Monday, May 4, 2015

Negative Interest Rates and the Definition of Security

In some European countries, bank interest rates have dropped below zero. (See here and here.) That’s right; it actually costs you to put your money in the bank. You put $1,000 in a savings account and the bank promises to pay you, say, $999, in a year.

I came of age in the Gerald Ford/Jimmy Carter years, when annual inflation rates were in the double digits. Whip Inflation Now!  (Yes, children, I’m ancient.) I find it almost unbelievable that nominal interest rate (and bond yields) could drop below zero.

That hasn’t happened in the United States (yet), but what if it did? Set aside the huge macroeconomic issues, and let’s focus on a topic of greater interest to the readers of this blog—the effect on federal securities law, particularly the core notion of what constitutes a security.

The most important case in defining the scope of federal securities law is probably SEC v. W.J. Howey Co., 328 U.S. 293 (1946).  Howey says that an investment is an investment contract, and therefore a security, if people invest money in a common enterprise with an expectation of profits coming from the efforts of others.

The “expectation of profits” part of the Howey test is the problem in a negative-interest-rate economy. Assume, for example, that an entrepreneur asks people for money to start a business and promises to return that money, without interest, in two years. In other words, you put in $1,000 and he’ll pay you back $1,000 in two years.

That investment would not ordinarily be treated as a security because there’s no profit. That’s how the Kiva crowdfunding site,  which is based on no-interest lending, can avoid federal securities law. But, in a negative-interest world, a mere return of your principal is, in effect, profitable. Considering your opportunity cost, you come out ahead.

If we ever have negative interest rates and the courts hold that no-interest investments are securities, remember that you read it here first.

C. Steven Bradford, Financial Markets, Securities Regulation | Permalink


This is fascinating. And you know, it has happened in the US, briefly, for Treasuries - a few times since the crisis, I think.

Posted by: Ann Lipton | May 4, 2015 6:26:22 AM

Interesting post, Steve. I would expect that no-interest debt issued at an original issue discount would raise the same issue. Have you seen anything on that?

Posted by: joanheminway | May 6, 2015 6:11:49 PM


Setting aside the question of whether Reves rather than Howey would apply if this really was debt, I think the answer to your question is easier. If there's an original issue discount, then the issuer is clearly offering interest. I don't think the nominal principal amount and interest rate are important. If the investor is paying $900, and the issuer will pay back $1,000, that's profit.

The question I pose in the post is harder, where the issuer is selling the debt for $1,000 and only offering $1,000 on maturity, but in a world where everyone else is offering negative interest rates.

Posted by: Steve Bradford | May 7, 2015 5:39:39 AM

Absolutely, Steve. You are taking on a more difficult issue. But your post did get me thinking. And I have never seen anything on the OID issue and the "what is a security?" question.

Of course, you also raise a good point about the Reves test likely being the applicable definitional rubric if the security really is debt. The reasonable expectations of the investing public who would buy OID debt would be that the debt is a security, I would think. So, assuming all other factors point to security status, it's probably (as you suggest) a no-brainer.

Anyway, thanks for making me think.

Posted by: joanheminway | May 7, 2015 10:44:12 AM

Steve, I follow your logic, though I wonder if the ability to put your money under your mattress at the same "return" cuts against your conclusion.

Posted by: Haskell Murray | May 7, 2015 11:41:21 AM


I don't think so, because the mattress wouldn't meet the other requirements to be an investment contract. Putting the money in a mattress in a negative-interest-rate world is no different from earning a return on your own in a positive-interest-rate world. In both cases, it's your own efforts producing the "profit."

Posted by: Steve Bradford | May 7, 2015 12:05:31 PM

Understand that the mattress wouldn't meet the other requirements. I was trying to get at the underlying policy. Why do you think 0% investment, like Kiva, are excluded now?

Not my area, so thanks for engaging.

Posted by: Haskell Murray | May 7, 2015 1:08:43 PM

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