In his Ode on a Grecian Urn, the English Romantic poet John Keats declared: “Beauty is truth, truth beauty.” In derivatives, especially the recent Greek case, it seems transactions may be “beautiful”, but are frequently not “truthful”.
Advocates of derivatives argue that they are primarily used to hedge and manage risk. 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 start 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 then has “zero” value—in effect, no payment is required between the parties.
Illustration: Jayachandran / Mint
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. That means that that party receives a payment today which it will repay with higher-than-market payments in the future—identical to the characteristics of a loan.
There’s now a history to this. 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”). In 2001, academic Gustavo Piga identified the case of an unnamed European country, that everyone assumed was Italy, using derivatives for window dressing to meet its obligations under the European Union’s (EU) Maastricht treaty—this agreement mandates budget deficits at 3% of gross domestic product (GDP).
It appeared that in December 1996, Italy used a currency swap against an existing ¥200 billion ($1.6 billion) bond 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, the interest rate paid by Italy was negative, in effect making it a loan where Italy accepted an off-market unfavourable exchange rate and received cash in return.
The payments were used to reduce Italy’s deficit, helping it meet Maastricht targets. Between 1996 and 1997, Italy had cut its budget deficit from 6.7% to 2.7% of GDP to meet EU criteria. The suspicion was that it hadn’t exactly cut the deficit but, among other things, it had used derivatives for window dressing.
A key element of the recent Greek debt problems, too, has been the use of derivative transactions to disguise the true level of borrowing, again to meet EU mandates. 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 involve a notional principal of approximately $10 billion with maturities of 15-20 years.
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 such contracts. This follows a series of revelations regarding the use of derivatives by municipal authorities in the US, Italy, Germany, Austria and France. Many of these transactions resulted in substantial losses and are now in dispute.
Whether illegality is involved has not been established. However, at a minimum, the arrangements raise important questions about public finances and financial products. They also raise questions about the skills of regulators and reporting agencies in understanding and dealing with such structures. Most of all, they highlight inadequacies in public accounting.
In these cases, reported statistics fail to provide adequate information of the real cost of debt and 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 basis, requiring greater disclosure of the details—especially noting the large negative market value (since the participant owes future payments at higher-than-market rates) of the derivative 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-to-GDP ratio from 107% in 2001 to 104.9% in 2002 and lowered interest payments from 7.4% of GDP 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.
In the long term, such arrangements actually increase costs for the sovereign borrower, compared with traditional debt. In the Greek swaps, these costs include charges for counterparty credit risk and hedging costs. 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 are 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 disclosing—or even recognizing—the problem. Thus, normal commercial transactions can be readily disguised using derivatives, exacerbating risks and reducing market transparency. Current global proposals to regulate derivatives unfortunately do not focus on this issue despite the fact that the policy case for permitting these types of applications of derivatives is not even clear.
Such derivative schemes are neither “beautiful” nor “true”. Now that India is back on the financial sector reform path, legislators and regulators should perhaps ponder these issues while they consider market deregulation.
Satyajit Das is a risk consultant and the author of Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives (revised edition, forthcoming May). Comments are welcome at firstname.lastname@example.org