Settling derivatives trades
Trades in the over-the-counter derivatives market are settled through the banking system, according to standards established by each country’s banking authorities. Central bankers, under the aegis of the Bank for International Settlements in Basel, Switzerland, have made a concerted effort to reduce the time within which the parties to a derivatives transaction must exchange contracts and money. Given the magnitude of derivatives positions, the failure of a major bank with many unsettled trades could cause the immediate failure of the banks with which it has been trading. Market forces have mitigated this risk to some extent, as banks are increasingly reluctant to trade with other banks whose creditworthiness they suspect; the weakness of Japanese banks in the late 1990s and early 2000s, for example, forced many of them to retreat from the market. Despite these advances, banking experts still consider unsettled derivatives trades to be one of the main factors that could threaten the stability of the world’s banking system, and regulators continue to push banks to settle trades more quickly.
Derivatives disasters
Derivatives have made it possible for firms and government agencies to manage their risks to an extent unimaginable only a decade ago. But derivatives are far from riskless. Used carelessly, they can increase risks in ways that users often fail to understand. As individual derivatives can be quite complex and difficult to comprehend, they have been blamed for a series of highly publicised financial disasters. In some cases, the dealers have been accused of selling products that were not suited to the users’ needs. In other situations, the problem has been not with the instruments themselves, but with the financial controls of the organisation trading or using them.
Metallgesellschaft, a large German company with a big oil-trading operation, reported a $1.9 billion loss in 1993 on its positions in oil futures and swaps. The company was seeking to hedge contracts to supply petrol, heating oil and other products to customers. But its hedge, like most hedges, was not perfect, and declines in oil prices caused its derivative position to lose value more rapidly than its contracts to deliver oil in future gained value. The company’s directors may have compounded the loss by ordering that the hedge be unwound, or sold off, before it was scheduled to expire. Procter & Gamble, a large American consumer-products company, and Gibson Greetings, a manufacturer of greeting cards, announced huge losses from derivatives trading in April 1994. If the resulting number is positive, the dealer must make a payment to the user. As interest rates rose early in 1994, however, the numerator rose geometrically, drastically increasing the users’ losses. Procter & Gamble admitted to losing $157m, and Gibson’s loss was about $20m. Both firms recovered part of their losses from the dealer, Bankers Trust Company. In both cases, the firms’ derivative investments were made in violation of their own investment policies. Barings, a venerable British investment bank, collapsed in February 1995 as a result of a loss of $1.47 billion on exchange-traded options on Japan’s Nikkei 225 share index. Investigation subsequently revealed that the bank’s management had exercised lax oversight of its trading position and had violated standard securities-industry procedures by allowing a staff member in Singapore, Nick Leeson, to both trade options and oversee the processing of his own trades, which enabled him to obscure his activities. Mr Leeson subsequently served a prison term in Singapore. Orange County, California, suffered a loss ultimately reckoned to be $1.69 billion after Robert Citron, the county’s treasurer and manager of its investment fund, borrowed through repurchase agreements in order to speculate on lower interest rates. In the end, about $8 billion of a fund totalling $20 billion was invested in interest-sensitive derivatives such as inverse floaters, which magnify the gains or losses from interest-rate changes. These derivatives were designed to stop paying interest if market interest rates rose beyond a certain point. This large position was unhedged, and when the Federal Reserve raised interest rates six times within a nine-month period in 1994 the value of the fund’s assets collapsed. Sumitomo, a Japanese trading company, announced total losses of ¥330 billion ($3 billion) from derivatives transactions undertaken by its former chief copper trader, Yasuo Hamanaka. Mr Hamanaka, known for being one of the leading traders in the copper futures and options markets, was accused of having used fraud and forgery to conceal losses from his employer, while continuing to trade in an effort to recoup the losses. Inadequate financial controls apparently allowed the problems to mount unnoticed for a decade. After Sumitomo’s huge losses were revealed in 1996, Mr Hamanaka was convicted and sentenced to a prison term.
Derivatives played a role in the financial crisis that crippled Thailand in the summer of 1997. Many investors misjudged the country’s situation because the Thai central bank reported holding large foreign currency reserves. The central bank did not report that most of these reserves were committed to forward contracts intended to support the currency, the baht. Once the baht’s market value fell, the bank suffered huge losses on its derivatives and its reserves were wiped out. A year later several American and European banks reported significant derivatives losses in Russia after a sharp fall in the country’s currency led to the failure of several banks and caused local counter parties to derivatives trades to default.
Accounting risks
Many problems such as these can be attributed to inadequate financial controls on the part of firms using derivatives. But the difficulty of applying strict and consistent accounting standards to derivatives positions makes it difficult for investors to assess a company’s condition. Furthermore, derivatives may provide a means for users to avoid restrictions on their activities. For example, a firm that has stated that it will not purchase foreign equities could purchase a derivative that mimics the behaviour of foreign equities, exposing the firm and its investors to the same risks as if they did own foreign equities. Inadequate disclosure often makes it difficult for investors to determine whether a given firm is in fact using derivatives to circumvent limits on its activity.
Derivatives disasters
Derivatives have made it possible for firms and government agencies to manage their risks to an extent unimaginable only a decade ago. But derivatives are far from riskless. Used carelessly, they can increase risks in ways that users often fail to understand. As individual derivatives can be quite complex and difficult to comprehend, they have been blamed for a series of highly publicised financial disasters. In some cases, the dealers have been accused of selling products that were not suited to the users’ needs. In other situations, the problem has been not with the instruments themselves, but with the financial controls of the organisation trading or using them.
Metallgesellschaft, a large German company with a big oil-trading operation, reported a $1.9 billion loss in 1993 on its positions in oil futures and swaps. The company was seeking to hedge contracts to supply petrol, heating oil and other products to customers. But its hedge, like most hedges, was not perfect, and declines in oil prices caused its derivative position to lose value more rapidly than its contracts to deliver oil in future gained value. The company’s directors may have compounded the loss by ordering that the hedge be unwound, or sold off, before it was scheduled to expire. Procter & Gamble, a large American consumer-products company, and Gibson Greetings, a manufacturer of greeting cards, announced huge losses from derivatives trading in April 1994. If the resulting number is positive, the dealer must make a payment to the user. As interest rates rose early in 1994, however, the numerator rose geometrically, drastically increasing the users’ losses. Procter & Gamble admitted to losing $157m, and Gibson’s loss was about $20m. Both firms recovered part of their losses from the dealer, Bankers Trust Company. In both cases, the firms’ derivative investments were made in violation of their own investment policies. Barings, a venerable British investment bank, collapsed in February 1995 as a result of a loss of $1.47 billion on exchange-traded options on Japan’s Nikkei 225 share index. Investigation subsequently revealed that the bank’s management had exercised lax oversight of its trading position and had violated standard securities-industry procedures by allowing a staff member in Singapore, Nick Leeson, to both trade options and oversee the processing of his own trades, which enabled him to obscure his activities. Mr Leeson subsequently served a prison term in Singapore. Orange County, California, suffered a loss ultimately reckoned to be $1.69 billion after Robert Citron, the county’s treasurer and manager of its investment fund, borrowed through repurchase agreements in order to speculate on lower interest rates. In the end, about $8 billion of a fund totalling $20 billion was invested in interest-sensitive derivatives such as inverse floaters, which magnify the gains or losses from interest-rate changes. These derivatives were designed to stop paying interest if market interest rates rose beyond a certain point. This large position was unhedged, and when the Federal Reserve raised interest rates six times within a nine-month period in 1994 the value of the fund’s assets collapsed. Sumitomo, a Japanese trading company, announced total losses of ¥330 billion ($3 billion) from derivatives transactions undertaken by its former chief copper trader, Yasuo Hamanaka. Mr Hamanaka, known for being one of the leading traders in the copper futures and options markets, was accused of having used fraud and forgery to conceal losses from his employer, while continuing to trade in an effort to recoup the losses. Inadequate financial controls apparently allowed the problems to mount unnoticed for a decade. After Sumitomo’s huge losses were revealed in 1996, Mr Hamanaka was convicted and sentenced to a prison term.
Derivatives played a role in the financial crisis that crippled Thailand in the summer of 1997. Many investors misjudged the country’s situation because the Thai central bank reported holding large foreign currency reserves. The central bank did not report that most of these reserves were committed to forward contracts intended to support the currency, the baht. Once the baht’s market value fell, the bank suffered huge losses on its derivatives and its reserves were wiped out. A year later several American and European banks reported significant derivatives losses in Russia after a sharp fall in the country’s currency led to the failure of several banks and caused local counter parties to derivatives trades to default.
Accounting risks
Many problems such as these can be attributed to inadequate financial controls on the part of firms using derivatives. But the difficulty of applying strict and consistent accounting standards to derivatives positions makes it difficult for investors to assess a company’s condition. Furthermore, derivatives may provide a means for users to avoid restrictions on their activities. For example, a firm that has stated that it will not purchase foreign equities could purchase a derivative that mimics the behaviour of foreign equities, exposing the firm and its investors to the same risks as if they did own foreign equities. Inadequate disclosure often makes it difficult for investors to determine whether a given firm is in fact using derivatives to circumvent limits on its activity.
Comments
Post a Comment