Thursday, February 18, 2010

Stripping away the disguise of derivatives

Posted in the Financial Times by Satyajit Das:

Reaction to revelations that Greece used derivatives to disguise its true level of borrowing is reminiscent of Captain Renault (played by Claude Rains) in Casablanca: “I am shocked, shocked to find that gambling is going on in here.”

Use of derivatives to disguise debt and arbitrage regulations and accounting rules is not new. In the 1990s Japanese companies and investors pioneered the use of derivatives to hide losses – a practice called “tobashi” – “to make fly away”.

Derivatives, such as interest rate and currency swaps, are used to alter the interest rates 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) value 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 upfront 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. Any number of strategies involving combinations of different derivatives can achieve this effect.

Greece may be merely following the precedent of another Club Med member. In 2001 academic Gustavo Piga identified Italy’s use of derivatives to provide window dressing to meet its obligations under the European Union’s Maastricht treaty.

In December 1996 Italy used a currency swap against an existing Y200bn bond to lock in profits from the depreciation of the yen. Italy set the exchange rate for the swap at off-market rates – at the May 1995 level rather than the current rate.

Under the swap, Italy paid a rate of dollar Libor minus 16.77 per cent reflecting the large foreign exchange gain for the counterparty. Given Libor rates of 5 per cent, the interest rate paid by Italy was negative. The swap was really a loan where Italy had accepted an 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 per cent of GDP.

The Greek transactions are believed to be similar cross-currency swaps linked to the country’s foreign currency debt, structured with off-market rates. Analysts suggest that the cash received from the transactions may have reduced Greece’s debt/GDP ratio from 107 per cent in 2001 to 104.9 per cent in 2002 and lowered interest payments from 7.4 per cent in 2001 to 6.4 per cent in 2002.

Securitisation, non-consolidated borrowers, private-public financing arrangements supported indirectly by the state and leasing of assets can also be used to disguise levels of debt.

Although no illegality is involved, the arrangements raise important questions about public finances and financial products.

The episodes also raise questions of the skills of regulators and reporting agencies in understanding and dealing with complex 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 future repayment commitments. Under international standards applicable to corporations, such an off-market swap would have had to be accounted for on a mark-to-market requiring greater disclosure, especially the large negative market value (representing future payment obligations) as a future liability.

Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. The true cost to the borrower and profit to the counterparty is also not known, because of the absence of any requirement for detailed disclosure in derivative transactions.

Derivative professionals argue that the instruments are used to hedge and manage risk. While they do play this role, derivatives are now used extensively to circumvent investment restrictions, accounting rules, securities and tax legislation.

Current proposals to regulate derivatives do not focus on this issue. The policy case for permitting such applications is not clear.

As the so-called Greek Job highlights, simple borrowing and lending can be readily disguised using derivatives, exacerbating risks and reducing market transparency.

Regulators need to heed the warning of the 17th-century French author Francois de La Rochefoucauld: “We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.”

Satyajit Das is the author of the recently released “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”

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