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Essay on Investment Theory: Continued

Uncontrollable Risk

No Planning, No Control

The derivatives markets are not planned by government and new instruments are invented at a feverish pace, without prior regulatory clearance.

Complexity grows faster than authorities or accountants can issue rules or guidelines.

Complexity grows faster than the authorities or accountants can issue rules or guidelines.

In the U.S., there is a bureaucratic turf war as to whether derivatives should be regulated as a commodity or as a security.

Much of the derivatives market has no supervision at all, since counterparties are situated in other countries, often in offshore financial centers.

A partial list of the names and acronyms used by derivative traders suggests the intricacy of this market:

American options, arrears swaps, Asian options, basis swaps, bear spreads, bearer Eurodollar collateralized securities (BECS), bearer exchange rate options (BERO), Boston options, break forward contracts, bull spreads, butterfly spreads, call options, callable swaps, caps with amortizing accreting schedules, captions, circus swaps, Citiplus contracts, commodity futures, commodity options, commodity swaps, compound options, contingent swaps, convertible option contracts, covered calls, covered warrants, cross currency warrants, currency coupon swaps, currency futures, currency options, currency swaps, cylinder options, debt-equity swaps,


deferred premium options, deferred caps, deferred swaps, detachable warrants, double options, drawdown swaps, European options, exchange rate agreements (ERAs), export tender risk avoidance contracts (EXTRAs), extendible swaps, fixed rate currency swaps, floortions, foreign exchange agreements (FXA), forward breaks, forward commodity contracts, forward foreign exchange contracts, forward contracts, forward rate agreements (FRAs), forward reverse options, forward spread agreements (FSAs), forwards with optional exits (FOXs), forwards with rebates, forward-forward deposits, futures contracts, Gensaki contracts, income warrants, interest rate caps (CAPs), interest rate collars, interest rate floors, interest rate futures, interest rate guarantees (IRGs), interest rate options, interest rate swaps, long dated forward rate agreements (LDFRAs), long straddles,

Parlez vous: swaps, options, puts, warrants, futures, swaptions, straddles, caps, spreads, calls, floortions, breaks, collars, tenders, synthetics, forwards?

look back options, matched REPOs, money back warrants, naked warrants, participating forward contracts, participating rate agreements (PRAs), principal only swaps, put options, puttable swaps, puttable warrants, quantity adjusting options (QUANTOs), range forward contracts, repurchase agreements (Repos), reset swaps, reverse REPOs, seasonal caps, securities transferred and repackaged into (STRIPES), securities transferred repackaged (STARs), serial FRAs, strip FRAs, shared currency option tenders (SCOUTs), shared option forward agreements (SOFAs), short straddles, simple hedges, stock futures, stock index futures, stock index options, swaps, swaptions, synthetic agreements for foreign exchange (SAFEs), synthetic futures, synthetic securities, tenders to contract options (TTCs), trust obligation participating securities (TOPS), warrants, window warrants, zero cost options, zero cost ratio options (ZECROs), and zero coupon swaps.

When over one hundred hedging arrangements are combined with hundreds of thousands of varieties of underlying assets (currencies, stocks, asset-backed securities, bonds, loans, commodities) and further complicated by joining multiple legs of a series of derivative transactions to form new instruments, the complexity of the market becomes truly infinite and the risks unknowable.

Sloppy Operations, Confused Trading

The OTC markets in derivatives are far from fair and orderly.

Unlike the organized exchanges, there is no central clearing house to demand and enforce collateral and to manage credit risk.

At the millennium, the back offices of the banks and dealers were sloppy and poorly managed. In 2000, the International Swaps and Derivatives Association (ISDA) published its first survey of dealer's back office practices (6), revealing an imperfect market.

Although derivative traders deal in standardized contracts, there is a high degree of customization in individual trades.

The OTC derivatives markets are far from fair and orderly.

Consequently, the ISDA study found a lack of uniform trade characteristics and terminology that led to disagreement among counterparties on such vital matters as cash settlement, early termination, and intervening events that changed the initial contract.

Furthermore, almost all agreements were verbal, later confirmed only by an exchange of forms.

The confirmation process was slow, inaccurate, and almost never resulted in a contract signed by both parties to show a meeting of the minds.

About forty percent of trades went unconfirmed for more than thirty days, and thirteen percent were still not formally agreed after three months.

The error rate on trades averaged twenty four percent and mistakes were concentrated in material aspects of the contracts such as the name of the counterparty, the method of payment, and the terms of settlement.

Eighteen percent of trades had to be rebooked.

On any day, the global notional value of trades in substantial dispute ran about seven hundred billion dollars!

A Destabilizing Force

Derivatives have a legitimate function of transferring risk in commodity, exchange, and loan markets from those who want to limit losses when prices fall to those who want to diminish the risks they would face should prices rise.

However, banks and hedge funds that speculate in this market for their own account are neither true insurers nor providers of liquidity, as their apologists claim.

Derivatives are not true insurance because most currency and interest rate risk cannot be diversified.

Unlike risk in traditional insurance markets, most currency and interest rate risk cannot be diversified, nor does liquidity of OTC derivative contracts hold up in a crisis, as LTCM was to find out in 1998.

During the Asian debacle, Mohammad Mahatir, the prime minister of Malaysia, railed against George Soros and hedge funds as destabilizing forces in the global market.

He was regarded as an uninformed scold by the intellectual financial elite, which included members of the Financial Economists Roundtable with links to LTCM and the U.S. Federal Reserve.

However, although he was right about some hedge funds, he did not target the bigger and more significant cause of instability, the giant international banks that themselves were playing the same speculative game as LTCM and Soros.

Lessons from Java

The inability of the derivative markets to serve as effective protection against drastic currency and interest rate movements was one of the lessons of the Asian crisis.

In 1997, the exchange rates and credit of a number of Asian countries collapsed, resulting in massive defaults on international bank loans and throwing economies with hundreds of millions of people into depression and poverty.

The Asian crisis made clear that there were systemic weaknesses in the international financial system, without bringing consensus as to exactly what these weaknesses were.

Indonesian business people, like executives in the U.S., used bank loans when equity would have been more appropriate.

The case of Indonesia illustrates this point.

Because of a long history of steady, fast economic growth, Indonesia had earned the praise of economists at the World Bank and the International Monetary Fund.

Foreign bankers were eager to loan to corporations and banks in this booming economy.

Tax laws in Indonesia, as in the U.S., favored debt over equity and commercial banks had long abandoned any preference for short-term, self-liquidating loans.

Consequently, Indonesian business people, like executives in the United States and elsewhere, became accustomed to using bank loans when equity would have been more appropriate.

Dollar Loans as 'Capital'

Bank Indonesia – the central bank of the country – had consistently defended the Rupiah against the dollar, allowing gradual devaluation of three to five percent per year to compensate for relative rates of inflation.

Bank Indonesia had twenty billion dollars in reserves to protect the currency and, on the eve of the crisis, the IMF, the Wall Street Journal, and Standard and Poor's gave Indonesia high marks for economic stability.

In early 1997, foreign banks were lending dollars to Indonesian businesses at an annual rate of about ten percent, whereas Rupiah loans cost eighteen percent.

Dollar loans seemed 'cheaper' than borrowing in Rupiah.

The expected devaluation of the Rupiah of two to five percent, added to the ten percent cost of a dollar loan, seemed cheaper than the cost of borrowing in Rupiah.

As a result, most Indonesia banks and businesses had substantial liabilities denominated in U.S. dollars and other hard currency.

Earlier in 1997, Korea and Thailand had been hit by severe foreign exchange problems and fell on hard times as the dollar dropped and foreign loans could not be repaid.

This naturally caused pressure against other Asian currencies, including the Indonesian Rupiah.

Advice from the Berkeley Mafia

Rather than use its twenty billion in dollar reserves to defend the currency, the IMF, the World Bank, and powerful Indonesian economists (known as the Berkeley Mafia) all demanded that Bank Indonesia save its dollars and let the Rupiah fluctuate freely.

This conformed to the popular notion that free markets were always better than controlled markets.

Unfortunately, before making this recommendation, none of these experts had done their homework.

Unfortunately, the experts had not done their homework.

In 1997, the majority of Indonesian borrowers did not earn dollars through exports and could only pay loans by buying dollars on the market.

The fact that Indonesian banks were heavily indebted in dollars was evident in Bank Indonesia's own statistical reports.

However, the financial authorities did not think to check with either banks or Indonesian debtors to see if these loans had been hedged against currency risk.

Bank Indonesia floated the Rupiah without enough information about the massive unhedged dollar debt outstanding.

They knew, however, that Bank Indonesia's twenty billions in dollar reserves were only a drop in the ocean, compared to the trillion dollars traded daily in the foreign exchange markets.

The Indonesian Economy Collapses

No central bank, other than the U.S. Federal Reserve, can long withstand a shift in world opinion as to the value of their national currency against the dollar, and Indonesia was no exception.

Indonesian borrowers had not purchased dollar calls to hedge the exchange rate risk on their loans because the risk premium on the Rupiah was high and foreign banks did not insist that clients protect themselves against currency devaluation to assure repayment.

If currency insurance had been demanded, foreign banks would have not been able to make the loans, because local Rupiah borrowing would have been cheaper.

The risk premium on the Rupiah was so high that borrowing in Rupiah would have been cheaper than currency insurance.

Furthermore, since the international banks were also the principal vendors of currency insurance, if banks sold both dollar loans and Rupiah insurance, they might just as well have made loans at a higher rate in Rupiah to simplify the process.

When Bank Indonesia suddenly declared that it would allow the Rupiah to float, debtors rushed to buy cover for dollar debt.

However, like homeowners trying to purchase insurance when hurricane flags are already flying, it was too late.

The derivatives market for Rupiah-dollar insurance dried up and spot markets crashed, driving most major Indonesian companies and banks into default.

The foreign banks, in turn, refused to roll-over dollar loans that were unwisely being used as capital, and the Indonesian economy fell apart.

The Illusion of Currency Risk Insurance

The Asian crisis exposed the essential flaw in arguments that derivatives are efficient insurance against currency and interest rate risk.

Unlike real insurance, which becomes more secure as more lives or homes are covered, there is no similar law of large numbers at work in the derivatives market.

Exchange rate derivatives present non-diversified risk From a macro view, derivatives are not true insurance. Risk portfolios cannot be diversified.

Whereas a few Indonesian borrowers might be able to gain protection against dollar devaluation, if all were to do so, the premiums would become prohibitively expensive.

The economists did not seem to understand that if all Indonesian borrowers had been hedged, not only would there have been no exchange crisis, but there also would have been no preceding economic boom based on bank loans, because the cost of foreign borrowing would have been too high.

Capital, in the hazardous form of bank loans, would not have been forthcoming.

Precursors of the LTCM Collapse

Throughout the 1990s there were rumblings of danger in the derivatives market.

Procter and Gamble, Orange County, Barings Bank, and Sumitomo Corporations were signs of deeper problems.

Procter & Gamble and Bankers Trust

On October 27, 2020, Procter & Gamble filed suit against Bankers Trust for fraud and racketeering in transactions in equity swaps that had produced a one hundred million dollar loss.

Their suit laid bare the moral hazards associated with OTC derivative trading. Banks with proprietary trading desks in derivatives have a natural conflict of interests with clients.

The P&G suit lay bare the moral hazards in OTC derivative trading.

Traders inevitably end up with positions they don't want and resort to high pressure selling to unload these positions on trusting clients so as not to miss performance targets.

This gives clients who are not financial intermediaries, like Procter & Gamble, an opening to allege fraud when their bets turn sour.

Bankers Trust, a pioneer in the OTC derivatives market, survived the financial cost of the P&G suit, but later succumbed to the same market pressures that downed LTCM following the Russian bond default in 1998.

Bankers Trust no longer exists, having been swallowed by Deutsche Bank.

Orange County and Merrill Lynch

In December 1994, Orange County, California, announced losses of $1.5 billion on a portfolio they were managing for other municipalities.

Merrill Lynch was raising capital for LTCM while still embroiled in the Orange County scandal.

The problem was a grave misunderstanding of the risks associated with a type of derivative called 'inverse floaters' that had been sold to them by Merrill Lynch.

The county eventually filed for bankruptcy under article nine of the code, reporting total losses of over two billion of taxpayers' dollars.

However, by the time the Orange County scandal had reached the headlines, Merrill Lynch had almost completed its project of raising money for Long Term Capital Management.

Nick Leeson and Barings Bank

Two months after the Orange Country affair, unauthorized trading in equity index derivatives brought down Barings Bank, with an estimated loss of $1.4 billion, an amount equal to the entire capital of the bank that held the Queen's accounts and that had been the pride of the City of London for generations.

The Barings case showed not only the problems that could arise from inadequate internal controls and casual audit procedures, but gave signs of growing ethical ambiguity in international banking.

The Barings case gave signs of growing ethical ambiguity in international banking.

Nick Leeson, the rogue trader who blew up Barings, had, according to Singaporean investigators, lied to the English government when registering with the Securities and Futures Authorities.

At the time, this was dismissed by Barings executives as of no importance and Leeson was given a mandate to trade derivatives in the name of the bank.

Mr. Leeson later went on to lie again to the licensing authorities in Singapore, as well as to the auditors and managers of Barings, but this was not discovered until after the bank folded.

Essay: continued >

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