to create from thi s amount of the currently strippable issues.

25 In deciding which further issues to make stri ppable, the desirability of a large, liquid strips market and its potential to reduce funding costs will be balanced against the cash flow costs to the Exchequer of paying gross dividends on strippable gilt issues13. The Bank would welcome further views on the desirable size of the pool of strippable gilts when the facility is introduced. (See also (f) below.)

(c) Strips of non-standard conventional gilts

26 Responses to the May 1995 consultative paper indicated that there would not be material interest in strips of non-standard conventional slocks such as, for example, callable gilt issues. Stripping of these instruments is not therefore planned. However, the legislation will not prevenr stripping of such issues, in case demand emerges in the future.

(d) Index-linked strips

27 By contrast, potential interest in index-linked strips was apparent, as they would provide guaranteed real returns on des ired cash flows. However, responses revealed a concern that the small size of 10 coupons would entail a relatively small pool of strips, and more generally that the index-linked market may not yet be sufficiently liquid for an efficient IG strips market to develop. A range of issues concerning the IO marke t' s development were addressed at a conference held by the Bank in September last yearl4.

The Bank announced on 14 December 1995 that, in the light of the conference discussions, it was holding

10 For example. for Ille strips derived from the exis ting slrippable issues with 7 June and 7 December coupon dates, there would be a register for a 7 June zero coupon gil t issue and for a 7 December zero coupon gill issue for each year up to and including 7 December WIS. whicll is the redemption date of the longest maturity gi lt so far declared strippable (g% Treasury 2015). Two striJl'l' will mature on, for eumple. 7 December 2015, one representing Ihe final coupon of 8% 2015 and one representing the redemption oflhe bond; there will be a separate register for the principal strip.

II l1le NSSR is a separate register for small inveslors run by tbe Department of National Savings. Orden are made on fonns from the Post Office. Investment advice is not made available by the Department of National Savings.

12 Around 95% of gilts by value are currently he ld in the eGO system.

13 As described in Section II. slrippable stocks will pay income gross. whether Ileld in stripped or unstripped fOI1l1.

14 Held in London on 14 and IS September 1995. l1le overv~w papen for the conference are available from Michelle Cook on 0 171 601 5fJJ7. TIle Bank aims to publish a record of the conference proceedings during the spring.

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III (continued)

detailed consultations on the merits and practicalities of introducing a separate list of index-linked market makers and of holding a pilot series of experimental IG auctions. The Bank has concluded that it is bener to resolve these issues first, and also that it should review the case for IG strips once experience has been gained with conventional gilt stripping. In the meantime, the Bank would welcome further views on the details of introducing IG strips in due course. (The legislation will permit IG stripping.)

(e) Fungibility of coupon strips and principal strips

28 The market's clear view is that coupon strips from different underlying bonds should be fungible in order to enhance liquidity. Steps have already been taken to help facilitate this: the gills so far declared strippable have common dividend dales (7 June and 7 December) and the legislation will permit fungibility.

29 Views varied on whether to make coupon strips fungible with principal stri ps l5. On the one hand, fungibility could increase liquidity. On the other hand, it is not a feature of other government bond strips markets and would mean that the market could create more of a coupon-bearing gilt, via the reconstitution facility, than had originally been issued. Some practitioners thought that this might be detrimental to holders of the stock, as the size of an issue would be uncertain.

30 The Bank has concluded that coupon and principal strips should not be fungible when the market is introduced, but that thi s issue should be reviewed as experience with gilt strips is establ ished. To that end, the legislation and upgraded CGO system will permit coupon/principal strip fungibility in case it is desired in the future.

(f) Aligned coupon dates

31 As already noted, the four stocks so far announced as strippable have 7 June and 7 December dividend dates. This means that an investor in strips will have a choice of two dates each year for receipt of cash flows. Two pairs of aligned coupon dates would increase investor choice over the timing of cash flows, but would reduce the outstanding amount of each coupon strip for any given quantity of strippable

stock, and so might reduce liquidity. Responses to the May paper indicated that opinion in the market was finely balanced on whether to have one or two pairs of aligned coupon dates. The Bank seeks further views on this and also on other options, such as for example having two sets of coupon dales out to, say, five years and one pair thereafter.

32 In this context, the Bank also seeks views on the extent to which the "critical mass" of strippable stock needed for adequate liquidity would be affected if a second pair of coupon dates were at any stage to be introduced.

(g) No limits on strippability

33 There will be no limit on the amount or proportion of any strippable gilt issue that can be stripped. While a limit might in principle help to avoid an underlying coupon-bearing gilt being in short supply in the secondary market, the reconstitution facility should ensure that that is achieved through market mechanisms. (There will, though, need to be a minimum strippable amount for each stock - see Section Iv')

34 Similarly, the only limit on the use made of the reconstitution facility will be the amount of the underlying coupon gilt in issue; this follows from the non-fungibility, at least initially, of coupon and principal strips. If in the future coupon and principal strips were made fungible, an important question wou ld be whether there should be a limit on the amount of a coupon gilt which could be created via reconstitution, so as to prevent the amount of a coupon-bearing gilt in market hands being larger than the size of the issue created by the authorities.

(h) Information on stripped gilts

35 The Bank envisages publishing weekly information on the amount of each gilt issue that has been stripped/reconstituted. This will be the only information made availab le, so as to ensure that everyone receives the same information at the same time and in a predictable way. The Bank seeks views on precisely what information the reports should contain and how the reports should be published/distributed. The following could, for example, be included:

15 Under the In reform being introduced in April 1996 (see 5«tion II). no dislin.ction will be made for tax purposes belween principal and COU]XIn strips. There willihus be no II)( obstacle 10 cou]XInlprincipal strip fungibility.

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the nominal amounts of each strippable stock in issue

the nominal amounts of each strippable issue held in stripped and unstripped form

• the nominal amounts that have been stripped and reconstituted, and the neL amount stripped, over the previous week.

(i) Trading in strips

36 Coupon and principal strips will be freely tradable (under Stock Exchange rules), for settlement on a next day basis except when otherwise agreed (ie the same as for coupon-bearing gilts). The Bank envisages that the gilt-edged market makers (Gemms) will make a market in strips as part of their general market-making obl igations. In the run up to the introduction of strips, it plans to di scuss with individual Gemms the service which they expect to provide. A separate list of strips market makers is not currently envisaged.

37 It will also be possible to lend and/or repo - and thus to short and borrow/reverse repo - coupon and principal strips in the stock lending and repo market, just like any coupon-bearing gilt. The Bank invites views on whether the loan and repo of strips raises any specific issues. (The market would, of course, have to take into account that strips will be more volatile than coupon-bearing bonds of the same maturity.)

38 The Bank envisages that the service provided by the gilt Inter Dealer Brokers, acting as matched principals between Gemms, will be extended to strips.

(j) Redemption of coupon strips

39 As registered securities, coupon strips held to maturity will be repaid under the procedures for redemption rather than those for dividend payments; repayment of coupon strips will therefore be made directly to a CGO member's settlement bank account rather than accordi ng to mandated dividend instructions. In order to facilitate this, the Bank has already aligned the final dates for recording the

transfer of rights to dividend and redemption payments; otherwise coupon-bearing gilts would have traded on a slightly different basis from the constituent coupon stripsl6.

(k) Deliverability into derivative contracts

40 Individual strips will not be deliverable into London International Financial Futures and Options Exchange contracts. The Bank seeks views on (i) whether difficulty could arise in respect of the deliverability of a strippable gilt if a very high proportion of it were held in stripped form; (ii) whether it would be practicable for a set of coupon and principal strips corresponding to the whole of an underlying deli verable gilt to be deli vered into a contract in stripped form.

(I) Stock Exchange rules

41 As noted in the Bank's May 1995 consultative paper, the rules of the Stock Exchange will need to be amended to recogni se strips as gilt-edged securities, and ISIN and SEDOL numbers 17 will need to be allocated to the coupon and principal st rip issues. The Bank and the Stock Exchange are d iscussing the technical details involved.

(m) Enabling legislation

42 The Finance Bill includes provisions relating to the definition of strips and the ir transfer a nd registration. It introduces powers to amend other legislation as necessary, consequent on the existence of strips as new legally defined objects. Secondary legislation will also need to be introduced in due course to implement such amendments and deal with various technical matters. The aim is to ensure a statutory framework which will enable the authorities to have flexibility in developing the gilt strips market.

(n) Supervision

43 As noted in the May 1995 paper, it is for the regulators of firms dealing in strips to ensure that their capital and other requirements capture the risks in such business. The Bank (for banks and gilt-edged market makers) and the Securities and Futures

16 From 1996. transfers of gilts are made elHlividcoo from 7 working days before the paylIll'n\ of the dividcoo. Transfers of a right to the proceeds of a maturing gilt are not accepted after 7 working days before redemption: thi s is known as the "sJ\Il\ting date". (For 3 112'1> Wax Loan. the period in each ease is 10 working days.) Previously, the periods were up to 37 and 30 caJendll1 days respectively. These changes were announced on 12 July 1995.

17 The ISIN (International Security hlentification Number) is !he 12 dillit internationally reco&'Iised securities identifier. h iflC()("JlOflltes the SEOOL (the Stock E~ehange Daily Official List) number for UK securities. including gills. The 7 digit SEDOL number is used domestically to identify securities.

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III (continued)

Aut hori ty are li kely to be the regulators of most regulated UK firms dealing in strips. They now have new capital requirements in force which address the market risk in strips dealing; questions on their detailed application to strips should be directed to the relevant regulato r. A range of other bus inesses authorised under the Financial Services Act or otherwise regulated (eg fund managers, insurance companies and building societies) might also be involved in the strips market, and would therefore need to di scuss any supervisory issues with the regulators concerned.

(0) Bank operations in gilt strips

44 The Bank plans to consider the details of taking gilt strips as collateral in its twice monthly gilt repo facility and daily late lending operations. This would probably require margin arrangements reflecting the duration, and so prospective volati lity, of strips.

45 More generally, the Bank will do whatever it sensibly can to facilitate market liquidity and efficiency. In particular, the Bank will reserve the right to re-open stri ppable issues with a view to increasing the size of the strips market. or via a tap fo r market management reasons if, for example, a strip was being squeezed; the responses to the May 1995 consultative paper were clearly in favour of this market management technique being available to the Bank. The Bank will also reserve the right to lend or repo strips if market conditions were to make this necessary.

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IV The mechanics of the eGO stripping/reconstruction facility

46 This section describes the main features of the stripping/reconstitution facility t hat is being developed by the Bank as part of the general upgrade of CGO, due in early 1997; the CREST software be ing used to upgrade the eGO sys tem does not include a stripping/reconstitution facility and so one is being added. The upgraded sys tem will have the flexibility to accommodate future developments of the market.

47 It is currently planned that the facility should be made ava ilable to the market as a whole via the Gemms. T he Bank is considering how this would operate and whether it would have implications for some of the technical details of the facility.

48 It would be possible to give the market the option of making stripping/reconstitution requests before the day on which they would be effected. The Bank seeks views on whether this would be useful, and on the time within the eGO day when the system should strip/reconstitute.

49 Once plans for the fac il ity are furthe r developed - including in the light of comments on thi s paper - a technical paper will be publi shed.

(a) Stripping

50 The information needed in a stripping request, input via file transfer or interactive terminal , will include:

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•

•

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•

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a unique transaction reference

the identifier of the relevant eGO account

th e nomina l amount of the coupon-bearing gilt to be stripped

the slOck's ISIN (there will be no need for eithe r the ISINs or the nominal amounts of the resulting strips to be provided)

the priorit y ass igned to the str ipping request, which will determine the order of processi ng if there is more th'an one request outstanding

the date on which the stock should be stripped.

51 Once the information has been received by eGO, the system will make various checks, including:

•

•

•

whether the stock is strippable

whether sufficient 'stock is held in the relevant eGO account, taking account of the request's priority relative to any other oUlstanding delivery requests from the same member

whether there is room under the relevant collaterali sed debit cap to accommodate any difference between the value of the coupon-bearing stock being stripped and the resulting strips18

• whether the amount to be stripped is in units accepted by the system (see below),

52 A request will automatically be rejected if the amount to be stripped is not in a size accepted by the system. The system could be designed so that if any of the other requirements is not met, the request could remain outstanding, entailing queuing overn ight or longer. Once the requirements are met, stripping will proceed, and the facility is being designed so that the strips should then be delivered to the relevant eGO acco unt wit hin minutes. It will be poss ibl e to withdraw a stripping request at any time prior to its being processed by the system. .

(b) Reconstitution

53 The system will deliver a coupon-bearing gilt in exchange for the appropriate principal strip together with all the unmatured coupon strips representing the bond's cash nows. The information needed in a request to reconstitute a strippab le stock will be broadly similar to that needed in a stripping request. It will need to include the ISIN of the stock to be reconstituted, rather than the ISINs of the component strips. The checks perfonned by the eGO system will also be similar.

54 The system will automatically search the relevant account for the requi site strips, which will need to be held on a single eGO account. If each of the constituent strips is not held in sufficient quantity

18 The need 10 make this cbed: arises from an important amendment to the Assured Payment Sy,~m being introduced with the upgraded CGO system. Following the CGO upgrade. the settlement bank acting for a COO member will be able to set a cap, representing the maximum net debit available 10 a member at any poiot during the day. Such debil ClIps will have co!ialeralised and unoollatera!ised elements. A~ now. the senlement b3nlr: will be able 10 take stock held in the member's account IIli collateral alainst any CGO exposure inoeurred by the b~nk on the member', behalf.

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IV (continued)

to reconstitute the amount of the coupon-bearing gilt required, partial fulfilment of the request will not occur. Instead, the request could be queued or rejected. The Bank seeks views on which would be the best course.

(c) Minimum units for stripping

55 For eac h stri ppable stock there will be a minimum amount below which the system will not accept a strip requesl. The need for thi s arises because nominal holdings of a gilt, whether of an unstripped bond or a strip. must be in multiples of one penny. This implies that, fo r example, at least £4 of a bond would need to be stripped if the annual interest payable was, say, 7 112%, because each six-month coupon would be de nominated in 114 pe rce ntage points (in thi s case a coupon of 33/4%). In the same way, the minimum strippable amoun t of a 7 1/4% stock would need to be £8, and of a 7 1/8% stock £16.

56 The Bank seeks views on whether it would be simpler to set the same minimum strippable amoum for all conventional stocks l9. This could be, say, £2,000, which in the case of a stock with a coupon of, say, 7 1/8% would produce a coupon strip of £71.25. Alternatively, it could be set at any multiple of this, for example £ 1 0,000.

57 A different approach is also available. For example the minimum strippable amount for each strippable issue could be determined so as to produce semi-annual coupon strips of, say, at least £1,000.

58 The sys tem will also need units for the strippability of stock in amounts above the minimum. This could simply be a mult iple of the mi nimum strippable amount; for example, if £ 10,000 was the base unit, stock could be st ripped in amounts of £10,000, £20,000, £30,000 etc. Alternatively, if the minimum was greater than the size needed to produce strips denominated in whole pennies, the sys tem could allow stripping requests in amounts equal to the minimum plus a multiple of a smaller unit. For example, if the minimum were £ 1 0,000, stripping

might be allowed for £ 10,000, £12,000, £14,000 etc of stock.

59 T he Bank seeks views o n the m inimum strippable amount; whether it ,should be standard for all stocks; and on the unit of strippability above the minimum.

60 Transfers of st rips in the secondary market could be made in units of one penny, as for un stripped gilts.

(d) Stripping stocks which are ex.-dividend

61 If a gilt is st ripped after it has gone ex dividend2o, a strip will not be issued in respect of the dividend in question, which will be paid in the usual way. A coupon-bearing gilt will not be eligible for strippi ng after its shutting date. After its shutting date, a coupon strip wi ll not be eligible for inclusion in a bundle of strips submitted for reconstitution into a coupon-bearing gilt.

(e) Strips and deliveries by value

62 Strips will be eligible for inclusion in DBYs21. The Bank seeks views on whether there should be an option, for either or both of the transferor or transferee, to exclude strips from a DBV.

(0 Information available from the eGO system

63 It is envisaged that any CGO member will be able to interrogate the system to find out:

• which stocks are slrippable

•

•

which coupon and principal strips result from stripping a part icular stock, or are necessary to reconsti tute a parti cula r coupon-bearing gilt

the member's ho ldings of each of the stripped components of a strippable stock and the amounts that it would need in order to reconstitute a given amount of a coupon-bearing gi lt.

19 'The position is more complicated where. for example, an issue of a new stock has a long or sho" fi~t coupon. or where a reo~ning of IIJ1 existing issue is not immediately fungible with the parent because it cames a different amount of accrued interest. This could be addressed by having a non·standard minimum strippable amount. Non-standard fi~t coupons or amounts of accrued interest are genemlly calculated to four or five decimal places: five decimal places would suggest that a minimum strippable amount of £100.000 woold be needed to ensure that fractions were avoided. Alternatively. such strippable issues could be stripped only after the first dividend payment has been made or, in the case of non-fungible reopenings. after tI'Ie additional amount of stock had become fungible with the parent.

20 See footnote 16 above.

21 .... delivery.by.value (DBV) transaction in CGO allows !toeb to a given aiiregate value (mther than specific securities) to be delivered to anOlher COO me mber on an overnigh t basis.

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V The way forward

64 This paper has set out preparations so far for the introduction of an official gilt strips facility. The Bank invites comments on all of the issues covered in the paper, and would especially like to hear views on:

• the size of the pool of strippable stocks needed for a su ffici ently liquid strips market

• the number of pa irs of aligned coupon dates

• any specific issues relating to the possibility of stripping index-linked gillS in due course

• the information to be published on the use of the stripping facility

• whether particular issues arise concerning the repo/loan of gilt strips

• the deliverability into derivative contracts of a coupon-bearing gilt if a very high proportion of it is held in stripped form, and whether a delivery obligatiofi could be met by delivering all of the constituent strips

• whether it would be useful to be able to input a request for stripping/ reconstitution before the day on which it is to be effected

• when during the day CGO should strip/reconstitute

• whether it would be useful for a stripping or recons titution request to rema in outstanding if, for any reason, it is nol effected on the day specified

• the minimum amount to be stripped/reconst ituted and the unil of strippability above the minimum

• whether gilts with a long or short first coupon should be strippable only after the first dividend date

• whether it would be helpful to be able to exclude strips from DBVs.

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65 Comments should be sent to the Head of Gilt-Edged and Money Markets Division by Friday I March.

66 The Bank plans to issue further updates on its preparations for the strips market as they proceed.

Bank of England January 1996

Annex

The coupon and principal strips from the existing strippable stocks The table below shows the cash flows on the four gilt-edged stocks so far declared strippable. Including the £3.0 bn of 8% 2000 due to be auctioned on Wednesday 31 lanuary*, the total amount of stock so far declared strippable is £32.2 bn (nominal), comprising £7.8bn of 8% 2000. £8.9bn of 8 1/2% 2005, £6.0bn of 7 1/2% 2006 and £9.5bn of 8% 20 15. In each case, the final payment comprises the redemption of the principal and the final dividend (or, if the bond is stripped, the redemption of the final coupon strip). The cash flows shown begin in the second half of 1996 as the start date for the official strips facility has not yet been decided . .

TafAL CASH FLOWS

(coupon (coupon and £mns 8% 2000 8 1/2 % 2005 7 1/2 % 2006 8% 2015 only) principal)

07-Dec 96 312.00 378.25 225.00 380.00 1295.25 1295.25 07-lun-97 312.00 378.25 225.00 380.00 1295.25 1295.25 07-Dee-97 3 12.00 378.25 225.00 380.00 1295.25 1295.25 07-Jun-98 3 12.00 378.25 225.00 380.00 1295.25 1295.25 07·Dec·98 312.00 378.25 225.00 380.00 1295.25 1295.25 07-Jun-99 312.00 378.25 225.00 380.00 1295.25 1295.25 07-Dee-99 312.00 378.25 225.00 380.00 1295.25 1295.25 07-Jun-00 312.00 378.25 225.00 380.00 1295.25 1295.25 07·Dec·OO 8112.00 378.25 225.00 380.00 1295.25 9095.25 07-Jun-OI 378.25 225.00 380.00 983.25 983.25 07-Dee-OI 378.25 225.00 380.00 983.25 983.25 07-Jun-02 378.25 225.00 380.00 983.25 983.25 07-Dec-02 378.25 225.00 380.00 983.25 983.25 07·Jun-03 378.25 225.00 380.00 983.25 983.25 07-Dec-03 378.25 225.00 380.00 983.25 983.25 07-lun-04 378.25 225.00 380.00 983.25 983.25 07·Dec·04 378.25 225.00 380.00 983.25 983.25 07-Jun-OS 378.25 225.00 380.00 983.25 983.25 07·Dec·05 9278.25 225.00 380.00 983.25 9883.25 07-Jun-06 225.00 380.00 605.00 605.00 07-Dec-06 6225.00 380.00 605.00 6605.00 07-Jun-07 380.00 380.00 380.00 07·Dec·07 380.00 380.00 380.00 07-Jun-08 380.00 380.00 380.00 07-Dee-OS 380.00 380.00 380.00 07-Jun-09 380.00 380.00 380.00 07-Dec-09 380.00 380.00 380.00 07-lun-1O 380.00 380.00 380.00 07-Dec-IO 380.00 380.00 380.00 07-lun- 11 380.00 380.00 380.00 07-Dec-1I 380.00 380.00 380.00 07-Jun-12 380.00 380.00 380.00 07·Dec-12 380.00 380.00 380.00 07-Jun- I3 380.00 380.00 380.00 07·Dec· 13 380.00 380.00 380.00 07-Jun- 14 380.00 380.00 380.00 07-Dec- 14 380.00 380.00 380.00 07-Jun-I S 380.00 380.00 380.00 07-Dee-IS 9880.00 380.00 9880.00

TOTAL CASH FLOWS 10608.00 16086.75 !O725.00 24320.00 29539.75 61739.75

• As announced by the Bank on Tuesday 23 January 1996

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