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In his book "In Your Best Interest", Hank Cunningham tells some stories about the early days of stripping bonds in Canada. He and other traders had to do the complex calculations for stripping bonds using just hand-held calculators, not the computers that are common today.

I know the calculations for the traders were difficult in those days, but in my years at CDS (the Canadian Depository for Securities), I heard about, and saw much more of, the impacts of the early days of strip bonds on the back offices who were responsible for settling the trades, creating the strip bonds, the ongoing custody of the strip bonds, and ultimately collecting the payment for the strip bonds.

In the early days, the strip bonds were created by using scissors to separate the coupons on bearer bonds. Generally, the bonds were in $100,000 denominations, but some were as large as $1,000,000 and others as small as $5,000.

Regardless of the denomination, there was a lot of physical effort required to create the strip bonds before they could be delivered to clients. If $10,000,000 in 20-year bonds was being stripped using $100,000 certificates, then 100 certificates would be stripped into 2,100 individual pieces, most of them very tiny - about the size of your thumb.

Remember too that this clipping all had to be done quickly, since the dealer wanted to deliver out the strip bonds as soon as possible to the receiver, since any delay could cost money in overnight financing costs. While being done hurriedly, the clerks had to make sure they did not damage any coupons, since each was worth several thousand dollars and was not replaceable. When you consider that about $20 billion in coupons and residuals were created by physically stripping bonds, you can imagine the total number of physical strip bond pieces was very large indeed.

Expensive delivery

Hank tells a story about flying to Halifax to deliver some strip bonds. This might seem like an expensive way to make a delivery, but making physical deliveries was common in those days. Having Hank make the delivery instead of a regular messenger made it more expensive still, since I am sure his time was more valuable. However, he used the trip to meet with the client as well. (By comparison, making the delivery of the strip bonds electronically to a major client today would cost the dealer only the costs of the depository - usually under $2 - and its own internal processing costs.)

What Hank doesn't mention is that when he made that delivery, the receiver had no way to ensure that the residual certificates were in fact valid. They were bearer certificates and Hank told me he was wary because of this. However physical strip bonds have an additional risk that other bearer securities do not have - authenticity risk. They could not be taken to the issuer for exchange because they were missing all the remaining coupons. This means that the holder has no way to verify that the certificate is authentic until presenting it for payment when payment becomes due.

Now suppose 1) someone other than Hank made that delivery and 2) that person had access to today's colour copiers back then, that person could have left the client with good copies of the residuals.

The client might never have known that the residuals were invalid until 20 years later when they tried to present them at maturity to collect their money. Hank would never have done something like this, but the situation was a real risk for the industry and one of the reasons for moving to the electronic system.

Another concern is that if someone had stolen those strip bonds from him, the certificates could not have been replaced easily. Because they were stripped, the only option for his dealer would be to purchase the residuals on the open market from another dealer or create a new set of strip bonds, which means a new set of coupons would have to be sold.

In some cases, the entire issue was physically stripped, which would mean a purchase on the open market is the only option. In contrast, for regular bonds that are fully registered, there is a simple process to arrange for replacement certificates to be issued.

Frauds

Another real problem was that people would confuse the residuals (the bond minus the coupons) for the full bond. Some of the large Canadian banks and trust companies, and possibly individuals, were victims of frauds where someone would present a residual certificate as if it were the full bond certificate, and then borrow money against it.

For a $100,000 underlying bond maturing in 20 years, the residual might have been worth $20,000. If the bank loaned $75,000 against the certificate, the bank would end up with a loss of $55,000, as they would never see the person again. Examples of this were not widely reported, but were published in some newspapers at the time.

Storage of physical strip bonds

The handling of the physical strip bonds in the back office was a major issue. Hank mentions putting them into envelopes, which was one common way but made it difficult when doing certificate inventory counts.

One financial institution put them into sealed bubble packs, when they were immobilized, but these took up an enormous amount of space since each bubble was about an inch high. Another financial institution came up with the idea of using plastic sheets used for stamp collections, which made it easy to handle and file them and simplified the inventory count process.

I heard a story once of a financial institution that photocopied all their coupons, before putting them into envelopes. During this process, static electricity caused one coupon to stick to the cover of the photocopier and then it slid down behind the copier. It took quite a while before the coupon was eventually found there. (Fortunately, this was in a secure area.)

Humpty Dumpty

In 2002, CDS took direct custody of the remaining physical strip bonds. The Government of Canada physical strip bonds were shipped to the Bank of Canada for processing. For the other issuers, CDS undertook a massive project to actually reconstruct the actual physical certificates from the physical strip bonds.

As you can imagine, putting the pieces back together again is difficult. The traders' image of doing a Humpty Dumpty deal was truly appropriate here. Not only did CDS have to match the details on the underlying bond, but they also had to match the certificate number.

It was somewhat like a gigantic jigsaw puzzle with more than a million pieces, but done in a very high-security environment with security cameras and guards. Needless to say, it took a lot longer to reassemble the certificates than it did to cut them apart. CDS was successful to a large degree in this project and today the amount of physical strip bonds is less than 15% of its one-time peak.

Clarification

To clarify some points in the book,

the term "alter-ego receipt" as used in the legal documents is a certificate backed by physical strip bonds (either coupons or residuals). The certificates often can be exchanged for the actual coupons or residuals. TIGRs and some series of Cougars are of this type.
the term "non-alter-ego receipt" means a strip bond represented by a receipt or certificate which may be backed either 1) by future interest and principal payments on an underlying bond or 2) physical strip bonds (either coupons or residuals). In other words, a trustee or custodian holds the underlying bond or physical strip bonds and collects the interest and principal payments as they come due and then passes these payments on to the holders of the strip bonds. Sentinels and some series of Cougars are non-alter-ego receipts.
In these cases, the denominations of the strip bond certificates could vary from the value of the strip bonds, as long as the aggregate value was equal to or less than the value of the interest or principal payment that would be received from the corresponding interest or principal payment.
with the book-based or electronic stripping service offered by CDS today, there is no trustee involved. CDS acts as the custodian and record-keeper only, with an abundance of risk control mechanisms built in to the process, given that CDS holds almost $3 trillion in securities now.
there were a number of factors behind the move to an electronic system, primarily costs and risks. An industry committee, on which I served, summarized these reasons in a 1989 report. The committee recommended regulatory action since the main institutional players at the time were not making the switch away from physical strip bonds. Shortly after that report, the market began to move on its own and there was no need for regulatory action.

This move away from physical strip bonds was extremely positive for ordinary investors. Hank Cunningham discusses the economics of what makes it profitable for a trader to strip a bond or not, focusing on the interest rates. Traders also add on something for their processing costs when doing these deals.

I did some analysis of the costs back in the 1980's and early 90's, when the physical strip bonds were popular. For a trader stripping a $5 million bond maturing in 20 years, the costs of stripping the bond electronically were less than 10% of the costs of stripping the bond physically, representing a savings of more than $10,000 on a net present value basis. Doing the deal using a structure such as a Sentinel would add comparable costs. These costs would be recovered ultimately from investors. For investors, the move to electronic stripping brought much lower costs and risks.

Benefits of physical strip bonds

Yet for all the problems with physical strip bonds, I think that they did have one major benefit for the Canadian bond market that endures today. They provided a "competitor" for the book-entry stripping service that CDS offered, and for which I was responsible for several years. This forced CDS to improve its service so that it could handle all the same situations that were possible with physical strip bonds.

Without those improvements, traders basically said they would keep on creating physical strip bonds, despite the extra costs and risks. This perhaps says something about how large the profits from creating strips were back then, explaining why Hank and his colleagues did not mind the endless hours with their calculators. It also may suggest that the true costs for holding the strip bonds in safekeeping were not being allocated to the trading desk.

As a result, CDS began handling irregular coupons and callable bonds, introduced generic strip bonds (both coupons and residuals), strip bond packages, and other innovations that still make Canada a world leader in this market. As noted elsewhere on this site, the resulting service has added to the overall efficiency of the Canadian bond market.

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