By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).
In his “Ode on a Grecian Urn”, the English Romantic poet John Keats declared that “beauty is truth, truth beauty”. In derivatives, its seems transactions may be “beautiful” but are frequently not “truthful”.
Advocates of derivatives argue that derivatives are primarily used to hedge and manage risk. In order to do this, derivatives, such as interest rate and currency swaps, are used to alter the nature and currency of the cash flows on existing assets or liabilities. Transactions entail exchanges of one stream of payments for another. At the commencement of the transaction, if the contract is priced at current market rates, then the current (present) vale of the two sets of cash flows should be equal (ignoring any profit). The contract has “zero” value – in effect, no payment is required between the parties.
Using artificial “off-market” interest or currency rates, it is possible to create differences in value between payments and receipts. If the value of future payments is higher than future receipts, then one party receives an up-front payment reflecting the now positive value of the contract. In effect, the participant receives a payment today that is repaid by the higher than market payments in the future – identical to the characteristics of a loan. Any number of strategies involving combinations of different derivatives can achieve this effect.
In the 1990s, Japanese companies and investors pioneered the use of derivatives to hide losses – a practice called “tobashi” (from the Japanese, tobasu, the verb, means “to make fly away”). Since then, the use of derivatives to disguise debt and arbitrage regulations and accounting rules has increased.
In 2001, academic Gustavo Piga identified the case of an unnamed European country, that everyone assumed was Italy, using derivatives to provide window dressing to meet its obligations under the European Union (EU) Maastricht treaty. There were accusations and counter accusations. The report vanished from the International Securities Market Association (ISMA) web site.
It appeared that in December 1996, Italy used a currency swap against an existing Yen 200 billion bond ($1.6 billion) to lock in profits from the depreciation of the Yen. The swap was done at off-market rates with Italy setting the exchange rate for the swap at the May 1995 level rather than the rate at the time of entering the contract.
Under the swap, Italy paid a rate of dollar LIBOR minus 16.77% reflecting the large foreign exchange gain built into the contract for the counterparty. Given that LIBOR rates were around 5.00%, the interest rate paid by Italy was negative. In effect, the swap was really a loan where Italy had accepted an off-market unfavourable exchange rate and received cash in return.
The payments were used to reduce Italy’s deficit helping it meet the budget deficit targets of less than 3% of GDP (gross domestic product). Between 1996 and 1997, Italy had cut its budget deficit from 6.7% to 2.7% to meet the EU target. The suspicion was that, well, it hadn’t exactly cut the deficit but, among other things, it had used derivatives to provide window dressing. There were suspicions that other EU countries also used similar structures to fiddle their books to meet the Maastricht criteria.
A key element of the recent Greek debt problems has been the use of derivative transactions to disguise the true level of its borrowing.
The Greek transactions undertaken with Goldman Sachs and other dealers are believed to be similar cross-currency swaps linked to the country’s foreign currency debt, structured with off-market rates. The swaps are believed to have notional principal of approximately $10 billion with maturities between 15 and 20 years. The transactions were structured to provide Greece with funding.
More recently, similar structures have emerged in Latvia where Deutsche Bank arranged a 567 million lati ($1.086 billion) financing for Riga in June 2005 using a series of contracts, augmented with currency and credit default swaps. The bank is alleged to have claimed that the transaction would not count as debt.
This follows a series of revelation regrading the use of derivatives by municipal authorities in the U.S., Italy, German, Austria and France where complex bets on interest rates were used to provide funding or cosmetically lower borrowing costs. Many of these transactions resulted in substantial losses and are now in dispute.
Other financial products can also be used to reduce the level of reported debt. These include securitisation of future public sector receipts, the use of non-consolidated borrowing institutions, private-public financing arrangement supported indirectly by the State and leasing rather than direct ownership of assets. Greece may have also used some of these arrangements.
Whether illegality is involved has not been established. However, at a minimum, the arrangements raise important questions about public finances and financial products.
The episodes raise questions of the skills of regulators and reporting agencies in understanding and dealing with financial structures. They highlight inadequacies of public accounting.
Reported debt statistics fail to provide adequate information of the level of borrowing, the real cost of debt and also the future repayment commitments. Under international standards, such an off-market swap would have had to be accounted for by public corporations on a mark-to-market requiring greater disclosure of the details, especially the large negative market value (representing future payment obligations) as a future liability.
For example, the real effect of the Greek transaction is not clear. Analysts suggest that the cash received from the transactions may have reduced the country’s debt/GDP ratio from 107% in 2001 to 104.9% in 2002 and lowered interest payments from 7.4% in 2001 to 6.4% in 2002. However, the large negative market value of the currency swaps (representing future payment obligations) does not appear to have been reported as a future liability for Greece.
Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. For example, in the Greek swaps, these costs include charges for counterparty credit risk in the swap and hedging costs for the interest rate and currency risk. In addition, the cash bears a higher rate than the normal credit margin on the sovereign’s debt. In part, this reflects the premium for an illiquid loan compared to a more liquid, tradeable conventional bond.
The true cost to the borrower and profit to the counterparty is also not known, due to the absence of any requirement for detailed disclosure in derivative transactions. Goldman Sachs and other dealers reputedly earned hundreds of millions of dollars from these transactions.
The structures described as also used extensively to cover up existing losses on other transactions. Such arrangements are not unknown in Indian markets where participants with loss making positions have resorted, knowingly or unknowingly, to such techniques to avoid recognising the problem.
Normal commercial transactions can be readily disguised using derivatives exacerbating risks and reducing market transparency. Current proposals to regulate derivatives do not focus on this issue. The policy case for permitting these types of applications of derivatives is not clear.
Such derivative schemes are neither “beautiful” nor “true”. Legislators and regulators should perhaps ponder these issues.