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Finance
including Financial Markets,
Instruments, Corporate, Personal,
Public, Banks and Banking, Regulation,
and Standards.
Finance
including Financial Markets,
Instruments, Corporate, Personal,
Public, Banks and Banking, Regulation,
and Standards.
Finance, including An Outline of Finance and a List of Financial Categories
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Click here for a List of Financial Categories.
Finance is a field that deals with the study of investments. It includes the dynamics of assets and liabilities over time under conditions of different degrees of uncertainty and risk. Finance can also be defined as the science of money management. Finance aims to price assets based on their risk level and their expected rate of return. Finance can be broken into three sub-categories: public finance, corporate finance and personal finance.
Personal finance:
Main article: Personal finance
Questions in personal finance revolve around:
Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal finance may also involve paying for a loan, or debt obligations. The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:
Corporate finance:
Main article: Corporate finance
Corporate finance deals with the sources funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's assets, net incoming cash flow and the value of its stock, and generically entails three primary areas of capital resource allocation. In the first, "capital budgeting", management must choose which "projects" (if any) to undertake.
The discipline of capital budgeting may employ standard business valuation techniques or even extend to real options valuation; see Financial modeling.
The second, "sources of capital" relates to how these investments are to be funded: investment capital can be provided through different sources, such as by shareholders, in the form of equity (privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance between these elements forms the company's capital structure.
The third, "the dividend policy", requires management to determine whether any unappropriated profit (excess cash) is to be retained for future investment / operational requirements, or instead to be distributed to shareholders, and if so, in what form. Short term financial management is often termed "working capital management", and relates to cash-, inventory- and debtors management.
Corporate finance also includes within its scope business valuation, stock investing, or investment management. An investment is an acquisition of an asset in the hope that it will maintain or increase its value over time that will in hope give back a higher rate of return when it comes to disbursing dividends.
In investment management – in choosing a portfolio – one has to use financial analysis to determine what, how much and when to invest. To do this, a company must:
Financial management overlaps with the financial function of the accounting profession.
However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders and increase their rate of return on the investments.
Financial risk management, an element of corporate finance, is the practice of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include foreign exchange, shape, volatility, sector, liquidity, inflation risks, etc.) It focuses on when and how to hedge using financial instruments; in this sense it overlaps with financial engineering.
Similar to general risk management, financial risk management requires identifying its sources, measuring it (see: Risk measure#Examples), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.
Financial services:
Main article: Financial services
An entity whose income exceeds its expenditure can lend or invest the excess income to help that excess income produce more income in the future. Though on the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income.
The lender can find a borrower—a financial intermediary such as a bank—or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers.
Banks allow borrowers and lenders, of different sizes, to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance) and by a wide variety of other organizations such as schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments and methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes analysis related to the use and acquisition of funds for the enterprise.
In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One method is debt financing, which includes bank loans and bond sales.
Another method is equity financing – the sale of stock by a company to investors, the original shareholders (they own a portion of the business) of a share.
Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the proxy on important matters (e.g., board elections).
The owners of both bonds (either government bonds or corporate bonds) and stock (whether its preferred stock or common stock), may be institutional investors – financial institutions such as investment banks and pension funds or private individuals, called private investors or retail investors.
Public finance:
Main article: Public finance
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It usually encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods usually encompass five or more years. Public finance is primarily concerned with:
Capital:
Main article: Financial capital
Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the production of other goods or the offering of a service. (Capital has two types of sources, equity and debt).
The deployment of capital is decided by the budget. This may include the objective of business, targets set, and results in financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the planned sales, and financing source for the investment.
A budget may be long term or short term. Long term budgets have a time horizon of 5–10 years giving a vision to the company; short term is an annual budget which is drawn to control and operate in that particular year.
Budgets will include proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are often adjusted annually (done every year) and should be part of a longer-term Capital Improvements Plan.
A cash budget is also required. The working capital requirements of a business are monitored at all times to ensure that there are sufficient funds available to meet short-term expenses.
The cash budget is basically a detailed plan that shows all expected sources and uses of cash when it comes to spending it appropriately. The cash budget has the following six main sections:
Financial Theory:
Financial economics:
Main article: Financial economics
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to goods and services.
Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It centres on managing risk in the context of the financial markets, and the resultant economic and financial models. It essentially explores how rational investors would apply risk and return to the problem of an investment policy.
Here, the twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold, or are extended. "Financial economics", at least formally, also considers investment under "certainty" (Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem) and hence also contributes to corporate finance theory.
Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
Although closely related, the disciplines of economics and finance are distinct. The “economy” is a social institution that organizes a society’s production, distribution, and consumption of goods and services, all of which must be financed.
Financial mathematics:
Main article: Financial mathematics
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory that is involved in financial mathematics.
Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering).
Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modelling and derivation (see: Quantitative analyst). The field is largely focused on the modelling of derivatives, although other important sub-fields include insurance mathematics and quantitative portfolio problems. See later herein for "Outline of finance: Mathematical tools" and "Outline of finance: Derivatives pricing".
Experimental finance:
Main article: Experimental finance
Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanisms, and returns processes.
Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future financial decisions.
Research may proceed by conducting trading simulations or by establishing and studying the behavior, and the way that these people act or react, of people in artificial competitive market-like settings.
Behavioral finance:
Main article: Behavioral economics
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become central and very important to finance.
Behavioral finance includes such topics as:
A strand of behavioral finance has been dubbed quantitative behavioral finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation.
Some of these endeavors has been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated significant behavioral effects in stocks and exchange traded funds.
Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.
Professional Qualifications: Click Here.
Unsolved Problems in Finance:
As the debate to whether finance is an art or a science is still open, there have been recent efforts to organize a list of unsolved problems in finance.
See Also:
Outline of Finance:
The following outline is provided as an overview of and topical guide to finance:
Finance – addresses the ways in which individuals and organizations raise and allocate monetary resources over time, taking into account the risks entailed in their projects.
The word finance may incorporate any of the following:
Click on any of the following blue hyperlinks for more about the Outline of Finance:
Finance is a field that deals with the study of investments. It includes the dynamics of assets and liabilities over time under conditions of different degrees of uncertainty and risk. Finance can also be defined as the science of money management. Finance aims to price assets based on their risk level and their expected rate of return. Finance can be broken into three sub-categories: public finance, corporate finance and personal finance.
Personal finance:
Main article: Personal finance
Questions in personal finance revolve around:
- Protection against unforeseen personal events, as well as events in the wider economies
- Transference of family wealth across generations (bequests and inheritance)
- Effects of tax policies (tax subsidies or penalties) management of personal finances
- Effects of credit on individual financial standing
- Development of a savings plan or financing for large purchases (auto, education, home)
- Planning a secure financial future in an environment of economic instability
Personal finance may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Personal finance may also involve paying for a loan, or debt obligations. The six key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:
- Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flows. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all liabilities of the household, at one point in time. Household cash flows total up all from the expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and in what time the personal goals can be accomplished.
- Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks can be divided into the following: liability, property, death, disability, health and long term care. Some of these risks may be self-insurable, while most will require the purchase of an insurance contract. Determining how much insurance to get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners, professionals, athletes and entertainers require specialized insurance professionals to adequately protect themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of the overall investment planning.
- Tax planning: typically the income tax is the single largest expense in a household. Managing taxes is not a question of if you will pay taxes, but when and how much. Government gives many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically, as one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's personal finances can make a significant impact in which it can later save you money in the long term.
- Investment and accumulation goals: planning how to accumulate enough money – for large purchases and life events – is what most people consider to be financial planning. Major reasons to accumulate assets include purchasing a house or car, starting a business, paying for education expenses, and saving for retirement. Achieving these goals requires projecting what they will cost, and when you need to withdraw funds that will be necessary to be able to achieve these goals. A major risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks (either preferred stock or common stock), bonds (for example mutual bonds or government bonds, or corporate bonds), cash and alternative investments. The allocation should also take into consideration the personal risk profile of every investor, since risk attitudes vary from person to person.
- Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include taking advantage of government allowed structures to manage tax liability including: individual (IRA) structures, or employer sponsored retirement plans.
- Estate planning involves planning for the disposition of one's assets after death. Typically, there is a tax due to the state or federal government at one's death. Avoiding these taxes means that more of one's assets will be distributed to one's heirs. One can leave one's assets to family, friends or charitable groups.
Corporate finance:
Main article: Corporate finance
Corporate finance deals with the sources funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's assets, net incoming cash flow and the value of its stock, and generically entails three primary areas of capital resource allocation. In the first, "capital budgeting", management must choose which "projects" (if any) to undertake.
The discipline of capital budgeting may employ standard business valuation techniques or even extend to real options valuation; see Financial modeling.
The second, "sources of capital" relates to how these investments are to be funded: investment capital can be provided through different sources, such as by shareholders, in the form of equity (privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance between these elements forms the company's capital structure.
The third, "the dividend policy", requires management to determine whether any unappropriated profit (excess cash) is to be retained for future investment / operational requirements, or instead to be distributed to shareholders, and if so, in what form. Short term financial management is often termed "working capital management", and relates to cash-, inventory- and debtors management.
Corporate finance also includes within its scope business valuation, stock investing, or investment management. An investment is an acquisition of an asset in the hope that it will maintain or increase its value over time that will in hope give back a higher rate of return when it comes to disbursing dividends.
In investment management – in choosing a portfolio – one has to use financial analysis to determine what, how much and when to invest. To do this, a company must:
- Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax considerations;
- Identify the appropriate strategy: active versus passive hedging strategy
- Measure the portfolio performance
Financial management overlaps with the financial function of the accounting profession.
However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders and increase their rate of return on the investments.
Financial risk management, an element of corporate finance, is the practice of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include foreign exchange, shape, volatility, sector, liquidity, inflation risks, etc.) It focuses on when and how to hedge using financial instruments; in this sense it overlaps with financial engineering.
Similar to general risk management, financial risk management requires identifying its sources, measuring it (see: Risk measure#Examples), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.
Financial services:
Main article: Financial services
An entity whose income exceeds its expenditure can lend or invest the excess income to help that excess income produce more income in the future. Though on the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income.
The lender can find a borrower—a financial intermediary such as a bank—or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers.
Banks allow borrowers and lenders, of different sizes, to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance) and by a wide variety of other organizations such as schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments and methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes analysis related to the use and acquisition of funds for the enterprise.
In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One method is debt financing, which includes bank loans and bond sales.
Another method is equity financing – the sale of stock by a company to investors, the original shareholders (they own a portion of the business) of a share.
Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the proxy on important matters (e.g., board elections).
The owners of both bonds (either government bonds or corporate bonds) and stock (whether its preferred stock or common stock), may be institutional investors – financial institutions such as investment banks and pension funds or private individuals, called private investors or retail investors.
Public finance:
Main article: Public finance
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It usually encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods usually encompass five or more years. Public finance is primarily concerned with:
- Identification of required expenditure of a public sector entity
- Source(s) of that entity's revenue
- The budgeting process
- Debt issuance (municipal bonds) for public works projects
- Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on monetary and credit conditions in the economy.
Capital:
Main article: Financial capital
Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the production of other goods or the offering of a service. (Capital has two types of sources, equity and debt).
The deployment of capital is decided by the budget. This may include the objective of business, targets set, and results in financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the planned sales, and financing source for the investment.
A budget may be long term or short term. Long term budgets have a time horizon of 5–10 years giving a vision to the company; short term is an annual budget which is drawn to control and operate in that particular year.
Budgets will include proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are often adjusted annually (done every year) and should be part of a longer-term Capital Improvements Plan.
A cash budget is also required. The working capital requirements of a business are monitored at all times to ensure that there are sufficient funds available to meet short-term expenses.
The cash budget is basically a detailed plan that shows all expected sources and uses of cash when it comes to spending it appropriately. The cash budget has the following six main sections:
- Beginning cash balance – contains the last period's closing cash balance, in other words, the remaining cash of the last year.
- Cash collections – includes all expected cash receipts (all sources of cash for the period considered, mainly sales)
- Cash disbursements – lists all planned cash outflows for the period such as dividend, excluding interest payments on short-term loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list (e.g. depreciation, amortization, etc.)
- Cash excess or deficiency – a function of the cash needs and cash available. Cash needs are determined by the total cash disbursements plus the minimum cash balance required by company policy. If total cash available is less than cash needs, a deficiency exists.
- Financing – discloses the planned borrowings and repayments of those planned borrowings, including interest.
Financial Theory:
Financial economics:
Main article: Financial economics
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to goods and services.
Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It centres on managing risk in the context of the financial markets, and the resultant economic and financial models. It essentially explores how rational investors would apply risk and return to the problem of an investment policy.
Here, the twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold, or are extended. "Financial economics", at least formally, also considers investment under "certainty" (Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem) and hence also contributes to corporate finance theory.
Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
Although closely related, the disciplines of economics and finance are distinct. The “economy” is a social institution that organizes a society’s production, distribution, and consumption of goods and services, all of which must be financed.
Financial mathematics:
Main article: Financial mathematics
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory that is involved in financial mathematics.
Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering).
Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modelling and derivation (see: Quantitative analyst). The field is largely focused on the modelling of derivatives, although other important sub-fields include insurance mathematics and quantitative portfolio problems. See later herein for "Outline of finance: Mathematical tools" and "Outline of finance: Derivatives pricing".
Experimental finance:
Main article: Experimental finance
Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion and aggregation, price setting mechanisms, and returns processes.
Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future financial decisions.
Research may proceed by conducting trading simulations or by establishing and studying the behavior, and the way that these people act or react, of people in artificial competitive market-like settings.
Behavioral finance:
Main article: Behavioral economics
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become central and very important to finance.
Behavioral finance includes such topics as:
- Empirical studies that demonstrate significant deviations from classical theories.
- Models of how psychology affects and impacts trading and prices
- Forecasting based on these methods.
- Studies of experimental asset markets and use of models to forecast experiments.
A strand of behavioral finance has been dubbed quantitative behavioral finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation.
Some of these endeavors has been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated significant behavioral effects in stocks and exchange traded funds.
Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.
Professional Qualifications: Click Here.
Unsolved Problems in Finance:
As the debate to whether finance is an art or a science is still open, there have been recent efforts to organize a list of unsolved problems in finance.
See Also:
- Financial crisis of 2007–2010
- List of unsolved problems in finance
- Learn Finance Step by step with infographics tools
- OECD work on financial markets Observation of UK Finance Market
- Wharton Finance Knowledge Project – aimed to offer free access to finance knowledge for students, teachers, and self-learners.
- Professor Aswath Damodaran (New York University Stern School of Business) – provides resources covering three areas in finance: corporate finance, valuation and investment management and syndicate finance.
Outline of Finance:
The following outline is provided as an overview of and topical guide to finance:
Finance – addresses the ways in which individuals and organizations raise and allocate monetary resources over time, taking into account the risks entailed in their projects.
The word finance may incorporate any of the following:
- The study of money and other assets
- The management and control of those assets
- Profiling and managing project risks
Click on any of the following blue hyperlinks for more about the Outline of Finance:
- Fundamental financial concepts
- History
- Finance terms by field
- Financial markets
- Financial regulation
- Actuarial topics
- Asset types
- Raising capital
- Valuation
- Financial software tools
- Financial institutions
- Lists:
- See also:
- Actuarial topics
- Wharton Finance Knowledge Project – aimed to offer free access to finance knowledge for students, teachers, and self-learners.
- Comprehensive site about topics of financial theory, with a focus in Corporate Finance, Valuation and Investments. Updated Data, Excel Spreadsheets and more. Prof. Aswath Damodaran
- For links to finance web sites, grouped by topic see Web Sites for Discerning Finance Students, Prof. John M. Wachowicz -
- For the introductory finance web site at the University of Arizona, studyfinance.com
- For introductory articles, a full glossary and links to resources on behavioral finance see the BF gallery
- For the law of the financial markets see SECLaw.com
- For various shared blog posts on finance see fwisp.com
- For stock market related financial definitions see TheStreet.com Glossary
- The Finance Director provides access to essential suppliers of financial services and solutions
Financial Management
YouTube Video: Financial Planning 101 Introduction
Financial management refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. The significance of this function is not seen in the 'Line' but also in the capacity of 'Staff' in overall of a company. It has been defined differently by different experts in the field.
The term typically applies to an organization or company's financial strategy, while personal finance or financial life management refers to an individual's management strategy. It includes how to raise the capital and how to allocate capital, i.e. capital budgeting. Not only for long term budgeting, but also how to allocate the short term resources like current liabilities. It also deals with the dividend policies of the share holders.
Definitions:
Objectives:
Scope:
Financial Management for Startups:
For new enterprises, it is important to make a good estimation on costs, sales. Consideration on appropriate length sources of finances can help businesses avoid the cash flow problems even the failure of setting up. There are fixed and current sides of assets balance sheet:
See also:
The term typically applies to an organization or company's financial strategy, while personal finance or financial life management refers to an individual's management strategy. It includes how to raise the capital and how to allocate capital, i.e. capital budgeting. Not only for long term budgeting, but also how to allocate the short term resources like current liabilities. It also deals with the dividend policies of the share holders.
Definitions:
- "Planning is an inextricable dimension of financial management. The term financial management connotes that funds flows are directed according to some plan." By James Van Horne
- "Financial management is that activity of management which is concerned with the planning, procuring and controlling of the firm's financial resources. " By Deepika &Maya Rani
- “Financial Management is the Operational Activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operation.” By Joseph Massie
- “Business finance deals primarily with rising administering and disbursing funds by privately owned business units operating in non-financial fields of industry.”– By Kuldeep Roy
- “Financial Management is an area of financial decision making, harmonizing individual motives and enterprise goals." -By Weston and Brigham
- “Financial management is the area of business management devoted to a judicious use of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals.” – by J.F.Bradlery
- “Financial management is the application of the planning and control function to the finance function.” – by K.D. Willson
- “Financial management may be defined as that area or set of administrative function in an organization which relate with arrangement of cash and credit so that organization may have the means to carry out its objective as satisfactorily as possible." - by Howard & Opton.
- Business finance can be broadly defined as the activity concerned with planning, raising, controlling and administering of funds and in the business. “ by H.G Gathman & H.E Dougall
- Financial management is a body of business concerned with the efficient and effective use of either equity capital, borrowed cash or any other business funds as well as taking the right decision for profit maximization and value addition of an entity.- Kepher Petra; Kisii University.
- "Financial management refers to the proper and efficient use of money and it plays a significant role in analyzing to invest in profitable business enterprise. Return on Investment must be greater than the invested amount."
- "Financial management refers to the effective and efficient management of money and it is also process of planning, controlling,leading, directing of a firm's financial resources."
Objectives:
- Profit maximization happens when marginal cost is equal to marginal revenue. This is the main objective of Financial Management.
- Wealth maximization means maximization of shareholders' wealth. It is an advanced goal compared to profit maximization.
- Survival of company is an important consideration when the financial manager makes any financial decisions. One incorrect decision may lead company to be bankrupt.
- Maintaining proper cash flow is a short run objective of financial management. It is necessary for operations to pay the day-to-day expenses e.g. raw material, electricity bills, wages, rent etc. A good cash flow ensures the survival of company.
- Minimization on capital cost in financial management can help operations gain more profit.
- It is vague :- There are several types of profits before interest, depreciation and taxes,profit before taxes , profit after taxes , cash profit etc
Scope:
- Estimating the Requirement of Funds: Businesses make forecast on funds needed in both short run and long run, hence, they can improve the efficiency of funding. The estimation is based on the budget e.g. sales budget, production budget.
- Determining the Capital Structure: Capital structure is how a firm finances its overall operations and growth by using different sources of funds. Once the requirement of funds has estimated, the financial manager should decide the mix of debt and equity and also types of debt.
- Investment Fund: A good investment plan can bring businesses huge returns.
Financial Management for Startups:
For new enterprises, it is important to make a good estimation on costs, sales. Consideration on appropriate length sources of finances can help businesses avoid the cash flow problems even the failure of setting up. There are fixed and current sides of assets balance sheet:
- Fixed assets refers to assets that cannot be converted into cash easily, like plant, property, equipment etc.
- A current asset is an item on an entity's balance sheet that is either cash, a cash equivalent, or which can be converted into cash within one year. It is not easy for start ups to forecast the current asset, because there are changes in receivables and payables.
See also:
- Managerial finance, a branch of finance concerned with the managerial significance of financial techniques.
- Corporate finance, a branch of finance concerned with monetary resource allocations made by corporations
- Financial management for IT services, financial management of IT assets and resources
- Financial Planning Association, an organization for finance and economics students and professionals
- Financial Management Service, a bureau of the U.S. Treasury which provides financial services for the government.
- Financial planner
Corporate Finance
YouTube Video: Corporate Finance Explained in LESS than 3 minutes
Corporate finance is the area of finance dealing with the sources of funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources.
The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Correspondingly, corporate finance comprises two main sub-disciplines:
The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms "corporate finance" and "corporate financier" may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.
Recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions.
Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders.
Outline:
The primary goal of financial management is to maximize or to continually increase shareholder value. Maximizing shareholder value requires managers to be able to balance capital funding between investments in projects that increase the firm's long term profitability and sustainability, along with paying excess cash in the form of dividends to shareholders.
Managers of growth companies (i.e. firms that earn high rates of return on invested capital) will use most of the firm's capital resources and surplus cash on investments and projects so the company can continue to expand its business operations into the future. When companies reach maturity levels within their industry (i.e. companies that earn approximately average or lower returns on invested capital), managers of these companies will use surplus cash to payout dividends to shareholders.
Managers must do an analysis to determine the appropriate allocation of the firm's capital resources and cash surplus between projects and payouts of dividends to shareholders, as well as paying back creditor related debt.
Choosing between investment projects will be based upon several inter-related criteria:
This "capital budgeting" is the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm's capital structure. Management must allocate the firm's limited resources between competing opportunities (projects).
Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital.
Investments should be made on the basis of value-added to the future of the corporation. Projects that increase a firm's value may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions.
When no growth or expansion is possible by a corporation and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
Capital Structure:
Capitalization:
Main article: Capital structure
Further information: Security (finance)
Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt and equity (and hybrid- or convertible securities).
As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm. There are two interrelated considerations here:
Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when choosing how to allocate the company's resources. However economists have developed a set of alternative theories about how managers allocate a corporation's finances.
One of the main alternative theories of how firms manage their capital funds is the Pecking Order Theory (Stewart Myers), which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates.
Also, Capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions.
One of the more recent innovations in this area from a theoretical point of view is the Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature, states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.
Sources of capital:
Further information: Security (finance)
Debt capital:
Further information: Bankruptcy and Financial distress
Corporations may rely on borrowed funds (debt capital or credit) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in several forms, such as through bank loans, notes payable, or bonds issued to the public.
Bonds require the corporations to make regular interest payments (interest expenses) on the borrowed capital until the debt reaches its maturity date, therein the firm must pay back the obligation in full.
Debt payments can also be made in the form of sinking fund provisions, whereby the corporation pays annual installments of the borrowed debt above regular interest charges.
Corporations that issue callable bonds are entitled to pay back the obligation in full whenever the company feels it is in their best interest to pay off the debt payments. If interest expenses cannot be made by the corporation through cash payments, the firm may also use collateral assets as a form of repaying their debt obligations (or through the process of liquidation).
Equity capital:
Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or shareholders, expect that there will be an upward trend in value of the company (or appreciate in value) over time to make their investment a profitable purchase. Shareholder value is increased when corporations invest equity capital and other funds into projects (or investments) that earn a positive rate of return for the owners.
Investors prefer to buy shares of stock in companies that will consistently earn a positive rate of return on capital in the future, thus increasing the market value of the stock of that corporation. Shareholder value may also be increased when corporations payout excess cash surplus (funds from retained earnings that are not needed for business) in the form of dividends.
Preferred stock:
Preferred stock is an equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company).
Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.
Preferred stock is a special class of shares which may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock:
Investment and project valuation:
Further information: Business valuation, stock valuation, and fundamental analysis
In general, each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951).
This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling.
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the project "hurdle rate" – is critical to choosing good projects and investments for the firm. The hurdle rate is the minimum acceptable return on an investment – i.e., the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing mix.
Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include the following:
Alternatives (complements) to NPV include the following:
See list of valuation topics.
Valuing flexibility:
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach.
Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the forecast numbers).
Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment. Management will therefore (sometimes) employ tools which place an explicit value on these options.
So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the "flexible and staged nature" of the investment is modelled, and hence "all" potential payoffs are considered. See further under Real options valuation. The difference between the two valuations is the "value of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) and Real options valuation (ROV); they may often be used interchangeably:
DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise.
In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be modeled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management.
Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this "knowledge" of the events that could follow, and assuming rational decision making, management chooses the branches (i.e. actions) corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory#Choice under uncertainty.
ROV is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body.
Again, a DCF valuation would capture only one of these outcomes:
(1) using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option;
(2) an appropriate valuation technique is then employed – usually a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation.
(3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.) See also Option pricing approaches under Business valuation.
Quantifying uncertainty:
Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance.
Given the uncertainty inherent in project forecasting and valuation, analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model.
In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor.
For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula.
Often, several variables may be of interest, and their various combinations produce a "value-surface", (or even a "value-space",) where NPV is then a function of several variables. See also Stress testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...).
As an example, the analyst may specify various revenue growth scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each.
Note that for scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial modeling), whereas for the sensitivity approach these need not be so.
An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the probability-weighted average of the various scenarios; see First Chicago Method. (See also rNPV, where cash flows, as opposed to scenarios, are probability-weighted.)
A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the effects of all possible combinations of variables and their realizations" is to construct stochastic or probabilistic financial models – as opposed to the traditional static and deterministic models as above.
For this purpose, the most common method is to use Monte Carlo simulation to analyze the project's NPV. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics".
In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or trials, "covering all conceivable real world contingencies in proportion to their likelihood;" see Monte Carlo Simulation versus "What If" Scenarios.
The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).
Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly – incorporating this correlation – so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram.
The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs.
Dividend Policy:
Main article: Dividend policy
Dividend policy is concerned with financial policies regarding the payment of a cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power.
When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions.
For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess cash surplus so as to fund future projects internally to help increase the value of the firm.
Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding.
Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders.
As a general rule, shareholders of growth companies would prefer managers to retain earnings and pay no dividends (use excess cash to reinvest into the company's operations), whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends when a positive return cannot be earned through the reinvestment of undistributed earnings.
A share buyback program may be accepted when the value of the stock is greater than the returns to be realized from the reinvestment of undistributed profits. In all instances, the appropriate dividend policy is usually directed by that which maximizes long-term shareholder value.
Working Capital Management:
Main article: Working capital
Managing the corporation's working capital position to sustain ongoing business operations is referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.
In general this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital budgeting, firm value is enhanced through appropriately selecting and funding NPV positive investments.
These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long-term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA). Managing short term finance and long term finance is one task of a modern CFO.
Working capital:
Working capital is the amount of funds which are necessary to an organization to continue its ongoing business operations, until the firm is reimbursed through payments for the goods or services it has delivered to its customers.
Working capital is measured through the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, capital resource allocations relating to working capital are always current, i.e. short-term.
In addition to time horizon, working capital management differs from capital budgeting in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although some constraints – such as those imposed by loan covenants – may be more relevant here).
The (short term) goals of working capital are therefore not approached on the same basis as (long term) profitability, and working capital management applies different criteria in allocating resources: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the most important).
Management of working capital:
Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable:
Relationship with other areas in finance:
Investment banking:
Use of the term "corporate finance" varies considerably across the world. In the United States it is used, as above, to describe activities, analytical methods and techniques that deal with many aspects of a company's finances and capital. In the United Kingdom and Commonwealth countries, the terms "corporate finance" and "corporate financier" tend to be associated with investment banking – i.e. with transactions in which capital is raised for the corporation. These may include
Financial risk management:
Main article: Financial risk management
See also:
Risk management is the process of measuring risk and then developing and implementing strategies to manage ("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to adverse changes in commodity prices, interest rates, foreign exchange rates and stock prices (market risk).
Risk Management will also play an important role in short term cash- and treasury management; see above. It is common for large corporations to have risk management teams; often these overlap with the internal audit function. While it is impractical for small firms to have a formal risk management function, many still apply risk management informally. See also Enterprise risk management.
The discipline typically focuses on risks that can be hedged using traded financial instruments, typically derivatives.
See also:
Because company specific, "over the counter" (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets or exchanges are often preferred. These standard derivative instruments include the following:
The "second generation" exotic derivatives usually trade OTC. Note that hedging-related transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB 133, IAS 39.
This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct result of previous capital financial investments. Secondly, both disciplines share the goal of enhancing, or preserving, firm value.
There is a fundamental debate relating to "Risk Management" and shareholder value.
Per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress.
A further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk management in a market to the cost of bankruptcy in that market.
See also:
The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Correspondingly, corporate finance comprises two main sub-disciplines:
- Capital budgeting is concerned with the setting of criteria about which value-adding projects should receive investment funding, and whether to finance that investment with equity or debt capital.
- Working capital management is the management of the company's monetary funds that deal with the short-term operating balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).
The terms corporate finance and corporate financier are also associated with investment banking. The typical role of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best fits those needs. Thus, the terms "corporate finance" and "corporate financier" may be associated with transactions in which capital is raised in order to create, develop, grow or acquire businesses.
Recent legal and regulatory developments in the U.S. will likely alter the makeup of the group of arrangers and financiers willing to arrange and provide financing for certain highly leveraged transactions.
Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders.
Outline:
The primary goal of financial management is to maximize or to continually increase shareholder value. Maximizing shareholder value requires managers to be able to balance capital funding between investments in projects that increase the firm's long term profitability and sustainability, along with paying excess cash in the form of dividends to shareholders.
Managers of growth companies (i.e. firms that earn high rates of return on invested capital) will use most of the firm's capital resources and surplus cash on investments and projects so the company can continue to expand its business operations into the future. When companies reach maturity levels within their industry (i.e. companies that earn approximately average or lower returns on invested capital), managers of these companies will use surplus cash to payout dividends to shareholders.
Managers must do an analysis to determine the appropriate allocation of the firm's capital resources and cash surplus between projects and payouts of dividends to shareholders, as well as paying back creditor related debt.
Choosing between investment projects will be based upon several inter-related criteria:
- Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of risk.
- These projects must also be financed appropriately.
- If no growth is possible by the company and excess cash surplus is not needed to the firm, then financial theory suggests that management should return some or all of the excess cash to shareholders (i.e., distribution via dividends).
This "capital budgeting" is the planning of value-adding, long-term corporate financial projects relating to investments funded through and affecting the firm's capital structure. Management must allocate the firm's limited resources between competing opportunities (projects).
Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital.
Investments should be made on the basis of value-added to the future of the corporation. Projects that increase a firm's value may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions.
When no growth or expansion is possible by a corporation and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
Capital Structure:
Capitalization:
Main article: Capital structure
Further information: Security (finance)
Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. The sources of financing are, generically, capital self-generated by the firm and capital from external funders, obtained by issuing new debt and equity (and hybrid- or convertible securities).
As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix will impact the valuation of the firm. There are two interrelated considerations here:
- Management must identify the "optimal mix" of financing – the capital structure that results in maximum firm value, (See Balance sheet, WACC) but must also take other factors into account (see trade-off theory below). Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow implications independent of the project's degree of success. Equity financing is less risky with respect to cash flow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity (see CAPM and APT) is also typically higher than the cost of debt - which is, additionally, a deductible expense – and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
- Management must attempt to match the long-term financing mix to the assets being financed as closely as possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap entails matching the assets and liabilities respectively according to maturity pattern ("Cashflow matching") or duration ("immunization"); managing this relationship in the short-term is a major function of working capital management, as discussed below. Other techniques, such as securitization, or hedging using interest rate- or credit derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate risk.
Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when choosing how to allocate the company's resources. However economists have developed a set of alternative theories about how managers allocate a corporation's finances.
One of the main alternative theories of how firms manage their capital funds is the Pecking Order Theory (Stewart Myers), which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates.
Also, Capital structure substitution theory hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized. An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions.
One of the more recent innovations in this area from a theoretical point of view is the Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature, states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.
Sources of capital:
Further information: Security (finance)
Debt capital:
Further information: Bankruptcy and Financial distress
Corporations may rely on borrowed funds (debt capital or credit) as sources of investment to sustain ongoing business operations or to fund future growth. Debt comes in several forms, such as through bank loans, notes payable, or bonds issued to the public.
Bonds require the corporations to make regular interest payments (interest expenses) on the borrowed capital until the debt reaches its maturity date, therein the firm must pay back the obligation in full.
Debt payments can also be made in the form of sinking fund provisions, whereby the corporation pays annual installments of the borrowed debt above regular interest charges.
Corporations that issue callable bonds are entitled to pay back the obligation in full whenever the company feels it is in their best interest to pay off the debt payments. If interest expenses cannot be made by the corporation through cash payments, the firm may also use collateral assets as a form of repaying their debt obligations (or through the process of liquidation).
Equity capital:
Corporations can alternatively sell shares of the company to investors to raise capital. Investors, or shareholders, expect that there will be an upward trend in value of the company (or appreciate in value) over time to make their investment a profitable purchase. Shareholder value is increased when corporations invest equity capital and other funds into projects (or investments) that earn a positive rate of return for the owners.
Investors prefer to buy shares of stock in companies that will consistently earn a positive rate of return on capital in the future, thus increasing the market value of the stock of that corporation. Shareholder value may also be increased when corporations payout excess cash surplus (funds from retained earnings that are not needed for business) in the form of dividends.
Preferred stock:
Preferred stock is an equity security which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferreds are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company).
Preferred stock usually carries no voting rights, but may carry a dividend and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a "Certificate of Designation".
Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferreds is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.
Preferred stock is a special class of shares which may have any combination of features not possessed by common stock. The following features are usually associated with preferred stock:
- Preference in dividends
- Preference in assets, in the event of liquidation
- Convertibility to common stock.
- Callability, at the option of the corporation
- Nonvoting
Investment and project valuation:
Further information: Business valuation, stock valuation, and fundamental analysis
In general, each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to Corporate Finance by Joel Dean in 1951).
This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling.
The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the project "hurdle rate" – is critical to choosing good projects and investments for the firm. The hurdle rate is the minimum acceptable return on an investment – i.e., the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing mix.
Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)
In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include the following:
- discounted payback period,
- IRR,
- Modified IRR,
- equivalent annuity,
- capital efficiency,
- and ROI.
Alternatives (complements) to NPV include the following:
See list of valuation topics.
Valuing flexibility:
Main articles: Real options analysis and decision tree
In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach.
Some analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the forecast numbers).
Even when employed, however, these latter methods do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt the risk adjustment. Management will therefore (sometimes) employ tools which place an explicit value on these options.
So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the "flexible and staged nature" of the investment is modelled, and hence "all" potential payoffs are considered. See further under Real options valuation. The difference between the two valuations is the "value of flexibility" inherent in the project.
The two most common tools are Decision Tree Analysis (DTA) and Real options valuation (ROV); they may often be used interchangeably:
DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise.
In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be modeled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management.
Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this "knowledge" of the events that could follow, and assuming rational decision making, management chooses the branches (i.e. actions) corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory#Choice under uncertainty.
ROV is usually used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body.
Again, a DCF valuation would capture only one of these outcomes:
(1) using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option;
(2) an appropriate valuation technique is then employed – usually a variant on the Binomial options model or a bespoke simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation.
(3) The "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options was originally per Timothy Luehrman, in the late 1990s.) See also Option pricing approaches under Business valuation.
Quantifying uncertainty:
Further information: Sensitivity analysis, Scenario planning, and Monte Carlo methods in finance.
Given the uncertainty inherent in project forecasting and valuation, analysts will wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model.
In a typical sensitivity analysis the analyst will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor.
For example, the analyst will determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity using this formula.
Often, several variables may be of interest, and their various combinations produce a "value-surface", (or even a "value-space",) where NPV is then a function of several variables. See also Stress testing.
Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as well as for company-specific factors (unit costs, etc...).
As an example, the analyst may specify various revenue growth scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each.
Note that for scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial modeling), whereas for the sensitivity approach these need not be so.
An application of this methodology is to determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV for the project is then the probability-weighted average of the various scenarios; see First Chicago Method. (See also rNPV, where cash flows, as opposed to scenarios, are probability-weighted.)
A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the effects of all possible combinations of variables and their realizations" is to construct stochastic or probabilistic financial models – as opposed to the traditional static and deterministic models as above.
For this purpose, the most common method is to use Monte Carlo simulation to analyze the project's NPV. This method was introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are even able to run simulations in spreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics".
In contrast to the scenario approach above, the simulation produces several thousand random but possible outcomes, or trials, "covering all conceivable real world contingencies in proportion to their likelihood;" see Monte Carlo Simulation versus "What If" Scenarios.
The output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any other value).
Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions would then be "sampled" repeatedly – incorporating this correlation – so as to generate several thousand random but possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram.
The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the scenario based approach. These are often used as estimates of the underlying "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive variations in one or more of the DCF model inputs.
Dividend Policy:
Main article: Dividend policy
Dividend policy is concerned with financial policies regarding the payment of a cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit (excess cash) and influenced by the company's long-term earning power.
When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.
If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, and excess cash surplus is not needed, then – finance theory suggests – management should return some or all of the excess cash to shareholders as dividends. This is the general case, however there are exceptions.
For example, shareholders of a "growth stock", expect that the company will, almost by definition, retain most of the excess cash surplus so as to fund future projects internally to help increase the value of the firm.
Management must also choose the form of the dividend distribution, generally as cash dividends or via a share buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding.
Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Financial theory suggests that the dividend policy should be set based upon the type of company and what management determines is the best use of those dividend resources for the firm to its shareholders.
As a general rule, shareholders of growth companies would prefer managers to retain earnings and pay no dividends (use excess cash to reinvest into the company's operations), whereas shareholders of value or secondary stocks would prefer the management of these companies to payout surplus earnings in the form of cash dividends when a positive return cannot be earned through the reinvestment of undistributed earnings.
A share buyback program may be accepted when the value of the stock is greater than the returns to be realized from the reinvestment of undistributed profits. In all instances, the appropriate dividend policy is usually directed by that which maximizes long-term shareholder value.
Working Capital Management:
Main article: Working capital
Managing the corporation's working capital position to sustain ongoing business operations is referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities.
In general this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long term, capital budgeting, firm value is enhanced through appropriately selecting and funding NPV positive investments.
These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has sufficient cash flow to service long-term debt, and to satisfy both maturing short-term debt and upcoming operational expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value added (EVA). Managing short term finance and long term finance is one task of a modern CFO.
Working capital:
Working capital is the amount of funds which are necessary to an organization to continue its ongoing business operations, until the firm is reimbursed through payments for the goods or services it has delivered to its customers.
Working capital is measured through the difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements (Current Liabilities). As a result, capital resource allocations relating to working capital are always current, i.e. short-term.
In addition to time horizon, working capital management differs from capital budgeting in terms of discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk appetite and return targets remain identical, although some constraints – such as those imposed by loan covenants – may be more relevant here).
The (short term) goals of working capital are therefore not approached on the same basis as (long term) profitability, and working capital management applies different criteria in allocating resources: the main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which cash flow is probably the most important).
- The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle except that it does not take into account the creditors deferral period.)
- In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on capital exceeds the cost of capital.
Management of working capital:
Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable:
- Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
- Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials – and minimizes reordering costs – and hence increases cash flow. Note that "inventory" is usually the realm of operations management: given the potential impact on cash flow, and on the balance sheet in general, finance typically "gets involved in an oversight or policing way". See also:
- Debtors management. There are two inter-related roles here: Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances. Implement appropriate Credit scoring policies and techniques such that the risk of default on any new business is acceptable given these criteria.
- Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".
Relationship with other areas in finance:
Investment banking:
Use of the term "corporate finance" varies considerably across the world. In the United States it is used, as above, to describe activities, analytical methods and techniques that deal with many aspects of a company's finances and capital. In the United Kingdom and Commonwealth countries, the terms "corporate finance" and "corporate financier" tend to be associated with investment banking – i.e. with transactions in which capital is raised for the corporation. These may include
- Raising seed, start-up, development or expansion capital
- Mergers, demergers, acquisitions or the sale of private companies
- Mergers, demergers and takeovers of public companies, including public-to-private deals
- Management buy-out, buy-in or similar of companies, divisions or subsidiaries – typically backed by private equity
- Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise capital for development and/or to restructure ownership
- Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and restructuring of businesses
- Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations
- Secondary equity issues, whether by means of private placing or further issues on a stock market, especially where linked to one of the transactions listed above.
- Raising debt and restructuring debt, especially when linked to the types of transactions listed above
Financial risk management:
Main article: Financial risk management
See also:
- Credit risk,
- Default (finance),
- Financial risk,
- Interest rate risk,
- Liquidity risk,
- Operational risk,
- Settlement risk,
- Value at Risk,
- Volatility risk,
- and Insurance
Risk management is the process of measuring risk and then developing and implementing strategies to manage ("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to adverse changes in commodity prices, interest rates, foreign exchange rates and stock prices (market risk).
Risk Management will also play an important role in short term cash- and treasury management; see above. It is common for large corporations to have risk management teams; often these overlap with the internal audit function. While it is impractical for small firms to have a formal risk management function, many still apply risk management informally. See also Enterprise risk management.
The discipline typically focuses on risks that can be hedged using traded financial instruments, typically derivatives.
See also:
Because company specific, "over the counter" (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets or exchanges are often preferred. These standard derivative instruments include the following:
The "second generation" exotic derivatives usually trade OTC. Note that hedging-related transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB 133, IAS 39.
This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct result of previous capital financial investments. Secondly, both disciplines share the goal of enhancing, or preserving, firm value.
There is a fundamental debate relating to "Risk Management" and shareholder value.
Per the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability of financial distress.
A further question, is the shareholder's desire to optimize risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk management in a market to the cost of bankruptcy in that market.
See also:
- Financial accounting
- Stock market
- Security (finance)
- Growth stock
- Financial planning
- Investment bank
- Venture capital
- Financial statement analysis
- Corporate tax
- Corporate governance
- Lists:
Personal Finance, including Credit Bureaus (and credit score) in the United States under the Fair Credit Reporting Act
YouTube Video by Quicken*demonstrating Quicken 2017 Personal Budgeting Software
*- Quicken website
Pictured: Monthly Personal Budget Template for Excel
Personal finance is the financial management which an individual or a family unit performs to budget, save, and spend monetary resources over time, taking into account various financial risks and future life events.
When planning personal finances, the individual would consider the suitability to his or her needs of a range of banking products (checking, savings accounts, credit cards and consumer loans) or investment private equity, (stock market, bonds, mutual funds) and insurance (life insurance, health insurance, disability insurance) products or participation and monitoring of and- or employer-sponsored retirement plans, social security benefits, and income tax management.
Before a specialty in personal finance was developed, various disciplines which are closely related to it, such as family economics, and consumer economics were taught in various colleges as part of home economics for over 100 years.
The earliest known research in personal finance was done in 1920 by Hazel Kyrk. Her dissertation at University of Chicago laid the foundation of consumer economics and family economics. Margaret Reid, a professor of Home Economics at the same university, is recognized as one of the pioneers in the study of consumer behavior and Household behavior.
In 1947, Herbert A. Simon, a Nobel laureate, suggested that a decision maker did not always make the best financial decision because of limited educational resources and personal inclinations. In 2009, Dan Ariely suggested the 2008 financial crisis showed that human beings do not always make rational financial decisions, and the market is not necessarily self-regulating and corrective of any imbalances in the economy.
Therefore, personal finance education is needed to help an individual or a family make rational financial decisions throughout their life. Before 1990, mainstream economists and business faculty paid little attention to personal finance.
However, several American universities such as Brigham Young University, Iowa State University, and San Francisco State University have started to offer financial educational programs in both undergraduate and graduate programs in the last 30 years. These institutions have published several works in journals such as The Journal of Financial Counseling and Planning and the Journal of Personal Finance.
Research into personal finance is based on several theories such as social exchange theory and andragogy (adult learning theory). Professional bodies such as American Association of Family and Consumer Sciences and American Council on Consumer Interests started to play an important role in the development of this field from the 1950s to 1970s.
The establishment of the Association for Financial Counseling and Planning Education (AFCPE) in 1984 at Iowa State University and the Academy of Financial Services (AFS) in 1985 marked an important milestone in personal finance history. Attendances of the two societies mainly come from faculty and graduates from business and home economics colleges.
AFCPE has since offered several certifications for professionals in this field such as Accredited Financial Counselor (AFC) and Certified Housing Counselors (CHC).
Meanwhile, AFS cooperates with Certified Financial Planner (CFP Board).
As the concerns about consumers' financial capability have increased in recent years, a variety of education programs has emerged, catering to a broad audience or to a specific group of people such as youth and women. The educational programs are frequently known as "financial literacy". However, there was no standardized curriculum for personal finance education until after the 2008 financial crisis.
The United States President’s Advisory Council on Financial Capability was set up in 2008 in order to encourage financial literacy among the American people. It also stressed the importance of developing a standard in the field of financial education.
Personal financial planning process:
The key component of personal finance is financial planning, which is a dynamic process that requires regular monitoring and re-evaluation. In general, it involves five steps:
Typical goals that most adults and young adults have are paying off credit card/student loan/housing/car loan debt, investing for retirement, investing for college costs for children, paying medical expenses.
Personal finance principles:
Personal circumstances differ considerably, with respect to patterns of income, wealth, and consumption needs. Tax and finance laws also differ from country to country, and market conditions vary geographically and over time. This means that advice appropriate for one person might not be appropriate for another.
A financial advisor can offer personalized advice in complicated situations and for high-wealth individuals, but University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States good personal finance advice boils down to a few simple points:
The limits stated by laws may be different in each countries; in any case personal finance should not disregard correct behavioral principles: people should not develop attachment to the idea of money, morally reprehensible, and, when investing, should maintain the medium-long term horizon avoiding hazards in the expected return of investment.
Areas of focus:
Key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:
Education and Tools:
Main article: Financial literacy
According to a survey done by Harris Interactive, 99% of the adults agreed that personal finance should be taught in schools. Financial authorities and the American federal government had offered free educational materials online to the public. However, according to a Bank of America poll, 42% of adults were discouraged while 28% of adults thought that personal finance is a difficult subject because of vast amount of information available online.
As of 2015, 17 out of 50 states in the United States requires high school students to study personal finance before graduation. The effectiveness of financial education on general audience is controversial. For example, a study done by Bell, Gorin and Hogarth (2009) stated that those who undergo financial education were more likely to use a formal spending plan.
Financially educated high school students are more likely to have a savings account with regular savings, fewer overdrafts and more likely to pay off their credit card balances.
However, another study was done by Cole and Shastry (Harvard Business School, 2009) found that there were no differences in saving behaviors of people in American states with financial literacy mandate enforced and the states without a literacy mandate.
Kiplinger publishes magazines on personal finance. Several notable personal finance software tools include the following:
Depreciating Assets:
One thing to consider with personal finance and net worth goals is depreciating assets. A depreciating asset is an asset that loses value over time or with use. A few examples would be the vehicle that a person owns, boats, and capitalized expenses. They add value to a person's life but unlike other assets they do not make money and should be a class of their own.
In the business world, for tax and bookkeeping purposes, these are depreciated over time due to the fact that their useful life runs out. This is known as accumulated depreciation and the asset will eventually need to be replaced.
See Also:
The Fair Credit Reporting Act, 15 U.S.C. § 1681 (“FCRA”) is U.S. Federal Government legislation enacted to promote the accuracy, fairness, and privacy of consumer information contained in the files of consumer reporting agencies. It was intended to protect consumers from the willful and/or negligent inclusion of inaccurate information in their credit reports.
To that end, the FCRA regulates the collection, dissemination, and use of consumer information, including consumer credit information. Together with the Fair Debt Collection Practices Act ("FDCPA"), the FCRA forms the foundation of consumer rights law in the United States. It was originally passed in 1970, and is enforced by the US Federal Trade Commission, the Consumer Financial Protection Bureau and private litigants.
Click on any of the following blue hyperlinks for more about "The Fair Credit Reporting Act":
The following is from the Government Website "USA.Gov":
Find out how to get your credit report, make corrections, and more.
Credit reports contain information about your bill payment history, loans, current debt, and other financial information. They show where you work and live and whether you've been sued, arrested, or filed for bankruptcy. Credit reports help lenders decide whether or not to extend you credit or approve a loan, and determine what interest rate they will charge you.
Prospective employers, insurers, and rental property owners may also look at your credit report.
It's important to check your credit report regularly to ensure that your personal information and financial accounts are being accurately reported and that no fraudulent accounts have been opened in your name. If you find errors on your credit report, take steps to have them corrected.
Free Credit Reports:
You are entitled to a free credit report from each of the three credit reporting agencies (Equifax, Experian, and TransUnion) once every 12 months. You can request all three reports at once, or space them out throughout the year. Learn about other situations in which you can request a free credit report.
Request your free credit report:
If your request for a free credit report is denied: Contact the credit reporting agency (CRA) directly to try and resolve the issue. The CRA should inform you of the reason they denied your request and explain what to do next. Often, you will only need to provide information that was missing or incorrect on your application for a free credit report.
If you are unable to resolve your dispute with the CRA, contact the Consumer Financial Protection Bureau (CFPB).
___________________________________________________________________________
A credit bureau is a collection agency that gathers account information from various creditors and provides that information to a consumer reporting agency in the United States and also to private lenders. It is not the same as a credit rating agency.
Click on any of the following blue hyperlinks for more about a Credit Bureau:
A credit score in the United States is a number representing the creditworthiness of a person, the likelihood that person will pay his or her debts.
Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers. Widespread use of credit scores has made credit more widely available and less expensive for many consumers.
Click on any of the following blue hyperlinks for more about Credit Scores in the United States:
When planning personal finances, the individual would consider the suitability to his or her needs of a range of banking products (checking, savings accounts, credit cards and consumer loans) or investment private equity, (stock market, bonds, mutual funds) and insurance (life insurance, health insurance, disability insurance) products or participation and monitoring of and- or employer-sponsored retirement plans, social security benefits, and income tax management.
Before a specialty in personal finance was developed, various disciplines which are closely related to it, such as family economics, and consumer economics were taught in various colleges as part of home economics for over 100 years.
The earliest known research in personal finance was done in 1920 by Hazel Kyrk. Her dissertation at University of Chicago laid the foundation of consumer economics and family economics. Margaret Reid, a professor of Home Economics at the same university, is recognized as one of the pioneers in the study of consumer behavior and Household behavior.
In 1947, Herbert A. Simon, a Nobel laureate, suggested that a decision maker did not always make the best financial decision because of limited educational resources and personal inclinations. In 2009, Dan Ariely suggested the 2008 financial crisis showed that human beings do not always make rational financial decisions, and the market is not necessarily self-regulating and corrective of any imbalances in the economy.
Therefore, personal finance education is needed to help an individual or a family make rational financial decisions throughout their life. Before 1990, mainstream economists and business faculty paid little attention to personal finance.
However, several American universities such as Brigham Young University, Iowa State University, and San Francisco State University have started to offer financial educational programs in both undergraduate and graduate programs in the last 30 years. These institutions have published several works in journals such as The Journal of Financial Counseling and Planning and the Journal of Personal Finance.
Research into personal finance is based on several theories such as social exchange theory and andragogy (adult learning theory). Professional bodies such as American Association of Family and Consumer Sciences and American Council on Consumer Interests started to play an important role in the development of this field from the 1950s to 1970s.
The establishment of the Association for Financial Counseling and Planning Education (AFCPE) in 1984 at Iowa State University and the Academy of Financial Services (AFS) in 1985 marked an important milestone in personal finance history. Attendances of the two societies mainly come from faculty and graduates from business and home economics colleges.
AFCPE has since offered several certifications for professionals in this field such as Accredited Financial Counselor (AFC) and Certified Housing Counselors (CHC).
Meanwhile, AFS cooperates with Certified Financial Planner (CFP Board).
As the concerns about consumers' financial capability have increased in recent years, a variety of education programs has emerged, catering to a broad audience or to a specific group of people such as youth and women. The educational programs are frequently known as "financial literacy". However, there was no standardized curriculum for personal finance education until after the 2008 financial crisis.
The United States President’s Advisory Council on Financial Capability was set up in 2008 in order to encourage financial literacy among the American people. It also stressed the importance of developing a standard in the field of financial education.
Personal financial planning process:
The key component of personal finance is financial planning, which is a dynamic process that requires regular monitoring and re-evaluation. In general, it involves five steps:
- Assessment: A person's financial situation is assessed by compiling simplified versions of financial statements including balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car, house, clothes, stocks, bank account), along with personal liabilities (e.g., credit card debt, bank loan, mortgage). A personal income statement lists personal income and expenses.
- Goal setting: Having multiple goals is common, including a mix of short- and long-term goals. For example, a long-term goal would be to "retire at age 65 with a personal net worth of $1,000,000," while a short-term goal would be to "save up for a new computer in the next month." Setting financial goals helps to direct financial planning. Goal setting is done with an objective to meet specific financial requirements.
- Plan creation: The financial plan details how to accomplish the goals. It could include, for example, reducing unnecessary expenses, increasing the employment income, or investing in the stock market.
- Execution: Execution of a financial plan often requires discipline and perseverance. Many people obtain assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.
- Monitoring and reassessment: As time passes, the financial plan is monitored for possible adjustments or reassessments.
Typical goals that most adults and young adults have are paying off credit card/student loan/housing/car loan debt, investing for retirement, investing for college costs for children, paying medical expenses.
Personal finance principles:
Personal circumstances differ considerably, with respect to patterns of income, wealth, and consumption needs. Tax and finance laws also differ from country to country, and market conditions vary geographically and over time. This means that advice appropriate for one person might not be appropriate for another.
A financial advisor can offer personalized advice in complicated situations and for high-wealth individuals, but University of Chicago professor Harold Pollack and personal finance writer Helaine Olen argue that in the United States good personal finance advice boils down to a few simple points:
- Pay off your credit card balance every month, in full
- Save 20% of your income
- Maximize contributions to tax-advantaged funds such as a 401(k) retirement funds, individual retirement accounts, and 529 education savings plans
- When investing savings:
- Don't attempt to trade individual securities
- Avoid high-fee and actively managed funds
- Look for low-cost, highly diversified mutual funds that balance risk vs. reward appropriately to your target retirement year
- If using a financial advisor, require them to commit to a fiduciary duty to act in your best interest
- Advocate for government social insurance programs
The limits stated by laws may be different in each countries; in any case personal finance should not disregard correct behavioral principles: people should not develop attachment to the idea of money, morally reprehensible, and, when investing, should maintain the medium-long term horizon avoiding hazards in the expected return of investment.
Areas of focus:
Key areas of personal financial planning, as suggested by the Financial Planning Standards Board, are:
- Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flow. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all liabilities of the household, at one point in time. Household cash flow totals up all the expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and in what time the personal goals can be accomplished.
- Adequate protection: or insurance, the analysis of how to protect a household from unforeseen risks. These risks can be divided into liability, property, death, disability, health and long-term care. Some of these risks may be self-insurable while most will require the purchase of an insurance contract. Determining how much insurance to get, at the most cost effective terms requires knowledge of the market for personal insurance. Business owners, professionals, athletes and entertainers require specialized insurance professionals to adequately protect themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of the overall investment planning.
- Tax planning: typically, the income tax is the single largest expense in a household. Managing taxes is not a question whether or not taxes will be paid, but when and how much. The government gives many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically, as one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's personal finances can make a significant impact.
- Investment and accumulation goals: planning how to accumulate enough money for large purchases and life events is what most people consider to be financial planning. Major reasons to accumulate assets include, purchasing a house or car, starting a business, paying for education expenses, and saving for retirement.Achieving these goals requires projecting what they will cost, and when one needs to withdraw funds. A major risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks, bonds, cash and alternative investments. The allocation should also take into consideration the personal risk profile of every investor, since risk attitudes vary from person to person.
- Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plan include taking advantage of government allowed structures to manage tax liability including: individual (IRA) structures, or employer sponsored retirement plans.
- Estate planning involves planning for the disposition of one's assets after death. Typically, there is a tax due to the state or federal government when one dies. Avoiding these taxes means that more of one's assets will be distributed to their heirs. One can leave their assets to family, friends or charitable groups.
- Delayed gratification: Delayed gratification, or deferred gratification is the ability to resist the temptation for an immediate reward and wait for a later reward. For creation of personal wealth this is one of the key. .
- Cash Management: It is the soul of your financial planning, whether you are an employee or planning your retirement. It is a must for every financial planner to know how much he/she spends prior to his/her retirement so that he/she can save a significant amount. This analysis is a wake-up call as many of us are aware of our income but very few actually track their expenses.
- Revisiting Written Financial Plan Regularly: Make it a habit to monitor your financial plan regularly. An annual review of your financial planning with a professional keeps you well-positioned, and informed about the required changes, if any, in your needs or life circumstances. You should be well- prepared for all sudden curve balls that life inevitably throws in your way.
- Education Planning: With the growing interests on students’ loan, having a proper financial plan in place is crucial. Parents often want to save for their kids but end up taking the wrong decisions, which affect the savings adversely. We often observe that, many parents give their kids expensive gifts, or unintentionally endanger the opportunity to obtain the much-needed grant. Instead, one should make their kids prepare for the future and support them financially in their education.
Education and Tools:
Main article: Financial literacy
According to a survey done by Harris Interactive, 99% of the adults agreed that personal finance should be taught in schools. Financial authorities and the American federal government had offered free educational materials online to the public. However, according to a Bank of America poll, 42% of adults were discouraged while 28% of adults thought that personal finance is a difficult subject because of vast amount of information available online.
As of 2015, 17 out of 50 states in the United States requires high school students to study personal finance before graduation. The effectiveness of financial education on general audience is controversial. For example, a study done by Bell, Gorin and Hogarth (2009) stated that those who undergo financial education were more likely to use a formal spending plan.
Financially educated high school students are more likely to have a savings account with regular savings, fewer overdrafts and more likely to pay off their credit card balances.
However, another study was done by Cole and Shastry (Harvard Business School, 2009) found that there were no differences in saving behaviors of people in American states with financial literacy mandate enforced and the states without a literacy mandate.
Kiplinger publishes magazines on personal finance. Several notable personal finance software tools include the following:
- Controle.Finance,
- CountAbout,
- Buxfer,
- Geezeo,
- Home Accountz,
- Moneyspire,
- GNUCash,
- Mint.com,
- Birch Finance,
- Quicken,
- Wesabe,
- Moneydance
- and MoneyWiz.
Depreciating Assets:
One thing to consider with personal finance and net worth goals is depreciating assets. A depreciating asset is an asset that loses value over time or with use. A few examples would be the vehicle that a person owns, boats, and capitalized expenses. They add value to a person's life but unlike other assets they do not make money and should be a class of their own.
In the business world, for tax and bookkeeping purposes, these are depreciated over time due to the fact that their useful life runs out. This is known as accumulated depreciation and the asset will eventually need to be replaced.
See Also:
- Accounting software
- Comparison of accounting software
- Asset allocation
- Asset location
- Corporate finance
- Debt consolidation
- Equity investment
- Family planning
- Financial life management
- Microeconomics
- Money management
- Personal budget
- Separately managed account
- Wealth management
The Fair Credit Reporting Act, 15 U.S.C. § 1681 (“FCRA”) is U.S. Federal Government legislation enacted to promote the accuracy, fairness, and privacy of consumer information contained in the files of consumer reporting agencies. It was intended to protect consumers from the willful and/or negligent inclusion of inaccurate information in their credit reports.
To that end, the FCRA regulates the collection, dissemination, and use of consumer information, including consumer credit information. Together with the Fair Debt Collection Practices Act ("FDCPA"), the FCRA forms the foundation of consumer rights law in the United States. It was originally passed in 1970, and is enforced by the US Federal Trade Commission, the Consumer Financial Protection Bureau and private litigants.
Click on any of the following blue hyperlinks for more about "The Fair Credit Reporting Act":
- History
- Consumer reports
- Inaccuracies in consumer reports
- Civil liability
- Users of consumer reports
- Employment background checks
- Furnishers of information
- Consumer reporting agencies ("CRAs"): see below.
- See also:
- annualcreditreport.com
- Adverse Credit History
- Background check
- Credit card
- Credit history
- Credit rating agency
- Credit score
- Fair and Accurate Credit Transactions Act
- Fair Credit Billing Act
- Identity theft
- Identity Theft Resource Center
- Tenant Screening
- Text of the law from the Federal Trade Commission
- Consumer attorney's testimony testifying as to how credit report disputes are actually normally handled, in violation the Act.
- Mymoney.gov, U.S. Financial Literacy and Education Commission
- The Fair Credit Reporting Act (FCRA) and the Privacy of Your Credit Report Electronic Privacy Information Center (EPIC)
- Consumer Financial Protection Bureau (CFPB) list of consumer reporting companies current as of January 2016
The following is from the Government Website "USA.Gov":
Find out how to get your credit report, make corrections, and more.
- Credit Reports
- Credit Scores
- Credit Reporting Agencies
- Errors on Your Credit Report
- Negative Information in a Credit Report
- Equifax Data Breach
Credit reports contain information about your bill payment history, loans, current debt, and other financial information. They show where you work and live and whether you've been sued, arrested, or filed for bankruptcy. Credit reports help lenders decide whether or not to extend you credit or approve a loan, and determine what interest rate they will charge you.
Prospective employers, insurers, and rental property owners may also look at your credit report.
It's important to check your credit report regularly to ensure that your personal information and financial accounts are being accurately reported and that no fraudulent accounts have been opened in your name. If you find errors on your credit report, take steps to have them corrected.
Free Credit Reports:
You are entitled to a free credit report from each of the three credit reporting agencies (Equifax, Experian, and TransUnion) once every 12 months. You can request all three reports at once, or space them out throughout the year. Learn about other situations in which you can request a free credit report.
Request your free credit report:
- Online: Visit AnnualCreditReport.com
- By Phone: Call 1-877-322-8228. Deaf and hard of hearing consumers can access the TTY service by calling 711 and referring the Relay Operator to 1-800-821-7232.
- By Mail: Complete the Annual Credit Report Request Form (PDF, Download Adobe Reader) and mail it to:
- Annual Credit Report Request Service
- PO Box 105281
- Atlanta, GA 30348-5281
If your request for a free credit report is denied: Contact the credit reporting agency (CRA) directly to try and resolve the issue. The CRA should inform you of the reason they denied your request and explain what to do next. Often, you will only need to provide information that was missing or incorrect on your application for a free credit report.
If you are unable to resolve your dispute with the CRA, contact the Consumer Financial Protection Bureau (CFPB).
___________________________________________________________________________
A credit bureau is a collection agency that gathers account information from various creditors and provides that information to a consumer reporting agency in the United States and also to private lenders. It is not the same as a credit rating agency.
Click on any of the following blue hyperlinks for more about a Credit Bureau:
- Description
- United States including Tort liability for business defamation
- Controversy
- Business Credit Reporting Agencies
- List of credit reporting agencies
- See also:
- Credit history
- Credit risk
- Credit circle
- World Bank GFDR Report
- Federal Trade Commission Governmental Page on Free Credit Reports
- Federal Trade Commission Governmental Page on FCRA and consumer rights
- OCC - Office of the Comptroller of the Currency
- Consumer Financial Protection Bureau (CFPB) List of Consumer Reporting Agencies (CRAs) as of January 2015
A credit score in the United States is a number representing the creditworthiness of a person, the likelihood that person will pay his or her debts.
Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers. Widespread use of credit scores has made credit more widely available and less expensive for many consumers.
Click on any of the following blue hyperlinks for more about Credit Scores in the United States:
- Click here for credit scoring models (p/below)
- FICO score
- Makeup
- Ranges
- NextGen Risk Score
- FICO SBSS
- VantageScore
- CE Score
- Other credit scores
- Free annual credit report
- Non-traditional uses of credit scores
- Criticism:
- Easily gamed
- Not a good predictor of risk
- Use in employment decisions
- Other concerns
- Credit score
- Credit history
- Credit bureau (above)
- Comparison of free credit report websites
- Bankruptcy risk score
- Credit scorecards
- Alternative data
- Seasoned trade line
- "Credit Scores: What You Should Know About Your Own", by Malgorzata Wozniacka and Snigdha Sen (November 2004). Frontline. PBS.
Banking in the United States, including its History as well as a List of the Largest Banks
YouTube Video: An Exclusive Look at Central Banking In the United States
Pictured below: Bank Branch Locator helps you find all national and regional bank offices in United States.
YouTube Video: An Exclusive Look at Central Banking In the United States
Pictured below: Bank Branch Locator helps you find all national and regional bank offices in United States.
Click here for a List of the Largest Banks in the United States.
Banking in the United States began in the late 1790s along with the country's founding and has developed into highly influential and complex system of banking and financial services.
Anchored by New York City and Wall Street, it is centered on various financial services namely private banking, asset management, and deposit security.
The earliest remnants of the banking industry can be traced to 1790 when the Bank of Pennsylvania was founded to fund the American Revolutionary War. After merchants from the Thirteen Colonies needed a current as a medium of exchange, the Bank of North America was opened to facilitate more advanced financial transactions.
As of 2018, the largest banks the United States were JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, and Goldman Sachs. It is estimated that banking assets were equal to 56 percent of the U.S. economy.
Click on any of the following blue hyperlinks for more about Banking in the United States:
Banking in the United States began in the late 1790s along with the country's founding and has developed into highly influential and complex system of banking and financial services.
Anchored by New York City and Wall Street, it is centered on various financial services namely private banking, asset management, and deposit security.
The earliest remnants of the banking industry can be traced to 1790 when the Bank of Pennsylvania was founded to fund the American Revolutionary War. After merchants from the Thirteen Colonies needed a current as a medium of exchange, the Bank of North America was opened to facilitate more advanced financial transactions.
As of 2018, the largest banks the United States were JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, and Goldman Sachs. It is estimated that banking assets were equal to 56 percent of the U.S. economy.
Click on any of the following blue hyperlinks for more about Banking in the United States:
Credit Unions in the United States
YouTube Video: Advantages of a Credit Union Over Banks
Pictured below: There are almost 60,000 credit unions in 105 countries. That’s 217 million members worldwide taking advantage of the credit union difference at over 57,000 credit unions. Credit unions are recognized as a force for positive economic and social change and have provided significant value in both developed and emerging nations.
YouTube Video: Advantages of a Credit Union Over Banks
Pictured below: There are almost 60,000 credit unions in 105 countries. That’s 217 million members worldwide taking advantage of the credit union difference at over 57,000 credit unions. Credit unions are recognized as a force for positive economic and social change and have provided significant value in both developed and emerging nations.
Credit unions in the United States serve 100 million members, comprising 43.7% of the economically active population.
U.S. credit unions are not-for-profit, cooperative, tax-exempt organizations. The clients of the credit unions became partner of the financial institution and their presence focuses in certain neighborhoods because they center their services in one specific community.
As of March 2016, the largest American credit union was Navy Federal Credit Union, serving U.S. Department of Defense employees, contractors, and families of service people, with over $75 billion USD in assets and over 6.1 million members.
Total credit union assets in the U.S. reached $1 trillion as of March 2012. Approximately 236,056 people were directly employed by credit unions per data derived from the 2012 NCUA Credit Union Directory.
Due to their small size and limited exposure to mortgage securitizations, credit unions have weathered the financial meltdown of 2008 reasonably well. However, two of the biggest corporate credit unions in the United States (U.S. Central Credit Union and WesCorp) with combined assets of more than $57 billion were taken over by the federal government National Credit Union Administration on March 20, 2009.
Click on any of the following blue hyperlinks for more about Credit Unions in the United States:
U.S. credit unions are not-for-profit, cooperative, tax-exempt organizations. The clients of the credit unions became partner of the financial institution and their presence focuses in certain neighborhoods because they center their services in one specific community.
As of March 2016, the largest American credit union was Navy Federal Credit Union, serving U.S. Department of Defense employees, contractors, and families of service people, with over $75 billion USD in assets and over 6.1 million members.
Total credit union assets in the U.S. reached $1 trillion as of March 2012. Approximately 236,056 people were directly employed by credit unions per data derived from the 2012 NCUA Credit Union Directory.
Due to their small size and limited exposure to mortgage securitizations, credit unions have weathered the financial meltdown of 2008 reasonably well. However, two of the biggest corporate credit unions in the United States (U.S. Central Credit Union and WesCorp) with combined assets of more than $57 billion were taken over by the federal government National Credit Union Administration on March 20, 2009.
Click on any of the following blue hyperlinks for more about Credit Unions in the United States:
- History
- Constitution and regulation
- Membership restrictions
- Underserved and low-income areas
- Interest rates
- Leagues and associations
- Credit unions vs banks
- Credit union-to-bank conversions
- See also:
- America's Credit Union Museum
- American Credit Union Mortgage Association
- Roy Bergengren
- Bond of association
- Credit Union National Association
- Edward Filene
- History of credit unions
- List of credit unions in the United States
- Dora Maxwell
- Credit unions in Canada
- Branchspot - Locate credit unions in the US, read information, and reviews.
- USA Credit Unions - credit unions information in the US
- National Federation of Community Development Credit Unions - a trade body representing more than 240 community development credit unions (CDCUs) across the US
- Credit Union Database - all credit unions in the US
Federal Reserve System of the United States: including The Monetary Policy of the United States. The United States Dollar, and The United States Mint
- YouTube Video: The Federal Reserve During the Economic Recession by the Brookings Institution
- YouTube Video: What gives a dollar bill its value? - by Doug Levinson TED-Ed
The Federal Reserve System (also known as the Federal Reserve or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to the desire for central control of the monetary system in order to alleviate financial crises.
Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.
The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act:
The first two objectives are sometimes referred to as the Federal Reserve's dual mandate.
Its duties have expanded over the years, and currently also include supervising and regulating banks, maintaining the stability of the financial system, and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed conducts research into the economy and provides numerous publications, such as the Beige Book and the FRED database.
The Federal Reserve System is composed of several layers. It is governed by the presidentially appointed board of governors or Federal Reserve Board (FRB). Twelve regional Federal Reserve Banks, located in cities throughout the nation, regulate and oversee privately owned commercial banks.
Nationally chartered commercial banks are required to hold stock in, and can elect some of the board members of, the Federal Reserve Bank of their region. The Federal Open Market Committee (FOMC) sets monetary policy. It consists of all seven members of the board of governors and the twelve regional Federal Reserve Bank presidents, though only five bank presidents vote at a time (the president of the New York Fed and four others who rotate through one-year voting terms). There are also various advisory councils.
Thus, the Federal Reserve System has both public and private components. It has a structure unique among central banks, and is also unusual in that the United States Department of the Treasury, an entity outside of the central bank, prints the currency used.
The federal government sets the salaries of the board's seven governors. The federal government receives all the system's annual profits, after a statutory dividend of 6% on member banks' capital investment is paid, and an account surplus is maintained. In 2015, the Federal Reserve earned net income of $100.2 billion and transferred $97.7 billion to the U.S. Treasury.
Although an instrument of the US Government, the Federal Reserve System considers itself "an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the board of governors span multiple presidential and congressional terms."
Click on any of the following blue hyperlinks for more about the United States Federal Reserve System:
Monetary Policy of the United States:
Monetary policy concerns the actions of a central bank or other regulatory authorities that determine the size and rate of growth of the money supply. For example, in the United States, the Federal Reserve is in charge of monetary policy, and implements it primarily by performing operations that influence short-term interest rates.
Money Supply:
The money supply has different components, generally broken down into "narrow" and "broad" money, reflecting the different degrees of liquidity ('spendability') of each different type, as broader forms of money can be converted into narrow forms of money (or may be readily accepted as money by others, such as personal checks).
For example, demand deposits are technically promises to pay on demand, while savings deposits are promises to pay subject to some withdrawal restrictions, and Certificates of Deposit are promises to pay only at certain specified dates; each can be converted into money, but "narrow" forms of money can be converted more readily.
The Federal Reserve directly controls only the most narrow form of money, physical cash outstanding along with the reserves of banks throughout the country (known as M0 or the monetary base); the Federal Reserve indirectly influences the supply of other types of money.
Broad money includes money held in deposit balances in banks and other forms created in the financial system. Basic economics also teaches that the money supply shrinks when loans are repaid; however, the money supply will not necessarily decrease depending on the creation of new loans and other effects.
Other than loans, investment activities of commercial banks and the Federal Reserve also increase and decrease the money supply. Discussion of "money" often confuses the different measures and may lead to misguided commentary on monetary policy and misunderstandings of policy discussions.
Click on any of the following blue hyperlinks for more about Monetary Policy of the United States:
United States Dollar:
The United States dollar (sign: $; code: USD; also abbreviated US$ and referred to as the dollar, U.S. dollar, or American dollar) is the official currency of the United States and its territories per the United States Constitution since 1792. For most practical purposes, it is divided into 100 smaller cent (¢) units, but is occasionally divided into 1000 mills (₥) for accounting purposes. The circulating paper money consists of Federal Reserve Notes that are denominated in United States dollars (12 U.S.C. § 418).
Since the suspension in 1971 of convertibility of paper U.S. currency into any precious metal, the U.S. dollar is, de facto, fiat money. As it is the most used in international transactions, the U.S. dollar is the world's primary reserve currency.
Several countries use it as their official currency, and in many others it is the de facto currency. Besides the United States, it is also used as the sole currency in two British Overseas Territories in the Caribbean: the British Virgin Islands and Turks and Caicos Islands.
A few countries use the Federal Reserve Notes for paper money, while still minting their own coins, or also accept U.S. dollar coins (such as the Sacagawea or presidential dollar).
As of June 27, 2018, there are approximately $1.67 trillion in circulation, of which $1.62 trillion is in Federal Reserve notes (the remaining $50 billion is in the form of coins).
Click on any of the following blue hyperlinks for more about the U.S. Dollar:
The United States Mint:
The United States Mint produces circulating coinage for the United States to conduct its trade and commerce, as well as controlling the movement of bullion. It does not produce paper money; that responsibility belongs to the Bureau of Engraving and Printing.
The Mint was created in Philadelphia in 1792, and soon joined by other centers, whose coins were identified by their own mint marks. There are currently four active coin-producing mints: Philadelphia, Denver, San Francisco, and West Point.
Click on any of the following blue hyperlinks for more about the United States Mint:
Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.
The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act:
- maximizing employment,
- stabilizing prices,
- and moderating long-term interest rates.
The first two objectives are sometimes referred to as the Federal Reserve's dual mandate.
Its duties have expanded over the years, and currently also include supervising and regulating banks, maintaining the stability of the financial system, and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed conducts research into the economy and provides numerous publications, such as the Beige Book and the FRED database.
The Federal Reserve System is composed of several layers. It is governed by the presidentially appointed board of governors or Federal Reserve Board (FRB). Twelve regional Federal Reserve Banks, located in cities throughout the nation, regulate and oversee privately owned commercial banks.
Nationally chartered commercial banks are required to hold stock in, and can elect some of the board members of, the Federal Reserve Bank of their region. The Federal Open Market Committee (FOMC) sets monetary policy. It consists of all seven members of the board of governors and the twelve regional Federal Reserve Bank presidents, though only five bank presidents vote at a time (the president of the New York Fed and four others who rotate through one-year voting terms). There are also various advisory councils.
Thus, the Federal Reserve System has both public and private components. It has a structure unique among central banks, and is also unusual in that the United States Department of the Treasury, an entity outside of the central bank, prints the currency used.
The federal government sets the salaries of the board's seven governors. The federal government receives all the system's annual profits, after a statutory dividend of 6% on member banks' capital investment is paid, and an account surplus is maintained. In 2015, the Federal Reserve earned net income of $100.2 billion and transferred $97.7 billion to the U.S. Treasury.
Although an instrument of the US Government, the Federal Reserve System considers itself "an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the board of governors span multiple presidential and congressional terms."
Click on any of the following blue hyperlinks for more about the United States Federal Reserve System:
- Purpose
- Structure
- Monetary policy
- History
- Measurement of economic variables
- Budget
- Net worth including Balance sheet
- Criticism
- See also:
- Official website
- Records of the Federal Reserve System in the National Archives (Record Group 82)
- Consumer Leverage Ratio
- Core inflation
- Farm Credit System
- Fed model
- Federal Home Loan Banks
- Federal Reserve Police
- Federal Reserve Statistical Release
- Free banking
- Gold standard
- Government debt
- Greenspan put
- History of Federal Open Market Committee actions
- History of central banking in the United States
- Independent Treasury
- Legal Tender Cases
- List of economic reports by U.S. government agencies
- Securities market participants (United States)
- Title 12 of the Code of Federal Regulations
- United States Bullion Depository—known as Fort Knox
Monetary Policy of the United States:
Monetary policy concerns the actions of a central bank or other regulatory authorities that determine the size and rate of growth of the money supply. For example, in the United States, the Federal Reserve is in charge of monetary policy, and implements it primarily by performing operations that influence short-term interest rates.
Money Supply:
The money supply has different components, generally broken down into "narrow" and "broad" money, reflecting the different degrees of liquidity ('spendability') of each different type, as broader forms of money can be converted into narrow forms of money (or may be readily accepted as money by others, such as personal checks).
For example, demand deposits are technically promises to pay on demand, while savings deposits are promises to pay subject to some withdrawal restrictions, and Certificates of Deposit are promises to pay only at certain specified dates; each can be converted into money, but "narrow" forms of money can be converted more readily.
The Federal Reserve directly controls only the most narrow form of money, physical cash outstanding along with the reserves of banks throughout the country (known as M0 or the monetary base); the Federal Reserve indirectly influences the supply of other types of money.
Broad money includes money held in deposit balances in banks and other forms created in the financial system. Basic economics also teaches that the money supply shrinks when loans are repaid; however, the money supply will not necessarily decrease depending on the creation of new loans and other effects.
Other than loans, investment activities of commercial banks and the Federal Reserve also increase and decrease the money supply. Discussion of "money" often confuses the different measures and may lead to misguided commentary on monetary policy and misunderstandings of policy discussions.
Click on any of the following blue hyperlinks for more about Monetary Policy of the United States:
- Structure of modern US institutions
- Money creation
- Significant effects
- Uncertainties
- Opinions of the Federal Reserve
- See also:
United States Dollar:
The United States dollar (sign: $; code: USD; also abbreviated US$ and referred to as the dollar, U.S. dollar, or American dollar) is the official currency of the United States and its territories per the United States Constitution since 1792. For most practical purposes, it is divided into 100 smaller cent (¢) units, but is occasionally divided into 1000 mills (₥) for accounting purposes. The circulating paper money consists of Federal Reserve Notes that are denominated in United States dollars (12 U.S.C. § 418).
Since the suspension in 1971 of convertibility of paper U.S. currency into any precious metal, the U.S. dollar is, de facto, fiat money. As it is the most used in international transactions, the U.S. dollar is the world's primary reserve currency.
Several countries use it as their official currency, and in many others it is the de facto currency. Besides the United States, it is also used as the sole currency in two British Overseas Territories in the Caribbean: the British Virgin Islands and Turks and Caicos Islands.
A few countries use the Federal Reserve Notes for paper money, while still minting their own coins, or also accept U.S. dollar coins (such as the Sacagawea or presidential dollar).
As of June 27, 2018, there are approximately $1.67 trillion in circulation, of which $1.62 trillion is in Federal Reserve notes (the remaining $50 billion is in the form of coins).
Click on any of the following blue hyperlinks for more about the U.S. Dollar:
- Overview
- Etymology including Nicknames
- Dollar sign
- History
- Coins
- Collector coins
- Dollar coins
- Mint marks including Notes
- Banknotes
- Means of issue
- Value
- Exchange rates
- See also:
- Government of the United States portal
- Numismatics portal
- 50 State Quarters
- Coins of the United States dollar
- Counterfeit United States currency
- Federal Reserve Note
- International use of the U.S. dollar
- Large denominations of United States currency
- Series (United States currency)
- Strong dollar policy
- U.S. Dollar Index
- U.S. Bureau of Engraving and Printing
- U.S. Currency Education Program page with images of all current banknotes
- American Currency Exhibit at the San Francisco Federal Reserve Bank
- Relative values of the U.S. dollar, from 1774 to present
- Historical Currency Converter
- Summary of BEP Production Statistics
- U.S. Currency tracking experiment
- 50 Factors that Affect the Value of the U.S. Dollar – Currency Trading.net
- Askar Akaev forecasts the collapse of U.S. dollar in December 2012
- U.S. Currency Education Program: Banknotes
- U.S. Mint: Image Library
- Historical and current banknotes of the United States (in English) (in German)
The United States Mint:
The United States Mint produces circulating coinage for the United States to conduct its trade and commerce, as well as controlling the movement of bullion. It does not produce paper money; that responsibility belongs to the Bureau of Engraving and Printing.
The Mint was created in Philadelphia in 1792, and soon joined by other centers, whose coins were identified by their own mint marks. There are currently four active coin-producing mints: Philadelphia, Denver, San Francisco, and West Point.
Click on any of the following blue hyperlinks for more about the United States Mint:
- History
- Current facilities
- Functions
- Mintmarks
- See also:
- U.S. Mint website
- American Arts Commemorative Series medallion
- Bureau of Engraving and Printing
- Coins of the United States dollar
- Early United States commemorative coins
- First Strike Coins
- Modern United States commemorative coins
- United States commemorative coin
- United States Mint coin sets
- U.S. Mint in the Federal Register
Federal Deposit Insurance Corporation (FDIC)
YouTube Video: The FDIC Fund and How it Works
The Federal Deposit Insurance Corporation (FDIC) is a United States government corporation providing deposit insurance to depositors in U.S. commercial banks and savings institutions.
The FDIC was created by the 1933 Banking Act, enacted during the Great Depression to restore trust in the American banking system. More than one-third of banks failed in the years before the FDIC's creation, and bank runs were common.
The insurance limit was initially US$2,500 per ownership category, and this was increased several times over the years. Since the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2011, the FDIC insures deposits in member banks up to US$250,000 per ownership category.
The FDIC and its reserves are not funded by public funds; member banks' insurance dues are the FDIC's primary source of funding. The FDIC also has a US$100 billion line of credit with the United States Department of the Treasury.
Only banks are insured by the FDIC; credit unions are insured up to the same insurance limit by the National Credit Union Administration, which is also a government agency.
As of the end of 2017, the FDIC provided deposit insurance at 5,670 institutions. The FDIC also examines and supervises certain financial institutions for safety and soundness, performs certain consumer-protection functions, and manages receiverships of failed banks.
Ownership Categories:
Each ownership category of a depositor's money is insured separately up to the insurance limit, and separately at each bank. Thus a depositor with $250,000 in each of three ownership categories at each of two banks would have six different insurance limits of $250,000, for total insurance coverage of 6 × $250,000 = $1,500,000. The distinct ownership categories are:
All amounts that a particular depositor has in accounts in any particular ownership category at a particular bank are added together and are insured up to $250,000.
For joint accounts, each co-owner is assumed (unless the account specifically states otherwise) to own the same fraction of the account as does each other co-owner (even though each co-owner may be eligible to withdraw all funds from the account). Thus if three people jointly own a $750,000 account, the entire account balance is insured because each depositor's $250,000 share of the account is insured.
The owner of a revocable trust account is generally insured up to $250,000 for each unique beneficiary (subject to special rules if there are more than five of them). Thus if there is a single owner of an account that is specified as in trust for (payable on death to, etc.) three different beneficiaries, the funds in the account are insured up to $750,000.
Click on any of the following blue hyperlinks for more about the FDIC:
The FDIC was created by the 1933 Banking Act, enacted during the Great Depression to restore trust in the American banking system. More than one-third of banks failed in the years before the FDIC's creation, and bank runs were common.
The insurance limit was initially US$2,500 per ownership category, and this was increased several times over the years. Since the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2011, the FDIC insures deposits in member banks up to US$250,000 per ownership category.
The FDIC and its reserves are not funded by public funds; member banks' insurance dues are the FDIC's primary source of funding. The FDIC also has a US$100 billion line of credit with the United States Department of the Treasury.
Only banks are insured by the FDIC; credit unions are insured up to the same insurance limit by the National Credit Union Administration, which is also a government agency.
As of the end of 2017, the FDIC provided deposit insurance at 5,670 institutions. The FDIC also examines and supervises certain financial institutions for safety and soundness, performs certain consumer-protection functions, and manages receiverships of failed banks.
Ownership Categories:
Each ownership category of a depositor's money is insured separately up to the insurance limit, and separately at each bank. Thus a depositor with $250,000 in each of three ownership categories at each of two banks would have six different insurance limits of $250,000, for total insurance coverage of 6 × $250,000 = $1,500,000. The distinct ownership categories are:
- Single accounts (accounts not falling into any other category)
- Certain retirement accounts (including Individual Retirement Accounts (IRAs))
- Joint accounts (accounts with more than one owner with equal rights to withdraw)
- Revocable trust accounts (containing the words "Payable on death", "In trust for", etc.)
- Irrevocable trust accounts
- Employee Benefit Plan accounts (deposits of a pension plan)
- Corporation/Partnership/Unincorporated Association accounts
- Government accounts
All amounts that a particular depositor has in accounts in any particular ownership category at a particular bank are added together and are insured up to $250,000.
For joint accounts, each co-owner is assumed (unless the account specifically states otherwise) to own the same fraction of the account as does each other co-owner (even though each co-owner may be eligible to withdraw all funds from the account). Thus if three people jointly own a $750,000 account, the entire account balance is insured because each depositor's $250,000 share of the account is insured.
The owner of a revocable trust account is generally insured up to $250,000 for each unique beneficiary (subject to special rules if there are more than five of them). Thus if there is a single owner of an account that is specified as in trust for (payable on death to, etc.) three different beneficiaries, the funds in the account are insured up to $750,000.
Click on any of the following blue hyperlinks for more about the FDIC:
- Board of directors
- History
- Funds
- Insurance requirements
- Resolution of insolvent banks
- Insured products
- Items not insured
- See also:
- Federal Deposit Insurance Corporation (official website)
- Federal Deposit Insurance Corporation in the Federal Register
- FDIC Statistics at a Glance
- FDIC List of Failed Banks
- Title 12 of the Code of Federal Regulations
- 2008–2010 bank failures in the United States
- Canada Deposit Insurance Corporation
- Financial crisis of 2007-2010
- List of acquired or bankrupt United States banks in the late 2000s financial crisis
- List of largest U.S. bank failures
- Too Big to Fail policy
- Related agencies and programs:
- CAMELS Rating System – used by the FDIC's Division of Risk Management Supervision (RMS) examiners to rate each bank and the FDIC problem bank list
- FDIC Enterprise Architecture Framework
- National Credit Union Administration
- Temporary Liquidity Guarantee Program
Savings & Loan Association including the Savings & Loan Crisis of the 1980s-1990s
YouTube Video about the Savings and Loan Crisis: Explained, Summary, Timeline, Bailout, Finance, Cost, History
Pictured below: Savings and Loan Crisis
YouTube Video about the Savings and Loan Crisis: Explained, Summary, Timeline, Bailout, Finance, Cost, History
Pictured below: Savings and Loan Crisis
A savings and loan association (S&L), or thrift institution, is a financial institution that specializes in accepting savings, deposits, and making mortgage and other loans.
The terms "S&L" or "thrift" are mainly used in the United States; similar institutions in the United Kingdom, Ireland and some Commonwealth countries include building societies and trustee savings banks. They are often mutually held (often called mutual savings banks), meaning that the depositors and borrowers are members with voting rights, and have the ability to direct the financial and managerial goals of the organization like the members of a credit union or the policyholders of a mutual insurance company.
While it is possible for an S&L to be a joint-stock company, and even publicly traded; in such instances it is no longer truly a mutual association, and depositors and borrowers no longer have membership rights and managerial control. By law, thrifts can have no more than 20 percent of their lending in commercial loans — their focus on mortgage and consumer loans makes them particularly vulnerable to housing downturns such as the deep one the U.S. has experienced since 2007.
Click on any of the following blue hyperlinks for more about Savings and Loans:
Savings and Loan Crisis (1980s-1990s)
The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995: the Federal Savings and Loan Insurance Corporation (FSLIC) closed or otherwise resolved 296 institutions from 1986 to 1989 and the Resolution Trust Corporation (RTC) closed or otherwise resolved 747 institutions from 1989 to 1995.
A savings and loan or "thrift" is a financial institution that accepts savings deposits and makes mortgage, car and other personal loans to individual members (a cooperative venture known in the United Kingdom as a building society).
By 1995, the RTC had closed 747 failed institutions nationwide, worth a total possible book value of between $402 and $407 billion. In 1996, the General Accounting Office estimated the total cost to be $160 billion, including $132.1 billion taken from taxpayers. The RTC was created to resolve the S&L crisis.
In 1979, the Federal Reserve System of the United States raised the discount rate that it charged its member banks from 9.5% to 12% in an effort to reduce inflation. The building or savings and loans associations (S&Ls) had issued long-term loans at fixed interest rates that were lower than the interest rate at which they could borrow. In addition, the S&Ls had the liability of the deposits which paid higher interest rates than the rate at which they could borrow.
When interest rates at which they could borrow increased, the S&Ls could not attract adequate capital, from deposits to savings accounts of members for instance, they became insolvent. Rather than admit to insolvency, lax regulatory oversight allowed some S&Ls to invest in highly speculative investment strategies. This had the effect of extending the period where S&Ls were likely technically insolvent.
These adverse actions also substantially increased the economic losses for the S&Ls than would otherwise have been realized had their insolvency been discovered earlier. One extreme example was that of financier Charles Keating, who paid $51 million financed through Michael Milken's "junk bond" operation, for his Lincoln Savings and Loan Association which at the time had a negative net worth exceeding $100 million.
Others, such as author/financial historian Kenneth J. Robinson or the account of the crisis published in 2000 by the Federal Deposit Insurance Corporation (FDIC), give multiple reasons as to why the Savings and Loan Crisis came to pass.
In no particular order of significance, they identify the rising monetary inflation beginning in the late 1960s spurred by simultaneous domestic spending programs of President Lyndon B. Johnson's "Great Society" programs coupled with the military expenses of the continuing Vietnam War that continued into the late 1970s.
The efforts to end rampant inflation of the late 1970s and early 1980s by raising interest rates brought on recession in the early 1980s and the beginning of the S&L crisis. Deregulation of the S&L industry, combined with regulatory forbearance, and fraud worsened the crisis.
Click on any of the following blue hyperlinks for more about the Savings & Loan Crisis of the 1980s-1990s:
The terms "S&L" or "thrift" are mainly used in the United States; similar institutions in the United Kingdom, Ireland and some Commonwealth countries include building societies and trustee savings banks. They are often mutually held (often called mutual savings banks), meaning that the depositors and borrowers are members with voting rights, and have the ability to direct the financial and managerial goals of the organization like the members of a credit union or the policyholders of a mutual insurance company.
While it is possible for an S&L to be a joint-stock company, and even publicly traded; in such instances it is no longer truly a mutual association, and depositors and borrowers no longer have membership rights and managerial control. By law, thrifts can have no more than 20 percent of their lending in commercial loans — their focus on mortgage and consumer loans makes them particularly vulnerable to housing downturns such as the deep one the U.S. has experienced since 2007.
Click on any of the following blue hyperlinks for more about Savings and Loans:
- Early history
- U.S. savings and loan in the 20th century
- Mortgage lending
- Further advantages
- Decline: See next topic
- Characteristics
- See also:
Savings and Loan Crisis (1980s-1990s)
The savings and loan crisis of the 1980s and 1990s (commonly dubbed the S&L crisis) was the failure of 1,043 out of the 3,234 savings and loan associations in the United States from 1986 to 1995: the Federal Savings and Loan Insurance Corporation (FSLIC) closed or otherwise resolved 296 institutions from 1986 to 1989 and the Resolution Trust Corporation (RTC) closed or otherwise resolved 747 institutions from 1989 to 1995.
A savings and loan or "thrift" is a financial institution that accepts savings deposits and makes mortgage, car and other personal loans to individual members (a cooperative venture known in the United Kingdom as a building society).
By 1995, the RTC had closed 747 failed institutions nationwide, worth a total possible book value of between $402 and $407 billion. In 1996, the General Accounting Office estimated the total cost to be $160 billion, including $132.1 billion taken from taxpayers. The RTC was created to resolve the S&L crisis.
In 1979, the Federal Reserve System of the United States raised the discount rate that it charged its member banks from 9.5% to 12% in an effort to reduce inflation. The building or savings and loans associations (S&Ls) had issued long-term loans at fixed interest rates that were lower than the interest rate at which they could borrow. In addition, the S&Ls had the liability of the deposits which paid higher interest rates than the rate at which they could borrow.
When interest rates at which they could borrow increased, the S&Ls could not attract adequate capital, from deposits to savings accounts of members for instance, they became insolvent. Rather than admit to insolvency, lax regulatory oversight allowed some S&Ls to invest in highly speculative investment strategies. This had the effect of extending the period where S&Ls were likely technically insolvent.
These adverse actions also substantially increased the economic losses for the S&Ls than would otherwise have been realized had their insolvency been discovered earlier. One extreme example was that of financier Charles Keating, who paid $51 million financed through Michael Milken's "junk bond" operation, for his Lincoln Savings and Loan Association which at the time had a negative net worth exceeding $100 million.
Others, such as author/financial historian Kenneth J. Robinson or the account of the crisis published in 2000 by the Federal Deposit Insurance Corporation (FDIC), give multiple reasons as to why the Savings and Loan Crisis came to pass.
In no particular order of significance, they identify the rising monetary inflation beginning in the late 1960s spurred by simultaneous domestic spending programs of President Lyndon B. Johnson's "Great Society" programs coupled with the military expenses of the continuing Vietnam War that continued into the late 1970s.
The efforts to end rampant inflation of the late 1970s and early 1980s by raising interest rates brought on recession in the early 1980s and the beginning of the S&L crisis. Deregulation of the S&L industry, combined with regulatory forbearance, and fraud worsened the crisis.
Click on any of the following blue hyperlinks for more about the Savings & Loan Crisis of the 1980s-1990s:
- Background
- Causes
- Failures
- Scandals
- Financial Institutions Reform, Recovery and Enforcement Act of 1989
- Consequences
- See also:
- Financial crisis
- Fractional-reserve banking
- List of corporate scandals
- List of largest U.S. bank failures
- Resolution Trust Corporation
- Subprime mortgage crisis
- Tax Reform Act of 1986
- Cottage Savings Association v. Commissioner, a United States Supreme Court case dealing with the tax consequences of the S&L crisis
- United States v. Winstar Corp., a U.S. Supreme Court case that gives a concise but useful history of the crisis and the accounting practices that aggravated that crisis.
- FDIC: The S&L Crisis: A Chrono-Bibliography
- Classic Financial and Corporate Scandals
Cryptocurrency including BitCoins (Updated 2/11/2023)
- YouTube Video Bitcoin explained: How do cryptocurrencies work? - BBC News
- YouTube Video: How to Use a Cryptocurrency Exchange
- YouTube Video: Are Bitcoins Secure? by Duke University
[WebHost: this topic was expanded to update Cryptocurrency topics to include Forbes Magazine articles]
Cryptocurrency Wikipedia
Click here for a List of Cryptocurrencies.
Cryptocurrency (or crypto currency) is a digital asset designed to work as a medium of exchange that uses strong cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets.
Cryptocurrencies are a kind of alternative currency and digital currency (of which virtual currency is a subset). Cryptocurrencies use decentralized control as opposed to centralized digital currency and central banking systems. The decentralized control of each cryptocurrency works through distributed ledger technology, typically a blockchain, that serves as a public financial transaction database.
Bitcoin (see next topic) first released as open-source software in 2009, is generally considered the first decentralized cryptocurrency. Since the release of Bitcoin, over 4,000 altcoins (alternative variants of Bitcoin, or other cryptocurrencies) have been created.
Click on any of the following blue hyperlinks for more about Crytocurrency:
Forbes Magazine (6/6/2022)
What is Cryptocurrency?
Cryptocurrency is decentralized digital money that’s based on blockchain technology. You may be familiar with the most popular versions, Bitcoin and Ethereum, but there are more than 19,000 different cryptocurrencies in circulation.
How Does Cryptocurrency Work?
A cryptocurrency is a digital, encrypted, and decentralized medium of exchange. Unlike the U.S. Dollar or the Euro, there is no central authority that manages and maintains the value of a cryptocurrency. Instead, these tasks are broadly distributed among a cryptocurrency’s users via the internet.
You can use crypto to buy regular goods and services, although most people invest in cryptocurrencies as they would in other assets, like stocks or precious metals. While cryptocurrency is a novel and exciting asset class, purchasing it can be risky as you must take on a fair amount of research to understand how each system works fully.
Bitcoin was the first cryptocurrency, first outlined in principle by Satoshi Nakamoto in a 2008 paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” Nakamoto described the project as “an electronic payment system based on cryptographic proof instead of trust.”
That cryptographic proof comes in the form of transactions that are verified and recorded on a blockchain.
What Is a Blockchain?
A blockchain is an open, distributed ledger that records transactions in code. In practice, it’s a little like a checkbook that’s distributed across countless computers around the world. Transactions are recorded in “blocks” that are then linked together on a “chain” of previous cryptocurrency transactions.
“Imagine a book where you write down everything you spend money on each day,” says Buchi Okoro, CEO and co-founder of African cryptocurrency exchange Quidax. “Each page is similar to a block, and the entire book, a group of pages, is a blockchain.”
With a blockchain, everyone who uses a cryptocurrency has their own copy of this book to create a unified transaction record. Each new transaction as it happens is logged, and every copy of the blockchain is updated simultaneously with the new information, keeping all records identical and accurate.
To prevent fraud, each transaction is checked using a validation technique, such as proof of work or proof of stake.
Proof of Work vs. Proof of Stake:
Proof of work and proof of stake are the two most widely used consensus mechanisms to verify transactions before adding them to a blockchain. Verifiers are then rewarded with cryptocurrency for their efforts.
Proof of Work:
“Proof of work is a method of verifying transactions on a blockchain in which an algorithm provides a mathematical problem that computers race to solve,” says Simon Oxenham, social media manager at Xcoins.com.
Each participating computer, often referred to as a “miner,” solves a mathematical puzzle that helps verify a group of transactions—referred to as a block—then adds them to the blockchain ledger. The first computer to do so successfully is rewarded with a small amount of cryptocurrency for its efforts.
Bitcoin, for example, rewards a miner 6.25 BTC (which is roughly $200,000) for validating a new block.
The race to solve blockchain puzzles can require intense computer power and electricity. That means the miners might barely break even with the crypto they receive for validating transactions after considering the costs of power and computing resources.
Proof of Stake:
Some cryptocurrencies use a proof of stake verification method to reduce the amount of power necessary to check transactions. With proof of stake, the number of transactions each person can verify is limited by the amount of cryptocurrency they’re willing to “stake,” or temporarily lock up in a communal safe for the chance to participate in the process.
“It’s almost like bank collateral,” says Okoro. Each person who stakes crypto is eligible to verify transactions, but the odds you’ll be chosen typically increase with the amount you front.
“Because proof of stake removes energy-intensive equation solving, it’s much more efficient than proof of work, allowing for faster verification/confirmation times for transactions,” says Anton Altement, CEO of Osom Finance.
In comparison, for example, the average transaction speed for Bitcoin is at least 10 minutes. Now compare that with Solana, a crypto platform that uses the proof-of-stake mechanism, which averages around 3,000 transactions per second (TPS), making it much faster than the sluggish Bitcoin blockchain.
Also on the horizon is Bitcoin’s biggest rival, Ethereum, is switching fully to a proof-of-stake mechanism. Ethereum estimates its energy usage will decrease by 99.95% once it closes “the final chapter of proof of work on Ethereum.”
The Role of Consensus in Crypto:
Both proof of stake and proof of work rely on consensus mechanisms to verify transactions.
This means while each uses individual users to verify transactions, each verified transaction must be checked and approved by the majority of ledger holders.
How Can You Mine Cryptocurrency?
Mining is how new units of cryptocurrency are released into the world, generally in exchange for validating transactions. While it’s theoretically possible for the average person to mine cryptocurrency, it’s increasingly difficult in proof-of-work systems, like Bitcoin.
“As the Bitcoin network grows, it gets more complicated, and more processing power is required,” says Spencer Montgomery, founder of Uinta Crypto Consulting. “The average consumer used to be able to do this, but now it’s just too expensive. There are too many people who have optimized their equipment and technology to outcompete.”
Proof-of-work cryptocurrencies also require huge amounts of energy to mine. For example, Bitcoin mining currently consumes electricity at an annualized rate of 127 terawatt-hours (TWh), which exceeds Norway’s entire annual electricity consumption.
While it’s impractical for the average person to earn crypto by mining in a proof of work system, the proof-of-stake model requires less high-powered computing as validators are chosen randomly based on the amount they stake. It does, however, require that you already own a cryptocurrency to participate. (If you have no crypto, you have nothing to stake.)
How Can You Use Cryptocurrency?
While there are a number of goods and services that you can buy with crypto, particularly with Litecoin, Bitcoin or Ethereum, you may also use crypto as an alternative investment option outside of stocks and bonds.
“The best-known crypto, Bitcoin, is a secure, decentralized currency that has become a store of value like gold,” says David Zeiler, a cryptocurrency expert at financial news site Money Morning. “Some people even refer to it as ‘digital gold.’”
How to Use Cryptocurrency for Secure Purchases:
Using crypto to make purchases securely depends on what you’re trying to buy.
If you’re trying to make a payment in cryptocurrency, you’ll most likely need a cryptocurrency wallet. One type of wallet is a “hot wallet,” a software program that interacts with the blockchain and allows users to send and receive their stored cryptocurrency.
Remember that transactions are not instantaneous as they must be validated by some form of mechanism.
Best Crypto Exchanges:
Cryptocurrencies can be purchased through crypto exchanges, such as Coinbase, Kraken or Gemini. They offer the ability to trade some of the most popular cryptocurrencies, including Bitcoin, Ethereum and Dogecoin. Still, they may also have limitations. You’ll have to check to see if your exchange supports the right crypto pairing you need to make a purchase.
For example, you can use your stash of USD Coin, a crypto stablecoin, to buy Ethereum on Coinbase Exchange.
“It was once fairly difficult but now it’s relatively easy, even for crypto novices,” Zeiler says. “An exchange like Coinbase caters to nontechnical folks. It’s very easy to set up an account there and link it to a bank account.”
Keep an eye out for fees, though, as some of these exchanges charge prohibitively high costs on small crypto purchases.
How to Invest in Cryptocurrency:
Some brokerage platforms—like Robinhood, Webull and eToro—let you invest in crypto. That’s in addition to crypto exchanges.
It’s best to keep in mind that buying individual cryptocurrencies are similar to buying individual stocks. In essence, they are risk assets.
If you want exposure to the crypto market, you might invest in individual stocks of crypto companies. “There are also a few Bitcoin mining stocks such as Hive Blockchain (HIVE),” says Zeiler. “If you want some crypto exposure with less risk, you can invest in big companies that are adopting blockchain technology, such as IBM, Bank of America and Microsoft.”
How Does Cryptocurrency Gain Value?
To illustrate how some cryptos can appreciate in value, let’s look at the ultimate crypto bellwether: Bitcoin.
Bitcoin nearly quadrupled in value throughout 2020, closing out the year above $28,900. By April 2021, the price of BTC had more than doubled from where it started the year, but all those gains had been lost by July. Then BTC more than doubled again, hitting an intraday high above $68,990 on November 10, 2021—and then dropped to around $46,000 at the end of 2021. As of early June 2022, Bitcoin trades for just over $31,000 per coin.
While the original crypto is down by 35% year to date, Bitcoin has seen an appreciation of more than 1,000% over the past five years.
Should You Invest in Cryptocurrency?
Experts hold mixed opinions about investing in cryptocurrency. Because crypto is a highly speculative investment, with the potential for intense price swings, some financial advisors don’t recommend people invest at all.
Pros and Cons of Cryptocurrency:
Peter Palion, a certified financial planner (CFP) in East Norwich, New York, thinks it’s safer to stick to a currency backed by a government, like the U.S. dollar.
“If you have the U.S. dollar in your cash reserves, you know you can pay your mortgage, you can pay your electricity bill,” Palion says. “When you look at the last 12 months, Bitcoin looks basically like my last EKG, and the U.S. dollar index is more or less a flat line.
Something that drops by 50% is not suitable for anything but speculation.”
That said, for clients who are specifically interested in cryptocurrency, Ian Harvey, a New York-based wealth advisor, helps them put some money into it. “The weight in a client’s portfolio should be large enough to feel meaningful while not derailing their long-term plan should the investment go to zero,” says Harvey.
As for how much to invest, Harvey talks to investors about what percentage of their portfolio they’re willing to lose if the investment goes south. “It could be 1% to 5%, it could be 10%,” he says. “It depends on how much they have now, and what’s really at stake for them, from a loss perspective.”
___________________________________________________________________________
10 Best Crypto Apps & Exchanges Of 2023:
By Forbes Advisor 2/1/2023
Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.
If you’re interested in buying cryptocurrency, you need to open an account with a crypto exchange. There are around 500 examples to choose from, and Forbes Advisor combed through the leading players to determine the best crypto exchanges for both new and experienced investors.
Why you can trust Forbes Advisor: Our editors are committed to bringing you unbiased ratings and information—our editorial content is not influenced by advertisers. We use data-driven methodologies to evaluate investing and retirement products, helping you to find the best accounts and assets for your money. You can read more about our editorial guidelines and the methodology for the ratings below.
Featured Forbes Partners:
Crypto Exchange FAQs
What is a crypto exchange? A crypto exchange is a marketplace where you can buy and sell cryptocurrencies, like Bitcoin, Ether or Dogecoin.
How does a crypto exchange work? Crypto exchanges work a lot like brokerage platforms, and each offers a portal where you can create different order types to buy, sell and speculate on cryptocurrencies with other users.
Crypto exchanges can be centralized, meaning they are managed by one corporate authority, like a brokerage company that facilitates the security of trades, or decentralized.
Decentralized exchanges generally distribute verification powers to anyone willing to join a network and certify transactions, much like cryptocurrency blockchains. This may help increase accountability and transparency and ensure an exchange can keep running if something happens to a company running an exchange.
How do you buy crypto? To buy cryptocurrency, open an account with a crypto exchange or an online brokerage that allows crypto trading. In addition, you’ll need a crypto wallet to hold your cryptocurrency, although your exchange may provide one.
Be careful when picking a crypto exchange. Some crypto trading apps, like PayPal or Venmo, do not let you transfer your coins off the platform. This is a major limitation for serious crypto investors.
Once you’ve picked an exchange and a wallet, you’ll be able to buy crypto by transferring U.S. dollars into your account via an ACH or wire transfer. You may even be able to buy crypto with a credit or debit card. However, this may carry additional fees, some of which can get quite high.
Some crypto exchanges will let you use other cryptocurrencies or their own branded stablecoins, like Binance Coin (BNB) on Binance.US, to fund transactions.
How much money do you need to buy crypto? Exchanges have different requirements, often depending on the type of cryptocurrency you want to buy.
You may be able to buy fractional shares of coins for pennies or just a few dollars. Be sure to check your chosen crypto exchange’s requirements for the coin you want to buy.
How do I open a crypto exchange account? To open a crypto exchange account, visit the exchange’s website or download its app.
Each crypto exchange has its own unique registration process. With some, you may be able to make an account and buy and sell small amounts of crypto without verifying your identity or submitting much sensitive information.
But as the industry has evolved, the U.S. government has introduced certain Know Your Customer regulations to prevent money laundering and fraud.
In general, you’ll need to provide:
You may also have to verify your identity by submitting a photo or scan of a government-issued ID.
Next Up in Crytocurrency:
[End of Forbes articles]
___________________________________________________________________________
Wikipedia Articles:
Bitcoin:
Click here for a List of Bitcoin Companies
Click here for a List of Bitcoin Organizations
Bitcoin (₿) is a cryptocurrency (see above), a form of electronic cash. It is a decentralized digital currency without a central bank or single administrator that can be sent from user to user on the peer-to-peer bitcoin network without the need for intermediaries.
Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain. Bitcoin was invented by an unknown person or group of people using the name Satoshi Nakamoto and released as open-source software in 2009.
Bitcoins are created as a reward for a process known as mining. They can be exchanged for other currencies, products, and services. Research produced by the University of Cambridge estimates that in 2017, there were 2.9 to 5.8 million unique users using a cryptocurrency wallet, most of them using bitcoin.
Bitcoin has been criticized for its use in illegal transactions, its high electricity consumption, price volatility, thefts from exchanges, and the possibility that bitcoin is an economic bubble. Bitcoin has also been used as an investment, although several regulatory agencies have issued investor alerts about bitcoin.
Click on any of the following blue hyperlinks for more about Bitcoins:
Cryptocurrency Wikipedia
Click here for a List of Cryptocurrencies.
Cryptocurrency (or crypto currency) is a digital asset designed to work as a medium of exchange that uses strong cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets.
Cryptocurrencies are a kind of alternative currency and digital currency (of which virtual currency is a subset). Cryptocurrencies use decentralized control as opposed to centralized digital currency and central banking systems. The decentralized control of each cryptocurrency works through distributed ledger technology, typically a blockchain, that serves as a public financial transaction database.
Bitcoin (see next topic) first released as open-source software in 2009, is generally considered the first decentralized cryptocurrency. Since the release of Bitcoin, over 4,000 altcoins (alternative variants of Bitcoin, or other cryptocurrencies) have been created.
Click on any of the following blue hyperlinks for more about Crytocurrency:
- History
- Formal definition
- Architecture
- Blockchain including Timestamping
- Mining including GPU price rise
- Wallets
- Anonymity
- Fungibility
- Economics
- Legality
- Reception
- See also:
- 2018 crypto crash
- Cryptocurrency bubble
- Cryptocurrency exchange
- Cryptographic protocol
- Virtual currency law in the United States
- Media related to Cryptocurrency at Wikimedia Commons
Forbes Magazine (6/6/2022)
What is Cryptocurrency?
Cryptocurrency is decentralized digital money that’s based on blockchain technology. You may be familiar with the most popular versions, Bitcoin and Ethereum, but there are more than 19,000 different cryptocurrencies in circulation.
How Does Cryptocurrency Work?
A cryptocurrency is a digital, encrypted, and decentralized medium of exchange. Unlike the U.S. Dollar or the Euro, there is no central authority that manages and maintains the value of a cryptocurrency. Instead, these tasks are broadly distributed among a cryptocurrency’s users via the internet.
You can use crypto to buy regular goods and services, although most people invest in cryptocurrencies as they would in other assets, like stocks or precious metals. While cryptocurrency is a novel and exciting asset class, purchasing it can be risky as you must take on a fair amount of research to understand how each system works fully.
Bitcoin was the first cryptocurrency, first outlined in principle by Satoshi Nakamoto in a 2008 paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” Nakamoto described the project as “an electronic payment system based on cryptographic proof instead of trust.”
That cryptographic proof comes in the form of transactions that are verified and recorded on a blockchain.
What Is a Blockchain?
A blockchain is an open, distributed ledger that records transactions in code. In practice, it’s a little like a checkbook that’s distributed across countless computers around the world. Transactions are recorded in “blocks” that are then linked together on a “chain” of previous cryptocurrency transactions.
“Imagine a book where you write down everything you spend money on each day,” says Buchi Okoro, CEO and co-founder of African cryptocurrency exchange Quidax. “Each page is similar to a block, and the entire book, a group of pages, is a blockchain.”
With a blockchain, everyone who uses a cryptocurrency has their own copy of this book to create a unified transaction record. Each new transaction as it happens is logged, and every copy of the blockchain is updated simultaneously with the new information, keeping all records identical and accurate.
To prevent fraud, each transaction is checked using a validation technique, such as proof of work or proof of stake.
Proof of Work vs. Proof of Stake:
Proof of work and proof of stake are the two most widely used consensus mechanisms to verify transactions before adding them to a blockchain. Verifiers are then rewarded with cryptocurrency for their efforts.
Proof of Work:
“Proof of work is a method of verifying transactions on a blockchain in which an algorithm provides a mathematical problem that computers race to solve,” says Simon Oxenham, social media manager at Xcoins.com.
Each participating computer, often referred to as a “miner,” solves a mathematical puzzle that helps verify a group of transactions—referred to as a block—then adds them to the blockchain ledger. The first computer to do so successfully is rewarded with a small amount of cryptocurrency for its efforts.
Bitcoin, for example, rewards a miner 6.25 BTC (which is roughly $200,000) for validating a new block.
The race to solve blockchain puzzles can require intense computer power and electricity. That means the miners might barely break even with the crypto they receive for validating transactions after considering the costs of power and computing resources.
Proof of Stake:
Some cryptocurrencies use a proof of stake verification method to reduce the amount of power necessary to check transactions. With proof of stake, the number of transactions each person can verify is limited by the amount of cryptocurrency they’re willing to “stake,” or temporarily lock up in a communal safe for the chance to participate in the process.
“It’s almost like bank collateral,” says Okoro. Each person who stakes crypto is eligible to verify transactions, but the odds you’ll be chosen typically increase with the amount you front.
“Because proof of stake removes energy-intensive equation solving, it’s much more efficient than proof of work, allowing for faster verification/confirmation times for transactions,” says Anton Altement, CEO of Osom Finance.
In comparison, for example, the average transaction speed for Bitcoin is at least 10 minutes. Now compare that with Solana, a crypto platform that uses the proof-of-stake mechanism, which averages around 3,000 transactions per second (TPS), making it much faster than the sluggish Bitcoin blockchain.
Also on the horizon is Bitcoin’s biggest rival, Ethereum, is switching fully to a proof-of-stake mechanism. Ethereum estimates its energy usage will decrease by 99.95% once it closes “the final chapter of proof of work on Ethereum.”
The Role of Consensus in Crypto:
Both proof of stake and proof of work rely on consensus mechanisms to verify transactions.
This means while each uses individual users to verify transactions, each verified transaction must be checked and approved by the majority of ledger holders.
How Can You Mine Cryptocurrency?
Mining is how new units of cryptocurrency are released into the world, generally in exchange for validating transactions. While it’s theoretically possible for the average person to mine cryptocurrency, it’s increasingly difficult in proof-of-work systems, like Bitcoin.
“As the Bitcoin network grows, it gets more complicated, and more processing power is required,” says Spencer Montgomery, founder of Uinta Crypto Consulting. “The average consumer used to be able to do this, but now it’s just too expensive. There are too many people who have optimized their equipment and technology to outcompete.”
Proof-of-work cryptocurrencies also require huge amounts of energy to mine. For example, Bitcoin mining currently consumes electricity at an annualized rate of 127 terawatt-hours (TWh), which exceeds Norway’s entire annual electricity consumption.
While it’s impractical for the average person to earn crypto by mining in a proof of work system, the proof-of-stake model requires less high-powered computing as validators are chosen randomly based on the amount they stake. It does, however, require that you already own a cryptocurrency to participate. (If you have no crypto, you have nothing to stake.)
How Can You Use Cryptocurrency?
While there are a number of goods and services that you can buy with crypto, particularly with Litecoin, Bitcoin or Ethereum, you may also use crypto as an alternative investment option outside of stocks and bonds.
“The best-known crypto, Bitcoin, is a secure, decentralized currency that has become a store of value like gold,” says David Zeiler, a cryptocurrency expert at financial news site Money Morning. “Some people even refer to it as ‘digital gold.’”
How to Use Cryptocurrency for Secure Purchases:
Using crypto to make purchases securely depends on what you’re trying to buy.
If you’re trying to make a payment in cryptocurrency, you’ll most likely need a cryptocurrency wallet. One type of wallet is a “hot wallet,” a software program that interacts with the blockchain and allows users to send and receive their stored cryptocurrency.
Remember that transactions are not instantaneous as they must be validated by some form of mechanism.
Best Crypto Exchanges:
Cryptocurrencies can be purchased through crypto exchanges, such as Coinbase, Kraken or Gemini. They offer the ability to trade some of the most popular cryptocurrencies, including Bitcoin, Ethereum and Dogecoin. Still, they may also have limitations. You’ll have to check to see if your exchange supports the right crypto pairing you need to make a purchase.
For example, you can use your stash of USD Coin, a crypto stablecoin, to buy Ethereum on Coinbase Exchange.
“It was once fairly difficult but now it’s relatively easy, even for crypto novices,” Zeiler says. “An exchange like Coinbase caters to nontechnical folks. It’s very easy to set up an account there and link it to a bank account.”
Keep an eye out for fees, though, as some of these exchanges charge prohibitively high costs on small crypto purchases.
How to Invest in Cryptocurrency:
Some brokerage platforms—like Robinhood, Webull and eToro—let you invest in crypto. That’s in addition to crypto exchanges.
It’s best to keep in mind that buying individual cryptocurrencies are similar to buying individual stocks. In essence, they are risk assets.
If you want exposure to the crypto market, you might invest in individual stocks of crypto companies. “There are also a few Bitcoin mining stocks such as Hive Blockchain (HIVE),” says Zeiler. “If you want some crypto exposure with less risk, you can invest in big companies that are adopting blockchain technology, such as IBM, Bank of America and Microsoft.”
How Does Cryptocurrency Gain Value?
To illustrate how some cryptos can appreciate in value, let’s look at the ultimate crypto bellwether: Bitcoin.
Bitcoin nearly quadrupled in value throughout 2020, closing out the year above $28,900. By April 2021, the price of BTC had more than doubled from where it started the year, but all those gains had been lost by July. Then BTC more than doubled again, hitting an intraday high above $68,990 on November 10, 2021—and then dropped to around $46,000 at the end of 2021. As of early June 2022, Bitcoin trades for just over $31,000 per coin.
While the original crypto is down by 35% year to date, Bitcoin has seen an appreciation of more than 1,000% over the past five years.
Should You Invest in Cryptocurrency?
Experts hold mixed opinions about investing in cryptocurrency. Because crypto is a highly speculative investment, with the potential for intense price swings, some financial advisors don’t recommend people invest at all.
Pros and Cons of Cryptocurrency:
Peter Palion, a certified financial planner (CFP) in East Norwich, New York, thinks it’s safer to stick to a currency backed by a government, like the U.S. dollar.
“If you have the U.S. dollar in your cash reserves, you know you can pay your mortgage, you can pay your electricity bill,” Palion says. “When you look at the last 12 months, Bitcoin looks basically like my last EKG, and the U.S. dollar index is more or less a flat line.
Something that drops by 50% is not suitable for anything but speculation.”
That said, for clients who are specifically interested in cryptocurrency, Ian Harvey, a New York-based wealth advisor, helps them put some money into it. “The weight in a client’s portfolio should be large enough to feel meaningful while not derailing their long-term plan should the investment go to zero,” says Harvey.
As for how much to invest, Harvey talks to investors about what percentage of their portfolio they’re willing to lose if the investment goes south. “It could be 1% to 5%, it could be 10%,” he says. “It depends on how much they have now, and what’s really at stake for them, from a loss perspective.”
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10 Best Crypto Apps & Exchanges Of 2023:
By Forbes Advisor 2/1/2023
Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.
If you’re interested in buying cryptocurrency, you need to open an account with a crypto exchange. There are around 500 examples to choose from, and Forbes Advisor combed through the leading players to determine the best crypto exchanges for both new and experienced investors.
Why you can trust Forbes Advisor: Our editors are committed to bringing you unbiased ratings and information—our editorial content is not influenced by advertisers. We use data-driven methodologies to evaluate investing and retirement products, helping you to find the best accounts and assets for your money. You can read more about our editorial guidelines and the methodology for the ratings below.
Featured Forbes Partners:
- The Best Crypto Apps & Exchanges of February 2023
- Kraken
- Gemini
- Crypto.com
- KuCoin
- Coinbase
- The Best Crypto Apps & Exchanges for Beginners of February 2023
- Gemini
- BitYard
- Kraken
- Crypto.com
- Coinbase
- Best Crypto Apps & Exchanges - Explained
- Our Methodology
- What Is a Crypto Exchange and How Does It Work?
- Different Types of Crypto Exchanges
- Crypto Exchange Fees
- How to Choose a Crypto Exchange
Crypto Exchange FAQs
What is a crypto exchange? A crypto exchange is a marketplace where you can buy and sell cryptocurrencies, like Bitcoin, Ether or Dogecoin.
How does a crypto exchange work? Crypto exchanges work a lot like brokerage platforms, and each offers a portal where you can create different order types to buy, sell and speculate on cryptocurrencies with other users.
Crypto exchanges can be centralized, meaning they are managed by one corporate authority, like a brokerage company that facilitates the security of trades, or decentralized.
Decentralized exchanges generally distribute verification powers to anyone willing to join a network and certify transactions, much like cryptocurrency blockchains. This may help increase accountability and transparency and ensure an exchange can keep running if something happens to a company running an exchange.
How do you buy crypto? To buy cryptocurrency, open an account with a crypto exchange or an online brokerage that allows crypto trading. In addition, you’ll need a crypto wallet to hold your cryptocurrency, although your exchange may provide one.
Be careful when picking a crypto exchange. Some crypto trading apps, like PayPal or Venmo, do not let you transfer your coins off the platform. This is a major limitation for serious crypto investors.
Once you’ve picked an exchange and a wallet, you’ll be able to buy crypto by transferring U.S. dollars into your account via an ACH or wire transfer. You may even be able to buy crypto with a credit or debit card. However, this may carry additional fees, some of which can get quite high.
Some crypto exchanges will let you use other cryptocurrencies or their own branded stablecoins, like Binance Coin (BNB) on Binance.US, to fund transactions.
How much money do you need to buy crypto? Exchanges have different requirements, often depending on the type of cryptocurrency you want to buy.
You may be able to buy fractional shares of coins for pennies or just a few dollars. Be sure to check your chosen crypto exchange’s requirements for the coin you want to buy.
How do I open a crypto exchange account? To open a crypto exchange account, visit the exchange’s website or download its app.
Each crypto exchange has its own unique registration process. With some, you may be able to make an account and buy and sell small amounts of crypto without verifying your identity or submitting much sensitive information.
But as the industry has evolved, the U.S. government has introduced certain Know Your Customer regulations to prevent money laundering and fraud.
In general, you’ll need to provide:
- Name
- Date of birth
- Mailing address
- Social Security number.
You may also have to verify your identity by submitting a photo or scan of a government-issued ID.
Next Up in Crytocurrency:
- What Is Ethereum And How Does It Work?
- An Introduction to Dogecoin, The Meme Cryptocurrency
- Meet Ripple & XRP, Cryptocurrency For Banks
- Coinbase IPO: Here’s What You Need To Know
- Are Bitcoin and Gold Good Investments?
[End of Forbes articles]
___________________________________________________________________________
Wikipedia Articles:
Bitcoin:
Click here for a List of Bitcoin Companies
Click here for a List of Bitcoin Organizations
Bitcoin (₿) is a cryptocurrency (see above), a form of electronic cash. It is a decentralized digital currency without a central bank or single administrator that can be sent from user to user on the peer-to-peer bitcoin network without the need for intermediaries.
Transactions are verified by network nodes through cryptography and recorded in a public distributed ledger called a blockchain. Bitcoin was invented by an unknown person or group of people using the name Satoshi Nakamoto and released as open-source software in 2009.
Bitcoins are created as a reward for a process known as mining. They can be exchanged for other currencies, products, and services. Research produced by the University of Cambridge estimates that in 2017, there were 2.9 to 5.8 million unique users using a cryptocurrency wallet, most of them using bitcoin.
Bitcoin has been criticized for its use in illegal transactions, its high electricity consumption, price volatility, thefts from exchanges, and the possibility that bitcoin is an economic bubble. Bitcoin has also been used as an investment, although several regulatory agencies have issued investor alerts about bitcoin.
Click on any of the following blue hyperlinks for more about Bitcoins:
Banking Regulation in the United States, including the Causes of the 2010 Stock Market Crash
- YouTube Video: The Fed Explains Bank Supervision and Regulation
- YouTube Video: Warren Buffett on Bank Regulation
- YouTube Video: The 2010 Flash Crash explained | Financial Times Markets
Amplification of above image by Bloomberg Opinion:
"Guy Trading at Home Caused the Flash Crash:
Also he was pretty obvious about spoofing for five years, but got away with it by being rude.
By Matt Levine
April 21, 2015, 5:37 PM CDT
Hey look, they caught the guy who caused the flash crash of 2010! His name is Navinder Singh Sarao, and he lives in London and in 2009 he asked someone to help him build a spoofing robot:
On or about June 12, 2009, SARAO sent an email to a representative of his FCM in which he explained that he "need[ed] to get in touch with a technician at the company that provided his trading software ("Trading Software Company #1")] that will be able to program for me extra features on [the software]," namely, "a cancel if close function, so that an order is canceled if the market gets close."
Sarao was trading E-mini S&P 500 futures contracts, but he wanted a more convenient way to not trade them, so he e-mailed his FCM (futures commission merchant, i.e. broker) for help automating that. The idea is that he would put in a big order to sell a whole bunch of futures at a price a few ticks higher than the best offer. So probably he wouldn't sell any futures, since he wasn't offering the best price.
But Sarao had to keep constantly updating his orders to keep them a few ticks higher than the best offer, to make sure that he didn't accidentally sell any futures as the market moved. And that's a bit of a pain, so he programmed an algorithm to do it for him. Though he also seems to have done similar things manually, to support the algorithm's efforts, or to stave off boredom while the algorithm did its thing. 1
The point of this -- according to the federal prosecutors, the Federal Bureau of Investigation and the Commodity Futures Trading Commission, who are not happy with Sarao -- is that by placing all these fake sell orders, Sarao would artificially drive down the price of the E-mini futures.
It's classic spoofing: He'd place a lot of big orders to sell, everyone else would say, "Ooh look at all those big sell orders, I'd better sell too," they'd sell, the market would go down, he'd buy, he'd turn off his algorithm, everyone else would say, "Oh hey never mind, things are great again, there are no more big sell orders," they'd buy, the price would go back up, and Sarao would sell the futures he'd bought at a lower price a moment ago.
We've talked about spoofing before, and I've always been a little troubled that it works, but what can I say, it works.
On May 6, 2010, according to the authorities, it worked a little too well: Sarao did such a good job of driving down the price of the E-mini future that he caused a flash crash in which "investors saw nearly $1 trillion of value erased from U.S. stocks in just minutes." I'll put some more details downstairs but honestly they are boring details.
Sarao traded a ton of E-mini futures during the flash crash -- "62,077 E-mini S&P contracts with a notional value of $3.5 billion" -- and made "approximately $879,018 in net profits" that day, or a profit of about 2.5 basis points on the notional amount, which I guess isn't bad for one day's work. He did this by, basically, putting in orders to sell thousands of contracts away from the best offer. Those orders were never executed, or intended to be executed, but they tricked people into thinking that there was a lot more selling interest than there actually was.
That combined with a collapse in buying interest -- at one point Sarao's fake sell orders alone "were almost equal to the entire buyside of the Order Book" -- to create a collapse in prices. He profited from those collapsing prices by selling high and buying back lower. It's a pretty straightforward spoofing story.
So straightforward that one of the biggest puzzles here is why it took so long -- and the help of a whistleblower -- for regulators to figure it out. They came tantalizingly close.
As reflected in correspondence with both SARAO and an FCM he used, the CME observed that, between September 2008 and October 2009, SARAO had engaged in pre-opening activity -- specifically, entering orders and then canceling them -- that "appeared to have a significant impact on the Indicative Opening Price."
The CME contacted SARAO about this activity in March 2009 and notified him, via correspondence dated May 6, 2010, that "all orders entered on Globex during the pre-opening are expected to be entered in good faith for the purpose of executing bona fide transactions."
The CME provided a copy of the latter correspondence to SARAO's FCM, which suggested to SARAO in an email that he call the FCM's compliance department if he had any questions.
In a responsive email dated May 25, 2010, SARAO wrote to his FCM that he had "just called" the CME "and told em to kiss my ass."
Emphasis added because come on: The futures exchange wrote to Sarao on the day of the flash crash, telling him to stop spoofing, and he called them back "and told em to kiss my ass." And then regulators pondered that reply for five years before deciding that they'd prefer to have him arrested in London and extradited to face criminal spoofing charges. One conclusion here might be that rudeness to regulators really works.
Even odder, Sarao didn't just retire to a supervillain lair after the flash crash. The CFTC lists "at least" 12 days on which he allegedly manipulated the futures market; eight of them came after the flash crash, and he allegedly continued to manipulate the futures market more or less up to the moment he was arrested. The CFTC claims that Sarao basically started his spoofing career by causing the flash crash, and then went ahead and kept spoofing for another five years without much interruption.
I guess he got more subtle at it? Not very subtle though; he was a consistently large trader, "placing, repeatedly modifying, and ultimately canceling multiple 200-, 250-, 300-, 400-, 500-, 550-, 600-, and 900-lot sell orders," versus an average order size of seven contracts. He also seems to have had some patterns (like putting in orders for exactly 188 or 289 contracts that never executed) that you'd think would make him easier for regulators or exchanges to spot.
If regulators think that Sarao's behavior on May 6, 2010, caused the flash crash, and if they think he continued that behavior for much of the subsequent five years, and if that behavior was screamingly obvious, maybe they should have stopped him a little earlier?
Also, I mean, if his behavior on May 6, 2010, caused the flash crash, and if he continued it for much of the subsequent five years, why didn't he cause, you know, a dozen flash crashes?
So I mean ... maybe he didn't cause the flash crash? There's a joint CFTC and Securities and Exchange Commission report that came out a few months after the flash crash that blames it on an effort by Waddell & Reed to sell some E-mini futures with an inept algorithm; lots of people have long had their doubts about that theory, and now the CFTC itself seems to have abandoned it in favor of the new one-guy-in-London theory.
You could maintain a skeptical attitude about the one-guy-in-London theory too though. The CFTC says that Sarao's "Layering Algorithm" was turned on between 11:17 a.m. and 1:40 p.m. Central time, and that "the Layering Algorithm caused the price in the E-mini S&P contract to be temporarily artificially depressed while the Layering Algorithm was active.
Once the Layering Algorithm was turned off and the orders were canceled, the market price typically rebounded." But the CFTC also describes the flash crash this way: "Between 1:41 and 1:44 p.m. CT, the E-mini S&P market price suffered a sharp decline of 3%. Then, at 1:45 p.m. CT, in a matter of 15 seconds, the E-mini S&P market price declined another 1.7%. The price crash in the E-mini S&P market quickly spread to major U.S. equities indices which suffered precipitous declines in value of approximately 5 to 6%, with some individual equities suffering much larger declines."
[End of Opinion Piece by Bloomberg]
___________________________________________________________________________
Bank regulation in the United States is highly fragmented compared with other G10 countries, where most countries have only one bank regulator. In the U.S., banking is regulated at both the federal and state level. Depending on the type of charter a banking organization has and on its organizational structure, it may be subject to numerous federal and state banking regulations.
Apart from the bank regulatory agencies the U.S. maintains separate securities, commodities, and insurance regulatory agencies at the federal and state level, unlike Japan and the United Kingdom (where regulatory authority over the banking, securities and insurance industries is combined into one single financial-service agency). Bank examiners are generally employed to supervise banks and to ensure compliance with regulations.
U.S. banking regulation addresses privacy, disclosure, fraud prevention, anti-money laundering, anti-terrorism, anti-usury lending, and the promotion of lending to lower-income populations. Some individual cities also enact their own financial regulation laws (for example, defining what constitutes usurious lending).
Click on any of the following blue hyperlinks for more about Banking Regulation in the United States:
2010 Flash Crash
The May 6, 2010, Flash Crash, also known as the Crash of 2:45, the 2010 Flash Crash or simply the Flash Crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes. Stock indices, such as the S&P 500, Dow Jones Industrial Average and Nasdaq Composite, collapsed and rebounded very rapidly.
The Dow Jones Industrial Average had its second biggest intra-day point drop (from the opening) up to that point, plunging 998.5 points (about 9%), most within minutes, only to recover a large part of the loss. It was also the second-largest intra-day point swing (difference between intra-day high and intra-day low) up to that point, at 1,010.14 points.
The prices of stocks, stock index futures, options and exchange-traded funds (ETFs) were volatile, thus trading volume spiked. A CFTC 2014 report described it as one of the most turbulent periods in the history of financial markets.
When new regulations put in place following the 2010 Flash Crash proved to be inadequate to protect investors in the August 24, 2015 flash crash—"when the price of many ETFs appeared to come unhinged from their underlying value"—ETFs were put under greater scrutiny by regulators and investors.
On April 21, 2015, nearly five years after the incident, the U.S. Department of Justice laid "22 criminal counts, including fraud and market manipulation" against Navinder Singh Sarao, a trader (see opening article, above).
Among the charges included was the use of spoofing algorithms; just prior to the Flash Crash, he placed thousands of E-mini S&P 500 stock index futures contracts which he planned on canceling later. These orders amounting to about "$200 million worth of bets that the market would fall" were "replaced or modified 19,000 times" before they were canceled. Spoofing, layering, and front running are now banned.
The Commodity Futures Trading Commission (CFTC) investigation concluded that Sarao "was at least significantly responsible for the order imbalances" in the derivatives market which affected stock markets and exacerbated the flash crash. Sarao began his alleged market manipulation in 2009 with commercially available trading software whose code he modified "so he could rapidly place and cancel orders automatically."
Traders Magazine journalist, John Bates, argued that blaming a 36-year-old small-time trader who worked from his parents' modest stucco house in suburban west London for sparking a trillion-dollar stock market crash is "a little bit like blaming lightning for starting a fire" and that the investigation was lengthened because regulators used "bicycles to try and catch Ferraris." Furthermore, he concluded that by April 2015, traders can still manipulate and impact markets in spite of regulators and banks' new, improved monitoring of automated trade systems.
As recently as May 2014, a CFTC report concluded that high-frequency traders "did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants."
Some recent peer-reviewed research shows that flash crashes are not isolated occurrences, but have occurred quite often. Gao and Mizrach studied US equities over the period of 1993–2011. They show that breakdowns in market quality (such as flash crashes) have occurred in every year they examined and that, apart from the financial crisis, such problems have declined since the introduction of Reg NMS. They also show that 2010, while infamous for the Flash Crash, was not a year with an inordinate number of breakdowns in market quality.
Click on any of the following blue hyperlinks for more about the "2010 Flash Crash":
"Guy Trading at Home Caused the Flash Crash:
Also he was pretty obvious about spoofing for five years, but got away with it by being rude.
By Matt Levine
April 21, 2015, 5:37 PM CDT
Hey look, they caught the guy who caused the flash crash of 2010! His name is Navinder Singh Sarao, and he lives in London and in 2009 he asked someone to help him build a spoofing robot:
On or about June 12, 2009, SARAO sent an email to a representative of his FCM in which he explained that he "need[ed] to get in touch with a technician at the company that provided his trading software ("Trading Software Company #1")] that will be able to program for me extra features on [the software]," namely, "a cancel if close function, so that an order is canceled if the market gets close."
Sarao was trading E-mini S&P 500 futures contracts, but he wanted a more convenient way to not trade them, so he e-mailed his FCM (futures commission merchant, i.e. broker) for help automating that. The idea is that he would put in a big order to sell a whole bunch of futures at a price a few ticks higher than the best offer. So probably he wouldn't sell any futures, since he wasn't offering the best price.
But Sarao had to keep constantly updating his orders to keep them a few ticks higher than the best offer, to make sure that he didn't accidentally sell any futures as the market moved. And that's a bit of a pain, so he programmed an algorithm to do it for him. Though he also seems to have done similar things manually, to support the algorithm's efforts, or to stave off boredom while the algorithm did its thing. 1
The point of this -- according to the federal prosecutors, the Federal Bureau of Investigation and the Commodity Futures Trading Commission, who are not happy with Sarao -- is that by placing all these fake sell orders, Sarao would artificially drive down the price of the E-mini futures.
It's classic spoofing: He'd place a lot of big orders to sell, everyone else would say, "Ooh look at all those big sell orders, I'd better sell too," they'd sell, the market would go down, he'd buy, he'd turn off his algorithm, everyone else would say, "Oh hey never mind, things are great again, there are no more big sell orders," they'd buy, the price would go back up, and Sarao would sell the futures he'd bought at a lower price a moment ago.
We've talked about spoofing before, and I've always been a little troubled that it works, but what can I say, it works.
On May 6, 2010, according to the authorities, it worked a little too well: Sarao did such a good job of driving down the price of the E-mini future that he caused a flash crash in which "investors saw nearly $1 trillion of value erased from U.S. stocks in just minutes." I'll put some more details downstairs but honestly they are boring details.
Sarao traded a ton of E-mini futures during the flash crash -- "62,077 E-mini S&P contracts with a notional value of $3.5 billion" -- and made "approximately $879,018 in net profits" that day, or a profit of about 2.5 basis points on the notional amount, which I guess isn't bad for one day's work. He did this by, basically, putting in orders to sell thousands of contracts away from the best offer. Those orders were never executed, or intended to be executed, but they tricked people into thinking that there was a lot more selling interest than there actually was.
That combined with a collapse in buying interest -- at one point Sarao's fake sell orders alone "were almost equal to the entire buyside of the Order Book" -- to create a collapse in prices. He profited from those collapsing prices by selling high and buying back lower. It's a pretty straightforward spoofing story.
So straightforward that one of the biggest puzzles here is why it took so long -- and the help of a whistleblower -- for regulators to figure it out. They came tantalizingly close.
As reflected in correspondence with both SARAO and an FCM he used, the CME observed that, between September 2008 and October 2009, SARAO had engaged in pre-opening activity -- specifically, entering orders and then canceling them -- that "appeared to have a significant impact on the Indicative Opening Price."
The CME contacted SARAO about this activity in March 2009 and notified him, via correspondence dated May 6, 2010, that "all orders entered on Globex during the pre-opening are expected to be entered in good faith for the purpose of executing bona fide transactions."
The CME provided a copy of the latter correspondence to SARAO's FCM, which suggested to SARAO in an email that he call the FCM's compliance department if he had any questions.
In a responsive email dated May 25, 2010, SARAO wrote to his FCM that he had "just called" the CME "and told em to kiss my ass."
Emphasis added because come on: The futures exchange wrote to Sarao on the day of the flash crash, telling him to stop spoofing, and he called them back "and told em to kiss my ass." And then regulators pondered that reply for five years before deciding that they'd prefer to have him arrested in London and extradited to face criminal spoofing charges. One conclusion here might be that rudeness to regulators really works.
Even odder, Sarao didn't just retire to a supervillain lair after the flash crash. The CFTC lists "at least" 12 days on which he allegedly manipulated the futures market; eight of them came after the flash crash, and he allegedly continued to manipulate the futures market more or less up to the moment he was arrested. The CFTC claims that Sarao basically started his spoofing career by causing the flash crash, and then went ahead and kept spoofing for another five years without much interruption.
I guess he got more subtle at it? Not very subtle though; he was a consistently large trader, "placing, repeatedly modifying, and ultimately canceling multiple 200-, 250-, 300-, 400-, 500-, 550-, 600-, and 900-lot sell orders," versus an average order size of seven contracts. He also seems to have had some patterns (like putting in orders for exactly 188 or 289 contracts that never executed) that you'd think would make him easier for regulators or exchanges to spot.
If regulators think that Sarao's behavior on May 6, 2010, caused the flash crash, and if they think he continued that behavior for much of the subsequent five years, and if that behavior was screamingly obvious, maybe they should have stopped him a little earlier?
Also, I mean, if his behavior on May 6, 2010, caused the flash crash, and if he continued it for much of the subsequent five years, why didn't he cause, you know, a dozen flash crashes?
So I mean ... maybe he didn't cause the flash crash? There's a joint CFTC and Securities and Exchange Commission report that came out a few months after the flash crash that blames it on an effort by Waddell & Reed to sell some E-mini futures with an inept algorithm; lots of people have long had their doubts about that theory, and now the CFTC itself seems to have abandoned it in favor of the new one-guy-in-London theory.
You could maintain a skeptical attitude about the one-guy-in-London theory too though. The CFTC says that Sarao's "Layering Algorithm" was turned on between 11:17 a.m. and 1:40 p.m. Central time, and that "the Layering Algorithm caused the price in the E-mini S&P contract to be temporarily artificially depressed while the Layering Algorithm was active.
Once the Layering Algorithm was turned off and the orders were canceled, the market price typically rebounded." But the CFTC also describes the flash crash this way: "Between 1:41 and 1:44 p.m. CT, the E-mini S&P market price suffered a sharp decline of 3%. Then, at 1:45 p.m. CT, in a matter of 15 seconds, the E-mini S&P market price declined another 1.7%. The price crash in the E-mini S&P market quickly spread to major U.S. equities indices which suffered precipitous declines in value of approximately 5 to 6%, with some individual equities suffering much larger declines."
[End of Opinion Piece by Bloomberg]
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Bank regulation in the United States is highly fragmented compared with other G10 countries, where most countries have only one bank regulator. In the U.S., banking is regulated at both the federal and state level. Depending on the type of charter a banking organization has and on its organizational structure, it may be subject to numerous federal and state banking regulations.
Apart from the bank regulatory agencies the U.S. maintains separate securities, commodities, and insurance regulatory agencies at the federal and state level, unlike Japan and the United Kingdom (where regulatory authority over the banking, securities and insurance industries is combined into one single financial-service agency). Bank examiners are generally employed to supervise banks and to ensure compliance with regulations.
U.S. banking regulation addresses privacy, disclosure, fraud prevention, anti-money laundering, anti-terrorism, anti-usury lending, and the promotion of lending to lower-income populations. Some individual cities also enact their own financial regulation laws (for example, defining what constitutes usurious lending).
Click on any of the following blue hyperlinks for more about Banking Regulation in the United States:
- Regulatory authority
- Privacy
- Anti-money laundering and anti-terrorism
- Community reinvestment
- Deposit account regulation
- Lending regulation
- Central banking regulation
- Regulation of bank affiliates and holding companies
- 2018 deregulation announcement
- See also:
- Bank regulation
- Financial privacy laws in the United States
- FRB Regulations
- Kaufman, George G. (2002). "Deposit Insurance". In Henderson, David R. (ed.). Concise Encyclopedia of Economics (1st ed.). Library of Economics and Liberty. OCLC 317650570.
- Banking laws and legislation dating back to the first Bank of the United States
2010 Flash Crash
The May 6, 2010, Flash Crash, also known as the Crash of 2:45, the 2010 Flash Crash or simply the Flash Crash, was a United States trillion-dollar stock market crash, which started at 2:32 p.m. EDT and lasted for approximately 36 minutes. Stock indices, such as the S&P 500, Dow Jones Industrial Average and Nasdaq Composite, collapsed and rebounded very rapidly.
The Dow Jones Industrial Average had its second biggest intra-day point drop (from the opening) up to that point, plunging 998.5 points (about 9%), most within minutes, only to recover a large part of the loss. It was also the second-largest intra-day point swing (difference between intra-day high and intra-day low) up to that point, at 1,010.14 points.
The prices of stocks, stock index futures, options and exchange-traded funds (ETFs) were volatile, thus trading volume spiked. A CFTC 2014 report described it as one of the most turbulent periods in the history of financial markets.
When new regulations put in place following the 2010 Flash Crash proved to be inadequate to protect investors in the August 24, 2015 flash crash—"when the price of many ETFs appeared to come unhinged from their underlying value"—ETFs were put under greater scrutiny by regulators and investors.
On April 21, 2015, nearly five years after the incident, the U.S. Department of Justice laid "22 criminal counts, including fraud and market manipulation" against Navinder Singh Sarao, a trader (see opening article, above).
Among the charges included was the use of spoofing algorithms; just prior to the Flash Crash, he placed thousands of E-mini S&P 500 stock index futures contracts which he planned on canceling later. These orders amounting to about "$200 million worth of bets that the market would fall" were "replaced or modified 19,000 times" before they were canceled. Spoofing, layering, and front running are now banned.
The Commodity Futures Trading Commission (CFTC) investigation concluded that Sarao "was at least significantly responsible for the order imbalances" in the derivatives market which affected stock markets and exacerbated the flash crash. Sarao began his alleged market manipulation in 2009 with commercially available trading software whose code he modified "so he could rapidly place and cancel orders automatically."
Traders Magazine journalist, John Bates, argued that blaming a 36-year-old small-time trader who worked from his parents' modest stucco house in suburban west London for sparking a trillion-dollar stock market crash is "a little bit like blaming lightning for starting a fire" and that the investigation was lengthened because regulators used "bicycles to try and catch Ferraris." Furthermore, he concluded that by April 2015, traders can still manipulate and impact markets in spite of regulators and banks' new, improved monitoring of automated trade systems.
As recently as May 2014, a CFTC report concluded that high-frequency traders "did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants."
Some recent peer-reviewed research shows that flash crashes are not isolated occurrences, but have occurred quite often. Gao and Mizrach studied US equities over the period of 1993–2011. They show that breakdowns in market quality (such as flash crashes) have occurred in every year they examined and that, apart from the financial crisis, such problems have declined since the introduction of Reg NMS. They also show that 2010, while infamous for the Flash Crash, was not a year with an inordinate number of breakdowns in market quality.
Click on any of the following blue hyperlinks for more about the "2010 Flash Crash":
- Background
- Explanation
- Aftermath
- See also:
- List of largest daily changes in the Dow Jones Industrial Average
- High-frequency trading
- Algorithmic trading
- Interactive Intraday Chart of the SP500 Index on May 6, 2010, University of Toronto, May 6, 2010
- Preliminary Findings Regarding the Market Events of May 6, 2010, Report of the staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, May 18, 2010
- Findings Regarding the Market Events of May 6, 2010, Report of the staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, September 30, 2010
- The Microstructure of the ‘Flash Crash’: Flow Toxicity, Liquidity Crashes and the Probability of Informed Trading, David Easley (Cornell University), Marcos López de Prado (Tudor Investment Corp., RCC at Harvard University) and Maureen O'Hara (Cornell University), The Journal of Portfolio Management, Vol. 37, No. 2, pp. 118–128, Winter 2011
- The Flash Crash: The Impact of High Frequency Trading on an Electronic Market, Andrei A. Kirilenko (Commodity Futures Trading Commission) Albert S. Kyle (University of Maryland; National Bureau of Economic Research (NBER)) Mehrdad Samadi (Commodity Futures Trading Commission) Tugkan Tuzun (University of Maryland—Robert H. Smith School of Business), October 1, 2010
- Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency, Technical Committee of the International Organization of Securities Commissions, July 2011
- An Agent-Based Model of the Flash Crash of May 6, 2010, with Policy Implications, Tommi A. Vuorenmaa (Valo Research and Trading), Liang Wang (University of Helsinki – Department of Computer Science), October 2013
- SEC Regulation NMS (Final Rule)
- 17 CFR 242.606 - Disclosure of order routing information
- SEC FAQs re Reg NMS Rule 610 and 611 - April 4, 2008 Update
- SEC FAQs re Reg NMS Rule 610 and 611
- Reg NMS Marketing Fact Sheet, from Nasdaq
- SEC Release Regarding the Proposed Rule
- Reg NMS - Securities Lawyer's Deskbook by The University of Cincinnati College of Law
U.S. Commodity Futures Trading Commission
(CFTC) @ (Website)
(CFTC) @ (Website)
- YouTube Video: U.S. Commodity Futures Trading Commission
- YouTube Video: Derivatives Explained
- YouTube Video: Learning How To Trade Just Got Cheaper
The U.S. Commodity Futures Trading Commission (CFTC) is an independent agency of the US government created in 1974, that regulates the U.S. derivatives markets, which includes futures, swaps, and certain kinds of options.
The Commodity Exchange Act ("CEA"), 7 U.S.C. § 1 et seq., prohibits fraudulent conduct in the trading of futures, swaps, and other derivatives.
The stated mission of the CFTC is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation. After the financial crisis of 2007–2008 and since 2010 with the Dodd–Frank Wall Street Reform and Consumer Protection Act, CFTC has been transitioning to bring more transparency and sound regulation to the multitrillion dollar swaps market.
Regulated Markets:
The CFTC oversees the derivatives markets by encouraging their competitiveness and efficiency, ensuring their integrity, protecting market participants against manipulation, abusive trading practices, fraud, and ensuring the financial integrity of the clearing process.
The CFTC generally does not directly regulate the safety and soundness of individual firms, with the exception of newly regulated swap dealers and major swap participants, for whom it sets capital standards pursuant to Dodd-Frank. Through oversight, the CFTC enables the derivatives markets to serve the function of price discovery and offsetting price risk.
As of 2014 the CFTC oversees 'designated contract markets' (DCMs) or exchanges, swap execution facilities (SEFs), derivatives clearing organizations, swap data repositories (SDRs), swap dealers, futures commission merchants, commodity pool operators and other intermediaries. The CFTC coordinates its work with foreign regulators, such as its UK counterpart, the Financial Conduct Authority, which supervises the London Metal Exchange.
Over-the-counter derivatives:
In 1998 CFTC chairperson Brooksley E. Born lobbied Congress and the President to give the CFTC oversight of 'off-exchange markets' for over-the-counter (OTC) derivatives in addition to its existing oversight of exchange-traded derivatives, but her warnings were opposed by other regulators.
Two actions by the CFTC in 1998 led some market participants to express concerns that the CFTC might modify the "Swap Exemption" and attempt to impose new regulations on the swaps market. First, in a February 1998 comment letter addressing the SEC's "broker-dealer lite" proposal, the CFTC stated that the SEC's proposal would create the potential for conflict with the Commodity Exchange Act (CEA) to the extent that certain OTC derivative instruments fall within the ambit of the CEA and are subject to the exclusive statutory authority of the CFTC.
In May 1998 the CFTC issued a 'concept release' requesting comment on whether regulation of OTC derivatives markets was appropriate and, if so, what form such regulation should take. Legislation enacted in 1999 at the request of the US Treasury, the Federal Reserve Board, and the SEC limited the CFTC's rulemaking authority with respect to swaps and hybrid instruments until March 30, 1999, and froze the pre-existing legal status of swap agreements and hybrid instruments entered into in reliance on the 'Swap Exemption', the 'Hybrid Instrument Rule', the 'Swap Policy Statement, or the 'Hybrid Interpretation'.
The text of that act read: "...the Commission may not propose or issue any rule or regulation, or issue any interpretation or policy statement, that restricts or regulates activity in a qualifying hybrid instrument or swap agreement". Shortly after Congress had passed this legislation prohibiting CFTC from regulating derivatives, Born resigned. She later commented the failure of Long-Term Capital Management and the subsequent bailout as being indicative what she had been trying to prevent.
Regulating digital currencies:
In March 2014 the CFTC acknowledged it was considering the regulation of Bitcoin. The CFTC has since taken the position that Bitcoin is a commodity under the CEA. In October 2019, CFTC Chairman Heath Tarbert declared that ether was also a commodity under the CEA.
In 2015, the CFTC ruled that for purposes of trading, cryptocurrencies were legally classified as commodities. However, in view of market volatility and other factors, the CFTC noted several risks associated with trading virtual currencies. In 2017, the CFTC cited the US SEC’s warning against digital token sales and initial coin offerings (ICOs) that can “improperly entice investors with promises of high returns”. In recent years, the CFTC has expanded its efforts to civilly prosecute fraud and misappropriation in the digital asset markets.
Click on any of the following blue hyperlinks for more about the Commodity Futures Trading Commission (CFTC):
The Commodity Exchange Act ("CEA"), 7 U.S.C. § 1 et seq., prohibits fraudulent conduct in the trading of futures, swaps, and other derivatives.
The stated mission of the CFTC is to promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation. After the financial crisis of 2007–2008 and since 2010 with the Dodd–Frank Wall Street Reform and Consumer Protection Act, CFTC has been transitioning to bring more transparency and sound regulation to the multitrillion dollar swaps market.
Regulated Markets:
The CFTC oversees the derivatives markets by encouraging their competitiveness and efficiency, ensuring their integrity, protecting market participants against manipulation, abusive trading practices, fraud, and ensuring the financial integrity of the clearing process.
The CFTC generally does not directly regulate the safety and soundness of individual firms, with the exception of newly regulated swap dealers and major swap participants, for whom it sets capital standards pursuant to Dodd-Frank. Through oversight, the CFTC enables the derivatives markets to serve the function of price discovery and offsetting price risk.
As of 2014 the CFTC oversees 'designated contract markets' (DCMs) or exchanges, swap execution facilities (SEFs), derivatives clearing organizations, swap data repositories (SDRs), swap dealers, futures commission merchants, commodity pool operators and other intermediaries. The CFTC coordinates its work with foreign regulators, such as its UK counterpart, the Financial Conduct Authority, which supervises the London Metal Exchange.
Over-the-counter derivatives:
In 1998 CFTC chairperson Brooksley E. Born lobbied Congress and the President to give the CFTC oversight of 'off-exchange markets' for over-the-counter (OTC) derivatives in addition to its existing oversight of exchange-traded derivatives, but her warnings were opposed by other regulators.
Two actions by the CFTC in 1998 led some market participants to express concerns that the CFTC might modify the "Swap Exemption" and attempt to impose new regulations on the swaps market. First, in a February 1998 comment letter addressing the SEC's "broker-dealer lite" proposal, the CFTC stated that the SEC's proposal would create the potential for conflict with the Commodity Exchange Act (CEA) to the extent that certain OTC derivative instruments fall within the ambit of the CEA and are subject to the exclusive statutory authority of the CFTC.
In May 1998 the CFTC issued a 'concept release' requesting comment on whether regulation of OTC derivatives markets was appropriate and, if so, what form such regulation should take. Legislation enacted in 1999 at the request of the US Treasury, the Federal Reserve Board, and the SEC limited the CFTC's rulemaking authority with respect to swaps and hybrid instruments until March 30, 1999, and froze the pre-existing legal status of swap agreements and hybrid instruments entered into in reliance on the 'Swap Exemption', the 'Hybrid Instrument Rule', the 'Swap Policy Statement, or the 'Hybrid Interpretation'.
The text of that act read: "...the Commission may not propose or issue any rule or regulation, or issue any interpretation or policy statement, that restricts or regulates activity in a qualifying hybrid instrument or swap agreement". Shortly after Congress had passed this legislation prohibiting CFTC from regulating derivatives, Born resigned. She later commented the failure of Long-Term Capital Management and the subsequent bailout as being indicative what she had been trying to prevent.
Regulating digital currencies:
In March 2014 the CFTC acknowledged it was considering the regulation of Bitcoin. The CFTC has since taken the position that Bitcoin is a commodity under the CEA. In October 2019, CFTC Chairman Heath Tarbert declared that ether was also a commodity under the CEA.
In 2015, the CFTC ruled that for purposes of trading, cryptocurrencies were legally classified as commodities. However, in view of market volatility and other factors, the CFTC noted several risks associated with trading virtual currencies. In 2017, the CFTC cited the US SEC’s warning against digital token sales and initial coin offerings (ICOs) that can “improperly entice investors with promises of high returns”. In recent years, the CFTC has expanded its efforts to civilly prosecute fraud and misappropriation in the digital asset markets.
Click on any of the following blue hyperlinks for more about the Commodity Futures Trading Commission (CFTC):
- History
- Organization
- Funding/budget
- Primary exchanges monitored
- See also:
- Official website
- Commodity Futures Trading Commission in the Federal Register
- Commodity
- Federal Trade Commission
- Forex scam
- Hunter Wise Commodities
- Managed futures account
- Futures Industry Association, trade organization
- Securities market participants (United States)
- Title 17 of the Code of Federal Regulations
Digital Currency
- YouTube Video Bitcoin: Your Guide To Understanding Digital Currency
- YouTube Video: Facebook launches new digital currency
- YouTube Video: Investing Basics: Bitcoin and Blockchain TD Ameritrade
Click Here for a List of digital currencies
The rise of digital currency
OpEd by Tobias Adrian, Tommaso Mancini-Griffoli 09 September 2019
New entrants are vying to occupy the space once used by paper bills. This column, part of the VoxEU debate on the future of digital money, proposes a simple framework to make sense of who is attempting to pry our wallets open.
It argues that the adoption of new digital means of payment could be rapid and bring significant benefits to customers and society, but that the risks must be tackled with innovative approaches and heightened collaboration across borders and sectors.
One approach is for central banks to engage in a public–private partnership with fintech firms to provide a safe, liquid, and digital alternative to cash: synthetic central bank digital currency.
A battle is raging…for your wallet. With sharp elbows, new entrants are vying to occupy the space once used by paper bills, or that reserved for your debit card.
Alipay, Libra, M-Pesa, stablecoins – we first need to make sense of just who is attempting to pry our wallets open.
We propose a simple framework to do so.
We then argue that the adoption of new, digital means of payment could be rapid. It could bring significant benefits to customers and society, including efficiency gains in payments, greater competition, financial inclusion, and innovation in related sectors. But risks are also paramount to financial stability and integrity, monetary policy transmission, and anti-trust.
These must be tackled with innovative approaches and heightened collaboration across borders and sectors.
Policymakers will not be able to remain bystanders. In fact, their actions will influence the adoption of new means of payment, and their design. One approach is for central banks to engage in a public–private partnership with fintech firms to provide a safe, liquid, and digital alternative to cash – synthetic central bank digital currency, or sCBDC for short – which comes with its own benefits and risks.
The literature is quickly picking up on the potential disruption caused by new means of payment (e.g. Duffie 2019, BIS 2019).
A framework of analysis:
To help make sense of the plethora of new entrants in the payments space, we offer a simple classification scheme that we call the ‘Money Tree’ (Adrian and Mancini-Griffoli 2019). At its heart are four key features that help distinguish different forms of money: type, value, backstop, and technology. We illustrate this scheme in Figure 1 by contrasting bank deposits and stablecoins. Further details and discussions of other forms of money are in Adrian and Mancini-Griffoli (2019).
Figure 1 (above) Simplified money tree to classify different forms of money
Bank deposits are the most popular means of payment in many countries. These are claims on banks, as opposed to objects with intrinsic value. Bank deposits have fixed value to the extent they can be redeemed into currency – or cash – at face value.
Ten euros deposited in a bank can be redeemed against a ten-euro note with reasonable certainty in many countries. That is an incredibly useful feature, allowing payments in bank deposits to be made without concern for exchange rate risk.
Trust in the redemption guarantee rests on government backstops: deposit insurance, lender of last resort and emergency liquidity facilities, as well as careful supervision and oversight of banks. And finally, the settlement technology is usually centralised, as banks and central banks collaborate to maintain a shared ledger of account balances.
New means of payment such as stablecoins differ in important ways. Most stablecoins continue to be claims on the issuing institution. Many also offer redemption guarantees at face value – a coin bought for ten euros can be exchanged back for a ten-euro note (a sort of money-back guarantee).
However, trust in this pledge does not rest on government backstops. It must be generated privately by fully backing coin issuance with safe and liquid assets. Finally, the settlement technology is usually decentralised, based on the blockchain model.
Some stablecoins do not offer redemptions at fixed prices, but at market prices instead. We
say their value is variable relative to the domestic unit of account. This is the case of commodity tokens, such as gold coins, and of coins that are exchanged or redeemed for the going value of the assets backing them. One example is mutual fund shares written to digital tokens that can be readily exchanged. Libra may fit this model.
Stablecoin adoption:
Adoption of new forms of money will depend on their attractiveness as a store of value and means of payment. Cash fares well on the first count, and bank deposits on both. So why hold stablecoins? Why are stablecoins taking off? Why did USD Coin recently launch in 85 countries, Facebook invest heavily in Libra, and centralized variants of the stablecoin business model become so widespread? Consider that 90% of Kenyans over the age of 14 use M-Pesa and the value of Alipay and WeChat Pay transactions in China surpasses that of Visa and Mastercard worldwide combined.
The question is all the more intriguing as stablecoins are not an especially stable store of value. As discussed, they are a claim on a private institution whose viability could prevent it from honouring its pledge to redeem coins at face value. Stablecoin providers must generate trust through the prudent and transparent management of safe and liquid assets, as well as sound legal structures. In a way, this class of stablecoins is akin to constant net asset value funds which can break the buck – i.e. pay out less than their face value – as we found out during the global financial crisis.
However, the strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Also, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications by an active developer community given their open architecture, as opposed to the proprietary legacy systems of banks.
And, in many countries, stablecoins may be issued by firms benefitting from greater public trust than banks. Several of these advantages exist even when compared to cutting-edge payment solutions offered by banks called fast-payments.
But the real enticement comes from the networks that promise to make transacting as easy as using social media. Economists beware: payments are not the mere act of extinguishing a debt. They are a fundamentally social experience tying people together. Stablecoins are better integrated into our digital lives and designed by firms that live and breathe user-centric design.
And they may be issued by large technology firms that already benefit from enormous global user bases over which new payment services could spread like wildfire. Network effects – the gains to a new user growing exponentially with the number of users – can be staggering.
Take WhatsApp, for instance, which grew to nearly 2 billion users in ten years without any advertisement, based only on word of mouth!
Risks of stablecoins:
Risks are multiple, though that is not an excuse for policymakers to throw in the towel. On the contrary, they must create an environment in which the benefits of technology can be reaped while minimizing risks, as discussed in Lipton (2019). Policymakers will need to be innovative themselves and to collaborate – across countries, but also across sectors. Central bankers, regulators, ministries of finance, antitrust authorities, currency issuers, and technology experts will need to speak a common language for a common purpose.
The first risk is to the disintermediation of banks, which could lose deposits to stablecoin providers. However, banks will try to compete by offering their own innovative solutions and higher interest on deposits. And stablecoin providers could recycle their funds back into the banking system or decide to engage themselves in maturity transformation by turning themselves into banks.
Second, we could face new monopolies. Tech giants could use their networks to shut out competitors and monetize information. At the heart of this power is proprietary access to data on customer transactions. We need new standards for data protection, control, and ownership.
Third, there is a threat to weaker currencies. In countries with high inflation and weak institutions, people might give up local currencies for stablecoins in foreign currency. This would be a new form of ‘dollarisation’ and might undermine monetary policy, financial development, and economic growth. To avoid this, countries must improve their monetary and fiscal policies. The question is whether they can or should restrict foreign currency stablecoins in the interim.
Fourth, stablecoins could foster illicit activities. Providers must show how they will prevent the use of their networks for activities like money laundering and terrorist financing. This means complying with international standards. New technologies offer opportunities to improve monitoring. So, supervisors will need to adapt to the more fragmented value chain of stablecoins, including wallet providers, crypto exchanges, validation nodes, and investment vehicles.
The fifth risk is loss of ‘seigniorage’. Central banks have long captured, on behalf of taxpayers, the profits stemming from the difference between a currency’s face value and its cost of manufacture. Issuers could siphon off profits if their stablecoins do not carry interest but the hard currency backing them is invested at a return. One way to address this issue is to promote competition so issuers would eventually pay interest on coins.
Sixth, we must ensure consumer protection and financial stability. Customer funds need to be safe and protected from runs like the one that took down Lehman Brothers investment bank.
In part, this calls for legal clarity on what kind of financial instruments stablecoins represent.
One approach would be to regulate stablecoins like money market funds that guarantee fixed nominal returns, requiring providers to maintain sufficient liquidity and capital. We could call this the ‘shadow banking’ approach, which attempts to extend prudential regulation beyond the classic banking perimeter.
Synthetic central bank digital currency (sCBDC):
Another option is the ‘narrow banking’ approach. In this case, the central bank could require stablecoin providers to back coins with central bank reserves. The approach is not unheard of. The People’s Bank of China requires giant payment providers AliPay and WeChat Pay to abide by these standards, and central banks around the world are considering giving fintech companies access to their reserves – though only after satisfying a number of requirements related to financial integrity, interoperability, security, and data protection, among others.
Clearly, doing so would enhance the attractiveness of stablecoins as a store of value.
Competition with banks would only grow stronger. The social price tag is up for debate.
But there are also clearer-cut advantages of offering stablecoin providers access to central bank reserves:
A final consideration jumps out: if stablecoin providers held client assets in reserves at the central bank, clients would essentially be able to hold, and transact in, central bank liabilities. That, after all, is the essence of CBDC.3
Bingo! We have thus manufactured what we call synthetic CBDC (sCBDC). We remain, however, fully aware that the stablecoins are the liability of private-sector firms despite the public determining the size of central bank liabilities.
sCBDC offers significant advantages over its full-fledged cousin. The latter, discussed widely in the literature and envisioned by central banks, requires getting involved in many of the steps of the payments value chain. This can be costly and risky for central banks. Steps include interfacing with users and managing brand reputation; complying with integrity standards; offering clients an interface to hold and trade the payment instrument; picking, managing, and evolving technology; offering a settlement system; and managing data and monitoring transactions.
In the sCBDC model – which is a public–private partnership – central banks would go back to focusing on their core function: providing trust and efficiency by means of state-of-the-art settlement systems. The private sector – stablecoin providers – would be left to satisfy the remaining steps under appropriate supervision and oversight, and focus on their own competitive advantage – innovating and interacting with customers.
Whether central banks adopt CBDC at all is another matter and will result from carefully weighing pros and cons. But to the extent central banks wish to offer a digital alternative to cash, they should consider sCBDC as a potentially attractive option.
That is only one of the incarnations of stablecoins. Others will no doubt materialise and colour the future of payments and the financial industry. If anything, existing players will be induced to offer new and more attractive services in the payments – and especially cross-border payments – space. From desktop publishing, the digital revolution has finally reached the shores of consumer finance too.
Editor's Note: The views expressed are those of the author(s) and do not necessarily represent the views of the IMF and its Executive Board
[End of OpEd]
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Digital currency (digital money, electronic money or electronic currency) is a type of currency available in digital form (in contrast to physical, such as banknotes and coins). It exhibits properties similar to physical currencies, but can allow for instantaneous transactions and borderless transfer-of-ownership.
Examples include virtual currencies, cryptocurrencies, and central bank digital currency. These currencies may be used to buy physical goods and services, but may also be restricted to certain communities such as for use inside an online game.
Digital currency is a money balance recorded electronically on a stored-value card or other devices. Another form of electronic money is network money, allowing the transfer of value on computer networks, particularly the Internet. Electronic money is also a claim on a private bank or other financial institution such as bank deposits.
Digital money can either be centralized, where there is a central point of control over the money supply, or decentralized, where the control over the money supply can come from various sources.
Comparisons:
Digital versus virtual currency:
According to the European Central Bank's 2015 "Virtual currency schemes – a further analysis" report, virtual currency is a digital representation of value, not issued by a central bank, credit institution or e-money institution, which, in some circumstances, can be used as an alternative to money.
In the previous report of October 2012, the virtual currency was defined as a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.
According to the Bank for International Settlements' November 2015 "Digital currencies" report, it is an asset represented in digital form and having some money characteristics.
Digital currency can be denominated to a sovereign currency and issued by the issuer responsible to redeem digital money for cash. In that case, digital currency represents electronic money (e-money). Digital currency denominated in its own units of value or with decentralized or automatic issuance will be considered as a virtual currency.
As such, bitcoin is a digital currency but also a type of virtual currency. Bitcoin and its alternatives are based on cryptographic algorithms, so these kinds of virtual currencies are also called cryptocurrencies.
Digital versus traditional currency:
Most of the traditional money supply is bank money held on computers. This is also considered digital currency. One could argue that our increasingly cashless society means that all currencies are becoming digital, but they are not presented to us as such.
Types of systems:
Centralized systems:
Main article: Electronic funds transfer
Currency can be exchanged electronically using debit cards and credit cards using electronic funds transfer at point of sale.
Mobile digital wallets:
A number of electronic money systems use contactless payment transfer in order to facilitate easy payment and give the payee more confidence in not letting go of their electronic wallet during the transaction.
Decentralized systems:
A cryptocurrency is a type of digital asset that relies on cryptography for chaining together digital signatures of asset transfers, peer-to-peer networking and decentralization. In some cases a proof-of-work or proof-of-stake scheme is used to create and manage the currency.
Cryptocurrencies allow electronic money systems to be decentralized. The first and most popular system is bitcoin, a peer-to-peer electronic monetary system based on cryptography.
Virtual currency:
Main article: Virtual currency
A virtual currency has been defined in 2012 by the European Central Bank as "a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community". The US Department of Treasury in 2013 defined it more tersely as "a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency". The key attribute a virtual currency does not have according to these definitions, is the status as legal tender.
Law:
Since 2001, the European Union has implemented the E-Money Directive "on the taking up, pursuit and prudential supervision of the business of electronic money institutions" last amended in 2009.
Doubts on the real nature of EU electronic money have arisen, since calls have been made in connection with the 2007 EU Payment Services Directive in favor of merging payment institutions and electronic money institutions. Such a merger could mean that electronic money is of the same nature as bank money or scriptural money.
In the United States, electronic money is governed by Article 4A of the Uniform Commercial Code for wholesale transactions and the Electronic Fund Transfer Act for consumer transactions. Provider's responsibility and consumer's liability are regulated under Regulation E.
Regulation:
Virtual currencies pose challenges for central banks, financial regulators, departments or ministries of finance, as well as fiscal authorities and statistical authorities.
U.S. Treasury guidance:
On 20 March 2013, the Financial Crimes Enforcement Network issued a guidance to clarify how the U.S. Bank Secrecy Act applied to persons creating, exchanging, and transmitting virtual currencies.
Securities and Exchange Commission guidance:
In May 2014 the U.S. Securities and Exchange Commission (SEC) "warned about the hazards of bitcoin and other virtual currencies".
New York state regulation:
In July 2014, the New York State Department of Financial Services proposed the most comprehensive regulation of virtual currencies to date, commonly called BitLicense. It has gathered input from bitcoin supporters and the financial industry through public hearings and a comment period until 21 October 2014 to customize the rules.
The proposal per NY DFS press release "sought to strike an appropriate balance that helps protect consumers and root out illegal activity". It has been criticized by smaller companies to favor established institutions, and Chinese bitcoin exchanges have complained that the rules are "overly broad in its application outside the United States".
Click on any of the following blue hyperlinks for more about Digital Currencies:
The rise of digital currency
OpEd by Tobias Adrian, Tommaso Mancini-Griffoli 09 September 2019
New entrants are vying to occupy the space once used by paper bills. This column, part of the VoxEU debate on the future of digital money, proposes a simple framework to make sense of who is attempting to pry our wallets open.
It argues that the adoption of new digital means of payment could be rapid and bring significant benefits to customers and society, but that the risks must be tackled with innovative approaches and heightened collaboration across borders and sectors.
One approach is for central banks to engage in a public–private partnership with fintech firms to provide a safe, liquid, and digital alternative to cash: synthetic central bank digital currency.
A battle is raging…for your wallet. With sharp elbows, new entrants are vying to occupy the space once used by paper bills, or that reserved for your debit card.
Alipay, Libra, M-Pesa, stablecoins – we first need to make sense of just who is attempting to pry our wallets open.
We propose a simple framework to do so.
We then argue that the adoption of new, digital means of payment could be rapid. It could bring significant benefits to customers and society, including efficiency gains in payments, greater competition, financial inclusion, and innovation in related sectors. But risks are also paramount to financial stability and integrity, monetary policy transmission, and anti-trust.
These must be tackled with innovative approaches and heightened collaboration across borders and sectors.
Policymakers will not be able to remain bystanders. In fact, their actions will influence the adoption of new means of payment, and their design. One approach is for central banks to engage in a public–private partnership with fintech firms to provide a safe, liquid, and digital alternative to cash – synthetic central bank digital currency, or sCBDC for short – which comes with its own benefits and risks.
The literature is quickly picking up on the potential disruption caused by new means of payment (e.g. Duffie 2019, BIS 2019).
A framework of analysis:
To help make sense of the plethora of new entrants in the payments space, we offer a simple classification scheme that we call the ‘Money Tree’ (Adrian and Mancini-Griffoli 2019). At its heart are four key features that help distinguish different forms of money: type, value, backstop, and technology. We illustrate this scheme in Figure 1 by contrasting bank deposits and stablecoins. Further details and discussions of other forms of money are in Adrian and Mancini-Griffoli (2019).
Figure 1 (above) Simplified money tree to classify different forms of money
Bank deposits are the most popular means of payment in many countries. These are claims on banks, as opposed to objects with intrinsic value. Bank deposits have fixed value to the extent they can be redeemed into currency – or cash – at face value.
Ten euros deposited in a bank can be redeemed against a ten-euro note with reasonable certainty in many countries. That is an incredibly useful feature, allowing payments in bank deposits to be made without concern for exchange rate risk.
Trust in the redemption guarantee rests on government backstops: deposit insurance, lender of last resort and emergency liquidity facilities, as well as careful supervision and oversight of banks. And finally, the settlement technology is usually centralised, as banks and central banks collaborate to maintain a shared ledger of account balances.
New means of payment such as stablecoins differ in important ways. Most stablecoins continue to be claims on the issuing institution. Many also offer redemption guarantees at face value – a coin bought for ten euros can be exchanged back for a ten-euro note (a sort of money-back guarantee).
However, trust in this pledge does not rest on government backstops. It must be generated privately by fully backing coin issuance with safe and liquid assets. Finally, the settlement technology is usually decentralised, based on the blockchain model.
Some stablecoins do not offer redemptions at fixed prices, but at market prices instead. We
say their value is variable relative to the domestic unit of account. This is the case of commodity tokens, such as gold coins, and of coins that are exchanged or redeemed for the going value of the assets backing them. One example is mutual fund shares written to digital tokens that can be readily exchanged. Libra may fit this model.
Stablecoin adoption:
Adoption of new forms of money will depend on their attractiveness as a store of value and means of payment. Cash fares well on the first count, and bank deposits on both. So why hold stablecoins? Why are stablecoins taking off? Why did USD Coin recently launch in 85 countries, Facebook invest heavily in Libra, and centralized variants of the stablecoin business model become so widespread? Consider that 90% of Kenyans over the age of 14 use M-Pesa and the value of Alipay and WeChat Pay transactions in China surpasses that of Visa and Mastercard worldwide combined.
The question is all the more intriguing as stablecoins are not an especially stable store of value. As discussed, they are a claim on a private institution whose viability could prevent it from honouring its pledge to redeem coins at face value. Stablecoin providers must generate trust through the prudent and transparent management of safe and liquid assets, as well as sound legal structures. In a way, this class of stablecoins is akin to constant net asset value funds which can break the buck – i.e. pay out less than their face value – as we found out during the global financial crisis.
However, the strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Also, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications by an active developer community given their open architecture, as opposed to the proprietary legacy systems of banks.
And, in many countries, stablecoins may be issued by firms benefitting from greater public trust than banks. Several of these advantages exist even when compared to cutting-edge payment solutions offered by banks called fast-payments.
But the real enticement comes from the networks that promise to make transacting as easy as using social media. Economists beware: payments are not the mere act of extinguishing a debt. They are a fundamentally social experience tying people together. Stablecoins are better integrated into our digital lives and designed by firms that live and breathe user-centric design.
And they may be issued by large technology firms that already benefit from enormous global user bases over which new payment services could spread like wildfire. Network effects – the gains to a new user growing exponentially with the number of users – can be staggering.
Take WhatsApp, for instance, which grew to nearly 2 billion users in ten years without any advertisement, based only on word of mouth!
Risks of stablecoins:
Risks are multiple, though that is not an excuse for policymakers to throw in the towel. On the contrary, they must create an environment in which the benefits of technology can be reaped while minimizing risks, as discussed in Lipton (2019). Policymakers will need to be innovative themselves and to collaborate – across countries, but also across sectors. Central bankers, regulators, ministries of finance, antitrust authorities, currency issuers, and technology experts will need to speak a common language for a common purpose.
The first risk is to the disintermediation of banks, which could lose deposits to stablecoin providers. However, banks will try to compete by offering their own innovative solutions and higher interest on deposits. And stablecoin providers could recycle their funds back into the banking system or decide to engage themselves in maturity transformation by turning themselves into banks.
Second, we could face new monopolies. Tech giants could use their networks to shut out competitors and monetize information. At the heart of this power is proprietary access to data on customer transactions. We need new standards for data protection, control, and ownership.
Third, there is a threat to weaker currencies. In countries with high inflation and weak institutions, people might give up local currencies for stablecoins in foreign currency. This would be a new form of ‘dollarisation’ and might undermine monetary policy, financial development, and economic growth. To avoid this, countries must improve their monetary and fiscal policies. The question is whether they can or should restrict foreign currency stablecoins in the interim.
Fourth, stablecoins could foster illicit activities. Providers must show how they will prevent the use of their networks for activities like money laundering and terrorist financing. This means complying with international standards. New technologies offer opportunities to improve monitoring. So, supervisors will need to adapt to the more fragmented value chain of stablecoins, including wallet providers, crypto exchanges, validation nodes, and investment vehicles.
The fifth risk is loss of ‘seigniorage’. Central banks have long captured, on behalf of taxpayers, the profits stemming from the difference between a currency’s face value and its cost of manufacture. Issuers could siphon off profits if their stablecoins do not carry interest but the hard currency backing them is invested at a return. One way to address this issue is to promote competition so issuers would eventually pay interest on coins.
Sixth, we must ensure consumer protection and financial stability. Customer funds need to be safe and protected from runs like the one that took down Lehman Brothers investment bank.
In part, this calls for legal clarity on what kind of financial instruments stablecoins represent.
One approach would be to regulate stablecoins like money market funds that guarantee fixed nominal returns, requiring providers to maintain sufficient liquidity and capital. We could call this the ‘shadow banking’ approach, which attempts to extend prudential regulation beyond the classic banking perimeter.
Synthetic central bank digital currency (sCBDC):
Another option is the ‘narrow banking’ approach. In this case, the central bank could require stablecoin providers to back coins with central bank reserves. The approach is not unheard of. The People’s Bank of China requires giant payment providers AliPay and WeChat Pay to abide by these standards, and central banks around the world are considering giving fintech companies access to their reserves – though only after satisfying a number of requirements related to financial integrity, interoperability, security, and data protection, among others.
Clearly, doing so would enhance the attractiveness of stablecoins as a store of value.
Competition with banks would only grow stronger. The social price tag is up for debate.
But there are also clearer-cut advantages of offering stablecoin providers access to central bank reserves:
- stability, given the backing in perfectly safe and liquid assets;
- regulatory clarity as narrow banks would fit neatly into existing regulatory frameworks;
- interoperability among stablecoins (as client funds would be exchanged between reserve accounts) and thus greater competition;
- support for domestic payment solutions rivalling foreign currency stablecoins offered by monopolies that are hard to regulate; and
- better monetary policy transmission, thanks to lower pressure on currency substitution, and more immediate transmission of interest rates if reserves held by stablecoin providers were remunerated.
A final consideration jumps out: if stablecoin providers held client assets in reserves at the central bank, clients would essentially be able to hold, and transact in, central bank liabilities. That, after all, is the essence of CBDC.3
Bingo! We have thus manufactured what we call synthetic CBDC (sCBDC). We remain, however, fully aware that the stablecoins are the liability of private-sector firms despite the public determining the size of central bank liabilities.
sCBDC offers significant advantages over its full-fledged cousin. The latter, discussed widely in the literature and envisioned by central banks, requires getting involved in many of the steps of the payments value chain. This can be costly and risky for central banks. Steps include interfacing with users and managing brand reputation; complying with integrity standards; offering clients an interface to hold and trade the payment instrument; picking, managing, and evolving technology; offering a settlement system; and managing data and monitoring transactions.
In the sCBDC model – which is a public–private partnership – central banks would go back to focusing on their core function: providing trust and efficiency by means of state-of-the-art settlement systems. The private sector – stablecoin providers – would be left to satisfy the remaining steps under appropriate supervision and oversight, and focus on their own competitive advantage – innovating and interacting with customers.
Whether central banks adopt CBDC at all is another matter and will result from carefully weighing pros and cons. But to the extent central banks wish to offer a digital alternative to cash, they should consider sCBDC as a potentially attractive option.
That is only one of the incarnations of stablecoins. Others will no doubt materialise and colour the future of payments and the financial industry. If anything, existing players will be induced to offer new and more attractive services in the payments – and especially cross-border payments – space. From desktop publishing, the digital revolution has finally reached the shores of consumer finance too.
Editor's Note: The views expressed are those of the author(s) and do not necessarily represent the views of the IMF and its Executive Board
[End of OpEd]
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Digital currency (digital money, electronic money or electronic currency) is a type of currency available in digital form (in contrast to physical, such as banknotes and coins). It exhibits properties similar to physical currencies, but can allow for instantaneous transactions and borderless transfer-of-ownership.
Examples include virtual currencies, cryptocurrencies, and central bank digital currency. These currencies may be used to buy physical goods and services, but may also be restricted to certain communities such as for use inside an online game.
Digital currency is a money balance recorded electronically on a stored-value card or other devices. Another form of electronic money is network money, allowing the transfer of value on computer networks, particularly the Internet. Electronic money is also a claim on a private bank or other financial institution such as bank deposits.
Digital money can either be centralized, where there is a central point of control over the money supply, or decentralized, where the control over the money supply can come from various sources.
Comparisons:
Digital versus virtual currency:
According to the European Central Bank's 2015 "Virtual currency schemes – a further analysis" report, virtual currency is a digital representation of value, not issued by a central bank, credit institution or e-money institution, which, in some circumstances, can be used as an alternative to money.
In the previous report of October 2012, the virtual currency was defined as a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.
According to the Bank for International Settlements' November 2015 "Digital currencies" report, it is an asset represented in digital form and having some money characteristics.
Digital currency can be denominated to a sovereign currency and issued by the issuer responsible to redeem digital money for cash. In that case, digital currency represents electronic money (e-money). Digital currency denominated in its own units of value or with decentralized or automatic issuance will be considered as a virtual currency.
As such, bitcoin is a digital currency but also a type of virtual currency. Bitcoin and its alternatives are based on cryptographic algorithms, so these kinds of virtual currencies are also called cryptocurrencies.
Digital versus traditional currency:
Most of the traditional money supply is bank money held on computers. This is also considered digital currency. One could argue that our increasingly cashless society means that all currencies are becoming digital, but they are not presented to us as such.
Types of systems:
Centralized systems:
Main article: Electronic funds transfer
Currency can be exchanged electronically using debit cards and credit cards using electronic funds transfer at point of sale.
Mobile digital wallets:
A number of electronic money systems use contactless payment transfer in order to facilitate easy payment and give the payee more confidence in not letting go of their electronic wallet during the transaction.
- In 1994 Mondex and National Westminster Bank provided an "electronic purse" to residents of Swindon
- In about 2005 Telefónica and BBVA Bank launched a payment system in Spain called Mobipay which used simple short message service facilities of feature phones intended for pay-as you go services including taxis and pre-pay phone recharges via a BBVA current bank account debit.
- In January 2010, Venmo launched as a mobile payment system through SMS, which transformed into a social app where friends can pay each other for minor expenses like a cup of coffee, rent and paying your share of the restaurant bill when you forget your wallet. It is popular with college students, but has some security issues. It can be linked to your bank account, credit/debit card or have a loaded value to limit the amount of loss in case of a security breach. Credit cards and non-major debit cards incur a 3% processing fee.
- On 19 September 2011, Google Wallet released in the United States to make it easy to carry all your credit/debit cards on your phone.
- In 2012 Ireland's O2 (owned by Telefónica) launched Easytrip to pay road tolls which were charged to the mobile phone account or prepay credit.
- The UK's O2 invented O2 Wallet at about the same time. The wallet can be charged with regular bank accounts or cards and discharged by participating retailers using a technique known as 'money messages'. The service closed in 2014.
- On 9 September 2014, Apple Pay was announced at the iPhone 6 event. In October 2014 it was released as an update to work on iPhone 6 and Apple Watch. It is very similar to Google Wallet, but for Apple devices only.
Decentralized systems:
- Main article: Cryptocurrency
- See also: List of cryptocurrencies
A cryptocurrency is a type of digital asset that relies on cryptography for chaining together digital signatures of asset transfers, peer-to-peer networking and decentralization. In some cases a proof-of-work or proof-of-stake scheme is used to create and manage the currency.
Cryptocurrencies allow electronic money systems to be decentralized. The first and most popular system is bitcoin, a peer-to-peer electronic monetary system based on cryptography.
Virtual currency:
Main article: Virtual currency
A virtual currency has been defined in 2012 by the European Central Bank as "a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community". The US Department of Treasury in 2013 defined it more tersely as "a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency". The key attribute a virtual currency does not have according to these definitions, is the status as legal tender.
Law:
Since 2001, the European Union has implemented the E-Money Directive "on the taking up, pursuit and prudential supervision of the business of electronic money institutions" last amended in 2009.
Doubts on the real nature of EU electronic money have arisen, since calls have been made in connection with the 2007 EU Payment Services Directive in favor of merging payment institutions and electronic money institutions. Such a merger could mean that electronic money is of the same nature as bank money or scriptural money.
In the United States, electronic money is governed by Article 4A of the Uniform Commercial Code for wholesale transactions and the Electronic Fund Transfer Act for consumer transactions. Provider's responsibility and consumer's liability are regulated under Regulation E.
Regulation:
Virtual currencies pose challenges for central banks, financial regulators, departments or ministries of finance, as well as fiscal authorities and statistical authorities.
U.S. Treasury guidance:
On 20 March 2013, the Financial Crimes Enforcement Network issued a guidance to clarify how the U.S. Bank Secrecy Act applied to persons creating, exchanging, and transmitting virtual currencies.
Securities and Exchange Commission guidance:
In May 2014 the U.S. Securities and Exchange Commission (SEC) "warned about the hazards of bitcoin and other virtual currencies".
New York state regulation:
In July 2014, the New York State Department of Financial Services proposed the most comprehensive regulation of virtual currencies to date, commonly called BitLicense. It has gathered input from bitcoin supporters and the financial industry through public hearings and a comment period until 21 October 2014 to customize the rules.
The proposal per NY DFS press release "sought to strike an appropriate balance that helps protect consumers and root out illegal activity". It has been criticized by smaller companies to favor established institutions, and Chinese bitcoin exchanges have complained that the rules are "overly broad in its application outside the United States".
Click on any of the following blue hyperlinks for more about Digital Currencies:
- History
- Adoption by governments
- Adoption by financial actors
- Hard vs. soft digital currencies
- Criticism
- See also:
- Central bank digital currency
- Alternative currency
- Local exchange trading system
- Cashless society
- Digital currency exchanger
- Private currency
- Automated Clearing House
- Cashless catering
- Community Exchange System
- Digital wallet
- Cryptocurrency wallet
- E-commerce payment system
- Electronic Money Association
- Electronic Payment System
- Payment system
U.S. Securities and Exchange Commission (SEC)
- YouTube Video What Is the Securities & Exchange Commission? Is It Effective?
- YouTube Video: SEC's Enforcement Actions Are Increasing
- YouTube Video: SEC Commissioner Daniel Gallagher on Financial Regulation
The U.S. Securities and Exchange Commission (SEC) is an independent agency of the United States federal government. The SEC holds primary responsibility for enforcing the federal securities laws, proposing securities rules, and regulating the securities industry, the nation's stock and options exchanges, and other activities and organizations, including the electronic securities markets in the United States.
In addition to the Securities Exchange Act of 1934, which created it, the SEC enforces the following:
The SEC was created by Section 4 of the Securities Exchange Act of 1933 (now codified as 15 U.S.C. § 78d and commonly referred to as the Exchange Act or the 1934 Act).
Overview:
The SEC has a three-part mission:
To achieve its mandate, the SEC enforces the statutory requirement that public companies and other regulated companies submit quarterly and annual reports, as well as other periodic reports. In addition to annual financial reports, company executives must provide a narrative account, called the "management discussion and analysis" (MD&A), that outlines the previous year of operations and explains how the company fared in that time period.
MD&A will usually also touch on the upcoming year, outlining future goals and approaches to new projects. In an attempt to level the playing field for all investors, the SEC maintains an online database called EDGAR (the Electronic Data Gathering, Analysis, and Retrieval system) online from which investors can access this and other information filed with the agency.
Quarterly and semiannual reports from public companies are crucial for investors to make sound decisions when investing in the capital markets. Unlike banking, investment in the capital markets is not guaranteed by the federal government. The potential for big gains needs to be weighed against that of sizable losses.
Mandatory disclosure of financial and other information about the issuer and the security itself gives private individuals as well as large institutions the same basic facts about the public companies they invest in, thereby increasing public scrutiny while reducing insider trading and fraud.
The SEC makes reports available to the public through the EDGAR system. The SEC also offers publications on investment-related topics for public education. The same online system also takes tips and complaints from investors to help the SEC track down violators of the securities laws. The SEC adheres to a strict policy of never commenting on the existence or status of an ongoing investigation.
Click on any of the following blue hyperlinks for more about The United States Securities and Exchange Commission:
In addition to the Securities Exchange Act of 1934, which created it, the SEC enforces the following:
- Securities Act of 1933,
- the Trust Indenture Act of 1939,
- the Investment Company Act of 1940,
- the Investment Advisers Act of 1940,
- the Sarbanes–Oxley Act of 2002,
- and other statutes.
The SEC was created by Section 4 of the Securities Exchange Act of 1933 (now codified as 15 U.S.C. § 78d and commonly referred to as the Exchange Act or the 1934 Act).
Overview:
The SEC has a three-part mission:
- to protect investors;
- maintain fair, orderly, and efficient markets;
- and facilitate capital formation.
To achieve its mandate, the SEC enforces the statutory requirement that public companies and other regulated companies submit quarterly and annual reports, as well as other periodic reports. In addition to annual financial reports, company executives must provide a narrative account, called the "management discussion and analysis" (MD&A), that outlines the previous year of operations and explains how the company fared in that time period.
MD&A will usually also touch on the upcoming year, outlining future goals and approaches to new projects. In an attempt to level the playing field for all investors, the SEC maintains an online database called EDGAR (the Electronic Data Gathering, Analysis, and Retrieval system) online from which investors can access this and other information filed with the agency.
Quarterly and semiannual reports from public companies are crucial for investors to make sound decisions when investing in the capital markets. Unlike banking, investment in the capital markets is not guaranteed by the federal government. The potential for big gains needs to be weighed against that of sizable losses.
Mandatory disclosure of financial and other information about the issuer and the security itself gives private individuals as well as large institutions the same basic facts about the public companies they invest in, thereby increasing public scrutiny while reducing insider trading and fraud.
The SEC makes reports available to the public through the EDGAR system. The SEC also offers publications on investment-related topics for public education. The same online system also takes tips and complaints from investors to help the SEC track down violators of the securities laws. The SEC adheres to a strict policy of never commenting on the existence or status of an ongoing investigation.
Click on any of the following blue hyperlinks for more about The United States Securities and Exchange Commission:
- History
- Organizational structure
- SEC communications
- Freedom of Information Act processing performance
- Operations
- Relationship to other agencies
- Related legislation
- See also:
Stock Market Crash and How to Avoid the Next Potential Stock Market Crash (Fortune Magazine 9/2/2015)
How to Avoid the Next Potential Stock Market Crash (Fortune Magazine, 9/2/2015):
Until now, Wall Street lobby groups have been able to largely ignore any calls for taxing the financial services industry.
Eleven European governments say they’re going to implement a coordinated tax on stock market transactions, but progress has been slow and U.S. policymakers have been much more cautious.
Now, with Bernie Sanders, a major proponent of such taxes, surging in the polls and market volatility rattling investors, the momentum behind this idea is likely to build—as will the backlash.
What we’re talking about here is a small tax, at a fraction of 1%, on each trade of stocks, bonds and derivatives. Opponents argue this would reduce “market liquidity.” Our ability to buy or sell securities at their so-called “equilibrium value” would be limited. And this, in turn, would translate into poorer resource allocation in the economy, and weaker economic growth.
These fears are misplaced.
In a “bull market” there is plenty of liquidity – it is easy to buy and sell a lot of stock when folks are optimistic and prices are rising. But in a “crisis,” it becomes very difficult to trade.
The observed changes in “liquidity conditions” in these two types of market environments have nothing to do with transactions costs and everything to do with the fear of losing money when prices are falling.
The sad reality is markets mis-price assets all the time. Just take a look at the market this past week. What was the “equilibrium level” of the S&P 500? Was it the low on Tuesday of 1867, or was it the high on Friday of 1990? Was it somewhere in between?
The truth is we don’t know. Stock prices are simply far more volatile than the earnings and cash flows of the companies they represent. And this mispricing of securities often persists for long periods of time, and results in “sub-optimal” resource allocation for our economy.
A tax on stock trades isn’t a magic elixir. It won’t prevent stock prices from moving far away from their “equilibrium values” any more than high transactions costs prevented house prices from moving far away from their equilibrium values. But nor will a transactions tax make our financial markets any less “liquid” of any less “efficient” than they already are.
So why then would a tax on stock transactions be a perfect tax? There are three reasons why.
First, billions of dollars of stock market transactions are already being “taxed.” For more than a decade, so-called high-frequency traders have used so-called “latency arbitrage” to take a little bite from hundreds of millions of transactions in U.S. equity markets.
While a purchase order is slowly making its way to an exchange (the “latency” part), a trader with higher-speed access to that exchange intercepts the order and pre-emptively buys and marks up the price of the shares, and then sells them back at a higher price to the slower-moving buyer (the “arbitrage”).
This activity plays out in milliseconds over and over again, and the victim is unaware of the bite. This transactions “tax” does not do the public a whit of good, but it definitely enriches a handful of traders whose low-percentage, high-volume skimming went, until recently, unnoticed.
An explicit transaction tax could transparently and legitimately capture revenue for public purposes and put the high-volume skimmers out of business.
For believers in efficient markets, low-priced, easy-access trading — so-called “frictionless markets” — has been the great dream. But the reality uncovered by psychologists and behavioral economists is that low-priced trading actually harms the vast majority of Americans that embrace it.
Humans overreact to new stimuli, as do the machines they construct, to trade on their behalf. In financial markets, people and their machines move in herds, watching others and emulating them, buying as prices rise and selling as they fall.
At the supermarket, we respond to higher prices by cutting back purchases and we respond to lower prices by loading up the shopping cart. But in the stock market, buyers flock to stocks that have rallied and shy away from stocks that have slumped.
Low-priced easy-access trading makes stock flipping as easy as Tweeting. It enables our primal urges to follow the crowd and to chase the market. Turning the most straightforward market dictum on its head, low-priced trading – by both humans and by machines — leads us to “buy high and sell low.” We hurt ourselves by frequently flipping stocks and we hurt others by amplifying the volatility of stock price movements.
To quote Jack Bogle, founder of the fund management company Vanguard: “When it comes to trading, the greater the activity, the worse the returns.”
Taxing stock market transactions – intentionally adding meaningful friction to the market – can reduce wasteful trading and improve our financial well-being.
Finally, the proceeds from a tax on financial transactions could do a lot of social good. It could support cash-starved financial regulators desperately seeking funds to fulfill their policy mandates. It could help to fund more generous social security benefits to the millions of Americans with nowhere near enough 401K or IRA savings to support a decent standard of living in their retirement years. It could do many positive things.
The social costs of a financial transactions tax appear to be close to zero, and the potential benefits to society loom large. The perfect tax.
[End of Article]
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A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.
Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell.
Generally speaking, crashes usually occur under the following conditions: a prolonged period of declining stock prices and excessive economic optimism, a market where P/E ratios (Price-Earning ratio) exceed long-term averages, and extensive use of margin debt and leverage by market participants.
Other aspects such as wars, large-corporation hacks, changes in federal laws and regulations, and natural disasters of highly economically productive areas may also influence a significant decline in the stock market value of a wide range of stocks. All such stock drops may result in the rise of stock prices for corporations competing against the affected corporations.
There is no numerically specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index over a period of several days.
Crashes are often distinguished from bear markets by panic selling and abrupt, dramatic price declines. Bear markets are periods of declining stock market prices that are measured in months or years. Crashes are often associated with bear markets, however, they do not necessarily go hand in hand. The crash of 1987, for example, did not lead to a bear market.
Likewise, the Japanese bear market of the 1990s occurred over several years without any notable crashes.
Major crashes in the United States
Panic of 1907:
Main article: Panic of 1907
In 1907 and in 1908, the NYSE fell by nearly 50% due to a variety of factors, led by the manipulation of copper stocks by the Knickerbocker company. Shares of United Copper rose gradually up to October, and thereafter crashed, leading to panic. A number of investment trusts and banks that had invested their money in the stock market fell and started to close down. Further bank runs were prevented due to the intervention of J. P. Morgan. The panic continued to 1908 and led to the formation of the Federal Reserve in 1913.
Wall Street Crash of 1929:
Main article: Wall Street Crash of 1929
The economy had been growing for most of the Roaring Twenties. It was a technological golden age, as innovations such as the radio, automobile, aviation, telephone, and the power grid were deployed and adopted. Companies that had pioneered these advances, like Radio Corporation of America (RCA) and General Motors, saw their stocks soar.
Financial corporations also did well, as Wall Street bankers floated mutual fund companies (then known as investment trusts) like the Goldman Sachs Trading Corporation. Investors were infatuated with the returns available in the stock market, especially by the use of leverage through margin debt.
On August 24, 1921, the Dow Jones Industrial Average stood at a value of 63.9. By September 3, 1929, it had risen more than sixfold, touching 381.2. It would not regain this level for another 25 years.
By the summer of 1929, it was clear that the economy was contracting, and the stock market went through a series of unsettling price declines. These declines fed investor anxiety, and events came to a head on October 24, 28, and 29 (known respectively as Black Thursday, Black Monday, and Black Tuesday).
On Black Monday, the Dow Jones Industrial Average fell 38.33 points to 260, a drop of 12.8%. The deluge of selling overwhelmed the ticker tape system that normally gave investors the current prices of their shares. Telephone lines and telegraphs were clogged and were unable to cope. This information vacuum only led to more fear and panic. The technology of the New Era, previously much celebrated by investors, now served to deepen their suffering.
The following day, Black Tuesday, was a day of chaos. Forced to liquidate their stocks because of margin calls, overextended investors flooded the exchange with sell orders. The Dow fell 30.57 points to close at 230.07 on that day. The glamour stocks of the age saw their values plummet. Across the two days, the Dow Jones Industrial Average fell 23%.
By the end of the weekend of November 11, the index stood at 228, a cumulative drop of 40% from the September high. The markets rallied in succeeding months, but it was a temporary recovery that led unsuspecting investors into further losses.
The Dow Jones Industrial Average lost 89% of its value before finally bottoming out in July 1932. The crash was followed by the Great Depression, the worst economic crisis of modern times, which plagued the stock market and Wall Street throughout the 1930s.
October 19, 1987:
Main article: Black Monday (1987)
The mid-1980s were a time of strong economic optimism. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2722. The rise in market indices for the 19 largest markets in the world averaged 296 percent during this period. The average number of shares traded on the NYSE (New York Stock Exchange) had risen from 65 million shares to 181 million shares.
The crash on October 19, 1987, a date that is also known as Black Monday, was the climactic culmination of a market decline that had begun five days before on October 14. The DJIA fell 3.81 percent on October 14, followed by another 4.60 percent drop on Friday, October 16.
On Black Monday, the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its value in one day. The S&P 500 dropped 20.4%, falling from 282.7 to 225.06.
The NASDAQ Composite lost only 11.3%, not because of restraint on the part of sellers, but because the NASDAQ market system failed. Deluged with sell orders, many stocks on the NYSE faced trading halts and delays. Of the 2,257 NYSE-listed stocks, there were 195 trading delays and halts during the day. The NASDAQ market fared much worse.
Because of its reliance on a "market making" system that allowed market makers to withdraw from trading, liquidity in NASDAQ stocks dried up. Trading in many stocks encountered a pathological condition where the bid price for a stock exceeded the asking price. These "locked" conditions severely curtailed trading. On October 19, trading in Microsoft shares on the NASDAQ lasted a total of 54 minutes.
The Crash was the greatest single-day loss that Wall Street had ever suffered in continuous trading up to that point. Between the start of trading on October 14 to the close on October 19, the DJIA lost 760 points, a decline of over 31 percent.
The 1987 Crash was a worldwide phenomenon. The FTSE 100 Index lost 10.8% on that Monday and a further 12.2% the following day. In the month of October, all major world markets declined substantially. The least affected was Austria (a fall of 11.4%) while the most affected was Hong Kong with a drop of 45.8%. Out of 23 major industrial countries, 19 had a decline greater than 20%.
Despite fears of a repeat of the 1930s Depression, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September 1989, the market had regained all of the value it had lost in the 1987 crash. The Dow Jones Industrial Average gained six-tenths of a percent during the calendar year 1987.
No definitive conclusions have been reached on the reasons behind the 1987 Crash. Stocks had been in a multi-year bull run and market P/E ratios in the U.S. were above the post-war average. The S&P 500 was trading at 23 times earnings, a postwar high and well above the average of 14.5 times earnings. Herd behavior and psychological feedback loops play a critical part in all stock market crashes but analysts have also tried to look for external triggering events.
Aside from the general worries of stock market overvaluation, blame for the collapse has been apportioned to such factors as program trading, portfolio insurance and derivatives, and prior news of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a falling U.S. dollar, which seemed to imply future interest rate hikes).
One of the consequences of the 1987 Crash was the introduction of the circuit breaker or trading curb on the NYSE. Based upon the idea that a cooling off period would help dissipate investor panic, these mandatory market shutdowns are triggered whenever a large pre-defined market decline occurs during the trading day.
Crash of 2008–2009:
Main article: Financial crisis of 2007–2008
On September 16, 2008, failures of massive financial institutions in the United States, due primarily to exposure to packaged subprime loans and credit default swaps issued to insure these loans and their issuers, rapidly devolved into a global crisis.
This resulted in a number of bank failures in Europe and sharp reductions in the value of stocks and commodities worldwide. The failure of banks in Iceland resulted in a devaluation of the Icelandic króna and threatened the government with bankruptcy. Iceland obtained an emergency loan from the International Monetary Fund in November.
In the United States, 15 banks failed in 2008, while several others were rescued through government intervention or acquisitions by other banks. On October 11, 2008, the head of the International Monetary Fund (IMF) warned that the world financial system was teetering on the "brink of systemic meltdown".
The economic crisis caused countries to close their markets temporarily.
On October 8, the Indonesian stock market halted trading, after a 10% drop in one day.
The Times of London reported that the meltdown was being called the Crash of 2008, and older traders were comparing it with Black Monday in 1987. The fall that week of 21% compared to a 28.3% fall 21 years earlier, but some traders were saying it was worse. "At least then it was a short, sharp, shock on one day. This has been relentless all week."
Business Week also referred to the crisis as a "stock market crash" or the "Panic of 2008".
From October 6–10 the Dow Jones Industrial Average (DJIA) closed lower in all five sessions. Volume levels were record-breaking. The DJIA fell over 1,874 points, or 18%, in its worst weekly decline ever on both a points and percentage basis. The S&P 500 fell more than 20%.
The week also set 3 top ten NYSE Group Volume Records with October 8 at #5, October 9 at #10, and October 10 at #1.
Having been suspended for three successive trading days (October 9, 10, and 13), the Icelandic stock market reopened on 14 October, with the main index, the OMX Iceland 15, closing at 678.4, which was about 77% lower than the 3,004.6 at the close on October 8. This reflected that the value of the three big banks, which had formed 73.2% of the value of the OMX Iceland 15, had been set to zero.
On October 24, many of the world's stock exchanges experienced the worst declines in their history, with drops of around 10% in most indices. In the US, the DJIA fell 3.6%, i.e. not as much as other markets. Instead, both the US dollar and Japanese yen soared against other major currencies, particularly the British pound and Canadian dollar, as world investors sought safe havens.
Later that day, the deputy governor of the Bank of England, Charles Bean, suggested that "This is a once in a lifetime crisis, and possibly the largest financial crisis of its kind in human history."
By March 6, 2009 the DJIA had dropped 54% to 6,469 (before beginning to recover) from its peak of 14,164 on October 9, 2007, over a span of 17 months.
Mitigation strategies:
One mitigation strategy has been the introduction of trading curbs, also known as "circuit breakers", which are a trading halt in the cash market and the corresponding trading halt in the derivative markets triggered by the halt in the cash market, all of which are affected based on substantial movements in a broad market indicator. Since their inception, circuit breakers have been modified to prevent both speculative gains and dramatic losses within a small time frame.
United States:
There are three thresholds, which represent different levels of decline in the DJIA in terms of points. These thresholds are set at the beginning of each quarter to establish a specific point value. For example, in the second quarter of 2011, Threshold 1 was a drop of 1200 points, Threshold 2 was 2400 points, and Threshold 3 was 3600 points.
See also:
Until now, Wall Street lobby groups have been able to largely ignore any calls for taxing the financial services industry.
Eleven European governments say they’re going to implement a coordinated tax on stock market transactions, but progress has been slow and U.S. policymakers have been much more cautious.
Now, with Bernie Sanders, a major proponent of such taxes, surging in the polls and market volatility rattling investors, the momentum behind this idea is likely to build—as will the backlash.
What we’re talking about here is a small tax, at a fraction of 1%, on each trade of stocks, bonds and derivatives. Opponents argue this would reduce “market liquidity.” Our ability to buy or sell securities at their so-called “equilibrium value” would be limited. And this, in turn, would translate into poorer resource allocation in the economy, and weaker economic growth.
These fears are misplaced.
In a “bull market” there is plenty of liquidity – it is easy to buy and sell a lot of stock when folks are optimistic and prices are rising. But in a “crisis,” it becomes very difficult to trade.
The observed changes in “liquidity conditions” in these two types of market environments have nothing to do with transactions costs and everything to do with the fear of losing money when prices are falling.
The sad reality is markets mis-price assets all the time. Just take a look at the market this past week. What was the “equilibrium level” of the S&P 500? Was it the low on Tuesday of 1867, or was it the high on Friday of 1990? Was it somewhere in between?
The truth is we don’t know. Stock prices are simply far more volatile than the earnings and cash flows of the companies they represent. And this mispricing of securities often persists for long periods of time, and results in “sub-optimal” resource allocation for our economy.
A tax on stock trades isn’t a magic elixir. It won’t prevent stock prices from moving far away from their “equilibrium values” any more than high transactions costs prevented house prices from moving far away from their equilibrium values. But nor will a transactions tax make our financial markets any less “liquid” of any less “efficient” than they already are.
So why then would a tax on stock transactions be a perfect tax? There are three reasons why.
First, billions of dollars of stock market transactions are already being “taxed.” For more than a decade, so-called high-frequency traders have used so-called “latency arbitrage” to take a little bite from hundreds of millions of transactions in U.S. equity markets.
While a purchase order is slowly making its way to an exchange (the “latency” part), a trader with higher-speed access to that exchange intercepts the order and pre-emptively buys and marks up the price of the shares, and then sells them back at a higher price to the slower-moving buyer (the “arbitrage”).
This activity plays out in milliseconds over and over again, and the victim is unaware of the bite. This transactions “tax” does not do the public a whit of good, but it definitely enriches a handful of traders whose low-percentage, high-volume skimming went, until recently, unnoticed.
An explicit transaction tax could transparently and legitimately capture revenue for public purposes and put the high-volume skimmers out of business.
For believers in efficient markets, low-priced, easy-access trading — so-called “frictionless markets” — has been the great dream. But the reality uncovered by psychologists and behavioral economists is that low-priced trading actually harms the vast majority of Americans that embrace it.
Humans overreact to new stimuli, as do the machines they construct, to trade on their behalf. In financial markets, people and their machines move in herds, watching others and emulating them, buying as prices rise and selling as they fall.
At the supermarket, we respond to higher prices by cutting back purchases and we respond to lower prices by loading up the shopping cart. But in the stock market, buyers flock to stocks that have rallied and shy away from stocks that have slumped.
Low-priced easy-access trading makes stock flipping as easy as Tweeting. It enables our primal urges to follow the crowd and to chase the market. Turning the most straightforward market dictum on its head, low-priced trading – by both humans and by machines — leads us to “buy high and sell low.” We hurt ourselves by frequently flipping stocks and we hurt others by amplifying the volatility of stock price movements.
To quote Jack Bogle, founder of the fund management company Vanguard: “When it comes to trading, the greater the activity, the worse the returns.”
Taxing stock market transactions – intentionally adding meaningful friction to the market – can reduce wasteful trading and improve our financial well-being.
Finally, the proceeds from a tax on financial transactions could do a lot of social good. It could support cash-starved financial regulators desperately seeking funds to fulfill their policy mandates. It could help to fund more generous social security benefits to the millions of Americans with nowhere near enough 401K or IRA savings to support a decent standard of living in their retirement years. It could do many positive things.
The social costs of a financial transactions tax appear to be close to zero, and the potential benefits to society loom large. The perfect tax.
[End of Article]
___________________________________________________________________________
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.
Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell.
Generally speaking, crashes usually occur under the following conditions: a prolonged period of declining stock prices and excessive economic optimism, a market where P/E ratios (Price-Earning ratio) exceed long-term averages, and extensive use of margin debt and leverage by market participants.
Other aspects such as wars, large-corporation hacks, changes in federal laws and regulations, and natural disasters of highly economically productive areas may also influence a significant decline in the stock market value of a wide range of stocks. All such stock drops may result in the rise of stock prices for corporations competing against the affected corporations.
There is no numerically specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index over a period of several days.
Crashes are often distinguished from bear markets by panic selling and abrupt, dramatic price declines. Bear markets are periods of declining stock market prices that are measured in months or years. Crashes are often associated with bear markets, however, they do not necessarily go hand in hand. The crash of 1987, for example, did not lead to a bear market.
Likewise, the Japanese bear market of the 1990s occurred over several years without any notable crashes.
Major crashes in the United States
Panic of 1907:
Main article: Panic of 1907
In 1907 and in 1908, the NYSE fell by nearly 50% due to a variety of factors, led by the manipulation of copper stocks by the Knickerbocker company. Shares of United Copper rose gradually up to October, and thereafter crashed, leading to panic. A number of investment trusts and banks that had invested their money in the stock market fell and started to close down. Further bank runs were prevented due to the intervention of J. P. Morgan. The panic continued to 1908 and led to the formation of the Federal Reserve in 1913.
Wall Street Crash of 1929:
Main article: Wall Street Crash of 1929
The economy had been growing for most of the Roaring Twenties. It was a technological golden age, as innovations such as the radio, automobile, aviation, telephone, and the power grid were deployed and adopted. Companies that had pioneered these advances, like Radio Corporation of America (RCA) and General Motors, saw their stocks soar.
Financial corporations also did well, as Wall Street bankers floated mutual fund companies (then known as investment trusts) like the Goldman Sachs Trading Corporation. Investors were infatuated with the returns available in the stock market, especially by the use of leverage through margin debt.
On August 24, 1921, the Dow Jones Industrial Average stood at a value of 63.9. By September 3, 1929, it had risen more than sixfold, touching 381.2. It would not regain this level for another 25 years.
By the summer of 1929, it was clear that the economy was contracting, and the stock market went through a series of unsettling price declines. These declines fed investor anxiety, and events came to a head on October 24, 28, and 29 (known respectively as Black Thursday, Black Monday, and Black Tuesday).
On Black Monday, the Dow Jones Industrial Average fell 38.33 points to 260, a drop of 12.8%. The deluge of selling overwhelmed the ticker tape system that normally gave investors the current prices of their shares. Telephone lines and telegraphs were clogged and were unable to cope. This information vacuum only led to more fear and panic. The technology of the New Era, previously much celebrated by investors, now served to deepen their suffering.
The following day, Black Tuesday, was a day of chaos. Forced to liquidate their stocks because of margin calls, overextended investors flooded the exchange with sell orders. The Dow fell 30.57 points to close at 230.07 on that day. The glamour stocks of the age saw their values plummet. Across the two days, the Dow Jones Industrial Average fell 23%.
By the end of the weekend of November 11, the index stood at 228, a cumulative drop of 40% from the September high. The markets rallied in succeeding months, but it was a temporary recovery that led unsuspecting investors into further losses.
The Dow Jones Industrial Average lost 89% of its value before finally bottoming out in July 1932. The crash was followed by the Great Depression, the worst economic crisis of modern times, which plagued the stock market and Wall Street throughout the 1930s.
October 19, 1987:
Main article: Black Monday (1987)
The mid-1980s were a time of strong economic optimism. From August 1982 to its peak in August 1987, the Dow Jones Industrial Average (DJIA) grew from 776 to 2722. The rise in market indices for the 19 largest markets in the world averaged 296 percent during this period. The average number of shares traded on the NYSE (New York Stock Exchange) had risen from 65 million shares to 181 million shares.
The crash on October 19, 1987, a date that is also known as Black Monday, was the climactic culmination of a market decline that had begun five days before on October 14. The DJIA fell 3.81 percent on October 14, followed by another 4.60 percent drop on Friday, October 16.
On Black Monday, the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its value in one day. The S&P 500 dropped 20.4%, falling from 282.7 to 225.06.
The NASDAQ Composite lost only 11.3%, not because of restraint on the part of sellers, but because the NASDAQ market system failed. Deluged with sell orders, many stocks on the NYSE faced trading halts and delays. Of the 2,257 NYSE-listed stocks, there were 195 trading delays and halts during the day. The NASDAQ market fared much worse.
Because of its reliance on a "market making" system that allowed market makers to withdraw from trading, liquidity in NASDAQ stocks dried up. Trading in many stocks encountered a pathological condition where the bid price for a stock exceeded the asking price. These "locked" conditions severely curtailed trading. On October 19, trading in Microsoft shares on the NASDAQ lasted a total of 54 minutes.
The Crash was the greatest single-day loss that Wall Street had ever suffered in continuous trading up to that point. Between the start of trading on October 14 to the close on October 19, the DJIA lost 760 points, a decline of over 31 percent.
The 1987 Crash was a worldwide phenomenon. The FTSE 100 Index lost 10.8% on that Monday and a further 12.2% the following day. In the month of October, all major world markets declined substantially. The least affected was Austria (a fall of 11.4%) while the most affected was Hong Kong with a drop of 45.8%. Out of 23 major industrial countries, 19 had a decline greater than 20%.
Despite fears of a repeat of the 1930s Depression, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September 1989, the market had regained all of the value it had lost in the 1987 crash. The Dow Jones Industrial Average gained six-tenths of a percent during the calendar year 1987.
No definitive conclusions have been reached on the reasons behind the 1987 Crash. Stocks had been in a multi-year bull run and market P/E ratios in the U.S. were above the post-war average. The S&P 500 was trading at 23 times earnings, a postwar high and well above the average of 14.5 times earnings. Herd behavior and psychological feedback loops play a critical part in all stock market crashes but analysts have also tried to look for external triggering events.
Aside from the general worries of stock market overvaluation, blame for the collapse has been apportioned to such factors as program trading, portfolio insurance and derivatives, and prior news of worsening economic indicators (i.e. a large U.S. merchandise trade deficit and a falling U.S. dollar, which seemed to imply future interest rate hikes).
One of the consequences of the 1987 Crash was the introduction of the circuit breaker or trading curb on the NYSE. Based upon the idea that a cooling off period would help dissipate investor panic, these mandatory market shutdowns are triggered whenever a large pre-defined market decline occurs during the trading day.
Crash of 2008–2009:
Main article: Financial crisis of 2007–2008
On September 16, 2008, failures of massive financial institutions in the United States, due primarily to exposure to packaged subprime loans and credit default swaps issued to insure these loans and their issuers, rapidly devolved into a global crisis.
This resulted in a number of bank failures in Europe and sharp reductions in the value of stocks and commodities worldwide. The failure of banks in Iceland resulted in a devaluation of the Icelandic króna and threatened the government with bankruptcy. Iceland obtained an emergency loan from the International Monetary Fund in November.
In the United States, 15 banks failed in 2008, while several others were rescued through government intervention or acquisitions by other banks. On October 11, 2008, the head of the International Monetary Fund (IMF) warned that the world financial system was teetering on the "brink of systemic meltdown".
The economic crisis caused countries to close their markets temporarily.
On October 8, the Indonesian stock market halted trading, after a 10% drop in one day.
The Times of London reported that the meltdown was being called the Crash of 2008, and older traders were comparing it with Black Monday in 1987. The fall that week of 21% compared to a 28.3% fall 21 years earlier, but some traders were saying it was worse. "At least then it was a short, sharp, shock on one day. This has been relentless all week."
Business Week also referred to the crisis as a "stock market crash" or the "Panic of 2008".
From October 6–10 the Dow Jones Industrial Average (DJIA) closed lower in all five sessions. Volume levels were record-breaking. The DJIA fell over 1,874 points, or 18%, in its worst weekly decline ever on both a points and percentage basis. The S&P 500 fell more than 20%.
The week also set 3 top ten NYSE Group Volume Records with October 8 at #5, October 9 at #10, and October 10 at #1.
Having been suspended for three successive trading days (October 9, 10, and 13), the Icelandic stock market reopened on 14 October, with the main index, the OMX Iceland 15, closing at 678.4, which was about 77% lower than the 3,004.6 at the close on October 8. This reflected that the value of the three big banks, which had formed 73.2% of the value of the OMX Iceland 15, had been set to zero.
On October 24, many of the world's stock exchanges experienced the worst declines in their history, with drops of around 10% in most indices. In the US, the DJIA fell 3.6%, i.e. not as much as other markets. Instead, both the US dollar and Japanese yen soared against other major currencies, particularly the British pound and Canadian dollar, as world investors sought safe havens.
Later that day, the deputy governor of the Bank of England, Charles Bean, suggested that "This is a once in a lifetime crisis, and possibly the largest financial crisis of its kind in human history."
By March 6, 2009 the DJIA had dropped 54% to 6,469 (before beginning to recover) from its peak of 14,164 on October 9, 2007, over a span of 17 months.
Mitigation strategies:
One mitigation strategy has been the introduction of trading curbs, also known as "circuit breakers", which are a trading halt in the cash market and the corresponding trading halt in the derivative markets triggered by the halt in the cash market, all of which are affected based on substantial movements in a broad market indicator. Since their inception, circuit breakers have been modified to prevent both speculative gains and dramatic losses within a small time frame.
United States:
There are three thresholds, which represent different levels of decline in the DJIA in terms of points. These thresholds are set at the beginning of each quarter to establish a specific point value. For example, in the second quarter of 2011, Threshold 1 was a drop of 1200 points, Threshold 2 was 2400 points, and Threshold 3 was 3600 points.
- If Threshold 2 is breached before 1 pm, the market closes for two hours. If such a decline occurs between 1 pm and 2 pm, there is a one-hour pause. The market would close for the day if stocks sank to that level after 2 pm
- If Threshold 3 is breached, the market would close for the day, regardless of the time.
See also:
- List of stock market crashes and bear markets
- VIX, Chicago Board Options Exchange Market Volatility Index
- Mass hysteria
- Behavioral finance
- Business cycle
- Causes of the Great Depression
- Economic bubble
- Economic collapse
- Financial market
- Financial stability
- Financial crisis
- Flight-to-liquidity
- Great Contraction
- Market trend
- Modeling and analysis of financial markets
- Stock market boom
- Stock market bubble
- Financial crisis of 2007–08
- Great Depression
- Meltdown Monday
- Subprime mortgage crisis
- Flash crash
- 2015–16 Chinese stock market crash
- 2016 United Kingdom European Union membership referendum
- Le Bris, David. "What is a market crash?" The Economic History Review
- Stock Market Crash of 1929.
Stock Market Index
- YouTube Video: How to Invest in the Stock Market for Beginners
- YouTube Video: Why New Investors Lose Money
- YouTube Video: Just a regular billionaire (Warren Buffett)
A stock index or stock market index is a measurement of a section of the stock market. It is computed from the prices of selected stocks (typically a weighted average). It is a tool used by investors and financial managers to describe the market, and to compare the return on specific investments.
Two of the primary criteria of an index are that it is investable and transparent: the method of its construction should be clear. Many mutual funds and exchange-traded funds attempt to "track" an index (see index fund) with varying degrees of success. The difference between an index fund's performance and the index is called tracking error.
Types of indices:
Stock market indices may be classified in many ways. A 'world' or 'global' stock market index — such as the MSCI World or the S&P Global 100 — includes stocks from multiple regions. Regions may be defined geographically (e.g., Europe, Asia) or by levels of industrialization or income (e.g., Developed Markets, Frontier Markets).
A 'national' index represents the performance of the stock market of a given nation—and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225, the Indian NIFTY 50, and the British FTSE 100.
Many indices are regional, such as the FTSE Developed Europe Index or the FTSE Developed Asia Pacific Index. Indexes may be based on exchange, such as the NASDAQ-100 or NYSE US 100, or groups of exchanges, such as the Euronext 100 or OMX Nordic 40.
The concept may be extended well beyond an exchange. The Wilshire 5000 Index, the original total market index, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs nor limited partnerships), NASDAQ and American Stock Exchange.
Russell Investment Group added to the family of indices by launching the Russell Global Index.
More specialized indices exist tracking the performance of specific sectors of the market. Some examples include the Wilshire US REIT which tracks more than 80 American real estate investment trusts and the Morgan Stanley Biotech Index which consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria — one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.
Index versions:
Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for.
For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax.
As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each:
Weighting:
An index may also be classified according to the method used to determine its price. In a price-weighted index such as the Dow Jones Industrial Average, NYSE Arca Major Market Index, and the NYSE Arca Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index.
Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole.
In contrast, a capitalization-weighted (also called market-value-weighted) index such as the S&P 500 or Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index.
Traditionally, capitalization- or share-weighted indices all had a full weighting, i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing.
An equal-weighted index is one in which all components are assigned the same value. For example, the Barron's 400 Index assigns an equal value of 0.25% to each of the 400 stocks included in the index, which together add up to the 100% whole.
A modified capitalization-weighted index is a hybrid between capitalization weighting and equal weighting. It is similar to a capitalization weighting with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap.
Moreover, in 2005, Standard & Poor's introduced the S&P Pure Growth Style Index and S&P Pure Value Style Index which was attribute-weighted. That is, a stock's weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place.
For these two indexes, a score is calculated for every stock, be it their growth score or the value score (a stock cannot be both) and accordingly they are weighted for the index.
Criticism of capitalization-weighting:
One argument for capitalization weighting is that investors must, in aggregate, hold a capitalization-weighted portfolio anyway. This then gives the average return for all investors; if some investors do worse, other investors must do better (excluding costs).
Investors use theories such as modern portfolio theory to determine allocations.
This considers risk and return and does not consider weights relative to the entire market. This may result in overweighting assets such as value or small-cap stocks, if they are believed to have a better return for risk profile. These investors believe that they can get a better result because other investors are not very good.
The capital asset pricing model says that all investors are highly intelligent, and it is impossible to do better than the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indices are not efficient.
This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method.
As a consequence, capitalization-weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization-weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.
Also, while capitalization-weighting is the standard in equity index construction, different weighting schemes exist.
First, while most indices use capitalization-weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the “Guide to the Dow Jones Global Titan 50 Index”, January 2006).
Second, as an answer to the critiques of capitalization-weighting, equity indices with different weighting schemes have emerged, such as "wealth"-weighted (Morris, 1996), “fundamental”-weighted (Arnott, Hsu and Moore 2005), “diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.[12]
Indices and passive investment management:
There has been an accelerating trend in recent decades to invest in passively managed mutual funds that are based on market indices, known as index funds. SPIVA's annual "U.S. Scorecard", which measures the performance of indices versus actively managed mutual funds, finds the vast majority of actively managed mutual funds underperform their benchmarks.
One study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio).
Since index funds attempt to replicate the holdings of an index, they eliminate the need for — and thus many costs of — the research entailed in active management, and have a lower churn rate (the turnover of securities which lose fund managers' favor and are sold, with the attendant cost of commissions and capital gains taxes).
Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short.
Ethical stock market indices:
A notable specialized index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of:
In 2010, the OIC announced the initiation of a stock index that complies with Islamic law's ban on alcohol, tobacco and gambling. Other such equities, such as the Dow Jones Islamic Market Index, already exist.
Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 30% of the TSE 300 index value.
Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria.
Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.
Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams.
One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "market transparency" and "disclosure" are the only long-term-effective paths to fair markets.
From a financial perspective, it is not obvious whether ethical indices or ethical funds will out-perform their more conventional counterparts. Theory might suggest that returns would be lower since the investible universe is artificially reduced and with it portfolio efficiency.
On the other hand, companies with good social performances might be better run, have more committed workers and customers, and be less likely to suffer reputational damage from incidents (oil spillages, industrial tribunals, etc.) and this might result in lower share price volatility. The empirical evidence on the performance of ethical funds and of ethical firms versus their mainstream comparators is very mixed for both stock and debt markets.
Innovation awards to stock indices:
The William F. Sharpe Indexing Achievement Awards are presented annually in order to recognize the most important contributions to the indexing industry over the preceding year:
See also:
Two of the primary criteria of an index are that it is investable and transparent: the method of its construction should be clear. Many mutual funds and exchange-traded funds attempt to "track" an index (see index fund) with varying degrees of success. The difference between an index fund's performance and the index is called tracking error.
Types of indices:
Stock market indices may be classified in many ways. A 'world' or 'global' stock market index — such as the MSCI World or the S&P Global 100 — includes stocks from multiple regions. Regions may be defined geographically (e.g., Europe, Asia) or by levels of industrialization or income (e.g., Developed Markets, Frontier Markets).
A 'national' index represents the performance of the stock market of a given nation—and by proxy, reflects investor sentiment on the state of its economy. The most regularly quoted market indices are national indices composed of the stocks of large companies listed on a nation's largest stock exchanges, such as the American S&P 500, the Japanese Nikkei 225, the Indian NIFTY 50, and the British FTSE 100.
Many indices are regional, such as the FTSE Developed Europe Index or the FTSE Developed Asia Pacific Index. Indexes may be based on exchange, such as the NASDAQ-100 or NYSE US 100, or groups of exchanges, such as the Euronext 100 or OMX Nordic 40.
The concept may be extended well beyond an exchange. The Wilshire 5000 Index, the original total market index, represents the stocks of nearly every publicly traded company in the United States, including all U.S. stocks traded on the New York Stock Exchange (but not ADRs nor limited partnerships), NASDAQ and American Stock Exchange.
Russell Investment Group added to the family of indices by launching the Russell Global Index.
More specialized indices exist tracking the performance of specific sectors of the market. Some examples include the Wilshire US REIT which tracks more than 80 American real estate investment trusts and the Morgan Stanley Biotech Index which consists of 36 American firms in the biotechnology industry. Other indices may track companies of a certain size, a certain type of management, or even more specialized criteria — one index published by Linux Weekly News tracks stocks of companies that sell products and services based on the Linux operating environment.
Index versions:
Some indices, such as the S&P 500, have multiple versions. These versions can differ based on how the index components are weighted and on how dividends are accounted for.
For example, there are three versions of the S&P 500 index: price return, which only considers the price of the components, total return, which accounts for dividend reinvestment, and net total return, which accounts for dividend reinvestment after the deduction of a withholding tax.
As another example, the Wilshire 4500 and Wilshire 5000 indices have five versions each:
- full capitalization total return,
- full capitalization price,
- float-adjusted total return,
- float-adjusted price, and equal weight.
- The difference between the full capitalization, float-adjusted, and equal weight versions is in how index components are weighted.
Weighting:
An index may also be classified according to the method used to determine its price. In a price-weighted index such as the Dow Jones Industrial Average, NYSE Arca Major Market Index, and the NYSE Arca Tech 100 Index, the price of each component stock is the only consideration when determining the value of the index.
Thus, price movement of even a single security will heavily influence the value of the index even though the dollar shift is less significant in a relatively highly valued issue, and moreover ignoring the relative size of the company as a whole.
In contrast, a capitalization-weighted (also called market-value-weighted) index such as the S&P 500 or Hang Seng Index factors in the size of the company. Thus, a relatively small shift in the price of a large company will heavily influence the value of the index.
Traditionally, capitalization- or share-weighted indices all had a full weighting, i.e. all outstanding shares were included. Recently, many of them have changed to a float-adjusted weighting which helps indexing.
An equal-weighted index is one in which all components are assigned the same value. For example, the Barron's 400 Index assigns an equal value of 0.25% to each of the 400 stocks included in the index, which together add up to the 100% whole.
A modified capitalization-weighted index is a hybrid between capitalization weighting and equal weighting. It is similar to a capitalization weighting with one main difference: the largest stocks are capped to a percent of the weight of the total stock index and the excess weight will be redistributed equally amongst the stocks under that cap.
Moreover, in 2005, Standard & Poor's introduced the S&P Pure Growth Style Index and S&P Pure Value Style Index which was attribute-weighted. That is, a stock's weight in the index is decided by the score it gets relative to the value attributes that define the criteria of a specific index, the same measure used to select the stocks in the first place.
For these two indexes, a score is calculated for every stock, be it their growth score or the value score (a stock cannot be both) and accordingly they are weighted for the index.
Criticism of capitalization-weighting:
One argument for capitalization weighting is that investors must, in aggregate, hold a capitalization-weighted portfolio anyway. This then gives the average return for all investors; if some investors do worse, other investors must do better (excluding costs).
Investors use theories such as modern portfolio theory to determine allocations.
This considers risk and return and does not consider weights relative to the entire market. This may result in overweighting assets such as value or small-cap stocks, if they are believed to have a better return for risk profile. These investors believe that they can get a better result because other investors are not very good.
The capital asset pricing model says that all investors are highly intelligent, and it is impossible to do better than the market portfolio, the capitalization-weighted portfolio of all assets. However, empirical tests conclude that market indices are not efficient.
This can be explained by the fact that these indices do not include all assets or by the fact that the theory does not hold. The practical conclusion is that using capitalization-weighted portfolios is not necessarily the optimal method.
As a consequence, capitalization-weighting has been subject to severe criticism (see e.g. Haugen and Baker 1991, Amenc, Goltz, and Le Sourd 2006, or Hsu 2006), pointing out that the mechanics of capitalization-weighting lead to trend-following strategies that provide an inefficient risk-return trade-off.
Also, while capitalization-weighting is the standard in equity index construction, different weighting schemes exist.
First, while most indices use capitalization-weighting, additional criteria are often taken into account, such as sales/revenue and net income (see the “Guide to the Dow Jones Global Titan 50 Index”, January 2006).
Second, as an answer to the critiques of capitalization-weighting, equity indices with different weighting schemes have emerged, such as "wealth"-weighted (Morris, 1996), “fundamental”-weighted (Arnott, Hsu and Moore 2005), “diversity”-weighted (Fernholz, Garvy, and Hannon 1998) or equal-weighted indices.[12]
Indices and passive investment management:
There has been an accelerating trend in recent decades to invest in passively managed mutual funds that are based on market indices, known as index funds. SPIVA's annual "U.S. Scorecard", which measures the performance of indices versus actively managed mutual funds, finds the vast majority of actively managed mutual funds underperform their benchmarks.
One study claimed that over time, the average actively managed fund has returned 1.8% less than the S&P 500 index - a result nearly equal to the average expense ratio of mutual funds (fund expenses are a drag on the funds' return by exactly that ratio).
Since index funds attempt to replicate the holdings of an index, they eliminate the need for — and thus many costs of — the research entailed in active management, and have a lower churn rate (the turnover of securities which lose fund managers' favor and are sold, with the attendant cost of commissions and capital gains taxes).
Indices are also a common basis for a related type of investment, the exchange-traded fund or ETF. Unlike an index fund, which is priced daily, an ETF is priced continuously, is optionable, and can be sold short.
Ethical stock market indices:
A notable specialized index type is those for ethical investing indices that include only those companies satisfying ecological or social criteria, e.g. those of:
- The Calvert Group,
- KLD,
- FTSE4Good Index,
- Dow Jones Sustainability Index,
- STOXX Global ESG Leaders Index,
- several Standard Ethics Aei indices
- and Wilderhill Clean Energy Index.
In 2010, the OIC announced the initiation of a stock index that complies with Islamic law's ban on alcohol, tobacco and gambling. Other such equities, such as the Dow Jones Islamic Market Index, already exist.
Another important trend is strict mechanical criteria for inclusion and exclusion to prevent market manipulation, e.g. in Canada when Nortel was permitted to rise to over 30% of the TSE 300 index value.
Ethical indices have a particular interest in mechanical criteria, seeking to avoid accusations of ideological bias in selection, and have pioneered techniques for inclusion and exclusion of stocks based on complex criteria.
Another means of mechanical selection is mark-to-future methods that exploit scenarios produced by multiple analysts weighted according to probability, to determine which stocks have become too risky to hold in the index of concern.
Critics of such initiatives argue that many firms satisfy mechanical "ethical criteria", e.g. regarding board composition or hiring practices, but fail to perform ethically with respect to shareholders, e.g. Enron. Indeed, the seeming "seal of approval" of an ethical index may put investors more at ease, enabling scams.
One response to these criticisms is that trust in the corporate management, index criteria, fund or index manager, and securities regulator, can never be replaced by mechanical means, so "market transparency" and "disclosure" are the only long-term-effective paths to fair markets.
From a financial perspective, it is not obvious whether ethical indices or ethical funds will out-perform their more conventional counterparts. Theory might suggest that returns would be lower since the investible universe is artificially reduced and with it portfolio efficiency.
On the other hand, companies with good social performances might be better run, have more committed workers and customers, and be less likely to suffer reputational damage from incidents (oil spillages, industrial tribunals, etc.) and this might result in lower share price volatility. The empirical evidence on the performance of ethical funds and of ethical firms versus their mainstream comparators is very mixed for both stock and debt markets.
Innovation awards to stock indices:
The William F. Sharpe Indexing Achievement Awards are presented annually in order to recognize the most important contributions to the indexing industry over the preceding year:
- Most Innovative Benchmark Index
- 2004 — CBOE S&P 500 BuyWrite Index (BXM)
- 2005 — FTSE/RAFI Fundamental Index Series
- 2006 — Standard and Poor’s Case-Shiller House Prices Indices
- 2007 - CBOE S&P 500 PutWrite Index (PUT)
- 2011 - S&P GSCI Dynamic Roll Index
- Most Innovative ETF
- 2004 — iShares MSCI EAFE (EFA) and Emerging Markets
- 2005 — EasyETF GSCI Commodities ETF
- 2006 — PowerShares DB Commodity Index Tracking Fund (DBC) and PowerShares G10 Currency Harvest Fund (DBV)
- 2007 - SPDR DJ Wilshire International Real Estate ETF SPDR
- 2011 - ProShares VIX Short-term Futures ETF (VIXY)
- Most Innovative Index Product
- 2004 — CBOE Volatility Index (VIX) Futures
- 2005 — Options on Vanguard VIPERS at the CBOE
- 2006 — Chicago Board Options Exchange Options on the CBOE Volatility Index (VIX)
- 2007 - iPath ETNs
- 2009 - Thomson Reuters Realized Volatility Index
- Best Index-related Research Paper
- 2004 — Steven Schoenfeld
- 2005 — Rob Arnott, Jason Hsu and Philip Moore of Research Affiliates, LLC
- 2006 — Eugene Fama and Kenneth French
- 2007 - Benchmarking Benchmarks: Measuring Characteristic Selectivity, By Kingsley Fong, David R. Gallagher, Adrian Lee, University of New South Wales
- 2011 - Index Volatility in Perspective, by Joanne Hill
- Lifetime Achievement Award
- 2004 — Tim Harbert
- 2005 — William F. Sharpe and Nathan Most
- 2006 — Burton Malkiel and Ronald J. Ryan
- 2007 - John C. Bogle, Paul Samuelson, Patricia C. Dunn, William L. Fouse and John A. Prestbo
- 2008 - Leo Melamed, Joanne Hill, Joe Levin, and Kelly Haughton
- 2009 - William J. Brodsky and Gus Sauter
- 2011 - Lee Kranefuss
- 2015 - Robert E. Whaley
- Index of accounting articles
- Index of economics articles
- Index of management articles
- List of stock market indices
- Outline of finance
- Outline of marketing
See also:
Financial Markets, including a List of Stock Exchanges
as well as the Glossary of Stock Market Terms
** -- Enron Scandal
Pictured below: Financial Markets – Functions, Importance And Types
as well as the Glossary of Stock Market Terms
- YouTube Video: "How I learned to read -- and trade stocks -- in prison | Curtis "Wall Street" Carroll
- YouTube Video: Warren Buffett*: How Many Stocks Should You Own In Your Portfolio?
- YouTube Video: Enron* - The Biggest Fraud in History
** -- Enron Scandal
Pictured below: Financial Markets – Functions, Importance And Types
Click here for a Glossary of Stock Market Terms.
A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Securities include stocks and bonds, and precious metals.
The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (such as the NYSE, LSE, JSE, BSE) or an electronic system (such as NASDAQ).
Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, to stock exchanges.
Types of financial markets:
Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below.
The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets allow investors to buy and sell existing securities. The transactions in primary markets exist between issuers and investors, while secondary market transactions exist among investors.
Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount.
Raising capital:
Financial markets attract funds from investors and channel them to corporations—they thus allow corporations to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term basis, while capital markets allow corporations to gain long-term funding to support expansion (known as maturity transformation).
Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.
The following table illustrates where financial markets fit in the relationship between lenders and borrowers:
A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Securities include stocks and bonds, and precious metals.
The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (such as the NYSE, LSE, JSE, BSE) or an electronic system (such as NASDAQ).
Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, to stock exchanges.
Types of financial markets:
Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below.
- Capital markets which consist of:
- Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.
- Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.
- Commodity markets, which facilitate the trading of commodities.
- Money markets, which provide short term debt financing and investment.
- Derivatives markets, which provide instruments for the management of financial risk.
- Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market.
- Foreign exchange markets, which facilitate the trading of foreign exchange.
- Cryptocurrency market which facilitate the trading of digital assets and financial technologies.
- Spot market
- Interbank lending market
The capital markets may also be divided into primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets allow investors to buy and sell existing securities. The transactions in primary markets exist between issuers and investors, while secondary market transactions exist among investors.
Liquidity is a crucial aspect of securities that are traded in secondary markets. Liquidity refers to the ease with which a security can be sold without a loss of value. Securities with an active secondary market mean that there are many buyers and sellers at a given point in time. Investors benefit from liquid securities because they can sell their assets whenever they want; an illiquid security may force the seller to get rid of their asset at a large discount.
Raising capital:
Financial markets attract funds from investors and channel them to corporations—they thus allow corporations to finance their operations and achieve growth. Money markets allow firms to borrow funds on a short term basis, while capital markets allow corporations to gain long-term funding to support expansion (known as maturity transformation).
Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks, Investment Banks, and Boutique Investment Banks can help in this process. Banks take deposits from those who have money to save. They can then lend money from this pool of deposited money to those who seek to borrow. Banks popularly lend money in the form of loans and mortgages.
More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. A good example of a financial market is a stock exchange. A company can raise money by selling shares to investors and its existing shares can be bought or sold.
The following table illustrates where financial markets fit in the relationship between lenders and borrowers:
- In the above, Financial Intermediaries is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, pooled investment funds, and stock exchanges. Financial intermediaries reallocate otherwise un-invested capital to productive enterprises through a variety of debt, equity, or hybrid stake-holding structures.
Lenders:
The lender temporarily gives money to somebody else, on the condition of getting back the principal amount together with some interest or profit or charge.
Individuals and doubles:
Many individuals are not aware that they are lenders, but almost everybody does lend money in many ways. A person lends money when he or she:
- Puts money in a savings account at a bank
- Contributes to a pension plan
- Pays premiums to an insurance company
- Invests in government bonds
Companies:
Companies tend to be lenders of capital. When companies have surplus cash that is not needed for a short period of time, they may seek to make money from their cash surplus by lending it via short term markets called money markets. Alternatively, such companies may decide to return the cash surplus to their shareholders (e.g. via a share repurchase or dividend payment).
Borrowers:
- Individuals borrow money via bankers' loans for short term needs or longer term mortgages to help finance a house purchase.
- Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernization or future business expansion. It is common for companies to use mixed packages of different types of funding for different purposes – especially where large complex projects such as company management buyouts are concerned.
- Governments often find their spending requirements exceed their tax revenues. To make up this difference, they need to borrow. Governments also borrow on behalf of nationalized industries, municipalities, local authorities and other public sector bodies. In the UK, the total borrowing requirement is often referred to as the Public sector net cash requirement (PSNCR).
Governments borrow by issuing bonds. In the UK, the government also borrows from individuals by offering bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed, the debt seemingly expands rather than being paid off. One strategy used by governments to reduce the value of the debt is to influence inflation.
Municipalities and local authorities may borrow in their own name as well as receiving funding from national governments. In the UK, this would cover an authority like Hampshire County Council.
Public Corporations typically include nationalized industries. These may include the postal services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.
Borrowers having similar needs can form into a group of borrowers. They can also take an organizational form like Mutual Funds. They can provide mortgage on weight basis. The main advantage is that this lowers the cost of their borrowings.
Derivative products:
During the 1980s and 1990s, a major growth sector in financial markets was the trade in so called derivatives.
In the financial markets, stock prices,share prices, bond prices, currency rates, interest rates and dividends go up and down, creating risk. Derivative products are financial products which are used to control risk or paradoxically exploit risk. It is also called financial economics.
Derivative products or instruments help the issuers to gain an unusual profit from issuing the instruments. For using the help of these products a contract has to be made. Derivative contracts are mainly 4 types:
- Future
- Forward
- Option
- Swap
Seemingly, the most obvious buyers and sellers of currency are importers and exporters of goods. While this may have been true in the distant past, when international trade created the demand for currency markets, importers and exporters now represent only 1/32 of foreign exchange dealing, according to the Bank for International Settlements.
The picture of foreign currency transactions today shows:
- Banks/Institutions
- Speculators
- Government spending (for example, military bases abroad)
- Importers/Exporters
- Tourists
Analysis of financial markets:
See Statistical analysis of financial markets, statistical finance
Much effort has gone into the study of financial markets and how prices vary with time. Charles Dow, one of the founders of Dow Jones & Company and The Wall Street Journal, enunciated a set of ideas on the subject which are now called Dow theory. This is the basis of the so-called technical analysis method of attempting to predict future changes. One of the tenets of "technical analysis" is that market trends give an indication of the future, at least in the short term.
The claims of the technical analysts are disputed by many academics, who claim that the evidence points rather to the random walk hypothesis, which states that the next change is not correlated to the last change. The role of human psychology in price variations also plays a significant factor.
Large amounts of volatility often indicate the presence of strong emotional factors playing into the price. Fear can cause excessive drops in price and greed can create bubbles. In recent years the rise of algorithmic and high-frequency program trading has seen the adoption of momentum, ultra-short term moving average and other similar strategies which are based on technical as opposed to fundamental or theoretical concepts of market
The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoit Mandelbrot that changes in prices do not follow a normal distribution, but are rather modeled better by Lévy stable distributions. The scale of change, or volatility, depends on the length of the time unit to a power a bit more than 1/2. Large changes up or down are more likely than what one would calculate using a normal distribution with an estimated standard deviation.
Financial market slang:
- Poison pill, when a company issues more shares to prevent being bought out by another company, thereby increasing the number of outstanding shares to be bought by the hostile company making the bid to establish majority.
- Bips, meaning "bps" or basis points. A basis point is a financial unit of measurement used to describe the magnitude of percent change in a variable. One basis point is the equivalent of one hundredth of a percent. For example, if a stock price were to rise 100bit/s, it means it would increase 1%.
- Quant, a quantitative analyst with advanced training in mathematics and statistical methods.
- Rocket scientist, a financial consultant at the zenith of mathematical and computer programming skill. They are able to invent derivatives of high complexity and construct sophisticated pricing models. They generally handle the most advanced computing techniques adopted by the financial markets since the early 1980s. Typically, they are physicists and engineers by training.
- IPO, stands for initial public offering, which is the process a new private company goes through to "go public" or become a publicly traded company on some index.
- White Knight, a friendly party in a takeover bid. Used to describe a party that buys the shares of one organization to help prevent against a hostile takeover of that organization by another party.
- Round-tripping
- Smurfing, a deliberate structuring of payments or transactions to conceal it from regulators or other parties, a type of money laundering that is often illegal.
- Bid–ask spread, the difference between the highest bid and the lowest offer.
- Pip, smallest price move that a given exchange rate makes based on market convention.
- Pegging, when a country wants to obtain price stability, it can use pegging to fix their exchange rate relative to another currency.
Functions of financial markets:
- Intermediary functions: The intermediary functions of financial markets include the following:
- Transfer of resources: Financial markets facilitate the transfer of real economic resources from lenders to ultimate borrowers.
- Enhancing income: Financial markets allow lenders to earn interest or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income.
- Productive usage: Financial markets allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.
- Capital formation: Financial markets provide a channel through which new savings flow to aid capital formation of a country.
- Price determination: Financial markets allow for the determination of price of the traded financial assets through the interaction of buyers and sellers. They provide a sign for the allocation of funds in the economy based on the demand and to the supply through the mechanism called price discovery process.
- Sale mechanism: Financial markets provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets.
- Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.
- Financial Functions
- Providing the borrower with funds so as to enable them to carry out their investment plans.
- Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures.
- Providing liquidity in the market so as to facilitate trading of funds.
- Providing liquidity to commercial bank
- Facilitating credit creation
- Promoting savings
- Promoting investment
- Facilitating balanced economic growth
- Improving trading floors
Components of financial market:
Based on market levels:
- Primary market: Primary market is a market for new issues or new financial claims. Hence it’s also called new issue market. The primary market deals with those securities which are issued to the public for the first time.
- Secondary market: A market for secondary sale of securities. In other words, securities which have already passed through the new issue market are traded in this market. Generally, such securities are quoted in the stock exchange and it provides a continuous and regular market for buying and selling of securities.
Simply put, primary market is the market where the newly started company issued shares to the public for the first time through IPO (initial public offering). Secondary market is the market where the second hand securities are sold (securitCommodity Marketies).
Based on security types:
- Money market: Money market is a market for dealing with the financial assets and securities which have a maturity period of up to one year. In other words, it’s a market for purely short-term funds.
- Capital market: A capital market is a market for financial assets which have a long or indefinite maturity. Generally, it deals with long-term securities which have a maturity period of above one year. The capital market may be further divided into (a) industrial securities market (b) Govt. securities market and (c) long-term loans market.
- Equity markets: A market where ownership of securities are issued and subscribed is known as equity market. An example of a secondary equity market for shares is the New York (NYSE) stock exchange.
- Debt market: The market where funds are borrowed and lent is known as debt market. Arrangements are made in such a way that the borrowers agree to pay the lender the original amount of the loan plus some specified amount of interest.
- Derivative markets: A market where financial instruments are derived and traded based on an underlying asset such as commodities or stocks.
- Financial service market: A market that comprises participants such as commercial banks that provide various financial services like ATM. Credit cards. Credit rating, stock broking etc. is known as financial service market. Individuals and firms use financial services markets, to purchase services that enhance the workings of debt and equity markets.
- Depository markets: A depository market consists of depository institutions (such as banks) that accept deposits from individuals and firms and uses these funds to participate in the debt market, by giving loans or purchasing other debt instruments such as treasury bills.
- Non-depository market: Non-depository market carry out various functions in financial markets ranging from financial intermediary to selling, insurance etc. The various constituencies in non-depositary markets are mutual funds, insurance companies, pension funds, brokerage firms etc.
See also:
- Finance capitalism
- Financial services
- Financial instrument
- Financial market efficiency
- Brownian Model of Financial Markets
- Investment theory
- Quantitative behavioral finance
- Mathematical finance
- Stock investor
- Financial Market Theory of Development
- Liquidity
- Cooperative banking
- Financial Markets with Yale Professor Robert Shiller
- Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial Markets Group
List of stock exchanges:
This is a list of major stock exchanges. Those futures exchanges that also offer trading in securities besides trading in futures contracts are listed both here and in the list of futures exchanges.
There are sixteen stock exchanges in the world that have a market capitalization of over US$1 trillion each. They are sometimes referred to as the "$1 Trillion Club". These exchanges accounted for 87% of global market capitalization in 2015. Some exchanges do include companies from outside the country where the exchange is located.
Click on any of the following blue hyperlinks for the List of Stock Exchanges:
Commodity Markets, List of Traded Commodities, and Their Commodity Exchanges
- YouTube Video: Commodity Trading for Dummies
- YouTube Video: Introduction to commodities - MoneyWeek Investment Tutorials
- YouTube Video: What are futures? - MoneyWeek Investment Tutorials
Click here for a List of traded commodities.
Click here List of commodities exchanges.
A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil.
Investors access about 50 major commodity markets worldwide with purely financial transactions increasingly outnumbering physical trades in which goods are delivered. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets.
Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.
A financial derivative is a financial instrument whose value is derived from a commodity termed an underlyer. Derivatives are either exchange-traded or over-the-counter (OTC).
An increasing number of derivatives are traded via clearing houses some with central counterparty clearing, which provide clearing and settlement services on a futures exchange, as well as off-exchange in the OTC market.
Derivatives such as futures contracts, Swaps (1970s-), Exchange-traded Commodities (ETC) (2003-), forward contracts have become the primary trading instruments in commodity markets. Futures are traded on regulated commodities exchanges. Over-the-counter (OTC) contracts are "privately negotiated bilateral contracts entered into between the contracting parties directly".
Exchange-traded funds (ETFs) began to feature commodities in 2003. Gold ETFs are based on "electronic gold" that does not entail the ownership of physical bullion, with its added costs of insurance and storage in repositories such as the London bullion market. According to the World Gold Council, ETFs allow investors to be exposed to the gold market without the risk of price volatility associated with gold as a physical commodity.
Commodity price index:
In 1934, the US Bureau of Labor Statistics began the computation of a daily Commodity price index that became available to the public in 1940.
By 1952, the Bureau of Labor Statistics issued a Spot Market Price Index that measured the price movements of "22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity."
Commodity index fund:
A commodity index fund is a fund whose assets are invested in financial instruments based on or linked to a commodity index. In just about every case the index is in fact a Commodity Futures Index.
The first such index was the Commodity Research Bureau (CRB) Index, which began in 1958. Its construction made it unuseful as an investment index.
The first practically investable commodity futures index was the Goldman Sachs Commodity Index, created in 1991, and known as the "GSCI".
The next was the Dow Jones AIG Commodity Index. It differed from the GSCI primarily in the weights allocated to each commodity. The DJ AIG had mechanisms to periodically limit the weight of any one commodity and to remove commodities whose weights became too small.
After AIG's financial problems in 2008 the Index rights were sold to UBS and it is now known as the DJUBS index. Other commodity indices include the Reuters / CRB index (which is the old CRB Index as re-structured in 2005) and the Rogers Index.
Cash commodity:
Cash commodities or "actuals" refer to the physical goods—e.g., wheat, corn, soybeans, crude oil, gold, silver—that someone is buying/selling/trading as distinguished from derivatives.
Call options:
In a call option, counterparties enter into a financial contract option where the buyer purchases the right but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
Electronic commodities trading:
In traditional stock market exchanges such as the New York Stock Exchange (NYSE), most trading activity took place in the trading pits in face-to-face interactions between brokers and dealers in open outcry trading. In 1992 the Financial Information eXchange (FIX) protocol was introduced, allowing international real-time exchange of information regarding market transactions.
The U.S. Securities and Exchange Commission ordered U.S. stock markets to convert from the fractional system to a decimal system by April 2001. Metrification, conversion from the imperial system of measurement to the metrical, increased throughout the 20th century.
Eventually FIX-compliant interfaces were adopted globally by commodity exchanges using the FIX Protocol. In 2001 the Chicago Board of Trade and the Chicago Mercantile Exchange (later merged into the CME group, the world's largest futures exchange company) launched their FIX-compliant interface.
By 2011, the alternative trading system (ATS) of electronic trading featured computers buying and selling without human dealer intermediation. High-frequency trading (HFT) algorithmic trading, had almost phased out "dinosaur floor-traders".
Complexity and interconnectedness of global market
The robust growth of emerging market economies (EMEs, such as Brazil, Russia, India, and China), beginning in the 1990s, "propelled commodity markets into a supercycle". The size and diversity of commodity markets expanded internationally, and pension funds and sovereign wealth funds started allocating more capital to commodities, in order to diversify into an asset class with less exposure to currency depreciation.
In 2012, as emerging-market economies slowed down, commodity prices peaked and started to decline. From 2005 through 2013, energy and metals' real prices remained well above their long-term averages. In 2012, real food prices were their highest since 1982.
The price of gold bullion fell dramatically on 12 April 2013 and analysts frantically sought explanations. Rumors spread that the European Central Bank (ECB) would force Cyprus to sell its gold reserves in response to its financial crisis. Major banks such as Goldman Sachs began immediately to short gold bullion.
Investors scrambled to liquidate their exchange-traded funds (ETFs) and margin call selling accelerated. George Gero, precious metals commodities expert at the Royal Bank of Canada (RBC) Wealth Management section reported that he had not seen selling of gold bullion as panicked as this in his forty years in commodity markets.
The earliest commodity exchange-traded fund (ETFs), such as SPDR Gold Shares NYSE Arca: GLD and iShares Silver Trust NYSE Arca: SLV, actually owned the physical commodities. Similar to these are NYSE Arca: PALL (palladium) and NYSE Arca: PPLT (platinum). However, most Exchange Traded Commodities (ETCs) implement a futures trading strategy.
At the time Russian Prime Minister Dmitry Medvedev warned that Russia could sink into recession. He argued that "We live in a dynamic, fast-developing world. It is so global and so complex that we sometimes cannot keep up with the changes". Analysts have claimed that Russia's economy is overly dependent on commodities.
Contracts in the commodity market:
A Spot contract is an agreement where delivery and payment either takes place immediately, or with a short lag. Physical trading normally involves a visual inspection and is carried out in physical markets such as a farmers market. Derivatives markets, on the other hand, require the existence of agreed standards so that trades can be made without visual inspection.
Standardization:
US soybean futures, for something else, are of not being standard grade if they are "GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Indiana, Ohio and Michigan origin produced in the U.S.A. (Non-screened, stored in silo)". They are of "deliverable grade" if they are "GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Iowa, Illinois and Wisconsin origin produced in the U.S.A. (Non-screened, stored in silo)". Note the distinction between states, and the need to clearly mention their status as GMO (genetically modified organism) which makes them unacceptable to most organic food buyers.
Similar specifications apply for any of the following:
Standardization has also occurred technologically, as the use of the FIX Protocol by commodities exchanges has allowed trade messages to be sent, received and processed in the same format as stocks or equities. This process began in 2001 when the Chicago Mercantile Exchange launched a FIX-compliant interface that was adopted by commodity exchanges around the world.
Derivatives:
Derivatives evolved from simple commodity future contracts into a diverse group of financial instruments that apply to every kind of asset, including mortgages, insurance and many more.
Futures contracts, Swaps (1970s-), Exchange-traded Commodities (ETC) (2003-), forward contracts, etc. are examples. They can be traded through formal exchanges or through Over-the-counter (OTC). Commodity market derivatives unlike credit default derivatives for example, are secured by the physical assets or commodities.
Forward contracts:
A forward contract is an agreement between two parties to exchange at a fixed future date a given quantity of a commodity for a specific price defined when the contract is finalized. The fixed price is also called forward price. Such forward contracts began as a way of reducing pricing risk in food and agricultural product markets.
By agreeing in advance on a price for a future delivery, farmers were able protect their output against a possible fall of market prices and in contrast buyers were able to protect themselves against's a possible rise of market prices.
Forward contracts for example, were used for rice in seventeenth century Japan.
Futures contract:
Futures contracts are standardized forward contracts that are transacted through an exchange.
In futures contracts the buyer and the seller stipulate product, grade, quantity and location and leaving price as the only variable.
Agricultural futures contracts are the oldest, in use in the United States for more than 170 years.
Modern futures agreements, began in Chicago in the 1840s, with the appearance of the railroads. Chicago, centrally located, emerged as the hub between Midwestern farmers and east coast consumer population centers.
Swaps:
A swap is a derivative in which counterparties exchange the cash flows of one party's financial instrument for those of the other party's financial instrument. They were introduced in the 1970s.
Exchange-traded commodities (ETCs):
Main article: Exchange-traded product
Exchange-traded commodity is a term used for commodity exchange-traded funds (which are funds) or commodity exchange-traded notes (which are notes). These track the performance of an underlying commodity index including total return indices based on a single commodity.
They are similar to ETFs and traded and settled exactly like stock funds. ETCs have market maker support with guaranteed liquidity, enabling investors to easily invest in commodities.
They were introduced in 2003.
At first only professional institutional investors had access, but online exchanges opened some ETC markets to almost anyone. ETCs were introduced partly in response to the tight supply of commodities in 2000, combined with record low inventories and increasing demand from emerging markets such as China and India.
Prior to the introduction of ETCs, by the 1990s ETFs pioneered by Barclays Global Investors (BGI) revolutionized the mutual funds industry. By the end of December 2009 BGI assets hit an all-time high of $1 trillion.
Gold was the first commodity to be securitised through an Exchange Traded Fund (ETF) in the early 1990s, but it was not available for trade until 2003. The idea of a Gold ETF was first officially conceived by Benchmark Asset Management Company Private Ltd in India, when they filed a proposal with the Securities and Exchange Board of India in May 2002.
The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares, was the second-largest ETF by market capitalization.
Generally, commodity ETFs are index funds tracking non-security indices. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.
The earliest commodity ETFs, such as SPDR Gold Shares NYSE Arca: GLD and iShares Silver Trust NYSE Arca: SLV, actually owned the physical commodity (e.g., gold and silver bars).
Similar to these are NYSE Arca: PALL (palladium) and NYSE Arca: PPLT (platinum). However, most ETCs implement a futures trading strategy, which may produce quite different results from owning the commodity.
Commodity ETFs trade provide exposure to an increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. Many commodity funds, such as oil roll so-called front-month futures contracts from month to month. This provides exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.
ETCs in China and India gained in importance due to those countries' emergence as commodities consumers and producers. China accounted for more than 60% of exchange-traded commodities in 2009, up from 40% the previous year. The global volume of ETCs increased by a 20% in 2010, and 50% since 2008, to around 2.5 billion million contracts.
Over-the-counter (OTC) commodities derivatives:
Over-the-counter (OTC) commodities derivatives trading originally involved two parties, without an exchange. Exchange trading offers greater transparency and regulatory protections. In an OTC trade, the price is not generally made public. OTC commodities derivatives are higher risk but may also lead to higher profits.
Between 2007 and 2010, global physical exports of commodities fell by 2%, while the outstanding value of OTC commodities derivatives declined by two-thirds as investors reduced risk following a five-fold increase in the previous three years.
Money under management more than doubled between 2008 and 2010 to nearly $380 billion. Inflows into the sector totaled over $60 billion in 2010, the second highest year on record, down from $72 billion the previous year. The bulk of funds went into precious metals and energy products. The growth in prices of many commodities in 2010 contributed to the increase in the value of commodities funds under management.
Contract for Difference (CFD):
A commodity contract for difference (CFD) is a derivative instrument that mirrors the price movements of the commodity underlying the contract.
Commodity CFDs are transacted worldwide (apart from the US) through regulated brokers. CFD investors can speculate on the price of a commodity moving higher (going long the CFD) or lower (going short the CFD). CFD investors do not actually own the commodity.
Instead, they enter into a contract with a broker to capture the difference between the price of the commodity at the time that they transact the CFD and the price at the time they choose to exit. CFDs typically require the investor to put up margin of about 3-5% of the price of the underlying commodity contract.
For example; Imagine you’re bullish on oil. You decide to acquire CFDs to capitalize on this. You can acquire a long contract for $60.50. To buy 20 long CFDs on 3% margin, you would need $3,630 in your account ($60.50 [long price] x 20 [number of contracts] x 100 [number of barrels in a standard contract] x 0.03 [margin percent]). You would then “control” $121,000 worth of oil for your $3,630.
That afternoon, you notice the price is up to $62.50 to $62.75, so you exit the trade, which now has a value of $125,500. Your profit would be approximately $4,500 on the deal. Of course, had the market moved against you, the leverage can have the opposite impact and losses can be significant.
Commodities exchange:
Main article: Commodities exchange
A commodities exchange is an exchange where various commodities and derivatives are traded. Most commodity markets across the world trade in agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them. These contracts can include spot prices, forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or freight contracts.
Click on any of the following blue hyperlinks for more about the Commodities Market:
Click here List of commodities exchanges.
A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil.
Investors access about 50 major commodity markets worldwide with purely financial transactions increasingly outnumbering physical trades in which goods are delivered. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets.
Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.
A financial derivative is a financial instrument whose value is derived from a commodity termed an underlyer. Derivatives are either exchange-traded or over-the-counter (OTC).
An increasing number of derivatives are traded via clearing houses some with central counterparty clearing, which provide clearing and settlement services on a futures exchange, as well as off-exchange in the OTC market.
Derivatives such as futures contracts, Swaps (1970s-), Exchange-traded Commodities (ETC) (2003-), forward contracts have become the primary trading instruments in commodity markets. Futures are traded on regulated commodities exchanges. Over-the-counter (OTC) contracts are "privately negotiated bilateral contracts entered into between the contracting parties directly".
Exchange-traded funds (ETFs) began to feature commodities in 2003. Gold ETFs are based on "electronic gold" that does not entail the ownership of physical bullion, with its added costs of insurance and storage in repositories such as the London bullion market. According to the World Gold Council, ETFs allow investors to be exposed to the gold market without the risk of price volatility associated with gold as a physical commodity.
Commodity price index:
In 1934, the US Bureau of Labor Statistics began the computation of a daily Commodity price index that became available to the public in 1940.
By 1952, the Bureau of Labor Statistics issued a Spot Market Price Index that measured the price movements of "22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity."
Commodity index fund:
A commodity index fund is a fund whose assets are invested in financial instruments based on or linked to a commodity index. In just about every case the index is in fact a Commodity Futures Index.
The first such index was the Commodity Research Bureau (CRB) Index, which began in 1958. Its construction made it unuseful as an investment index.
The first practically investable commodity futures index was the Goldman Sachs Commodity Index, created in 1991, and known as the "GSCI".
The next was the Dow Jones AIG Commodity Index. It differed from the GSCI primarily in the weights allocated to each commodity. The DJ AIG had mechanisms to periodically limit the weight of any one commodity and to remove commodities whose weights became too small.
After AIG's financial problems in 2008 the Index rights were sold to UBS and it is now known as the DJUBS index. Other commodity indices include the Reuters / CRB index (which is the old CRB Index as re-structured in 2005) and the Rogers Index.
Cash commodity:
Cash commodities or "actuals" refer to the physical goods—e.g., wheat, corn, soybeans, crude oil, gold, silver—that someone is buying/selling/trading as distinguished from derivatives.
Call options:
In a call option, counterparties enter into a financial contract option where the buyer purchases the right but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or "writer") is obligated to sell the commodity or financial instrument should the buyer so decide. The buyer pays a fee (called a premium) for this right.
Electronic commodities trading:
In traditional stock market exchanges such as the New York Stock Exchange (NYSE), most trading activity took place in the trading pits in face-to-face interactions between brokers and dealers in open outcry trading. In 1992 the Financial Information eXchange (FIX) protocol was introduced, allowing international real-time exchange of information regarding market transactions.
The U.S. Securities and Exchange Commission ordered U.S. stock markets to convert from the fractional system to a decimal system by April 2001. Metrification, conversion from the imperial system of measurement to the metrical, increased throughout the 20th century.
Eventually FIX-compliant interfaces were adopted globally by commodity exchanges using the FIX Protocol. In 2001 the Chicago Board of Trade and the Chicago Mercantile Exchange (later merged into the CME group, the world's largest futures exchange company) launched their FIX-compliant interface.
By 2011, the alternative trading system (ATS) of electronic trading featured computers buying and selling without human dealer intermediation. High-frequency trading (HFT) algorithmic trading, had almost phased out "dinosaur floor-traders".
Complexity and interconnectedness of global market
The robust growth of emerging market economies (EMEs, such as Brazil, Russia, India, and China), beginning in the 1990s, "propelled commodity markets into a supercycle". The size and diversity of commodity markets expanded internationally, and pension funds and sovereign wealth funds started allocating more capital to commodities, in order to diversify into an asset class with less exposure to currency depreciation.
In 2012, as emerging-market economies slowed down, commodity prices peaked and started to decline. From 2005 through 2013, energy and metals' real prices remained well above their long-term averages. In 2012, real food prices were their highest since 1982.
The price of gold bullion fell dramatically on 12 April 2013 and analysts frantically sought explanations. Rumors spread that the European Central Bank (ECB) would force Cyprus to sell its gold reserves in response to its financial crisis. Major banks such as Goldman Sachs began immediately to short gold bullion.
Investors scrambled to liquidate their exchange-traded funds (ETFs) and margin call selling accelerated. George Gero, precious metals commodities expert at the Royal Bank of Canada (RBC) Wealth Management section reported that he had not seen selling of gold bullion as panicked as this in his forty years in commodity markets.
The earliest commodity exchange-traded fund (ETFs), such as SPDR Gold Shares NYSE Arca: GLD and iShares Silver Trust NYSE Arca: SLV, actually owned the physical commodities. Similar to these are NYSE Arca: PALL (palladium) and NYSE Arca: PPLT (platinum). However, most Exchange Traded Commodities (ETCs) implement a futures trading strategy.
At the time Russian Prime Minister Dmitry Medvedev warned that Russia could sink into recession. He argued that "We live in a dynamic, fast-developing world. It is so global and so complex that we sometimes cannot keep up with the changes". Analysts have claimed that Russia's economy is overly dependent on commodities.
Contracts in the commodity market:
A Spot contract is an agreement where delivery and payment either takes place immediately, or with a short lag. Physical trading normally involves a visual inspection and is carried out in physical markets such as a farmers market. Derivatives markets, on the other hand, require the existence of agreed standards so that trades can be made without visual inspection.
Standardization:
US soybean futures, for something else, are of not being standard grade if they are "GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Indiana, Ohio and Michigan origin produced in the U.S.A. (Non-screened, stored in silo)". They are of "deliverable grade" if they are "GMO or a mixture of GMO and Non-GMO No. 2 yellow soybeans of Iowa, Illinois and Wisconsin origin produced in the U.S.A. (Non-screened, stored in silo)". Note the distinction between states, and the need to clearly mention their status as GMO (genetically modified organism) which makes them unacceptable to most organic food buyers.
Similar specifications apply for any of the following:
- cotton,
- orange juice,
- cocoa,
- sugar,
- wheat,
- corn,
- barley,
- pork bellies,
- milk,
- feed,
- stuffs,
- fruits,
- vegetables,
- other grains,
- other beans,
- hay,
- other livestock,
- meats,
- poultry,
- eggs,
- or any other commodity which is so traded.
Standardization has also occurred technologically, as the use of the FIX Protocol by commodities exchanges has allowed trade messages to be sent, received and processed in the same format as stocks or equities. This process began in 2001 when the Chicago Mercantile Exchange launched a FIX-compliant interface that was adopted by commodity exchanges around the world.
Derivatives:
Derivatives evolved from simple commodity future contracts into a diverse group of financial instruments that apply to every kind of asset, including mortgages, insurance and many more.
Futures contracts, Swaps (1970s-), Exchange-traded Commodities (ETC) (2003-), forward contracts, etc. are examples. They can be traded through formal exchanges or through Over-the-counter (OTC). Commodity market derivatives unlike credit default derivatives for example, are secured by the physical assets or commodities.
Forward contracts:
A forward contract is an agreement between two parties to exchange at a fixed future date a given quantity of a commodity for a specific price defined when the contract is finalized. The fixed price is also called forward price. Such forward contracts began as a way of reducing pricing risk in food and agricultural product markets.
By agreeing in advance on a price for a future delivery, farmers were able protect their output against a possible fall of market prices and in contrast buyers were able to protect themselves against's a possible rise of market prices.
Forward contracts for example, were used for rice in seventeenth century Japan.
Futures contract:
Futures contracts are standardized forward contracts that are transacted through an exchange.
In futures contracts the buyer and the seller stipulate product, grade, quantity and location and leaving price as the only variable.
Agricultural futures contracts are the oldest, in use in the United States for more than 170 years.
Modern futures agreements, began in Chicago in the 1840s, with the appearance of the railroads. Chicago, centrally located, emerged as the hub between Midwestern farmers and east coast consumer population centers.
Swaps:
A swap is a derivative in which counterparties exchange the cash flows of one party's financial instrument for those of the other party's financial instrument. They were introduced in the 1970s.
Exchange-traded commodities (ETCs):
Main article: Exchange-traded product
Exchange-traded commodity is a term used for commodity exchange-traded funds (which are funds) or commodity exchange-traded notes (which are notes). These track the performance of an underlying commodity index including total return indices based on a single commodity.
They are similar to ETFs and traded and settled exactly like stock funds. ETCs have market maker support with guaranteed liquidity, enabling investors to easily invest in commodities.
They were introduced in 2003.
At first only professional institutional investors had access, but online exchanges opened some ETC markets to almost anyone. ETCs were introduced partly in response to the tight supply of commodities in 2000, combined with record low inventories and increasing demand from emerging markets such as China and India.
Prior to the introduction of ETCs, by the 1990s ETFs pioneered by Barclays Global Investors (BGI) revolutionized the mutual funds industry. By the end of December 2009 BGI assets hit an all-time high of $1 trillion.
Gold was the first commodity to be securitised through an Exchange Traded Fund (ETF) in the early 1990s, but it was not available for trade until 2003. The idea of a Gold ETF was first officially conceived by Benchmark Asset Management Company Private Ltd in India, when they filed a proposal with the Securities and Exchange Board of India in May 2002.
The first gold exchange-traded fund was Gold Bullion Securities launched on the ASX in 2003, and the first silver exchange-traded fund was iShares Silver Trust launched on the NYSE in 2006. As of November 2010 a commodity ETF, namely SPDR Gold Shares, was the second-largest ETF by market capitalization.
Generally, commodity ETFs are index funds tracking non-security indices. Because they do not invest in securities, commodity ETFs are not regulated as investment companies under the Investment Company Act of 1940 in the United States, although their public offering is subject to SEC review and they need an SEC no-action letter under the Securities Exchange Act of 1934. They may, however, be subject to regulation by the Commodity Futures Trading Commission.
The earliest commodity ETFs, such as SPDR Gold Shares NYSE Arca: GLD and iShares Silver Trust NYSE Arca: SLV, actually owned the physical commodity (e.g., gold and silver bars).
Similar to these are NYSE Arca: PALL (palladium) and NYSE Arca: PPLT (platinum). However, most ETCs implement a futures trading strategy, which may produce quite different results from owning the commodity.
Commodity ETFs trade provide exposure to an increasing range of commodities and commodity indices, including energy, metals, softs and agriculture. Many commodity funds, such as oil roll so-called front-month futures contracts from month to month. This provides exposure to the commodity, but subjects the investor to risks involved in different prices along the term structure, such as a high cost to roll.
ETCs in China and India gained in importance due to those countries' emergence as commodities consumers and producers. China accounted for more than 60% of exchange-traded commodities in 2009, up from 40% the previous year. The global volume of ETCs increased by a 20% in 2010, and 50% since 2008, to around 2.5 billion million contracts.
Over-the-counter (OTC) commodities derivatives:
Over-the-counter (OTC) commodities derivatives trading originally involved two parties, without an exchange. Exchange trading offers greater transparency and regulatory protections. In an OTC trade, the price is not generally made public. OTC commodities derivatives are higher risk but may also lead to higher profits.
Between 2007 and 2010, global physical exports of commodities fell by 2%, while the outstanding value of OTC commodities derivatives declined by two-thirds as investors reduced risk following a five-fold increase in the previous three years.
Money under management more than doubled between 2008 and 2010 to nearly $380 billion. Inflows into the sector totaled over $60 billion in 2010, the second highest year on record, down from $72 billion the previous year. The bulk of funds went into precious metals and energy products. The growth in prices of many commodities in 2010 contributed to the increase in the value of commodities funds under management.
Contract for Difference (CFD):
A commodity contract for difference (CFD) is a derivative instrument that mirrors the price movements of the commodity underlying the contract.
Commodity CFDs are transacted worldwide (apart from the US) through regulated brokers. CFD investors can speculate on the price of a commodity moving higher (going long the CFD) or lower (going short the CFD). CFD investors do not actually own the commodity.
Instead, they enter into a contract with a broker to capture the difference between the price of the commodity at the time that they transact the CFD and the price at the time they choose to exit. CFDs typically require the investor to put up margin of about 3-5% of the price of the underlying commodity contract.
For example; Imagine you’re bullish on oil. You decide to acquire CFDs to capitalize on this. You can acquire a long contract for $60.50. To buy 20 long CFDs on 3% margin, you would need $3,630 in your account ($60.50 [long price] x 20 [number of contracts] x 100 [number of barrels in a standard contract] x 0.03 [margin percent]). You would then “control” $121,000 worth of oil for your $3,630.
That afternoon, you notice the price is up to $62.50 to $62.75, so you exit the trade, which now has a value of $125,500. Your profit would be approximately $4,500 on the deal. Of course, had the market moved against you, the leverage can have the opposite impact and losses can be significant.
Commodities exchange:
Main article: Commodities exchange
A commodities exchange is an exchange where various commodities and derivatives are traded. Most commodity markets across the world trade in agricultural products and other raw materials (like wheat, barley, sugar, maize, cotton, cocoa, coffee, milk products, pork bellies, oil, metals, etc.) and contracts based on them. These contracts can include spot prices, forwards, futures and options on futures. Other sophisticated products may include interest rates, environmental instruments, swaps, or freight contracts.
Click on any of the following blue hyperlinks for more about the Commodities Market:
- History
- Commodities exchange
- Traded commodity classes
- Regulatory bodies and policies
- Trading systems
- See also:
Currency, including a List of Circulating Currencies and Their Exchange Rates
- YouTube Video: How to spot counterfeit money
- YouTube Video: Nobody Understands the Stock Market (by Michael Lewis, Bloomberg)
- YouTube Video: Who Controls All of Our Money?
A currency in the most specific use of the word refers to money in any form when in actual use or circulation as a medium of exchange, especially circulating banknotes and coins.
A more general definition is that a currency is a system of money (monetary units) in common use, especially in a nation.
Under this definition, US dollars, British pounds, Australian dollars, and European euros are examples of currency. These various currencies are recognized stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.
Other definitions of the term "currency" are discussed in their respective synonymous articles banknote, coin, and money. The latter definition, pertaining to the currency systems of nations, is the topic of this article.
Currencies can be classified into two monetary systems: fiat money and commodity money, depending on what guarantees the value (the economy at large vs. the government's physical metal reserves).
Some currencies are legal tender in certain political jurisdictions, which means they cannot be refused as payment for debt. Others are simply traded for their economic value. Digital currency has arisen with the popularity of computers and the Internet.
Click on any of the following blue hyperlinks for more about Currency:
List of Circulating Currencies Worldwide:
This list contains the 180 currencies recognized as legal tender in United Nations (UN) member states, UN observer states, partially recognized or unrecognized states, and their dependencies. Dependencies and unrecognized states are listed here only if another currency is used in their territory that is different from the one of the state that administers them or has jurisdiction over them.
A currency is a kind of money and medium of exchange. Currency includes paper, cotton, or polymer banknotes and metal coins. States generally have a monopoly on the issuing of currency, although some states share currencies with other states.
For the purposes of this list, only currencies that are legal tender, including those used in actual commerce or issued for commemorative purposes, are considered "circulating currencies". This includes fractional units that have no physical form but are recognized by the issuing state, such as the United States mill, the Egyptian millime, and the Japanese rin.
Currencies used by non-state entities, like the Sovereign Military Order of Malta, scrips used by private entities, and other private, virtual, and alternative currencies are not under the purview of this list.
Click on any of the following blue hyperlinks for a List of Circulating Currencies Worldwide: ___________________________________________________________________________
In finance, an exchange rate of two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in relation to another currency.
For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥114. In this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.
Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers, and where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
In the retail currency exchange market, different buying and selling rates will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell that currency.
The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way. Different rates may also be quoted for cash , a documentary form or electronically .
The higher rate on documentary transactions has been justified as compensating for the additional time and cost of clearing the document. On the other hand, cash is available for resale immediately, but brings security, storage, and transportation costs, and the cost of tying up capital in a stock of banknotes (bills).
Click on any of the following blue hyperlinks for more about The Currency Exchange Rate:
A more general definition is that a currency is a system of money (monetary units) in common use, especially in a nation.
Under this definition, US dollars, British pounds, Australian dollars, and European euros are examples of currency. These various currencies are recognized stores of value and are traded between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in this sense are defined by governments, and each type has limited boundaries of acceptance.
Other definitions of the term "currency" are discussed in their respective synonymous articles banknote, coin, and money. The latter definition, pertaining to the currency systems of nations, is the topic of this article.
Currencies can be classified into two monetary systems: fiat money and commodity money, depending on what guarantees the value (the economy at large vs. the government's physical metal reserves).
Some currencies are legal tender in certain political jurisdictions, which means they cannot be refused as payment for debt. Others are simply traded for their economic value. Digital currency has arisen with the popularity of computers and the Internet.
Click on any of the following blue hyperlinks for more about Currency:
- History
- Early currency
Coinage
Paper money
Banknote era
- Early currency
- Modern currencies
- Alternative currencies
- Control and production
- Currency convertibility
- Local currencies
- List of Major World Payments Currencies
- Proposed currencies
- See also:
- Related concepts
- Accounting units:
- Lists:
List of Circulating Currencies Worldwide:
This list contains the 180 currencies recognized as legal tender in United Nations (UN) member states, UN observer states, partially recognized or unrecognized states, and their dependencies. Dependencies and unrecognized states are listed here only if another currency is used in their territory that is different from the one of the state that administers them or has jurisdiction over them.
A currency is a kind of money and medium of exchange. Currency includes paper, cotton, or polymer banknotes and metal coins. States generally have a monopoly on the issuing of currency, although some states share currencies with other states.
For the purposes of this list, only currencies that are legal tender, including those used in actual commerce or issued for commemorative purposes, are considered "circulating currencies". This includes fractional units that have no physical form but are recognized by the issuing state, such as the United States mill, the Egyptian millime, and the Japanese rin.
Currencies used by non-state entities, like the Sovereign Military Order of Malta, scrips used by private entities, and other private, virtual, and alternative currencies are not under the purview of this list.
Click on any of the following blue hyperlinks for a List of Circulating Currencies Worldwide: ___________________________________________________________________________
In finance, an exchange rate of two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in relation to another currency.
For example, an interbank exchange rate of 114 Japanese yen to the United States dollar means that ¥114 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥114. In this case it is said that the price of a dollar in relation to yen is ¥114, or equivalently that the price of a yen in relation to dollars is $1/114.
Exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers, and where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
In the retail currency exchange market, different buying and selling rates will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell that currency.
The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way. Different rates may also be quoted for cash , a documentary form or electronically .
The higher rate on documentary transactions has been justified as compensating for the additional time and cost of clearing the document. On the other hand, cash is available for resale immediately, but brings security, storage, and transportation costs, and the cost of tying up capital in a stock of banknotes (bills).
Click on any of the following blue hyperlinks for more about The Currency Exchange Rate:
- The retail exchange market
- Quotations
- Exchange rate regime
- Fluctuations in exchange rates
- Purchasing power of currency
- Bilateral vs. effective exchange rate
- Parallel exchange rate
- Uncovered interest rate parity
- Balance of payments model
- Asset market model
- Manipulation of exchange rates
- See also:
Wall Street and The Financial District in Manhattan, including the Wall Street Journal (Re-directs from "Free Press" web page) Pictured below: The Financial District of Lower Manhattan viewed from New York Harbor, near the Statue of Liberty, October 2013
Click here to be taken to the topic about the "Wall Street Journal"
Wall Street is an eight-block-long street running roughly northwest to southeast from Broadway to South Street, at the East River, in the Financial District of Lower Manhattan in New York City.
Over time, the term has become a metonym for the financial markets of the United States as a whole, the American financial services industry (even if financial firms are not physically located there), or New York–based financial interests.
Anchored by Wall Street, New York City has been called both the most economically powerful city and the leading financial center of the world, and the city is home to the world's two largest stock exchanges by total market capitalization: the New York Stock Exchange and NASDAQ.
Several other major exchanges have or had headquarters in the Wall Street area, including the New York Mercantile Exchange, the New York Board of Trade, and the former American Stock Exchange.
Click here for more about Wall Street.
___________________________________________________________________________
The Financial District of Lower Manhattan, also known as FiDi, is a neighborhood located on the southern tip of Manhattan island in New York City. It is bounded by the West Side Highway on the west, Chambers Street and City Hall Park on the north, Brooklyn Bridge on the northeast, the East River to the southeast, and The Battery on the south.
The City of New York was created in the Financial District in 1624, and the neighborhood roughly overlaps with the boundaries of the New Amsterdam settlement in the late 17th century.
The district comprises the offices and headquarters of many of the city's major financial institutions, including the New York Stock Exchange and the Federal Reserve Bank of New York.
Anchored on Wall Street in the Financial District, New York City has been called both the most financially powerful city and the leading financial center of the world, and the New York Stock Exchange is the world's largest stock exchange by total market capitalization.
Several other major exchanges have or had headquarters in the Financial District, including:
The Financial District is part of Manhattan Community District 1 and its primary ZIP Codes are 10004, 10005, 10006, and 10038. It is patrolled by the 1st Precinct of the New York City Police Department.
Description:
The Financial District encompasses roughly the area south of City Hall Park in Lower Manhattan but excludes Battery Park and Battery Park City.
The former World Trade Center complex was located in the neighborhood until the September 11, 2001 attacks; the neighborhood includes the successor One World Trade Center.
The heart of the Financial District is often considered to be the corner of Wall Street and Broad Street, both of which are contained entirely within the district. The northeastern part of the financial district (along Fulton Street and John Street) was known in the early 20th century as the Insurance District, due to the large number of insurance companies that were either headquartered there, or maintained their New York offices there.
Although the term is sometimes used as a synonym for Wall Street, the latter term is often applied metonymously to the financial markets as a whole (and is also a street in the district), whereas "the Financial District" implies an actual geographical location.
The Financial District is part of Manhattan Community Board 1, which also includes five other neighborhoods:
Architecture:
The Financial District's architecture is generally rooted in the Gilded Age, though there are also some art deco influences in the neighborhood. The area is distinguished by narrow streets, a steep topography, and high-rises Construction in such narrow steep areas has resulted in occasional accidents such as a crane collapse.
One report divided lower Manhattan into three basic districts:
Federal Hall National Memorial, on the site of the first U.S. capitol and the first inauguration of George Washington as the first President of the United States, is located at the corner of Wall Street and Nassau Street.
The Financial District has a number of tourist attractions such as:
Another key anchor for the area is the New York Stock Exchange. City authorities realize its importance, and believed that it has "outgrown its neoclassical temple at the corner of Wall and Broad streets", and in 1998 offered substantial tax incentives to try to keep it in the Financial District.
Plans to rebuild it were delayed by the September 11, 2001 attacks. The exchange still occupies the same site. The exchange is the locus for a large amount of technology and data. For example, to accommodate the three thousand persons who work directly on the Exchange floor requires 3,500 kilowatts of electricity, along with 8,000 phone circuits on the trading floor alone, and 200 miles of fiber-optic cable below ground.
Surrounding neighborhood:
During most of the 20th century, the Financial District was a business community with practically only offices which emptied out at night. A report in The New York Times in 1961 described a "deathlike stillness that settles on the district after 5:30 and all day Saturday and Sunday".
But there has been a change towards greater residential use of the area, pushed forwards by technological changes and shifting market conditions. The general pattern is for several hundred thousand workers to commute into the area during the day, sometimes by sharing a taxicab from other parts of the city as well as from New Jersey and Long Island, and then leave at night.
In 1970 only 833 people lived "south of Chambers Street"; by 1990, 13,782 people were residents with the addition of areas such as Battery Park City and Southbridge Towers.
Battery Park City was built on 92 acres of landfill, and 3,000 people moved there beginning about 1982, but by 1986 there was evidence of more shops and stores and a park, along with plans for more residential development.
According to one description in 1996, "The area dies at night ... It needs a neighborhood, a community." During the past two decades there has been a shift towards greater residential living areas in the Financial District, with incentives from city authorities in some instances.
Many empty office buildings have been converted to lofts and apartments; for example, the office building of Harry Sinclair, the oil magnate involved with the Teapot Dome scandal, was converted to a co-op in 1979.
In 1996, a fifth of buildings and warehouses were empty, and many were converted to living areas. Some conversions met with problems, such as aging gargoyles on building exteriors having to be expensively restored to meet with current building codes.
Residents in the area have sought to have a supermarket, a movie theater, a pharmacy, more schools, and a "good diner". The discount retailer named Job Lot used to be located at the World Trade Center but moved to Church Street; merchants bought extra unsold items at steep prices and sold them as a discount to consumers, and shoppers included "thrifty homemakers and browsing retirees" who "rubbed elbows with City Hall workers and Wall Street executives"; but the firm went bust in 1993.
There were reports that the number of residents increased by 60% during the 1990s to about 25,000 although a second estimate (based on the 2000 census based on a different map) places the residential population in 2000 at 12,042.
By 2001 there were several grocery stores, dry cleaners, and two grade schools and a top high school. There is also a long-standing a barber shop across from the New York Stock Exchange. Additionally, there were more signs of dogwalkers at night and a 24-hour neighborhood, although the general pattern of crowds during the working hours and emptiness at night was still apparent.
There were also ten hotels and thirteen museums. Stuyvesant High School moved to its present location near Battery Park City in 1992 and has been described as one of the nation's premier high schools with emphasis on science and mathematics.
In 2007 the French fashion retailer Hermès opened a store in the financial district to sell items such as a "$4,700 custom-made leather dressage saddle or a $47,000 limited edition alligator briefcase".
However, there are reports of panhandlers like elsewhere in the city. By 2010 the residential population had increased to 24,400 residents. and the area was growing with luxury high-end apartments and upscale retailers.
Street grid:
The streets in the area were laid out prior to the Commissioners' Plan of 1811, a grid plan that dictates the placement of most of Manhattan's streets north of Houston Street. Thus, it has small streets "barely wide enough for a single lane of traffic are bordered on both sides by some of the tallest buildings in the city", according to one description, which creates "breathtaking artificial canyons" offering spectacular views in some instances.
Some streets have been designated as pedestrian-only with vehicular traffic prohibited.
Tourism:
The Financial District is a major location of tourism in New York City. One report described lower Manhattan as "swarming with camera-carrying tourists". Tour guides highlight places such as Trinity Church, the Federal Reserve gold vaults 80 feet below street level (worth $100 billion), and the NYSE. A Scoundrels of Wall Street Tour is a walking historical tour which includes a museum visit and discussion of various financiers "who were adept at finding ways around finance laws or loopholes through them".
Occasionally artists make impromptu performances; for example, in 2010, a troupe of 22 dancers "contort their bodies and cram themselves into the nooks and crannies of the Financial District in Bodies in Urban Spaces" choreographed by Willi Donner.
One chief attraction, the Federal Reserve Building in lower Manhattan, paid $750,000 to open a visitors' gallery in 1997. The New York Stock Exchange and the American Stock Exchange also spent money in the late 1990s to upgrade facilities for visitors. Attractions include the gold vault beneath the Federal Reserve and that "staring down at the trading floor was as exciting as going to the Statue of Liberty".
Click on any of the following blue hyperlinks for more about the Financial District of Manhattan:
Wall Street is an eight-block-long street running roughly northwest to southeast from Broadway to South Street, at the East River, in the Financial District of Lower Manhattan in New York City.
Over time, the term has become a metonym for the financial markets of the United States as a whole, the American financial services industry (even if financial firms are not physically located there), or New York–based financial interests.
Anchored by Wall Street, New York City has been called both the most economically powerful city and the leading financial center of the world, and the city is home to the world's two largest stock exchanges by total market capitalization: the New York Stock Exchange and NASDAQ.
Several other major exchanges have or had headquarters in the Wall Street area, including the New York Mercantile Exchange, the New York Board of Trade, and the former American Stock Exchange.
Click here for more about Wall Street.
___________________________________________________________________________
The Financial District of Lower Manhattan, also known as FiDi, is a neighborhood located on the southern tip of Manhattan island in New York City. It is bounded by the West Side Highway on the west, Chambers Street and City Hall Park on the north, Brooklyn Bridge on the northeast, the East River to the southeast, and The Battery on the south.
The City of New York was created in the Financial District in 1624, and the neighborhood roughly overlaps with the boundaries of the New Amsterdam settlement in the late 17th century.
The district comprises the offices and headquarters of many of the city's major financial institutions, including the New York Stock Exchange and the Federal Reserve Bank of New York.
Anchored on Wall Street in the Financial District, New York City has been called both the most financially powerful city and the leading financial center of the world, and the New York Stock Exchange is the world's largest stock exchange by total market capitalization.
Several other major exchanges have or had headquarters in the Financial District, including:
- the New York Mercantile Exchange,
- NASDAQ,
- the New York Board of Trade,
- and the former American Stock Exchange.
The Financial District is part of Manhattan Community District 1 and its primary ZIP Codes are 10004, 10005, 10006, and 10038. It is patrolled by the 1st Precinct of the New York City Police Department.
Description:
The Financial District encompasses roughly the area south of City Hall Park in Lower Manhattan but excludes Battery Park and Battery Park City.
The former World Trade Center complex was located in the neighborhood until the September 11, 2001 attacks; the neighborhood includes the successor One World Trade Center.
The heart of the Financial District is often considered to be the corner of Wall Street and Broad Street, both of which are contained entirely within the district. The northeastern part of the financial district (along Fulton Street and John Street) was known in the early 20th century as the Insurance District, due to the large number of insurance companies that were either headquartered there, or maintained their New York offices there.
Although the term is sometimes used as a synonym for Wall Street, the latter term is often applied metonymously to the financial markets as a whole (and is also a street in the district), whereas "the Financial District" implies an actual geographical location.
The Financial District is part of Manhattan Community Board 1, which also includes five other neighborhoods:
Architecture:
The Financial District's architecture is generally rooted in the Gilded Age, though there are also some art deco influences in the neighborhood. The area is distinguished by narrow streets, a steep topography, and high-rises Construction in such narrow steep areas has resulted in occasional accidents such as a crane collapse.
One report divided lower Manhattan into three basic districts:
- The Financial District proper—particularly along John Street
- South of the World Trade Center area—the handful of blocks south of the World Trade Center along Greenwich, Washington and West Streets
- Seaport district—characterized by century-old low-rise buildings and South Street Seaport; the seaport is "quiet, residential, and has an old world charm" according to one description.
Federal Hall National Memorial, on the site of the first U.S. capitol and the first inauguration of George Washington as the first President of the United States, is located at the corner of Wall Street and Nassau Street.
The Financial District has a number of tourist attractions such as:
- the South Street Seaport Historic District,
- newly renovated Pier 17,
- the New York City Police Museum, and Museum of American Finance.
- National Museum of the American Indian, Trinity Church, St. Paul's Chapel, and the famous bull. Bowling Green is the starting point of traditional ticker-tape parades on Broadway, where here it is also known as the Canyon of Heroes.
- The Museum of Jewish Heritage and the Skyscraper Museum are both in adjacent Battery Park City which is also home to the Brookfield Place (formerly World Financial Center).
Another key anchor for the area is the New York Stock Exchange. City authorities realize its importance, and believed that it has "outgrown its neoclassical temple at the corner of Wall and Broad streets", and in 1998 offered substantial tax incentives to try to keep it in the Financial District.
Plans to rebuild it were delayed by the September 11, 2001 attacks. The exchange still occupies the same site. The exchange is the locus for a large amount of technology and data. For example, to accommodate the three thousand persons who work directly on the Exchange floor requires 3,500 kilowatts of electricity, along with 8,000 phone circuits on the trading floor alone, and 200 miles of fiber-optic cable below ground.
Surrounding neighborhood:
During most of the 20th century, the Financial District was a business community with practically only offices which emptied out at night. A report in The New York Times in 1961 described a "deathlike stillness that settles on the district after 5:30 and all day Saturday and Sunday".
But there has been a change towards greater residential use of the area, pushed forwards by technological changes and shifting market conditions. The general pattern is for several hundred thousand workers to commute into the area during the day, sometimes by sharing a taxicab from other parts of the city as well as from New Jersey and Long Island, and then leave at night.
In 1970 only 833 people lived "south of Chambers Street"; by 1990, 13,782 people were residents with the addition of areas such as Battery Park City and Southbridge Towers.
Battery Park City was built on 92 acres of landfill, and 3,000 people moved there beginning about 1982, but by 1986 there was evidence of more shops and stores and a park, along with plans for more residential development.
According to one description in 1996, "The area dies at night ... It needs a neighborhood, a community." During the past two decades there has been a shift towards greater residential living areas in the Financial District, with incentives from city authorities in some instances.
Many empty office buildings have been converted to lofts and apartments; for example, the office building of Harry Sinclair, the oil magnate involved with the Teapot Dome scandal, was converted to a co-op in 1979.
In 1996, a fifth of buildings and warehouses were empty, and many were converted to living areas. Some conversions met with problems, such as aging gargoyles on building exteriors having to be expensively restored to meet with current building codes.
Residents in the area have sought to have a supermarket, a movie theater, a pharmacy, more schools, and a "good diner". The discount retailer named Job Lot used to be located at the World Trade Center but moved to Church Street; merchants bought extra unsold items at steep prices and sold them as a discount to consumers, and shoppers included "thrifty homemakers and browsing retirees" who "rubbed elbows with City Hall workers and Wall Street executives"; but the firm went bust in 1993.
There were reports that the number of residents increased by 60% during the 1990s to about 25,000 although a second estimate (based on the 2000 census based on a different map) places the residential population in 2000 at 12,042.
By 2001 there were several grocery stores, dry cleaners, and two grade schools and a top high school. There is also a long-standing a barber shop across from the New York Stock Exchange. Additionally, there were more signs of dogwalkers at night and a 24-hour neighborhood, although the general pattern of crowds during the working hours and emptiness at night was still apparent.
There were also ten hotels and thirteen museums. Stuyvesant High School moved to its present location near Battery Park City in 1992 and has been described as one of the nation's premier high schools with emphasis on science and mathematics.
In 2007 the French fashion retailer Hermès opened a store in the financial district to sell items such as a "$4,700 custom-made leather dressage saddle or a $47,000 limited edition alligator briefcase".
However, there are reports of panhandlers like elsewhere in the city. By 2010 the residential population had increased to 24,400 residents. and the area was growing with luxury high-end apartments and upscale retailers.
Street grid:
The streets in the area were laid out prior to the Commissioners' Plan of 1811, a grid plan that dictates the placement of most of Manhattan's streets north of Houston Street. Thus, it has small streets "barely wide enough for a single lane of traffic are bordered on both sides by some of the tallest buildings in the city", according to one description, which creates "breathtaking artificial canyons" offering spectacular views in some instances.
Some streets have been designated as pedestrian-only with vehicular traffic prohibited.
Tourism:
The Financial District is a major location of tourism in New York City. One report described lower Manhattan as "swarming with camera-carrying tourists". Tour guides highlight places such as Trinity Church, the Federal Reserve gold vaults 80 feet below street level (worth $100 billion), and the NYSE. A Scoundrels of Wall Street Tour is a walking historical tour which includes a museum visit and discussion of various financiers "who were adept at finding ways around finance laws or loopholes through them".
Occasionally artists make impromptu performances; for example, in 2010, a troupe of 22 dancers "contort their bodies and cram themselves into the nooks and crannies of the Financial District in Bodies in Urban Spaces" choreographed by Willi Donner.
One chief attraction, the Federal Reserve Building in lower Manhattan, paid $750,000 to open a visitors' gallery in 1997. The New York Stock Exchange and the American Stock Exchange also spent money in the late 1990s to upgrade facilities for visitors. Attractions include the gold vault beneath the Federal Reserve and that "staring down at the trading floor was as exciting as going to the Statue of Liberty".
Click on any of the following blue hyperlinks for more about the Financial District of Manhattan:
- Demographics
- Police and crime
- Fire safety
- Health
- Post offices and ZIP codes
- Education
- Transportation
- Tallest buildings
- Gallery
- See also:
- Economy of New York City
- Financial District, Manhattan travel guide from Wikivoyage
- Photographs of Financial District
- Wikipages Financial District, a wiki-based business directory for New York's Financial District.
Taxation in the United States
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The United States of America has separate federal, state, and local governments with taxes imposed at each of these levels.
Taxes are levied on income, payroll, property, sales, capital gains, dividends, imports, estates and gifts, as well as various fees. In 2010, taxes collected by federal, state, and municipal governments amounted to 24.8% of GDP. In the OECD, only Chile and Mexico are taxed less as a share of their GDP.
However, taxes fall much more heavily on labor income than on capital income. Divergent taxes and subsidies for different forms of income and spending can also constitute a form of indirect taxation of some activities over others. For example, individual spending on higher education can be said to be "taxed" at a high rate, compared to other forms of personal expenditure which are formally recognized as investments.
Taxes are imposed on net income of individuals and corporations by the federal, most state, and some local governments. Citizens and residents are taxed on worldwide income and allowed a credit for foreign taxes. Income subject to tax is determined under tax accounting rules, not financial accounting principles, and includes almost all income from whatever source.
Most business expenses reduce taxable income, though limits apply to a few expenses.
Individuals are permitted to reduce taxable income by personal allowances and certain non-business expenses, including home mortgage interest, state and local taxes, charitable contributions, and medical and certain other expenses incurred above certain percentages of income.
State rules for determining taxable income often differ from federal rules. Federal marginal tax rates vary from 10% to 37% of taxable income. State and local tax rates vary widely by jurisdiction, from 0% to 13.30% of income, and many are graduated.
State taxes are generally treated as a deductible expense for federal tax computation, although the 2017 tax law imposed a $10,000 limit on the state and local tax ("SALT") deduction, which raised the effective tax rate on medium and high earners in high tax states.
Prior to the SALT deduction limit, the average deduction exceeded $10,000 in most of the Midwest, and exceeded $11,000 in most of the Northeastern United States, as well as California and Oregon. The states impacted the most by the limit were the tri-state area (NY, NJ, and CT) and California; the average SALT deduction in those states was greater than $17,000 in 2014.
The United States is one of two countries in the world that taxes its non-resident citizens on worldwide income, in the same manner and rates as residents; the other is Eritrea. The U.S. Supreme Court upheld the constitutionality of imposition of such a tax in the case of Cook v. Tait.
Payroll taxes are imposed by the federal and all state governments. These include Social Security and Medicare taxes imposed on both employers and employees, at a combined rate of 15.3% (13.3% for 2011 and 2012).
Social Security tax applies only to the first $106,800 of wages in 2009 through 2011. However, benefits are only accrued on the first $106,800 of wages. Employers must withhold income taxes on wages. An unemployment tax and certain other levies apply to employers.
Payroll taxes have dramatically increased as a share of federal revenue since the 1950s, while corporate income taxes have fallen as a share of revenue. (Corporate profits have not fallen as a share of GDP).
Property taxes are imposed by most local governments and many special purpose authorities based on the fair market value of property. School and other authorities are often separately governed, and impose separate taxes. Property tax is generally imposed only on realty, though some jurisdictions tax some forms of business property. Property tax rules and rates vary widely with annual median rates ranging from 0.2% to 1.9% of a property's value depending on the state.
Sales taxes are imposed by most states and some localities on the price at retail sale of many goods and some services. Sales tax rates vary widely among jurisdictions, from 0% to 16%, and may vary within a jurisdiction based on the particular goods or services taxed. Sales tax is collected by the seller at the time of sale, or remitted as use tax by buyers of taxable items who did not pay sales tax.
The United States imposes tariffs or customs duties on the import of many types of goods from many jurisdictions. These tariffs or duties must be paid before the goods can be legally imported. Rates of duty vary from 0% to more than 20%, based on the particular goods and country of origin.
Estate and gift taxes are imposed by the federal and some state governments on the transfer of property inheritance, by will, or by lifetime donation. Similar to federal income taxes, federal estate and gift taxes are imposed on worldwide property of citizens and residents and allow a credit for foreign taxes.
Levels and the Types of Taxation:
The U.S. has an assortment of federal, state, local, and special-purpose governmental jurisdictions. Each imposes taxes to fully or partly fund its operations. These taxes may be imposed on the same income, property or activity, often without offset of one tax against another.
The types of tax imposed at each level of government vary, in part due to constitutional restrictions. Income taxes are imposed at the federal and most state levels. Taxes on property are typically imposed only at the local level, although there may be multiple local jurisdictions that tax the same property.
Other excise taxes are imposed by the federal and some state governments. Sales taxes are imposed by most states and many local governments. Customs duties or tariffs are only imposed by the federal government. A wide variety of user fees or license fees are also imposed.
A federal wealth tax would be required by the U.S. Constitution to be distributed to the States according to their populations, as this type of tax is considered a direct tax. State and local government property taxes are wealth taxes on real estate.
Types of taxpayers:
Taxes may be imposed on individuals (natural persons), business entities, estates, trusts, or other forms of organization. Taxes may be based on property, income, transactions, transfers, importations of goods, business activities, or a variety of factors, and are generally imposed on the type of taxpayer for whom such tax base is relevant.
Thus, property taxes tend to be imposed on property owners. In addition, certain taxes, particularly income taxes, may be imposed on the members of organizations for the organization's activities. Therefore, partners are taxed on the income of their partnership.
With fewer exceptions, one level of government does not impose tax on another level of government or its instrumentalities.
Income tax:
Main article: Income tax in the United States
Taxes based on income are imposed at the federal, most state, and some local levels within the United States. The tax systems within each jurisdiction may define taxable income separately. Many states refer to some extent to federal concepts for determining taxable income.
History of the income tax:
The first Income tax in the United States was implemented with the Revenue Act of 1861 by Abraham Lincoln during the Civil War. In 1895 the Supreme Court ruled that the U.S. federal income tax on interest income, dividend income and rental income was unconstitutional in Pollock v. Farmers' Loan & Trust Co., because it was a direct tax.
The Pollock decision was overruled by the ratification of the Sixteenth Amendment to the United States Constitution in 1913, and by subsequent U.S. Supreme Court decisions including Graves v. New York ex rel. O'Keefe, South Carolina v. Baker, and Brushaber v. Union Pacific Railroad Co.
Basic concepts:
The U.S. income tax system imposes a tax based on income on individuals, corporations, estates, and trusts. The tax is taxable income, as defined, times a specified tax rate. This tax may be reduced by credits, some of which may be refunded if they exceed the tax calculated.
Taxable income may differ from income for other purposes (such as for financial reporting). The definition of taxable income for federal purposes is used by many, but far from all states.
Income and deductions are recognized under tax rules, and there are variations within the rules among the states. Book and tax income may differ. Income is divided into "capital gains", which are taxed at a lower rate and only when the taxpayer chooses to "realize" them, and "ordinary income", which is taxed at higher rates and on an annual basis. Because of this distinction, capital is taxed much more lightly than labor.
Under the U.S. system, individuals, corporations, estates, and trusts are subject to income tax. Partnerships are not taxed; rather, their partners are subject to income tax on their shares of income and deductions, and take their shares of credits. Some types of business entities may elect to be treated as corporations or as partnerships.
Taxpayers are required to file tax returns and self assess tax. Tax may be withheld from payments of income (e.g., withholding of tax from wages). To the extent taxes are not covered by withholdings, taxpayers must make estimated tax payments, generally quarterly.
Tax returns are subject to review and adjustment by taxing authorities, though far fewer than all returns are reviewed.
Taxable income is gross income less exemptions, deductions, and personal exemptions.
Gross income includes "all income from whatever source". Certain income, however, is subject to tax exemption at the federal or state levels. This income is reduced by tax deductions including most business and some nonbusiness expenses. Individuals are also allowed a deduction for personal exemptions, a fixed dollar allowance. The allowance of some nonbusiness deductions is phased out at higher income levels.
The U.S. federal and most state income tax systems tax the worldwide income of citizens and residents. A federal foreign tax credit is granted for foreign income taxes. Individuals residing abroad may also claim the foreign earned income exclusion. Individuals may be a citizen or resident of the United States but not a resident of a state. Many states grant a similar credit for taxes paid to other states. These credits are generally limited to the amount of tax on income from foreign (or other state) sources.
Filing status:
Main article: Filing Status (federal income tax)
Federal and state income tax is calculated, and returns filed, for each taxpayer. Two married individuals may calculate tax and file returns jointly or separately. In addition, unmarried individuals supporting children or certain other relatives may file a return as a head of household. Parent-subsidiary groups of companies may elect to file a consolidated return.
Graduated tax rates:
Income tax rates differ at the federal and state levels for corporations and individuals. Federal and many state income tax rates are higher (graduated) at higher levels of income. The income level at which various tax rates apply for individuals varies by filing status.
The income level at which each rate starts generally is higher (i.e., tax is lower) for married couples filing a joint return or single individuals filing as head of household.
Individuals are subject to federal graduated tax rates from 10% to 39.6%. Corporations are subject to federal graduated rates of tax from 15% to 35%; a rate of 34% applies to income from $335,000 to $15,000,000. State income tax rates, in states which have a tax on personal incomes, vary from 1% to 16%, including local income tax where applicable.
Nine (9) states do not have a tax on ordinary personal incomes. These include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Two states with a tax only on interest and dividend income of individuals, are New Hampshire and Tennessee.
Main article: State income tax
State and local taxes are generally deductible in computing federal taxable income. Federal and many state individual income tax rate schedules differ based on the individual's filing status.
Income:
Main articles:
Taxable income is gross income less adjustments and allowable tax deductions. Gross income for federal and most states is receipts and gains from all sources less cost of goods sold. Gross income includes "all income from whatever source", and is not limited to cash received. Income from illegal activities is taxable and must be reported to the IRS.
The amount of income recognized is generally the value received or which the taxpayer has a right to receive. Certain types of income are specifically excluded from gross income. The time at which gross income becomes taxable is determined under federal tax rules. This may differ in some cases from accounting rules.
Certain types of income are excluded from gross income (and therefore subject to tax exemption). The exclusions differ at federal and state levels. For federal income tax, interest income on state and local bonds is exempt, while few states exempt any interest income except from municipalities within that state. In addition, certain types of receipts, such as gifts and inheritances, and certain types of benefits, such as employer-provided health insurance, are excluded from income.
Foreign non-resident persons are taxed only on income from U.S. sources or from a U.S. business. Tax on foreign non-resident persons on non-business income is at 30% of the gross income, but reduced under many tax treaties.
These brackets are the taxable income plus the standard deduction for a joint return. That deduction is the first bracket. For example, a couple earning $88,600 by September owes $10,453; $1,865 for 10% of the income from $12,700 to $31,500, plus $8,588 for 15% of the income from $31,500 to $88,600. Now, for every $100 they earn, $25 is taxed until they reach the next bracket.
After making $400 more; going down to the 89,000 row the tax is $100 more. The next column is the tax divided by 89,000. The new law is the next column. This tax equals 10% of their income from $24,000 to $43,050 plus 12% from $43,050 to $89,000. The singles' sets of markers can be set up quickly. The brackets with its tax are cut in half.
Itemizers can figure the tax without moving the scale by taking the difference off the top. The couple above, having receipts for $22,700 in deductions, means that the last $10,000 of their income is tax free. After seven years the papers can be destroyed; if unchallenged.
Deductions and exemptions:
Main article: Tax deduction
The U.S. system allows reduction of taxable income for both business and some nonbusiness expenditures, called deductions. Businesses selling goods reduce gross income directly by the cost of goods sold. In addition, businesses may deduct most types of expenses incurred in the business.
Some of these deductions are subject to limitations. For example, only 50% of the amount incurred for any meals or entertainment may be deducted. The amount and timing of deductions for business expenses is determined under the taxpayer's tax accounting method, which may differ from methods used in accounting records.
Some types of business expenses are deductible over a period of years rather than when incurred. These include the cost of long lived assets such as buildings and equipment. The cost of such assets is recovered through deductions for depreciation or amortization.
In addition to business expenses, individuals may reduce income by an allowance for personal exemptions and either a fixed standard deduction or itemized deductions. One personal exemption is allowed per taxpayer, and additional such deductions are allowed for each child or certain other individuals supported by the taxpayer.
The standard deduction amount varies by taxpayer filing status. Itemized deductions by individuals include home mortgage interest, property taxes, certain other taxes, contributions to recognized charities, medical expenses in excess of 7.5% of adjusted gross income, and certain other amounts.
Personal exemptions, the standard deduction, and itemized deductions are limited (phased out) above certain income levels.
Business entities:
Main articles:
Corporations must pay tax on their taxable income independently of their shareholders. Shareholders are also subject to tax on dividends received from corporations. By contrast, partnerships are not subject to income tax, but their partners calculate their taxes by including their shares of partnership items.
Corporations owned entirely by U.S. citizens or residents (S corporations) may elect to be treated similarly to partnerships. A limited liability company and certain other business entities may elect to be treated as corporations or as partnerships. States generally follow such characterization. Many states also allow corporations to elect S corporation status.
Charitable organizations are subject to tax on business income.
Certain transactions of business entities are not subject to tax. These include many types of formation or reorganization.
Credits:
Main article: Tax credit
A wide variety of tax credits may reduce income tax at the federal and state levels. Some credits are available only to individuals, such as the child tax credit for each dependent child, American Opportunity Tax Credit for education expenses, or the Earned Income Tax Credit for low income wage earners.
Some credits, such as the Work Opportunity Tax Credit, are available to businesses, including various special industry incentives. A few credits, such as the foreign tax credit, are available to all types of taxpayers.
Payment or withholding of taxes:
Main article: Withholding tax
The United States federal and state income tax systems are self-assessment systems.
Taxpayers must declare and pay tax without assessment by the taxing authority. Quarterly payments of tax estimated to be due are required to the extent taxes are not paid through withholdings.
Employers must withhold income tax, as well as Social Security and Medicare taxes, from wages. Amounts to be withheld are computed by employers based on representations of tax status by employees on Form W-4, with limited government review.
State variations:
Main article: State income tax
Forty-three states and many localities in the U.S. impose an income tax on individuals. Forty-seven states and many localities impose a tax on the income of corporations. Tax rates vary by state and locality, and may be fixed or graduated. Most rates are the same for all types of income. State and local income taxes are imposed in addition to federal income tax.
State income tax is allowed as a deduction in computing federal income, but is capped at $10,000 per household since the passage of the 2017 tax law. Prior to the change, the average deduction exceeded $10,000 in most of the Midwest, most of the Northeast, as well as California and Oregon.
State and local taxable income is determined under state law, and often is based on federal taxable income. Most states conform to many federal concepts and definitions, including defining income and business deductions and timing thereof. State rules vary widely regarding to individual itemized deductions.
Most states do not allow a deduction for state income taxes for individuals or corporations, and impose tax on certain types of income exempt at the federal level.
Some states have alternative measures of taxable income, or alternative taxes, especially for corporations.
States imposing an income tax generally tax all income of corporations organized in the state and individuals residing in the state. Taxpayers from another state are subject to tax only on income earned in the state or apportioned to the state. Businesses are subject to income tax in a state only if they have sufficient nexus in (connection to) the state.
Non-residents:
Foreign individuals and corporations not resident in the United States are subject to federal income tax only on income from a U.S. business and certain types of income from U.S. sources.
States tax individuals resident outside the state and corporations organized outside the state only on wages or business income within the state. Payers of some types of income to non-residents must withhold federal or state income tax on the payment. Federal withholding of 30% on such income may be reduced under a tax treaty. Such treaties do not apply to state taxes.
Alternative tax bases (AMT, states):
An alternative minimum tax (AMT) is imposed at the federal level on a somewhat modified version of taxable income. The tax applies to individuals and corporations. The tax base is adjusted gross income reduced by a fixed deduction that varies by taxpayer filing status.
Itemized deductions of individuals are limited to home mortgage interest, charitable contributions, and a portion of medical expenses. AMT is imposed at a rate of 26% or 28% for individuals and 20% for corporations, less the amount of regular tax. A credit against future regular income tax is allowed for such excess, with certain restrictions.
Many states impose minimum income taxes on corporations or a tax computed on an alternative tax base. These include taxes based on capital of corporations and alternative measures of income for individuals. Details vary widely by state.
Differences between book and taxable income for businesses:
In the United States, taxable income is computed under rules that differ materially from U.S. generally accepted accounting principles. Since only publicly traded companies are required to prepare financial statements, many non-public companies opt to keep their financial records under tax rules.
Corporations that present financial statements using other than tax rules must include a detailed reconciliation of their financial statement income to their taxable income as part of their tax returns.
Key areas of difference include depreciation and amortization, timing of recognition of income or deductions, assumptions for cost of goods sold, and certain items (such as meals and entertainment) the tax deduction for which is limited.
Reporting under self-assessment system:
Main article: Tax return (United States)
Income taxes in the United States are self-assessed by taxpayers by filing required tax returns. Taxpayers, as well as certain non-tax-paying entities, like partnerships, must file annual tax returns at the federal and applicable state levels. These returns disclose a complete computation of taxable income under tax principles.
Taxpayers compute all income, deductions, and credits themselves, and determine the amount of tax due after applying required prepayments and taxes withheld. Federal and state tax authorities provide preprinted forms that must be used to file tax returns. IRS Form 1040 series is required for individuals, Form 1120 series for corporations, Form 1065 for partnerships, and Form 990 series for tax exempt organizations.
The state forms vary widely, and rarely correspond to federal forms. Tax returns vary from the two-page (Form 1040EZ) used by nearly 70% of individual filers to thousands of pages of forms and attachments for large entities. Groups of corporations may elect to file consolidated returns at the federal level and with a few states.
Electronic filing of federal and many state returns is widely encouraged and in some cases required, and many vendors offer computer software for use by taxpayers and paid return preparers to prepare and electronically file returns.
Capital gains tax:
Main article: Capital gains tax in the United States
Individuals and corporations pay U.S. federal income tax on the net total of all their capital gains. The tax rate depends on both the investor's tax bracket and the amount of time the investment was held.
Short-term capital gains are taxed at the investor's ordinary income tax rate and are defined as investments held for a year or less before being sold. Long-term capital gains, on dispositions of assets held for more than one year, are taxed at a lower rate.
Payroll taxes:
In the United States, payroll taxes are assessed by the federal government, many states, the District of Columbia, and numerous cities. These taxes are imposed on employers and employees and on various compensation bases. They are collected and paid to the taxing jurisdiction by the employers.
Most jurisdictions imposing payroll taxes require reporting quarterly and annually in most cases, and electronic reporting is generally required for all but small employers. Because payroll taxes are imposed only on wages and not on income from investments, taxes on labor income are much heavier than taxes on income from capital.
Income tax withholding:
Main article: Tax withholding in the United States
Federal, state, and local withholding taxes are required in those jurisdictions imposing an income tax. Employers having contact with the jurisdiction must withhold the tax from wages paid to their employees in those jurisdictions.
Computation of the amount of tax to withhold is performed by the employer based on representations by the employee regarding his/her tax status on IRS Form W-4. Amounts of income tax so withheld must be paid to the taxing jurisdiction, and are available as refundable tax credits to the employees.
Income taxes withheld from payroll are not final taxes, merely prepayments. Employees must still file income tax returns and self assess tax, claiming amounts withheld as payments.
Social Security and Medicare taxes:
Main article: Federal Insurance Contributions Act tax
Federal social insurance taxes are imposed equally on employers and employees, consisting of a tax of 6.2% of wages up to an annual wage maximum ($118,500 in 2015) for Social Security plus a tax of 1.45% of total wages for Medicare.
For 2011, the employee's contribution was reduced to 4.2%, while the employer's portion remained at 6.2%. To the extent an employee's portion of the 6.2% tax exceeds the maximum by reason of multiple employers (each of whom will collect up to the annual wage maximum), the employee is entitled to a refundable tax credit upon filing an income tax return for the year.
Unemployment taxes:
Main article: Federal Unemployment Tax Act
Employers are subject to unemployment taxes by the federal and all state governments. The tax is a percentage of taxable wages with a cap. The tax rate and cap vary by jurisdiction and by employer's industry and experience rating. For 2009, the typical maximum tax per employee was under $1,000. Some states also impose unemployment, disability insurance, or similar taxes on employees.
Reporting and payment:
Employers must report payroll taxes to the appropriate taxing jurisdiction in the manner each jurisdiction provides. Quarterly reporting of aggregate income tax withholding and Social Security taxes is required in most jurisdictions. Employers must file reports of aggregate unemployment tax quarterly and annually with each applicable state, and annually at the federal level.
Each employer is required to provide each employee an annual report on IRS Form W-2 of wages paid and federal, state and local taxes withheld, with a copy sent to the IRS and the taxation authority of the state. These are due by January 31 and February 28 (March 31 if filed electronically), respectively, following the calendar year in which wages are paid. The Form W-2 constitutes proof of payment of tax for the employee.
Employers are required to pay payroll taxes to the taxing jurisdiction under varying rules, in many cases within 1 banking day. Payment of federal and many state payroll taxes is required to be made by electronic funds transfer if certain dollar thresholds are met, or by deposit with a bank for the benefit of the taxing jurisdiction.
Penalties:
Failure to timely and properly pay federal payroll taxes results in an automatic penalty of 2% to 10%.
Similar state and local penalties apply. Failure to properly file monthly or quarterly returns may result in additional penalties. Failure to file Forms W-2 results in an automatic penalty of up to $50 per form not timely filed. State and local penalties vary by jurisdiction.
A particularly severe penalty applies where federal income tax withholding and Social Security taxes are not paid to the IRS. The penalty of up to 100% of the amount not paid can be assessed against the employer entity as well as any person (such as a corporate officer) having control or custody of the funds from which payment should have been made.
Sales and excise taxes as sales and use tax:
Main article: Sales taxes in the United States
There is no federal sales or use tax in the United States. All but five states impose sales and use taxes on retail sale, lease and rental of many goods, as well as some services. Many cities, counties, transit authorities and special purpose districts impose an additional local sales or use tax.
Sales and use tax is calculated as the purchase price times the appropriate tax rate. Tax rates vary widely by jurisdiction from less than 1% to over 10%. Sales tax is collected by the seller at the time of sale. Use tax is self assessed by a buyer who has not paid sales tax on a taxable purchase.
Unlike value added tax, sales tax is imposed only once, at the retail level, on any particular goods. Nearly all jurisdictions provide numerous categories of goods and services that are exempt from sales tax, or taxed at a reduced rate.
Purchase of goods for further manufacture or for resale is uniformly exempt from sales tax. Most jurisdictions exempt food sold in grocery stores, prescription medications, and many agricultural supplies. Generally cash discounts, including coupons, are not included in the price used in computing tax.
Sales taxes, including those imposed by local governments, are generally administered at the state level. States imposing sales tax require retail sellers to register with the state, collect tax from customers, file returns, and remit the tax to the state. Procedural rules vary widely.
Sellers generally must collect tax from in-state purchasers unless the purchaser provides an exemption certificate. Most states allow or require electronic remittance of tax to the state.
States are prohibited from requiring out of state sellers to collect tax unless the seller has some minimal connection with the state.
Excise taxes:
Main article: Excise tax in the United States
Excise taxes may be imposed on the sales price of goods or on a per unit or other basis, in theory to discourage consumption of the taxed goods or services. Excise tax may be required to be paid by the manufacturer at wholesale sale, or may be collected from the customer at retail sale.
Excise taxes are imposed at the federal and state levels on a variety of goods, including alcohol, tobacco, tires, gasoline, diesel fuel, coal, firearms, telephone service, air transportation, unregistered bonds, and many other goods and services. Some jurisdictions require that tax stamps be affixed to goods to demonstrate payment of the tax.
Property Tax:
Main article: Property tax in the United States
Most jurisdictions below the state level in the United States impose a tax on interests in real property (land, buildings, and permanent improvements). Some jurisdictions also tax some types of business personal property. Rules vary widely by jurisdiction. Many overlapping jurisdictions (counties, cities, school districts) may have authority to tax the same property. Few states impose a tax on the value of property.
Property tax is based on fair market value of the subject property. The amount of tax is determined annually based on the market value of each property on a particular date, and most jurisdictions require re-determinations of value periodically. The tax is computed as the determined market value times an assessment ratio times the tax rate.
Assessment ratios and tax rates vary widely among jurisdictions, and may vary by type of property within a jurisdiction. Where a property has recently been sold between unrelated sellers, such sale establishes fair market value. In other (i.e., most) cases, the value must be estimated. Common estimation techniques include comparable sales, depreciated cost, and an income approach. Property owners may also declare a value, which is subject to change by the tax assessor.
Types of property taxed:
Property taxes are most commonly applied to real estate and business property. Real property generally includes all interests considered under that state's law to be ownership interests in land, buildings, and improvements. Ownership interests include ownership of title as well as certain other rights to property. Automobile and boat registration fees are a subset of this tax. Usually, other non-business goods are not subject to property tax.
Assessment and collection:
The assessment process varies by state, and sometimes within a state. Each taxing jurisdiction determines values of property within the jurisdiction and then determines the amount of tax to assess based on the value of the property. Tax assessors for taxing jurisdictions are generally responsible for determining property values. The determination of values and calculation of tax is generally performed by an official referred to as a tax assessor.
Property owners have rights in each jurisdiction to declare or contest the value so determined. Property values generally must be coordinated among jurisdictions, and such coordination is often performed by a board of equalization.
Once value is determined, the assessor typically notifies the last known property owner of the value determination. After values are settled, property tax bills or notices are sent to property owners.
Payment times and terms vary widely. If a property owner fails to pay the tax, the taxing jurisdiction has various remedies for collection, in many cases including seizure and sale of the property. Property taxes constitute a lien on the property to which transfers are also subject.
Mortgage companies often collect taxes from property owners and remit them on behalf of the owner.
Customs duties:
The United States imposes tariffs or customs duties on imports of goods. The duty is levied at the time of import and is paid by the importer of record. Customs duties vary by country of origin and product. Goods from many countries are exempt from duty under various trade agreements.
Certain types of goods are exempt from duty regardless of source. Customs rules differ from other import restrictions. Failure to properly comply with customs rules can result in seizure of goods and criminal penalties against involved parties. United States Customs and Border Protection ("CBP") enforces customs rules.
Import of goods:
Goods may be imported to the United States subject to import restrictions. Importers of goods may be subject to tax ("customs duty" or "tariff") on the imported value of the goods.
"Imported goods are not legally entered until after the shipment has arrived within the port of entry, delivery of the merchandise has been authorized by CBP, and estimated duties have been paid." Importation and declaration and payment of customs duties is done by the importer of record, which may be the owner of the goods, the purchaser, or a licensed customs broker.
Goods may be stored in a bonded warehouse or a Foreign-Trade Zone in the United States for up to five years without payment of duties. Goods must be declared for entry into the U.S. within 15 days of arrival or prior to leaving a bonded warehouse or foreign trade zone. Many importers participate in a voluntary self-assessment program with CBP. Special rules apply to goods imported by mail.
All goods imported into the United States are subject to inspection by CBP. Some goods may be temporarily imported to the United States under a system similar to the ATA Carnet system. Examples include laptop computers used by persons traveling in the U.S. and samples used by salesmen.
Origin:
Rates of tax on transaction values vary by country of origin. Goods must be individually labeled to indicate country of origin, with exceptions for specific types of goods. Goods are considered to originate in the country with the highest rate of duties for the particular goods unless the goods meet certain minimum content requirements.
Extensive modifications to normal duties and classifications apply to goods originating in Canada or Mexico under the North American Free Trade Agreement.
Classification:
All goods that are not exempt are subject to duty computed according to the Harmonized Tariff Schedule published by CBP and the U.S. International Trade Commission. This lengthy schedule provides rates of duty for each class of goods. Most goods are classified based on the nature of the goods, though some classifications are based on use.
Duty rate:
Customs duty rates may be expressed as a percentage of value or dollars and cents per unit. Rates based on value vary from zero to 20% in the 2011 schedule. Rates may be based on relevant units for the particular type of goods (per ton, per kilogram, per square meter, etc.). Some duties are based in part on value and in part on quantity.
Where goods subject to different rates of duty are commingled, the entire shipment may be taxed at the highest applicable duty rate.
Procedures:
Imported goods are generally accompanied by a bill of lading or air waybill describing the goods. For purposes of customs duty assessment, they must also be accompanied by an invoice documenting the transaction value. The goods on the bill of lading and invoice are classified and duty is computed by the importer or CBP. The amount of this duty is payable immediately, and must be paid before the goods can be imported.
Most assessments of goods are now done by the importer and documentation filed with CBP electronically.
After duties have been paid, CBP approves the goods for import. They can then be removed from the port of entry, bonded warehouse, or Free-Trade Zone.
After duty has been paid on particular goods, the importer can seek a refund of duties if the goods are exported without substantial modification. The process of claiming a refund is known as duty drawback.
Penalties:
Certain civil penalties apply for failures to follow CBP rules and pay duty. Goods of persons subject to such penalties may be seized and sold by CBP. In addition, criminal penalties may apply for certain offenses. Criminal penalties may be as high as twice the value of the goods plus twenty years in jail.
Foreign-Trade Zones:
Foreign-Trade Zones are secure areas physically in the United States but legally outside the customs territory of the United States. Such zones are generally near ports of entry. They may be within the warehouse of an importer. Such zones are limited in scope and operation based on approval of the Foreign-Trade Zones Board.
Goods in a Foreign-Trade Zone are not considered imported to the United States until they leave the Zone. Foreign goods may be used to manufacture other goods within the zone for export without payment of customs duties.
Estate and gift taxes:
Main articles:
Estate and gift taxes in the United States are imposed by the federal and some state governments. The estate tax is an excise tax levied on the right to pass property at death. It is imposed on the estate, not the beneficiary.
Some states impose an inheritance tax on recipients of bequests. Gift taxes are levied on the giver (donor) of property where the property is transferred for less than adequate consideration. An additional generation-skipping transfer (GST) tax is imposed by the federal and some state governments on transfers to grandchildren (or their descendants).
The federal gift tax is applicable to the donor, not the recipient, and is computed based on cumulative taxable gifts, and is reduced by prior gift taxes paid. The federal estate tax is computed on the sum of taxable estate and taxable gifts, and is reduced by prior gift taxes paid.
These taxes are computed as the taxable amount times a graduated tax rate (up to 35% in 2011). The estate and gift taxes are also reduced by a "unified credit" equivalent to an exclusion ($5 million in 2011). Rates and exclusions have varied, and the benefits of lower rates and the credit have been phased out during some years.
Taxable gifts are certain gifts of U.S. property by nonresident aliens, most gifts of any property by citizens or residents, in excess of an annual exclusion ($13,000 for gifts made in 2011) per donor per donee. Taxable estates are certain U.S. property of non-resident alien decedents, and most property of citizens or residents.
For aliens, residence for estate tax purposes is primarily based on domicile, but U.S. citizens are taxed regardless of their country of residence. U.S. real estate and most tangible property in the U.S. are subject to estate and gift tax whether the decedent or donor is resident or nonresident, citizen or alien.
The taxable amount of a gift is the fair market value of the property in excess of consideration received at the date of gift. The taxable amount of an estate is the gross fair market value of all rights considered property at the date of death (or an alternative valuation date) ("gross estate"), less liabilities of the decedent, costs of administration (including funeral expenses) and certain other deductions. State estate taxes are deductible, with limitations, in computing the federal taxable estate. Bequests to charities reduce the taxable estate.
Gift tax applies to all irrevocable transfers of interests in tangible or intangible property. Estate tax applies to all property owned in whole or in part by a citizen or resident at the time of his or her death, to the extent of the interest in the property. Generally, all types of property are subject to estate tax. Whether a decedent has sufficient interest in property for the property to be subject to gift or estate tax is determined under applicable state property laws.
Certain interests in property that lapse at death (such as life insurance) are included in the taxable estate.
Taxable values of estates and gifts are the fair market value. For some assets, such as widely traded stocks and bonds, the value may be determined by market listings. The value of other property may be determined by appraisals, which are subject to potential contest by the taxing authority.
Special use valuation applies to farms and closely held businesses, subject to limited dollar amount and other conditions. Monetary assets, such as cash, mortgages, and notes, are valued at the face amount, unless another value is clearly established.
Life insurance proceeds are included in the gross estate. The value of a right of a beneficiary of an estate to receive an annuity is included in the gross estate. Certain transfers during lifetime may be included in the gross estate. Certain powers of a decedent to control the disposition of property by another are included in the gross estate.
The taxable estate of a married decedent is reduced by a deduction for all property passing to the decedent's spouse. Certain terminable interests are included. Other conditions may apply.
Donors of gifts in excess of the annual exclusion must file gift tax returns on IRS Form 709 and pay the tax. Executors of estates with a gross value in excess of the unified credit must file an estate tax return on IRS Form 706 and pay the tax from the estate. Returns are required if the gifts or gross estate exceed the exclusions. Each state has its own forms and filing requirements. Tax authorities may examine and adjust gift and estate tax returns.
Licenses and occupational taxes:
Many jurisdictions within the United States impose taxes or fees on the privilege of carrying on a particular business or maintaining a particular professional certification. These licensing or occupational taxes may be a fixed dollar amount per year for the licensee, an amount based on the number of practitioners in the firm, a percentage of revenue, or any of several other bases.
Persons providing professional or personal services are often subject to such fees. Common examples include accountants, attorneys, barbers, casinos, dentists, doctors, auto mechanics, plumbers, and stock brokers. In addition to the tax, other requirements may be imposed for licensure.
All 50 states impose vehicle license fee. Generally, the fees are based on type and size of vehicle and are imposed annually or biannually. All states and the District of Columbia also impose a fee for a driver's license, which generally must be renewed with payment of fee every few years.
User fees:
Fees are often imposed by governments for use of certain facilities or services. Such fees are generally imposed at the time of use. Multi-use permits may be available. For example, fees are imposed for use of national or state parks, for requesting and obtaining certain rulings from the U.S. Internal Revenue Service (IRS), for the use of certain highways (called "tolls" or toll roads), for parking on public streets, and for the use of public transit.
Tax administration:
Taxes in the United States are administered by hundreds of tax authorities. At the federal level there are three tax administrations. Most domestic federal taxes are administered by the Internal Revenue Service, which is part of the Department of the Treasury. Alcohol, tobacco, and firearms taxes are administered by the Alcohol and Tobacco Tax and Trade Bureau (TTB).
Taxes on imports (customs duties) are administered by U.S. Customs and Border Protection (CBP). TTB is also part of the Department of the Treasury and CBP belongs to the Department of Homeland Security.
Organization of state and local tax administrations varies widely. Every state maintains a tax administration. A few states administer some local taxes in whole or part. Most localities also maintain a tax administration or share one with neighboring localities.
Federal: Internal Revenue Service:
Main article: Internal Revenue Service
The Internal Revenue Service administers all U.S. federal tax laws on domestic activities, except those taxes administered by TTB. IRS functions include:
The IRS maintains several Service Centers at which tax returns are processed. Taxpayers generally file most types of tax returns by mail with these Service Centers, or file electronically. The IRS also maintains a National Office in Washington, DC, and numerous local offices providing taxpayer services and administering tax examinations.
Examination:
Tax returns filed with the IRS are subject to examination and adjustment, commonly called an IRS audit. Only a small percentage of returns (about 1% of individual returns in IRS FY 2008) are examined each year. The selection of returns uses a variety of methods based on IRS experiences.
On examination, the IRS may request additional information from the taxpayer by mail, in person at IRS local offices, or at the business location of the taxpayer. The taxpayer is entitled to representation by an attorney, Certified Public Accountant (CPA), or enrolled agent, at the expense of the taxpayer, who may make representations to the IRS on behalf of the taxpayer.
Taxpayers have certain rights in an audit. Upon conclusion of the audit, the IRS may accept the tax return as filed or propose adjustments to the return. The IRS may also assess penalties and interest. Generally, adjustments must be proposed within three years of the due date of the tax return. Certain circumstances extend this time limit, including substantial understatement of income and fraud.
The taxpayer and the IRS may agree to allow the IRS additional time to conclude an audit. If the IRS proposes adjustments, the taxpayer may agree to the adjustment, appeal within the IRS, or seek judicial determination of the tax.
Published and private rulings:
In addition to enforcing tax laws, the IRS provides formal and informal guidance to taxpayers. While often referred to as IRS Regulations, the regulations under the Internal Revenue Code are issued by the Department of Treasury. IRS guidance consists of:
Alcohol and Tobacco Tax and Trade Bureau:
Main article: Alcohol and Tobacco Tax and Trade Bureau
The Alcohol and Tobacco Tax Trade Bureau (TTB), a division of the Department of the Treasury, enforces federal excise tax laws related to alcohol, tobacco, and firearms. TTB has six divisions, each with discrete functions:
Criminal enforcement related to TTB is done by the Bureau of Alcohol, Tobacco, Firearms, and Explosives, a division of the Justice Department.
Customs and Border Protection:
Main article: U.S. Customs and Border Protection
U.S. Customs and Border Protection (CBP), an agency of the United States Department of Homeland Security, collects customs duties and regulates international trade. It has a workforce of over 58,000 employees covering over 300 official ports of entry to the United States. CBP has authority to seize and dispose of cargo in the case of certain violations of customs rules.
State administrations:
Every state in the United States has its own tax administration, subject to the rules of that state's law and regulations. These are referred to in most states as the Department of Revenue or Department of Taxation.
The powers of the state taxing authorities vary widely. Most enforce all state level taxes but not most local taxes. However, many states have unified state-level sales tax administration, including for local sales taxes.
State tax returns are filed separately with those tax administrations, not with the federal tax administrations. Each state has its own procedural rules, which vary widely.
Local administrations:
Most localities within the United States administer most of their own taxes. In many cases, there are multiple local taxing jurisdictions with respect to a particular taxpayer or property.
For property taxes, the taxing jurisdiction is typically represented by a tax assessor/collector whose offices are located at the taxing jurisdiction's facilities.
Legal basis:
The United States Constitution provides that Congress "shall have the power to lay and collect Taxes, Duties, Imposts, and Excises ... but all Duties, Imposts, and Excises shall be uniform throughout the United States." Prior to amendment, it provided that "No Capitation, or other direct, Tax shall be Laid unless in proportion to the Census ..." The 16th Amendment provided that "Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."
The 10th Amendment provided that "powers not delegated to the United States by this Constitution, nor prohibited to the States, are reserved to the States respectively, or to the people."
Congress has enacted numerous laws dealing with taxes since adoption of the Constitution. Those laws are now codified as Title 19, Customs Duties, Title 26, Internal Revenue Code, and various other provisions. These laws specifically authorize the United States Secretary of the Treasury to delegate various powers related to levy, assessment and collection of taxes.
State constitutions uniformly grant the state government the right to levy and collect taxes. Limitations under state constitutions vary widely.
Various fringe individuals and groups have questioned the legitimacy of United States federal income tax. These arguments are varied, but have been uniformly rejected by the Internal Revenue Service and by the courts and ruled to be frivolous.
Policy issues:
Main article: Progressivity in United States income tax
Commentators Benjamin Page, Larry Bartels and Jason Seawright contend that Federal tax policy in relation to regulation and reform in the United States tends to favor wealthy Americans. They assert that political influence is a legal right the wealthy can exercise by contributing funds to lobby for their policy preference.
Each major type of tax in the United States has been used by some jurisdiction at some time as a tool of social policy.
Both liberals and conservatives have called for more progressive taxes in the U.S. Page, Bartels and Seawright assert that although members of the government favor a move toward progressive taxes, due to budget deficits upper class citizens are not yet willing to make a push for the change. Tax cuts were provided during the Bush administration, and were extended in 2010, making federal income taxes less progressive.
Tax evasion:
Main article: Tax evasion in the United States
The Internal Revenue Service estimated that in 2001, the tax gap was $345 billion. The tax gap is the difference between the amount of tax legally owed and the amount actually collected by the government.
The tax gap in 2006 was estimated to be $450 billion. The tax gap two years later in 2008 was estimated to be in the range of $450–$500 billion and unreported income was estimated to be approximately $2 trillion. Therefore, 18–19 percent of total reportable income was not properly reported to the IRS.
Economics:
Main article: Economics of taxation in the United States
The complexity of the US tax code causes economic inefficiency.
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Taxes are levied on income, payroll, property, sales, capital gains, dividends, imports, estates and gifts, as well as various fees. In 2010, taxes collected by federal, state, and municipal governments amounted to 24.8% of GDP. In the OECD, only Chile and Mexico are taxed less as a share of their GDP.
However, taxes fall much more heavily on labor income than on capital income. Divergent taxes and subsidies for different forms of income and spending can also constitute a form of indirect taxation of some activities over others. For example, individual spending on higher education can be said to be "taxed" at a high rate, compared to other forms of personal expenditure which are formally recognized as investments.
Taxes are imposed on net income of individuals and corporations by the federal, most state, and some local governments. Citizens and residents are taxed on worldwide income and allowed a credit for foreign taxes. Income subject to tax is determined under tax accounting rules, not financial accounting principles, and includes almost all income from whatever source.
Most business expenses reduce taxable income, though limits apply to a few expenses.
Individuals are permitted to reduce taxable income by personal allowances and certain non-business expenses, including home mortgage interest, state and local taxes, charitable contributions, and medical and certain other expenses incurred above certain percentages of income.
State rules for determining taxable income often differ from federal rules. Federal marginal tax rates vary from 10% to 37% of taxable income. State and local tax rates vary widely by jurisdiction, from 0% to 13.30% of income, and many are graduated.
State taxes are generally treated as a deductible expense for federal tax computation, although the 2017 tax law imposed a $10,000 limit on the state and local tax ("SALT") deduction, which raised the effective tax rate on medium and high earners in high tax states.
Prior to the SALT deduction limit, the average deduction exceeded $10,000 in most of the Midwest, and exceeded $11,000 in most of the Northeastern United States, as well as California and Oregon. The states impacted the most by the limit were the tri-state area (NY, NJ, and CT) and California; the average SALT deduction in those states was greater than $17,000 in 2014.
The United States is one of two countries in the world that taxes its non-resident citizens on worldwide income, in the same manner and rates as residents; the other is Eritrea. The U.S. Supreme Court upheld the constitutionality of imposition of such a tax in the case of Cook v. Tait.
Payroll taxes are imposed by the federal and all state governments. These include Social Security and Medicare taxes imposed on both employers and employees, at a combined rate of 15.3% (13.3% for 2011 and 2012).
Social Security tax applies only to the first $106,800 of wages in 2009 through 2011. However, benefits are only accrued on the first $106,800 of wages. Employers must withhold income taxes on wages. An unemployment tax and certain other levies apply to employers.
Payroll taxes have dramatically increased as a share of federal revenue since the 1950s, while corporate income taxes have fallen as a share of revenue. (Corporate profits have not fallen as a share of GDP).
Property taxes are imposed by most local governments and many special purpose authorities based on the fair market value of property. School and other authorities are often separately governed, and impose separate taxes. Property tax is generally imposed only on realty, though some jurisdictions tax some forms of business property. Property tax rules and rates vary widely with annual median rates ranging from 0.2% to 1.9% of a property's value depending on the state.
Sales taxes are imposed by most states and some localities on the price at retail sale of many goods and some services. Sales tax rates vary widely among jurisdictions, from 0% to 16%, and may vary within a jurisdiction based on the particular goods or services taxed. Sales tax is collected by the seller at the time of sale, or remitted as use tax by buyers of taxable items who did not pay sales tax.
The United States imposes tariffs or customs duties on the import of many types of goods from many jurisdictions. These tariffs or duties must be paid before the goods can be legally imported. Rates of duty vary from 0% to more than 20%, based on the particular goods and country of origin.
Estate and gift taxes are imposed by the federal and some state governments on the transfer of property inheritance, by will, or by lifetime donation. Similar to federal income taxes, federal estate and gift taxes are imposed on worldwide property of citizens and residents and allow a credit for foreign taxes.
Levels and the Types of Taxation:
The U.S. has an assortment of federal, state, local, and special-purpose governmental jurisdictions. Each imposes taxes to fully or partly fund its operations. These taxes may be imposed on the same income, property or activity, often without offset of one tax against another.
The types of tax imposed at each level of government vary, in part due to constitutional restrictions. Income taxes are imposed at the federal and most state levels. Taxes on property are typically imposed only at the local level, although there may be multiple local jurisdictions that tax the same property.
Other excise taxes are imposed by the federal and some state governments. Sales taxes are imposed by most states and many local governments. Customs duties or tariffs are only imposed by the federal government. A wide variety of user fees or license fees are also imposed.
A federal wealth tax would be required by the U.S. Constitution to be distributed to the States according to their populations, as this type of tax is considered a direct tax. State and local government property taxes are wealth taxes on real estate.
Types of taxpayers:
Taxes may be imposed on individuals (natural persons), business entities, estates, trusts, or other forms of organization. Taxes may be based on property, income, transactions, transfers, importations of goods, business activities, or a variety of factors, and are generally imposed on the type of taxpayer for whom such tax base is relevant.
Thus, property taxes tend to be imposed on property owners. In addition, certain taxes, particularly income taxes, may be imposed on the members of organizations for the organization's activities. Therefore, partners are taxed on the income of their partnership.
With fewer exceptions, one level of government does not impose tax on another level of government or its instrumentalities.
Income tax:
Main article: Income tax in the United States
Taxes based on income are imposed at the federal, most state, and some local levels within the United States. The tax systems within each jurisdiction may define taxable income separately. Many states refer to some extent to federal concepts for determining taxable income.
History of the income tax:
The first Income tax in the United States was implemented with the Revenue Act of 1861 by Abraham Lincoln during the Civil War. In 1895 the Supreme Court ruled that the U.S. federal income tax on interest income, dividend income and rental income was unconstitutional in Pollock v. Farmers' Loan & Trust Co., because it was a direct tax.
The Pollock decision was overruled by the ratification of the Sixteenth Amendment to the United States Constitution in 1913, and by subsequent U.S. Supreme Court decisions including Graves v. New York ex rel. O'Keefe, South Carolina v. Baker, and Brushaber v. Union Pacific Railroad Co.
Basic concepts:
The U.S. income tax system imposes a tax based on income on individuals, corporations, estates, and trusts. The tax is taxable income, as defined, times a specified tax rate. This tax may be reduced by credits, some of which may be refunded if they exceed the tax calculated.
Taxable income may differ from income for other purposes (such as for financial reporting). The definition of taxable income for federal purposes is used by many, but far from all states.
Income and deductions are recognized under tax rules, and there are variations within the rules among the states. Book and tax income may differ. Income is divided into "capital gains", which are taxed at a lower rate and only when the taxpayer chooses to "realize" them, and "ordinary income", which is taxed at higher rates and on an annual basis. Because of this distinction, capital is taxed much more lightly than labor.
Under the U.S. system, individuals, corporations, estates, and trusts are subject to income tax. Partnerships are not taxed; rather, their partners are subject to income tax on their shares of income and deductions, and take their shares of credits. Some types of business entities may elect to be treated as corporations or as partnerships.
Taxpayers are required to file tax returns and self assess tax. Tax may be withheld from payments of income (e.g., withholding of tax from wages). To the extent taxes are not covered by withholdings, taxpayers must make estimated tax payments, generally quarterly.
Tax returns are subject to review and adjustment by taxing authorities, though far fewer than all returns are reviewed.
Taxable income is gross income less exemptions, deductions, and personal exemptions.
Gross income includes "all income from whatever source". Certain income, however, is subject to tax exemption at the federal or state levels. This income is reduced by tax deductions including most business and some nonbusiness expenses. Individuals are also allowed a deduction for personal exemptions, a fixed dollar allowance. The allowance of some nonbusiness deductions is phased out at higher income levels.
The U.S. federal and most state income tax systems tax the worldwide income of citizens and residents. A federal foreign tax credit is granted for foreign income taxes. Individuals residing abroad may also claim the foreign earned income exclusion. Individuals may be a citizen or resident of the United States but not a resident of a state. Many states grant a similar credit for taxes paid to other states. These credits are generally limited to the amount of tax on income from foreign (or other state) sources.
Filing status:
Main article: Filing Status (federal income tax)
Federal and state income tax is calculated, and returns filed, for each taxpayer. Two married individuals may calculate tax and file returns jointly or separately. In addition, unmarried individuals supporting children or certain other relatives may file a return as a head of household. Parent-subsidiary groups of companies may elect to file a consolidated return.
Graduated tax rates:
Income tax rates differ at the federal and state levels for corporations and individuals. Federal and many state income tax rates are higher (graduated) at higher levels of income. The income level at which various tax rates apply for individuals varies by filing status.
The income level at which each rate starts generally is higher (i.e., tax is lower) for married couples filing a joint return or single individuals filing as head of household.
Individuals are subject to federal graduated tax rates from 10% to 39.6%. Corporations are subject to federal graduated rates of tax from 15% to 35%; a rate of 34% applies to income from $335,000 to $15,000,000. State income tax rates, in states which have a tax on personal incomes, vary from 1% to 16%, including local income tax where applicable.
Nine (9) states do not have a tax on ordinary personal incomes. These include Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming.
Two states with a tax only on interest and dividend income of individuals, are New Hampshire and Tennessee.
Main article: State income tax
State and local taxes are generally deductible in computing federal taxable income. Federal and many state individual income tax rate schedules differ based on the individual's filing status.
Income:
Main articles:
Taxable income is gross income less adjustments and allowable tax deductions. Gross income for federal and most states is receipts and gains from all sources less cost of goods sold. Gross income includes "all income from whatever source", and is not limited to cash received. Income from illegal activities is taxable and must be reported to the IRS.
The amount of income recognized is generally the value received or which the taxpayer has a right to receive. Certain types of income are specifically excluded from gross income. The time at which gross income becomes taxable is determined under federal tax rules. This may differ in some cases from accounting rules.
Certain types of income are excluded from gross income (and therefore subject to tax exemption). The exclusions differ at federal and state levels. For federal income tax, interest income on state and local bonds is exempt, while few states exempt any interest income except from municipalities within that state. In addition, certain types of receipts, such as gifts and inheritances, and certain types of benefits, such as employer-provided health insurance, are excluded from income.
Foreign non-resident persons are taxed only on income from U.S. sources or from a U.S. business. Tax on foreign non-resident persons on non-business income is at 30% of the gross income, but reduced under many tax treaties.
These brackets are the taxable income plus the standard deduction for a joint return. That deduction is the first bracket. For example, a couple earning $88,600 by September owes $10,453; $1,865 for 10% of the income from $12,700 to $31,500, plus $8,588 for 15% of the income from $31,500 to $88,600. Now, for every $100 they earn, $25 is taxed until they reach the next bracket.
After making $400 more; going down to the 89,000 row the tax is $100 more. The next column is the tax divided by 89,000. The new law is the next column. This tax equals 10% of their income from $24,000 to $43,050 plus 12% from $43,050 to $89,000. The singles' sets of markers can be set up quickly. The brackets with its tax are cut in half.
Itemizers can figure the tax without moving the scale by taking the difference off the top. The couple above, having receipts for $22,700 in deductions, means that the last $10,000 of their income is tax free. After seven years the papers can be destroyed; if unchallenged.
Deductions and exemptions:
Main article: Tax deduction
The U.S. system allows reduction of taxable income for both business and some nonbusiness expenditures, called deductions. Businesses selling goods reduce gross income directly by the cost of goods sold. In addition, businesses may deduct most types of expenses incurred in the business.
Some of these deductions are subject to limitations. For example, only 50% of the amount incurred for any meals or entertainment may be deducted. The amount and timing of deductions for business expenses is determined under the taxpayer's tax accounting method, which may differ from methods used in accounting records.
Some types of business expenses are deductible over a period of years rather than when incurred. These include the cost of long lived assets such as buildings and equipment. The cost of such assets is recovered through deductions for depreciation or amortization.
In addition to business expenses, individuals may reduce income by an allowance for personal exemptions and either a fixed standard deduction or itemized deductions. One personal exemption is allowed per taxpayer, and additional such deductions are allowed for each child or certain other individuals supported by the taxpayer.
The standard deduction amount varies by taxpayer filing status. Itemized deductions by individuals include home mortgage interest, property taxes, certain other taxes, contributions to recognized charities, medical expenses in excess of 7.5% of adjusted gross income, and certain other amounts.
Personal exemptions, the standard deduction, and itemized deductions are limited (phased out) above certain income levels.
Business entities:
Main articles:
Corporations must pay tax on their taxable income independently of their shareholders. Shareholders are also subject to tax on dividends received from corporations. By contrast, partnerships are not subject to income tax, but their partners calculate their taxes by including their shares of partnership items.
Corporations owned entirely by U.S. citizens or residents (S corporations) may elect to be treated similarly to partnerships. A limited liability company and certain other business entities may elect to be treated as corporations or as partnerships. States generally follow such characterization. Many states also allow corporations to elect S corporation status.
Charitable organizations are subject to tax on business income.
Certain transactions of business entities are not subject to tax. These include many types of formation or reorganization.
Credits:
Main article: Tax credit
A wide variety of tax credits may reduce income tax at the federal and state levels. Some credits are available only to individuals, such as the child tax credit for each dependent child, American Opportunity Tax Credit for education expenses, or the Earned Income Tax Credit for low income wage earners.
Some credits, such as the Work Opportunity Tax Credit, are available to businesses, including various special industry incentives. A few credits, such as the foreign tax credit, are available to all types of taxpayers.
Payment or withholding of taxes:
Main article: Withholding tax
The United States federal and state income tax systems are self-assessment systems.
Taxpayers must declare and pay tax without assessment by the taxing authority. Quarterly payments of tax estimated to be due are required to the extent taxes are not paid through withholdings.
Employers must withhold income tax, as well as Social Security and Medicare taxes, from wages. Amounts to be withheld are computed by employers based on representations of tax status by employees on Form W-4, with limited government review.
State variations:
Main article: State income tax
Forty-three states and many localities in the U.S. impose an income tax on individuals. Forty-seven states and many localities impose a tax on the income of corporations. Tax rates vary by state and locality, and may be fixed or graduated. Most rates are the same for all types of income. State and local income taxes are imposed in addition to federal income tax.
State income tax is allowed as a deduction in computing federal income, but is capped at $10,000 per household since the passage of the 2017 tax law. Prior to the change, the average deduction exceeded $10,000 in most of the Midwest, most of the Northeast, as well as California and Oregon.
State and local taxable income is determined under state law, and often is based on federal taxable income. Most states conform to many federal concepts and definitions, including defining income and business deductions and timing thereof. State rules vary widely regarding to individual itemized deductions.
Most states do not allow a deduction for state income taxes for individuals or corporations, and impose tax on certain types of income exempt at the federal level.
Some states have alternative measures of taxable income, or alternative taxes, especially for corporations.
States imposing an income tax generally tax all income of corporations organized in the state and individuals residing in the state. Taxpayers from another state are subject to tax only on income earned in the state or apportioned to the state. Businesses are subject to income tax in a state only if they have sufficient nexus in (connection to) the state.
Non-residents:
Foreign individuals and corporations not resident in the United States are subject to federal income tax only on income from a U.S. business and certain types of income from U.S. sources.
States tax individuals resident outside the state and corporations organized outside the state only on wages or business income within the state. Payers of some types of income to non-residents must withhold federal or state income tax on the payment. Federal withholding of 30% on such income may be reduced under a tax treaty. Such treaties do not apply to state taxes.
Alternative tax bases (AMT, states):
An alternative minimum tax (AMT) is imposed at the federal level on a somewhat modified version of taxable income. The tax applies to individuals and corporations. The tax base is adjusted gross income reduced by a fixed deduction that varies by taxpayer filing status.
Itemized deductions of individuals are limited to home mortgage interest, charitable contributions, and a portion of medical expenses. AMT is imposed at a rate of 26% or 28% for individuals and 20% for corporations, less the amount of regular tax. A credit against future regular income tax is allowed for such excess, with certain restrictions.
Many states impose minimum income taxes on corporations or a tax computed on an alternative tax base. These include taxes based on capital of corporations and alternative measures of income for individuals. Details vary widely by state.
Differences between book and taxable income for businesses:
In the United States, taxable income is computed under rules that differ materially from U.S. generally accepted accounting principles. Since only publicly traded companies are required to prepare financial statements, many non-public companies opt to keep their financial records under tax rules.
Corporations that present financial statements using other than tax rules must include a detailed reconciliation of their financial statement income to their taxable income as part of their tax returns.
Key areas of difference include depreciation and amortization, timing of recognition of income or deductions, assumptions for cost of goods sold, and certain items (such as meals and entertainment) the tax deduction for which is limited.
Reporting under self-assessment system:
Main article: Tax return (United States)
Income taxes in the United States are self-assessed by taxpayers by filing required tax returns. Taxpayers, as well as certain non-tax-paying entities, like partnerships, must file annual tax returns at the federal and applicable state levels. These returns disclose a complete computation of taxable income under tax principles.
Taxpayers compute all income, deductions, and credits themselves, and determine the amount of tax due after applying required prepayments and taxes withheld. Federal and state tax authorities provide preprinted forms that must be used to file tax returns. IRS Form 1040 series is required for individuals, Form 1120 series for corporations, Form 1065 for partnerships, and Form 990 series for tax exempt organizations.
The state forms vary widely, and rarely correspond to federal forms. Tax returns vary from the two-page (Form 1040EZ) used by nearly 70% of individual filers to thousands of pages of forms and attachments for large entities. Groups of corporations may elect to file consolidated returns at the federal level and with a few states.
Electronic filing of federal and many state returns is widely encouraged and in some cases required, and many vendors offer computer software for use by taxpayers and paid return preparers to prepare and electronically file returns.
Capital gains tax:
Main article: Capital gains tax in the United States
Individuals and corporations pay U.S. federal income tax on the net total of all their capital gains. The tax rate depends on both the investor's tax bracket and the amount of time the investment was held.
Short-term capital gains are taxed at the investor's ordinary income tax rate and are defined as investments held for a year or less before being sold. Long-term capital gains, on dispositions of assets held for more than one year, are taxed at a lower rate.
Payroll taxes:
In the United States, payroll taxes are assessed by the federal government, many states, the District of Columbia, and numerous cities. These taxes are imposed on employers and employees and on various compensation bases. They are collected and paid to the taxing jurisdiction by the employers.
Most jurisdictions imposing payroll taxes require reporting quarterly and annually in most cases, and electronic reporting is generally required for all but small employers. Because payroll taxes are imposed only on wages and not on income from investments, taxes on labor income are much heavier than taxes on income from capital.
Income tax withholding:
Main article: Tax withholding in the United States
Federal, state, and local withholding taxes are required in those jurisdictions imposing an income tax. Employers having contact with the jurisdiction must withhold the tax from wages paid to their employees in those jurisdictions.
Computation of the amount of tax to withhold is performed by the employer based on representations by the employee regarding his/her tax status on IRS Form W-4. Amounts of income tax so withheld must be paid to the taxing jurisdiction, and are available as refundable tax credits to the employees.
Income taxes withheld from payroll are not final taxes, merely prepayments. Employees must still file income tax returns and self assess tax, claiming amounts withheld as payments.
Social Security and Medicare taxes:
Main article: Federal Insurance Contributions Act tax
Federal social insurance taxes are imposed equally on employers and employees, consisting of a tax of 6.2% of wages up to an annual wage maximum ($118,500 in 2015) for Social Security plus a tax of 1.45% of total wages for Medicare.
For 2011, the employee's contribution was reduced to 4.2%, while the employer's portion remained at 6.2%. To the extent an employee's portion of the 6.2% tax exceeds the maximum by reason of multiple employers (each of whom will collect up to the annual wage maximum), the employee is entitled to a refundable tax credit upon filing an income tax return for the year.
Unemployment taxes:
Main article: Federal Unemployment Tax Act
Employers are subject to unemployment taxes by the federal and all state governments. The tax is a percentage of taxable wages with a cap. The tax rate and cap vary by jurisdiction and by employer's industry and experience rating. For 2009, the typical maximum tax per employee was under $1,000. Some states also impose unemployment, disability insurance, or similar taxes on employees.
Reporting and payment:
Employers must report payroll taxes to the appropriate taxing jurisdiction in the manner each jurisdiction provides. Quarterly reporting of aggregate income tax withholding and Social Security taxes is required in most jurisdictions. Employers must file reports of aggregate unemployment tax quarterly and annually with each applicable state, and annually at the federal level.
Each employer is required to provide each employee an annual report on IRS Form W-2 of wages paid and federal, state and local taxes withheld, with a copy sent to the IRS and the taxation authority of the state. These are due by January 31 and February 28 (March 31 if filed electronically), respectively, following the calendar year in which wages are paid. The Form W-2 constitutes proof of payment of tax for the employee.
Employers are required to pay payroll taxes to the taxing jurisdiction under varying rules, in many cases within 1 banking day. Payment of federal and many state payroll taxes is required to be made by electronic funds transfer if certain dollar thresholds are met, or by deposit with a bank for the benefit of the taxing jurisdiction.
Penalties:
Failure to timely and properly pay federal payroll taxes results in an automatic penalty of 2% to 10%.
Similar state and local penalties apply. Failure to properly file monthly or quarterly returns may result in additional penalties. Failure to file Forms W-2 results in an automatic penalty of up to $50 per form not timely filed. State and local penalties vary by jurisdiction.
A particularly severe penalty applies where federal income tax withholding and Social Security taxes are not paid to the IRS. The penalty of up to 100% of the amount not paid can be assessed against the employer entity as well as any person (such as a corporate officer) having control or custody of the funds from which payment should have been made.
Sales and excise taxes as sales and use tax:
Main article: Sales taxes in the United States
There is no federal sales or use tax in the United States. All but five states impose sales and use taxes on retail sale, lease and rental of many goods, as well as some services. Many cities, counties, transit authorities and special purpose districts impose an additional local sales or use tax.
Sales and use tax is calculated as the purchase price times the appropriate tax rate. Tax rates vary widely by jurisdiction from less than 1% to over 10%. Sales tax is collected by the seller at the time of sale. Use tax is self assessed by a buyer who has not paid sales tax on a taxable purchase.
Unlike value added tax, sales tax is imposed only once, at the retail level, on any particular goods. Nearly all jurisdictions provide numerous categories of goods and services that are exempt from sales tax, or taxed at a reduced rate.
Purchase of goods for further manufacture or for resale is uniformly exempt from sales tax. Most jurisdictions exempt food sold in grocery stores, prescription medications, and many agricultural supplies. Generally cash discounts, including coupons, are not included in the price used in computing tax.
Sales taxes, including those imposed by local governments, are generally administered at the state level. States imposing sales tax require retail sellers to register with the state, collect tax from customers, file returns, and remit the tax to the state. Procedural rules vary widely.
Sellers generally must collect tax from in-state purchasers unless the purchaser provides an exemption certificate. Most states allow or require electronic remittance of tax to the state.
States are prohibited from requiring out of state sellers to collect tax unless the seller has some minimal connection with the state.
Excise taxes:
Main article: Excise tax in the United States
Excise taxes may be imposed on the sales price of goods or on a per unit or other basis, in theory to discourage consumption of the taxed goods or services. Excise tax may be required to be paid by the manufacturer at wholesale sale, or may be collected from the customer at retail sale.
Excise taxes are imposed at the federal and state levels on a variety of goods, including alcohol, tobacco, tires, gasoline, diesel fuel, coal, firearms, telephone service, air transportation, unregistered bonds, and many other goods and services. Some jurisdictions require that tax stamps be affixed to goods to demonstrate payment of the tax.
Property Tax:
Main article: Property tax in the United States
Most jurisdictions below the state level in the United States impose a tax on interests in real property (land, buildings, and permanent improvements). Some jurisdictions also tax some types of business personal property. Rules vary widely by jurisdiction. Many overlapping jurisdictions (counties, cities, school districts) may have authority to tax the same property. Few states impose a tax on the value of property.
Property tax is based on fair market value of the subject property. The amount of tax is determined annually based on the market value of each property on a particular date, and most jurisdictions require re-determinations of value periodically. The tax is computed as the determined market value times an assessment ratio times the tax rate.
Assessment ratios and tax rates vary widely among jurisdictions, and may vary by type of property within a jurisdiction. Where a property has recently been sold between unrelated sellers, such sale establishes fair market value. In other (i.e., most) cases, the value must be estimated. Common estimation techniques include comparable sales, depreciated cost, and an income approach. Property owners may also declare a value, which is subject to change by the tax assessor.
Types of property taxed:
Property taxes are most commonly applied to real estate and business property. Real property generally includes all interests considered under that state's law to be ownership interests in land, buildings, and improvements. Ownership interests include ownership of title as well as certain other rights to property. Automobile and boat registration fees are a subset of this tax. Usually, other non-business goods are not subject to property tax.
Assessment and collection:
The assessment process varies by state, and sometimes within a state. Each taxing jurisdiction determines values of property within the jurisdiction and then determines the amount of tax to assess based on the value of the property. Tax assessors for taxing jurisdictions are generally responsible for determining property values. The determination of values and calculation of tax is generally performed by an official referred to as a tax assessor.
Property owners have rights in each jurisdiction to declare or contest the value so determined. Property values generally must be coordinated among jurisdictions, and such coordination is often performed by a board of equalization.
Once value is determined, the assessor typically notifies the last known property owner of the value determination. After values are settled, property tax bills or notices are sent to property owners.
Payment times and terms vary widely. If a property owner fails to pay the tax, the taxing jurisdiction has various remedies for collection, in many cases including seizure and sale of the property. Property taxes constitute a lien on the property to which transfers are also subject.
Mortgage companies often collect taxes from property owners and remit them on behalf of the owner.
Customs duties:
The United States imposes tariffs or customs duties on imports of goods. The duty is levied at the time of import and is paid by the importer of record. Customs duties vary by country of origin and product. Goods from many countries are exempt from duty under various trade agreements.
Certain types of goods are exempt from duty regardless of source. Customs rules differ from other import restrictions. Failure to properly comply with customs rules can result in seizure of goods and criminal penalties against involved parties. United States Customs and Border Protection ("CBP") enforces customs rules.
Import of goods:
Goods may be imported to the United States subject to import restrictions. Importers of goods may be subject to tax ("customs duty" or "tariff") on the imported value of the goods.
"Imported goods are not legally entered until after the shipment has arrived within the port of entry, delivery of the merchandise has been authorized by CBP, and estimated duties have been paid." Importation and declaration and payment of customs duties is done by the importer of record, which may be the owner of the goods, the purchaser, or a licensed customs broker.
Goods may be stored in a bonded warehouse or a Foreign-Trade Zone in the United States for up to five years without payment of duties. Goods must be declared for entry into the U.S. within 15 days of arrival or prior to leaving a bonded warehouse or foreign trade zone. Many importers participate in a voluntary self-assessment program with CBP. Special rules apply to goods imported by mail.
All goods imported into the United States are subject to inspection by CBP. Some goods may be temporarily imported to the United States under a system similar to the ATA Carnet system. Examples include laptop computers used by persons traveling in the U.S. and samples used by salesmen.
Origin:
Rates of tax on transaction values vary by country of origin. Goods must be individually labeled to indicate country of origin, with exceptions for specific types of goods. Goods are considered to originate in the country with the highest rate of duties for the particular goods unless the goods meet certain minimum content requirements.
Extensive modifications to normal duties and classifications apply to goods originating in Canada or Mexico under the North American Free Trade Agreement.
Classification:
All goods that are not exempt are subject to duty computed according to the Harmonized Tariff Schedule published by CBP and the U.S. International Trade Commission. This lengthy schedule provides rates of duty for each class of goods. Most goods are classified based on the nature of the goods, though some classifications are based on use.
Duty rate:
Customs duty rates may be expressed as a percentage of value or dollars and cents per unit. Rates based on value vary from zero to 20% in the 2011 schedule. Rates may be based on relevant units for the particular type of goods (per ton, per kilogram, per square meter, etc.). Some duties are based in part on value and in part on quantity.
Where goods subject to different rates of duty are commingled, the entire shipment may be taxed at the highest applicable duty rate.
Procedures:
Imported goods are generally accompanied by a bill of lading or air waybill describing the goods. For purposes of customs duty assessment, they must also be accompanied by an invoice documenting the transaction value. The goods on the bill of lading and invoice are classified and duty is computed by the importer or CBP. The amount of this duty is payable immediately, and must be paid before the goods can be imported.
Most assessments of goods are now done by the importer and documentation filed with CBP electronically.
After duties have been paid, CBP approves the goods for import. They can then be removed from the port of entry, bonded warehouse, or Free-Trade Zone.
After duty has been paid on particular goods, the importer can seek a refund of duties if the goods are exported without substantial modification. The process of claiming a refund is known as duty drawback.
Penalties:
Certain civil penalties apply for failures to follow CBP rules and pay duty. Goods of persons subject to such penalties may be seized and sold by CBP. In addition, criminal penalties may apply for certain offenses. Criminal penalties may be as high as twice the value of the goods plus twenty years in jail.
Foreign-Trade Zones:
Foreign-Trade Zones are secure areas physically in the United States but legally outside the customs territory of the United States. Such zones are generally near ports of entry. They may be within the warehouse of an importer. Such zones are limited in scope and operation based on approval of the Foreign-Trade Zones Board.
Goods in a Foreign-Trade Zone are not considered imported to the United States until they leave the Zone. Foreign goods may be used to manufacture other goods within the zone for export without payment of customs duties.
Estate and gift taxes:
Main articles:
Estate and gift taxes in the United States are imposed by the federal and some state governments. The estate tax is an excise tax levied on the right to pass property at death. It is imposed on the estate, not the beneficiary.
Some states impose an inheritance tax on recipients of bequests. Gift taxes are levied on the giver (donor) of property where the property is transferred for less than adequate consideration. An additional generation-skipping transfer (GST) tax is imposed by the federal and some state governments on transfers to grandchildren (or their descendants).
The federal gift tax is applicable to the donor, not the recipient, and is computed based on cumulative taxable gifts, and is reduced by prior gift taxes paid. The federal estate tax is computed on the sum of taxable estate and taxable gifts, and is reduced by prior gift taxes paid.
These taxes are computed as the taxable amount times a graduated tax rate (up to 35% in 2011). The estate and gift taxes are also reduced by a "unified credit" equivalent to an exclusion ($5 million in 2011). Rates and exclusions have varied, and the benefits of lower rates and the credit have been phased out during some years.
Taxable gifts are certain gifts of U.S. property by nonresident aliens, most gifts of any property by citizens or residents, in excess of an annual exclusion ($13,000 for gifts made in 2011) per donor per donee. Taxable estates are certain U.S. property of non-resident alien decedents, and most property of citizens or residents.
For aliens, residence for estate tax purposes is primarily based on domicile, but U.S. citizens are taxed regardless of their country of residence. U.S. real estate and most tangible property in the U.S. are subject to estate and gift tax whether the decedent or donor is resident or nonresident, citizen or alien.
The taxable amount of a gift is the fair market value of the property in excess of consideration received at the date of gift. The taxable amount of an estate is the gross fair market value of all rights considered property at the date of death (or an alternative valuation date) ("gross estate"), less liabilities of the decedent, costs of administration (including funeral expenses) and certain other deductions. State estate taxes are deductible, with limitations, in computing the federal taxable estate. Bequests to charities reduce the taxable estate.
Gift tax applies to all irrevocable transfers of interests in tangible or intangible property. Estate tax applies to all property owned in whole or in part by a citizen or resident at the time of his or her death, to the extent of the interest in the property. Generally, all types of property are subject to estate tax. Whether a decedent has sufficient interest in property for the property to be subject to gift or estate tax is determined under applicable state property laws.
Certain interests in property that lapse at death (such as life insurance) are included in the taxable estate.
Taxable values of estates and gifts are the fair market value. For some assets, such as widely traded stocks and bonds, the value may be determined by market listings. The value of other property may be determined by appraisals, which are subject to potential contest by the taxing authority.
Special use valuation applies to farms and closely held businesses, subject to limited dollar amount and other conditions. Monetary assets, such as cash, mortgages, and notes, are valued at the face amount, unless another value is clearly established.
Life insurance proceeds are included in the gross estate. The value of a right of a beneficiary of an estate to receive an annuity is included in the gross estate. Certain transfers during lifetime may be included in the gross estate. Certain powers of a decedent to control the disposition of property by another are included in the gross estate.
The taxable estate of a married decedent is reduced by a deduction for all property passing to the decedent's spouse. Certain terminable interests are included. Other conditions may apply.
Donors of gifts in excess of the annual exclusion must file gift tax returns on IRS Form 709 and pay the tax. Executors of estates with a gross value in excess of the unified credit must file an estate tax return on IRS Form 706 and pay the tax from the estate. Returns are required if the gifts or gross estate exceed the exclusions. Each state has its own forms and filing requirements. Tax authorities may examine and adjust gift and estate tax returns.
Licenses and occupational taxes:
Many jurisdictions within the United States impose taxes or fees on the privilege of carrying on a particular business or maintaining a particular professional certification. These licensing or occupational taxes may be a fixed dollar amount per year for the licensee, an amount based on the number of practitioners in the firm, a percentage of revenue, or any of several other bases.
Persons providing professional or personal services are often subject to such fees. Common examples include accountants, attorneys, barbers, casinos, dentists, doctors, auto mechanics, plumbers, and stock brokers. In addition to the tax, other requirements may be imposed for licensure.
All 50 states impose vehicle license fee. Generally, the fees are based on type and size of vehicle and are imposed annually or biannually. All states and the District of Columbia also impose a fee for a driver's license, which generally must be renewed with payment of fee every few years.
User fees:
Fees are often imposed by governments for use of certain facilities or services. Such fees are generally imposed at the time of use. Multi-use permits may be available. For example, fees are imposed for use of national or state parks, for requesting and obtaining certain rulings from the U.S. Internal Revenue Service (IRS), for the use of certain highways (called "tolls" or toll roads), for parking on public streets, and for the use of public transit.
Tax administration:
Taxes in the United States are administered by hundreds of tax authorities. At the federal level there are three tax administrations. Most domestic federal taxes are administered by the Internal Revenue Service, which is part of the Department of the Treasury. Alcohol, tobacco, and firearms taxes are administered by the Alcohol and Tobacco Tax and Trade Bureau (TTB).
Taxes on imports (customs duties) are administered by U.S. Customs and Border Protection (CBP). TTB is also part of the Department of the Treasury and CBP belongs to the Department of Homeland Security.
Organization of state and local tax administrations varies widely. Every state maintains a tax administration. A few states administer some local taxes in whole or part. Most localities also maintain a tax administration or share one with neighboring localities.
Federal: Internal Revenue Service:
Main article: Internal Revenue Service
The Internal Revenue Service administers all U.S. federal tax laws on domestic activities, except those taxes administered by TTB. IRS functions include:
- Processing federal tax returns (except TTB returns), including those for Social Security and other federal payroll taxes
- Providing assistance to taxpayers in completing tax returns
- Collecting all taxes due related to such returns
- Enforcement of tax laws through examination of returns and assessment of penalties
- Providing an appeals mechanism for federal tax disputes
- Referring matters to the Justice Department for prosecution
- Publishing information about U.S. federal taxes, including forms, publications, and other materials
- Providing written guidance in the form of rulings binding on the IRS for the public and for particular taxpayers
The IRS maintains several Service Centers at which tax returns are processed. Taxpayers generally file most types of tax returns by mail with these Service Centers, or file electronically. The IRS also maintains a National Office in Washington, DC, and numerous local offices providing taxpayer services and administering tax examinations.
Examination:
Tax returns filed with the IRS are subject to examination and adjustment, commonly called an IRS audit. Only a small percentage of returns (about 1% of individual returns in IRS FY 2008) are examined each year. The selection of returns uses a variety of methods based on IRS experiences.
On examination, the IRS may request additional information from the taxpayer by mail, in person at IRS local offices, or at the business location of the taxpayer. The taxpayer is entitled to representation by an attorney, Certified Public Accountant (CPA), or enrolled agent, at the expense of the taxpayer, who may make representations to the IRS on behalf of the taxpayer.
Taxpayers have certain rights in an audit. Upon conclusion of the audit, the IRS may accept the tax return as filed or propose adjustments to the return. The IRS may also assess penalties and interest. Generally, adjustments must be proposed within three years of the due date of the tax return. Certain circumstances extend this time limit, including substantial understatement of income and fraud.
The taxpayer and the IRS may agree to allow the IRS additional time to conclude an audit. If the IRS proposes adjustments, the taxpayer may agree to the adjustment, appeal within the IRS, or seek judicial determination of the tax.
Published and private rulings:
In addition to enforcing tax laws, the IRS provides formal and informal guidance to taxpayers. While often referred to as IRS Regulations, the regulations under the Internal Revenue Code are issued by the Department of Treasury. IRS guidance consists of:
- Revenue Rulings, Revenue Procedures, and various IRS pronouncements applicable to all taxpayers and published in the Internal Revenue Bulletin, which are binding on the IRS,
- Private letter rulings on specific issues, applicable only to the taxpayer who applied for the ruling,
- IRS Publications providing informal instruction to the public on tax matters,
- IRS forms and instructions,
- A comprehensive web site, and
- Informal (nonbinding) advice by telephone.
Alcohol and Tobacco Tax and Trade Bureau:
Main article: Alcohol and Tobacco Tax and Trade Bureau
The Alcohol and Tobacco Tax Trade Bureau (TTB), a division of the Department of the Treasury, enforces federal excise tax laws related to alcohol, tobacco, and firearms. TTB has six divisions, each with discrete functions:
- Revenue Center: processes tax returns and issues permits, and related activities
- Risk Management: internally develops guidelines and monitors programs
- Tax Audit: verifies filing and payment of taxes
- Trade Investigations: investigating arm for non-tobacco items
- Tobacco Enforcement Division: enforcement actions for tobacco
- Advertising, Labeling, and Formulation Division: implements various labeling and ingredient monitoring
Criminal enforcement related to TTB is done by the Bureau of Alcohol, Tobacco, Firearms, and Explosives, a division of the Justice Department.
Customs and Border Protection:
Main article: U.S. Customs and Border Protection
U.S. Customs and Border Protection (CBP), an agency of the United States Department of Homeland Security, collects customs duties and regulates international trade. It has a workforce of over 58,000 employees covering over 300 official ports of entry to the United States. CBP has authority to seize and dispose of cargo in the case of certain violations of customs rules.
State administrations:
Every state in the United States has its own tax administration, subject to the rules of that state's law and regulations. These are referred to in most states as the Department of Revenue or Department of Taxation.
The powers of the state taxing authorities vary widely. Most enforce all state level taxes but not most local taxes. However, many states have unified state-level sales tax administration, including for local sales taxes.
State tax returns are filed separately with those tax administrations, not with the federal tax administrations. Each state has its own procedural rules, which vary widely.
Local administrations:
Most localities within the United States administer most of their own taxes. In many cases, there are multiple local taxing jurisdictions with respect to a particular taxpayer or property.
For property taxes, the taxing jurisdiction is typically represented by a tax assessor/collector whose offices are located at the taxing jurisdiction's facilities.
Legal basis:
The United States Constitution provides that Congress "shall have the power to lay and collect Taxes, Duties, Imposts, and Excises ... but all Duties, Imposts, and Excises shall be uniform throughout the United States." Prior to amendment, it provided that "No Capitation, or other direct, Tax shall be Laid unless in proportion to the Census ..." The 16th Amendment provided that "Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."
The 10th Amendment provided that "powers not delegated to the United States by this Constitution, nor prohibited to the States, are reserved to the States respectively, or to the people."
Congress has enacted numerous laws dealing with taxes since adoption of the Constitution. Those laws are now codified as Title 19, Customs Duties, Title 26, Internal Revenue Code, and various other provisions. These laws specifically authorize the United States Secretary of the Treasury to delegate various powers related to levy, assessment and collection of taxes.
State constitutions uniformly grant the state government the right to levy and collect taxes. Limitations under state constitutions vary widely.
Various fringe individuals and groups have questioned the legitimacy of United States federal income tax. These arguments are varied, but have been uniformly rejected by the Internal Revenue Service and by the courts and ruled to be frivolous.
Policy issues:
Main article: Progressivity in United States income tax
Commentators Benjamin Page, Larry Bartels and Jason Seawright contend that Federal tax policy in relation to regulation and reform in the United States tends to favor wealthy Americans. They assert that political influence is a legal right the wealthy can exercise by contributing funds to lobby for their policy preference.
Each major type of tax in the United States has been used by some jurisdiction at some time as a tool of social policy.
Both liberals and conservatives have called for more progressive taxes in the U.S. Page, Bartels and Seawright assert that although members of the government favor a move toward progressive taxes, due to budget deficits upper class citizens are not yet willing to make a push for the change. Tax cuts were provided during the Bush administration, and were extended in 2010, making federal income taxes less progressive.
Tax evasion:
Main article: Tax evasion in the United States
The Internal Revenue Service estimated that in 2001, the tax gap was $345 billion. The tax gap is the difference between the amount of tax legally owed and the amount actually collected by the government.
The tax gap in 2006 was estimated to be $450 billion. The tax gap two years later in 2008 was estimated to be in the range of $450–$500 billion and unreported income was estimated to be approximately $2 trillion. Therefore, 18–19 percent of total reportable income was not properly reported to the IRS.
Economics:
Main article: Economics of taxation in the United States
The complexity of the US tax code causes economic inefficiency.
Click on any of the following blue hyperlinks for more about Taxation in the United States:
- History
- See also:
Investopedia Financial Website
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Investopedia is an American website based in New York City that provides investing and finance education along with reviews, ratings, and comparisons of various financial products such as brokerage accounts.
History:
Investopedia was founded in 1999 by Cory Wagner and Cory Janssen in Edmonton, Alberta at the height of the dot-com era. Wagner focused on business development and R&D, and Janssen focused on marketing and sales.
Investopedia drew about 2,500,000 monthly users and provided a financial dictionary with about 5,000 terms from personal finance, banking and accounting. It also provided articles by financial experts and a stock market simulator.
Timeline:
Stock simulator:
Investopedia runs a stock market simulator, in which the player is given a virtual portfolio and money to spend on the stock market.
Website: the following Investopedia website topics are reflected as of 6/1/2020, and may be subject to later change by Investopedia:
History:
Investopedia was founded in 1999 by Cory Wagner and Cory Janssen in Edmonton, Alberta at the height of the dot-com era. Wagner focused on business development and R&D, and Janssen focused on marketing and sales.
Investopedia drew about 2,500,000 monthly users and provided a financial dictionary with about 5,000 terms from personal finance, banking and accounting. It also provided articles by financial experts and a stock market simulator.
Timeline:
- Founding in 1999
- In April 2007, Forbes Media acquired Investopedia.com for an undisclosed amount.
- In 2010, Forbes sold Investopedia to ValueClick Inc. for $42 Million.
- In 2013, Valueclick sold Investopedia and a group of other properties to IAC/InterActive Corp for $80 Million.
- In 2015, David Siegel joined Investopedia as Chief Executive Officer (CEO).
- In June 2016, Investopedia launched Investopedia Academy to sell premium video educational courses.
- In July 2018, IAC sold Investopedia to Dotdash.
Stock simulator:
Investopedia runs a stock market simulator, in which the player is given a virtual portfolio and money to spend on the stock market.
Website: the following Investopedia website topics are reflected as of 6/1/2020, and may be subject to later change by Investopedia:
- Official website and its Topics (below):
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Ponzi Schemes, e.g., Bernie Madoff
- YouTube Video about How A Ponzi Scheme Works
- YouTube Video: Ponzi Scheme Explained And The Story Of Bernie Madoff
- YouTube Video: The Man Who Stole $65 Billion - Largest Ponzi Scheme In History (Bernie Madoff)
A Ponzi scheme is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. Named after Italian businessman Charles Ponzi, this scheme misleads investors by either falsely suggesting that profits are derived from legitimate business activities (whereas the business activities are non-existent), or by exaggerating the extent and profitability of the legitimate business activities, leveraging new investments to fabricate or supplement these profits.
A Ponzi scheme can maintain the illusion of a sustainable business as long as investors continue to contribute new funds, and as long as most of the investors do not demand full repayment or lose faith in the non-existent assets they are purported to own.
Some of the first recorded incidents to meet the modern definition of the Ponzi scheme were carried out from 1869 to 1872 by Adele Spitzeder in Germany and by Sarah Howe in the United States in the 1880s through the "Ladies' Deposit". Howe offered a solely female clientele an 8% monthly interest rate and then stole the money that the women had invested.
She was eventually discovered and served three years in prison. The Ponzi scheme was also previously described in novels; Charles Dickens's 1844 novel Martin Chuzzlewit and his 1857 novel Little Dorrit both feature such a scheme.
In the 1920s, Charles Ponzi carried out this scheme and became well known throughout the United States because of the huge amount of money that he took in. His original scheme was based on the legitimate arbitrage of international reply coupons for postage stamps, but he soon began diverting new investors' money to make payments to earlier investors and to himself.
Unlike earlier similar schemes, Ponzi's gained considerable press coverage both within the United States and internationally while it was being perpetrated and after it collapsed – this notoriety eventually led to the type of scheme being named after him.
Characteristics;
In a Ponzi scheme, a con artist offers investments that promise very high returns with little or no risk to their victims. The returns are said to originate from a business or a secret idea run by the con artist.
In reality, the business does not exist or the idea does not work in the way it is described. The con artist pays the high returns promised to their earlier investors by using the money obtained from later investors. Instead of engaging in a legitimate business activity, the con artist attempts to attract new investors to make the payments that were promised to earlier investors.
The operator of the scheme also diverts clients' funds for the operator's personal use.
With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive.
When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes collapse. As a result, most investors end up losing all or much of the money they invested. In some cases, the operator of the scheme may simply disappear with the money.
Red flags:
According to the U.S. Securities and Exchange Commission (SEC), many Ponzi schemes share characteristics that should be "red flags" for investors:
According to criminologist Marie Springer, the following red flags can also be of relevance:
Methods:
Typically, Ponzi schemes require an initial investment and promise above-average returns. They use vague verbal guises such as "hedge futures trading", "high-yield investment programs", or "offshore investment" to describe their income strategy. It is common for the operator to take advantage of a lack of investor knowledge or competence, or sometimes claim to use a proprietary, secret investment strategy to avoid giving information about the scheme.
The basic premise of a Ponzi scheme is "to rob Peter to pay Paul". Initially, the operator pays high returns to attract investors and entice current investors to invest more money. When other investors begin to participate, a cascade effect begins. The schemer pays a "return" to initial investors from the investments of new participants, rather than from genuine profits.
Often, high returns encourage investors to leave their money in the scheme, so that the operator does not actually have to pay very much to investors. The operator simply sends statements showing how much they have earned, which maintains the deception that the scheme is an investment with high returns.
Investors within a Ponzi scheme may face difficulties when trying to get their money out of the investment.
Operators also try to minimize withdrawals by offering new plans to investors where money cannot be withdrawn for a certain period of time in exchange for higher returns. The operator sees new cash flows as investors cannot transfer money.
If a few investors do wish to withdraw their money in accordance with the terms allowed, their requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent and financially sound.
Ponzi schemes sometimes begin as legitimate investment vehicles, such as hedge funds that can easily degenerate into a Ponzi-type scheme if they unexpectedly lose money or fail to legitimately earn the returns expected. The operators fabricate false returns or produce fraudulent audit reports instead of admitting their failure to meet expectations, from which point on the operation can be considered a Ponzi scheme.
A wide variety of investment vehicles and strategies, typically legitimate, have become the basis of Ponzi schemes. For instance, Allen Stanford used bank certificates of deposit to defraud tens of thousands of people. Certificates of deposit are usually low-risk and insured instruments, but the Stanford certificates of deposit were fraudulent.
Unraveling:
Theoretically, it is possible for certain Ponzi schemes to ultimately "succeed" financially, at least so long as a Ponzi scheme was not what the promoters were initially intending to operate. For example, a failing hedge fund reporting fraudulent returns could conceivably "make good" its reported numbers, for example by making a successful high-risk investment.
Moreover, if the operators of such a scheme are facing the likelihood of imminent collapse accompanied by criminal charges, they may see little additional "risk" to themselves in attempting to cover their tracks by engaging in further illegal acts to try and make good the shortfall (for example, by engaging in insider trading).
Especially with investment vehicles like hedge funds that are regulated and monitored less heavily than other investment vehicles such as mutual funds, in the absence of a whistleblower or accompanying illegal acts, any fraudulent content in reports is often difficult to detect unless and until the investment vehicles ultimately collapse.
Typically, however, if a Ponzi scheme is not stopped by authorities it usually falls apart for one or more of the following reasons:
In some cases, two or more of the aforementioned factors may be at play. For example, news of a police investigation into a Ponzi scheme may cause investors to immediately demand their money, and in turn cause the promoters to flee the jurisdiction sooner than planned (assuming they intended to eventually abscond in the first place), thus causing the scheme to collapse much faster than if the police investigation had simply been permitted to run its course.
Actual losses are extremely difficult to calculate. The amounts that investors thought they had were never attainable in the first place. The wide gap between "money in" and "fictitious gains" make it virtually impossible to know how much was lost in any Ponzi scheme.
Similar schemes:
Pyramid scheme:
A pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in a nonexistent financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:
Cryptocurrency Ponzi:
Cryptocurrencies have been employed by scammers attempting a new generation of Ponzi schemes. For example, misuse of initial coin offerings, or "ICOs", has been one such method, known as "smart Ponzis" per the Financial Times. Most schemes have a low recovery rate with investors losing their funds permanently.
The novelty of ICOs means that there is currently a lack of regulatory clarity on the classification of these financial devices, allowing scammers wide leeway to develop Ponzi schemes using these pseudo-assets.
Also, the pseudonymity of cryptocurrency transactions and their international nature involving countless jurisdictions in many different countries can make it much more difficult to identify and take legal action (whether civil or criminal) against perpetrators.
The May 2022 collapse of TerraUSD, a stablecoin propped up by a complex algorithmic mechanism offering 20% yields, was described as "Ponzinomics" by Wired. Another example of a well known ponzi scheme involving cryptoassets was the ICO of AriseBank or AriseCoin, involving claims about founding the world's first "decentralized bank".
The SEC successfully recovered the funds stolen in the ICO. A similar scheme was perpetrated by the founders of the fraudulent cryptocurrency Bitconnect. In September 2022, Jamie Dimon, CEO of JPMorgan, described cryptocurrencies as "Decentralised Ponzi Schemes".
Economic bubble:
Economic bubbles are also similar to a Ponzi scheme in that one participant gets paid by contributions from a subsequent participant until inevitable collapse. A bubble involves ever-rising prices in an open market (for example stock, housing, cryptocurrency, tulip bulbs, or the Mississippi Company) where prices rise because buyers bid more, and buyers bid more because prices are rising.
Bubbles are often said to be based on the "greater fool" theory. As with the Ponzi scheme, the price exceeds the intrinsic value of the item, but unlike the Ponzi scheme:
Exit scam:
A Ponzi scheme which ultimately terminates with the operator absconding is similar to an exit scam. The main difference is that an exit scam does not involve any sort of investment vehicle with the accompanying promised returns.
Instead, exit scammers either accept payment for product which they never ship (usually after gaining a reputation for reliably shipping product) or steal funds held in escrow on behalf of third parties (the latter often involves the operators of illegal darknet markets that facilitate the sale of illicit goods and services).
Related concepts:
Ponzi finance:
The term "ponzi finance" generally designates non-sustainable patterns of finance, such as borrowers who can only meet their debt commitment if they continuously obtain new sources of financing, often at an accelerating pace and/or ever-increasing interest rates until the borrower cannot secure more financing at any interest rate and becomes insolvent. The term was first coined by economist Hyman Minsky.
Ponzi game:
In economics, the term "ponzi game" designates a hypothesis where a government continuously defers the repayment of its public debt by issuing new debt: each time its existing debt arrives at maturity, it borrows funds from new and/or existing lenders in order to repay its existing debt.
See also:
Bernard Lawrence Madoff (April 29, 1938 – April 14, 2021) was an American financial criminal and financier who was the admitted mastermind of the largest known Ponzi scheme in history, worth an estimated $65 billion. He was at one time chairman of the Nasdaq stock exchange. Madoff's firm had two basic units: a stock brokerage and an asset management business; the Ponzi scheme was centered in the asset management business.
Madoff founded a penny stock brokerage in 1960, which eventually grew into Bernard L. Madoff Investment Securities. He served as the company's chairman until his arrest on December 11, 2008. That year, the firm was the 6th-largest market maker in S&P 500 stocks. While the stock brokerage part of the business had a public profile, Madoff tried to keep his asset management business low profile and exclusive.
At the firm, he employed his brother Peter Madoff as senior managing director and chief compliance officer, Peter's daughter Shana Madoff as the firm's rules and compliance officer and attorney, and his now-deceased sons Mark Madoff and Andrew Madoff. Peter was sentenced to 10 years in prison in 2012, and Mark hanged himself in 2010, exactly two years after his father's arrest. Andrew died of lymphoma on September 3, 2014.
On December 10, 2008, Madoff's sons Mark and Andrew told authorities that their father had confessed to them that the asset management unit of his firm was a massive Ponzi scheme, and quoted him as saying that it was "one big lie". The following day, agents from the Federal Bureau of Investigation arrested Madoff and charged him with one count of securities fraud.
The U.S. Securities and Exchange Commission (SEC) had previously conducted multiple investigations into his business practices but had not uncovered the massive fraud. On March 12, 2009, Madoff pleaded guilty to 11 federal felonies and admitted to turning his wealth management business into a massive Ponzi scheme.
The Madoff investment scandal defrauded thousands of investors of billions of dollars. Madoff said that he began the Ponzi scheme in the early 1990s, but an ex-trader admitted in court to faking records for Madoff since the early 1970s. Those charged with recovering the missing money believe that the investment operation may never have been legitimate.
The amount missing from client accounts was almost $65 billion, including fabricated gains. The Securities Investor Protection Corporation (SIPC) trustee estimated actual direct losses to investors of $18 billion, of which $14.418 billion has been recovered and returned, while the search for additional funds continues. On June 29, 2009, Madoff was sentenced to 150 years in prison, the maximum sentence allowed.
On April 14, 2021, he died at the Federal Medical Center, Butner, in North Carolina, from chronic kidney disease.
Click on any of the following blue hyperlinks for more about Bernie Madoff:
See also:
A Ponzi scheme can maintain the illusion of a sustainable business as long as investors continue to contribute new funds, and as long as most of the investors do not demand full repayment or lose faith in the non-existent assets they are purported to own.
Some of the first recorded incidents to meet the modern definition of the Ponzi scheme were carried out from 1869 to 1872 by Adele Spitzeder in Germany and by Sarah Howe in the United States in the 1880s through the "Ladies' Deposit". Howe offered a solely female clientele an 8% monthly interest rate and then stole the money that the women had invested.
She was eventually discovered and served three years in prison. The Ponzi scheme was also previously described in novels; Charles Dickens's 1844 novel Martin Chuzzlewit and his 1857 novel Little Dorrit both feature such a scheme.
In the 1920s, Charles Ponzi carried out this scheme and became well known throughout the United States because of the huge amount of money that he took in. His original scheme was based on the legitimate arbitrage of international reply coupons for postage stamps, but he soon began diverting new investors' money to make payments to earlier investors and to himself.
Unlike earlier similar schemes, Ponzi's gained considerable press coverage both within the United States and internationally while it was being perpetrated and after it collapsed – this notoriety eventually led to the type of scheme being named after him.
Characteristics;
In a Ponzi scheme, a con artist offers investments that promise very high returns with little or no risk to their victims. The returns are said to originate from a business or a secret idea run by the con artist.
In reality, the business does not exist or the idea does not work in the way it is described. The con artist pays the high returns promised to their earlier investors by using the money obtained from later investors. Instead of engaging in a legitimate business activity, the con artist attempts to attract new investors to make the payments that were promised to earlier investors.
The operator of the scheme also diverts clients' funds for the operator's personal use.
With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive.
When it becomes hard to recruit new investors, or when large numbers of existing investors cash out, these schemes collapse. As a result, most investors end up losing all or much of the money they invested. In some cases, the operator of the scheme may simply disappear with the money.
Red flags:
According to the U.S. Securities and Exchange Commission (SEC), many Ponzi schemes share characteristics that should be "red flags" for investors:
- High investment returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Any "guaranteed" investment opportunity should be considered suspect.
- Overly consistent returns. Investment values tend to go up and down over time, especially those offering potentially high returns. An investment that continues to generate regular positive returns regardless of overall market conditions is considered suspicious.
- Unregistered investments. Ponzi schemes typically involve investments that have not been registered with financial regulators (like the SEC or the FCA). Registration is important because it provides investors with access to key information about the company's management, products, services, and finances.
- Unlicensed sellers. In the United States, federal and state securities laws require that investment professionals and their firms be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.
- Secretive or complex strategies. Investments that cannot be understood or on which no complete information can be found or obtained are considered suspicious.
- Issues with paperwork. Account statement errors may be a sign that funds are not being invested as promised.
- Difficulty receiving payments. Investors should be suspicious of cases where they don't receive a payment or have difficulty cashing out. Ponzi scheme promoters sometimes try to prevent participants from cashing out by offering even higher returns for staying put.
According to criminologist Marie Springer, the following red flags can also be of relevance:
- The sales personnel or adviser are overly pushy or aggressive (may involve high-pressure sales).
- The initial contact took place by a cold call or through a social network, a language-based radio or a religious radio advertisement.
- The client cannot determine the actual trades or investments that have been carried out.
- The clients are asked to write checks with a different name than the name of the corporation (such as an individual) or to send checks to a different address than the corporate address.
- Once the maturity date of their investment arrives, clients are pressured to roll over the principal and the profits.
Methods:
Typically, Ponzi schemes require an initial investment and promise above-average returns. They use vague verbal guises such as "hedge futures trading", "high-yield investment programs", or "offshore investment" to describe their income strategy. It is common for the operator to take advantage of a lack of investor knowledge or competence, or sometimes claim to use a proprietary, secret investment strategy to avoid giving information about the scheme.
The basic premise of a Ponzi scheme is "to rob Peter to pay Paul". Initially, the operator pays high returns to attract investors and entice current investors to invest more money. When other investors begin to participate, a cascade effect begins. The schemer pays a "return" to initial investors from the investments of new participants, rather than from genuine profits.
Often, high returns encourage investors to leave their money in the scheme, so that the operator does not actually have to pay very much to investors. The operator simply sends statements showing how much they have earned, which maintains the deception that the scheme is an investment with high returns.
Investors within a Ponzi scheme may face difficulties when trying to get their money out of the investment.
Operators also try to minimize withdrawals by offering new plans to investors where money cannot be withdrawn for a certain period of time in exchange for higher returns. The operator sees new cash flows as investors cannot transfer money.
If a few investors do wish to withdraw their money in accordance with the terms allowed, their requests are usually promptly processed, which gives the illusion to all other investors that the fund is solvent and financially sound.
Ponzi schemes sometimes begin as legitimate investment vehicles, such as hedge funds that can easily degenerate into a Ponzi-type scheme if they unexpectedly lose money or fail to legitimately earn the returns expected. The operators fabricate false returns or produce fraudulent audit reports instead of admitting their failure to meet expectations, from which point on the operation can be considered a Ponzi scheme.
A wide variety of investment vehicles and strategies, typically legitimate, have become the basis of Ponzi schemes. For instance, Allen Stanford used bank certificates of deposit to defraud tens of thousands of people. Certificates of deposit are usually low-risk and insured instruments, but the Stanford certificates of deposit were fraudulent.
Unraveling:
Theoretically, it is possible for certain Ponzi schemes to ultimately "succeed" financially, at least so long as a Ponzi scheme was not what the promoters were initially intending to operate. For example, a failing hedge fund reporting fraudulent returns could conceivably "make good" its reported numbers, for example by making a successful high-risk investment.
Moreover, if the operators of such a scheme are facing the likelihood of imminent collapse accompanied by criminal charges, they may see little additional "risk" to themselves in attempting to cover their tracks by engaging in further illegal acts to try and make good the shortfall (for example, by engaging in insider trading).
Especially with investment vehicles like hedge funds that are regulated and monitored less heavily than other investment vehicles such as mutual funds, in the absence of a whistleblower or accompanying illegal acts, any fraudulent content in reports is often difficult to detect unless and until the investment vehicles ultimately collapse.
Typically, however, if a Ponzi scheme is not stopped by authorities it usually falls apart for one or more of the following reasons:
- The operator vanishes, taking all the remaining investment money. Promoters who intend to abscond often attempt to do so as returns due to be paid are about to exceed new investments, as this is when the investment capital available will be at its maximum.
- Since the scheme requires a continual stream of investments to fund higher returns, if the number of new investors slows down, the scheme collapses as the operator can no longer pay the promised returns (the higher the returns, the greater the risk of the Ponzi scheme collapsing). Such liquidity crises often trigger panics, as more people start asking for their money, similar to a bank run.
- External market forces, such as a sharp decline in the economy, can often hasten the collapse of a Ponzi scheme (for example, the Madoff investment scandal during the market downturn of 2008 (See below), since they often cause many investors to attempt to withdraw part or all of their funds sooner than they had intended.
In some cases, two or more of the aforementioned factors may be at play. For example, news of a police investigation into a Ponzi scheme may cause investors to immediately demand their money, and in turn cause the promoters to flee the jurisdiction sooner than planned (assuming they intended to eventually abscond in the first place), thus causing the scheme to collapse much faster than if the police investigation had simply been permitted to run its course.
Actual losses are extremely difficult to calculate. The amounts that investors thought they had were never attainable in the first place. The wide gap between "money in" and "fictitious gains" make it virtually impossible to know how much was lost in any Ponzi scheme.
Similar schemes:
Pyramid scheme:
A pyramid scheme is a form of fraud similar in some ways to a Ponzi scheme, relying as it does on a mistaken belief in a nonexistent financial reality, including the hope of an extremely high rate of return. However, several characteristics distinguish these schemes from Ponzi schemes:
- In a Ponzi scheme, the schemer acts as a "hub" for the victims, interacting with all of them directly. In a pyramid scheme, those who recruit additional participants benefit directly. Failure to recruit typically means no investment return.
- A Ponzi scheme claims to rely on some esoteric investment approach, and often attracts well-to-do investors, whereas pyramid schemes explicitly claim that new money will be the source of payout for the initial investments.
- A pyramid scheme typically collapses much faster because it requires exponential increases in participants to sustain it. By contrast, Ponzi schemes can survive (at least in the short-term) simply by persuading most existing participants to reinvest their money, with a relatively small number of new participants.
Cryptocurrency Ponzi:
Cryptocurrencies have been employed by scammers attempting a new generation of Ponzi schemes. For example, misuse of initial coin offerings, or "ICOs", has been one such method, known as "smart Ponzis" per the Financial Times. Most schemes have a low recovery rate with investors losing their funds permanently.
The novelty of ICOs means that there is currently a lack of regulatory clarity on the classification of these financial devices, allowing scammers wide leeway to develop Ponzi schemes using these pseudo-assets.
Also, the pseudonymity of cryptocurrency transactions and their international nature involving countless jurisdictions in many different countries can make it much more difficult to identify and take legal action (whether civil or criminal) against perpetrators.
The May 2022 collapse of TerraUSD, a stablecoin propped up by a complex algorithmic mechanism offering 20% yields, was described as "Ponzinomics" by Wired. Another example of a well known ponzi scheme involving cryptoassets was the ICO of AriseBank or AriseCoin, involving claims about founding the world's first "decentralized bank".
The SEC successfully recovered the funds stolen in the ICO. A similar scheme was perpetrated by the founders of the fraudulent cryptocurrency Bitconnect. In September 2022, Jamie Dimon, CEO of JPMorgan, described cryptocurrencies as "Decentralised Ponzi Schemes".
Economic bubble:
Economic bubbles are also similar to a Ponzi scheme in that one participant gets paid by contributions from a subsequent participant until inevitable collapse. A bubble involves ever-rising prices in an open market (for example stock, housing, cryptocurrency, tulip bulbs, or the Mississippi Company) where prices rise because buyers bid more, and buyers bid more because prices are rising.
Bubbles are often said to be based on the "greater fool" theory. As with the Ponzi scheme, the price exceeds the intrinsic value of the item, but unlike the Ponzi scheme:
- In most economic bubbles, there is no single person or group misrepresenting the intrinsic value. A common exception is a pump and dump scheme (typically involving buyers and holders of thinly-traded stocks), which has much more in common with a Ponzi scheme compared to other types of bubbles.
- Ponzi schemes typically result in criminal charges when authorities discover them, but other than pump and dump schemes, economic bubbles do not typically involve unlawful activity, or even bad faith on the part of any participant. Laws are only broken if someone perpetuates the bubble by knowingly and deliberately misrepresenting facts to inflate the value of an item (as with a pump and dump scheme). Even when this occurs, wrongdoing (and especially criminal activity) is often much more difficult to prove in court compared to a Ponzi scheme. Therefore, the collapse of an economic bubble rarely results in criminal charges (which require proof beyond a reasonable doubt to secure a conviction) and, even when charges are pursued, they are often against corporations, which can be easier to pursue in court compared to charges against people but also can only result in fines as opposed to jail time. The more commonly-pursued legal recourse in situations where someone suspects an economic bubble is the result of nefarious activity is to sue for damages in civil court, where the standard of proof is only balance of probabilities and where the plaintiff need not demonstrate mens rea.
- In some jurisdictions, following the collapse of a Ponzi scheme, even the "innocent" beneficiaries are liable to repay any gains for distribution to the victims. In this context, "innocent" beneficiaries can include anyone who unwittingly profited without being aware of the fraudulent nature of the scheme, and even charities to which perpetrators often give to relatively generously while a scheme is in operation in an effort to enhance their own profile and thereby "profit" from the resulting positive media coverage. This typically does not happen in the case of an economic bubble, especially if nobody can prove the bubble was caused by anyone acting in bad faith, moreover a person whose own participation in an economic bubble is not particularly notable is not likely to enhance participation in the bubble and thus personally profit by donating to charity.
- Items traded in an economic bubble are much more likely to have an intrinsic value that is worth a substantial proportion of the market price. Therefore, following collapse of an economic bubble (especially one in a commodity such as real estate) the items affected will often retain some value, whereas an investment that is part of a Ponzi scheme will typically be worthless (or very close to worthless). On the other hand, it is much easier to obtain financing for many items that are the frequent subject of bubbles. If an investor trading on margin or borrowing to finance investments becomes the victim of a bubble, he or she can still lose all (or a very substantial portion) of his or her investment capital, or even be liable for losses in excess of the original capital investment.
Exit scam:
A Ponzi scheme which ultimately terminates with the operator absconding is similar to an exit scam. The main difference is that an exit scam does not involve any sort of investment vehicle with the accompanying promised returns.
Instead, exit scammers either accept payment for product which they never ship (usually after gaining a reputation for reliably shipping product) or steal funds held in escrow on behalf of third parties (the latter often involves the operators of illegal darknet markets that facilitate the sale of illicit goods and services).
Related concepts:
Ponzi finance:
The term "ponzi finance" generally designates non-sustainable patterns of finance, such as borrowers who can only meet their debt commitment if they continuously obtain new sources of financing, often at an accelerating pace and/or ever-increasing interest rates until the borrower cannot secure more financing at any interest rate and becomes insolvent. The term was first coined by economist Hyman Minsky.
Ponzi game:
In economics, the term "ponzi game" designates a hypothesis where a government continuously defers the repayment of its public debt by issuing new debt: each time its existing debt arrives at maturity, it borrows funds from new and/or existing lenders in order to repay its existing debt.
See also:
- List of Ponzi schemes
- Black Friday (1869), also referred to as the Gold Panic of 1869
- Bucket shop (stock market)
- Chain letter
- Football Index
- Gary Sorenson
- Get-rich-quick scheme
- Matrix scheme
- Minsky moment
- Money multiplier
- Non-fungible token
- Saradha Group financial scandal
- Steven Hoffenberg
- Towers Financial Corporation
- White-collar crime
- United States Postal Inspection Service
- Media related to Pyramid and Ponzi schemes at Wikimedia Commons
- Ponzi Schemes FAQ Information and advice from the US Securities and Exchange Commission
- Fraud Awareness and Prevention Information about spotting fraud from the US Commodities Futures Trading Commission
- Ponzimonium Free e-book about Ponzi schemes from the US Commodity Futures Trading Commission
Bernard Lawrence Madoff (April 29, 1938 – April 14, 2021) was an American financial criminal and financier who was the admitted mastermind of the largest known Ponzi scheme in history, worth an estimated $65 billion. He was at one time chairman of the Nasdaq stock exchange. Madoff's firm had two basic units: a stock brokerage and an asset management business; the Ponzi scheme was centered in the asset management business.
Madoff founded a penny stock brokerage in 1960, which eventually grew into Bernard L. Madoff Investment Securities. He served as the company's chairman until his arrest on December 11, 2008. That year, the firm was the 6th-largest market maker in S&P 500 stocks. While the stock brokerage part of the business had a public profile, Madoff tried to keep his asset management business low profile and exclusive.
At the firm, he employed his brother Peter Madoff as senior managing director and chief compliance officer, Peter's daughter Shana Madoff as the firm's rules and compliance officer and attorney, and his now-deceased sons Mark Madoff and Andrew Madoff. Peter was sentenced to 10 years in prison in 2012, and Mark hanged himself in 2010, exactly two years after his father's arrest. Andrew died of lymphoma on September 3, 2014.
On December 10, 2008, Madoff's sons Mark and Andrew told authorities that their father had confessed to them that the asset management unit of his firm was a massive Ponzi scheme, and quoted him as saying that it was "one big lie". The following day, agents from the Federal Bureau of Investigation arrested Madoff and charged him with one count of securities fraud.
The U.S. Securities and Exchange Commission (SEC) had previously conducted multiple investigations into his business practices but had not uncovered the massive fraud. On March 12, 2009, Madoff pleaded guilty to 11 federal felonies and admitted to turning his wealth management business into a massive Ponzi scheme.
The Madoff investment scandal defrauded thousands of investors of billions of dollars. Madoff said that he began the Ponzi scheme in the early 1990s, but an ex-trader admitted in court to faking records for Madoff since the early 1970s. Those charged with recovering the missing money believe that the investment operation may never have been legitimate.
The amount missing from client accounts was almost $65 billion, including fabricated gains. The Securities Investor Protection Corporation (SIPC) trustee estimated actual direct losses to investors of $18 billion, of which $14.418 billion has been recovered and returned, while the search for additional funds continues. On June 29, 2009, Madoff was sentenced to 150 years in prison, the maximum sentence allowed.
On April 14, 2021, he died at the Federal Medical Center, Butner, in North Carolina, from chronic kidney disease.
Click on any of the following blue hyperlinks for more about Bernie Madoff:
- Early life
- Career
- Government access
- Investment scandal
- Plea, sentencing, and prison life
- Death
- Personal life
- Philanthropy and other activities
- In the media
- Allen Stanford
- Financial crisis of 2007–2008
- A Kaddish for Bernie Madoff: The Film
- List of investors in Bernard L. Madoff Investment Securities
- Madoff investment scandal
- Participants in the Madoff investment scandal
- Recovery of funds from the Madoff investment scandal
- White-collar crime
- Criminal complaint, transcripts of hearings and other documents from the United States Department of Justice at the Wayback Machine (archived August 22, 2007)
- Madoff.com The Owner's Name was on the Door at the Wayback Machine (archived December 14, 2008)
- The Independent: Madoff reveals his suffering
- The Face That Launched A Thousand Lawsuits – Madoff's Legacy
See also:
- Allen Stanford
- Financial crisis of 2007–2008
- A Kaddish for Bernie Madoff: The Film
- List of investors in Bernard L. Madoff Investment Securities
- Madoff investment scandal
- Participants in the Madoff investment scandal
- Recovery of funds from the Madoff investment scandal
- White-collar crime
- Criminal complaint, transcripts of hearings and other documents from the United States Department of Justice at the Wayback Machine (archived August 22, 2007)
- Madoff.com The Owner's Name was on the Door at the Wayback Machine (archived December 14, 2008)
- The Independent: Madoff reveals his suffering
- The Face That Launched A Thousand Lawsuits – Madoff's Legacy
Bankruptcy in the United States
Bankruptcies filed by type per year:United States Courts - https://www.uscourts.gov/statistics-reports/analysis-reports/bankruptcy-filings-statistics/bankruptcy-statistics-data
- YouTube Video: The Pros and Cons of Declaring Bankruptcy
- YouTube Video: Personal Bankruptcy (and Its Alternatives) Explained
- YouTube Video: "The Secrets About Bankruptcy they Don't Want You to Know"
Bankruptcies filed by type per year:United States Courts - https://www.uscourts.gov/statistics-reports/analysis-reports/bankruptcy-filings-statistics/bankruptcy-statistics-data
Bankruptcy in the United States
In the United States, bankruptcy is largely governed by federal law, commonly referred to as the "Bankruptcy Code" ("Code"). The United States Constitution (Article 1, Section 8, Clause 4) authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States".
Congress has exercised this authority several times since 1801, including through adoption of the Bankruptcy Reform Act of 1978, as amended, codified in Title 11 of the United States Code and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA).
Some laws relevant to bankruptcy are found in other parts of the United States Code. For example:
Bankruptcy cases are filed in United States bankruptcy court (units of the United States District Courts), and federal law governs procedure in bankruptcy cases. However, state laws are often applied to determine how bankruptcy affects the property rights of debtors.
For example, laws governing the validity of liens or rules protecting certain property from creditors (known as exemptions), may derive from state law or federal law. Because state law plays a major role in many bankruptcy cases, it is often unwise to generalize some bankruptcy issues across state lines.
History:
Main article: History of bankruptcy law in the United States
Originally, bankruptcy in the United States, as nearly all matters directly concerning individual citizens, was a subject of state law.
However, there were several short-lived federal bankruptcy laws before the Act of 1898:
The first more lasting federal bankruptcy law, sometimes called the "Nelson Act", initially entered into force in 1898. The current Bankruptcy Code was enacted in 1978 by § 101 of the Bankruptcy Reform Act of 1978, and generally became effective on October 1, 1979; it completely replaced the former bankruptcy law, the "Chandler Act" of 1938, which had given unprecedented power to the Securities and Exchange Commission for the regulation of bankruptcy filings.
The current code has been amended numerous times since 1978. See also the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
Chapters of the Bankruptcy Code:
Entities seeking relief under the Bankruptcy Code may file a petition for relief under a number of different chapters of the Code, depending on circumstances. Title 11 contains nine chapters, six of which provide for the filing of a petition.
The other three chapters provide rules governing bankruptcy cases in general. A case is typically referred to by the chapter under which the petition is filed. These chapters are described below.
Chapter 7: Liquidation:
Main article: Chapter 7, Title 11, United States Code
Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors.
Because all states allow for debtors to keep essential property, Chapter 7 cases are often "no asset" cases, meaning that the bankrupt estate has no non-exempt assets to fund a distribution to creditors.
Chapter 7 bankruptcy remains on a bankruptcy filer's credit report for 10 years.
United States bankruptcy law significantly changed in 2005 with the passage of Bankruptcy Abuse Prevention and Consumer Protection Act (US) —- BAPCPA, which made it more difficult for consumer debtors to file bankruptcy in general and Chapter 7 in particular.
Advocates of BAPCPA claimed that its passage would reduce losses to creditors such as credit card companies, and that those creditors would then pass on the savings to other borrowers in the form of lower interest rates. Critics assert that these claims turned out to be false, observing that although credit card company losses decreased after passage of the Act, prices charged to customers increased, and credit card company profits increased.
Chapter 9: Reorganization for municipalities:
Main article: Chapter 9, Title 11, United States Code
A Chapter 9 bankruptcy is available only to municipalities. Chapter 9 is a form of reorganization, not liquidation. Notable examples of municipal bankruptcies include that of Orange County, California (1994 to 1996) and the bankruptcy of the city of Detroit, Michigan in 2013.
Chapters 11, 12, and 13: Reorganization:
Main articles below:
Bankruptcy under Chapter 11, Chapter 12, or Chapter 13 is a more complex reorganization and involves allowing the debtor to keep some or all of his or her property and to use future earnings to pay off creditors.
Consumers usually file chapter 7 or chapter 13. Chapter 11 filings by individuals are allowed, but are rare.
Chapter 12 is similar to Chapter 13 but is available only to "family farmers" and "family fisherman" in certain situations. Chapter 12 generally has more generous terms for debtors than a comparable Chapter 13 case would have available.
As recently as mid-2004 Chapter 12 was scheduled to expire, but in late 2004 it was renewed and made permanent.
Chapter 15: Cross-border insolvency:
Main article: Chapter 15, Title 11, United States Code
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 added Chapter 15 (as a replacement for section 304) and deals with cross-border insolvency: foreign companies with US debts.
Features of U.S. bankruptcy law:
Voluntary versus involuntary bankruptcy
As a threshold matter, bankruptcy cases are either voluntary or involuntary. In voluntary bankruptcy cases, which account for the overwhelming majority of cases, debtors petition the bankruptcy court.
With involuntary bankruptcy, creditors, rather than the debtor, file the petition in bankruptcy. Involuntary petitions are rare, however, and are occasionally used in business settings to force a company into bankruptcy so that creditors can enforce their rights.
The estate:
Except in Chapter 9 cases, commencement of a bankruptcy case creates an "estate". Generally, the debtor's creditors must look to the assets of the estate for satisfaction of their claims. The estate consists of all property interests of the debtor at the time of case commencement, subject to certain exclusions and exemptions.
In the case of a married person in a community property state, the estate may include certain community property interests of the debtor's spouse even if the spouse has not filed bankruptcy.
The estate may also include other items, including but not limited to property acquired by will or inheritance within 180 days after case commencement.
For federal income tax purposes, the bankruptcy estate of an individual in a Chapter 7 or 11 case is a separate taxable entity from the debtor. The bankruptcy estate of a corporation, partnership, or other collective entity, or the estate of an individual in Chapters 12 or 13, is not a separate taxable entity from the debtor.
Bankruptcy court:
Main article: United States bankruptcy court
In 1982, in the case of Northern Pipeline Co. v. Marathon Pipe Line Co., the United States Supreme Court held that certain provisions of the law relating to Article I bankruptcy judges (who are not life-tenured "Article III" judges) are unconstitutional. Congress responded in 1984 with changes to remedy the constitutional defects.
Under the revised law, bankruptcy judges in each judicial district constitute a "unit" of the applicable United States District Court. Each judge is appointed for a term of 14 years by the United States Court of Appeals for the circuit in which the applicable district is located.
The United States District Courts have subject-matter jurisdiction over bankruptcy matters. However, each such district court may, by order, "refer" bankruptcy matters to the Bankruptcy Court, and most district courts have a standing "reference" order to that effect, so that all bankruptcy cases are handled by the Bankruptcy Court.
In unusual circumstances, a district court may "withdraw the reference" (i.e., taking a particular case or proceeding within the case away from the bankruptcy court) and decide the matter itself.
Decisions of the bankruptcy court are generally appealable to the district court, and then to the Court of Appeals. However, in a few jurisdictions a separate court called a Bankruptcy Appellate Panel (composed of bankruptcy judges) hears certain appeals from bankruptcy courts.
United States Trustee:
Main article: United States Trustee
The United States Attorney General appoints a separate United States Trustee for each of twenty-one geographical regions for a five-year term. Each Trustee is removable from office by and works under the general supervision of the Attorney General.
The U.S. Trustees maintain regional offices that correspond with federal judicial districts and are administratively overseen by the Executive Office for United States Trustees in Washington, D.C. Each United States Trustee, an officer of the U.S. Department of Justice, is responsible for maintaining and supervising a panel of private trustees for chapter 7 bankruptcy cases.
The Trustee has other duties including the administration of most bankruptcy cases and trustees. Under Section 307 of Title 11 of the U.S. Code, a U.S. Trustee "may raise and may appear and be heard on any issue in any case or proceeding" in bankruptcy except for filing a plan of reorganization in a chapter 11 case.
The automatic stay:
Main article: Automatic stay
Bankruptcy Code § 362 imposes the automatic stay at the moment a bankruptcy petition is filed. The automatic stay generally prohibits the commencement, enforcement or appeal of actions and judgments, judicial or administrative, against a debtor for the collection of a claim that arose prior to the filing of the bankruptcy petition.
The automatic stay also prohibits collection actions and proceedings directed toward property of the bankruptcy estate itself.
In some courts, violations of the stay are treated as void ab initio as a matter of law, although the court may annul the stay to give effect to otherwise void acts. Other courts treat violations as voidable (not necessarily void ab initio).
Any violation of the stay may give rise to damages being assessed against the violating party. Non-willful violations of the stay are often excused without penalty, but willful violators are liable for punitive damages and may also be found to be in contempt of court.
A secured creditor may be allowed to take the applicable collateral if the creditor first obtains permission from the court. Permission is requested by a creditor by filing a motion for relief from the automatic stay. The court must either grant the motion or provide adequate protection to the secured creditor that the value of their collateral will not decrease during the stay.
Without the bankruptcy protection of the automatic stay, creditors might race to the courthouse to improve their positions against a debtor. If the debtor's business were facing a temporary crunch, but were nevertheless viable in the long term, it might not survive a "run" by creditors.
A run could also result in waste and unfairness among similarly situated creditors.
Bankruptcy Code 362(d) gives four ways that a creditor can get the automatic stay removed.
Avoidance actions:
Debtors, or the trustees that represent them, gain the ability to reject, or avoid actions taken with respect to the debtor's property for a specified time prior to the filing of the bankruptcy.
While the details of avoidance actions are nuanced, there are three general categories of avoidance actions:
All avoidance actions attempt to limit the risk of the legal system accelerating the financial demise of a financially unstable debtor who has not yet declared bankruptcy. The bankruptcy system generally endeavors to reward creditors who continue to extend financing to debtors and discourage creditors from accelerating their debt collection efforts. Avoidance actions are some of the most obvious of the mechanisms to encourage this goal.
Despite the apparent simplicity of these rules, a number of exceptions exist in the context of each category of avoidance action.
Preferences:
Preference actions generally permit the trustee to avoid (that is, to void an otherwise legally binding transaction) certain transfers of the debtor's property that benefit creditors where the transfers occur on or within 90 days of the date of filing of the bankruptcy petition.
For example, if a debtor has a debt to a friendly creditor and a debt to an unfriendly creditor, and pays the friendly creditor, and then declares bankruptcy one week later, the trustee may be able to recover the money paid to the friendly creditor under 11 U.S.C. § 547.
While this "reach back" period typically extends 90 days backwards from the date of the bankruptcy, the amount of time is longer in the case of "insiders"—typically one year. Insiders include family and close business contacts of the debtor.
Fraudulent transfer:
Bankruptcy fraudulent transfer law is similar in practice to non-bankruptcy fraudulent transfer law. Some terms, however, are more generous in bankruptcy than they are otherwise.
For instance, the statute of limitations within bankruptcy is two years as opposed to a shorter time frame in some non-bankruptcy contexts. Generally a fraudulent transfer action operates in much the same way as a preference avoidance. Fraudulent transfer actions, however, sometimes require a showing of intent to shelter the property from a creditor.
Fraudulent transfer may involve an actual or a "constructive" fraud. Actual fraud is based upon the on intent of the transfer, whereas constructive fraud may be inferred based upon economic factors.
Factors that may lead to an inference of fraud include whether the transfer was for reasonably equivalent value and whether the debtor was insolvent at the time of the transfer.
The conversion of nonexempt assets into exempt assets on the eve of bankruptcy is not an indicia of fraud per se. However, depending on the amount of the exemption and the circumstances surrounding the conversion, a court may find the conversion to be a fraudulent transfer. This is especially true when the conversion amounts to nothing more than a temporary arrangement.
When finding the conversion of nonexempt into exempt assets to be a fraudulent transfer, courts tend to focus on the existence of an independent reason for the conversion. For example, if a debtor purchased a residence protected by a homestead exemption with the intent to reside in such residence that would be an allowable conversion into nonexempt property.
But where the debtor purchased the residence with all of their available funds, leaving no money to live off, that presumed that the conversion was temporary, indicating a fraudulent transfer. Courts look at the timing of the transfer as the most important factor.
Non-bankruptcy law creditor – "strong arm"
The strong arm avoidance power stems from 11 U.S.C. § 544 and permits the trustee to exercise the rights that a debtor in the same situation would have under the relevant state law.
Specifically, § 544(a) grants the trustee the rights of avoidance of:
(1) a judicial lien creditor,
(2) an unsatisfied lien creditor,
and (3) a bona fide purchaser of real property.
In practice these avoidance powers often overlap with preference and fraudulent transfer avoidance powers.
The creditors:
Secured creditors whose security interests survive the commencement of the case may look to the property that is the subject of their security interests, after obtaining permission from the court (in the form of relief from the automatic stay). Security interests, created by what are called secured transactions, are liens on the property of a debtor.
Unsecured creditors are generally divided into two classes: unsecured priority creditors and general unsecured creditors. Unsecured priority creditors are further subdivided into classes as described in the law. In some cases the assets of the estate are insufficient to pay all priority unsecured creditors in full; in such cases the general unsecured creditors receive nothing.
Because of the priority and rank ordering feature of bankruptcy law, debtors sometimes collude with others (who may be related to the debtor) to prefer them, by for example granting them a security interest in otherwise unpledged assets.
For this reason, the bankruptcy trustee is permitted to reverse certain transactions of the debtor within a period of time prior to the date of the bankruptcy filing. The time period varies depending on the relationship of the parties to the debtor and the nature of the transaction.
In Chapters 7, 12, and 13, creditors must file a "proof of claim" to be paid. In a Chapter 11 case, a creditor is not required to file a proof of claim (that is, a proof of claim is "deemed filed") if the creditor's claim is listed on the debtor's bankruptcy schedules, unless the claim is scheduled as "disputed, contingent, or unliquidated".
If the creditor's claim is not listed on the schedules in a Chapter 11 case, the creditor must file a proof of claim.
Absolute priority:
A distinctive feature of U.S. bankruptcy law is the absolute priority rule, codified at 11 U.S.C. § 1129(b)(2)(B)(ii). The rule provides that "[w]ith respect to a class of unsecured claims . . . the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property."
This requirement means that if any class of creditors votes against a plan of reorganization, the bankruptcy court may not confirm the plan if any class of claims or interests junior to the dissenting class (e.g., subordinated creditors or shareholders) receives any distribution of the debtor's estate pursuant to the plan.
In practice, the rule requires that debtors satisfy the claims of senior creditors in full before distributing any estate property to junior creditors or shareholders under the plan, although senior creditors will often consent to a de minimis recovery for junior stakeholders in exchange for their support for the plan.
The Supreme Court has recognized an exception to the absolute priority rule known as the "new value" exception that allows junior stakeholders to recover property under a plan over the objection of senior creditors if the junior stakeholders provide "new value" to the restructured enterprise (typically defined as an upfront monetary contribution to the reorganized debtor that is commensurate with the property received or retained under the plan).
The basis for the new value exception is that the holder of a junior claim or interest under such circumstances does not "receive or retain under the plan on account of such junior claim or interest any property" but rather receives or retains property under the plan on account of the new value contribution. 11 U.S.C. § 1129(b)(2)(B)(ii) (emphasis added).
Executory contracts:
The bankruptcy trustee may reject certain executory contracts and unexpired leases. For bankruptcy purposes, a contract is generally considered executory when both parties to the contract have not yet fully performed a material obligation of the contract.
If the Trustee (or debtor in possession, in many chapter 11 cases) rejects a contract, the debtor's bankruptcy estate is subject to ordinary breach of contract damages, but the damages amount is an obligation and is generally treated as an unsecured claim.
Committees:
Under some chapters, notably chapters 7, 9 and 11, committees of various stakeholders are appointed by the bankruptcy court. In Chapter 11 and 9, these committees consist of entities that hold the seven largest claims of the kinds represented by the committee.
Other committees may also be appointed by the court.
Committees have regular communications with the debtor and the debtor's advisers and have access to a wide variety of documents as part of their functions and responsibilities.
Exempt property:
Although in theory all property of the debtor that is not excluded from the estate under the Bankruptcy Code becomes property of the estate (i.e., is automatically transferred from the debtor to the estate) at the time of commencement of a case, an individual debtor (not a partnership, corporation, etc.) may claim certain items of property as "exempt" and thereby keep those items (subject, however, to any valid liens or other encumbrances).
An individual debtor may choose between a federal list of exemptions and a list of exemptions provided by the law of the state in which the debtor files the bankruptcy case unless the state in which the debtor files the bankruptcy case has enacted legislation prohibiting the debtor from choosing the exemptions on the federal list, which almost 40 states have done.
In states where the debtor is allowed to choose between the federal and state exemptions, the debtor has the opportunity to choose the exemptions that most fully benefit him or her and, in many cases, may convert at least some of his or her property from non-exempt form (e.g., cash) to exempt form (e.g., increased equity in a home created by using the cash to pay down a mortgage) prior to filing the bankruptcy case.
The exemption laws vary greatly from state to state. In some states, exempt property includes equity in a home or car, tools of the trade, and some personal effects. In other states an asset class such as tools of trade will not be exempt by virtue of its class except to the extent it is claimed under a more general exemption for personal property.
One major purpose of bankruptcy is to ensure orderly and reasonable management of debt. Thus, exemptions for personal effects are thought to prevent punitive seizures of items of little or no economic value (personal effects, personal care items, ordinary clothing), since this does not promote any desirable economic result.
Similarly, tools of the trade may, depending on the available exemptions, be a permitted exemption as their continued possession allows the insolvent debtor to move forward into productive work as soon as possible.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 placed pension plans not subject to the Employee Retirement Income Security Act of 1974 (ERISA), like 457 and 403(b) plans, in the same status as ERISA qualified plans with respect to having exemption status akin to spendthrift trusts.
SEP-IRAs and SIMPLEs still are outside federal protection and must rely on state law.
Spendthrift trusts:
Most states have property laws that allow a trust agreement to contain a legally enforceable restriction on the transfer of a beneficial interest in the trust (sometimes known as an "anti-alienation provision").
The anti-alienation provision generally prevents creditors of a beneficiary from acquiring the beneficiary's share of the trust. Such a trust is sometimes called a spendthrift trust. To prevent fraud, most states allow this protection only to the extent that the beneficiary did not transfer property to the trust.
Also, such provisions do not protect cash or other property once it has been transferred from the trust to the beneficiary. Under the US Bankruptcy Code, an anti-alienation provision in a spendthrift trust is recognized. This means that the beneficiary's share of the trust generally does not become property of the bankruptcy estate.
Redemption:
In a Chapter 7 liquidation case, an individual debtor may redeem certain "tangible personal property intended primarily for personal, family, or household use" that is encumbered by a lien.
To qualify, the property generally either (A) must be exempt under section 522 of the Bankruptcy Code, or (B) must have been abandoned by the trustee under section 554 of the Bankruptcy Code. To redeem the property, the debtor must pay the lienholder the full amount of the applicable allowed secured claim against the property.
Debtor's discharge:
Main article: Bankruptcy discharge
Key concepts in bankruptcy include the debtor's discharge and the related "fresh start". Discharge is available in some but not all cases. For example, in a Chapter 7 case only an individual debtor (not a corporation, partnership, etc.) can receive a discharge.
The effect of a bankruptcy discharge is to eliminate only the debtor's personal liability, not the in rem liability for a secured debt to the extent of the value of collateral. The term "in rem" essentially means "with respect to the thing itself" (i.e., the collateral).
For example, if a debt in the amount of $100,000 is secured by property having a value of only $80,000, the $20,000 deficiency is treated, in bankruptcy, as an unsecured claim (even though it is part of a "secured" debt). The $80,000 portion of the debt is treated as a secured claim.
Assuming a discharge is granted and none of the $20,000 deficiency is paid (e.g., due to insufficiency of funds), the $20,000 deficiency—the debtor's personal liability—is discharged (assuming the debt is not non-dischargeable under another Bankruptcy Code provision).
The $80,000 portion of the debt is the in rem liability, and it is not discharged by the court's discharge order. This liability can presumably be satisfied by the creditor taking the asset itself.
An essential concept is that when commentators say that a debt is "dischargeable", they are referring only to the debtor's personal liability on the debt. To the extent that a liability is covered by the value of collateral, the debt is not discharged.
This analysis assumes, however, that the collateral does not increase in value after commencement of the case. If the collateral increases in value and the debtor (rather than the estate) keeps the collateral (e.g., where the asset is exempt or is abandoned by the trustee back to the debtor), the amount of the creditor's security interest may or may not increase.
In situations where the debtor (rather than the creditor) is allowed to benefit from the increase in collateral value, the effect is called "lien stripping" or "paring down". Lien stripping is allowed only in certain cases depending on the kind of collateral and the particular chapter of the Code under which the discharge is granted.
The discharge also does not eliminate certain rights of a creditor to setoff (or "offset") certain mutual debts owed by the creditor to the debtor against certain claims of that creditor against the debtor, where both the debt owed by the creditor and the claim against the debtor arose prior to the commencement of the case.
Not every debt may be discharged under every chapter of the Code. Certain taxes owed to federal, state or local government, student loans, and child support obligations are not dischargeable. (Guaranteed student loans are potentially dischargeable, however, if the debtor prevails in a difficult-to-win adversary proceeding against the lender commenced by a complaint to determine dischargeability.
Also, the debtor can petition the court for a financial hardship discharge, but the grant of such discharges is rare.)
The debtor's liability on a secured debt, such as a mortgage or mechanic's lien on a home, may be discharged. The effects of the mortgage or mechanic's lien, however, cannot be discharged in most cases if the lien affixed prior to filing.
Therefore, if the debtor wishes to retain the property, the debt must usually be paid as agreed. (See also lien avoidance, reaffirmation agreement) (Note: there may be additional flexibility available in Chapter 13 for debtors dealing with oversecured collateral such as a financed auto, so long as the oversecured property is not the debtor's primary residence.)
Any debt tainted by one of a variety of wrongful acts recognized by the Bankruptcy Code, including defalcation, or consumer purchases or cash advances above a certain amount incurred a short time before filing, cannot be discharged. However, certain kinds of debt, such as debts incurred by way of fraud, may be dischargeable through the Chapter 13 "super discharge".
All in all, as of 2005, there are 19 general categories of debt that cannot be discharged in a Chapter 7 bankruptcy, and fewer debts that cannot be discharged under Chapter 13.
Valuation and recapitalization:
In a corporate or business bankruptcy, an indebted company that files bankruptcy is typically recapitalized so that it emerges from bankruptcy with more equity and less debt. During this process, many debts may be "discharged", meaning that the company will no longer be legally obligated to pay them.
Which debts are discharged, and how equity and other entitlements are distributed to various groups of investors, typically turns on valuation issues. Bankruptcy valuation is often highly contentious because it is both subjective and important to case outcomes.
The methods of valuation used in bankruptcy have changed over time, generally tracking methods used in investment banking, Delaware corporate law, and corporate and academic finance, but with a significant time lag.
Entities that cannot be debtors:
The section of the Bankruptcy code that governs which entities are permitted to file a bankruptcy petition is 11 U.S.C. § 109.
Banks and other deposit institutions, insurance companies, railroads, and certain other financial institutions and entities regulated by the federal and state governments, and Private and Personal Trusts, except Statutory Business Trusts, as permitted by some States, cannot be a debtor under the Bankruptcy Code.
Instead, special state and federal laws govern the liquidation or reorganization of these companies. In the U.S. context at least, it is incorrect to refer to a bank or insurer as being "bankrupt". The terms "insolvent", "in liquidation", or "in receivership" would be appropriate under some circumstances.
Status of certain defined benefit pension plan liabilities in bankruptcy:
The Pension Benefit Guaranty Corporation (PBGC), a U.S. government corporation that insures certain defined benefit pension plan obligations, may assert liens in bankruptcy under either of two separate statutory provisions:
In bankruptcy, PBGC liens (like Federal tax liens) generally are not valid against certain competing liens that were perfected before a notice of the PBGC lien was filed.
Bankruptcy costs:
In 2013, 91 percent of U.S. individuals filing bankruptcy hire an attorney to file their Chapter 7 petition. The typical cost of an attorney was $1,170. Alternatives to filing with an attorney are: filing pro se, meaning without an attorney, which requires an individual to fill out at least sixteen separate forms, hiring a petition preparer, or using online software to generate the petition.
The U.S. Bankruptcy Court also charges fees. The amounts of these fees vary depending on the Chapter of bankruptcy being filed. As of 2016, the filing fee is $335 for Chapter 7 and $310 for Chapter 13. It is possible to apply for an installment payment plan in cases of financial hardship.
Additional fees are charged for adding creditors after filing ($31), converting the case from one chapter to another ($10-$45), and reopening the case ($245 for Chapter 7 and $235 in Chapter 13).
Bankruptcy crimes:
In the United States, criminal provisions relating to bankruptcy fraud and other bankruptcy crimes are found in sections 151 through 158 of Title 18 of the United States Code.
Bankruptcy fraud includes filing a bankruptcy petition or any other document in a bankruptcy case for the purpose of attempting to execute or conceal a scheme or artifice to defraud.
Bankruptcy fraud also includes making a false or fraudulent representation, claim or promise in connection with a bankruptcy case, either before or after the commencement of the case, for the purpose of attempting to execute or conceal a scheme or artifice to defraud.
Bankruptcy fraud is punishable by a fine, or by up to five years in prison, or both.
Knowingly and fraudulently concealing property of the estate from a custodian, trustee,marshal, or other court officer is a separate offense, and may also be punishable by a fine, or by up to five years in prison, or both.
The same penalty may be imposed for knowingly and fraudulently concealing, destroying, mutilating, falsifying, or making a false entry in any books, documents, records, papers, or other recorded information relating to the property or financial affairs of the debtor after a case has been filed.
Certain offenses regarding fraud in connection with a bankruptcy case may also be classified as "racketeering activity" for purposes of the Racketeer Influenced and Corrupt Organizations Act (RICO).
Any person who receives income directly or indirectly derived from a "pattern" of such racketeering activity (generally, two or more offensive acts within a ten-year period) and who uses or invests any part of that income in the acquisition, establishment, or operation of any enterprise engaged in (or affecting) interstate or foreign commerce may be punished by up to twenty years in prison.
Bankruptcy crimes are prosecuted by the United States Attorney, typically after a reference from the United States Trustee, the case trustee, or a bankruptcy judge.
Bankruptcy fraud can also sometimes lead to criminal prosecution in state courts, under the charge of theft of the goods or services obtained by the debtor for which payment, in whole or in part, was evaded by the fraudulent bankruptcy filing.
Bankruptcy and federalism:
On January 23, 2006, the Supreme Court, in Central Virginia Community College v. Katz, declined to apply state sovereign immunity from Seminole Tribe v. Florida, to defeat a trustee's action under 11 U.S.C. § 547 to recover preferential transfers made by a debtor to a state agency.
The Court ruled that Article I, section 8, clause 4 of the U.S. Constitution (empowering Congress to establish uniform laws on the subject of bankruptcy) abrogates the state's sovereign immunity in suits to recover preferential payments.
Social and economic factors;
In 2008, there were 1,117,771 bankruptcy filings in the United States courts. Of those, 744,424 were chapter 7 bankruptcies, while 362,762 were chapter 13. Apart from social and economic factors such as education and income, there is often also a correlation between race and bankruptcy outcome.
For example, for personal bankruptcy claims, minority debtors had an approximately 40% decreased chance of receiving a discharge in Chapter 13 bankruptcy. These racial disparities are aggravated by the fact that many minority debtors lack appropriate attorney representation.
Personal bankruptcy:
See also: Personal bankruptcy § United States
Personal bankruptcies may be caused by a number of factors. In 2008, over 96% of all bankruptcy filings were non-business filings, and of those, approximately two-thirds were chapter 7 cases.
Although the individual causes of bankruptcy are complex and multifaceted, the majority of personal bankruptcies involve substantial medical bills. Personal bankruptcies are typically filed under Chapter 7 or Chapter 13. Personal Chapter 11 bankruptcies are relatively rare.
The American Journal of Medicine says over 3 out of 5 personal bankruptcies are due to medical debt.
There were 175,146 individual bankruptcies filed in the United States during the first quarter of 2020. Some 66.5 percent were directly tied to medical issues. Critical illness insurance Association report June 2, 2020
Corporate bankruptcy:
Corporate bankruptcy can arise as a result of two broad categories—business failure or financial distress. Business failure stems from flaws in the company's business model that prohibit it from producing the necessary level of profit to justify its capital investment.
Conversely, financial distress stems from flaws in the way the company is financed or its capital structure. Continued financial distress leads to either technical insolvency (assets outweigh liabilities, but the firm is unable to meet current obligations) or bankruptcy (liabilities outweigh assets, and the firm has a negative net worth).
A company experiencing business failure can stave off bankruptcy as long as it has access to funding; conversely, a company that is experiencing financial failure will be pushed into bankruptcy regardless of the soundness of its business model.
The actual causes of corporate bankruptcies are difficult to establish, due to the compounding effects of external (macroeconomic, industry) and internal (business or financial) factors.
However, some studies have indicated that financial leverage and working capital mismanagement are likely two of the major causes of corporate failure and bankruptcy in the US.
Largest bankruptcies:
The largest bankruptcy in U.S. history occurred on September 15, 2008, when Lehman Brothers Holdings Inc. filed for Chapter 11 protection with more than $639 billion in assets
Click on below image for accessing original table: close added table when through:
In the United States, bankruptcy is largely governed by federal law, commonly referred to as the "Bankruptcy Code" ("Code"). The United States Constitution (Article 1, Section 8, Clause 4) authorizes Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States".
Congress has exercised this authority several times since 1801, including through adoption of the Bankruptcy Reform Act of 1978, as amended, codified in Title 11 of the United States Code and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA).
Some laws relevant to bankruptcy are found in other parts of the United States Code. For example:
- bankruptcy crimes are found in Title 18 of the United States Code (Crimes).
- Tax implications of bankruptcy are found in Title 26 of the United States Code (Internal Revenue Code),
- and the creation and jurisdiction of bankruptcy courts are found in Title 28 of the United States Code (Judiciary and Judicial procedure).
Bankruptcy cases are filed in United States bankruptcy court (units of the United States District Courts), and federal law governs procedure in bankruptcy cases. However, state laws are often applied to determine how bankruptcy affects the property rights of debtors.
For example, laws governing the validity of liens or rules protecting certain property from creditors (known as exemptions), may derive from state law or federal law. Because state law plays a major role in many bankruptcy cases, it is often unwise to generalize some bankruptcy issues across state lines.
History:
Main article: History of bankruptcy law in the United States
Originally, bankruptcy in the United States, as nearly all matters directly concerning individual citizens, was a subject of state law.
However, there were several short-lived federal bankruptcy laws before the Act of 1898:
- the Bankruptcy Act of 1800, which was repealed in 1803;
- the Act of 1841, which was repealed in 1843;
- and the Act of 1867, which was amended in 1874 and repealed in 1878.
The first more lasting federal bankruptcy law, sometimes called the "Nelson Act", initially entered into force in 1898. The current Bankruptcy Code was enacted in 1978 by § 101 of the Bankruptcy Reform Act of 1978, and generally became effective on October 1, 1979; it completely replaced the former bankruptcy law, the "Chandler Act" of 1938, which had given unprecedented power to the Securities and Exchange Commission for the regulation of bankruptcy filings.
The current code has been amended numerous times since 1978. See also the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
Chapters of the Bankruptcy Code:
Entities seeking relief under the Bankruptcy Code may file a petition for relief under a number of different chapters of the Code, depending on circumstances. Title 11 contains nine chapters, six of which provide for the filing of a petition.
The other three chapters provide rules governing bankruptcy cases in general. A case is typically referred to by the chapter under which the petition is filed. These chapters are described below.
Chapter 7: Liquidation:
Main article: Chapter 7, Title 11, United States Code
Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors.
Because all states allow for debtors to keep essential property, Chapter 7 cases are often "no asset" cases, meaning that the bankrupt estate has no non-exempt assets to fund a distribution to creditors.
Chapter 7 bankruptcy remains on a bankruptcy filer's credit report for 10 years.
United States bankruptcy law significantly changed in 2005 with the passage of Bankruptcy Abuse Prevention and Consumer Protection Act (US) —- BAPCPA, which made it more difficult for consumer debtors to file bankruptcy in general and Chapter 7 in particular.
Advocates of BAPCPA claimed that its passage would reduce losses to creditors such as credit card companies, and that those creditors would then pass on the savings to other borrowers in the form of lower interest rates. Critics assert that these claims turned out to be false, observing that although credit card company losses decreased after passage of the Act, prices charged to customers increased, and credit card company profits increased.
Chapter 9: Reorganization for municipalities:
Main article: Chapter 9, Title 11, United States Code
A Chapter 9 bankruptcy is available only to municipalities. Chapter 9 is a form of reorganization, not liquidation. Notable examples of municipal bankruptcies include that of Orange County, California (1994 to 1996) and the bankruptcy of the city of Detroit, Michigan in 2013.
Chapters 11, 12, and 13: Reorganization:
Main articles below:
- Chapter 11, Title 11, United States Code;
- Chapter 12, Title 11, United States Code;
- and Chapter 13, Title 11, United States Code
Bankruptcy under Chapter 11, Chapter 12, or Chapter 13 is a more complex reorganization and involves allowing the debtor to keep some or all of his or her property and to use future earnings to pay off creditors.
Consumers usually file chapter 7 or chapter 13. Chapter 11 filings by individuals are allowed, but are rare.
Chapter 12 is similar to Chapter 13 but is available only to "family farmers" and "family fisherman" in certain situations. Chapter 12 generally has more generous terms for debtors than a comparable Chapter 13 case would have available.
As recently as mid-2004 Chapter 12 was scheduled to expire, but in late 2004 it was renewed and made permanent.
Chapter 15: Cross-border insolvency:
Main article: Chapter 15, Title 11, United States Code
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 added Chapter 15 (as a replacement for section 304) and deals with cross-border insolvency: foreign companies with US debts.
Features of U.S. bankruptcy law:
Voluntary versus involuntary bankruptcy
As a threshold matter, bankruptcy cases are either voluntary or involuntary. In voluntary bankruptcy cases, which account for the overwhelming majority of cases, debtors petition the bankruptcy court.
With involuntary bankruptcy, creditors, rather than the debtor, file the petition in bankruptcy. Involuntary petitions are rare, however, and are occasionally used in business settings to force a company into bankruptcy so that creditors can enforce their rights.
The estate:
Except in Chapter 9 cases, commencement of a bankruptcy case creates an "estate". Generally, the debtor's creditors must look to the assets of the estate for satisfaction of their claims. The estate consists of all property interests of the debtor at the time of case commencement, subject to certain exclusions and exemptions.
In the case of a married person in a community property state, the estate may include certain community property interests of the debtor's spouse even if the spouse has not filed bankruptcy.
The estate may also include other items, including but not limited to property acquired by will or inheritance within 180 days after case commencement.
For federal income tax purposes, the bankruptcy estate of an individual in a Chapter 7 or 11 case is a separate taxable entity from the debtor. The bankruptcy estate of a corporation, partnership, or other collective entity, or the estate of an individual in Chapters 12 or 13, is not a separate taxable entity from the debtor.
Bankruptcy court:
Main article: United States bankruptcy court
In 1982, in the case of Northern Pipeline Co. v. Marathon Pipe Line Co., the United States Supreme Court held that certain provisions of the law relating to Article I bankruptcy judges (who are not life-tenured "Article III" judges) are unconstitutional. Congress responded in 1984 with changes to remedy the constitutional defects.
Under the revised law, bankruptcy judges in each judicial district constitute a "unit" of the applicable United States District Court. Each judge is appointed for a term of 14 years by the United States Court of Appeals for the circuit in which the applicable district is located.
The United States District Courts have subject-matter jurisdiction over bankruptcy matters. However, each such district court may, by order, "refer" bankruptcy matters to the Bankruptcy Court, and most district courts have a standing "reference" order to that effect, so that all bankruptcy cases are handled by the Bankruptcy Court.
In unusual circumstances, a district court may "withdraw the reference" (i.e., taking a particular case or proceeding within the case away from the bankruptcy court) and decide the matter itself.
Decisions of the bankruptcy court are generally appealable to the district court, and then to the Court of Appeals. However, in a few jurisdictions a separate court called a Bankruptcy Appellate Panel (composed of bankruptcy judges) hears certain appeals from bankruptcy courts.
United States Trustee:
Main article: United States Trustee
The United States Attorney General appoints a separate United States Trustee for each of twenty-one geographical regions for a five-year term. Each Trustee is removable from office by and works under the general supervision of the Attorney General.
The U.S. Trustees maintain regional offices that correspond with federal judicial districts and are administratively overseen by the Executive Office for United States Trustees in Washington, D.C. Each United States Trustee, an officer of the U.S. Department of Justice, is responsible for maintaining and supervising a panel of private trustees for chapter 7 bankruptcy cases.
The Trustee has other duties including the administration of most bankruptcy cases and trustees. Under Section 307 of Title 11 of the U.S. Code, a U.S. Trustee "may raise and may appear and be heard on any issue in any case or proceeding" in bankruptcy except for filing a plan of reorganization in a chapter 11 case.
The automatic stay:
Main article: Automatic stay
Bankruptcy Code § 362 imposes the automatic stay at the moment a bankruptcy petition is filed. The automatic stay generally prohibits the commencement, enforcement or appeal of actions and judgments, judicial or administrative, against a debtor for the collection of a claim that arose prior to the filing of the bankruptcy petition.
The automatic stay also prohibits collection actions and proceedings directed toward property of the bankruptcy estate itself.
In some courts, violations of the stay are treated as void ab initio as a matter of law, although the court may annul the stay to give effect to otherwise void acts. Other courts treat violations as voidable (not necessarily void ab initio).
Any violation of the stay may give rise to damages being assessed against the violating party. Non-willful violations of the stay are often excused without penalty, but willful violators are liable for punitive damages and may also be found to be in contempt of court.
A secured creditor may be allowed to take the applicable collateral if the creditor first obtains permission from the court. Permission is requested by a creditor by filing a motion for relief from the automatic stay. The court must either grant the motion or provide adequate protection to the secured creditor that the value of their collateral will not decrease during the stay.
Without the bankruptcy protection of the automatic stay, creditors might race to the courthouse to improve their positions against a debtor. If the debtor's business were facing a temporary crunch, but were nevertheless viable in the long term, it might not survive a "run" by creditors.
A run could also result in waste and unfairness among similarly situated creditors.
Bankruptcy Code 362(d) gives four ways that a creditor can get the automatic stay removed.
Avoidance actions:
Debtors, or the trustees that represent them, gain the ability to reject, or avoid actions taken with respect to the debtor's property for a specified time prior to the filing of the bankruptcy.
While the details of avoidance actions are nuanced, there are three general categories of avoidance actions:
- Preferences: 11 U.S.C. § 547
- Federal fraudulent transfer: 11 U.S.C. § 548
- Non-bankruptcy law creditor: 11 U.S.C. § 544
All avoidance actions attempt to limit the risk of the legal system accelerating the financial demise of a financially unstable debtor who has not yet declared bankruptcy. The bankruptcy system generally endeavors to reward creditors who continue to extend financing to debtors and discourage creditors from accelerating their debt collection efforts. Avoidance actions are some of the most obvious of the mechanisms to encourage this goal.
Despite the apparent simplicity of these rules, a number of exceptions exist in the context of each category of avoidance action.
Preferences:
Preference actions generally permit the trustee to avoid (that is, to void an otherwise legally binding transaction) certain transfers of the debtor's property that benefit creditors where the transfers occur on or within 90 days of the date of filing of the bankruptcy petition.
For example, if a debtor has a debt to a friendly creditor and a debt to an unfriendly creditor, and pays the friendly creditor, and then declares bankruptcy one week later, the trustee may be able to recover the money paid to the friendly creditor under 11 U.S.C. § 547.
While this "reach back" period typically extends 90 days backwards from the date of the bankruptcy, the amount of time is longer in the case of "insiders"—typically one year. Insiders include family and close business contacts of the debtor.
Fraudulent transfer:
Bankruptcy fraudulent transfer law is similar in practice to non-bankruptcy fraudulent transfer law. Some terms, however, are more generous in bankruptcy than they are otherwise.
For instance, the statute of limitations within bankruptcy is two years as opposed to a shorter time frame in some non-bankruptcy contexts. Generally a fraudulent transfer action operates in much the same way as a preference avoidance. Fraudulent transfer actions, however, sometimes require a showing of intent to shelter the property from a creditor.
Fraudulent transfer may involve an actual or a "constructive" fraud. Actual fraud is based upon the on intent of the transfer, whereas constructive fraud may be inferred based upon economic factors.
Factors that may lead to an inference of fraud include whether the transfer was for reasonably equivalent value and whether the debtor was insolvent at the time of the transfer.
The conversion of nonexempt assets into exempt assets on the eve of bankruptcy is not an indicia of fraud per se. However, depending on the amount of the exemption and the circumstances surrounding the conversion, a court may find the conversion to be a fraudulent transfer. This is especially true when the conversion amounts to nothing more than a temporary arrangement.
When finding the conversion of nonexempt into exempt assets to be a fraudulent transfer, courts tend to focus on the existence of an independent reason for the conversion. For example, if a debtor purchased a residence protected by a homestead exemption with the intent to reside in such residence that would be an allowable conversion into nonexempt property.
But where the debtor purchased the residence with all of their available funds, leaving no money to live off, that presumed that the conversion was temporary, indicating a fraudulent transfer. Courts look at the timing of the transfer as the most important factor.
Non-bankruptcy law creditor – "strong arm"
The strong arm avoidance power stems from 11 U.S.C. § 544 and permits the trustee to exercise the rights that a debtor in the same situation would have under the relevant state law.
Specifically, § 544(a) grants the trustee the rights of avoidance of:
(1) a judicial lien creditor,
(2) an unsatisfied lien creditor,
and (3) a bona fide purchaser of real property.
In practice these avoidance powers often overlap with preference and fraudulent transfer avoidance powers.
The creditors:
Secured creditors whose security interests survive the commencement of the case may look to the property that is the subject of their security interests, after obtaining permission from the court (in the form of relief from the automatic stay). Security interests, created by what are called secured transactions, are liens on the property of a debtor.
Unsecured creditors are generally divided into two classes: unsecured priority creditors and general unsecured creditors. Unsecured priority creditors are further subdivided into classes as described in the law. In some cases the assets of the estate are insufficient to pay all priority unsecured creditors in full; in such cases the general unsecured creditors receive nothing.
Because of the priority and rank ordering feature of bankruptcy law, debtors sometimes collude with others (who may be related to the debtor) to prefer them, by for example granting them a security interest in otherwise unpledged assets.
For this reason, the bankruptcy trustee is permitted to reverse certain transactions of the debtor within a period of time prior to the date of the bankruptcy filing. The time period varies depending on the relationship of the parties to the debtor and the nature of the transaction.
In Chapters 7, 12, and 13, creditors must file a "proof of claim" to be paid. In a Chapter 11 case, a creditor is not required to file a proof of claim (that is, a proof of claim is "deemed filed") if the creditor's claim is listed on the debtor's bankruptcy schedules, unless the claim is scheduled as "disputed, contingent, or unliquidated".
If the creditor's claim is not listed on the schedules in a Chapter 11 case, the creditor must file a proof of claim.
Absolute priority:
A distinctive feature of U.S. bankruptcy law is the absolute priority rule, codified at 11 U.S.C. § 1129(b)(2)(B)(ii). The rule provides that "[w]ith respect to a class of unsecured claims . . . the holder of any claim or interest that is junior to the claims of such class will not receive or retain under the plan on account of such junior claim or interest any property."
This requirement means that if any class of creditors votes against a plan of reorganization, the bankruptcy court may not confirm the plan if any class of claims or interests junior to the dissenting class (e.g., subordinated creditors or shareholders) receives any distribution of the debtor's estate pursuant to the plan.
In practice, the rule requires that debtors satisfy the claims of senior creditors in full before distributing any estate property to junior creditors or shareholders under the plan, although senior creditors will often consent to a de minimis recovery for junior stakeholders in exchange for their support for the plan.
The Supreme Court has recognized an exception to the absolute priority rule known as the "new value" exception that allows junior stakeholders to recover property under a plan over the objection of senior creditors if the junior stakeholders provide "new value" to the restructured enterprise (typically defined as an upfront monetary contribution to the reorganized debtor that is commensurate with the property received or retained under the plan).
The basis for the new value exception is that the holder of a junior claim or interest under such circumstances does not "receive or retain under the plan on account of such junior claim or interest any property" but rather receives or retains property under the plan on account of the new value contribution. 11 U.S.C. § 1129(b)(2)(B)(ii) (emphasis added).
Executory contracts:
The bankruptcy trustee may reject certain executory contracts and unexpired leases. For bankruptcy purposes, a contract is generally considered executory when both parties to the contract have not yet fully performed a material obligation of the contract.
If the Trustee (or debtor in possession, in many chapter 11 cases) rejects a contract, the debtor's bankruptcy estate is subject to ordinary breach of contract damages, but the damages amount is an obligation and is generally treated as an unsecured claim.
Committees:
Under some chapters, notably chapters 7, 9 and 11, committees of various stakeholders are appointed by the bankruptcy court. In Chapter 11 and 9, these committees consist of entities that hold the seven largest claims of the kinds represented by the committee.
Other committees may also be appointed by the court.
Committees have regular communications with the debtor and the debtor's advisers and have access to a wide variety of documents as part of their functions and responsibilities.
Exempt property:
Although in theory all property of the debtor that is not excluded from the estate under the Bankruptcy Code becomes property of the estate (i.e., is automatically transferred from the debtor to the estate) at the time of commencement of a case, an individual debtor (not a partnership, corporation, etc.) may claim certain items of property as "exempt" and thereby keep those items (subject, however, to any valid liens or other encumbrances).
An individual debtor may choose between a federal list of exemptions and a list of exemptions provided by the law of the state in which the debtor files the bankruptcy case unless the state in which the debtor files the bankruptcy case has enacted legislation prohibiting the debtor from choosing the exemptions on the federal list, which almost 40 states have done.
In states where the debtor is allowed to choose between the federal and state exemptions, the debtor has the opportunity to choose the exemptions that most fully benefit him or her and, in many cases, may convert at least some of his or her property from non-exempt form (e.g., cash) to exempt form (e.g., increased equity in a home created by using the cash to pay down a mortgage) prior to filing the bankruptcy case.
The exemption laws vary greatly from state to state. In some states, exempt property includes equity in a home or car, tools of the trade, and some personal effects. In other states an asset class such as tools of trade will not be exempt by virtue of its class except to the extent it is claimed under a more general exemption for personal property.
One major purpose of bankruptcy is to ensure orderly and reasonable management of debt. Thus, exemptions for personal effects are thought to prevent punitive seizures of items of little or no economic value (personal effects, personal care items, ordinary clothing), since this does not promote any desirable economic result.
Similarly, tools of the trade may, depending on the available exemptions, be a permitted exemption as their continued possession allows the insolvent debtor to move forward into productive work as soon as possible.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 placed pension plans not subject to the Employee Retirement Income Security Act of 1974 (ERISA), like 457 and 403(b) plans, in the same status as ERISA qualified plans with respect to having exemption status akin to spendthrift trusts.
SEP-IRAs and SIMPLEs still are outside federal protection and must rely on state law.
Spendthrift trusts:
Most states have property laws that allow a trust agreement to contain a legally enforceable restriction on the transfer of a beneficial interest in the trust (sometimes known as an "anti-alienation provision").
The anti-alienation provision generally prevents creditors of a beneficiary from acquiring the beneficiary's share of the trust. Such a trust is sometimes called a spendthrift trust. To prevent fraud, most states allow this protection only to the extent that the beneficiary did not transfer property to the trust.
Also, such provisions do not protect cash or other property once it has been transferred from the trust to the beneficiary. Under the US Bankruptcy Code, an anti-alienation provision in a spendthrift trust is recognized. This means that the beneficiary's share of the trust generally does not become property of the bankruptcy estate.
Redemption:
In a Chapter 7 liquidation case, an individual debtor may redeem certain "tangible personal property intended primarily for personal, family, or household use" that is encumbered by a lien.
To qualify, the property generally either (A) must be exempt under section 522 of the Bankruptcy Code, or (B) must have been abandoned by the trustee under section 554 of the Bankruptcy Code. To redeem the property, the debtor must pay the lienholder the full amount of the applicable allowed secured claim against the property.
Debtor's discharge:
Main article: Bankruptcy discharge
Key concepts in bankruptcy include the debtor's discharge and the related "fresh start". Discharge is available in some but not all cases. For example, in a Chapter 7 case only an individual debtor (not a corporation, partnership, etc.) can receive a discharge.
The effect of a bankruptcy discharge is to eliminate only the debtor's personal liability, not the in rem liability for a secured debt to the extent of the value of collateral. The term "in rem" essentially means "with respect to the thing itself" (i.e., the collateral).
For example, if a debt in the amount of $100,000 is secured by property having a value of only $80,000, the $20,000 deficiency is treated, in bankruptcy, as an unsecured claim (even though it is part of a "secured" debt). The $80,000 portion of the debt is treated as a secured claim.
Assuming a discharge is granted and none of the $20,000 deficiency is paid (e.g., due to insufficiency of funds), the $20,000 deficiency—the debtor's personal liability—is discharged (assuming the debt is not non-dischargeable under another Bankruptcy Code provision).
The $80,000 portion of the debt is the in rem liability, and it is not discharged by the court's discharge order. This liability can presumably be satisfied by the creditor taking the asset itself.
An essential concept is that when commentators say that a debt is "dischargeable", they are referring only to the debtor's personal liability on the debt. To the extent that a liability is covered by the value of collateral, the debt is not discharged.
This analysis assumes, however, that the collateral does not increase in value after commencement of the case. If the collateral increases in value and the debtor (rather than the estate) keeps the collateral (e.g., where the asset is exempt or is abandoned by the trustee back to the debtor), the amount of the creditor's security interest may or may not increase.
In situations where the debtor (rather than the creditor) is allowed to benefit from the increase in collateral value, the effect is called "lien stripping" or "paring down". Lien stripping is allowed only in certain cases depending on the kind of collateral and the particular chapter of the Code under which the discharge is granted.
The discharge also does not eliminate certain rights of a creditor to setoff (or "offset") certain mutual debts owed by the creditor to the debtor against certain claims of that creditor against the debtor, where both the debt owed by the creditor and the claim against the debtor arose prior to the commencement of the case.
Not every debt may be discharged under every chapter of the Code. Certain taxes owed to federal, state or local government, student loans, and child support obligations are not dischargeable. (Guaranteed student loans are potentially dischargeable, however, if the debtor prevails in a difficult-to-win adversary proceeding against the lender commenced by a complaint to determine dischargeability.
Also, the debtor can petition the court for a financial hardship discharge, but the grant of such discharges is rare.)
The debtor's liability on a secured debt, such as a mortgage or mechanic's lien on a home, may be discharged. The effects of the mortgage or mechanic's lien, however, cannot be discharged in most cases if the lien affixed prior to filing.
Therefore, if the debtor wishes to retain the property, the debt must usually be paid as agreed. (See also lien avoidance, reaffirmation agreement) (Note: there may be additional flexibility available in Chapter 13 for debtors dealing with oversecured collateral such as a financed auto, so long as the oversecured property is not the debtor's primary residence.)
Any debt tainted by one of a variety of wrongful acts recognized by the Bankruptcy Code, including defalcation, or consumer purchases or cash advances above a certain amount incurred a short time before filing, cannot be discharged. However, certain kinds of debt, such as debts incurred by way of fraud, may be dischargeable through the Chapter 13 "super discharge".
All in all, as of 2005, there are 19 general categories of debt that cannot be discharged in a Chapter 7 bankruptcy, and fewer debts that cannot be discharged under Chapter 13.
Valuation and recapitalization:
In a corporate or business bankruptcy, an indebted company that files bankruptcy is typically recapitalized so that it emerges from bankruptcy with more equity and less debt. During this process, many debts may be "discharged", meaning that the company will no longer be legally obligated to pay them.
Which debts are discharged, and how equity and other entitlements are distributed to various groups of investors, typically turns on valuation issues. Bankruptcy valuation is often highly contentious because it is both subjective and important to case outcomes.
The methods of valuation used in bankruptcy have changed over time, generally tracking methods used in investment banking, Delaware corporate law, and corporate and academic finance, but with a significant time lag.
Entities that cannot be debtors:
The section of the Bankruptcy code that governs which entities are permitted to file a bankruptcy petition is 11 U.S.C. § 109.
Banks and other deposit institutions, insurance companies, railroads, and certain other financial institutions and entities regulated by the federal and state governments, and Private and Personal Trusts, except Statutory Business Trusts, as permitted by some States, cannot be a debtor under the Bankruptcy Code.
Instead, special state and federal laws govern the liquidation or reorganization of these companies. In the U.S. context at least, it is incorrect to refer to a bank or insurer as being "bankrupt". The terms "insolvent", "in liquidation", or "in receivership" would be appropriate under some circumstances.
Status of certain defined benefit pension plan liabilities in bankruptcy:
The Pension Benefit Guaranty Corporation (PBGC), a U.S. government corporation that insures certain defined benefit pension plan obligations, may assert liens in bankruptcy under either of two separate statutory provisions:
- The first is found in the Internal Revenue Code, at 26 U.S.C. § 412, which provides that liens held by the PBGC have the status of a tax lien. Under this provision, the unpaid mandatory pension contributions must exceed one million dollars for the lien to arise.
- The second statute is 29 U.S.C. § 1368, under which a PBGC lien has the status of a tax lien in bankruptcy. Under this provision, the lien may not exceed 30% of the net worth of all persons liable under a separate provision, 29 U.S.C. § 1362.
In bankruptcy, PBGC liens (like Federal tax liens) generally are not valid against certain competing liens that were perfected before a notice of the PBGC lien was filed.
Bankruptcy costs:
In 2013, 91 percent of U.S. individuals filing bankruptcy hire an attorney to file their Chapter 7 petition. The typical cost of an attorney was $1,170. Alternatives to filing with an attorney are: filing pro se, meaning without an attorney, which requires an individual to fill out at least sixteen separate forms, hiring a petition preparer, or using online software to generate the petition.
The U.S. Bankruptcy Court also charges fees. The amounts of these fees vary depending on the Chapter of bankruptcy being filed. As of 2016, the filing fee is $335 for Chapter 7 and $310 for Chapter 13. It is possible to apply for an installment payment plan in cases of financial hardship.
Additional fees are charged for adding creditors after filing ($31), converting the case from one chapter to another ($10-$45), and reopening the case ($245 for Chapter 7 and $235 in Chapter 13).
Bankruptcy crimes:
In the United States, criminal provisions relating to bankruptcy fraud and other bankruptcy crimes are found in sections 151 through 158 of Title 18 of the United States Code.
Bankruptcy fraud includes filing a bankruptcy petition or any other document in a bankruptcy case for the purpose of attempting to execute or conceal a scheme or artifice to defraud.
Bankruptcy fraud also includes making a false or fraudulent representation, claim or promise in connection with a bankruptcy case, either before or after the commencement of the case, for the purpose of attempting to execute or conceal a scheme or artifice to defraud.
Bankruptcy fraud is punishable by a fine, or by up to five years in prison, or both.
Knowingly and fraudulently concealing property of the estate from a custodian, trustee,marshal, or other court officer is a separate offense, and may also be punishable by a fine, or by up to five years in prison, or both.
The same penalty may be imposed for knowingly and fraudulently concealing, destroying, mutilating, falsifying, or making a false entry in any books, documents, records, papers, or other recorded information relating to the property or financial affairs of the debtor after a case has been filed.
Certain offenses regarding fraud in connection with a bankruptcy case may also be classified as "racketeering activity" for purposes of the Racketeer Influenced and Corrupt Organizations Act (RICO).
Any person who receives income directly or indirectly derived from a "pattern" of such racketeering activity (generally, two or more offensive acts within a ten-year period) and who uses or invests any part of that income in the acquisition, establishment, or operation of any enterprise engaged in (or affecting) interstate or foreign commerce may be punished by up to twenty years in prison.
Bankruptcy crimes are prosecuted by the United States Attorney, typically after a reference from the United States Trustee, the case trustee, or a bankruptcy judge.
Bankruptcy fraud can also sometimes lead to criminal prosecution in state courts, under the charge of theft of the goods or services obtained by the debtor for which payment, in whole or in part, was evaded by the fraudulent bankruptcy filing.
Bankruptcy and federalism:
On January 23, 2006, the Supreme Court, in Central Virginia Community College v. Katz, declined to apply state sovereign immunity from Seminole Tribe v. Florida, to defeat a trustee's action under 11 U.S.C. § 547 to recover preferential transfers made by a debtor to a state agency.
The Court ruled that Article I, section 8, clause 4 of the U.S. Constitution (empowering Congress to establish uniform laws on the subject of bankruptcy) abrogates the state's sovereign immunity in suits to recover preferential payments.
Social and economic factors;
In 2008, there were 1,117,771 bankruptcy filings in the United States courts. Of those, 744,424 were chapter 7 bankruptcies, while 362,762 were chapter 13. Apart from social and economic factors such as education and income, there is often also a correlation between race and bankruptcy outcome.
For example, for personal bankruptcy claims, minority debtors had an approximately 40% decreased chance of receiving a discharge in Chapter 13 bankruptcy. These racial disparities are aggravated by the fact that many minority debtors lack appropriate attorney representation.
Personal bankruptcy:
See also: Personal bankruptcy § United States
Personal bankruptcies may be caused by a number of factors. In 2008, over 96% of all bankruptcy filings were non-business filings, and of those, approximately two-thirds were chapter 7 cases.
Although the individual causes of bankruptcy are complex and multifaceted, the majority of personal bankruptcies involve substantial medical bills. Personal bankruptcies are typically filed under Chapter 7 or Chapter 13. Personal Chapter 11 bankruptcies are relatively rare.
The American Journal of Medicine says over 3 out of 5 personal bankruptcies are due to medical debt.
There were 175,146 individual bankruptcies filed in the United States during the first quarter of 2020. Some 66.5 percent were directly tied to medical issues. Critical illness insurance Association report June 2, 2020
Corporate bankruptcy:
Corporate bankruptcy can arise as a result of two broad categories—business failure or financial distress. Business failure stems from flaws in the company's business model that prohibit it from producing the necessary level of profit to justify its capital investment.
Conversely, financial distress stems from flaws in the way the company is financed or its capital structure. Continued financial distress leads to either technical insolvency (assets outweigh liabilities, but the firm is unable to meet current obligations) or bankruptcy (liabilities outweigh assets, and the firm has a negative net worth).
A company experiencing business failure can stave off bankruptcy as long as it has access to funding; conversely, a company that is experiencing financial failure will be pushed into bankruptcy regardless of the soundness of its business model.
The actual causes of corporate bankruptcies are difficult to establish, due to the compounding effects of external (macroeconomic, industry) and internal (business or financial) factors.
However, some studies have indicated that financial leverage and working capital mismanagement are likely two of the major causes of corporate failure and bankruptcy in the US.
Largest bankruptcies:
The largest bankruptcy in U.S. history occurred on September 15, 2008, when Lehman Brothers Holdings Inc. filed for Chapter 11 protection with more than $639 billion in assets
Click on below image for accessing original table: close added table when through:
Alternatives to bankruptcy:
Main article: Texas two-step bankruptcy
A Texas divisional merger is a process allowed by Texas law in which a company can create a separate company to take over liabilities, with the existing company operating normally.
The new company, with a different name, can locate in a state such as North Carolina where bankruptcy laws are different, and then declare bankruptcy, paying less than the original company would have.
The latest case of a Texas divisional merger was by company, Johnson & Johnson. Recently, J&J has been hit by thousands of lawsuits by women claiming that J&J baby powder, containing talc, caused their ovarian cancer. While the company has held that their products do not cause ovarian cancer, they lost many cases and a lot of money.
This is what led them to perform a Texas divisional merger. They split their company, putting all talc liabilities on the new company, and keeping all assets within the original. This halted all cases by women with ovarian cancer, and has been seen as controversial since it keeps women from receiving compensation from Johnson & Johnson.
See also:
- United Kingdom insolvency law
- United States Courts bankruptcy information from uscourts.gov
- Links to federal bankruptcy courts from uscourts.gov
- United States bankruptcy court forms from uscourts.gov
- Title 11 of the U.S. Code from the Office of the Law Revision Counsel, U.S. House of Representatives
- Title 11 of the U.S. Code via law.cornell.edu
- United States Bankruptcy Code and Rules from the American Bankruptcy Institute
- Rules of Bankruptcy Procedure from law.cornell.edu
- Current Rules of Practice and Procedure from uscourts.gov
- The Evolution of U.S. Bankruptcy Law: A Time Line from Federal Judicial Center
Chapter 13, Title 11, United States Code
Title 11 of the United States Code sets forth the statutes governing the various types of relief for bankruptcy in the United States.
Chapter 13 of the United States Bankruptcy Code provides an individual with the opportunity to propose a plan of reorganization to reorganize their financial affairs while under the bankruptcy court's protection.
The purpose of chapter 13 is to enable an individual with a regular source of income to propose a chapter 13 plan that provides for their various classes of creditors. Under chapter 13, the Bankruptcy Court has the power to approve a chapter 13 plan without the approval of creditors as long as it meets the statutory requirements under chapter 13.
Chapter 13 plans are usually three to five years in length and may not exceed five years. Chapter 13 is in contrast to the purpose of Chapter 7, which does not provide for a plan of reorganization, but provides for the discharge of certain debt and the liquidation of non-exempt property.
A Chapter 13 plan may be looked at as a form of debt consolidation, but a Chapter 13 allows a person to achieve much more than simply consolidating his or her unsecured debt such as credit cards and personal loans. A chapter 13 plan may provide for the four general categories of debt:
- priority claims,
- secured claims,
- priority unsecured claims,
- and general unsecured claims.
Chapter 13 plans are often used to cure arrearages on a mortgage, avoid "underwater" junior mortgages or other liens, pay back taxes over time, or partially repay general unsecured debt.
In recent years, some bankruptcy courts have allowed Chapter 13 to be used as a platform to expedite a mortgage modification application.
Choice of chapter:
An individual who is badly in debt can typically file for bankruptcy either under Chapter 7 (liquidation, or straight bankruptcy) or Chapter 13 (reorganization). In some cases, options may also include Chapter 12 (family farmer reorganization) and Chapter 11 (reorganization of a company, or an individual debtor whose debts exceed the limits for a Chapter 13 filing).
As a Chapter 11 bankruptcy is considerably more complex and expensive than a Chapter 13 case, few debtors will choose Chapter 11 if a Chapter 13 bankruptcy is an option.
Debtors may also be forced into bankruptcy by creditors in the case of an involuntary bankruptcy, but only under Chapters 7 or 11. However, in most instances, the debtor may choose under which chapter to file. In the case of an involuntary bankruptcy, the debtor may also choose to convert from the forced Chapter 7 or 11 proceeding into a proceeding under another chapter.
The debtor's financial characteristics and the type of relief sought play a tremendous role in the choice of chapters. In some cases, the debtor simply cannot file under Chapter 13, as he or she lacks the disposable income necessary to fund a viable Chapter 13 plan (see below).
Furthermore, Section 109(e) of Title 11, United States Code sets forth debt limits for individuals to be eligible to file under Chapter 13: unsecured debts of less than $419,275, and secured debts of less than $1,257,850.
Under Chapter 13, the debtor proposes a plan to pay his or her creditors over a 3-to-5 year period. This written plan details all of the transactions (and their durations) that will occur, and repayment according to the plan must begin within 30 to 45 days after the case has started.
During this period, his or her creditors cannot attempt to collect on the individual's previously incurred debt except through the bankruptcy court. In general, the individual gets to keep their property, and his or her creditors end up with less money than they would have had the amount given to the debtor continued to collect interest, allowing the debtor to find a way to pay the amount owed without losing their assets.
Disadvantages:
The disadvantage of filing for personal bankruptcy is that, under the Fair Credit Reporting Act, a record of this stays on the individual's credit report for up to 7 years (up to 10 years for Chapter 7); still, it is possible to obtain new debt or credit (cards, auto, or consumer loans) after only 12–24 months, and a new FHA mortgage loan just 25 months after discharge, and Fannie Mae and Freddie Mac loans after 36 months.
However, during the pendency of a Chapter 13 case, the debtor is not permitted to obtain additional credit without the permission of the bankruptcy court. Moreover, creditors may not even be willing to risk lending money to such an individual, regardless of their legal ability to make a request.
However, this disadvantage is not unique to Chapter 13; it may also apply to individuals currently in a Chapter 11 or Chapter 12 case or those who are in (or have recently been in) a Chapter 7 case.
Advantages:
The advantages of Chapter 13 over Chapter 7 include the ability to stop foreclosures although a foreclosure would be reinstated upon completion of the bankruptcy; achieve a "super discharge" of debts not dischargeable under Chapter 7; "value collateral"; bifurcate the security interest of creditors in certain property that creditors are either charging too much interest for, or are over-secured, or both, and leading to a "cram down" modification of the debt; and prevent collection activities against non-filing co-signers ("co-debtors") during the life of the case.
Chapter 13 plan:
A chapter 13 plan is a document filed with or shortly after a debtor's Chapter 13 bankruptcy petition.
The plan details the treatment of debts, liens, and the secured status of assets and liabilities owned or owed by the debtor in regard to his bankruptcy petition. In order for a plan to take effect, it must meet a number of requirements. These are specified in § 1325 and include:
- providing that unsecured creditors will receive at least as much through the chapter 13 plan as they would in a chapter 7 liquidation.
- either not be objected to, repay all creditors in full, or commit all of the debtor's disposable income to the Chapter 13 plan for at least three years (or five years for a debtor who makes an above median income).
See also:
- United States Bankruptcy Code via Cornell Law School's Legal Information Institute
- National Association of Consumer Bankruptcy Attorneys
- United States Courts, Bankruptcy