What Is a Discount House?
In the financial world, a discount house is a firm that specializes in trading, discounting, and negotiating bills of exchange or promissory notes. Its transactions are generally performed on a large scale with transactions that also include government bonds and Treasury bills.
Also known as bill brokers, discount houses primarily operated in the United Kingdom, playing a key role in the financial system there until the mid-1990s. They no longer exist as separate financial institutions, though some still remain in India and other nations.
- Discount houses are financial institutions that act as money lenders, or serve as intermediaries between commerical lenders and borrowers, trading in various short-term securities and instruments.
- Mainly located in the U.K., discount houses once provided a ready secondary market, thus ensuring liquidity in the British monetary system. The Bank of England often operated through discount houses to help regulate the money supply, set interest rates, and extend credit to commercial banks.
- By 2000, British discount houses largely ceased to exist as separate financial institutions.
Understanding a Discount House
Originating in the 1820s, discount houses once sat at the heart of London’s money market system. They served in effect as money lenders that participate in the buying and discounting of bills of exchange and other financial products such as money market securities, certain government bonds, and banker's acceptances (BA). By providing a ready market for short-term government-guaranteed securities and other money market instruments, and discounting short-term obligations for other financial institutions in need of funds, they provided liquidity in the secondary money market.
A discount house specialized in discounting short-dated financial securities and acted as an intermediary between a lender and a borrower, negotiating the purchase of various certificates of deposit (CDs), commercial paper, and other money market instruments mentioned above at less than par value. Through these short-term securities, they borrowed funds from commercial banks at a rate below the market rate and lend these funds to borrowers at a slightly higher rate. The interest rate differential constituted a profit for the discount house.
Discount Banks and Financial System
The Bank of England (BoE) dealt directly with the discount houses to counteract shortages of day-to-day funds and credit in the interbank market. To regulate the money supply in the economy, the Bank conducts open market operations which involve expanding or contract the volume of assets held with the Bank. It once did this exclusively by offering loans to discount houses through commercial paper or government-backed securities.
The discount houses used the loans to purchase money market securities from commercial banks, thereby enabling these banks to meet their temporary needs for loanable funds or for cash reserves. In so doing, the discount houses acted as intermediaries between the central bank and the commercial banking system in England. By increasing or decreasing the discount rate—the rate at which the central bank lends reserves to its banking system—the Bank of England can control the cost of borrowing and, in effect, the money supply.
A discount house did not necessarily have to borrow funds from the central bank first to provide loans to commercial banks, however. It also functioned in the reverse scenario. Banks in need of funds wouldl sell commercial paper to the discount house, which took a small spread from the transaction. These bills would be sold to institutions with surplus cash, which provided the funds to be loaned. In turn, the Bank of England rediscounted the bills for the discount house and, thus, maintained a direct link with the money market and the prevailing interest rates in the economy.
Decline of the Discount House
Originating out of an informal network of bill brokers, who purchased bills of exchange and sold them to the Bank of England, the discount house system was formally set up in Britain after the financial crash of 1825. It remained virtually unchanged for 150 years. There were 12 discount houses, all based in the City (London's financial district), and they had a monopoly on daily dealings with the Bank of England in bills of exchange and, to a lesser extent, in gilts (British government securities, similar to U.S. Treasury bills and bonds).
Electronic trading, the launch of derivatives markets, and the growth in the repo market began to provide competition for discount houses' services in the early 1980s. But their death knell was sounded in the mid-1990s, when the Bank of England began radically restructuring the way it set interest rates and regulated the money supply. In 1996, it ended the privileged position of the discount houses by opening up dealings in short-term money market instruments to a wide range of banks, building societies, and securities firms, based both in Britain and abroad.
Within two years, almost all the discount houses ceased to exist.
The last discount house to close was Gerrard & King in November 2000.
All of Britain's international banks now have major treasury departments, which trade government bonds and instruments on a pan-European basis.
In the United States, a discount house refers to a large retail store that can offer consumer durables at below regular list prices, because of its ability to purchase in bulk and employ expense-controlling practices.