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.
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“The policy case for permitting these types of applications of derivatives is not clear.”
Au contraire, it is abundantly clear. It is the *policy* of politicians not to impede the fraudulent but profitable dealings of the financial types who bought and paid for those politicians. Das writes as if we are living under something other than a kleptocracy.
I fear Martin Armstrong is unfortunately correct in this instance. Our politicians are not interested in fixing anything, not interested in a policy case to prevent disaster. After it blows up and the politically-connected folk are bailed out (again), they will appoint a commission to determine a cause for the crisis, which ultimately pronounces, “Hoocoodanode?”
Agreed.
All markets are now so corrupted there’s no way back. What’s interesting to think about (war-game) is even IF the Kleptocracy wanted to reestablish a market economy, what process could be used that wouldn’t result in a complete panic in the existing casino? And, once a society’s peasants adopt into the sociopathic economic system how does one revert them back?
I’m always amazed when people “wonder” why “spreading freedom n democracy” is so hard. As tho it’s a process like growing tomatoes: Just plant the freedom tree and water. Grows like magic.
SO, there’s no way back. All that matters is how long the illusion can continue. The Soviet Union lasted ~70 years. Japan has had a 20 year illusion.
It’s really amazing to witness.
“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.
Normal commercial transactions can be readily disguised using derivatives exacerbating risks and reducing market transparency…
Such derivative schemes are neither “beautiful” nor “true”…”
Whoa…wait a minute. You’re not implying that derivatives have been used to obfuscate things are you? Why how dare you… I’m taking my bat, ball and jegyar and going home…hmmph!!!
“Such derivative schemes are neither “beautiful” nor “true”. Legislators and regulators should perhaps ponder these issues.”
Legislators and regulators are neither “beautiful” nor “true”. Perhaps you should ponder these issues before you suggest they ponder phony derivative scams.
You are either drinking the Kool aid or selling it.
Deception is the strongest political force on the planet.
As far as sovereign chicanery is concerned, derivatives are but a pimple on the landscape…how about tackling unfunded pension obligations first
You’d have to tackle the fiat currency before that.
The ultimate problem is: how do you keep the sociopaths from winning.
(Of course, you can’t. If you could human history would be totally different.)
Not really surprised, a lot of corporate concerns resort to off-balance sheet transactions specifically engineered to avoid awkward figures appearing on their balance sheet. Will not be surprised if our great financial minds thought it was a good idea to “disguise” the transactions to make things look like they are improving, it really is for the good of the “erm” panic-prone populace and of course the dear financial entities that are too big to collapse.
“a lot of corporate concerns resort to off-balance sheet transactions specifically engineered to avoid awkward figures appearing on their balance sheet.”
Is that from your personal experience? If so, how do the issuers get away with it?
The author above says-
“Normal commercial transactions can be readily disguised using derivatives exacerbating risks and reducing market transparency”
This seems to imply that the auditors aren’t being giving information about all of the exposures on the outstanding derivative contracts at year end. As a matter of fact, it sems it could be virtually impossible for an auditor to detect derivative exposures, especially if the derivative contract was created with a counterparty with which the company otherwise does not transact business.
Any thoughts from your perspective?
(a) Derivatives make traditional notions of accounting hopelessly obsolete. To pretend that a static balance sheet can convey any useful information about the financial health of an economic unit that deals with derivatives is naive.
(b) With these abstract financial entities notions of capital structure, the difference between debt and equity becomes obliterated. Financial regulations become impossible to enforce; default events become almost meaningless.
There is no denying that financial risk management requires some kind of market in abstract financial products. But it is also clear that these abstract financial products have for the most part been put to no good use and have served mainly as tool for obscuring the poor financial health of organizations and for enriching the persons marketing them.
Here’s the missing paper..
http://www.zerohedge.com/sites/default/files/Derivatives%20and%20Public%20Debt%20Management.pdf
Thanks Tyler ..
Derivatives can distort reality. Bingo! What a thought.
Mr. Das, QE and QE-2 have done more to distort reality than all the derivative contracts ever written.
HAMP, HARP and 125% FHA ReFi are more a bastard then anything Wall Street ever dreamed of.
The ECB is buying up Greek, Spanish and Irish bonds. We have an official “Dirty Float”.
The Swiss Central bank spent half a year of GDP to artificially support its currency. You should look at Italian derivatives in that light.
China is manipulating its currency and its economy in ways that are no less than shocking. And you are worried about some OTC derivatives.
I could go on but you get the point. Derivatives are not our problem. Government policies create far more distortions then they ever will.
bk
Perhaps someone on this website could comment on Betty Jensen’s defense of derivatives for farmers, recently published in the New York Times:
http://www.nytimes.com/2010/08/11/opinion/11jensen.html?ref=contributors
What do the NC bloggers think of her arguments?
It would be helpful to know the history of derivatives. Wasn’t Roosevelt’s “ever normal” grain supply another solution to the same problem of volatile farm prices? How do other countries insulate farmers from ups and downs?
Sorry to sound like an ass, but doesn’t Mr Das remember that Enron collapsed (more than a decade ago) precisley because the business he describes as it relates to sovereigns, was a key IB profit center more than a decade ago. As a refresher, go back and look at the global banks earnings reports in 99-00. Structured credit (Enronesque) was THE profit center for most.
The surprise here is that the fundamental tool (exploiting ISDA protocols to mask loans as swaps) was never shut down post Enron. Instead the tool survived and turned up in the form of CDOs/CDS and their spawn.
A similar fate is in store for us with ETFs and Commodity derivatives until the ISDA protocols lose their pride of place in modern finance.
Exhibit A- Total Return Swaps. These are the instruments used by the banks to hide their RMBS exposures. Perfectly legal, but Why?? Why are ISDA protocols financial law?
ETFs are portfolios of TRS.
While its useful to understand ancient applications of swap technology (i.e sovereign shenanigans), its probably more useful to explore the implications of the current expanded and widespread current use of that ‘technology’ and focus our attention on the role of powerful extra-regulatory bodies {ISDA) that impede regulators.
Derivatives reform discussion absent any check (or sunlight on) ISDAs role is whistling past the graveyard.